Microsoft Corp.
Mr. Softy & Mr. Market

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By Luwingo
September 21, 2004

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There was a lot of sturm und drang a few (dozen) posts back about Microsoft's stock price wallowing where it is at the moment. Now I pointed out the obvious: Microsoft has walloped the market in the long run. To which can be said the equally obvious: so what? Microsoft has under performed the market for six long and weary years, and it's unlikely (so it is written) that this is going to change in the future.

This brought to mind one of my favorite quotes from a certain Mr. Buffet. I imagine a few of you investors (however few of you happen to be left around here) have heard of this guy- he made a fortune out of, among other things, ignoring the market at large. The quote concerns an insecure character named Mr. Market, which I've very loosely paraphrased below.

Now, Mr. Market has this peculiar habit of using all existing information to come up with a price for anything you care to name. He doesn't even care if you reject his current price either, because he'll come back the next day with a new one, and again on the next, and again and again, until you agree with his price and buy something from him.

Well, what does Mr. Market think of MSFT as a stock?

Let's take the most basic of all numbers, the P/E ratio. Currently the P/E for this stock is 36.70. Some of you may ask, isn't this a tad expensive? After all, the historical market average P/E has only been 14, and the highest P/E multiple that's justifiable at the moment is perhaps in the 20-25 range.

Now let's look at some other numbers. Again, I quote the obvious:
1-yr sales: $36.84 billion
Net profit margin: 22.2%
Debt-Equity: 0
PSR: 8.12
PBV: 4.00
Current Ratio: 4.7
ROE (5-yr Avg): 15.6

And that's enough numbers for the moment, I think. What does all that add up to?

It's accepted wisdom that companies that have shown consistently strong earnings growth trade at a P/E premium relative to their industries and to the market at large. MSFT is one of these companies.

This company isn't just a cash cow, it's a cash jackpot. It generates cash at a fantastic pace, and its balance sheets are positively pristine. Under ordinary circumstances, investors would go charging out looking for companies like this the way that the knights of olde did for the Holy Grail!

Microsoft, however, is anything but ordinary. The last six years have also been anything but ordinary (philosophical question: just what does it mean to be "ordinary"? Anyone who has a copy of "Zen for Dummies" for sale, please let me know).

The last six years have seen an antitrust lawsuit in the USA that nearly broke MSFT apart. Litigation threats continue to hang a cloud over the company: there was a point when Microsoft was reluctant to acquire a company for fear of attracting the wrath of the DOJ once more. In the EU, Microsoft faces further opposition from (IMO overzealous and overpaid) EU commissioners who insist that Microsoft's grip on the media player market constitutes monopoly. Microsoft's upcoming operating system has experienced considerable and sometimes inexplicable delays, and Microsoft has been surprisingly slow in producing a 64-bit version of its software for mass consumption.

Added to that is the fact that very few of Microsoft's divisions other than the two cash cows, Office and Windows, have turned a profit. Even these two placid, rotund bovines that give investors that life-giving manna of the greenback are under attack. The attack comes from those who would argue that the OSS model is a better way of doing business than the proprietary, "closed" model that Softy holds so dear. Viruses and bugs persistently pop up in Windows software, undermining customer confidence and badly battering Microsoft's already dented and scarred image.

Is it any wonder, then, that Mr. Market doesn't particularly like this stock?

These are all very valid concerns. It also doesn't answer the basic question: why is Microsoft's stock priced so "high" as to outperform, yet the stock [is] under performing?

This, I think, has to do with Mr. Market's fundamental flaw: Mr. Market does not care about the long-term future.

First and foremost, Microsoft is not run by morons. This is a company that knows it cannot count on its two main revenue streams forever. That is why Microsoft has been branching out into other areas. Take the Xbox. Many have proclaimed this as a failed venture. Yet countless stories abound of companies that have suffered years of losses, yet stood the course and turned profits in the end, because management has stubbornly believed that profit exists in the sector.

Profit potential exists in the game console industry. Profit potential exists in the broadband industry. Profit potential exists in the database and server software industries. Profit potential exists in the operating systems industry. Profit potential exists in the search engine industry. In short, in just about every industry Microsoft is currently engaged in, profit potential exists. I also have grave doubts that Microsoft is going to be stupid enough to enter an industry simply on whimsy; hopefully the MBAs held by the company's managers are worth something more than the paper the degrees are printed on.

Microsoft is not a well-liked company. Its practices can be uncompetitive, rude and downright obnoxious. Its record in innovation pales in comparison with Apple's, or Netscape's. Yet in both cases it broke the backs of these companies and became the industry leader. Microsoft is very, very good at taking a technology and using its integration abilities to drive the competition out. Simply put, Microsoft is a ferociously competitive company.

Mr. Market knows all this. He knows that Microsoft is bullish about the future. He knows that Microsoft is a powerful and dominant company. He knows that Microsoft has the ability to continue with steady growth. This is why he prices MSFT at a P/E ratio of 37.

Yet Mr. Market also allows himself to be scared off by the problems- not inconsiderable, mind you- that beset the company. These problems, though, are by and large fleeting ones. This is why, over the next 20 years, there is a high probability that Microsoft will continue to perform as well, and possibly better, than its industry peers and the broader market.

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