ML reinstates cov, immed Acc, LT BUY, target $86
12 Month Price Objective: $86
Estimates (Jun) 1998A 1999E 2000E
EPS: $0.89 $1.36 $1.49
P/E: 86.5x 56.6x 51.7x
EPS Change (YoY): 53% 10%
Consensus EPS: $1.34 NA
(First Call: 26-Apr-1999)
Q4 EPS (Jun): $0.25 $0.35
Cash Flow/Share: $1.00 $1.50 $1.65
Price/Cash Flow: 77.0x 51.3x 46.7x
Dividend Rate: Nil Nil Nil
Dividend Yield: Nil Nil Nil
Opinion & Financial Data
Investment Opinion: A-2-1-9
Mkt. Value / Shares Outstanding (mn): $424,424 / 5,512
Book Value/Share (Mar-1999): $4.67
Price/Book Ratio: 16.5x
ROE 1999E Average: 27.8%
LT Liability % of Capital: 0.0%
Est. 5 Year EPS Growth: 20.0%
Stock Data
52-Week Range: $95 5/8-$41 7/16
Symbol / Exchange: MSFT / OTC
Options: Pacific
Institutional Ownership-Spectrum: 34.6%
Brokers Covering (First Call): 25
ML Industry Weightings & Ratings**
Strategy; Weighting Rel. to Mkt.:
Income: Underweight (07-Mar-1995)
Growth: Overweight (07-Mar-1995)
Income & Growth: Overweight (07-Mar-1995)
Investment Highlights:
· We are reinstating our investment opinion on
MSFT with intermediate-term Accumulate,
long-term Buy and $86 12-month price
objective.
· Given quality of earnings stream, tremendous
R&D machine and breadth of solutions reach,
MSFT should be a core holding for long-term
technology portfolios.
· We believe MSFT can sustain current 57-58
P/E on FY 99 EPS, rolled forward onto FY 00
EPS est. yields $86 price objective (+12%).
Fundamental Highlights:
· Microsoft continues to build its “Digital
Nervous System,” expanding its reach beyond
the desktop into high-end corporate
environments and consumer devices.
· Wealth of new product cycles over next
12 months (Windows 2000, Office 2000, and
BizTalk Server) sustain growth model.
· Trading volatility could increase as antitrust
outcome remains uncertain, Y2K drag and
product cycle pause possible 1H FY00.
· Microsoft drives the Digital Economy at all
levels and will become increasingly involved in
enterprise computing, e-commerce and
broadband access with aggressive investments.
A New View of the Digital Economy
Summary
We are reinstating research coverage of Microsoft
Corporation with an intermediate term Accumulate, long-term
Buy opinion with an $86 price objective. We believe
that Microsoft should be a core technology holding for
long-term investors, given the company's outstanding
management execution, high-quality earnings stream,
unparalleled breadth of technology platform and increasing
influence beyond the corporate desktop.
Microsoft, like any technology juggernaut, combines a
daunting market presence with an ability to adjust quickly
to changing market conditions. We find Microsoft's
agility in the software market impressive, especially with a
$424 billion market capitalization. In particular, we see a
continued stream of new product cycles and new market
entries over the next 12-18 months opening new growth
avenues for the company. We will explore later the
implications of Microsoft's Digital Nervous System
platform, and the broader market impact Microsoft can
bring to bear through this vision.
We do not expect MSFT's path to new highs to describe a
straight line; rather the volatility of this relatively stable
stock could increase as the interest in competing Linux
operating systems and the still-unresolved DOJ trial weigh
in over the next 6-12 months. We believe these issues may
stall MSFT's near-term upside, but present opportunities
for investors looking to build a core technology portfolio
for the long-term. We expect MSFT to hold its current
premium 57-58 P/E multiple on FY 99 EPS of $1.36.
Rolling that forward onto FY 00 EPS of $1.49 implies a
12-month price target of $86, or 12% upside from current
levels, warranting an Accumulate opinion.
Risk Factors
1. Y2K Drag and near-term pause in product cycle—
While Microsoft will be rolling out a raft of new
products (Windows 2000, Office 2000, BizTalk, etc.)
in the next 12 months, there will be a transition period
which could soften revenue strength in the near-term.
2. DOJ antitrust resolution—We are now moving into
the rebuttal phase of the Microsoft trial, with many
familiar faces returning to the stand. Microsoft will be
looking to reestablish momentum in the trial, while
the government seeks to drive home some of
Microsoft's earlier missteps.
3. Linux and the Internet camp—The Internet's
openness has given a competing operating system like
Linux an opportunity to establish itself on corporate
servers as an alternative to WindowsNT (and an
alternative to Unix). While still a relative rounding
error in terms of Windows NT unit installs, Linux's
growth rate on corporate platforms is gaining
investors' attention.
4. Premium valuation adds to volatility.
3Q 99 Results
Microsoft reported 3Q 99 (March) results which exceeded
consensus estimates. Revenues grew 15% to $4.33 billion,
excluding $400 million in unearned revenues from Office
2000 upgrade coupons, which should flow back over the
next two to three quarters as customers upgrade.
Operating margins were an industry-leading 51.5%, up 40
basis points from prior year. Net income was $1.92
billion, or $0.35 per share, a 40% increase over 3Q 98.
Platform revenues remained strong, growing 26% in the
quarter to $2.05 billion, Applications/Tools revenues grew
4% to $1.9 billion, with OEM revenues ahead 29% to
$1.6 billion. By geography, Europe/Mid-east/Africa grew
4% to $932 million (“solid” growth in France and
Germany) while Americas/South Pacific increased 6% to
$1.33 billion, with “moderate” growth in the US and a flat
performance in Latin America. Asia revenues were up
22% to $475 million as Japan firmed.
On the 3Q 99 balance sheet, cash/investments totaled
$21.8 billion, with cash flow from operations of
$2.7 billion. The company has no long term debt.
Unearned revenues (which are recognized as certain
technology upgrade and service obligations are fulfilled)
totaled $4.2 billion.
Deep Pockets and The Digital
Nervous System
Microsoft customers have captured massive amounts of
data in their Microsoft-based enterprise application
servers, messaging systems, database, e-commerce site
servers, etc. Unifying this information, making it palatable
and more usable to a broad user base, and linking the
extra-corporate world to corporate intranets is the goal of
Microsoft's Digital Nervous System (DNS). At the core of
this positioning is linking emerging Internet technologies,
decision support applications, and “bullet-proof” messaging
to bind all Microsoft-centric technologies together.
Critical to bringing the DNS beyond the corporate walls
and into customers and partners hands (and extending the
reach into the home consumer market) will be the role
Microsoft plays in the proliferation of software to power
new net-based devices and to deliver content via expanded
broadband media. Microsoft has opened its war chest of
nearly $22 billion in cash and investments to take equity
stakes in both AT&T and Nextel in the past few weeks,
signaling its broader intentions in broadband and wireless
services.
The 2K Product Cycles: Windows
and Office
Windows 2000 (Win2K), currently in its third beta release,
will represent a watershed product release for Microsoft
later this calendar year, as the company attempts to break
into high-end corporate computing environments. Win2K
will be the next-generation operating system for the
corporate environment, unifying desktops and servers on a
common “code base” for the first time. The benefits here
will be a standard administration model enterprise-wide,
enhancements to directory services, a common user
interface and application programming interface
(API) compatibility, improving integration efforts and
system stability.
We expect Microsoft will offer three Win2K server
platforms: Server for dual CPU systems, Advanced Server
for up to four CPUs and Datacenter for more than 4 CPUs.
Many Windows NT application developers are anxiously
awaiting the release of Win2K as a more stable alternative
to NT 4.0, which has been plagued with stability issues
limiting its usage to smaller applications servers and file
serving responsibilities. We understand that the scalability
and memory usage of beta versions of Win2K are
significantly improved, but it will take time for corporate
customers to let the new operating system prove itself as
worthy of the “glass house” and some application
compatibility issues remain. We expect final release of
Win2K in October.
We do not expect Office 2000, the company's next
generation desktop applications suite, to be a major
revenue accelerator in this calendar year, as the installed
revenue base is a massive $5.8 billion year-to-date.
However, with Office 2K now shipping, Microsoft will be
able to recognize approximately $200 million in 4Q 99
upgrade “coupons” that will be redeemed by existing
Office customers.
E-commerce and BizTalk
While Microsoft has turned its Microsoft Network (MSN)
franchise into a significant portal on the Web, we think the
recent moves in business-to-business e-commerce with
BizTalk Server signify Microsoft's acknowledgement of
the significantly greater revenue opportunity of business-to-
business e-commerce when compared to the consumer
market. In particular, it appears to us that Microsoft will
have to partner more aggressively and support more e-commerce
standards such as Extensible Markup Language
(XML) to gain a presence in this segment; Microsoft will
not carry the day alone here.
Case in point, Microsoft's recently-announced BizTalk
Server, an XML server that sits on top of its application
server to help businesses to share transactions with supply
chain partners over the internet, replacing expensive EDI
solutions. Microsoft will license webMethods B2B
software to facilitate the XML brokering. We expect
BizTalk to ship beta later this summer, but no date for
general availability has been set.
DOJ Antitrust Update
Microsoft's epic antitrust trial against the US Government
resumes in June, with rebuttal witnesses being called.
Microsoft made several missteps during the most recent
phase of the trial. Most familiar with the case believe
some kind of ruling against the company is likely, and that
begs the question as to what possible remedies the
government might have? The government is likely seeking
a breakup of the company or opening up Microsoft source
code to forced licensing. “Conduct” remedies, a more
temperate move, would require intense, long-term
government monitoring of the company's business
practices, not much more desirable than a break up into
“Baby Bills”.
Should the trial move against the company, we expect
Microsoft to make a case that such dramatic remedies
would raise user costs, as applications would have to be
developed for differing code bases, hurting the consumer.
At any rate, we believe that an initial ruling, followed
by an appeal phase will prevent any potential penalties
until 2001.
The Linux Groundswell
We assume most investors are aware of the recent
explosive fervor for the “open source” movement, and the
commercial inroads made by Linux, the “poster child” of
open source operating systems. Linux unit installs grew
by over 200% last year according to IDC, compared with
28% Win NT growth in 1998 on a much, much larger base.
Linux proponents have argued against Microsoft's
dominance of desktop computing with its closed-source
Windows offering and Linux has been used as an anti-Microsoft
rallying point. While we believe Linux will
continue to grow in popularity as an enterprise server,
Microsoft's powerful application developer channel will
continue to drive NT sales of mid-market, departmental
and (increasingly) higher-end corporate applications
deployments.
Earnings Outlook
Our initial MSFT earnings model anticipates 4Q 99 (June)
quarterly revenue growth of 21% to $4.85 billion and EPS
growth ahead 41% to $0.35. For FY 2000 (June), we
project annual revenues of $21.2 billion (+17%) and EPS
of $1.49 (+10%). In typical Microsoft spirit, we believe
that our estimates over the next four quarters to be
conservative and reflective of the usual “cautiously
optimistic” indications about Microsoft's core business.
As we mentioned under risk factors, the lack of material
near-term product cycles and a Y2K demand slump could
temper significant earnings breakouts like the 2Q 99
posted by the company. |
