The Case for Buying Microsoft

Giant Microsoft is still a stock to buy, in the view of Jonathan Rudy, analyst for Standard & Poor's Equity Research Services, thanks to its reasonable valuation and strong balance sheet and cash flow. "Reasonable valuation" means the price of Microsoft (MSFT) stock is low relative to some tech companies, which Rudy attributes to investors chasing companies that were hit harder by the tech collapse and thus have the potential for a more dramatic climb. But over the longer run, he still sees Microsoft as a bastion of strength.

Microsoft's antitrust troubles with the U.S. government are "largely over," Rudy observes, but it still faces legal issues involving the European Union and Sun Microsystems (SUNW), which may limit any early increases in Microsoft's recently announced dividend. In the meantime, Rudy expects it to use its cash on small acquisitions and stock buybacks.

Among other S&P buys in the software sector, Rudy lists Sybase (SY) and Automatic Data Processing (ADP), plus Network Associates (NET), which he upgraded to buy status on Dec. 2.

These were some of the points Rudy made in an investing chat presented Dec. 2 by BusinessWeek Online and Standard & Poor's, 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.

Note: Jonathan Rudy has no stock ownership or financial interest in any of the companies under discussion. Other S&P affiliates may provide services to the companies under discussion. Jonathan Rudy is a registered representative of Standard & Poor's Securities Inc.

Q: Can you give us a quick view from S&P of the current market? A little resting today after a record high yesterday.

A: I can't speak for the broader market, but software stocks in general have had a strong run and were due for a pullback at some point.

Q: Perhaps not surprisingly, the first three questions ask for your opinion on Microsoft (MSFT).

A: We have a buy recommendation on MSFT. This is due primarily to the company's reasonable valuation, strong balance sheet, and strong cash flow. Over the long term, we still think that MSFT is a very attractive, market-leading software company, and reports of its demise have been exaggerated.

Q: Get out your crystal ball, Jon. Will Microsoft split into five or six unique companies, rather than one huge one -- and what would happen to the stock?

A: I don't anticipate Microsoft splitting into five or six companies. It has given no indication that it would even consider any sort of breakup.... I would say this would be highly unlikely. We like Microsoft in total at these levels.

Q: Why do you think its stock price remains bogged down?

A: This year in technology, particularly software, investors have been chasing high-beta, weaker companies, in our view, that were thought to be going out of business 12 to 18 months ago, and potentially offer a sharper upside in a rebounding economy. However, we believe that quality companies like Microsoft will return to favor at some point.

Q: Will MSFT get antitrust grief for trying to corner other parts of the PC space?

A: I'm assuming that you're referring to the Windows Media Player concerns in Europe. While this will likely be an issue with the European Commission for possible settlement, we believe that antitrust issues between Microsoft and the U.S. government are largely over at this point.

One key point [to consider about] Microsoft is the rapidly changing technological landscape. The proliferation of smaller smart devices, such as handhelds and smart phones, is really outside the realm of Microsoft's dominance at this point. So they still have a challenge ahead of them in these specific product areas.

Q: What will Microsoft do with its large cash reserves?

A: We do anticipate a more substantial dividend over the long term. However, the company remains concerned over outstanding legal issues, such as the EU settlement and a lawsuit from Sun Microsystems. These legal issues will probably limit the upside and any dividend increase until they're resolved. Most likely at this point, we would anticipate small acquisitions and the continued repurchase of shares as the main uses of cash.

Q: Is there any sign of other software companies paying a dividend?

A: At this point, in the enterprise-software space, Microsoft, Autodesk (ADSK), and Computer Associates (CA) are the only companies we cover that pay a dividend. However, payroll providers, such as ADP and Paychex (PAYX), pay dividends of approximately 1.5%.

We believe that there's more upside in their dividend payout levels than for enterprise software companies at this point, and we don't see that changing any time soon. Our recommendation for PAYX is hold, CA is a hold, and ADSK is also a hold.

Q: What other software companies look good to you?

A: In my universe, I have buy recommendations on MSFT, Sybase (SY), and Automatic Data Processing (ADP). Today, I upgraded Network Associates (NET). We think it has gotten most of its problems behind it, and its current management team is doing a very good job of turning the company around. And we also believe it's attractively valued at these levels. Our 12-month target price for NET is $18 per share.

Q: Which, if any, Linux stocks can you recommend?

A: The only company that is Linux-related that I cover is Novell (NOVL), which recently acquired SuSe Linux, and we have a hold recommendation on Novell. Its latest strategy of getting into the Linux space is its most recent corporate strategy change. However, we believe that over the longer term, it makes a lot of sense. Current valuation and management miscues in recent years keep us from being more positive on the stock.

Q: What percentage chance do you give Oracle (ORCL) in its hostile bid for PeopleSoft (PSFT)?

A: That's a tough question at this point. It really depends on the antitrust ruling. And if the Justice Dept. turns the deal down, it's all over. However, if Justice says the merger is not anticompetitive, it could be a very long, protracted battle.

We would have to say our view is currently that Oracle will be unsuccessful with its acquisition, due primarily to the customer-reassurance agreements that PeopleSoft has been giving its customers as a result of Oracle's hostile offer.

Currently, as of the end of October, the additional cost of this program for Oracle would be $800 million, in addition to a $7.3 billion acquisition price. So at this rate, the deal is getting far more expensive than Oracle had originally planned on, in our opinion.

Q: How about Siebel Systems (SEBL)?

A: We have a hold recommendation on on SEBL. While it should benefit from a broader info-tech spending recovery, we remain concerned over valuation and the long-term viability of its CRM [customer-relationship management] strategy. However, with its strong balance sheet, it should not be likely to disappear any time soon.

Q: Jonathan, is there any software that will be a hit during the Christmas shopping season? And what company will benefit, if any?

A: We like Electronic Arts (ERTS) with its strong video-game library of brands, such as Lord of the Rings and Harry Potter, in addition to its market-dominant sports brands like Madden NFL Football and FIFA Soccer. We believe that ERTS should have a very strong Christmas selling season, as the current generation of hardware consoles continues to be built out.

Other than that, on a consumer retail basis, the antivirus providers, such as Symantec (SYMC) and Network Associates, should also benefit from strong PC sales growth. We have accumulate recommendations on all three of these names.

Q: How is the wireless boom affecting the software industry?

A: It's tough to say at this point. Wireless applications, such as video games, tend to have very low price points and need substantial volume to really benefit from. So I'd say the jury is still out over the real beneficiaries. Most likely, Internet security will be a critical issue as wireless Internet access becomes more prevalent, and in that area we like Symantec and Network Associates.

Q: Is there anything out on the leading edge of software we should keep our eyes on?

A: The real opportunities will be in Web services, a continued wireless buildout, and the continued convergence of consumer devices. However, the real winners of these various trends are tough to call at this point.

Q: Can we expect MSFT to home in on all those targets?

A: Microsoft is trying to benefit from all three trends, and with their research and development budget over $6 billion this upcoming fiscal year, they stand a very good chance to benefit from these emerging areas. However, the trend usually in technology is that tomorrow's leaders in emerging trends may not even be public corporations at this point.

Q: Do you cover any stocks that S&P says investors should avoid or sell?

A: Yes. Currently, I have two avoid recommendations. The first is RSA Security (RSAS). This is due mainly to valuation concerns. However, we do think management has positioned it much better than in recent years.

Our other avoid is THQ (THQI), which is a video-game provider whose games are targeted more at the younger gaming audience, in addition to wrestling fans with its WWE titles. We just don't believe that its brands are nearly as strong as [those of] a company like Electronic Arts, and thus THQ could be vulnerable to being squeezed out of shelf space at retail outlets this holiday season, in our opinion.

Q: How crucial are PC sales to software sales? Is software to some extent tied up with the long-awaited revival of corporate IT spending?

A: It really depends. Obviously, PC-related software such as Windows and Office from Microsoft has a much higher correlation with PC sales, and even the consumer antivirus providers like Symantec and Network Associates benefit from stronger PC sales.

But other areas of software, such as the video-game providers, really have very little direct correlation to PC sales in terms of a percentage of revenue. Their growth is dependent mainly on growth in the installed base of consoles such as Xbox, PlayStation 2, and GameCube.

Broader enterprise-software providers depend on corporate IT spending to really drive their growth. And while we expect IT spending to improve in 2004, we still see low- to mid-single-digit growth overall, as opposed to the double-digit growth rates of the 1990s.

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