Rule Maker To Buy
January 29, 1998
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Rule Maker Portfolio Buy Report (released 1/29/98)
Announcement: Purchasing $1,875 in Microsoft stock.
An Overview of the Company
If you are reading this report on a personal computer, it's almost certain that you have some knowledge of Microsoft. According to Hoovers Online, Microsoft is the #1 independent software company in the world (IBM is #1 overall). Softy, as the company is affectionately known, licenses the operating systems that are used by about 90% of all personal computers. Most of you are using a Microsoft product as you read this report.
However, Microsofts products cover far more than just operating systems:
The Microsoft Office suite of business productivity programs is the worlds most popular.
The recently released Internet Explorer Version 4.0 has been rated the best web browser currently available by several leading computer magazines.
The combination of Windows NT and Microsoft BackOffice is an increasing popular choice for companies establishing Intranets.
The Basic Financials (End of Fiscal Years)
1997 1993 5-Yr Annual Growth Sales (Billions) $11.4 $3.8 24.6% Gross Profit Margin 90.4% 83.2% 1.7% Net Profit (Billions) $3.5 $1.0 28.5% Net Profit Margin 30.4% 25.4% 3.7% EPS* $2.89 $0.85 27.7%
Price (as of 1/26/98)..........$145 1/2 Trailing earnings..............$2.88 Calendar 1998 Est. Earnings....$3.24 Calendar 1999 Est. Earnings....$3.96 P/E on Trailing Earnings..........48 P/E on This Year's Estimate.....42.7 P/E on Next Year's Estimate.....34.9
Basic Rule Maker Criteria
Market Cap.....................$174.6 billion Cash & Equivalents...............$9.6 billion Gross Profit Margin..............90.4% Avg. Net Profit Margin...........28.7% Cash as % of Debt.................n/a (no debt) Flow Ratio.......................0.31
Additional Financial Data
Consensus 5-Year Growth Rate....24.4% Debt as % of equity..............n/a Debt as % of revenues............n/a Dividend Yield...................n/a Return on Equity..................31% Return on Invested Capital........61%
Concentrated Look at the Business
The Company divides its software into two main products groups that produce roughly equal amounts of revenue. The first is the Platform Products Group, which includes licenses of PC operating systems (Windows 3.1, Windows 95, and Windows NT), business systems with client/server architecture (the BackOffice family), and software development tools (e.g., Visual Basic). About 90% of all personal computers use a Microsoft operating system.
The second is the Applications and Content Product Group, whose revenue comes from licenses of desktop and consumer productivity applications, interactive media programs, and input devices. The major consumer application is the Microsoft Office suite, which includes Word, Excel, Access, PowerPoint, and personal information manager Outlook. Interactive media programs include CD-ROM reference titles (Bookshelf, ENCARTA), programs for home and small office productivity (Money, Expedia, Greetings Workshop), and online Internet services (MSN, travel information and reservations, local event information, and car-buying). The two major input devices marketed are mice and keyboards.
Sales and Expenses
Microsoft's products are distributed through OEM (Original Equipment Manufacturer) licenses, corporation & organizational licenses, and retail packaged products. Geographically, there are three major marketing organizations: a) the United States and Canada, 2) Europe, and 3) Other International. About 1/3 of the companys revenue is collected in foreign currencies.
Microsoft's cost of revenues has astonishingly decreased to 9.6% for 1997 from 14.8% for 1995. This decrease was brought about by shifts in the mix to CD-ROMs (which carry lower cost of goods than disks), licenses to OEMs and corporations, and higher-margin products (Windows NT Server, BackOffice) as well as distribution through the Internet.
William H. Gates III - Chairman/CEO
Steve Balmer - EVP, Sales and Support
Bob Herbold - EVP/COO
Greg Maffei - CFO
Nathan Myhrvold - Chief Technology Officer
Pete Higgins - EVP/Group VP, Interactive Media
Paul Maritz - Group VP, Platforms and Applications
Jeff Raikes - Sr. VP, Sales & Marketing
Jim Allchin - Sr. VP, Personal & Business Systems Group
Brad Silverberg - Sr. VP, Applications and Internet Client Group
Microsoft has been an ardent supporter of the high-tech compensation practice of dealing out relatively low salaries combined with a generous stock-purchase plan and stock options. The stock-purchase plan allows employees to purchase stock at 85% of market value every six months, with a limit of 10% of their gross compensation. The stock option program is available to all employees. As a result, literally thousands of millionaires work for the company. As of June 30, 1997, options for 239 million shares were outstanding, 113 million of which were vested.
Historical Stock Performance
Over the past five years, fully diluted earnings per share have grown sequentially by 32%, 19%, 23%, 48%, and most recently 53%. The annual compound rate of earnings growth was 34% during that period. The stock price has done substantially better, growing sequentially by 26%, 17%, 75%, 33%, and most recently by 125% between June 30, 1996 and June 30, 1997. This equates to an annual rate of stock price increase of 50% for the five-year period.
As noted above, both gross margins and net margins are currently above their average value over the past five years. The same is true for return on equity, sales, and capital. In short, Microsoft's performance has been nothing short of phenomenal over the past five years and, indeed, throughout its 12-year life as a public company.
Concerns Going Forward
Achilles had his heel, David had Bathsheba, and Microsoft has its business practices.
The company has frequently been accused of using its dominant position with operating systems to strong-arm its competitors. For example, Microsoft executed several agreements with computer manufacturers that required the manufacturers to license Windows on every computer they sold, even if the computer used another operating system. In 1995, the company was sued for this practice by the Department of Justice (DOJ), and it signed a consent decree stipulating that it would no longer pursue that monopolistic course. More recently, the company has again been sued by the DOJ for the way it was bundling Internet Explorer into its Windows operating system.
Regardless of the outcome of this particular lawsuit, it's very likely that Microsoft will continue to face anti-trust pressures from the government in the years ahead. There is a real chance that, during what we expect to be a long holding period for us, the company will be broken up into smaller pieces and forced to compete as separate units. Certainly, some of the pieces will not do as well without the full suite of subsidiaries, without the internal keiretsu. In addition, current competitors are often potential future customers and the bad will engendered by some of Microsoft's business practices has resulted in a least a few lost sales.
Second, even though Microsoft has dominated the desktop, it is constantly looking at other areas for growth. The DOJ has been a hindrance here as well. For example, a couple of years back Microsoft was prevented from purchasing Intuit and its market-leading personal finance package. Microsoft has, however, been cleared to make investments in the cable industry and in 1997 acquired WebTV for $400 million.
Finally, from a strategic standpoint, many computer professionals feel that the rise of the Internet in general, and Java in particular, may make it much easier to operate a personal computer without any form of Windows. If this happens, the companys prospects could be adversely affected.
Prospects Going Forward
Currently, there is no real challenge to Windows stranglehold on the PC. The use of computers continues to expand both domestically and internationally, and each time a new computer is sold, Microsoft receives a royalty. Moreover, high-margin Windows NT and BackOffice applications are coming on like gangbusters. According to a recent report issued by IntelliQuest, fully 56% of organizations building Web applications on their corporate Intranets plan to deploy Windows NT Server 4.0. This figure compares with only 8% of organizations that plan to deploy Web applications on the competing UNIX platform.
Moreover, the dominant position of Microsoft Office on business desktops faces no major threat. Products are available that can compete with the individual components, but most organizations prefer to buy an integrated suite containing all the programs that they use. There is no such suite on the market that compares with Office.
Finally, the management team that has delivered this historic performance is still on board. The vast majority of the key managers are in their late 30s and early 40s, and no major management changes are expected any time soon. Bill Gates, the CEO, owns 24% of the company.
Why Microsoft is a Rule Maker Stock
Microsoft passes all the Rule Maker financial tests with flying colors. Gross margins are over 90% (the Rule Maker standard is 50%). Net margins are over 28% vs. a goal of 7%. The flow ratio, which should be less than 1.5, stands at a stunning 0.31 -- indicating incredibly tight management of the dollars that flow through the business. There is no long-term debt on the balance sheet. And Microsoft's $174 billion market cap is second highest of all companies traded on U.S. exchanges.
Qualitatively, we look for Rule Maker to have a global brand name, preferably in a repeat-purchase business. We also look for strong historical performance and compelling future prospects. In Microsoft's case, several of its major products, including Windows, Excel, Word, PowerPoint, and Access, are completely identified by their brand name. The historical performance has been outstanding. Future prospects are bright.
Arguably, Microsoft is not in a repeat-purchase business. The software is normally only purchased every two to three years, and some people are still quite happy with Microsoft software that they purchased five or more years ago. However, the product is used very frequently, often daily. This provides some, though not all, of the advantages of a repeat purchase business. Additionally, the Internet will present opportunities to distribute products directly through to consumers every day, week, month, and year.
Any stock that meets all of these tests is clearly a Rule Maker. We're looking forward to being happy Microsoft shareholders for many years to come.