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Caris & Co. analysts Mark Stahlman and Tim Boyd downgraded Microsoft from Buy to Above Average. In a note to clients they explain their rationale:

  • We are reducing our rating on MSFT to 2*/Above Average from 1*/Buy based on the likely adverse impact internal investment will have on intermediate term earnings.
  • We are lowering our GAAP EPS expectations to $0.30 from $0.36 for 4Q06 (June) and to $1.22, $1.43 and $1.82 from $1.32, $1.63, and $1.91 for FY06, FY07 and FY08, respectively.
  • Microsoft is at a turning point – it is no longer adequate to be a packaged software company. Despite its strong upcoming Vista product lineup, its dominant market position, its likely sales growth and its cash generating potential, Microsoft needs to remake itself. It is no longer a “product-driven” world; it is now a Digital Services world.
  • It is evident that Bill Gates is once again running Microsoft. For roughly 5 years Microsoft has been without strategic leadership. This has now changed. While this hiatus is normally discussed in terms of delayed products and a maturing company, the situation has been far more fundamental, in our view.
  • It is crucial to remember how Microsoft got into its current position. The company was nearly dismantled by the US government in a landmark anti-trust case filed in May 1998. Two years later Microsoft settled with the promise that it would do two things 1) learn how to build secure software and 2) remove Bill Gates as CEO. The release of Windows XP Service Pack 2 in late 2005 satisfied the second condition. We believe the result is that Gates has now resumed his leadership of Microsoft’s strategic direction. We regard this a positive longer term.
  • The upshot is that Microsoft will use the cash flow from the Vista “Wave” to build a new company-within-the-company. As we recently noted, there has been speculation that Microsoft would buy a media company. Our conclusion was that this would probably be a mistake. Likewise, we would view an effort by Microsoft to buy Time Warner’s AOL (NYSE:TWX) or Yahoo! (NASDAQ:YHOO) – as examples of rival Internet properties – to likely also be an error. We suspect that Microsoft will do better over the long term by investing internally.
  • How much will it cost to build a Digital Services company inside Microsoft? We believe that the price tag will be measured in 10’s of billions of dollars and could easily take 3-5 years to accomplish. We also think that it is a mistake to view this effort as simply competing with or trying to “match” the current capabilities of Google (NASDAQ:GOOG) or Yahoo! (YHOO). If we understand the way people like Gates think about such problems, we suspect that he is aiming at delivering capabilities that are not yet in demand. “What will people need 5 years from now? How can we uniquely deliver these services in the future?” are the sorts of questions Microsoft must now be asking itself.
  • Source: Caris & Co: Microsoft Should Use Vista Cashflow To Rebuild Itself (MSFT)