Microsoft Lacks Apple's Polish

Technology

Apple's strengths make the company's stock compelling here.
Microsoft has Vista buzz, but the company's myriad battles will be tough to win.
Stock vs. stock, Apple looks like a clear winner.

Hardware & PCs
Microsoft Lacks Apple's Polish
By Michael Comeau
Research Associate

6/27/2006 12:16 PM EDT
URL: http://www.thestreet.com/p/rmoney/computers/10293908.html

With the upcoming release of the Vista operating system, Wall Street is intensely focused on the possibility of Microsoft (MSFT:Nasdaq) returning to meaningful growth and the concomitant end to its weak stock market performance. That makes this a compelling time to compare the software colossus with Apple (AAPL:Nasdaq) , a company whose stock has ridden the iPod into the stratosphere.

Apple's focus on delivering highly distinctive and desirable products positions it to take market share in PCs, which should allow the company to continue driving blistering earnings growth. Microsoft, on the other hand, continues to bungle new-product introductions, and is facing tough, nimble competitors in several of its newer markets.

Given the myriad of challenges facing Microsoft and Apple's ability to capitalize quickly on and even create new trends, it makes sense to continue betting on Apple.

One of the biggest ingredients in Apple's success is its concentration on user-friendliness and security, which has won it countless fans who are singularly devoted to its products. Additional Apple stores and continued consumer penetration of the iPod are only expanding that population.

Like its product designs and stores, Apple's marketing message is simple and streamlined, pointing out that a Mac works right out of the box and can do anything Windows does without the security problems. This all helps Apple make it very easy for people to like their computers, even as they pay higher prices.

Despite its best efforts, including untold billions spent on marketing, Microsoft has never been able to create passion for its products. Windows is a passive choice, meaning very few if any people actively seek out the software. The closest that Microsoft gets to this type of dynamic is consumers postponing a PC purchase to wait for its new operating system. But that isn't loyalty, and it certainly isn't passion.

Right now, Microsoft is well on the road to creating confusion with Vista, as it's offering three consumer versions of the upcoming operating system, Home Premium, Home Basic and Ultimate. Microsoft made a similar error with the Xbox 360 (a mistake that Sony (SNE:NYSE ADR) is quite foolishly copying with the PlayStation 3) by creating two different versions of the gaming console.

Apple can simply say that you can do everything you want with a Mac, no premium or ultimate anything required, except for the price of course, which is not a barrier for Mac enthusiasts. Interestingly enough, Microsoft is well aware of its inept marketing strategies, as evidenced by this YouTube video created by Microsoft employees.

Apple, on the other hand, continues to streamline its selling processes. The continued expansion of the iPod, the iTunes online store, and the Apple store base enable the company to successfully cut out related parties and partners along the way, and make a potent play to control users' living rooms.

Who needs a retailer to sell computers when you have an Apple store? And who needs to buy CDs at Best Buy when you have iTunes? Apple is also selling televisions shows via iTunes, and it is not hard to imagine movies, possibly in high-definition, coming through the same pipe very soon.

Depending upon pricing and revenue sharing terms with content owners, downloads or streams of high-definition movies could be a huge potential moneymaker for Apple because of the confusion over next-generation DVD formats. By this time next year, it could be quite normal for a consumer to go to an Apple store to buy a Mac, go home and connect that Mac to a home theater, which might actually have an Apple LCD television, and watch a movie purchased through iTunes.

In addition, Apple eventually could add digital cameras to the mix, and even mobile phones, possibly in the form of a mobile virtual network operator, or MVNO -- a company that resells wireless services under its name, but uses the network of another mobile-phone operator. All these possibilities represent chances for Apple to use its strong brand name to tap into multibillion dollar commodity markets with highly differentiated, higher-priced products.

In the past, I have rolled my eyes at the idea of iTunes being a serious moneymaker, but I am much more positive now that it is expanding its reach to video because it clearly has the potential to function as a platform for sales of all forms of media. Right now, iTunes offers mostly music, podcasts and television shows, but movies are likely on the way, and eventually software (think video games) will be sold through iTunes as well.

Steady Evolution vs. Big Bang

This type of evolutionary strategy makes sense to me, as Apple expands one step at a time, unlike Microsoft, which seems to enter a new field (about three years late) every day. Just Monday morning, Microsoft announced a major effort to get into the business-phone market, a competitive space populated with names like Cisco (CSCO:Nasdaq) and Avaya (AV:NYSE) .

This situation is a major problem for Microsoft. The company is fighting huge wars on numerous fronts with tough competitors. In Web search, it is battling with Google (GOOG:Nasdaq) and Yahoo! (YHOO:Nasdaq) ; in video games, it is grappling with Sony and a reinvigorated Nintendo; and in PCs, the aforementioned Apple.

Microsoft also recently entered the crowded PC security space with Live OneCare, which to me is absurd and an insult to computer users. Live OneCare closes security holes within Windows, implying that Microsoft is charging for fixes that should be in Windows to begin with. Apple's computers were designed from the ground up to be secure, which is representative of its basic emphasis on product quality that is absent at Microsoft.

Taking a look back at this decade, Apple started with a great computer, added a terrific MP3 player that started a new era in portable music, next added an online store, and then added a chain of retail stores. Voila! You have what some people call an "ecosystem."

There is no doubt to me that Apple will continue taking "mindshare" -- meaning its products are key examples in their respective categories in consumers' minds -- and with it, a greater share of consumers' spending money. The significance of the continuing success of the Mac is enormous. According to market research firm Gartner, Apple's U.S. PC market share was a mere 3.6% in the first quarter of 2006. Even though this figure was artificially low because of customers waiting for newer Intel-based Macs, Apple obviously has an enormous amount of room to take market share.

Given the praise I've heaped upon Apple here, it should be no surprise that I like the stock quite a bit. With shares trading at 27 times expected calendar 2006 earnings, I believe the stock to be dirt cheap, considering the potential billions in revenue the company can take from competitors.

The fortunes of PC-makers like Dell (DELL:Nasdaq) and Hewlett-Packard (HPQ:NYSE) are largely dependent on events like the timing of operating system releases and shifts in PC market demand; Apple, on the other hand, is in a secular growth phase, unlike most companies of its size. Apple also has a great deal of financial strength, with a whopping $8.2 billion, or $9.36 a share, in cash on the balance sheet, giving the company a great deal of financial firepower to make investments in new products and services.

Outside of an economic downturn, the primary risk with Apple is obviously slower adoption of its PCs. However, I view this as highly unlikely, given how strong consumer awareness of Apple is becoming. The PC market is very mature, but Apple's different way of doing things is winning customers away from Windows, and I expect continued outsized earnings growth will be the result.

On the other hand, I find it hard to get behind Microsoft's shares, even though the stock is down pretty far from its highs, and Vista could very well provide a return to real revenue growth. However, Microsoft's spending is exploding as it makes investments in its Web initiatives, and I believe that software-development costs will also rise strongly in the years to come as Microsoft starts putting its software on both the Web and the desktop.

Microsoft is still a cash-generation machine and cheap on most valuation metrics, but just where its earnings will peak in the Vista cycle remains unclear. It is also disconcerting that the company can't find any new earnings drivers outside of Office and Windows despite the billions poured into new markets like video games. This is exacerbated by the fact that Microsoft has a $40 billion-plus revenue base, making it extremely difficult to build new businesses that can become significant revenue contributors.

So despite the buzz about Microsoft, Apple's stock looks like the winner.

In keeping with TSC's editorial policy, Michael Comeau doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Comeau is a research analyst at TheStreet.com. In this role he performs stock analysis for TheStreet.com Breakout Stocks, and is also a regular contributor to RealMoney.com. Prior to his arrival at TSC in June 2004, Comeau worked as a Consultant to Toyota Motor North America, performing in-depth research on automotive industry issues, primarily in the areas of alternative engine technologies, competitive analysis and macroeconomics. His primary market interests include consumer technology, specialty retail, and small-caps. Comeau received a bachelor's degree in Finance from Brooklyn College, and has completed Level 1 of the CFA program.. He appreciates your feedback; click here to send him an email.