Morningstar Analysis by Pat Dorsey 08/03/1999
Despite some near-term worries, Microsoft remains a solid long-term investment.
The financial performance of Bill Gates' behemoth is nothing short of awesome. Over the past three years, Microsoft posted annualized profit growth of almost 50%, and increased its net profit margins (income as a percentage of sales) from an impressive 25% to a mind-boggling 40%. The company also throws off more cash than most small countries. Microsoft's free cash flow (cash available after capital spending) was more than $6 billion in 1998, and the firm has more than $17 billion in cash on its balance sheet. If there's anything that keeps Gates up at night, it's certainly not the financial well-being of Microsoft.
There are, however, a few things that could trip up even the mighty Microsoft. The most immediate is the speed at which customers adopt the company's new Office 2000 suite of desktop applications and its much-delayed Windows 2000 operating system. Since more than three quarters of Microsoft's revenue comes from licensing operating systems and desktop programs, the rate at which customers convert to Office 2000 and Windows 2000 will largely determine the company's growth rate over the next year or so. Investors used to sales growth in the 30% range may have to get used to growth of just 20% or so--which, given the stock's high P/E, could hurt share prices.
The company itself warned of slowing growth in its recent fiscal fourth-quarter earnings release, citing slowing PC demand and uncertainty surrounding the Y2K issue. And even though Microsoft has a long history of reining in analysts' growth expectations, the company's words may very well ring true this time around.
In a way, Microsoft has become a victim of its own success. With almost 90% of the market for desktop operating systems and office applications, the company is being forced to look to other areas of the computing market for new growth opportunities. And in both of the markets that it's targeting--high-end "enterprise" systems and handheld information appliances--Microsoft faces some very tough competition.
On the high end, Microsoft will have to overcome the perception that its operating systems aren't as stable as the rock-solid ones offered by Sun Microsystems SUNW, IBM IBM and Hewlett-Packard HWP not to mention upstart competitors like the fast-growing Linux operating system. In handhelds, Microsoft's Windows CE has just 25% of the market, while 3Com's COMS Palm unit has become all the rage. Potentially even more threatening is the alliance of Motorola MOT, Nokia NOK, Ericsson ERICY, and Matsushita MC that is developing a handheld-specific operating system with the British firm Psion.
To fend off such challenges, Microsoft is willing to use its massive war chest liberally when the right opportunity presents itself. For example, Microsoft's recent $5 billion investment in AT&T T will enable it to provide the software for millions of cable TV set-top boxes. A $600 million investment in cellular-phone company Nextel NXTL will give Microsoft an important foothold in the handheld market. And with Gates at the helm, you can be sure that the company will do whatever it takes to succeed in whatever markets it tries to enter.
The bottom line is that although Microsoft will be undergoing some important transitions over the next year or so, which could dent its growth rates, the company is still a powerhouse. The stock is pricey, but growth-oriented investors should consider making it a core part of their portfolio--especially if the shares weaken over the next few months as Wall Street frets over Windows 2000 and Office 2000.
¸ Copyright 1999 Morningstar, Inc.
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