Rule Maker Portfolio Is Microsoft a Keeper?

The time has come to assess where Microsoft stands with the Rule Maker Portfolio. We're happy with how the company has performed, returning more than 42% since we first bought it, but the next five years could be the most important in its history. The company has entered new markets where its desktop dominance means much less, but we think these efforts are enough to increase the company's value by two times in five years.

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By Mike Trigg (TMF Tonto)
July 19, 2001

Microsoft (Nasdaq: MSFT), the largest and most profitable software company in the world, has performed well since the Rule Maker Portfolio first bought the stock back in February of 1998, returning more than 43%. In the initial buy report, we wrote, "we're looking forward to being happy Microsoft shareholders for many years to come" and it's fair to say things haven't changed much since then.

Now, the time has come to assess where we stand with Microsoft. We're happy with how the company has performed, but the next five years could be the most important in its history. Why? Because the company's strangleholds over the operating system and desktop applications markets won't provide it with the sustained growth necessary for shares to double in the next five years. Instead, it will have to succeed in new markets where desktop dominance means much less.

Microsoft's new vision embodies these efforts. Before it was fashionable, the company talked about a day when there would be a computer on every desk and in every home running its software. With that quickly becoming reality, it's now striving to provide access to its applications anywhere, anytime, and on any device. How will the company achieve such an ambitious plan? The answer: the .NET platform.

.NET provides access to software applications over the Internet, and offers developers tools and services to build applications. HailStorm, an early component of .NET, offers Web-based services including a calendar, address book, credit card information, and messaging capabilities. The catch is that you can access these services "anywhere, anytime, on any device" with a Web browser.

These applications and services will be made available through a subscription. Customers will be able to rent Office for a flat fee, for example, and gain additional services like Internet access and technical support. Other subscription-based services include MSN Internet access and the bCentral Internet site for small business. Starting at $25 a month, bCentral includes a website, email services, a shopping cart for e-commerce transactions, credit card services, and customer service capabilities.

We applaud the subscription model. Historically, software companies have earned the bulk of their revenue from upfront fees and upgrades -- resulting in an unpredictable stream of revenue -- but a subscription model gives greater insight into future results. Yes, Microsoft has been an exception because of the demand for its products, but the subscription model will make its revenue even more predictable.

We can see the benefits of subscription-based revenue in AOL Time Warner (NSYE: AOL), which has more than 130 million subscriptions to offerings like America Online, Time Warner Cable, HBO, and magazines. Last year, it had $14.7 billion (41% of its top line) in subscription revenue. This revenue also drives additional advertising and commerce sales, while giving the company great insight into its future results. Unlike many businesses that struggle when customers cut back spending, AOL has a great deal of its business already signed, sealed, and delivered.

Microsoft's subscription model could increase sales. Office, for instance, generates about $9 billion in annual revenues, but nearly every business already uses it and sees little reason to upgrade. The company could encounter the same trouble with Windows XP -- many businesses have yet to upgrade to Windows 2000, and the ones that have are so satisfied they don't see a compelling reason to upgrade.

While customers might not be inclined to upgrade with every release, the subscription model makes it a no-brainer to get the newest software by paying a fee. At the very least, the subscription model should cut costs because the company won't be required to spend millions on marketing to convince customers to upgrade.

To complete its vision for making applications available "anywhere, anytime, on any device" Microsoft has also entered the hardware market. Later this year, it will release the Xbox video-game console, attempting to grab hold of the $6.5 billion video game industry. Microsoft ultimately hopes consumers will use the Xbox to access the Internet and its slew of applications and services, in addition to using a PC. 

Microsoft also has plans to release a Web tablet PC that's more or less an electronic legal pad with a digital pen and special handwriting and speech recognition capabilities. While pen-based computing might sound foreign, UPS (NYSE: UPS) deliverymen have been using prehistoric versions for years. Gates thinks all PCs will eventually resemble tablet computers. Dell (Nasdaq: DELL), Compaq (NYSE: CPQ), Hewlett-Packard (NYSE: HWP), and Sony (NYSE: SNE) have all signed on as manufacturers. As early as this year, a smart device that encompasses mobile phone and personal digital assistant capabilities is also scheduled for release. 

With new products and services propelling the company into new markets, Microsoft also has a slew of new competitors, but specifically we think the growing competition from AOL Time Warner has the greatest long-term significance. True, these two companies have been competing for some time because of the MSN Network, but both companies are now going after the same piece of pie, a day when consumers will use their services in areas like entertainment, communication, business, and purchasing. Microsoft is betting its technology will make it the winner, while AOL is betting on its slew of subscribers and widespread consumer reach. Either way, the winner could ultimately be the biggest Rule Maker of all.

Microsoft appears to have identified the markets with enough growth that its shares could double over the next five years. The company closed yesterday at $70.57 per share with a market capitalization of $379.8 billion. That puts its value at 27 times trailing free cash flow. With its .NET strategy, subscription-based revenue model, and other areas like the Xbox, we think it can continue growing free cash flow 15% annually over the next five years, which would be enough for the stock to double in five years. Below are estimated price-to-free-cash-flow ratios and the growth rates required for the stock to double in five years.

Projected P/FCF             30      25       20
FCF Growth Rate for 2x/5y   13%     17%      22%

The ultimate success of the company's new efforts won't be known for some time, and we realize the road could be rocky early on. Microsoft rarely enters a new market and passes with flying colors on the first try. In fact, there were several failed versions of Windows until 1990 when version 3.0 reached mass success. The same will most likely be true for at least some of Microsoft's newest endeavors. However, that could create more favorable buying opportunities. At the moment, we like where the stock stands in our portfolio (second-largest holding) and look forward to remaining happy Microsoft shareholders for at least another five years.

[Ed. Note: For a perspective on Microsoft's Q4 earnings report, check out "Microsoft Faces Slumping Margins."]

Mike Trigg doesn't own shares of Microsoft, but loves pen-based computing.  His stock holdings can be viewed online, as can The Motley Fool's disclosure policy.


 

Rule Maker Portfolio


7/19/01 as of ~8:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AXPAMER EXPRESS0.501.33%38.00
CSCOCISCO SYSTEMS0.613.56%17.76
INTCINTEL CORP1.073.70%29.96
JNJJOHNSON & JOHNSON(0.20)(0.37%)54.20
KOCOCA-COLA CO0.481.04%46.70
MSFTMICROSOFT CORP2.002.83%72.57
NOKNOKIA CORP ADS2.5114.76%19.51
PFEPFIZER, INC0.120.29%41.13
SGPSCHERING-PLOUGH(0.33)(0.86%)38.12
TROWT.ROWE PRICE GRP INC(0.23)(0.64%)35.45
YHOOYAHOO INC0.402.35%17.43

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(1/6/1998)
Rule Maker2.81%0.30%(2.02%)(25.21%)(21.84%)
Comparable S&P 500n/an/an/an/a9.71%
S&P 5000.61%(0.05%)(0.76%)(7.97%)24.35%
S&P 500 (DA)0.60%(0.05%)(0.75%)(7.87%)26.13%
NASDAQ1.51%(1.83%)(5.27%)(17.16%)28.38%

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (1/6/1998)
Rule Maker(9.35%)
vs. S&P 5003.95%

Trade Date # Shares Ticker Cost/Share Price Total % Ret
2/3/9866PFE27.4341.1349.93%
2/3/9859MSFT49.3572.5747.04%
4/3/0110JNJ43.6554.2024.17%
2/13/98147INTC27.4429.969.20%
5/26/9879AXP36.4738.004.20%
2/3/9875TROW34.1235.453.90%
8/21/9844SGP47.9938.12(20.57%)
6/23/98182CSCO24.7217.76(27.90%)
2/27/9827KO69.1146.70(32.42%)
2/15/00132NOK40.2119.51(51.48%)
2/17/99106YHOO57.6017.43(69.74%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
2/3/9859MSFT$2,911.79$4,281.63$1,369.84
2/3/9866PFE$1,810.57$2,714.58$904.01
2/13/98147INTC$4,033.23$4,404.12$370.89
5/26/9879AXP$2,880.87$3,002.00$121.13
4/3/0110JNJ$436.50$542.00$105.50
2/3/9875TROW$2,559.06$2,658.75$99.69
8/21/9844SGP$2,111.70$1,677.28($434.42)
2/27/9827KO$1,865.89$1,260.90($604.99)
6/23/98182CSCO$4,498.75$3,232.32($1,263.40)
2/15/00132NOK$5,307.79$2,575.32($2,732.47)
2/17/99106YHOO$6,105.72$1,847.58($4,258.14)
 
Cash: 
Total: 
$548.21
$28,744.69
 


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.