Is Microsoft's good news bad for tech?

Microsoft got off easy. So why are its rivals rallying?
November 4, 2002: 4:56 PM EST
By Paul R. La Monica, CNN/Money Staff Writer

NEW YORK (CNN/Money) - Once a federal judge approved the terms of Microsoft's antitrust settlement with the government and nine states on Friday afternoon, you didn't need a clairvoyant to tell you that Microsoft's stock would be up on Monday.

But even the most talented of fortune-tellers probably couldn't have predicted the ripple effect that the favorable Microsoft ruling had on all tech stocks.

The Nasdaq gained 2.6 percent and even the shares of bitter Microsoft rivals like Oracle (ORCL: Research, Estimates) and AOL Time Warner (AOL: Research, Estimates), the parent of CNN/Money, took part in the rally. One notable exception was Sun Microsystems (SUNW: Research, Estimates), which fell about 2.5 percent.

It seems just a little bit odd, to say the least, that a company that has long been criticized for anti-competitive practices helped lead a tech surge on Monday, considering that Friday's court decision presumably will make Microsoft an even tougher competitor going forward.

"This doesn't change the size of the pie that people are fighting for. It just makes it more likely that Microsoft will get a bigger chunk of it without the government interfering," says Alex Vallecillo, senior portfolio manager of National City Investment Management, the subadvisor for the Armada family of funds. Vallecillo owns shares of Microsoft in some of Armada's growth funds.

Not much logic to rally

What's most curious, says Robert Lund, an analyst with Daiwa Securities, is that smaller companies that really stand to lose the most enjoyed big surges on Monday. Lund notes that RealNetworks, which makes media players that compete with Windows Media Player, was up more than 4 percent.

And Adobe, which develops the popular document viewing software Acrobat, was up nearly 12 percent...even though Microsoft recently unveiled Xdocs, a product that will compete against Acrobat. Microsoft (MSFT: Research, Estimates) gained about 6 percent.

But Lund says that because Judge Colleen Kollar-Kotelly rejected harsher remedies that would have made it easier to remove Microsoft features and icons from Windows, this could hurt Real Networks (RNWK: Research, Estimates) and Adobe (ADBE: Research, Estimates).

The more lenient settlement makes it less likely that computer manufacturers will decide to bundle software like RealPlayer and Acrobat with Windows instead of Microsoft's products, Lund says. He does not own any of the stocks he follows and Daiwa does not perform investment banking for these companies.

So why the big rally in these stocks? Vallecillo says that other factors lifting tech stocks were increasing chances that Republicans would win control of both houses on Tuesday and an anticipation of good results from networking equipment leader Cisco Systems (CSCO: Research, Estimates) as well as a rate cut by the Federal Reserve on Wednesday. But none of this changes the fact that Microsoft is probably in a stronger position now than it was on Friday.

Mike Mahoney, a principal with hedge fund firm EGM Capital, says that short sellers are probably continuing to buy beaten down tech stocks in order to close out bearish bets they made. Plus, he says, many investors appear to be afraid of missing out on the rally -- the Nasdaq is now up nearly 30 percent since October 9 -- and that has fueled further buying as well.

For these reasons, he thinks that the gains in stocks like Adobe, RealNetworks and AOL will probably be short-lived once the euphoria fades and investors realize that a more powerful Microsoft will make it tougher on competition. "The good news got people excited and a lot of shorts panicked but it will be interesting to see what happens Tuesday. I think Microsoft won't give back much of its gains on whereas Adobe and others will probably give back a lot more," Mahoney says.

Stocks getting pricey again

In other words, the risk of another tech letdown is getting greater. "This was a big win for Microsoft but it's virtually irrelevant for everyone else in technology," says John Rutledge, manager of the Evergreen Technology fund. It still looks like 2003 is going to be another tough year for most technology companies." Microsoft is Rutledge's fifth largest holding, accounting for about 4.8 percent of his fund.

Still, Rutledge says he would be wary of buying more Microsoft or other tech stocks any time soon. Rutledge says that in addition to little in the way of real improvement in earnings, valuations are once again looking expensive.