Microsoft (MSFT) -- Sell it or short it; Apple (AAPL) passes the test

July 24, 2009 by Kenneth Reid

Microsoft (MSFT), P/E 13, Market Cap $205 billion (and falling)

After a string of better than expected earnings reports from the likes of Apple, Intel and Texas Instruments, Microsoft offered a disappointing earnings and revenue picture this past week, with no silver lining.

Supposedly due to a slump in desktop and notebook demand, the company posted a 26% drop in quarterly profit and a 17% decline in sales. These figures failed to meet analysts' lowered targets. The news marked the software giant’s first full year of declining revenues since it went public at a split-adjusted price of $0.11/share.

Sure, it was a tough quarter for tech all over, but according to Gartner, PC shipments were down just 5% in the quarter worldwide, while Windows sales were off 29%. Of course a new operating system, Windows 7, will be out in October, so upgrade cycles are on hold. But that is not the whole story.

In one marketing survey, nearly 60% of companies said they had no plans to deploy Windows 7. Moreover, low priced net-books are booming, and many of these don't use Microsoft operating systems and are incapable of running the Microsoft Office suite, which is a memory and processor hog. This will permanently crimp margins in the software space.

MSFT faces competition from the free Open Office software by SUN, from Google docs and also from Google's free, open-source browser and soon-to-be computer operating system, Google Chrome. Whether Google takes down MSFT or not, the writing is on the wall.

There is another macro-economic factor working against the software giant that you won’t hear much about. The Internet is the great deflator. It has made 99% of all information instantly accessible and reduced the price of that information virtually to zero. It is called disintermediation and it is causing an irreversible shift in global business models.

The profoundly egalitarian technology means less control by middle men and the empowerment of the individual consumer-researcher-producer. While the Internet and its World Wide Web implementation are the principle engines of this shift, Google has been the inevitable integrator that has made the vast potential of the web accessible to the masses. Eventually that process will devalue not only information, but also the tools used to manipulate that information. That won't be good for MSFT. What’s left to value? Brains and the creative output itself; not the tools or raw materials used to produce it.

Anecdotally, one can often tell when a leading brand loses its corporate direction by evaluating the quality of its media advertising, or lack thereof. Over the last two years, MSFT has been the butt of television ads by Apple that portray the company as an overweight geek with flawed products (Vista) that is completely out of touch with the times. Microsoft has only recently fired back with an ad that attempts to counter the stodgy and self-serving image, but just as in politics, one must respond to attack ads quickly or they define you by default.

MSFT’s problem is not simply a matter of image. In the corporate culture in Bellevue, Steve Ballmer was the ‘bad cop’ to Gates ‘good cop,’ but he was not a true co-creator. Founder Bill Gates is basically gone from the helm and CEO Ballmer is unlikely to replace Gates at the creative level required to invigorate the company. The bottom line: even dominant companies have life cycles. Microsoft is not the company it once was and while cash flow is assured for a long time to come, growth is not. There are better investments than “Ballmersoft." I have a target of $2 for MSFT over the long term. That is not a typo.

We are short MSFT in Spear's Professional Edition model portfolio.

On the other hand, Apple (AAPL) appears to have passed the earnings test and the technical test at $155. I therefore have to reverse my sell recommendation and now predict that AAPL will make new all-time highs. There is no shame in being wrong; only in persisting in a wrong belief in the face of evidence to the contrary.