Nokia Makes The Deal With Microsoft: Patents Pending.

Microsoft made its inevitable announcement about Nokia's wireless devices and services businesses , but it was also wound up being a good deal for Nokia, which retains 50% of its pre-divestiture sales and adds a boat load of Microsoft's cash and access to cheap financing.

We were surprised by this part of Microsoft's announcement, namely

"Nokia will retain its patent portfolio and will grant Microsoft a 10-year license to its patents at the time of the closing. Microsoft will grant Nokia reciprocal rights to use Microsoft patents in its HERE services. In addition, Nokia will grant Microsoft an option to extend this mutual patent agreement in perpetuity.In addition, Microsoft will become a strategic licensee of the HERE platform, and will separately pay Nokia for a four-year license."

In the end, it may make no difference, given the option to extend the agreement; a purchase of the portfolio probably would have taken too much time for haggling about the valuation and it would have driven the price tag much higher. Microsoft's paying for the HERE product, a competitor of Google Maps,  with a four-year license, as opposed to a comparable ten-year license is interesting.

Steve Ballmer's letter to employees is really confusing for an outsider and reconfirms the point that the current Microsoft couldn't and shouldn't be the future Microsoft, if it is going to thrive.  Stephen Elop certainly moves higher in the next Microsoft CEO sweepstakes, and Julie Larson-Green moves off the list from reading the labyrinthine structure into which she falls after this acquisition.

The issue of Microsoft's other hardware partners being miffed by the acquisition seems off the mark.  Their relationship was always one of partner, not exclusive partner.  If Windows Phone has a 3% share of the mobile phone market, clearly Microsoft is commuting to make this bigger with the acquisition of Nokia's cellular assets.  Developing a proprietary mobile/table OS wouldn't seem like a good risk/reward proposition for HP. For Samsung, this is a different story, which probably is exactly what it needs to do over time. The unlocked Nokia 521 Windows Phone for T-Mobile certainly seems attractively priced for the features and is available at the new Windows Store; this could be the beginning of a more value-driven foray into the smartphone market. Let's see.

If Microsoft can organize the new mobile/wireless organization headed by Stephen Elop and reporting to Ballmer into a new kind of organization, i.e. working together as opposed to at cross purposes, this would be a step forward.

Microsoft Moves Towards A Reboot? Questionable Corporate Governance?

Well, it surely didn't take long.  We wrote a few days ago about Microsoft needing a major corporate reboot that should involve radically changing the corporate structure.  A day later, comes the announcement that the Microsoft board "offered" a board seat to ValueAct Capital Management, blandly characterized as an "activist investor."

The problematic question is "Why?"  The follow-up question is "Why this investor?"  Reuters reports ValueAct owning a 0.8% stake in Microsoft, hardly a level that bespeaks meriting a board seat on its own. Is there unique expertise at ValueAct?  Co-founder Jeff Ubben ran Fidelity Management's Value Fund, and when he left, it had $4 billion under management when he left to join the merchant bank Blum Capital. Again, this is certainly a high level of asset management experience, but hardly unique or noteworthy.

Here's an interesting video in which Jeff Ubben talks about ValueAct's approach to active investment management:

ValueAct, according to Reuters, will be prevented from launching any proxy action against Microsoft while serving on the board.  But, in a sense, ValueAct has become a "senior equity shareholder" to other larger, non-insider equity owners of Microsoft.  Why?

Can their stake change while they serve on board?  Hopefully not.  They could turn out to be a source of ideas to restructure the company, which I would believe would be along the lines we wrote about, which is about a fundamental rethinking of how capital is allocated within a different corporate structure.  The problem is that the option of getting feedback and ideas from shareholders is always open to a savvy management with open communications with all of its shareholders.  Handing a board seat to a small investor in order to get ideas hardly seems like a "value."

Just like Steve Ballmer's announcement, the timing and content of this announcement are quite peculiar, and it should be explained by the company, beyond shareholders having to read a Reuters news story.

Greg Mankiw and the Carbon Tax

For the past few years, we've written lots of posts around environmental policies and their nexus with the economics of energy sources, like oil, gas and coal.  "Cap and trade," a scam waiting to happen, seems to have faded with the European system's dysfunctional performance.

A "carbon tax" isn't the perfect instrument, but if the legions of environmentalists, government policy wonks, and corporate execs to who pay lip service to 'climate change' are serious about what they profess, then a carbon tax is the way to go to get real results, directed by market mechanisms and not by government czars.

Now, Professor Greg Mankiw of Harvard has written a New York Times editorial with a cogent, non-partisan article challenging the various academies to implement a carbon tax.

We wrote in 2011, "The carbon tax hasn't had a strong, visible voice in the political and economic markets for some time. Hopefully, one will emerge soon."  It's nice to see the hoped-for emergence. 

Ray Ozzie on Why Microsoft Needs To Smash Its Own 'Windows'

Here is what Microsoft's short-time executive Ray Ozzie wrote to Microsoft employees in 2010.  It's all here about Windows.  The Windows strategy was developed by a hyperagressive Microsoft team led by Bill Gates in partnership with Intel, and it certainly worked, but it sowed the seeds of its own demise, as many things in nature do.

"Complexity kills. Complexity sucks the life out of users, developers and IT.  Complexity makes products difficult to plan, build, test and use.  Complexity introduces security challenges.  Complexity causes administrator frustration.

And as time goes on and as software products mature – even with the best of intent – complexity is inescapable.

Indeed, many have pointed out that there’s a flip side to complexity:  in our industry, complexity of a successful product also tends to provide some assurance of its longevity.  Complex interdependencies and any product’s inherent ‘quirks’ will virtually guarantee that broadly adopted systems won’t simply vanish overnight.  And so long as a system is well-supported and continues to provide unique and material value to a customer, even many of the most complex and broadly maligned assets will hold their ground.  And why not?  They’re valuable.  They work.

But so long as customer or competitive requirements drive teams to build layers of new function on top of a complex core, ultimately a limit will be reached.  Fragility can grow to constrain agility.  Some deep architectural strengths can become irrelevant – or worse, can become hindrances.

Our PC software has driven the creation of an amazing ecosystem, and is incredibly valuable to a world of customers and partners.  And the PC and its ecosystem is going to keep growing, and growing, for a long time to come.  But today, as I wrote five years ago, ”Just as in the past, we must reflect upon what’s going on around us, and reflect upon our strengths, weaknesses and industry leadership responsibilities, and respond.  As much as ever, it’s clear that if we fail to do so, our business as we know it is at risk.”

And so at this juncture, given all that has transpired in computing and communications, it’s important that all of us do precisely what our competitors and customers will ultimately do: close our eyes and form a realistic picture of what a post-PC world might actually look like, if it were to ever truly occur.  How would customers accomplish the kinds of things they do today?  In what ways would it be better?  In what ways would it be worse, or just different?

Those who can envision a plausible future that’s brighter than today will earn the opportunity to lead."

No matter how much time Microsoft's executive recruiters spend on their search process, whomever they find through the predictable process, no matter how talented, will ultimately be chewed up by the stultifying Microsoft culture before (s)he claims victory and is replaced. The entrenched forces are too numerous and too deeply dug in to believe in another new messiah.

Rick Webb of Quotidian Ventures has a provocative thesis.  He believes that Microsoft will acquire Ray Ozzie's Taiko start-up and name him their new CEO. He recently joined H-P's board, which was a coup for them.  This would be a pretty radical move, but unless it's driven and approved by Bill Gates himself, it won't happen.  If Mr. Ozzie couldn't change Microsoft from inside before, what will have changed by taking the reins now?  Credit for a refreshing idea, Rick. 

Microsoft Needs A Major Reboot to Stay Relevant

Given the CEO Steve Ballmer's recent announcement of his intention to step down in 2014, I had to reprise this from a recent post.

"Here is my first clue that this announcement spells trouble:

                                                                                            credit: Getty Images
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.)

Culturally, it has long been the case within Microsoft that the Windows cabal carried the day for resources and rewards within the company.  The degree of this dysfunction may be subsiding but it is real and very problematic for the company and for its next CEO.  As Zach Nelson says later in the NYT article, "You can imagine a world without Windows..."  Microsoft itself needs to do this, but within the current corporate organization, addressing this kind of change is impossible no matter who the next CEO is.

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.

HP's Separation Anxiety: Take A Deep Breath

A friend of mine who is a globally traveled, senior tech industry executive and problem solver asked me this question, "How did HP do in its most recent quarter?."  The best answer I could give him was. "That depends on what you're looking at."

Overall, the quarter ending 7/31/13 was greeted by Wall Street sending the stock down 12% on the day: a pretty strong reaction.  But, putting it in perspective this left the stock's YTD run up at over 66% versus the prior day's number of 78%. This is still an extraordinarily robust gain, no matter how an investor looks at it.

GAAP revenue was down 8%, and down 7% on a constant currency basis.  Clearly this was a disappointment to the CEO, and a brave face couldn't disguise that it took some air out of her best positive face.

Total Personal Systems sales were down 11%, but really this shouldn't have been a surprise in direction, but perhaps in degree; industry reports on PC shipments and other anecdotal information intra-quarter would have suggested that it was going to be a tough quarter.  Notebook sales were down 16% in dollars, 14% in units and 2% in price.  Desktops were down 10% in sales, 9% in units and 1% in price.  Given the bad timing for the release of Windows 8.1, the notebook retail channel is probably congested with stale product. Pricing didn't collapse, but the fourth quarter might not be pretty either. Again, none of this is new.

Total Printing sales were down 4% y/y, with consumer hardware sales flat.  Overall, not a real negative surprise.

The real stinkers in the quarter from the revenue perspective were the Enterprise Group and Enterprise Services.  Again, the CEO made reference to the Enterprise Group's go-to-market issues which were clearly not something she expected with a mature product offering and long-serving executives.  ISS revenues were down 11%, but again this shouldn't have been much of a surprise since Dell's quarter showed a phenomenon, namely that industry standard servers are commodity products whose scale, cost, energy performance and computing power per rack will make them dinosaurs in an industry transition.  Overall, Enterprise Group revenue of $6.786 billion were down 9% y/y, with the higher margin Technology Services business declining 7% also. The Enterprise Group's operating margin had compressed sharply in the fiscal first quarter, and with continuing sales declines, this business needs to get its act together, but it's not exactly rocket science to determine what needs to be done.

The Enterprise Services Group, a business which we don't think is critical to HP's future in the current configuration, declined 9% y/y with the fading BPO business declining 7% and the Application and Services Business declining 11%.  This business carries a 3.3% operating margin which is comparable to that of the PC business, and yet this ESG gets no discussion on the investor calls.. We've said it before: HP can't be Accenture or IBM in this business, and it doesn't need to be in order to succeed.

So, to this point, the answer to my friend's question would be "It was a lousy quarter."  GAAP diluted EPS was $0.71 versus ($4.49), but clearly this isn't a useful comparison and it meant nothing to a trader reading the headline.  Adding back $0.15 per share for amortization of purchased intangibles, restructuring charges and acquisition-related charges, third quarter Non-GAAP diluted EPS was $0.86 versus $1.00 in the prior year period, on a comparable basis; the prior year period had $5.57 per share in charges for the same categories. Without the promised and delivered cost cutting, the comparison would have been much worse because of the revenue shortfalls discussed above.  The non-GAAP operating margin in the quarter was 8%, a 100 bp decline over the prior year period margin, despite an 8% decline in net revenue.

Cash flow from operations surprised most analysts to the upside with $2.7 billion in CFO, declining 6% y/y; total cash returned to shareholders is something we liked because of the $253 million returned in the fiscal third quarter, only $3 million came from share repurchases and $250 from dividends.  Altogether, looking at Non-GAAP EPS, CFO, funds returned to shareholders and paydown of debt it was really a solid quarter of financial performance.

Here are some bullet points from the Wall Street Journal's discordant story, "H-P's Separation Anxiety"

• Meg Whitman is shuffling deck chairs;
• Her strategy could "still sink Hewlett-Packard;"
• Ceding market share in order to maximize profitability "seems misguided."  
• The company seems as "strategically moribund and unmanageable as ever."
• Lenovo could be a strategic bidder.
• Dell is "cutting price on its gear so that it can grab customers who then sign higher-margin service contracts."  
• Bernstein analyst says the company is worth 50% more than its "current" price being sold for parts.

Let's start from the most trivial points first.  The same analyst who called the stock more undervalued than any stock he'd ever seen at $12 and stayed neutral as it ran away, and in January 2013 his sum-of-parts guesstimate was $29 per share.  Well, it's $22.40 today, with about $0.26 per share also having been returned to shareholders in the interim period.  This is beating the bushes for a deal and just self-serving. 

Dell: well there's certainly an industry leader worth emulating.  If they were cutting prices to grab customers, then that explained their most recent, horrendous quarter on all counts.  The CEO himself, in a totally disingenuous way, has said that he can't take the measures he needs to take to fix his business while all the financial dirty laundry is public.  Is there any evidence that Dell landed major service contracts from giving away gear?  That's a one-time only deal anyway, if it were true.  Trivial point two is laughable.

Lenovo a bidder?  Not likely, unless the Chinese government were to write the checks.  Even in that case, the announcement would crater the HP credit rating, hit the IGC bond holders--who are, in some cases, also equity holders--, and it would rile the U.S. Government and CIOs around the world.  Talk about uncertainty: if you thought the Dell process was a mess, this one would be a value destroying debacle. 

Picking up on the last point, the CEO in her opening plenary statement to Discover 2012 in front of 15,000 participants and 120 Chief Information Officers, said "You want us to win."  We've made this point before, namely that the CIOs want to have at least one or two viable global players who can sell and service platform agnostic solutions, as opposed to shilling appliances and applications separately. 

Remember when G.E. was the global darling of the financial press in Jack Welch's hey day?  Their corporate slogan was "We want to be #1 or #2 in every business we're in, otherwise G.E. will get out of that business." Well, according to Meg Whitman at Discover 2012, HP is #1 or #2 in every business in which it competes.  Now this clearly can't line up with the reporting segments, but I think that you get the idea.  HP has global distribution, presence, and scale that mimics the customers who will need to served in an IT industry that is going to shed many of the go-to-market practices of the past thirty years.  

So, what are the questions and some of the substantive issues at this point in the incipient turnaround?

First, the current strategy has been vetted and belongs to the board; it is not Meg Whitman's strategy any longer.  This is certainly more than can be said for those of Mark Hurd and Leo Apotheker, who did things that the board learned about by reading the newspaper.  It's a nuts and bolts, fundamental strategy of sizing the cost structure to the future business, and as such it's a marathon not a sprint. 

The CEO made a telling comment at Discover 2012, "It's hard to kill founder's DNA."  She was trying to portray the DNA of the founders as being in customer service.  I don't think that's what the business historians would say was the legacy of the founders. One element of their culture was clearly innovation.

CEO Whitman makes proud reference to the work of HP Labs, which is their equivalent of the iconic Bell Labs of the old ATT.  In an environment where the IT customer can't keep up with the future evolution of the industry, credible global players have to do this for the customers.  The CEO has refreshed HP Labs, but she has also said that they need to speed up the transition from a lab idea to a commercial product.  I would guess that the HP Moosnhot server platform is probably one such innovation, but there have to be more and they must be produced on a faster cycle.

The structure and culture of the company has become sprawling and ossified.  The CEO clearly has been giving unprecedented access to employees deep within the senior ranks through different communications media, and this takes time but it has impacted morale for the better.  To switch again would be deadly.  

The one valuable discussion that took place on the third quarter conference call was one about the to-date almost exclusive reliance on HP veterans to lead all the businesses, with the exception of Software.  This seemed to catch the CEO a bit by surprise, and she thoughtfully stated that she had looked to insiders for their knowledge and presence with customers, but that it was something to consider.  I do think that this is something to consider, and what looks like shuffling of deck chairs could be a prelude to more fundamental leadership changes, from which the company's strategy would benefit. 

The issue of Autonomy should be addressed once and for all. If the U.K. Office of Serious Fraud has yet to opine on Autonomy's numbers, it suggests that perhaps there was nothing there.  In her 2012 remarks to Discover, the CEO says that the company is "100 percent committed to Autonomy and Vertica" for products, technology and innovation.  She made specific references to Autonomy capabilities in new products.  If this is so, it's time to tell shareholders that a lot of remarks were made in the heat of the moment, perhaps driven by board members trying to save face and that the company has moved on.  

The final point: the new board members are promising, but an entire board that reflects the cloud, mobility and big data--the essence of the future HP---would be a boon to the CEO and for shareholders.

P.S. Another company in Redmond, WA announced earnings and an executive change.  Now this one should be drawing a lot more attention than it has.  More later.

A Preview from Jackson Hole

The Kansas City Fed's Jackson Hole Conference kicks off its working sessions tomorrow with this item,

 “The Natural Rate of Interest, Financial Crises and the Zero Lower Bound,” presented by Robert E. Hall, Stanford University
Discussant: Hyun Song Shin, professor, Princeton University (my economist Doppelgänger?)

Professor Hall has presented on these issues before.  Here's a link to a 2011 paper, "The Long Slump," in which he starts thinking about the interest rate as a key mediating factor. Professor Hall has extended this framework to the ZLB in some recent slide presentations.