Microsoft's Legal Picture Brightens...

...But its business fundamentals are weakening -- and its stock is still pricey

By Jonathan Rudy

If you have read a newspaper during the past week, you are probably well aware that the Microsoft (MSFT ) antitrust trial is back -- and it's as acrimonious as ever.

Both Microsoft and the government have been presenting their cases to the U.S. Court of Appeals this week, and it appears that the tide has turned in Microsoft's favor, at least for now. While comments from the appeals court make it seem less likely that Microsoft will be broken up, any potential resolution to this battle is still a way off.


  The trial dates back to May 1998, when the Department of Justice (DOJ) and 19 states filed a broad antitrust suit against Microsoft, charging that the company used its monopoly power in operating systems to gain an unfair advantage in the Internet browser market. The suit also addressed the issue of control over the initial screen that users see after a personal computer (PC) is turned on. The DOJ asserts that PC manufacturers should, but don't, have the option to direct users to their own software. The trial ended in June 1999.

In early April 2000, settlement talks between the government and Microsoft broke down, resulting in Judge Thomas Penfield Jackson's ruling that Microsoft violated antitrust laws. On June 7, 2000, Judge Jackson issued a final ruling that ordered the break-up of Microsoft into two companies. However, less than two weeks later, Judge Jackson indefinitely stayed the business restrictions against Microsoft until the appeals process had been fully exhausted. And that brings us up the events of this past week.

What's S&P's opinion on the current legal situation? While things appear to favor Microsoft at the moment, this will likely be a long and grueling process.


  Standard & Poor's presently has a hold (3 STARS) opinion on Microsoft and would not add to positions based on speculation over the appeals process. The hold recommendation is based on a weakening of Microsoft's fundamentals and continued high valuation.

One particular area of concern: the weakness in the PC market, particularly in the small to medium size business market. This market is critical to Microsoft's growth efforts. The slowdown in this market will have a substantially greater impact on Microsoft than the slowdown in the consumer PC market. Additionally, with the maturity of Microsoft's core desktop businesses, the company is rapidly trying to expand into new areas that will negatively impact the company's operating margins.

While new initiatives such as the X-box are highly anticipated, Microsoft's venture into the hardware console business is a step out of their key competency, software.

One potential positive catalyst on the horizon is the launch of Windows XP (Experience) in the second half of 2001. This product upgrade will likely have a more significant impact than Windows ME (Millennium Edition) had.

However, Microsoft still trades at 32 times our fiscal 2001 (June) EPS estimate of $1.80, with low single-digit growth expected in a challenging economic environment. S&P would recommend holding onto the shares based on the company's financial strength ($40 billion in cash and investments as of December 31) -- and on the potential impact of Windows XP -- but would advise against adding to positions at this time.

Rudy is a software industry analyst for Standard & Poor's

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