Stock Watch


Apple, Google and Microsoft:
Buy or Avoid?

Milllions use their products. And the shares of two of these three tech titans look attractive to investors as well.



Apple. Google. Microsoft. They aren’t necessarily the biggest U.S. technology companies (IBM’s stock-market value is slightly greater than Google’s), but they are arguably the tech titans most firmly ingrained in American consumers’ consciousness. After all, millions of us yak on Apple iPhones or listen to music on iPods while we google for information on a PC running a Microsoft operating system.

But prominence and stock performance are two different matters. Nowhere is that more evident than in the divergent paths the shares of Apple (symbol AAPL) and Microsoft (MSFT) have taken over the past ten years. Apple’s stock has been spectacular, while Microsoft’s has actually lost money. Meanwhile, Google (GOOG), which roared out of the gate after going public in 2004, has been treading water lately.

We think Microsoft and Apple are worth a hard look, but we have some concerns about Google. Here's our reasoning:

MICROSOFT MATURES

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Microsoft ruled the computer world from the late 1980s through the 1990s. The combination of its Windows operating system, Office software bundle and Internet Explorer proved so dominant that the U.S. government sued the company for antitrust violations.

In 2000, Bill Gates, Microsoft’s visionary founder, stepped down as chief executive officer and gave the position to Steve Ballmer, his top lieutenant. Since then, Microsoft has made its share of missteps. Its Vista operating system nearly ruined Windows’ reputation, and technical problems plagued its Xbox 360 video-game console. Bing, Microsoft’s money-losing search engine, has just one-fifth of Google’s Internet-search market share. And finding someone who uses a Zune MP3 player is almost as hard as finding the Loch Ness monster.

Even without these problems, Microsoft’s sheer immensity would have made it difficult for the company to match the breakneck growth of its early years. So, as the company enters middle age, it continues to expand but at a pace more befitting a company with annual sales that exceed $60 billion. Over the past ten years, according to Value Line, its revenues compounded at 15% per year, while earnings grew 13% a year. In the fiscal year that ended June 2009, a period that coincided with the worst downturn since the Great Depression, Microsoft posted its first yearly earnings decline since going public, in 1986.

Still, Microsoft continues to produce prodigious amounts of cash. The company began paying regular cash dividends in 2003, paid out a massive $32-billion cash dividend in 2004, and as of June 30 had nearly $37 billion in cash on its balance sheet. On September 21, Microsoft announced that it would raise its quarterly dividend by 23%, to a rate of 16 cents a share.

None of this seems to excite investors, though. The shares, which traded at about $60 in 1999, closed September 24 at $24.77. In 1999, Microsoft’s average price-earnings ratio was nearly 50. Today, the stock trades at ten times estimated earnings for the next four quarters.

Investors are unwilling to pay a premium for future earnings with good reason. Despite solid sales of its new Windows 7 operating system and Office 2010 software suite, Microsoft faces a stiff challenge from Google, which is offering free or low-cost alternatives. Considering that Office accounts for about 60% of Microsoft’s operating income, this is no small deal. In addition, Microsoft is late to enter the smart-phone market.

On the positive side, Windows 7 is a winner at a time when many companies are updating their computers. Microsoft is expected to launch its new Windows Phone 7 smart-phone operating system by year-end, and its Xbox is now the top-selling game console in the U.S.

Conclusion: BUY. The stock is too cheap to pass up. “The valuation is extraordinarily attractive,” says Steven Rogé, a money manager in Bohemia, N.Y.

UNSTOPPABLE APPLE

Economy in the dumps? No one seems to have told Apple. Through thick and thin, the maker of slick computers, phones and other gadgets continues to grow at a pace more associated with start-ups than with large, established firms. Consider this: In the fiscal year that ended September 2009, Apple’s earnings jumped 18% from the previous year. In the current fiscal year, analysts expect earnings gains of—get this—134%. Over the past ten years, Apple’s earnings have advanced at a stunning rate of 45% annualized.

It’s easy to forget that a struggling Apple once had to turn to Microsoft for assistance. On August 6, 1997, after years of loses and dismal stock performance, Apple CEO Steve Jobs announced that Microsoft would invest $150 million in his company and produce Office for Apple computers.

The reversal since then has been astounding. Microsoft fell into an innovation rut, while Apple, based in Cupertino, Cal., became the king of hot devices. Its iPod and iTunes changed the way people get music. The iPhone revolutionized the smart phone, and the newly released iPad has made mobility the new ideal in computing.

It doesn’t look like growth will slow anytime soon. When it released its earnings for the quarter that ended in June, Apple said it was selling every iPad and iPhone 4 as fast as it could build them. Even problems with the iPhone’s antenna did nothing to stifle demand. And if Apple gets out of its contract to provide the iPhone exclusively to AT&T, demand for the device could increase even more.

Apple’s shares have performed as spectacularly as the company. The stock, which traded for less than $7 in 2000, now fetches $292.32 and has returned an annualized 27.2% over the past decade. Yet it’s hard to make the case that the shares are expensive. They trade at less than 17 times estimated earnings for the fiscal year that ends in September 2011—a P/E that is below analysts’ estimated earnings growth of 20% annually over the next three to five years. Apple doesn’t pay a dividend, but with a cash stash of $24.3 billion, it clearly could afford to do so.

Conclusion: BUY. As long as Apple creates exciting new products that fuel strong sales, the stock should shine. Note: Steve Jobs’s health is a risk.

GOOGLE’S GROWTH SLOWS

Google, the undisputed leader in Internet search, has metamorphosed from a supernova to a company that merely delivers superior growth. The slowdown has taken a toll on Google’s stock price.

In the mid ’00s, Google grew at a mind-boggling pace: Earnings soared from $106 million, or 64 cents a share, in 2003 (the year before Google went public) to $5.3 billion, or $16.69 per share, in 2008. On average, profits more than doubled every year during that period. Earnings per share grew “only” 22% in recession-wracked 2009, and analysts see profits rising 34% this year.

Google’s shares, meanwhile, jumped from their initial offering price of $85 to as high as $747 in 2007. They now trade at $527.29, reflecting, as with Microsoft, investor reluctance to pay up for a company with decelerating profit growth. Google’s P/E averaged 53 in 2005. The stock now trades at little less than 18 times estimated earnings over the next four quarters.

Google derives the overwhelming majority of its revenues from “paid search”—that is, it gets money when someone clicks on another firm’s Web site after using Google to look for, say, a hotel or a discount broker. Google has 65% of the global search market, according to Internet marketing research firm ComScore, a market-research firm. But the growth in Google’s search business is slowing, as evidenced by modest revenue increases in the first quarter of 2010 from the last quarter of 2009, and in this year’s second quarter from the first quarter. “It’s the law of large numbers,” says Peter Wood, co-manager of the Chase Growth Fund. “The desktop search market is maturing, so you won’t see the exponential growth rates of a couple years ago.” Moreover, some analysts think Facebook could erode Google’s dominance in search.

Google isn’t resting on its search laurels. The Mountain View, Cal., company has developed Google Apps and its Chrome browser to challenge Microsoft’s Office and Internet Explorer. And Google’s move into wireless phones, with the company’s Android mobile operating system, is off to a good start. In the second quarter, users activated 165,000 Android devices each day, up from 65,000 in the first quarter.

Conclusion: AVOID. Google is facing headwinds that are visibly slowing its growth rate. Its P/E may come down further.



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