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Software Developers: Finding
the Next Microsoft |
Published:
January 21, 2008
Today Microsoft (Nasdaq: MSFT)
is a household name for most investors, and the company's products are
used by nearly 1 billion consumers worldwide. But in March 1986, when
the company first listed its stock, the world's largest software
developer was a relative unknown.
But investors with the prescience to jump into Microsoft's IPO
were amply rewarded -- through the end of 2000, Microsoft
returned more than +60,000%, enough to turn a $5,000 investment
into more than $3 million. And even if you were late to the
party, Microsoft was still a millionaire-maker -- returning a
total of +3,800% between 1992 and 2000.
Not surprisingly, the goal of every investor is to identify the
next Microsoft. Everyone would love to grab the next firm that
will come to dominate a market and produce phenomenal gains in a
matter of a few years.
Unfortunately, that's easier said than done -- there's no single
characteristic or quality that divides great companies from your
average, run-of-the-mill firm. If identifying the next Microsoft
were as easy as running as simple screen, everyone would be
doing it. But all is not lost; the companies behind the
best-performing stocks in history have frequently shared a few
basic characteristics such as a strong, defensible competitive
advantage and high profit margins.
Microsoft, for example, has several important competitive
advantages. First, the company's major programs, including its
Windows operating system and Office suite of software, are
dominant in their markets. Office and Windows are both used by
about 90% of all computer users worldwide. Even as a number of
competitors have emerged over the years, Microsoft has
maintained its dominance.
One major reason is that consumers have been trained to use
Microsoft products and are familiar with the software; switching
to a new program would require learning a new operating system
or word processor program.
In addition, consumers use Microsoft products because other
consumers use the same program -- what's often called a "network
effect." In other words, if you need to e-mail a file to someone,
you want to send it in a format that is widely used. Because
more than 90% of consumers globally use Microsoft's Word and
Excel programs, these have become the de-facto standards -- it
can be tough to convert files from Word to another word
processing program. Therefore, most users simply use Word, Excel
and other Microsoft products in order to avoid this problem. The
beauty of this network effect is that as Microsoft's base of
users becomes larger, this advantage continues to grow.
The second characteristic of many great companies is high profit
margins, the basis for what many analysts call "earnings
leverage." In many cases, high profit margins are the result of
a product with low marginal cost.
Again, take Microsoft as an example. The company sells software
either packaged on CDs or simply downloaded via the Internet.
Microsoft spends billions of dollars developing new software;
however, once those development costs are paid, the cost to
produce and sell one more copy is negligible. A set of CDs
containing Windows code costs less than $0.05 to produce, and
offering a program for download on the Internet is close to free
for Microsoft.
Thus, once Microsoft sells enough of its product to cover fixed
software development costs, most of its additional revenues drop
straight to the bottom line. This is one key reason that
Microsoft's profitability metrics are so reliably strong.
One of the most common measures of profitability is
operating margin. Calculated by dividing a company's
operating profit by its sales revenues, operating margins are
expressed in percentage terms. Microsoft's trailing operating
margin stands at just under 38%. To put that into context,
consider that the average operating margin for S&P 500 companies
is around 15% -- a margin of 38% puts Microsoft in the top 7% of
all companies in the U.S..
My decision to use Microsoft as an example of a profitable
company with competitive advantages wasn't random. After all,
Microsoft isn't the only software company to sport strong profit
margins and a wide moat.
The average operating profit margin for the Bloomberg World
Software Index currently stands at nearly +20%, significantly
greater than the S&P 500. Of course, that's just an average, the
best in the business sport margins significantly greater. As you
have learned, this metric means that software developers are
particularly profitable, and thus can make prudent investments.
In the table below, my staff and I list of some of the largest
software firms traded in the U.S. And in the text that follows,
we highlight a handful of the most promising plays in the
industry.
Important Note: In the
remainder of this article,
StreetAuthority Market Advisor editor Paul Tracy
provides a table listing 15 promising software companies with
operating margins as high as 42%, and he gives in-depth profiles
of the two companies he likes the most. However, in order to
view the remainder of this article, you'll need to subscribe to
our premium investing newsletter --
Market
Advisor. After you subscribe, you'll receive
immediate access to this full article, as well as our monthly
Market
Advisor newsletter and a host of additional premium
content. Please visit one of the following links to continue . .
.
-- Paul Tracy
Editor
StreetAuthority
Market Advisor
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