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Technology Stocks : How high will Microsoft fly? -- Ignore unavailable to you. Want to Upgrade?

To: Brian Sullivan who wrote (58773)	6/12/2001 6:52:22 PM
From: matt dillabough	Read Replies (1) \| Respond to of 74651

Microsoft Corporation (MSFT) 1H (Buy, High Risk) Mkt Cap: $401,203.6 mil. June 12, 2001 COMPANY DESCRIPTION Microsoft is the largest software vendor worldwide. The SOFTWARE company develops, manufactures, licenses, and supports a wide Richard range of software products for a variety of computing devices. Gardner In fact, there are relatively few segments of the $157B worldwide software market in which Microsoft is not a significant player today. It's products include a full suite of client and server operating systems, middleware, office productivity software, relational database management software, collaborative e-mail and scheduling software, consumer software and developer tools. Microsoft also offers consumer services such as the Microsoft Network (MSN), has significant investments in other Web properties, and is now venturing into the game console market with the debut of Xbox.. FUNDAMENTALS EPS (6/00A) $1.72 EPS (6/01E) $1.79 EPS (6/02E) $1.93 P/E (6/01E) 40.3x P/E (6/02E) 37.4x TEV/EBITDA (6/01E) 21.7x TEV/EBITDA (6/02E) 19.8x Book Value/Share (6/01E) $8.34 Price/Book Value 8.6x Dividend/Yield (6/01E) NA/NA Revenue (6/01E) $25,236.0 mil. Proj. Long-Term EPS Growth 10% ROE (6/01E) 21.4% Long-Term Debt to Capital(a) NA Convertible No MSFT is in the S&P 500(R) Index. (a) Data as of most recent quarter SHARE DATA RECOMMENDATION Price (6/11/01) $72.12 Rating 1H 52-Week Range $82.00-$41.50 Target Price $85.00 Shares Outstanding(a) 5,563.0 mil. First Call Consensus EPS: 6/01E $1.79; 6/02E $1.93; 6/03E NA Calendar Year EPS: 12/00A $1.82; 12/01E $1.80; 12/02E $2.04; 12/03E NA INVESTMENT THESIS There are several key investment points regarding Microsoft shares: 1) The company has become more mature and therefore more cyclical; it derives more than two-thirds of total revenue from client operating systems and office productivity applications, and commands more than a 90% share in each of these markets; 2) PC demand remains weak across all customer segments in the U.S. and in the European corporate segment, posing risk to OEM operating system revenue in the June quarter; 3) The antitrust trial is currently in the Court of Appeals and the legal mandate for a breakup appears unlikely; 4) Easy comps and product cycles will eventually spark an acceleration in Microsoft's revenue and earnings growth sometime during late CY01 to early CY02. In light of the issues cited above, we believe there is significant upside to MSFT shares. The company is currently embarking on major releases in all product segments (namely, operating systems and productivity software), which we believe presents an ideal time to build positions in MSFT shares as this is a major revenue contributor for the company. RECENT RESULTS 3Q revenue of $6.5B (+14% yoy) was well above our revised estimate of $6.0B and even above the company's guidance of $6.3-6.4B. Revenue upside was driven primarily by stronger than expected desktop platform and desktop application revenue. Desktop platform revenue of $2.1B (+16% yoy) was well above our estimate of $1.9B due to strong Windows 2000 Professional sales, which rose 40% yoy. Windows 2000 represented 35% of total 32 bit operating system sales during the quarter, up sharply from 31% in the prior quarter. The company managed to grow desktop platform revenue 16% yoy despite the fact that Windows ME and Windows 98 were nearly flat---this provides some indication of the growth rates that this category might achieve once corporate IT budgets are freed up, the economy reaccelerates, PC comps become easier in the second half of the year and Microsoft releases its next generation consumer operating system, Windows XP. Desktop applications revenue (which consists primarily of Microsoft Office) was our major concern this quarter. Given that the current version of Office has been on the market for more than 18 months and has already enjoyed a significant upgrade cycle, we surmised that it might be a source of recurring revenue and earnings disappointments pending the release of Office XP. In fact, Microsoft was able to prevent this by incentivizing its sales force to sell licensing agreements which permit an upgrade to Office XP when it becomes available. As a result, desktop applications revenue of $2.4B (+7% yoy) exceeded our estimate by a healthy $300M. Given that these types of licensing agreements generally include a recurring component, we do not consider this the equivalent of "robbing Paul to pay Peter," but rather solid management. The desktop applications category also benefited from strong sales of client access licenses (licenses that give a Windows desktop the right to interface with a Windows server). Enterprise software and services revenue, the fastest growing segment of Microsoft's software business, grew a healthy 22% during the quarter to $1.3B. Exchange (e-mail) and Sequel Server (relational database management) increased 53% yoy and enterprise services increased 38% yoy. Server platform growth of 5% yoy was the only disappointment in the quarter, which we attribute to tough comps with the CY00 dot com and service provider spending spree. We expect this quarter's introduction of BizTalk Server, Application Center Server and Internet Security and Accelerator Server to accelerate server platform growth in future quarters, and also point out that comps begin to ease significantly beginning in 4CQ01. Consumer Software, Services and Devices revenue increased 22% yoy, due primarily to strong growth in MSN Internet access revenue. The company added more than one million new subs during the quarter and ended the quarter with more than 5M total subs. Despite weak PC shipment growth (which MSFT management pegged at low single digits during the quarter), revenue from new license shipments through the PC OEM channel increased 19% yoy. The disparity between PC unit growth and growth in Microsoft's OEM revenue reflects a positive mix shift away from Windows 98 and Windows ME toward the higher priced Windows 2000. OEM revenue growth was also favorably impacted by the recognition of unearned revenue from prior periods when OEM revenue growth rates were higher. VALUATION Microsoft's business is becoming increasingly cyclical due to its large exposure to the highly penetrated and mature desktop operating system and office productivity markets---the ideal time to buy or overweight the shares is just ahead of significant product cycles within these two very important segments of the company's business. While the shares have already rebounded sharply from their late March trough of $50, we see upside to $85 (40X FY03E earnings of $2.14). While the stock may retrace some of its recent gains in a market pullback, we would use these retrenchments as opportunities to build or increase positions. RISKS The company faces uncertainty from the potential of a continued slowdown in corporate IT spending. Although we believe that many IT managers are cautiously investigating new projects, they have not been given the green light in terms of full execution. In these types of market conditions, desktop related products often deliver the lowest incremental ROI since there is already a substantial installed base that can be leveraged until a time of less constrained IT budgets. Microsoft's infrastructure products provide a larger initial impact in terms of delivering efficiencies to a company's IT position but it faces intense competition from company's such as Oracle, Sun, and IBM. Also, we believe Microsoft faces another potential hurdle from its corporate customer base. There is a scenario in which corporate clients will not see adequate incremental value in new product releases out of Microsoft. Many corporations might find their current Office suite and Windows operating system powerful enough for their current needs and will therefore opt out of any significant upgrade purchases