Dueling Fools

Dueling Fools

Microsoft 2000
Bear Argument

By Richard McCaffery (TMF Gibson)
November 17, 1999

OK, Microsoft is a great company, but there's a bear argument to be made about valuing it as though it's 1993. The business world has changed since Bill Gates described an Internet browser as an insignificant piece of software, and it's hard to see how Microsoft will defend its amazing margins.

I'm not going to dwell on the antitrust suit. Pondering break-up values, wondering whether Microsoft will have to publish its software code, is way too speculative. It will probably take years to play out. The real question is how Microsoft is going to repeat its PC success in an Internet economy.

Let's start with valuation. Microsoft is trading at nearly 60 times trailing earnings, more than twice the level of the average stock in the S&P 500. It's earned a high valuation, but I wouldn't price any company by looking in the rearview mirror.

Shareholders are paying 60x earnings for a company expected to grow profits 17% this year. In other words, they're paying $60 to buy $1 worth of earnings. Buying a Porsche is one thing, paying Lamborghini prices is another -- especially when the road ahead looks tough for a sports car.

Since P/Es are pretty wimpy as far as valuation tools, I took a shot at calculating Microsoft's intrinsic value Warren Buffett-style: by calculating future cash flows using owner earnings, and assuming a 15% growth rate over the next 10 years before the company settles into a long-term growth rate of 5%. The discount rate I used is the rate of the U.S. Government's long-term bond.

Lots of people will disagree with the numbers I used. That's fine. It's just to give you my idea of what the company's worth today if it can accomplish the amazing feat of growing earnings 15% annually over the next 10 years. I'm being conservative here since Microsoft grew earnings 40% annually over the last five years and is expected to grow at a 26% clip in the long term.

My model values Microsoft at $326 billion, more than $100 billion below its market cap, give or take a few billion. That works out to around $63 a share, versus the upper $80s it's currently trading at. For me, it doesn't exactly provide a margin of safety.

Let's move on to competition. Microsoft has three basic businesses: Windows operating system software; applications such as its suite of Office products; and consumer, commerce, and other, which includes its online services businesses.

The biggest money generator in Microsoft's purse is the suite of Office products, which includes applications such as Excel and PowerPoint. This division reported $8.8 billion in sales last year, slightly more than the $8.5 billion generated by Windows platform products. The Consumer, Commerce division was a distant third with $2.4 billion.

Early next year, Microsoft competitor Sun Microsystems (Nasdaq: SUNW) is releasing StarPortal, a suite of products that will compete directly with Microsoft Office. StarPortal applications include a word processor, spreadsheet, basic business drawing software, presentation software, and a few other handy office products.

Much of this will be compatible with Microsoft Office applications, meaning users won't have to throw away existing files. The real bonus, however, is that StarPortal will be delivered over the Web, unlike Microsoft Office (which comes on a CD that has to be loaded onto your PC). In addition, StarPortal will be free -- that's right, the same price Microsoft charges for its browser. (Microsoft has announced plans to deliver its Office suite over the Web at some point as well.)

I'm not suggesting Sun or anyone else will dominate Microsoft in this space. Far from it. Microsoft is too big and too well established, but I think the economics will change drastically and Microsoft's margins and earnings power will decrease.

Sun's StarPortal offering and other free, Web-based software products such as the Linux operating system will at some point force Microsoft to lower prices -- something it's never had to do before. This will take a bite out of its profitability and the risk of this is enough to make me think twice before paying $60 for $1 of profit.

Is Microsoft well positioned to profit from the Internet? You bet. I'm not discounting it as a major player, especially with its MSN suite of websites and strategic investments in bandwidth companies. But again, the economics will be different. Microsoft will have to compete on a level playing field with companies like Sun and AOL.

One final item that's unrelated to value or strategy: Why does Microsoft need more than $19 billion in liquid cash and short-term investments on its balance sheet? Buffet says the most important decision management makes is determining how to allocate earnings. In my book, $19 billion in cash is too much dough for one company to hoard. A portion of that money should be returned to shareholders.

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