FOOL ON THE HILL
An Investment Opinion
The Microsoft (Nasdaq: MSFT) vs. U.S. Government antitrust battle appears to be entering its final stretch. Now is when the game gets interesting. This past Friday, the government put the finishing touches on a breakup proposal that Judge Thomas Penfield Jackson is expected to sign in the very near future, perhaps even this week. Even with the final outcome still obscure, I think now's the time -- in the midst of such great uncertainty -- to get down to brass tacks regarding Microsoft's investment potential.
Some quick background is in order. The breakup plan calls for Microsoft to be split into almost equal halves: the $9.3 billion revenue operating system business (mostly Windows) and the $13.7 billion revenue applications group (mostly Office and, notably, Internet Explorer). Of course, this is only the beginning of the end, probably the seventh inning of a game that will go to the wire. Microsoft is sure to appeal, and that process will likely drag on for another year. It's anyone's guess as to which side will ultimately prevail. The media has provided us with exhaustive coverage of the case's legal issues (I like Yahoo!'s Full Coverage), so I'll assume we're all familiar with that material.
Let's focus instead on the broader dimensions of Microsoft's economic model and valuation. At its current price tag of $63 3/8 per stub -- which translates into a fully diluted market cap of around $350 billion -- we can assess the risks and rewards imbedded within the shares.
First, let's examine the risks. A final ruling to split up the company would chiefly damage Microsoft's long-term strategy of making the operating system (OS) work seamlessly with applications ("apps"). A quick skimming of the proposed breakup (linked above) reveals that Microsoft apps would be no more privy to Windows' technical information than any other software vendor. Also, Microsoft apps would no longer be given "default" status within Windows. Whether this makes Microsoft compete all the harder to build great products that customers choose based on the products' merits is open to debate. It's clear, though, that the breakup agreement would in many ways level the software playing field.
A second risk is the unknown impact of how the breakup could inhibit the viability of Microsoft's upcoming version of Windows for the Web, currently dubbed "Next Generation Windows Services." The inability to tie in Internet Explorer could be a threat, although from my tech-limited perspective, it's too early to tell. The same uncertainty applies to Microsoft's new handheld OS software, Pocket PC, which has an imbedded version of Pocket Internet Explorer, Pocket Excel, Pocket Word, and Pocket Outlook. Though I haven't personally used Pocket PC, I thought it looked pretty interesting based on its tight compatibility with all the usual Microsoft desktop apps. But how will this product fare if the applications are stripped out? That's a big risk in my mind.
Another risk is the very viability of Windows on a stand-alone basis. In an Internet-centric computing world, does Windows really have a franchise anymore? My gut feeling is that the entrenched base of Windows users is bound to keep the product dominant. But the reality is that Windows, in its current form, is just a stepping stone for hopping onboard the Internet and a few commonly used applications. A Windows-only company would need to re-establish its essential nature to users. Perhaps I'm overplaying this risk, as the operating system is so key to successfully running all types of applications. Plus, Windows 2000 has received a warm welcome based on its substantially improved reliability and its power management features for notebook computers. All that said, a Windows company stripped of its close ties to Microsoft apps does face the risk of disenfranchisement.
OK, there you have three significant threats should a breakup become reality. But what about the opportunity, breakup or not? I see three reward factors worth considering.
Numero uno is the software advantage. Companies that create software standards enjoy tremendous economics, including high barriers to entry, high profit margins, increasing returns to scale, low capital requirements, and no inventory costs or associated risks. Microsoft, whether in one piece or two, would retain its specialization in creating the de facto software standards of the world. To be sure, the company (-ies) would have to tread lightly with its business practices, but there's nothing illegal about creating a monopoly as long as it's not abused. Software monopolies are a dream come true for investors.
The second reward factor (or risk limiter, depending on how you want to look at it) is Microsoft's renowned cash horde. Liquid cash of $21.2 billion plus long-term equity and debt investments of $21.3 billion equals a total war chest of $42.5 billion, or $7.67 per share. As an offensive weapon, this sum could be used to scoop up acquisitions that create entirely new business lines. Alternatively, cash could be used defensively to protect the company's most vital asset -- its people. Since stock options constitute a major portion of the compensation for Microsofties, there has been some concern that employees may bail now that their options have stagnated in value for over a year. But, Microsoft could at any point in time utilize $5 billion of its cash to "motivate" each of its 35,000 employees with a cash bonus of $47,600 for each of the next three years.
Third and finally, Microsoft's valuation is low enough to present an attractive reward, assuming that the company can in fact continue to grow its profits at a decent pace. On the Fool on the Hill discussion board, I've posted what I think is a conservative discounted cash flow valuation model.
It's a three-stage growth model for the company as a whole. The starting point is Microsoft's trailing $2.34 per share in free cash flow (which includes the tax benefit from stock options). Starting with that number, I assumed growth of 15% over the first 10 years, followed by 10% growth for the second 10 years, and ended with 6% nominal growth during the terminal stage. The cash flows were discounted at 16% for the first 20 years, followed by 11% thereafter. (Those discount rates represent the return you can expect based on the assumptions made.)
The result? Continuing operations are valued at $65.28 per share. Add the $7.67 per share in cash on the balance sheet, and we arrive at an intrinsic value of $72.95. As with all valuation models, this is just an educated guess, but I think it shows solid appreciation potential if Microsoft can continue to execute its business with reasonable success.
Based on Microsoft's profit-rich economic model, top-notch management, and unparalleled financial resources, I think Microsoft is here to stay. The company may be split up, but I still see plenty of reasons to believe that Microsoft, in whole or the sum of its parts, will be an important part of the corporate landscape in 20 years. And for that reason, I think Microsoft's investment potential looks very good. What do you think? Come talk about it on the Fool on the Hill discussion board, linked below.