Microsoft Bull's Pen
by Jim Surowiecki ([email protected])

At a price-to-earnings ratio of more than 60, Microsoft can hardly be called a value play. Of course, in a market where the S&P 500 is trading at somewhere between 27 and 28 times trailing earnings, there aren't going to be too many value plays to be found. And in the context of this market, Microsoft is not just fairly valued. In fact, it's a stock that for the long-term investor will continue to be pure gold, the kind of gold that Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %>, Gillette <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: G)") else Response.Write("(NYSE: G)") end if %>, and Disney <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DIS)") else Response.Write("(NYSE: DIS)") end if %> have been over the last decade.

The mention of those consumer giants is no coincidence, of course, since in order to recognize the future value of Microsoft you have to recognize the way in which companies like Coke and Gillette -- companies with a dominant brand name and huge market share -- consistently trade at a premium to the discounted value of their future cash flows precisely because of their consistency in delivering earnings and the relative lack of serious downside risk. If anything, the fact that Coke and Gillette, which are currently growing earnings at somewhere between 12-18%, trade at P/E ratios of greater than 40 makes Microsoft look like an enormous bargain. Over the last year and a half, Microsoft has grown earnings at essentially a 50% clip. Measured against the S&P, that means its price premium is hardly any premium at all.

But perhaps you think Coke and Gillette are overvalued now and have been for a long time. In that case, let's just peruse the fundamentals behind Microsoft's business. This is by most accounts as well-run a corporation as exists in America. Microsoft has regularly made wrong guesses about the future of technology, but every time it has erred it has recognized its mistake quickly and rectified it. It has what amounts to monopoly control over the central nervous system of the most important consumer product of the next decade: the personal computer. It owns 97% of the new market for office-suite software. In all likelihood, it will soon have majority control of the market for Internet browsers, which it will seek to leverage into a small but very profitable licensing arrangement for commerce over the Net, a market that some estimate could be as large as $300 billion by the year 2002. And, perhaps most important, it's in the process of making a powerful move into the networking and database markets with Windows NT 5.0, which could establish a massive revenue stream that hardly exists today.

Microsoft's financials are, of course, impeccable, with more than $10 billion in cash and short-term securities and exactly no debt. Its gross margins are immense, above 90%, while its operating margins, which actually rose in the last quarter, are consistently above 45%. The reason that's impressive is that Microsoft has kept operating margins high even as it has continued to grow at a rapid pace. In other words, its earnings growth is not coming from cost-cutting. It's coming from real growth in revenue, close to 40% year-over-year, the kind of revenue growth you associate with very young companies, and not those that have been around for more than twenty years. And net margins are above 30%. Even after taxes, Microsoft pockets one of every three dollars it takes in. And you know Microsoft isn't getting any tax breaks to get there.

In essence, Microsoft has brought to its business the same fundamental insights that Gillette in particular has brought to its business: sell the blades and keep moving your customers up to blades of better quality. But Microsoft is in a better position even than Gillette, since its fixed costs are practically non-existent, it has no inventories, and the market for PC operating systems -- unlike the market for razor blades -- is booming. For a company in a cutting-edge business, Microsoft's approach is oddly simple: make something that everyone needs in order to make their computers work, and make it as cheaply as possible. The result has been something of an anomaly in the computer industry. Where every other company has watched the price of its products relative to performance fall, Microsoft has actually been able to raise prices. Windows 98 will be twice as expensive as Windows 3.1 was -- yet another reason to remember that the rule "Buy the monopolist" is a good one.

Of course, there is the Justice Department to worry about, but at this point it's difficult to imagine what remedy the Justice Department could come up with that would seriously affect Microsoft's business. Even if Microsoft has to offer a version of its operating system without an integrated Internet browser, that will hardly slow its growth. And even if Justice were to take the unimaginable step of breaking up Microsoft into an operating-systems company and an applications company, one suspects that shareholders might actually benefit. But nothing that extreme is going to happen, in any case.

There's no question that Microsoft is a pricey stock. Don't buy it expecting to reap a massive profit in your first year. But one of the real truths of this bull market is that everyone who has bet against Microsoft has lost. It is now and in the long run will continue to be a blue-chip stock. It is the dominant player in an industry that's continuing to grow faster than almost any other, and it has shown itself uniquely equipped to react quickly to change, which means that it will not be caught unawares. If the future belongs to the Information Revolution, then it belongs to Microsoft. For good and for ill.

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