Macrosoft
The Bull Argument

By Matt Richey (TMF Verve)
April 19, 2000

Microsoft is at a turning point. Antitrust pressure, open source software, and the Internet are all threatening the company's entrenched position as software king. Distraught over these obstacles, the market has pummeled the shares 38% from their 52-week high of $119 15/16 to levels not seen since January 1999. In the midst of all the negative sentiment surrounding Microsoft and weighing upon its shares, investors should carefully examine the company's broader strengths and long-term opportunities, which remain fully intact.

The most important of Microsoft's enduring strong suits is its business savvy. Microsoft's success, I believe, is a product of ingenious strategic business design, great marketing, and superb financial management. Ironically, for a company so closely associated with technology, Microsoft's specialty is not at all in developing innovative technology, but rather in designing profitable business models. Adrian Slywotzky and David Morrison said it best in their book, The Profit Zone:

"Microsoft creates standards. That's what it is best at. That's what its business model has been designed to do. It just so happens that a 'de facto standard' business deign is the most valuable type of business design. High margins, high profit protection, increasing returns to scale.... What's not well known is that, although a standards-based business design is the most valuable type of business model, it is also the single most difficult business design to create.... The technology inherent in a standard can be copied or replicated, but a standards-based business design will be very difficult for the competition to copy. The strategic control is imbedded in the business design, not in the technological invention."

There you have it. The right business strategy has led Microsoft to victory over IBM and Apple in the operating system war, over WordPerfect and Lotus in productivity applications, over Novell in enterprise computing, and over Netscape in the Web browser race. None of these battles was won because of technological innovation, but rather by smart application of technology to meet customers' needs better than the competition. In creating standards, Microsoft consistently seeks to fulfill the needs and priorities of ALL of its constituencies, including the OEMs (original equipment manufacturers), application developers, and end users. With support from all of these groups, a standard can become a very profitable fundamental building block around which an industry is built.

Microsoft's standards in the Windows operating system, Office suite of productivity applications, and the BackOffice suite of server software resulted in total sales of $21.9 billion during calendar 1999, representing 24.7% growth over the prior year. Profit margins on these revenues are extraordinarily high. Gross margins of 87% and net margins of 40% put Microsoft's profitability in a class all its own. Even more amazing, Microsoft's free cash flow profitability is even better. Free cash flow of $13.2 billion as a percentage of sales translates into a Cash King Margin of a jaw-dropping 60.6%. Now you know how the company has been able to sock away cash reserves of $17.8 billion, plus another $19.8 billion in long-term strategic equity investments -- all without any debt.

Microsoft just flat-out knows how to win at the game of business. Founder Bill Gates and CEO Steve Ballmer have been matching wits since their college days at Harvard, where they competed for the highest grades. Today, Gates and Ballmer are just as fiery as ever in their pursuit of success, and their competitive spirit is deeply ingrained within Microsoft's culture. Microsoft has a lot of ideas for both new profitable software standards as well as ways to more deeply establish some of its current standards. And now that the antitrust trial is headed for what is likely to be a lengthy appeals battle, Microsoft should have a good two years to roll out a whole series of promising new products.

The core of Microsoft's strategy for the next five years is wrapped up in Windows 2000. The long-awaited operating system is far more robust than its predecessors. Windows 2000 offers the reliability that people want, the manageability that IT departments insist on, and the scaleability that the Internet demands. Check out this laundry list of upbeat reviews.

Other goodies expected to arrive out of Redmond this year:

Pocket PC -- Today (Wednesday the 19th), Microsoft unveiled its newest version of a scaled-down Windows for palm devices. Unlike the clunky, overbuilt Windows CE, the Pocket PC software appears to have hit money this time with compact size and simplicity that rivals that of the PalmPilot. Key distinguishing features include pocket versions of Word, Excel, Outlook, and Internet Explorer, as well as a color screen.

Exchange 2000 -- This is Microsoft's next-generation mail and messaging system, which includes new functionality for serving wireless devices.

SQL 2000 -- The next generation of the popular database server adds native XML support, integrated data mining capabilities, and greater scalability.

AppCenter Server -- This is a new product for managing large numbers of Web servers or Web farms with the simplicity of managing a single machine.

Host Integration Server -- Also new, this tool basically allows companies to keep their investment in their legacy environment, but have bi-directional support for applications and data from the legacy environment out to their Web-enabled server farms.

BizTalk Server -- This is a new business process integration solution that allows companies to communicate without a huge amount of interface and custom programming.

Commerce Server -- Built for business-to-consumer commerce, this software offers the ability to construct transaction environments simply and inexpensively.

Next-Generation Windows Services -- This is a new programming platform that will be more fully unveiled in May. It will be an entirely new way of approaching business challenges. Instead of stand-alone applications, the NGWS is designed around components of Web services that developers create. These might include modules for calculating taxes, credit card authentication, and building blocks for data transfer.

One of the key technologies integrated in Windows 2000 and many of these other new products is the XML language, a technology that allows websites to "talk" to other websites as well as other software applications. Essentially, XML will usher in an age of Web programmability and, consequently, a whole new way of using the Internet.

Already we see how the Internet is ever becoming a more integral part of our lives, and with the promise of a programmable Web and unlimited bandwidth, software will be the basis behind all sorts of unimagined services. Microsoft is at a turning point, as previously static software products become dynamic software services. With this future in mind, Microsoft simply could not yield to the Department of Justice's demands that Microsoft give up its right to integrate new features into Windows.

The day is coming when Windows and Microsoft's other products will take care of themselves. Software updates and information management will occur on a constant, as-needed basis by having a component of the product that lives out in the Internet and a component that lives on the PC or other device. In fact, this is already happening on the WebTV box, which although customers never touch it, the device continuously copies, downloads new software, and manages that entire experience.

Even if Microsoft suffers a structural break-up, the downside risk appears to be limited with the shares trading at only 31x trailing free cash flow. And the upside would be substantial if the appeals court were to see the legitimate truth behind Microsoft's Freedom to Innovate campaign.

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