"Here is my first clue that this announcement spells trouble:
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This is the CEO who wrote the 2,700 word memo communicating the reasons why Microsoft was going to re-energize itself and its customers with a reorganization that would unleash "One Microsoft." One small problem: this man looks incredibly tired, bored, and devoid of any energy and enthusiasm for the message he is delivering. This is not a man who is going to take names; he badly wants to take a nap. He doesn't believe in what he is preaching: a Chinese menu of platitudes and buzz words."
Now, of course, the reason is clear: Mr. Ballmer knew he was a lame duck and was probably exhausted from coming to terms with the end of his tenure on a terrible quarter and on this dolorous announcement.
Microsoft is a AAA corporate credit with no net debt and $77 billion of cash on its balance sheet. Its operating income return on average equity for the fiscal year ended June 30, 2013 was 37%. Yet for investment returns over the trailing ten year period, its performance was marginally different from that of Cisco and Hewlett-Packard. Since 2000, according to the New York Times, Microsoft's shares are down 33 percent. Cisco shares are down 54 percent, Oracle's down 30 percent, and Dell is down 70% over the same period, according to the NYT.
Microsoft is a growth stock selling at 11x forward earnings? What gives?
The Windows Division is what the company was founded on in 1975, and 65% of the division's total revenues comes from the sale of the Windows operating system to OEM manufacturers who pre-install it on their desktops and notebooks. It also houses the Windows services and web services products like Outlook.com and SkyDrive. In the fiscal year ended 6/30/13, the Windows Division recorded $853 million of Surface RT and Surface Pro revenue. Sales of PC accessories like keyboards and pointing devices are also in this group. The operating margin for Windows Division, adjusted for the $900 million writeoff related to inventory of the Surface product inventory, was an incredible 54% of revenue.
This wonderful legacy business, which has a quasi-monopolistic stranglehold on corporate and consumer desktops, is also an Achilles Heel. The New York Times quotes Zach Nelson, CEO of Net-Suite saying,
"Microsoft had phones, Microsoft had tablets, but they tried to put Windows in them. They couldn't leave the PC world behind, even though they saw the change coming."Do you think that this issue is in the past? Think again. Read the Microsoft 10-K for the fiscal year ended 6/30/13, where the company talks about its big picture market opportunity. The company talks about (p.24, Pt. II, item 7) devoting substantial resources to:
- "Developing new form factors that have increasingly natural ways to use them, including touch, gesture, and speech. (Surface and successor devices which will mix segment margins down as volume increases.)
- Applying machine learning to make technology more intuitive and able to act on our behalf, instead of at our command.(Ray Ozzie's idea? AI may be for geeks, but this functionality is probably not what consumers will want)
- Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals.(Everybody is in this game. The winners could be new and several.)
- 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)
- Delivering new high-value experiences with improvements in how people learn, work, play, and interact with one another." (This sounds like a gaming company, like Nintendo, or a media company, or perhaps a new e-learning company. It doesn't sound at all like Microsoft.)
Can Microsoft "increase agility." Former CTO Ray Ozzie didn't see it MSFT's DNA in 2010 when he wrote, "Certain of our competitors’ products and their rapid advancement and refinement of new usage scenarios have been quite noteworthy. Our early and clear vision notwithstanding, their execution has surpassed our own in mobile experiences, in the seamless fusion of hardware, software and services, and in social networking and myriad new forms of internet-centric social interaction."
Steve Ballmer's announcement of the most recent reorganization was probably something that should have been left for a new CEO. What if (s)he has a completely different vision? This reorganization truly does look like rearranging deck chairs and a waste of resources, as we've said before.
Microsoft's board of directors is totally out of step with a company trying to step out and lead the transition to the kinds of market opportunities listed above in the company's own 10-K. The President of Harvey Mudd College. The CEO of Seagate, a key legacy device in the legacy PC. The former Vice Chairman of Bank of America. An investment banker with roots in the earliest days of the company. I've been tough on HP and its board, as have others, but this board is unworthy of one leading a company which, along with Intel, created a whole new industry and probably needs to reinvent that industry again.
They have left the succession issue too long, and the timing has been about as bad as it could be. The final reason for not owning the company now? Have you heard the names of some of the touted successors to Steve Ballmer? Carly Fiorina! Mark Hurd! Legacy CEOs-- and bad ones at that-- for a company struggling to go beyond its operating system legacy are not what the company needs. The stock should go down significantly on the announcement of either of these two candidates, and if it doesn't, a short position would probably pay off handsomely. Within eighteen months, the company would implode under the leadership of either of these two candidates.
More tech savvy CEOs who are strong operators have been mentioned, but one hire alone cannot overcome the cultural morass that is present-day Microsoft. The new CEO would get no useful assistance from the current board of directors. Overall, things are set up for the failure of a real outsider CEO. You say that Lew Gerstner did a comparable turnaround at IBM? The big difference is that the IBM board, a pretty decent one at the time, knew exactly what it wanted to do about its cultural issues, and it was willing to throw its intellectual and relationship capital behind their one and only preferred candidate. The Microsoft board has no comparable capital to offer a young CEO.
What's the real issue? As we've said before, and as you can see from Microsoft's own avowed market opportunities, there are probably three distinct technology companies within the current Microsoft. The first is the legacy Windows Division, which would have the enormous but tapering cash flows from OEM/PC Windows to switch over to Web based applications and services, along with tablets and phones for its future. If it wanted to develop a Windows replacement in parallel, it would have the cash to do so.
The second would be a fairly powerful and attractive Microsoft Business Division which would also include Servers and Tools. Revenues of this company would be north of $50 billion, and it would have extremely healthy operating margins, along with robust growth prospects compared to weakened competitors like Dell and others.
The third MiniMicrosoft would be an entertainment/gaming company with online services. This would be the company where, freed from an O/S legacy, some real risk taking and innovation could take place. It would need funding, but it would probably draw interest from institutional and strategic investors, provided that it had totally new management and a new culture.
This kind of change is unlikely, but it is necessary. Perhaps a holding company structure, where excess capital were dividended up to the HC and reallocated would be best. Some analysts talk about improving capital allocation within the new Microsoft. Highly unlikely. Microsoft is hugely overcapitalized, which is inefficient for investors in the current structure.
Put it all together, and there's no reason to own the stock now, but it does pay to keep the radio dial tuned to WMSFT-FM. I'll be listening.
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