or not to sell? That is the question -- once unthinkable, even heretical -- many investors have been asking of late. More specifically, is the software giant's recent rally a "gift" from the trading gods or the beginning of a long-awaited revival?
Early this month, Microsoft shares dipped below $50, a breach some technicians believed would trigger a move down to $40.25, their intraday low on Dec. 22, 2000. Break $40, and Microsoft might revisit its late-1997 levels near $30, claimed the hard-core bears. But the software giant clawed back above $50 and, spurred by rumors the company would preannounce better-than-expected earnings, closed at $55.54 last Wednesday. No such proclamation has been forthcoming, but Microsoft ended the week at $55.25 and was rallying again Monday morning amid an advance for major averages.
That Microsoft led major averages back from the brink of potential meltdown scenarios on both Wednesday and Friday last week was not coincidental. Conspiracy theories about the firm's shares being
artificially goosed aside, it's fair to say you can replace Microsoft for
in the old saying, "As IBM goes, so goes the market."
Given Microsoft's dominant position in computer software, its fate will very likely be shared by a host of other tech firms. Furthermore, because Microsoft is one of only two stocks that are components of all three major indices (
being the other) and its market cap of just over $300 billion is tops, having just supplanted
Microsoft truly is a bellwether, as it is the largest component of the
and top dog in the
In some ways, the question of "what to do with 'Soft?" boils down to one's view of stocks in general and outlook for the U.S. economy. If the economy is going to continue its rebound, there must be a recovery in business spending, especially if once-robust
consumer spending wanes. Given that information technology spending accounts for a sizable chunk of corporate America's capital expenditures, that, in turn, would provide a boost to Microsoft's bottom line. For all the hullabaloo about Xbox, .Net and Mr. Softee's ill-fated foray into cable and digital TV set-top boxes, the firm's meat-and-potatoes Windows unit still brings the bacon home to Redmond. Desktop and enterprise software and services accounted for $5.7 billion, or 89% of the firm's total revenue, for the quarter ended March 31. (Microsoft's fiscal fourth-quarter results are due the week of July 15.)
Leader of the Pack
"Microsoft is a gift at $50
plus if the economy is turning," said Noah Blackstein, a portfolio manager at Dynamic Mutual Funds, a Toronto-based firm with over $4.5 billion under management. Dynamic has a long position in Microsoft, although Blackstein does not own it in the general equities fund he manages, the $120 million Dynamic's Power American Growth fund.
"We do think the economy is recovering and there will be an upgrade cycle in 2002-03," Blackstein continued, suggesting Intel (which he is long) has greater operating leverage for that occurrence. "Most upgrades were done for Y2K,
and at some point people will replace
those computers. It's a matter of when, not if."
A recent survey by Giga Information Group and SoundViewTechnology Group, indicated that the "when" may be sooner rather than later. Based on responses at the GigaWorld IT Forum in mid-May, the survey suggested "a more stable, constructive IT spending environment for the second half of 2002," and that 2003 IT budgets are expected to be up 4.3%.
The Giga/Soundview survey was one reason Doug Kass, general partner for Seabreeze Partners and contributor to
, has recently been buying Microsoft.
"The survey suggested the prospects for a stronger-than-expected PC upgrade
cycle by corporate America in last half of 2002," Kass commented late last week. That is "more important than valuation" issues, the hedge fund manager said, noting that Microsoft's price-to-sales ratio is "way down from the halcyon levels of three years ago."
At a price-to-earnings ratio of 30 (based on forward projections) and price-to-sales of 11, Microsoft's valuation has certainly fallen considerably from 1999, when those metrics peaked at 84 and 33, respectively, according to Baseline.
Of course, just because Microsoft's valuations and shares -- off 53% from their peak on Dec. 31. 1999 -- are down considerably from the glory days, that don't make 'em cheap.
"Our view is that the stock is somewhat expensive," said Brett Gallagher, who oversees about $4 billion as head of U.S. equities at Julius Baer Asset Management, which has no position in Microsoft.
Microsoft is "clearly a super high-quality company" deserving of premium valuations and has held up relatively well -- the Comp is still down about 70% from its peak,
, for example, by more than 80% -- but it's still too rich for Gallagher's blood.
In the past, a P/E of 30 was "the absolute maximum people paid for high-growth names," the money manager recalled, suggesting Microsoft's fundamentals don't meet those standards. Forget the firm's ongoing antitrust litigation and
recent flak about its accounting. The fund manager frets about Microsoft's days sales outstanding (a measure of how long it takes a company to get paid by its customers), which totaled 54 in the third quarter of fiscal 2002 vs. 51.5 in fiscal 2001's third quarter and 40 in 2000. Not an onerous increase but a trend going in the wrong direction, and "one signal that things aren't as strong as in the past," Gallagher said.
To be fairly valued in the mid-$50s, Microsoft's long-term earnings growth rate would have to approach 18%, he continued. Microsoft's earnings have grown an average of 22% in the past five years, according to Baseline, but are expected to grow by about 15% going forward. Julius Baer is forecasting long-term growth of 13%, suggesting Microsoft's shares are fairly valued at about $46, Gallagher said. "The stock is a little overvalued.
Last week was probably a good point to maybe take a little profit."
Of course, Gallagher views the whole stock market as being "pretty much overvalued," and he has been raising cash to as much as 15% in portfolios he manages. Still, he is no stark-raving bear -- one of those who believes Microsoft shares will "crack" imminently and lead major averages back to at least their 1998 lows. He has positioned Julius Baer to take advantage of a potential "technical bounce" in equities by buying the
Nasdaq 100 Unit Trust
and the QQQ Dec. 30 calls while simultaneously selling (or shorting) twice as many QQQ December 34 calls.
The so-called accelerator strategy will generate double leverage on any rally in the QQQs until they hit $34 (they're currently trading at $28.50); beyond that, Gallagher will forfeit gains because of the short position on the December 34 calls.
A similar philosophical outlook sounds about right for Microsoft shareholders, barring dramatic exogenous events. In other words, expect more upside in the coming weeks but start looking for the exits if 'Soft gets much beyond $60.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.