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Too often given to knee-jerk reactions to news, investors occasionally show some striking independence that renews my faith in their judgment. Case in point: Microsoft (
MSFT
). The stock has remained strangely impervious to the U.S. Supreme Court's decision on Sept. 26 to push the software giant's antitrust case back to federal appeals court. You'd think the decision would have been worth a few days of euphoria. In fact, by the close of trading on Oct. 6, 10 days after the court's decision, Microsoft was trading at $56, just a couple of dollars above its 52-week low and more than 50% off its record high of $120.
Granted, the Supreme Court's decision is far from outright victory for Microsoft, but it's good news for Gates & Co. anyway you slice it. The appeals court is expected to be more sympathetic to Microsoft. The betting is that while it might restrict the company's business practices in some way, it probably won't split the giant Microsoft up. So why isn't the same stock market that exuberantly assigned multibillion-dollar market caps to unknown dot-coms without a prayer of earnings a little more jubilant about Microsoft -- which has a longtime track record of beating robust earnings expectations.
Simple: Microsoft's business fundamentals don't warrant unfettered jubilation. Justice Dept. threats aside, its latest version of the Windows operating system -- the company's signature product -- hasn't torn the cover off the ball. Analysts predict Windows 2000 will deliver a grand slam over the longer term. But if its sales don't show some pep in the quarter ending Dec. 31, don't look for any great surge in the stock's price in the short term, say analysts. For investors with steely nerves and a lot of patience, however, the stock is attractively priced given the company's long-term earnings potential.
"MORE SOLID." The problem with Windows 2000 isn't the software. It's getting good reviews. "Windows 2000 is the replacement for NT, and it's a pretty strong upgrade for the corporate and laptop market," says Scott McAdams, analyst at McAdams Wright Ragen. Windows NT Workstation was Microsoft's previous operating system aimed at the business market. Its main advantage over consumer products, such as Windows 95 or Windows 98, is reliability.
To be sure, Windows 2000 won't achieve the blockbuster sales of Windows 95, the software that revolutionized PC operating systems. The adoption rate of subsequent versions of Windows has seemed paltry by comparison. But Windows 2000 promises to at least outdo NT. "Windows 2000 is more solid than NT, it crashes less, and it's a lot easier to manage," says Jonathan Geurkink,vice-president and software analyst at Ragen MacKenzie, a subsidiary of Wells Fargo.
Still, sales are lagging because savvy information-technology professionals usually wait for several releases of new software before they buy it -- after most of the kinks will have been worked out. "Look at the way NT Workstation was adopted," points out Geurkink. "NT 4 came out in 1996 as the more industrial-strength version of the operating system, and it had strong sales through the end of 1999."
BARELY A BILLION. Another factor slowing adoption of Windows 2000 is its launch at a time when corporate PC sales are slowing. PC demand this year has increased 17% over last year, according to IDC statistics. But that growth is being powered by consumer purchases, which are increasing at a rate of 20% over last year, rather than by business buying, which is gaining at a rate of 8% or 9%.
IT professionals traditionally make a lot of purchases in the fourth quarter, which should boost demand of Windows 2000. But sales of Windows 2000 and NT together won't break the $1 billion mark in fiscal year 2001 that ends June 30, according to Melissa Eisenstat, software analyst at CIBC World Markets. That's barely noticeable in the $26 billion of Microsoft sales she estimates for the whole of this coming fiscal year.
So why would Microsoft focus on selling Windows 2000 to businesses instead of making a big push for its new consumer operating system, called "Whistler," which is in beta testing? Because margins on business software are much higher than on consumer software. For one thing, Windows 2000's price is probably twice that of a comparable consumer package. In addition, Win2000 is usually bundled with Microsoft Office software, which costs nearly four times more than Microsoft Works, the consumer version. Business sales may also include license fees for client access to Microsoft servers. That's a lot of additional revenue to be made on each business sale vs. each consumer sale.
"INEXORABLE." Windows 2000 is key to Microsoft's new enterprise server strategy, which accounts for about $4 billion of the company's sales. An enterprise server is the computer infrastructure that big companies with multiple locations need to communicate internally. Until recently, enterprise servers relied on a client/server network using dedicated high-speed data lines to connect a company's different locations.
Such networks are expensive to build and maintain, and Microsoft has been bested by Sun Microsystems and Oracle in this arena. In an effort to regain lost ground, Microsoft has introduced the .NET product line, a suite of eight products, which move much of the infrastructure onto the low-cost Internet. And Windows 2000 easily interfaces between the Net and internal corporate systems, which will also be able to connect to Microsoft hubs on the Web where companies can go to license bits of software code they need to run their systems. All the products, excluding a database-server offering, will run only on Windows 2000. "The adoption of Windows 2000 is inexorable," says Ragen MacKenzie's Geurkink. But it will probably be slow.
How slow? Geurkink expects that Microsoft revenue will grow 15% in 2001, to $26.4 billion. He assumes that the September quarter will show sales growth of 5%, ramping up to 24% by the end of this fiscal year in June, 2001. His fiscal 2001 earnings estimate is $1.88 a share. He estimates values at $120 a share in 12 months.
UPSIDE POTENTIAL. Those numbers sound reasonable to CIBC's Eisenstat, but she cautions that "the psychology on the stock is not good" because the company's legal troubles aren't over yet and Windows 2000 sales are sluggish. "People need to see Windows 2000 sales perk up," she adds. She's also predicting 2001 revenues of $26.3 billion and earnings per share of $1.88, but she has a much lower target price of $89 a share, about $33 a share more than it is now.
Sounds pretty good, right? With that kind of upside potential, the market would usually be all over Microsoft. But caution is still the watchword with investors. "A lot of factors with Microsoft are making people pause," says Geurkink. "For the last two quarters, management has lowered its guidance [on forecasted earnings]. People are waiting for them to report this quarter before they regain confidence in the stock."
For those investors who would rather jump now than wait for a clearer picture, the stock is attractively priced. For the rest, it may be too soon to go on a Microsoft buying spree.
Popper covers the markets for Business Week Online Edited by Beth Belton
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