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Is Microsoft a Screaming Buy? Not Exactly

By Amey Stone Should you invest in Microsoft now that the risk that it may be broken up has been all but removed? The simple answer is: Too late. Wall Street came to the conclusion months ago that the company wouldn't be split up, which means not much near-term upside is left on that score.

Indeed, following the June 28 Appeals Court decision that overturned a lower court's breakup order, Microsoft analysts didn't make any material changes to their earnings estimates or ratings, according to First Call. The stock price jumped temporarily following the announcement but then slipped back to around $70, where it has been since mid-April.

HELLO "SUNSHINE." However, the answer to our question over the longer haul is far more complicated. Given the stock's high price and the fact that Microsoft isn't out of the legal woods yet, this probably isn't the best time to buy. But for investors looking beyond the next few quarters, the breakup ruling's reversal improves Microsoft's long-term prospects.

First, the decision is a huge relief for management. In a conference call following it, none other than Bill Gates admitted: "The legal process can be hard on anyone who goes through it, and the last four years have been challenging for all of us here at Microsoft -- and for me personally." Jeff Raikes, Microsoft's group vice-president for productivity and business applications, was even more emotive: "All of us here at Microsoft see this ruling as the sunshine we have been waiting for, an endorsement of the right to go forward with the innovations that consumers want and the removal of the cloud of breakup."

It's clear that being split up is what management really worried about. While you can't measure their collective sigh of relief in dollars and cents, few analysts doubt that senior executives will be better able to focus on new-product rollouts and develop innovative technologies as a result of the ruling. Some critics would say it also frees Microsoft to return to monopolist tactics. But no question, the ruling will also boost employee morale, says Robertson Stephens analyst Eric Upin.

NO DENTS. Although the legal tussle will continue, the case could be a lot closer to settlement now that the breakup is off the table. Don't expect a solution in weeks, or even months -- there's still too much legal wrangling in just remanding the case to a lower court. But in a July 3 research report, Merrill Lynch analyst Henry Blodget said the case conceivably could be settled by yearend. "Microsoft is now in a position where it can get rid of this whole thing by just giving in a little," says Michael J. Davey, technology analyst at Investec Ernst.

Even if the case goes back to court and the company ultimately has to pay a penalty, reword some contracts with partners, or unbundle some applications from its operating system, such measures are unlikely to be significant enough to put the slightest dent in Microsoft's armor, says Davey. Given its operating-system monopoly and $30 billion cash horde, "these are really just marginal kinds of issues for Microsoft," he notes. "These other things affect their competitors much more than they affect Microsoft."

Looking beyond the Appeals Court decision, what really matters for Microsoft's stock over the next year is whether customers like its new products enough to upgrade. Among the offerings either out or coming soon are a revamp of its Office XP suite of desktop applications, its Xbox gaming console, and -- most important -- its new Windows XP operating system, due out this fall.

OVERVALUED? Let's assume for a moment that Microsoft has a successful slate of product launches over the next 12 months. Even then, analysts don't expect it to increase earnings by more than 10% to 15% a year. True, that's a healthy pace for such a large company (it's on track to rack up $25.3 billion in sales in its current fiscal year, up from $23 billion last year). But the stock is now valued at 40 times analysts estimates for 2001, and stocks are generally considered overvalued when their p-e exceeds their long-term growth rate. The S&P 500 now has a forward p-e of about 22, about half that of Microsoft.

Investors have been willing to pay a high price for Microsoft, despite the legal clouds, because it has provided a safe harbor in the tech storm. But when the economy turns up and technology spending resumes, investors will look for a lot faster growth than 10% to 15%. To keep Wall Street happy long-term, Microsoft will have to expand quicker than that.

Given its girth, that won't be easy. The Colossus of Redmond will have to dominate the next wave of technology to stay on top. "Right now, I'm just scratching my head and wondering what that [the next wave of technology] would be." says Peter Cohan, an Internet strategy consultant and author of E-Stocks.

RESTRAINED MUSCLE? While many in the programming community are excited about the potential for the Microsoft Web-services strategy known as .Net -- a plan that's being crafted by Gates -- it's tough to see how it will become a big business. Microsoft will also be going up against competitors like IBM, Oracle, and Sun Microsystems, which are working on their own strategies for Web services.

Moreover, because of self-policing as well as court-imposed remedies in the antitrust case (remember, the Appeals Court upheld the case's core contention -- that Microsoft acted as an abusive monopolist), the company won't be able to use all its muscle to beat competitors next time around.

Cohan believes Microsoft will have to come up with the next big thing all on its own and points out that it hasn't been a major innovator in the past. Some analysts think that may not be so difficult for a company that has showered so much funds on R&D recently. Davey, noting its estimated $4 billion in R&D spending this year, predicts: "I think you're going to start to see tremendous things coming out of their lab."

NO ROCKET. Maybe so, but that's not a strong argument for jumping in now at the current price. In a June 29 research note, Robertson Stephens' Upin valued Microsoft at $80 and suggested that investors may be able to get in at a better price. Even though he said he was "becoming increasingly positive on the stock," he retained his tepid market-perform rating.

The bottom line: Thanks to the court ruling, the software giant's long-term health is assured, and management should be better able to focus on its upcoming product launches. But that doesn't make the already expensive stock look any cheaper. Savvy long-term investors might still get some ride on Microsoft. It will be a slower ride. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.

Questions or comments? Join in the discussion at our Ask Amey Stone interactive forum

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