My Decision: Amgen Over Microsoft[Fool on the Hill] June 12, 2000

An Investment Opinion

My Decision: Amgen Over Microsoft

By Warren Gump (TMF Gump)
June 12, 2000

Reading my columns from the past couple of weeks, I noticed what might come across as a contradiction. Last week, in an article about the problematic treatment of stock options on the cash flow statement, I noted that I own shares of Amgen (Nasdaq: AMGN). Just a week earlier, however, I had written an article stating that Microsoft's (Nasdaq: MSFT) valuation still wasn't low enough to be compelling.

That doesn't seem to make much sense when Amgen is trading around 60x current year's earnings and Microsoft is in the 40x ballpark. Making this multiple disparity more dramatic, the long-term growth estimates for Microsoft are higher than Amgen's, at 25% vs. 19%. So not only is Amgen more highly priced on a P/E basis, it is even more highly valued on a P/E-to-growth evaluation (3.2x vs. 1.6x).

Basically, the reason for this contradiction is that I foresee Amgen enjoying a lot more growth than Microsoft over the next couple of decades. In my opinion, analysts' current long-term growth estimates for Amgen are too low, skewed by the relatively slow sales growth of the past few years when the company hasn't launched major new products.

Earnings have grown at about a 19% annual pace over the past three years, and analysts are not inclined to raise that number until some of the drugs in the company's pipeline make it through the approval process. More trepidation against raising this number arises from the fact that Amgen's earnings growth will slow down this year as it invests in preparation for several possible drug launches.

I fully appreciate their conservatism toward projecting Amgen's growth for the next few years, being a cheerleader and practitioner of keeping uncertain products or scenarios out of financial statement projections. If I were creating an earnings model for Amgen, I would be hesitant to assume that more than one or two of the four leading candidates would be approved for marketing. I would then probably incorporate only modest success for the drugs included in the income statement.

Why be so conservative? The FDA drug approval process is intense, and most companies run into problems. Even with promising drugs, there's a real risk that something will pop up at the last minute and delay or scuttle approval. After drugs are approved, figuring out how sales will ramp up is challenging. Modeling conservatively raises the likelihood of positive surprises, while minimizing the risk of negative ones. (For an analyst, this means increasing the likelihood of keeping a job, while lowering the chance of losing it.)

The next step is figuring out what to do with the earnings model you've created (or received from an analyst). You could take it as gospel and make your investment decision. Buy if it looks good, hold off if it doesn't. More likely than not, though, the earnings number from any model you have will not be accurate. It will simply represent the current best guess of what the company could achieve.

The potential to dramatically underestimate or overestimate the growth of companies has been clearly demonstrated over the past 15 years. Companies like Microsoft, Cisco (Nasdaq: CSCO), and Charles Schwab (NYSE: SCH) have regularly far surpassed what most people thought they could do over the long haul. Very few people (if anyone) could have correctly projected the magnitude of their success at the end of 1984. On the other hand, estimates can be way, way, way too optimistic. You need look no farther than Iomega (NYSE: IOM), Boston Market, or Lotus Development to see those examples.

Finding companies with a high likelihood of exceeding stated growth expectations can be an extraordinarily profitable endeavor. This additional growth could come from myriad factors, including larger-than-expected market potential, breakthrough new product development, or unexpectedly high market penetration. I prefer not to definitively assume that any company will achieve this success, but I will be less valuation-sensitive to those organizations that I clearly believe have the potential to tap into unchartered territory.

Back to the crux of this article, Amgen vs. Microsoft. As one of the biotech sector's leaders, Amgen seems well-positioned to partake in the rewards likely to emerge from the developments in the biotech world. The unraveling of the Human Genome, compounded with new research and development techniques, will contribute to these changes. As this industry is just starting to develop, it is basically impossible to determine the ultimate size or structure of the business 10 years hence. Nonetheless, I believe the chances of Amgen developing into a company worth far more than its $65 billion market value are relatively high.

Microsoft will also enjoy solid growth in the years ahead, whether as a unified company or as two separate entities. Moves into higher-end software markets, a more prominent role in the global information infrastructure, and ancillary businesses are likely to provide these opportunities. Nonetheless, with its $22 billion-plus revenue base, I fear that its revenue and earnings growth will have to slow down over the next few years -- particularly as its core business continues to mature.

To achieve 20% revenue growth next year, Microsoft will have to increase sales by more than $4.4 billion -- that's more than Amgen's total sales last year and a whole lot of MSN subscriptions. While not impossible, it's hard for me to imagine that Microsoft will grow its value by a greater percentage than Amgen over the next few years.

I won't know if my analysis is correct for another five or ten years. In the meantime, the only thing I can do is continue learning and putting my money into the most compelling investment opportunities that fit my expectations and investing style.

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Related Links:

  • Fool on the Hill, 6/1/00: Has Microsoft Hit Valueland
  • Rule Maker Portfolio, 4/24/00: Why I Still Like Microsoft
  • Motley Fool Research: Amgen