Party’s Over Microsoft
There’s a little game that Microsoft has been playing with Wall Street over the last few years. It is obvious to everyone Microsoft has been one of THE top blue-chip technology stocks for over a decade. Seemingly every quarter the company would significantly exceed expectations. And inevitably in the analyst conference call, Microsoft would warn that this sort of growth was not sustainable. The analysts would then project moderately conservative estimates and then Microsoft would come in next quarter and blow them away. This would happen time and time again. But now the party is over.
Let’s take a look at recent numbers. Microsoft is now worth over $350 billion ranking as one of the most valuable companies in the world. That’s enough money to give more than $1200 to every person in the United States.
In its most recent quarter, the company had revenue of $5.8 billion with a net income of $2.4 billion. The company has 90%+ market-shares in the two key markets of desktop operating systems and office applications. If you think about it, those are some pretty insane numbers. Clear dominance.
But it is this dominance itself that may be its downfall. What do you do when you conquer the world and beat all your competitors? When companies win all of the market-share game, they can’t grow faster than the market itself. Therein lies the problem for Microsoft.
Microsoft receives 41% of its revenue from operating systems, 45% of its revenue from desktop applications and only 14% of its revenue from the consumer division. In terms of profit margins, OS and applications divisions are by far the cash cows. With this revenue break-down, Microsoft’s fortunes are directly tied to PC sales and software upgrades.
The foundation for future stock appreciation is the future growth potential of a company. To value companies many analysts compare a company’s P/E ratio with its future growth rate and expect parity. Currently the Microsoft has a forward P/E of about 40, which puts the future expected growth rate at around 40% a year.
However unfortunately for Microsoft, overall PC sales are expected to grow around 15% and the ‘cash cow’ corporate PC segment is only growing in the upper single digit percentages. Even if corporate sales pick up in the fall, they will be nowhere near 30-40% growth number needed to justify the current valuation.
If you dig deeper into the recent quarterly report, the picture becomes even murkier. Microsoft’s revenue was only 1% higher than a year ago. Operating income from investments was a striking $1.13 billion in the quarter. If you take the investment gain income out of the equation, you’re left with an operating income of $2.5 billion, down from $2.9 billion a year ago. In the past year, Microsoft hardly grew at all. And to top it off the company itself forecasts only 15% revenue growth this coming year.
So the PC market isn’t going to be the growth engine it has in the past. Perhaps Windows 2000 sales will pick up later this year as the summer doldrums die down? Also Microsoft has this new Window.NET initiative. This revamped internet strategy along with consumer devices like the X-box should make up for the growth, right?
Let’s get a dose of reality. First of all, more than 86% of Microsoft revenue is tied to PC sales, which are probably going to grow in the mid-teens at best. Furthermore Windows 2000 has already shown not be the large upgrade cycle that Windows 95 and Office 2000 were in previous years.
Microsoft has been losing money on its consumer internet division and is set to go head-to-head against AOL and Yahoo. With competition like this, the unprofitable performance in recent years, along with the uncertainty in future revenue streams, it’s a tenuous proposition that it will add much to a top-line for a company that sells close to $6 billion a quarter.
Microsoft is also set to invest $500 million in marketing the X-box game console this coming year to go up against the Sony Playstation 2 juggernaut. However it will be years before the benefits will be returned, and the moreover success is certainly not assured.
The bottom line is Microsoft stock is priced with an optimistic growth rate today. The prospects for significant blockbuster growth in revenue and earnings for the coming year are slim-to-none. Consequently unless things become clearer, the stock will probably be dead money in the next 12 months.
On final note, remember if Microsoft was so confident that the stock would appreciate to new highs, why was the company compelled to issue a ton of new stock option grants at low strike price to retain employees? Think about it.
Tae J.Kim is Founder and Editor-in-Chief of TigerInvestor.com. At time of this article’s publication, he had no positions in any stocks mentioned. |
