Look for a Microsoft Buyback


Cash-rich Microsoft is likely to announce in July a sizable stock buyback and an increase in its annual dividend -- which itself was recently instituted. That's the word from Jonathan Rudy, Standard & Poor's analyst of software and commercial services stocks, who lists MSFT

as one of only three stocks in his coverage area rated as buys. The other two are BEA Systems (BEAS) and Sybase (SY).

On Microsoft, Rudy takes note of two significant projects in its pipeline -- Longhorn, the latest update to the Windows operating system, and the Xbox.2 console for the hot video-game market. Microsoft has lagged behind the Nasdaq over the last two years, but in Rudy's view, that stems from the company's continuing revenue stream during the downturn, at a time when investors were focusing on lower-quality companies that had higher to climb. At this point, he expects the stock to outperform the market.

For software stocks generally, which have mirrored the broader market's volatility, Rudy thinks that if earnings continue to come in strong, they will break out of the recent trading range.

These were a few of the points Rudy made in an investing chat presented June 22 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Jonathan Rudy is a Standard & Poor's Equity Analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat.

All of the views expressed in this chat accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat.

For required disclosure information and price charts for all S&P STARS-ranked companies go to www.spsecurities.com and click on "Investment Research," and then click on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts."

Q: Jon, the market overall is sort of marking time -- what's happening with the stocks you cover?

A: Within the software industry, it has been a similar situation. A lot of volatility -- but no real progress has been made. However, if earnings continue to be as strong as the first quarter, it should be, in my opinion, just a matter of time before we break out of this range.

Q: Is Microsoft (MSFT) going anywhere? What do you think MSFT will do with the pile of cash?

A: We have a buy recommendation on Microsoft.... My target price for Microsoft is $35 a share, based primarily on our discounted cash flow analysis.

Microsoft generates a substantial amount of free cash flow -- approximately $1 billion of free cash flow per month -- and we believe that at the company's analyst meeting in July, they will announce a significant stock buyback program and, potentially, a notable increase in its annual dividend. We're less optimistic that the company will announce a one-time special dividend. However, we believe that a substantial stock buyback and annual dividend increase are the best ways to reward long-term investors.

Q: What about innovation in its pipeline?

A: Microsoft has a number of significant projects going. However, the two most highly anticipated projects are currently the release of Longhorn, the next release of Microsoft's Windows operating system, which is scheduled for a 2006 release, and Xbox.2, which is scheduled for either a late 2005 or early 2006 launch.

Q: How do you account for the subdued behavior of MSFT stock recently?

A: Actually, it has acted quite well recently. However, over the previous two years, it has lagged the broader Nasdaq. We believe this is due to the fact that Microsoft was never really hit during the technology downturn. The company kept growing revenues throughout the technology downturn, and we believe that investors in 2003 were focused on lower-quality technology names that would significantly benefit from a rebound in the economy. However, going forward, we believe that the high-quality names such as Microsoft will outperform in this market.

Q: Do you think Network Associates (NET) is really a takeover target?

A: With NET's announcement that it's selling its Sniffer systems management business unit, we believe that the company is an attractive pure play in Internet security. However, our accumulate (4 STARS in S&P's Stock Appreciation Ranking System, or STARS) recommendation is based upon the improving outlook for its McAfee security business, in addition to the company's attractive valuation levels.

So we would recommend accumulating shares based on solid fundamentals and not takeover speculation. However, clearly, any takeover announcement would just be an added kicker.

Q: What's going on with Novell (NOVL)?

A: Novell has changed its long-term strategy with the relatively recent acquisitions of SUSE Linux and Ximian, in order to capture the growth of the Linux market. We believe that this strategy will eventually benefit the company.

However, our only concern presently is valuation. On a price-to-earnings basis, shares trade at a notable premium to peers, and we're somewhat concerned about the market getting ahead of itself. Thus, we have a "hold" recommendation on Novell.

Q: Are valuations a concern with other stocks in your coverage area?

A: For the most part, no. Generally speaking, valuations in the software industry have come down to reasonable levels. However, there are pockets of speculation where investors get overly excited about certain trends -- and right now, Linux is one of those areas.

Q: Is Linux going to make a dent in operating systems?

A: Linux continues to be the fastest-growing operating system. However, Windows, a competing operating system, continues to grow in the low double-digit range as well. It seems that the growth in Linux is coming at the expense of the Unix operating system. But the overall market continues to grow.

Q: BEA Systems (BEAS) is a fallen angel -- will it ever fly again?

A: Yeah. We have a buy recommendation on BEA Systems. And we believe in the long-term health and outlook for the company. Clearly, the first-quarter results were disappointing. However, we believe that as the enterprise IT spending market continues to recover and larger projects are initiated, BEA will benefit from increasing demand for software infrastructure. Specifically, product areas such as integration and portal software solutions should do well in 2004.

Our main concern at this point with BEA is pricing pressure in the application-server market, coming from IBM (IBM) and its WebSphere product on the high end and JBoss on the low end. However, we believe that at these valuation levels, with a strong balance sheet and solid cash flow, BEA is attractive.

Q: What are your best picks in software? Besides your buys on MSFT and BEAS.

A: Our buy recommendations are Microsoft, BEA, and Sybase (SY). We have "accumulate" recommendations on Oracle (ORCL); SAP (SAP), which we recently initiated coverage on; Network Associates (NET), as we discussed earlier; Check Point Software (CHKP); and Electronic Arts (ERTS).

Q: How do you feel about the takeover fight between Oracle and PeopleSoft (PSFT)?

A: At this point, from an investment perspective, we would prefer that Oracle walk away from its hostile tender offer. However, it appears that [Oracle CEO] Larry Ellison is dead-set against that.

Q: Your opinion, please, on Red Hat (RHAT). Do you have a target price?

A: I don't cover Red Hat. However, they've clearly been benefiting from the overall trend in Linux. However, it's not usually a good sign when a CFO resigns three days before the company's earnings call. But I don't have an official opinion on the company.

Q: Do you cover gaming? We've had questions on International Game Technology (IGT) and Midway Games (MWY).

A: I do cover the video-game-software companies. However, Midway is not one of the companies that I cover in this field. I cover Electronic Arts, which has an accumulate recommendation; Activision (ATVI), which has a hold (3 STARS) recommendation; THQ Inc. (THQI), which has an avoid (2-STAR) recommendation; and Take-Two Interactive Software (TTWO), which also has an avoid recommendation.

Our main concern overall in the video-game-software industry is that we're getting into the later innings of the current generation of hardware consoles, and gamers and companies are starting to anticipate the next-generation launches of Playstation 3 and Xbox.2 -- most likely in 2006. There's a chance that Microsoft will try to beat Sony to the market by launching Xbox.2 in time for the holiday season of 2005.

It's a cyclical business, and those releases lead to pricing pressure on the title side, in addition to higher operating expenses, as companies develop games for the next-generation platforms.

Q: Jon, are software sales still closely tied to PC sales? What's the current trend?

A: It depends on the software. Clearly, Microsoft is highly correlated to PC sales, but other enterprise-software companies are more dependent on IT spending and specific projects. For example, BEA is more dependent on software infrastructure projects, which typically are lengthy and expensive. Thus, BEA is more dependent on a loosening of the purse strings for IT budgets than PC sales specifically. However, as IT spending improves, PC shipments should also benefit.

Q: How much of a factor in software markets now is the obsolescence of hardware and software bought for Y2K?

A: Again, it depends on the specific area of software. Clearly, Microsoft is seeing solid demand for its Office products and Windows operating systems. However, in the broader enterprise-software industry, there's still some excess capacity being worked off, and companies have been cautious with their spending allocations because they overspent so much in the late 1990s and in 2000.

So while IT spending has been picking up, the focus remains on total cost of ownership and return on investment -- and not just buying for buying's sake.

Q: Any comment on rumors about Microsoft and SAP (SAP)?

A: That news came out because of the Oracle-PeopleSoft trial, and Microsoft and SAP thought that the news would come out anyway during this trial so they issued a press release stating that there had been very preliminary discussions late last year. But talks eventually broke down, and there are no current plans on the horizon for the two companies to merge.

We believe that the odds of this merger happening are unlikely, primarily due to the regulatory risks, in addition to the substantial integration risk that would be involved. So while this deal makes strategic sense, we just feel that it isn't likely to happen.

Q: You like SAP now, so it must be doing well -- specifics?

A: Sure. We believe SAP will continue to benefit from the ongoing uncertainly surrounding the Oracle-PeopleSoft situation, both of which are competitors to SAP. Typically, the corporate customers hate uncertainty, and we feel that SAP is in a good position to benefit from this competitive situation.

Additionally, SAP has significantly improved its operations in North America over the past couple of years, and we believe that they will notably benefit from an improvement in U.S. corporate IT spending.


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