Thinking About HP Enterprise

As we come closer to the official splitting of HP into two companies, I've been listening again to the HP presentations, looking at some of the other big players and reviewing  my SWOT analysis of HP Enterprise.

In the three year turnaround of HP, CEO Meg Whitman characterizes FY 15 as being a year of "accelerating progress," in which the combined company invested in security, networking, and cloud activities and acquisitions, as well as on improving execution.

She noted that research and development as a percent of sales increased in each of the three turnaround years.  The company, she said, introduced new products and services, e.g. all flash memory, 3Par storage, HP OneView, software defined networking, a Gen 9 server, enterprise-wide implementation solution for Office 365, and HP Helion, i.e. the public cloud.

Post-split, HP Enterprise will have pro-forma revenue of about $50 billion, with operating margins of over 9% and operating income of about $5 billion.  Fifty percent of revenue will come from enterprise hardware, 37% from enterprise services, 7% from software, and 6% from financial services.

Notice the absence of any reference to Big Data, a major theme of several conference calls during the three year turnaround period.  IBM still talks about this theme, especially in its research publications, and in connection with Watson.  What happened? Autonomy.  The only way this acquisition made sense was as the analytical engine and product generator for a Big Data effort.  That investment has been vaporized, and whatever remaining products are in the market can't sustain a major presence in this theme. A definite weakness going forward.

We've written for more than three years about the weak, commodity service focus of Enterprise Services.  Despite the cost base restructuring, the fundamental weaknesses of this business compared to others like IBM and Accenture remain.

A $4 billion software business which has flat lined for several years is too small to be important to the needs of CIOs in the transition to the next generation data centers.  Another weakness that we've identified for years is still in the standalone company.

I would surmise that CEO Whitman, in her heart of hearts, sees the same landscape.  How else to justify a statement like more than 90% of the IT spend over the next several years will be what she calls "traditional IT."  This should be comforting to investors, presumably, because 50% of HPE revenue will come from traditional hardware boxes.  Also, traditional hardware sales have historically been accompanied by enterprise services contracts.  Actually, these statements, which may be correct, are reasons to be very much afraid if one were an HPE shareholder.

Traditional IT Spend Means Further Hardware Commoditization

A recent podcast on the Andreessen Horowitz website, entitled "Dell + EMC: Say Why?" gives some interesting views on how CIOs will behave over the next few years.  The first generation model of the data center is what they call the "Wall Street Data Center," made up of server racks from vendors like Cisco, HP, Dell, storage products from EMC, and Oracle software.  The next gen data center is represented by Facebook, Google, and Amazon.

In their deployments, server hardware has been truly commoditized, to the point that the best way for Facebook to achieve performance for its particular business needs is to produce its own customized server designs.  The software layer of the stack is the critical element in this type of data center.

Dell's recent merger with EMC positions it as a systems provider to some types of enterprises in helping them get the the next gen data center configuration.  Dell, which survived commoditization of its once core PC product, is better equipped to survive a commoditization of server hardware than is HP, so the panelists suggest.

What Kind of Cloud For Large Scale Enterprises?

The Andreessen Horowitz panelists agree that the future will largely be made of up of hybrid enterprise clouds, incorporating some legacy structures alongside newer, next gen designs.  Public clouds are a losing business, given the efficient, excess capacity of Amazon Web Services.  As we have written for some time, AWS, despite some recent big wins in the public sector, won't be the option of choice for the largest, multinational corporations in data intensive, higher risk industries like financial services, energy, and transportation/logistics.  

HP recently announced that it is shutting down its Helion public cloud business touted as an exiting new product introduction by CEO Meg Whitman just a few weeks before; HP is sending its customers to AWS.  This leaves HP pursuing the hybrid cloud structure, against stronger competition.

The panelists cite the fact that relatively few companies have the kind of technically savvy, global sales forces to succeed in selling and implementing a hybrid cloud computing offering to the biggest global companies.  They name IBM, Microsoft, and EMC as being the strongest sales forces, and HP are not mentioned.  So, Dell's interest in EMC beyond storage is in acquiring a world class sales force in order to help it become a systems provider and service partner for its customers.  

Most companies, the panelists rightly say, cannot wave a wand, spend billions, and risk their businesses on a straight implementation from a Wall Street data center model to a Facebook-type data center. Instead, they reckon that most CIOs will recognize that there is excess capacity in public clouds and huge price pressures on hardware vendors; the customers will exploit both to give them a multi-year, relatively lower cost glide path to the development of some Facebook-style new data center architectures alongside legacy public clouds.  

The winners in the private enterprise clouds they reckon will be, as we have suggested, Microsoft Azure and IBM.  

HP Enterprises path to generating earnings growth beyond year 1 of easy comparisons will be fraught with difficulty, and raising research and development expenditures significantly or making big acquisitions will both be greeted by consternation on the part of new shareholders. HPE may still suffer from the past sins of the combined HP entity, despite a workmanlike, three year turnaround. 

Andreessen Horowitz and The End of Windows

I read a very interesting post by Ben Evans, a partner at Andreessen Horowitz, titled "Microsoft, capitulation, and the end of Windows Everywhere."

In many ways, what he says about Microsoft is right in alignment with our writing over the past few years.  In some other ways, namely about the future of computing, I am not sure that extrapolating the present gives the picture about the future winners.  It almost never does.

Mr. Evans introduces his article by saying that it's very difficult for large companies--like Cisco, HP, IBM and Microsoft--to throw in the towel on a business.  His identification of internal corporate processes driven by strategy teams and abetted by high price, outside consultants as outlawing giving up is hilarious, and true. I've sat through many of the "hundred-page decks" myself, arguing that tacking while staying the course was the best.

Back in 2013, we wrote,

• Establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market.(This means that the legacy though currently very profitable will inhibit real innovation.  Microsoft needs to let go of Windows and its legacy)

Ben Evans puts it succinctly, "Windows is not a point of leverage for Microsoft in mobile."  

He also debunks the strategy put forward by Microsoft CEO Satya Nadella which emphasized courting the developer community to build apps for Windows 10, which will appear across all computing form factors, from tablets to phones and desktops.  Again, Mr. Evans writes, "Uber doesn't have a desktop Windows app, and neither does Instacart, Pinterest, or Instagram.  The apps and services that consumers care about are either smartphone-only or address the desktop using the web, with only partial exceptions for the enterprise." 

He unfortunately confirms my suspicion that my value-driven move to Windows Phone on Nokia devices will leave me abandoned in the desert, as Microsoft often does to its loyal customers. Windows 10 will mean nothing to me on this device, as I have the look and feel, and the great apps like Here Maps already.  

We are in rabid agreement that "Microsoft has missed mobile," but I am not sure that I agree with Ben's  conclusion that all computing will be done on phones.  

The most current, relatively disinterested data on smartphone usage comes from Pew Research, and I direct my readers to their surveys and conclusions.  But, let's go back to another strand from the IT Guru Business, namely "Big Data," and Smart Cities and Smart Corporations.  We know that the back end of these houses are going to need massive computing power, mainly driven by cloud-style models with consulting and analytical support.  

On the front end, where are the analysts, directors, and VPs going to do all their data analysis, scenario testing, and supporting work for presentations?  Certainly, none of this can or will be done on a phone, unless people start carrying around 30" flat screens!  If this phenomenon is real, as all the tech CEOs have said, since they are reporting their multi-billion dollar revenue run rates on every conference call, then surely this significant transformation of enterprise research, analysis, business forecasting, risk management, and financial forecasting won't by supported by the growth in the number of smartphones.

Suddenly, a device like Microsoft Surface looks like a godsend, or Apple's Macbook Airs.  

Pew's research shows that, especially for younger users, whether students or entry level employees, smartphones are used to relieve boredom, to text, send photos, find friends who are in the neighborhood and other non-GDP enhancing uses.  

Is the smartphone the future of "computing?"  Who knows?  But, it surely depends on what's meant by "computing," The venture backed companies developing apps are doing it in office spaces, on big displays, backed by computing power supplied by Amazon Web Services and others.  They may use their phones to order pizza at the desk, but the future of computing is surely more complicated and nuanced than that.  

Cisco Hightails It Out of Some Businesses

Cisco made two executive announcements, namely a new CTO and a CDO ("Chief Digital Officer"--whatever that means).  The announcement about flattening the organization by eliminating layers of xVPs is long overdue, and it is a good, but unquantifiable, omen.

The more significant announcement is one about throwing in the towel on a September 2013 acquisition of flash storage provider Whiptail for $415 million. The legendary ability of Cisco to integrate acquisitions seamlessly has always seemed to me just that, a legend.

I have yet to learn about a large company acquisition of an entrepreneurial company that has resulted in an effective integration, including that of the founders and their internal teams. The particular fable of Whiptail is informatively told by a UK tech publication.

There will have to be more of this portfolio rationalization, given all the acquisitions Cisco has made. Cisco seems to have a really sales driven culture.  Delivering internally sourced, innovative new product on time seems not to have been a core competency, hence the acquisitions.

What will this look like going forward?  That will be the question for the new leadership team, with Mr. Chambers looking over the shoulders as Chairman of the Board.

Well, on the subject of the cloud, we really missed the boat on Amazon Web Services (AWS).  3 month revenue for AWS for the period ended June 30, 2015 was $1,824 million up 81% from the prior year period.  Even though segment expenses increased 54% on the same basis, the segment margin for AWS increased to 21% from 8% in the prior-year period.

Critics, of which I was one, will say that this public cloud revenue isn't where the action will be.  The truth is: nobody knows.  The CIA win for AWS over IBM was a real shot across the bow for the industry.  AWS revenues are annualizing at almost $7 billion based the six-month fiscal year-to-date numbers.  That Amazon was able to staff up both the technical, back office and sales organization for this kind of business growth so quickly should put the incumbents on notice.

What do you expert readers out there have to say about AWS?

Tech's Four Horsemen: A Midyear Checkup

Some of our leading, bellwether technology companies--Cisco, HP, IBM and Microsoft--have reported earnings recently, and although I have parsed them and listened to the basically uninspiring conference calls, the Four Horsemen all stand at the same crossroads, between reinvigoration or a secular irrelevance.

Notice that I avoid the word "reinvention," as I haven't seen organizations of the sizes of the four ever doing that; the word has become a cliche in financial lingo.  Lew Gerstner didn't "reinvent" IBM; he pruned the portfolio, changed players and shook up a staid culture, all of which together reinvigorated a sclerotic organization.

All of the organizations share one common fault: their boards and executive managements all misunderstood and underestimated the nature of the changing demands of their CIO customers and the rapidity with which their customers were being called on to respond to larger business issues, and not just technology issues as in the past.  They all missed the boat, and there are a lot of sharp people populating these behemoths.

Satya Nadella's remarks during his overview to his earnings call presentation referred to the "market transformation" that was hitting Microsoft, which he summarized as being comprising mobile computing and the cloud.  IBM and HP also talk about "big data," in addition to mobile and the cloud. John Chambers and his team intone about the "Internet of Things."

So, if the five year average revenue growth rates for IBM and HP are -0.6% and -0.5% respectively (according to Morningstar), then why are these companies furiously reacting rather than leading and innovating?  Cisco's revenue growth was 5.5%, and Microsoft's was 8.2% over the same period, but acquisitions and a virtual monopoly in a core business fortuitously helped these two companies perform respectably on the top line.

However, it is Microsoft CEO Satya Nadella who says that his company must undergo a "transformation" which will translate the market transformation into a "growth opportunity" in revenue, earnings and market capitalization.

With the recent CEO change at Cisco and with the relatively predictable character of their financial performance, I really don't have much insight into where this company is going, although with a median operating margin of 22%, healthy interest coverage of 18x, and relatively low debt-to-capitalization, it is positioned well to do something meaningful to reinvigorate a somewhat plodding, methodical story.

HP is creating a buzz for itself by splitting into two companies. HP Enterprise is their corporate IT facing business, the "growth company."  However, it's a very curious thing reading their red herring. Nowhere in the stated advantages of the split is there any reference to improving their ability and agility in serving their CIO customers better!

There are plenty of references to capital market issues, e.g. more strategic focus, better capital allocation, an optimal capital structure, and giving investors a growth company which should be valued better than a more diffuse portfolio.  Serving the customer should always come ahead of serving the shareholder, because without gaining more customers and increasing their retention and lifetime value, there will no source for rewarding the shareholders except financial engineering, up to a point.

For the six months to April 30th, HPE had revenue of $25.6 billion, down 6.4% from the prior-year period, with operating income of $1.2 billion, a 4.5% margin.  The Enterprise Group's revenue of $13.5 billion was relatively flat to a year-ago, and its operating income margin was 15.1%.  The Enterprise Services group had a woeful OI margin of 3.3%, and its issues are longstanding; the Software business revenue of $1.8 billion is far too small to drive the boat, and its operating margin of 17.9% is below par for the industry.  The successful reinvigoration of this company is by no means a slam dunk, and former CFO Cathy Lesjak, the voice of reason on Autonomy, has gone over to the former printer business.

IBM continue to attract the interest of legendary value investor Warren Buffett.  This aside, there is something really wrong at this company.  Writers at Forbes have cannily gone back to the career of retired CEO Sam Palmisano.  Thirteen consecutive quarters of revenue declines for a company of this size and pedigree ought to have generated board members handing in their resignations; it's inexcusable and unbelievable.

Mr. Palmisano's success came as a rainmaking salesman, but unfortunately that way of selling to the largely ignored, relatively lazy CIO has gone forever.  The nature of the sell has changed, and the customer, with some skin in the game for business success, is now asking questions and looking for value and partnership rather than new hardware and modest software updates.  Mr. Palmisano transformed his salesman's passions about quota records into a slavish focus on Wall Street numbers, hence the dreaded "Road Map."

Instead of returning all that money robotically to shareholders with declining revenues, acquisitions like SoftLayer should have been the focus much earlier.  The sales culture and organizational comfort have all got to change.  This late into the game, it won't be easy unless there are big, uncomfortable changes, which might make a somnolent board uncomfortable.  Gradualism has brought IBM's P/E to 10.3 according to Morningstar.  Warren Buffet has always said he is not interested in a mediocre company at a great price.  Does he own a great company at a great price? Only time will tell, along with a whole new attitude within Big Blue, and a new way of coming to market and making technical sales.

When IBM lost the CIA cloud contract assignment to Amazon Web Services, it was a big wake up call that even with a significant portfolio of federal government business, Big Blue lost a marquee contract to a relative upstart with better customer service, technical support, and hourly unit pricing. The company learned from this error and fixed many holes in its offering by acquiring SoftLayer.

Ending our review where we started, with Microsoft, we still wonder as we have since 2012's Microsoft Reboot post, if this company can reinvigorate itself with a portfolio serving two distinct markets--corporate and consumer--with one historically dysfunctional culture.  The consumer franchises should be extremely valuable to a different kind of company.  Despite its relatively high valuation metrics, Microsoft high returns, befitting of a software company, may be justified.  Its median operating margin is 33.2% according to Morningstar.  A true "transformation" of Microsoft in its current form seems very difficult, and some bloggers suggest that shareholder ValuAct has been lobbying for a split-up of the company.  This split-up would have all to do with core competencies, technical and engineering knowledge, versus understanding of gamers and the entertainment industry and what these actors want in terms of content and delivery models. Don't get me started on Windows Phone!

CEO Satya Nadella sounded a little frustrated on the company's most recent conference call, and he seemed to want to impose his stamp on every response to a question, a contrast to his more nuanced answers in the past, where he let his CFO take the lead.

We were very positive about Surface when it was a greenfield development project inside Microsoft, and indeed it sales more than doubled in the recent quarter, year-over-year, to $888 million. What's more the incremental gross profit contribution compared to the prior year was $1.33 billion.  When the company puts its mind to computing and making people more productive, that's more in its wheelhouse than are gaming and consumer entertainment.  Overall, there may have been some disappointment it Microsoft's most recent quarter, but there is lots of potential to unlock significant value if there can be a real cultural shift within this long dysfunctional organization.  Another wait and see.

Memo to CNOC: We Told You So About Canadian Oil Sands

In 2010, no less, when Canadian heavy oil deposits were beginning to have financial and energy pundits breathe heavily we posted about the economic and environmental problems associated with these deposits, based on our own work on these resources decades back. First of all, not all these deposits are created equal.

Extractive technologies may have improved, but the political and environmental risks, required returns on all-in costs, and realistic oil prices continue to place these resources, as a broad class, relatively low down the value chain.

Today, the CNOC's policy of trying to anticipate global energy futures and cement a strong position in extracting oil sands from its Long Lake project ran aground, according to the Wall Street Journal.
The problems are easy to enumerate, and they are not happening to state-owned Chinese enterprises for the first time:

• When venturing into production areas that are beyond the corporate technical competencies, don't go it alone and don't make big bets.  For this, see also Petrobras' experiences with deep offshore oil.
• Pick an established global partner, even if you have to give up some economics.
• Control is an illusion.  Global markets have confounded smart players in many fields since time immemorial.
• Environmental risks in environments like Alberta and the Arctic, for example, should never be underestimated.

Reducing its capital spending program will make it very unlikely that CNOC can fulfill its global aspirations without significantly reinventing its business model and strategy. 

Microsoft Says "Näkemiin" to Value from Nokia

Just before the closing of the Nokia acquisition, we had our doubts about Microsoft's ability to realize value from it. Some comments,

• "Microsoft too, under Steve Ballmer, has said "it's all about services," but the current Nokia platform is poorly positioned to garner anything more than the current 2-3% of all handset sales."
• "When the Nokia deal goes through I will be curious to read the level of charges taken for workforce reductions in Finland and for the allocation of the purchase price to intangibles and to goodwill.  That will tell a lot about this story will work, or not, in the future."

Well, the auditors went along with whatever rosy forecasts Microsoft had for handset sales, and they waited.  CEO Nadella made very bullish comments about understanding how app developers looked at the world; he was very bold in personally engaging with them about the future merits of writing for Windows 10 on multiple platforms, including tablets, combos, and mobile. 

Bulls talk about the fact that a $7.6 billion impairment charge on a less than $8 billion acquisition, net of cash, only enhances shareholder value because losses will be stemmed after the restructuring and the company can get on with its business of being a cloud services and enterprise software company. That is a pretty mechanical, textbook accounting view of the world.

As a shareholder, what if your company continues to trail developments in its industry?  What if it is always the perennial bridesmaid, late for her own wedding?  As a pure play cloud company, MSFT is probably overvalued, or fairly valued at best. 

What is the future for Windows Phone owners?  What if 2% of the handset owners switch over to Android?  

HP recently released a Red for its upcoming creation of HP Enterprise.  Among the reasons for the split, there was nary a single one that had to do with how the company put on a better face or presented a better value proposition to customers.  The rationale had to do with other things: you can guess what they were. 

After announcing the write-off of Nokia, it is very unclear what the Microsoft value creation proposition is going forward.  "One Windows Experience" across all platforms is pretty lame.  What if there is no one on the mobile platform?  Windows 10 has some slick features as far as controlling and working with smart tvs and other devices, but this isn't a big deal.  It's just catch-up....again. 

Twitter's Blue Bird Has the Blues

I confess that I have a Twitter account, at the suggestion of a tech industry CEO/founder friend who said it is essential to life on earth, but I also confess to not using it at all. I acknowledge that without Twitter, mainstream and cable news shows would almost certainly have less to talk about and therefore less broadcast time during which they can generate ad revenue.  They owe Twitter a debt of thanks.

I really enjoyed Twitter co-founder Biz Stone's book, "Things A Little Bird Told Me," which is about startups, a personal odyssey, the founding and internal culture of Twitter, and about his ultimate separation.  I really don't like business books, but this one rang true for me and was a fun read.

I remember from Stone's book that he was really the co-founder who interacted with the Twitter user base who, he says, effectively told the company how they wanted to use a new feature the company introduced.  There was such a community among the users, Stone, and the rest of the executive team that in the midst of one of Twitter's frequent outages, some users sent pizzas to the development team and Stone whom they all knew were pulling all-nighters to get things up and running.  When the delivery of the pizzas went momentarily unacknowledged, a big user Tweeted, "Didn't you get the pizzas?"  Such was the level of community among the corporation and the user community.

Stone goes to great lengths to say how much the 140 character limit, an inadvertent limitation caused by the early technology base, forced people to edit themselves and to be creative in how they did this.
Fast forward to today, and things seem different and exactly the same.  Instead of listening and watching how the user community deploys a new tool or feature, the corporation now uses the traditional A/B testing methodology used by direct marketers and catalogers since time immemorial.

The small, understaffed startup described in Stone's book now looks like a very bureaucratic, overstaffed, top heavy organization. It superficially seems like Google, but it seems more sclerotic.  It competes with Facebook for investors hearts, but it doesn't seem to have Facebook's culture.

Finally, executive infighting and the clash of personalities among co-founders has been going on since Biz Stone's early days.  This is exactly what the company doesn't need.

As the Wall Street Journal points out, the company seems afraid to incur the wrath of their high volume users, i.e. those who have trouble editing themselves; now the company is doing away with the 140 character limit which will encourage the fill the news feeds with endless oceans of boring and self-indulgent text.  But alienating these folks might be fine, if the company can find features and capabilities that will generate a large stream of new, active users.

This all feels so familiar, but Twitter had better rid itself of its worst cultural and organizational  practices before it becomes yesterdays news.

Windows Phone: Still Nobody at Home

I've owned a Windows Phone since they came out, because it was an inexpensive way to own a smart phone without succumbing to the siren song of Apple or to the the peculiarities of Android, where different users got or didn't get OS updates depending on their hardware maker.

I have written about the promise of the phones; because they are Nokia, they work well, and the Windows Phone OS isn't bad at all, and it works well with Outlook, which I have used for a long time.

I was impressed by CEO Nadella's comments when he first came on board about how he understood the needs of the developer community, and Microsoft would meet them where they live (their income statements) and increase the app store and therefore the user base.

Well, it looks like absolutely nothing has happened.  Windows Phone isn't an option for someone who wants to download popular consumer apps in many, many different areas.

I would guess that they are going to have to write-off some of the goodwill attached to the $7 billion plus Nokia acquisition, because surely the cash flows won't be there in the future.

At lease my phone still works, and Microsoft hasn't orphaned me as a user,....yet.

HP Buys Aruba: What Does It Mean?

Here we go again: HP makes another significant acquisition.  The timing, before effecting the separation of HPQ into HP Enterprise and HP, Inc. seems a bit awkward, but there were probably market reasons.

From what I can gather, Cisco having the dominant share in wireless networking (over 50% according to some industry research) couldn't have made a move on Aruba (around 13% according to industry trades) without some concerns about its prior Meraki Networks acquisition and without risks of being perceived by the Feds as anti-competitive.

Dell is probably preoccupied with its recent privatization and with internal redeployment of executives and resources to have done the deal now, but later...that could explain why HP moved now.  Many non-Cisco players have private-labeled or bundled Aruba's technology into their offerings already, including HP.  So now HP leaves Dell, Juniper Networks and Brocade out in the cold to forage over a smaller universe of targets to exploit new wireless standards with enhanced security.

According to Credit Suisse, the $2.7 billion price is 2.6x revenues, and CS projects that the acquisition will contribute about $0.07 per share to HP's FY 2015/16 earnings. According to Argus Research, HP's networking revenues in their prior fiscal year were $2.25 billion, and the annualized run rate of FY15 revenues for Aruba (based on their fiscal second quarter) is $852 million.  So, without any sales force synergies and without significant losses from Dell and other customers, Aruba's revenue contribution should be 25-35% of HP's 2015/16 networking revenues.

One thing this acquisition does point out: the acquisitions of Colubris Networks (2008) and 3Com (2010) weren't the best-timed, and the combination, along with deficient R+D spending dating back to CEO Mark Hurd's time, has failed to add value to make HP's offering credible in the future, without Aruba.

If HP Enterprise is indeed a "nimbler" company going forward and a more astute company, then the sales force, product development team and executives at Aruba will not only stay with HP Enterprise, but they will be enthused and energized by the possibilities for vastly increasing their distribution and market uptake.  If they get frustrated with a big bureaucracy of HP insiders who things the "HP Way," then this acquisition too could fall apart.

Creating an Enterprise-centric company via the split was probably a strong selling point to Aruba's management.  Let's hope that this acquisition is different.

Apple Pay on Your Apple Watch?

I forgot about the biggest head scratcher in thinking about Apple and what it really wants to be: Apple Pay.  There's nothing more profitable than a large payment network: just have a look at Visa, MasterCard, Discover and American Express.

Private label cards using the MasterCard or Visa networks are a wonderful business for their retail issuers, as research shows that they actually engender loyalty to the co-brander and, provided card users don't abuse their main card, the retail private label cards often get paid more consistently in times of financial difficulty for the card holder.

So, back to Apply Pay. Why?  Check out this link to the Apple Pay site. Look in particular at the picture that goes with this text:
"Apple Watch
 Double-click to pay and go. You can pay with Apple Watch — just double‑click the button next to  the Digital Crown and hold the face of your Apple Watch near the contactless reader. A gentle pulse  and beep confirm that your payment information was sent."

So, in order to save yourself the trouble of scanning the magnetic stripe or reading a security chip on a Bank of America card (pictured on the site), you are going to press a button on a screen which most people can barely read in order to save yourself a second or two, so your funds are debited faster? This physical action is exactly what I have to do on my old digital watches in order to change the modes: it's an awful movement, and in the case of the old watches, sometimes you have to press twice to engage the electronics properly.  The Apple consumer with a $500 watch gets her kicks out of this?

So, again, Apple wants a piece of the action from the big payment networks?  A company with a $700 billion capitalization is wasting its time doing this?

Meanwhile, MasterCard and Silicon Valley Bank have launched their own VC type effort to help entrepreneurial companies interested in setting up their own payment networks to profit from MasterCard's expertise on security and scale up strategies. The beauty of this effort is that MasterCard keeps tabs on what's out there, Silicon Valley Bank eventually gets a lending relationship with lots of warrants, and if successful, MasterCard buys new business.  Meanwhile, what will Apple Pay be doing?  Probably floundering around.

Much as I dislike the monopolistic payment networks whose interchange fees are still monstrously expensive given their economies of scale, it is good to deal with them when there are illegal or problem transactions on the card.  Because of bank and credit card industry regulations, it is easy to get problems on the record, with documentation, and eventually resolved, almost always to the consumer's satisfaction.

If Apple Pay were ever to become a significant enterprise, can you imagine contacting their customer support?  Who would they be?  Where would they be?  That organization would probably be as consumer friendly as Comcast.  What business is Apple in?  I think everyone knows.  Going forward, it may not be so clear, probably to the detriment of returns relative to the past decade.

What's Wrong With Technology's Four Horsemen?

It's the season for IBM, Cisco, H-P, and Microsoft to be in the financial news, with earnings results at the front of investor and customer psyches.

IBM

On the face of it, IBM appears to be remaking the portfolio with the sale of the commodity server business, semiconductor manufacturing, and exiting the low margin BPO business.  Acquisitions have continued, and the acquisition of SoftLayer looks like a good one, both timely and strategic. 

Along the way of this portfolio make-over, however, execution has really been poor, no matter what the geography and what the business, in constant currency terms. As a corollary to this, the Road Map finally lost any credibility and had to be abandoned.  For all the talk about seamless succession of executives, since this was a cornerstone of CEO Rometty's predecessor, it shows how quickly market changes can overtake even the industry leaders.  

Finally, we have noted before an undercurrent of frustration in the CEO's otherwise aggressively sunny presentation when she talks of "execution" issues.  Whenever this happens, an executive change within the CEO's senior leadership is announced, as it has for IBM and H-P.  More on this later.

Microsoft

Microsoft is trying to be two companies, one consumer-focused and the other aimed at the enterprise customer.  The new CEO was the right choice at the right time and seems to be doing and saying the right things.  This organization, however, isn't doing a great job on the consumer side, as we've said many times before.  

Look at Windows Phone.  Despite having a pretty neat OS that works on good Nokia phones, CEO Nadella's commitment to app developers to work on the Windows marketplace hasn't yielded any increase in the the share of Windows Phone.  Even Windows 10, which looks promising, is all about an operating system; consumers care about their experience on a device, whether a laptop, phone or a tablet. Somehow, in the Microsoft world, it's never as idiot proof to do things as it is in Apple's world. Surface Pro has had a tremendous ad campaign and exposure with the NFL, but it doesn't seem to be gaining meaningful share.

With recent product introductions by Dell and H-P in the laptop/hybrid form factors, maybe MSFT's intention was to force the OEM's to innovate more in response to Surface and Macbooks.  Maybe.

Microsoft's organization can use some serious rationalizing--the ill-chosen Ballmer reorg notwithstanding--- both in numbers and in the way the dual market-facing company works.

The stock has done exceptionally well, and the Enterprises businesses seem to be gaining a lot of traction.  After the recent quarterly results, brokerage houses have meaningfully trimmed EPS estimates for fiscal years ended 6/15-6/17.

Cisco

Besides managing the fortress balance sheet, their questions about margin compression in their core business product lines while managing their transformation into cloud, data center, and security products are largely unanswered.  The stock looks somewhat less expensive than their peers, but with the financial and operational murkiness, one wonders where this company is going over the next one-two years.

H-P

Breaking into two companies, which of course they now admit to discussing over the past year or two, shines a light away from the core concerns about the future, including the board, the M&A process, and how much more heavy lifting has to be done to truly transform the company, as opposed to the impressive and difficult financial realignment that has taken place so far.  

HP, Inc. based on 2014 results would have had $57.3 billion in revenue and $5.45 billion in earnings from operations, with a return on average assets of 24%, driven by a 40% return in Printing.  Future cash flows should be attractive and stable, and thiscompany won't grow too fast but can support debt and perhaps consolidate the printing business over time.  

HP Enterprise would have had $57.6 billion in revenue, $6.1 billion in earnings from operations, and an ROAA of 8.9%.  It is carrying a small, under performing Software segment with a 7.4% ROAA and only $3.9 billion in revenues, with too many small products.  The Services segment carries a 5.4% ROAA, the lowest in the portfolio, lower even than the rebounding Personal Systems group in HP, Inc. 

This business can do much better, but there are still many open questions.  Although the stock has rebounded since 2012, over the past five years it has dramatically under performed the S+P500 and the S+P IT Technology index, according to the 10-K.  

What's wrong with all these companies?  What's the common thread, the elephant in the room?

Going to market---it's the sales forces! Let's think about everything we've been fed by the company CEOs in conference calls, the CIOs, the industry gurus, the software gurus, and corporate governance gurus and put it together.

A New Selling Paradigm

1. Tech sales people have generally always made a great living, whether they sold hardware of software.  Marginal product improvements and enhancements, new models, and industry gurus crying wolf about security or energy efficiency were all enough to generally carry the day over a cycle.
2. IT executives were generally left alone by senior management, unless a VP were brought into the CEO's office to fix a printer or reboot a system.  Despite the governance gurus and folks Accenture and McKinsey protesting,  CIOs weren't real players in the C-suite.  I would bet most investors couldn't name the CIO of their portfolio companies. 
3. Business segment leaders cried directly to the CIOs about what they needed, and because they were the profit centers, they got it.  As long as the big budget came in where it needed to, nobody cared.
4. Sales were organized by geography, by product line, by type of account (national, global, key strategic etc) with lots of cross-over "sales teams" which never worked for the insiders or for the customers.
5. Going forward, things have to change.

• Issues like data security, especially in the case of global financial firms, e.g. JP Morgan Chase , now land right in the board room and the CEO's office.  It has to be a new kind of CIO, probably supported by other key executives like a Chief Data Security Officer, who is in the CEO's office answering questions and having accountability for lots more than a budget.  
• This new CIO will have to have a new relationship with the heads of business units, actually trying to understand their businesses, as opposed to just IT.  This CIO will have to respond quickly, without time for multi year major system makeovers or delayed data center openings. 
• IT, whether hardware, software, or services, probably won't be bought blindly from one vendor, just because of a history with a key sales person. The CIO and her staff won't have time for sexy sales presentations.
• The corporate sales staff too will have to understand their business unit customers and how they actually work, much better than in the past.
• In a sense, a new sales force will have to be more like Accenture-style consultants, but with specific product, software and application knowledge across a variety of offerings.
• This means a new kind of sales team, but a real team with accountability for more than hitting a quota or making the President's Club by individuals.  

IBM and H-P for sure have these issues to address, and the repeated references to "execution" during conference calls over the past two years have made this clear.  The Enterprise businesses within Microsoft have probably operated under the radar because all analysts used to care about was PC sales and Windows licensing.  VARs and other channels should be rationalized and used where appropriate, not just to move volume for reporting periods.  

Taking care of the new CIO and their more complex demands in a unique way with a best-of-breed offering and hands on service, perhaps at lower margins, will carry the day in the "new IT."  

HP in Barcelona Discover 2014

If like me you weren't able to attend the HP techfest in Barcelona, you can watch most of the speaker presentations on video.

As we said back in 2012, IT buyers needed a provider like HP that could deliver them solutions for their systems issues--legacy systems, burgeoning data, mobile applications, and higher hurdles for system security and compliance to name a few.  CEO Meg Whitman's accomplishments include convincing them that HP was such a partner.  Barcelona drives the same messages given consistently throughout 2014 with updates on new products and services, along with customer participation. 

A staple menu item in all the presentations is "Big Data," a term which clearly causes audiences to either cringe, yawn or glaze their eyes over.  

Software EVP Robert Youngjohns gave an interesting presentation on the New IT, forged from the fires of Big Data.  HP's approach, he says, distinguishes among three distinct types of Big Data:

• Business data, coming from traditional sources like the corporate ERP, CRM, BI, and HR systems, for example).
• Machine data (examples were log files and sensor data, i,e, the Internet of Things)
• Human data (Email, video, photos)

The first category, which seems to be where the corporate data engine room hits the financials, is growing slowly.  It is the other two categories, particularly the third where the growth is explosive. He went on to say that the HP big data platform distinguishes among each big data category and tailors the offering accordingly.

His presentation brings up my concerns about the vacuity of the term Big Data.  Businesses are still growing, in broad terms, at GDP-like rates, or at the upper end, single digit multiples of the same. Machine and human data are exploding at ridiculous rates.

He quotes another fluff statistic: more photos are being produced each day than in the first 100 years since the invention of the photographic process.  Surely, the obvious conclusion is that the value of machine and human data are fractions of traditional business data, from data about exploration wells to customer purchasing patterns. 

If the value were commensurate, IBM, Exxon and other Big Data producers capable of deploying new systems would be seeing explosive growth in revenue or profit.  However, nothing like this is visible. Bellwether companies like Cisco sometimes see revenue shrinking. 

Youngjohns gives a personal example that raises the same issue.  He is a tech geek at home too.  His home wireless network is very complex. He has the controls for his climate system managed by sensors and a panel.  He has imaging, music, television and other activities on wireless subsystems. He decided to find out why NetFlix was operating very slowly, and so created a reporting system of activity logs which, he said, soon generated a terabyte of data!  

Now, I couldn't hear anyone laughing in the audience, but they should have been. The architecture of this network is clearly faulty, at least the infrastructure and maybe more. Leaving this aside, big data in this case was bad data, and unproductive for its expected benefit, namely to make NetFlix run faster.  The hardware and software costs per unit of data are so low, which merely masks the unproductive nature of the activity. 

Moving on to another presentation on Data Centers and the Cloud, the same issues came up in a different way.  Data centers, we are told, have to provide services for all kinds of devices, like fitbits, videos, and sensors, again the Internet of Things. These apparently create large data streams. 

However, much of this are personal data, surely. Why should a commercial infrastructure expand to support this data demand?  One of the speakers really struggled to come up with examples of supported devices that didn't sound as ridiculous as Fitbits, but he couldn't.  The demands being put on data centers from personal uses like Instagram, SnapChat, Facebook and other social media stem from the BYOD policy that has become the standard in corporate America: it is a policy that requires more resources and which ultimately reduces employee productivity.  

He did cite an example of instrumenting the corporate vehicle fleet, where a large volume of operational data (speeds, routes, mileage, fuel consumption) would create large data center demands. This doesn't sound earth shattering, but just a move up from what's being done currently by operators like UPS.

The Haven platform brings together ArcSight, Autonomy and Vertica for data analytics, while also providing a broader platform and tools for asset and security management. Sounds like things are being put into place for HP.

Of course, now it is going to split into two pieces. Stay tuned. 

IT Buyers Face More Regulatory Risks For Business Interruptions

In yesterday's post about Cisco, we stated our belief that IT buyers, whatever their justifiable complaints against their traditional suppliers, need them as real partners going forward because of the increasing risks IT leaders face if their systems suffer business interruptions.

In today's Journal, the case of Royal Bank of Scotland made the business pages as RBS paid a fine of $88 million for an IT failure that kept customers from accessing or transacting from their accounts reportedly for weeks.

British regulators opined that there wasn't a underinvestment in IT systems which led to the failure, but rather an absence of adequate software testing systems which led to the outage.  Heaven only knows how regulators who were asleep during the global financial meltdown suddenly have become expert in software implementation and testing.  This is, however, the world in which IT buyers, particularly in financial services, are going to function from now on.

To save pennies on a project, bring in newer,smaller unproven partners, or to piece together hardware, software and services on an a la carte basis would be a risky way to do business and it wouldn't be good for an IT exec's career.

The Four Horsemen of Tech will continue to have an advantage going forward in the new world of IT, if they can change their go to market strategies and become more customer-centric: they don't have any other options.

Cisco's 1Q FY15: Looking Forward and Back.

Looking Back at Our Cisco Posts

"Cisco's 4th Quarter: A Tiger Changes Stripes," 8/16/2012

• Credit Suisse worried about 250-300 bp erosion in the gross margin rate going forward! (the time frame is not specified)

"Cisco: The Fourth Horseman Reports First Quarter 2014," 11/13/2013

• For the period 7/2008-2013, Cisco's shares return an average rate of 7.4% per annum, trailing both the Standard and Poors broad index (16.5%) and the Tech Index at 18%.
• $12.1 billion in revenue increases 1% y/o/y.
• It will take 4-5 years to transition the company away from a heavy reliance on its traditional core of switching and routing.  
• From 2008-2013 the gross margin rate declined 800 basis points.
• Long-term growth rates of 5-7% expected from a reconfigured Cisco. 
• If this were combined with operating leverage on a leaner company and better supply chain efficiencies, long-run value creation would be significant.

"Cisco's 2013 Financial Analysts Conference," 12/14/2013

• Core business growth might average 0-1% per annum over the next 3-5 years!
• Hardware still accounts for about 30% of data center spend.
• Servers account for 29%.
• Software accounts for 22% of the data center spend.
• "stock could have legs in 2014."

"Cisco's Fiscal Second Quarter 2014: Nothing New From the First," 2/13/2014.

• "When...(a stock is) priced like a 'going out of business' sale that's the time to take a look at the risk/reward ratio." 

"Cisco's Third Quarter and Cloud Computing," 5/18/2014.

• Customers apply 75% of their skilled labor to the management of their applications, software layers and infrastructure.  Over time, this ratio must fall to about 25% in order for them to meet the new demands on IT departments.
• This is the opportunity for vendors like CSCO, HPQ, MSFT, and IBM.

"Cisco's 4Q: FY'14: Low Quality of Earnings Concerns," 8/14/2014

• Concerns on the analyst call about the effects of software defined networks (SDNs).
• Switches are 30% of the quarter's revenues
• Acquisitions mentioned: Tail-f Systems; ThreatGRID; Assemblage, for mobile collaboration.
• Expect the share price to be range bound between $20-25 for the balance of the year.

Coming into 1Q FY15

• Facebook's announcement about its new data center architecture was seen as a negative for Cisco's earnings announcement and for sentiment on the stock's prospects: 

"Our previous data center networks were built using clusters. A cluster is a large unit of deployment, involving hundreds of server cabinets with top of rack (TOR) switches aggregated on a set of large, high-radix cluster switches. More than three years ago, we developed a reliable layer3 “four-post” architecture, offering 3+1 cluster switch redundancy and 10x the capacity of our previous cluster designs. But as effective as it was in our early data center builds, the cluster-focused architecture has its limitations.
First, the size of a cluster is limited by the port density of the cluster switch. To build the biggest clusters we needed the biggest networking devices, and those devices are available only from a limited set of vendors. Additionally, the need for so many ports in a box is orthogonal to the desire to provide the highest bandwidth infrastructure possible. Evolutionary transitions to the next interface speed do not come at the same XXL densities quickly. Operationally, the bigger bleeding-edge boxes are not better for us either. They have proprietary internal architectures that require extensive platform-specific hardware and software knowledge to operate and troubleshoot." [I love the unconventional use of the mathematical term 'orthogonal' in the press release]

The bears on all the Four Horsemen of Tech, especially CSCO and HPQ, would say that the mega-users are rebuilding their next-Gen data centers with their own designs, which include more software defined network architectures. (remember the concerns on the prior 4Q FY 14 call)

The 1Q FY 15 Results

• Revenue of $12.2 billion increases 1.3% over the prior-year period.
• The gross margin rate of 63.3% is the highest level in three years. (Remember Credit Suisse's projections from 2012)
• The operating margin rate is 29.2%
• Switching and routing are 47% of consolidated revenues versus earlier projections of two-thirds. (some of this might be bleeding off into new categories, but it shouldn't be that significant)
• New product introductions are cited, including ASA with FirePOWER, an industry-first threat focused firewall.  Perhaps the latter feature came from the ThreatGRID acquisition mentioned a quarter earlier.
• The stock price which began the year at $21.98 is at $26.59 intra-day as of this writing.  The stock indeed had legs in 2014!

What's Ahead?

• The world won't belong to Huawei.
• Even thought IT purchasers are taking longer to make their big purchase decisions, very few of them are going to design their own data center configurations.  Mix and matching will have its limits, as IT officers rise higher up in the executive chain with more visibility and accountability for performance and for mistakes. 
• The succession plan for CEO John Chambers is being signaled as evolving.  The revenue growth under Mr. Chambers has been nothing short of astonishing, although some of it was riding a tech wave for sure.  
• The next alignment of the executive team, the culture, and the ability to tell their story better will tell all about the stock's price appreciation potential.  Some board refresh would be appropriate.  
• So far, Cisco has been doing exactly what it said in 2012, which itself is unusual for mega-cap companies.  

Is Twitter For the Birds?

I recently read Biz Stone's book, "Things a Little Bird Told Me: Confessions of a Creative Mind." As a rule, I avoid business books because of their short half-lives, and in other cases their blustery tones from self-absorbed authors.  This book is relatively short, easy to read, and Stone co-founded Twitter whose market capitalization is $26 billion today.  Stone's personal story is interesting and different from that of the traditional, elitist Silicon Valley entrepreneur.  There are some interesting observations about start-up dynamics, personalities, and product development. I enjoyed the read, and wanted to catch up on Twitter today.

Among my network, there are lots of people who like Twitter for a variety of reasons.  I signed up without a smart phone, found it a bit hard to understand, and I am a member of the inactive users metric category.  Any way you cut it, Twitters valuations are off the charts, and today's junk credit rating from Standard and Poor's isn't encouraging.

In Biz Stone's book, he points out that Twitter's early user base helped define the platform's best features, like the hashtags and retweeting.  At the same time, he notes that the company's developer platform, today called "Fabric," was badly constructed and led to so many system crashes that users went to a site "IsTwitterDown.com."

Twitter had created something different, and its 140 character limit, which people loved or hated, turned out to be a real asset.  Users looked beyond the system issues and really became emotionally engaged with the company itself. Twitter goes public, and today it is close to where it started and the sentiment is decidedly negative.

I invested some time listening to a couple of presentations from their recent Analyst Day webcast.

The Public Company

Looking at the board of the company, two of the three (or four) co-founders remain on the board of directors, Evan Williams and Jack Dorsey.  So, in a sense, there should be continuity with the values and commitment to customer engagement which Stone writes about in his book.  

The board of directors seems okay for now.  There are two directors with venture capital and financial experience.  

It seems clear from the capital expenditures for the past two years that the company had been underinvested for some time, which is somewhat consistent with the crashes and continuous fire fighting recounted in the book.  Stock compensation expense is off the charts, but it's also clear that Twitter has built out a real management team befitting a valuable tech company, with the kind of experience it needs to go forward and innovate around its platform.  

The CEO and CFO presentations reflect the CEO's career at Anderson Consulting and they are cogent and pretty self-explanatory.  

The most interesting presentation for me was that of Adam Bain, President of Global Revenue and Partnerships. Given his prior corporate experience, he understands first-hand how advertisers work, think and buy media; he is a board member of the Ad Council.  If monetization is one of his main charters, this is the kind of profile he needs.

Having served as an officer of an NYSE direct marketer and with my analyst bent, I fully understand the importance of metrics.  This is where the bears are feeding on the Twitter story.  But, I also know from being a NASDAQ med device CFO that analysts can fixate on metrics that are important to them but that are not required for profit growth and success.

Some of My Bullet Point Notes

• Twitter has to become easier to use, for the novice user and for the discouraged, inactive user.
• Biz Stone noted this from his days at the company.
• Company acknowledged this under objectives "Strengthening the Core," and "Reducing Barriers to Use."
• Twitter connects users to their world and to the world, which are different.  The first is served by their current chronological stream of updates, while the latter will be served by tailored or curated products like "While You Were Away" under development. 
• Their approach to rolling out new products will be to do lots of testing before launch. This was spoken like a real, engineering driven company under some strict development protocols. This can be good and bad; I've experienced the bad, and I suspect Twitter has also.
• The last observation is based on executive comments about Engineering and Product teams being on the same page, with everyone having visibility into the timelines and to who is accountable.  This can be a real nasty problem, and it sounds like they've taken care of it going forward.  This can be a big deal.
• An analyst put forward his own metric on minutes spent on Facebook per user log-in versus minutes spent on Twitter; his score card was 40 minutes per user for Facebook and 3 minutes per user for Twitter.  
• There was a good response about looking at frequency, velocity and distance between visits at Twitter.
• The best response was "No advertiser buys on the basis of time spent on the site," which is paraphrasing Adam Bain, I think, since the speaker didn't identify himself. 'nuff said.
• Twitter commissioned interesting neuropsychological research from a British firm, 
• Twitter's emotional engagement with its sample users was 75% higher than the baseline sample population for similar brand and social network companies. This difference was the highest in the firm's experience.  Similarly, Twitter users' sense of relevance to their feeds were 51% higher than the baseline norm. Both of these translate into higher level memory retention, or "top of mind" which means more likely action.
• All of this is very consistent with the stories in Biz Stone's book.  (Look for the story about the tweet "Did you get the pizzas?" )
• Twitter has 672 million tweets sent out during the World Cup, the most watched sporting event in the world. I think that seems low, since the Cup usually has 900 million+ viewers: they can do better.
• But, when Luis Suarez of Uruguay bit Italy's Giorgio Chiellini, Twitter users got so emotionally engaged, it triggered a wave of targeted advertising by some of the biggest global advertisers for brands like Adidas, Snickers, McDonald's, and Cinnamon Toast Crunch.  
• It reinforced the immediacy of Twitter with both its users and the big advertisers who covet the ability to make multiple, direct connections to customers.
• 70% of their users are outside of the U.S., and the platform will be designed to work even in "low connectivity" environments which means for the emerging and frontier markets. 
• Analysts worried about their ability to get "free content" from big partners like the NFL.
• An executive gave a very cogent explanation why a rational mega-player who looked at their ROI would not immediately turn to a strategy of making Twiiter pay for highlights.
• Great example of a campaign for HP's "bendable laptop."
• Strong executive endorsements from T-Mobile, Pepsi and General Electric.
• Quite a spread of industries and customer types.

There's no hurry on this stock and although it appears priced for perfection, it may finally be on its way to becoming a company that creates shareholder value. 

A Wow! Quarter for Microsoft

Listening to the rebroadcast of the earnings call without visuals, one could sense CEO Satya Nadella verbally punching the air expressing his pleasure about Q1 2015's results demonstrating real changes at Microsoft in terms of execution, innovation, and putting the customer at the heart of what Microsoft does.  The customer is now regarded as a partner, not just as an ATM.

Look at what is happening to the competition. HP has chosen to split itself apart, which is probably the right action at the right time, but it will distract their customer-facing activities as the go-to-market operations change in size and charters.  IBM finally needs to go CEO Rometty's woodshed and reinvent its market proposition beyond the Smarter Planet commercials.  Cisco sits on its balance sheet and continues to blather on about the "Internet of Things."

Things don't buy hardware and software: people do.  Corporate buyers clearly want more from their go-to providers.

MSFT reported Q1 2015 revenue of $23,201 million, up 25% over the prior-year period, or up 11% excluding the $2.6 billion in Nokia Phone revenue (9.3 million Lumia smart phone units) included in the fiscal 2015 number.  Gross margin dollars increased 11% despite the inclusion of lower margin phone revenue and an unfavorable mix to low end equipment in that business.

Research and Development expenditures of $3,065 million increased 11% over the prior-year period. In addition to returning cash to shareholders, the company sends a message that it will continue to invest in innovation on behalf of the customer's future needs.

$1,140 million of integration and restructuring expense was recorded in the quarter, amounting to $0.11 per diluted share. GAAP diluted EPS of $0.54 in Q1 2015 compared to $0.62 in the prior-year period.  DPS of $0.31 increased by 11% year-over-year.

Apart from OEM Windows licensing revenue declining by 2% and Consumer revenue decreasing by 5% as the transition to Office 365 continues, all the businesses performed well, certainly compared to the competition.

Computing and Gaming Hardware revenue of $2,453 million grew by 74% year-over-year, and the gross margin rate increased by over five percentage points. $908 million of Surface 3 revenue in the quarter continued to demonstrate the potential for a device that can do real work, while having the look and feel of a tablet.

Devices and Consumer Other revenue of $1,809 million increased 16% year-over-year.  Search advertising revenue increased by 23% and Bing's share of U.S. search increased 140 basis points to 19.4%.  7 million Office 365 subscribers increased 25% sequentially over the prior quarter.

Finally, the Commercial Business revenue of $12,280 million increased a solid 10% over the prior-year period. Server product revenue grew 11%, and revenue increased across the range of servers from SQL to the newer, data center-oriented specialty servers.

Other Commercial Revenue of $2,407 million increased 50% over the prior-year period, driven by Commercial Cloud revenue growing 128%. The CEO noted in his remarks that 80% of the Fortune 500 use Microsoft's cloud infrastructure and services, while at the same time it was noted that the Azure pay-by-usage computing model is enjoying significant penetration into start-ups.  With Amazon's recent record losses, one would suspect that its commodity cloud services might be looked at askance as that company comes under pressure for its suspect business model.

Free cash flow in the three months ended September 30, 2014 was $7.1 billion, and $2,307 million in dividends were paid and $2,888 million in common shares were repurchased.

Finally, two new board members were joined the Microsoft board, both of whom add professional profiles and board experience that should serve the new CEO and the management team well.  Charles Scharf is the CEO of Visa, and he held senior executive positions at Bank One Corp., JP Morgan Chase, and Salomon Smith Barney.  Financial services companies with their massive volumes of transactions and their growing need for robust data security should be prime customers for Microsoft's commercial data center and cloud offerings.  Teri List-Stoll is the CEO of Kraft, Inc., and her twenty year career at Procter and Gamble should give her insight into the management and development of brand equity for consumer products; her service on the Danaher board is also useful because Danaher's culture (http://www.danaher.com/our-culture/danaher-business-system) which centers on the customer, measures efficiency and performance, and looks to optimize the portfolio is consonant with CEO Nadella's aspirations for the future Microsoft.

Overall, this quarter, especially in the current tech environment, demonstrates exceptional focus and performance across Microsoft, both in its business execution and its governance.  

IBM Folds the Road Map Hand

As far back as 2012,  we questioned the utility of the 2015 Road Map and its construction. Back in 2013, after CEO Virginia Rometty's overly enthusiastic presentation at Innovation Day, we felt that IBM may have been losing its way.  With the announcement of 3Q 2014 EPS, the Road Map has finally been abandoned. Better late than never.

The CEO's coming on to the investor conference call breaks with an IBM tradition: what a lousy tradition that was!  Abandoning the Road Map, though it came late, perhaps finally symbolizes CEO Rometty's uncoupling from the heritage of her predecessor, under whose leadership the company failed to act on a clearly emerging change in the demands customers would make on their key vendors for IT hardware, software, and services.

Shares outstanding have been reduced by a staggering fifty percent since they beginning of the mega-programs. We have written about these before, so need to go over the ground. Hopefully, it will become less of a focus.

We have always talked about the need for the Tech's Four Horsemen to reinvest in their core businesses, if indeed they want to stay relevant to their customers.  The good news is that IBM, in the CFO's prepared remarks, made specific reference to some sizeable initiatives:

"In the first quarter, you’ll remember that we announced a number of initiatives that
support the shift to our strategic areas of data, cloud, and systems of engagement.
These included the launch of Bluemix, which is our cloud platform-as-a service for
the enterprise, it included a $1.2 billion investment to globally expand SoftLayer
cloud hubs, and it included a $1 billion investment to bring Watson’s cognitive
capabilities to the enterprise. In the second quarter, we made progress to
implement these initiatives, including in June, Bluemix became generally available,
we opened new SoftLayer data centers, we started to ship POWER8, and expanded
the OpenPOWER consortium, and we completed substantially all of the divestiture
of our customer care business.
More recently, we announced additional actions to continue our shift to higher
value. You saw last week that we are investing $3 billion over the next 5 years in
research and early stage development to create the next generation of chip
technologies. Those will fuel the systems required for cloud, big data and
cognitive systems.And just a couple of days ago IBM and Apple announced a strategic global partnership to provide a new level of business value from mobility, for enterprise
clients."

SoftLayer was a big deal acquisition, and making these investments confirms the commitment to add value to it, not just to book revenue.

The next thing the CEO needs to do quickly is to act on something she noted in 2012, the irrelevance and misalignment of the go-to-market model of the old sales force.  Customers are crying out for a change: make it easier to deal with you and to figure out where our ROI lies!

Microsoft Is Changing For the Better: Evidence From 2014 4Q

Before looking at the numbers for FY14 Q4, I think it's more important to cover the many tells that things are really changing at Microsoft, for the better.

The first signs appear in Mr. Nadella's memo to employees about the 18,000 employee workforce reduction. Having been responsible for a reduction myself (about 1% of MSFT's, but 15% of our workforce), and having been part of several Wall Street reductions myself, I can say that they are almost always done badly for the organization's survivors and inhumanely for the affected employees. So what about this announcement?

The first was a quick reprise of contextual messages.  The company is on the road to becoming a platform and productivity company, which employees had heard the previous week. Having a focus, however, isn't a be all and end all.  

Aligning the organization, changing its culture, and improving communications and decision making within the organization are key initiatives that will take time.  The organizational staff reduction, unfortunately, is part of that longer-term change.  Thus, the CEO makes it clear that this is not an effort to cost cut one's way to success, as has been done with blazing incompetence by the likes of  "Chainsaw" Al Dunlap, and Ed Lampert at Sears, to name two. Along with these reductions will come resource additions in other areas.  The key message to employees: your organization is committed to grow, not to shrink its way to success. 

Finally, there is a human element, expressed in the statement, "We will offer severance to all employees impacted by these changes, as well as job transition help in many locations, and everyone can expect to be treated with the respect they deserve for their contributions to this company."  This isn't a phrase that would normally be offered by HR or by the general counsel; it really seems like it is a sentiment coming from the CEO, and that's good for the effected employees and for the survivors as they go through the grieving process with their former colleagues. 

On the quarterly conference call, there was a clear distinction between the styles, presentations, and nuances of the CEO and the CFO.  In fact, CFO Amy Hood sounded absolutely liberated from her former role of merely explicating and micro-parsing the financial numbers (deferred revenue forecasts, contracted versus billed revenue), and she added the CFO's restrained nuance to the always more enthusiastic and high level comments of a new CEO. Long term investors expect and like this differentiated,tag team approach. Together, it was a much more well stitched together set of messages than the previous environment, dominated by the overbearing Steve Ballmer.  
GAAP revenue for FY14 Q4 increased 18% year-over-year to $23,382 million, which included $1.99 billion of revenue from the inclusion of NDS for a partial quarter.  GAAP gross margin  of $15,787 million increased by 10%, and the GMR was a robust 67.5%, although this was down from an unusually higher rate in the prior year period.  

GAAP operating income of $6,482 million grew 7% over the prior-year period, and the margin was 27.7%, with all the moving parts. Nokia NDS contributed $(692) million to the quarter's operating income, of which $127 million was for integration and restructuring expense in the period. 

Diluted EPS of $0.55 per share declined 7% on a GAAP basis from $0.59 in the prior year period.  Dividends per share were $0.28 in FY14 Q4.  On a non-GAAP basis, which is interesting but not decisive to an investment thesis, diluted EPS of $0.66 increased 10% over the prior-year period. 

This Is A Software Company

While HP struggles to become more software-oriented, and while IBM divests a commodity server business to become more software oriented and relevant to corporate buyers, MSFT already is a software company with robust margins, despite appearing to become more of a hardware company through acquiring Nokia NDS.  

What's more important than this artificial hardware/software duality is the nature of the enterprises who will operate data centers, private, public, and hybrid clouds.  These are the customers who need to make significant investments, and they look to their trusted vendors to help them through their decision making process,  

Another thing about the new CEO is that it is clear that he can talk about customer requirements, hardware, software, data security, and computational issues with engineering, product development, and real life, customer-facing experience.  This kind of credibility will resonate with Microsoft sales forces and with the customers: this is a big deal and a big change from an MBA-type blathering on about "the cloud."  

This shows up, in our opinion, in the quarterly results where commercial cloud revenues increased by 147% year-over-year, driven by Azure, storage, computing services and the CRM online product.  The annualized revenue run rate for cloud revenues was cited as being $4.4 billion at the end of the quarter.

Microsoft Dynamics revenues were up 13%.  As a small enterprise, one of my companies adopted an early version of the former Great Plains/Dynamics software, and as a non-IT user, I found it uninviting and logically convoluted. However, for small and medium size businesses, facing the prospect of Oracle or SAP, is even more unpalatable. 

What About Commodity Hardware?

Server licensing revenue increased by 14% year-over-year.  Server product revenue increased by 16%. The Microsoft SQL Server product line had a major refresh with Server 14, and its revenues were up 19%.  

The corporate IT executives are under more and more pressure to deliver services of demonstrable performance and value from among the buzzwords, of clouds, big data, business intelligence, and BYOD. CEO Satya Nadella made the point when Microsoft, "operating some of the planet's most massive data centers," approaches customers with their Cloud OS platform, they build instant credibility.  He said that this platform represents one of the company's largest revenue opportunities, for as public cloud use increases the data center is where revenue growth will come from. 

Even, the much maligned Bing! search engine continues to garner share of U.S. searches, now north of 19% and revenue per search went up in the quarter.  This business is targeted to be stand alone profitable in 2016. 

Late To Tablets?

Microsoft Surface, for all of its being late to market, was built from the ground up on a totally different premise from most tablets, which as we've said are put to non-productive uses.  For business users, small, medium and large, productive work will involve working on documents, spreadsheets, and presentations. Surface has, and continues, to make its point that it is a viable laptop replacement with the virtues of a tablet. The CEO noted that a new form factor launch of Surface was tabled.  

The Surface Pro 3 is aimed at facilitating easy note taking, as with a pen, tying it in easily with One Note, which had been a forgotten application for a long time. 

Making Outlook.com and Office 365 accessible through apps for iOS was a small, but master stroke. Google Docs won't be the answer for most users, nor will Chromebooks for price/value.  The jury is still out on this venture, but Microsoft has planted a viable flag in the marketplace. 

The CEO's core investment principles were also interesting:

• Invest in the core platform and productivity businesses, e.g. cloud and device operating systems.
• Consolidate overlapping development efforts, which is a corollary of the reductions and reinvestment in fewer management layers and fewer competing groups.
• Run all businesses on a clear, simple model of business and productivity metrics.  This will be interesting and if it takes, it will mean that the culture will have changed dramatically.

There is a lot to like in the way FY 2014 closed under CEO Satya Nadella. 

HP's Business Risks

The "Risk Factors" section of a company's 10-Q is almost always a cover the waterfront, throw in the kitchen sink list that, once drafted at the behest of corporate counsel, is too rarely refreshed.  According to the securities regulations, however, it must bear some relationship to reality.  In that spirit, we looked at this section in the company's most recent quarterly for Q2 2014.

If we are unsuccessful at addressing our business challenges, our business and results of operations may be adversely affected and our ability to invest in and grow our business could be limited.
Three broad categories are discussed:

• Dynamic and accelerating market trends, but especially "the market shift to cloud-related infrastructure, software, and services, and the growth in software-as-a-service business models. After all, the CEO has said that this is the single most significant business development she has seen in her career. 
• Major competitors, e.g. IBM and Cisco, are expanding offerings of integrated products and solutions.
• Business specific competitors are targeting specific areas of HP's portfolio and going after new markets.
• Emerging competitors are introducing new technologies and new business models. 
• The final set of challenges "relates to business model and go-to-market execution."

The reference to business models is interesting: what does it mean?  It surely cannot refer to Software-as-a-Service, as this has been bandied about for a decade or more.  It also appears in relation to outside competition, and in the final bullet point as an internal challenge.  I believe that this could refer to the antiquated sales model in a large organization like HP, where sales forces are organized by consumer versus enterprise, by product, by customer size, geography, public versus private enterprise, and by product versus services.  Sales force effectiveness is often referred to in CEO code as "execution," which we have often heard from the CEO of IBM and the CEO of HP recently.  

Competitive pressures could harm our revenue, gross margin and prospects.

 "We have a large portfolio of businesses and must allocate resources across all of those businesses while competing with companies that have much smaller portfolios or specialize in one or more of these product lines. As a result, we may invest less in certain areas of our businesses than our competitors do, and these competitors may have greater financial, technical and marketing resources available to them than our businesses that compete against them. Industry consolidation also may affect competition by creating larger, more homogeneous and potentially stronger competitors in the markets"

This seemingly boilerplate paragraph addresses some of our repeated concerns.  HP's CFO has repeatedly made reference to decisions about share repurchases and other investment decisions being "returns based." HP's portfolio has some businesses that are being obsoleted by technological developments or changing customer requirements, e.g. UNIX based servers, developer reluctance to write new software for Itanium products, or lower demand for hardware being switched to cloud-based configurations. There is little reason to invest in these businesses from a returns standpoint.  The market will prune these parts of the HP portfolio.

There are other parts of the portfolio that HP should probably prune itself, like portions of Enterprise Services. 

HP has invested $1.4 billion through the first six months of fiscal 2014 for share repurchases.  There is no reason to make the suggestion that HP is at a disadvantage compared to competitors because it has to invest across a broader portfolio.  If "more homogeneous" competitors are potentially stronger, then surely HP can become more homogeneous, if the numbers and the customers will support this.  This shouldn't be a risk, nor should it be an excuse.  

Research and development expenditure of $873 million in 2Q 2014 increased 7.1 % year-over-year. Should it increase faster?  A big acquisition at this point, beyond the financial and integration risks, seems like it is unlikely to be successful because if the target had an entrepreneurial culture, it would have a difficult time maintaining that spirit in a behemoth that is in a continuing human capital restructuring that has just been extended.  

The post about 2Q 2014 is our jumping off point for this post, so have a look back. HP's evolution from this point forward has to move beyond quarterly guidance and forecasts.  The company is on a stable footing, and the financial risk has been sharply diminished, at great credit to the management.  However, from here it really has to be about a much more focused and clear picture of the future portfolio and investment requirements going forward.