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Microsoft Q3 2011: Priced for Failure

Alex Morris

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Well, that was an interesting five days for Microsoft (MSFT). Through the first four days of the week, the stock was on a nice run, moving nearly 5% higher. Then, after releasing what appeared to be strong earnings, the stock got plummeted, and was down more than 5% for part of the day (closed down 3%). This morning, the stock has once again opened lower, leaving us, when all is said and done, nearly flat with where we started on April 25. The question is, when we step back from the noise, what did the earnings report tell us about Microsoft the business? Most importantly, is there any indication from the quarterly report that the bears might be right and that Microsoft is a value trap?

To start with, let’s look at the quarterly results: Revenue, operating cash flow, net income and earnings per share increased 13%, 17%, 31% and 36%, respectively, in the third quarter (compared to last year’s results). Regardless, the stock was beaten down to a dip in sales in Windows & Windows Live Division. The average analyst estimate for 2011 EPS is $2.56, a nearly 22% increase in earnings from 2010; this is for a stock that is currently trading at 10x forward EPS and has roughly $40 billion in net cash on the balance sheet.

First, we need to clearly identify the bear argument. Here is what senior market analyst Joe Cusick of optionsXpress had to say on Friday: "Even though they had good earnings, the PC market is under scrutiny and there continues to be uncertainty on whether or not Microsoft can compete with the growing tablet and handheld devices from the likes of Samsung and Motorola (MOT).” One of the well articulated bear cases I have found was written in January by Adam Hartung of Forbes, who says that Microsoft “has almost no hope of moving beyond its lock-in to old products and markets which are declining.” Even Xbox and Kinect, which he calls “the only bright spot in Microsoft,” won’t live up to what it can because, “by all accounts Microsoft doesn’t realize what it has here.”

The bear case appears to have two separate pieces. The first stand alone piece is Microsoft’s “lock-in to old products and markets,” such as Windows and Office for PCs, which as noted by Mr. Hartung, are declining. The second part, which encompasses two separate issues, is an inability to compete in tablets and phones (collectively, new consumer markets), largely the result of incompetent management and a corporate bureaucracy that has stifled innovation.

First off, let’s look at the PC market for the quarter, as discussed in the 10-Q: “We estimate that sales of PCs to businesses grew approximately 9% this quarter and that sales of PCs to consumers declined approximately 8%. The decline in consumer PC sales included an approximately 40% decline in the sales of Netbooks. Taken together the total PC market declined an estimated 1% to 3%.”

Netbooks were on fire in the second half of 2009, growing more than 25% year over year in every month from July to December (booking 70% YOY growth in the last month). However, when Apple announced the iPad at the end of January 2010, retail sales for notebooks started to fall. By August, year over year sales had turned negative, suggesting that tablets were starting to cannibalize netbook sales; the 40% decline in this quarter is a testament to the way that tablets have taken netbooks to the cleaners.

But what about computers as a whole, like the one I’m typing this article on right now? Are people ditching their desktops and laptops in exchange for a tablet? The overall decline in PC sales of roughly 3% suggests otherwise (complementary rather than a substitute), especially when accounting for the fact that sales in Japan, which is a big market for PCs, was significantly lower due to the earthquake and tsunami; an additional adjustment for people who are delaying PC purchases due to macroeconomic concerns (such as myself) might also be worth consideration.

In 2010, global PC sales reached 346.2 million units, up 13.6% year over year; this idea that people are ditching their personal computers appears to be in stark contrast to the numbers. Gartner has predicted (as recently as March 2011) that PC sales will grow “only” 10.5% in 2011; there is a big difference between double digit growth and the end of PCs as we know them.

What about Mr. Hartung’s belief that Microsoft “has almost no hope of moving beyond its lock-in to old products and markets which are declining?” Is this an accurate assessment?

The recently announced agreement with Nokia (NOK), the largest maker of cell phones in the world (global share of 29.2% in Q1 2011), might suggest otherwise. As noted by CFO Peter Klein, “The great thing about the Nokia deal is this in an incredibly perfect opportunity for both of us to build a really compelling, vibrant third ecosystem, if you think about the complementary set of assets that we all bring to it… Clearly, this is a broad strategic alliance, it's a long-term strategic alliance, and we're going to be working closely together. And we are each making investments together along those lines. And I think the important thing to think about is, as we sort of build that out in its success, it's going to be a great thing for both companies and for customers and for other partners in the ecosystem.” If these two companies can come together and become the third horse in the fight for mobile share, watch out.

Bing is another area where Microsoft is inching forward, ending the quarter with a market share of 13.9%, up 190 basis points from the end of Q2; online advertising revenue increasing 17% to $586 million. Again, the company is taking steps in the right direction to develop a business unit outside of PC Windows and Office.

The bears will certainly jump on this: Microsoft has been dominated by Apple (AAPL) and Google (GOOG) in phones, and Bing continues to bleed cash. Part of the bull thesis is the realization that despite massive capital investments into areas that have thus far proven unsuccessful (grabbing share from Google is a slow and difficult process), Microsoft has been able to drive strong cash flow expansion due to an unrivaled core business.

The point is that the stock is priced for nothing to work; unlike growth stocks, which have every optimistic assumption for the next decade cooked into their stock price (take a peek at Salesforce.com (CRM)), Microsoft is priced as if Bing, Windows Phone, Kinect, Office 365, and many other business lines will never develop into a material addition to the company’s success; this may prove to be a grave miscalculation. Just some food for thought: Operating income in the Entertainment and Devices Division and the Server and Tools Division has increased 64% and 21%, respectively, through the first nine months of the year.

Gurus like Whitney Tilson, Jeff Auxier, Donald Yacktman, and Jeremy Grantham continue to pile into Microsoft; personally, I’m right there with them, and see value in Microsoft shares at these levels.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

Rating: 4.4/5 (46 votes)

Comments

mmel
Mmel - 2 years ago


Good article. Here is an interesting tidbit from this past weekend in Omaha that seems to be getting no traction in the news:

http://www.gannononinvesting.com/blog/warren-buffett-microsoft-looks-cheap-but-my-relationship-wit.html
Alex Morris
Alex Morris - 2 years ago
Hadn't even known about that Mmel, but interesting. Thanks for commenting.
DocMoney
DocMoney - 2 years ago
Alex, I've been shouting this about MSFT from the rooftops - and am nearly 10% of my total portfolio long the stock. In recent interview with Forbes, Paul Otellini said that 90% of enterprises are still on Win XP and it's time to upgrade. You and I seem to have similar investment philosophies - value often hides in plain sight (JNJ anyone?)
Alex Morris
Alex Morris - 2 years ago
Doc,

Thanks for the comment; agreed.
matsandalex
Matsandalex - 2 years ago
Great article Alex. Perhaps when the momentum investors see MSFT destroy Salesforce.com CRM in the "cloud", MSFT will get some respect.
Alex Morris
Alex Morris - 2 years ago
Thanks for pointing it out DocMoney. Here is what Mr. Hartung had to say:

"
At Gurufocus.com the argument is made “Microsoft Q3 2011: Priced for Failure“. Author Alex Morris contends that because Microsoft is unlikely to fail this year, it is underpriced. Actually, all we need to know is that Microsoft is unlikely to grow. Its cost to defend the old business is too high in the face of market shifts, and the money being spent to defend Microsoft will not go to investors – will not yield a positive rate of return."

I think what I was trying to say was misinterpreted (possibly I was not clear in my writing). I'm not sure what unlikely to fail this year means. My message was that the Windows & Windows Live Division is alive and well. Expectations for double digit growth in PC sales are a testament to the fact that tablets are not replacing computers; they are complementary devices. The 3% decline we saw this quarter had a lot to do with the absent Japanese consumer, and others (such as myself) who are putting off purchases and sticking with computers running XP until the job market and economy get stronger.

As always, the MSFT bears taunt the online costs; as I noted, they are bleeding cash here. However, there is a flip side to the bear view:

1. The strength of the core business enables them to invest in new product lines while still paying a nice dividend and pocketing billions every year.

2. As noted, Bing is two years old and grabbing market share; I'm not positive if Bing will ever achieve 40-50% share, but I think saying that it has high up front costs to take over the incumbent isn't a knock on the company; it is simply a fact of the business. Luckily for MSFT, they have the cash, and can pursue areas like search that most others cannot. Which brings me to my third point, and the articles point:

3. The price is set for everything to fail. This includes Kinect, Windows Mobile, Bing, etc. What if one of these ventures end up working? What if Microsoft/Nokia becomes the third horse? What if Bing has 30-40% share in search a couple years down the road? Bears will simply say, "they never will". As I said in the article, this may prove to be a grave miscalculation.

Luckily for investors, the stock is priced for nothing to work; the risk/reward balance is out of line in my opinion, and offers value to the patient investor.



adam
Adam - 2 years ago
Hi Alex, and I appreciate your review. It takes buyers, and sellers, to make a market - so it is good that you would represent the buyers. Unfortunately, I think the MSFT buyers are destined to lose money - maybe their entire investment.

While there is no doubt MSFT has had a monopoly in the enterprise, that is rapidly disappearing. We've seen the shift already happen with telephony, as enterprises are jumping fast from RIM to a mix of Apple and Android products. Microsoft is far too late here - and Nokia won't save Microsoft.

The same sort of shift is going to happen with PCs, as people move to tablets/smartphones with cloud apps. Just look around, in airports or in meetings, and compare how many people are looking at the latter screens, versus the former. Two years ago we couldn't live without a laptop - now nobody wants to carry one.

An economic recovery will not bring new PC buyers. Instead, it will be a wholesale sweep toward the newer technology. And Microsoft is far too late. It has spent too much trying defend its historical "core", which is practically now "hollowed out" by competition. And it is too late, with far too much cost, trying to extend into new markets --- plus Microsoft has never been any good at such extensions, losing billions in its efforts.

It's good some people are buying the "value trap" that is Microsoft, because I'm urging everyone to dump the stock in favor of the growth opportunities competitors provide. You're young, and this will be a good learning opportunity for you (lol - I really do mean that as a joke - if a bit snarky.)

Your readers can read my full review of Microsoft and its non-existent future at Forbes.com

http://onforb.es/k3lK26
Alex Morris
Alex Morris - 2 years ago
For interested readers, I have responded to Mr. Hartung's comments on his article; I have reposted them here:

"Thanks for the reply Mr. Hartung; I’m always looking to test my ideas, and am glad to have found a sensible bear case.

Our views on the PC market are probably the biggest disconnect. I see double digit growth in PC’s in 2011 (along with Gartner) and don’t think they are going anywhere (god knows I’m not going to start writing my articles on a tablet, but maybe I’m an outlier).

From there, our views on the other businesses will differ as well; I see billions being thrown off from Windows and Office, which will support capital intensive (but moving in the right direction) investments in search, Mobile, etc.

If you don’t think that W&WL will be there to finance ventures like Bing, they will undoubtedly fail. For now, they have the financing, and are continuing to strengthen their competitive position.

Thanks for the thought-provoking discussion Mr. Hartung."

It looks like I will need to conduct some market research; I have trouble believing people are looking to ditch computers completely (for example, in home use) in exchange for a small screen and no keyboard. Any thoughts from the readers of this article?

noblepaladin
Noblepaladin - 2 years ago
Microsoft's moat is definitely weaker today than it used to be. However, it is not going to be a binary outcome. People seem to be going delusional again and are starting to believe that in tech, you either become a trillion dollar company or you go bust. That is evident in the huge gaps in valuation, where companies like Microsoft, Cisco, and Intel are trading at ex-cash P/Es of under 10 while the hot companies like OpenTable, Netflix, and Salesforce are trading at P/Es of 200.

People are probably going to use smartphone or tablet plus a PC instead of a netbook plus PC (one for content consumption, one for content creation). That will slow Microsoft's growth. But the PCs are not going away. Everybody I know thinks that tablets are cool, but they are generally useless for creating content. Engineers are not going to start doing work on tablets, they need keyboards and processing power of a desktop or large notebook, as well as all the advanced software that is only available on PCs. Bankers are not going to make spreadsheets on tablets. Corporate America, which is the main customer of Microsoft, is not switching away. The same misconception is happening at a company like Dell. Sure Dell's retail market share is declining and retail guys are buying smartphones and tablets. However, their main business is with corporations. Tablets are great for reading emails, browsing Facebook, or watching YouTube, but are pretty useless when you actually need to do some real work.

The growth prospects for companies like Microsoft, Dell, or Intel are a lot weaker than it used to be. The retail market is going away from them. But they still dominate the enterprise market. This moat may weaken in the future, but at current prices, it certainly looks attractive. It looks a lot more attractive on a relative valuation basis than companies that have multiples that are 20-25x greater in OpenTable, Netflix, Salesforce, etc. Those companies have real competition and unproven moats. Those companies are a lot more likely to blow up than a Microsoft or Intel.
LakesideB
LakesideB - 2 years ago
I should apologize foremost for a rather long reply. The debate between Adam and Alex on Forbes page is interesting and that is what prompted me to write this response.

I am bullish on MSFT.

I think the popularity of phones/tablets has been staggering and has taken many by surprise. Apple really has captured everyone’s mind with some really great and innovative products – there is no question about this.

So this company enjoys a huge mindshare vs. others such as MSFT.

But when buying a company one has to think of not just 2-3 years in future but 10 – 20 – 30 years down. The thing is this is extremely difficult, if not impossible, to do in the technology sector. So Buffet and Munger stay wisely away.

So when I think about buying Apple vs MSFT, I have to take a very long term perspective. And I don’t have any particular future insights in the technology sector that would give me confidence in my abilities to take this long term perspective. So I look at what has worked in past and explore *why* it has worked.

What the hell did MSFT do in the personal computing space that allowed them to keep a 90%+ share in Windows, Office, etc for 20+ more years and completely dominate Apple even after having an inferior interface and less cool/innovate products (remember msdos vs mac OS)? Don't forget that Apple had a first movers advantage in the PC space ... yet got runover by MSFT!!! (so much for first mover advantage as being a competitive advantage!)

Focus + Captivity

I would say these were really the two big things that helped MSFT build a lead even though their product was years behind Apple. They were focused in their pursuit of perfecting one platform and getting everyone captive to that platform and then focused on expanding their ecosystem step by step and thus solidify further captivity in the process.

Sure msft benefited tremendously from IBM’s blunder to outsource their operating system to msft so there was an element of luck too. But boy did Microsoft just pounce on that opportunity. So while Apple focused on perfecting the full Mac experience from CPU, to operating system, to application software, MSFT just focused on perfecting their OS.

If given a choice to juggle 4 different balls perfectly at the same time vs one, which one has a more likely chance to succeed?

While Microsoft perfected their OS, they had the smarts to keep a sharp eye on making sure they get more and more people captive to their ecosystem. They did this by adding new features, and applications to increase the attractiveness of their platform. Thus they competed away Lotus smart suite with their own Office application. Then they expanded in the browser space and displaced Netscape with their own Internet Explorer. The idea was get more and more features to your ecosystem, to make it more attractive and get ever higher levels of captivity.

MSFT never made the mistake to juggle 4 different balls at the same time and focused on just working on copying successful concepts and making it available on their platform. To a viewer, windows, office, internet explorer might seem as different products ... but MSFT views this as one ecosystem.

So the take-way from the PC history was that there was no money in manufacturing of a PC (as Dell, HP, Hewlett Packard, Compaq all fought with each other for market share) and the real winner was the guy who took a focused approach towards getting customers captive to its product – the OS.

It helped that the software business is a fixed cost base business, which translates into huge economies of scale. The captivity combined with the scale advantage resulted in huge barrier to entry that prevented the likes of Apple to erode is for 20+ years

Anyway… that was a bit of history.

Let look at what’s happening in the phone/tablet space. Apple should be given full credit to come out with great products since early 2000. After Steve Jobs arrival, they kind of took a page out of MSFT success. Using the cash coming from Mac sales, they introduced iPod and later iTouch into the market. Once this was proved to be a blockbuster success, they then extended the iTouch experience into iPhone. Then they extended the same iPhone experience to iPad. Notice how they did this one step at a time. Instead of re-inventing 5 things at the same time, they just extended what worked onto other platforms. So I give them full marks for having a focused approach – a contrast to how Apple operated in 80s under Jobs (when they were trying to win in all the areas at the same time)

The problem is that having a focused approach is not good enough.

You need to get people captive to your ecosystem. Period.

The best barrier to entry is having the government outright protect you from competition. This is not possible in technology space so you have to look at what’s the next best way to create a barrier to entry. Having a customer who pays a premium to use your product and who keeps coming back to use your product day after day (in other works, become hostage to your product) while you are able to keep your costs ultra low as you spread it amongst more customer is the winning combination.

That creates an artificial barrier to entry. Your cost curve is downwards sloping … while your revenue curve is upward sloping due to captivity reinforced by network effects. It’s very hard to compete when you have this kind of economics working for you.

So now in Apple’s case, the question is how to get people captive to their products. The coolness and innovation can help you short-term. For long-term dominance you need to get people hostage to your ecosystem.

And thus Apple came up with the Apps. They realize that all the hardware and software OS slickness can be copied by competitors. If you are unable to even patent the gestures on your phone, then you certainly have no chance of patenting/protecting the slickness or polish of your phone. There really is nothing preventing a competitor to copy your hardware and copy your software innovation.

And this can already be seen by the meteoric rise of Andriod. While Google provides a free OS, the manufacturers (such as HTC, LG, Samsung, etc) focus on manufacturing the hardware. Its similar to what happened in PC space….. except that MSFT’s sole purpose was to build a company around that OS. Google has a different strategy and their focus seems scattered. So I am not sure how this will all work out.

So really the only way you are creating captivity is through Apps. You have to make sure that developer/users don’t start to develop apps for competing platforms. As well you have to ensure that there are some Apps that are *exclusive* to your platform. I am talking about some really high quality apps that people find enormously useful that is available *only* in your ecosystem. That is how you create captivity.

Apple has somewhat failed here as developers have actively been developing for Android, Blackberry, etc. Furthermore, MSFT and RIM are launching conversion tools that allow a developer to convert their application from Apple/Android to their own platform.

Also on the cost side, creating iPhone/iPad is not a fixed cost business. The economics of having one large upfront cost to create a piece of software and then spend pennies to publish it onto a CD or online download is very different to having a large part of your COGS go into manufacturing of each additional handset/tablet. So you don’t get to enjoy enormous economies of scale as more customers come to your ecosystem.

So right there you see chinks in the Apple’s ability to get people captive while having no real benefit of scale on the cost side. They can do this possibly for next few years … but can you confidently say that this will happen 10 – 20 years from now? I can’t .. so therefore I can’t invest in Apple.

I refuse to prepay for the future success that may materialize or may not materialize.

So lets look at MSFT. Sure the tablets are a disruptive force. The decrease in Windows sales has further provided proof to the bears that this disruptive force is bigger in nature. MSFT mentioned that PCs sold to business was up 9%, while those sold to consumers down 8% for a total decline in PC sales of 3-4%. This tells me that the enterprise is roughly between 65% to 70% of Microsoft’s base.

So while consumer is important, enterprise much more important. I just don’t see corporations switching to Tablets to get enterprise work done. I see Tablets as complementary devices. They can help in browsing, writing quick emails, reading pdf, etc - but for enterprise work you still need a PC workhorse… and that’s not about to change. Sure the headlines that all fortune 500 enterprises are thinking of trying out iPad’s etc make for great headlines, but iPad’s are probably only been given out to their top level executives not the guy who is sitting in his/her cubicle crunching umbers in excel.

The real threat is if corporations start to get their workers to use Ipad for enterprise work such as number crunching, etc. And as Alex has mentioned there are still a lot of consumers that still need a PC to get work done. IPad/tablets are great device for consumption of media ..but I still need a PC to do my tax return, to work on my spreadsheets, to write notes, etc. So I see tablets as complementary and not a replacement.

Gartner projects the *growth* in PC sales to decline to 10%. There is still growth. What’s declining precipitously is the complementary Notebook (decline of 40%) category, which was often used by the consumer to digest media. This category is getting slaughtered by the much more efficient Tablets as they are specifically designed for consumption of media - so no surprise there.

The next real disruptive force is cloud computing. That’s a real risk. This is a new field, and I have spent a lot of time trying to understand the economics and progress within the cloud computing space. There are only 3 big players here : MSFT, Google and Amazon.

I wouldn’t go down into many details here related to cloud (as the response length has already gotten enormous) … but my conclusion is that MSFT is positioned extremely well to become a leader in the cloud space. I can briefly say that MSFT is doing something very similar to what they did in OS space….they are focusing on getting people captive to their cloud offering and getting developers to develop everything in their cloud ecosystem to harness the full economics of cloud computing.

Again the focus here is to get people to become captive and they are the only guys who are providing a comprehensive solution that allows the customer to obtain the *full* benefit of cloud computing.

Additionally, they are creating new revenue streams such as going after the money a corporation spends on hardware and maintenance of their servers. As people decommission their networked PCs with the intent to put everything onto a cloud, they will be giving their money to the cloud provider instead of buying new hardware, etc. This is a huge untapped opportunity. IT spend is a $1.5 trillion business. 80% of IT spend is on hardware and maintenance with the other 20% used to develop new applications and other value added software.

Additionally, the company is thinking of slowly changing from a licensing to a pay-per-usage contract. I estimate I use 80% - 90% of my day time using MSFT products working as an employee for a firm. If MSFT finds a way to monetize this incredible usage by holding everyone captive to their cloud, that would be a huge success. They can initially charge low or the same amount it costs a firm for one copy of Windows OS and Office ... so initially the customers are indifferent towards their desktop vs cloud offering. However, once the customer is captive, they can gradually increase prices as people have no option but to use their products.

A win in cloud space will be huge for MSFT. The good thing is, at these levels, the company is seen a failure in cloud space too. I am not pre-paying for MSFT’s success in the cloud space.

Conclusion

Innovation doesn’t result in long term profitability, Captivity does.

What you innovate today can and will become a commodity tomorrow. You can’t build a durable and deep moat on innovation alone. You create it via captivity and focus. Focus is easier to get … captivity enormously difficult.

stevenwcronin
Stevenwcronin - 2 years ago
great comments LakesideB . I agree with most of what you said in your lengthy history of computing and what seems to mater in the long run. I also recently bought MSFT stock even though I love apple and google products much more. It's just the value investor in me. I was curious what your thoughts were on AAPL as it does seem to be reasonably valued as well (surprisingly so given their popularity and growth).

What I'd most like to understand though is microsoft's intent with azure/cloud computing, and how that will be moentized and used to create a great user experience. I hope they get it right, and provide a compelling offering, but it seems liek that will be tricky given that google docs is free. I guess in the end microsoft may wind up providing a compelling cloud computing offering for corporate america. Any idea what this will look like for corporate america vs end consumer as far as cloud computing and msft's monetization approach?

Interesting story this summer GE's former Chief innovation officer said that they were going to totally switch over to google docs, but google wouldn't keep their data on a dedicated server (doc security reasons I suppose) so GE didn't wind up using google docs. Seems like google just doesn't get corporate america's IT needs.

Your comments on microsoft azure are appreciated, morningstar discusses it a little bit, but didn't give much meat or details.

thanks much!

steve
DocMoney
DocMoney - 2 years ago
By the way, Microsoft Skydrive has recently torpedoed google docs... And it runs MS Office products in browser, gives you 25 gigs of storage and runs on PC and Mac! :)

What most people do not realize is that Microsoft is an expert at this - letting others take the risk, then replicate what works and eventually dominate the arena. Netscape anyone? Word Perfect? Videogame consoles?

Has anyone done any scuttlebutt and read Windows Phone 7 reviews on phonescoop.com? How about Engadget? People like it! They just want more/better devices... HTC and Nokia can give Apple a run for its money. Motorola Mobility is hot on Apple's heels. High margin businesses attract competition, Mr. Jobs - get ready for margin shrinkage. Using aluminum and white plastic will only get you so far - HP is already producing an aluminum laptop that's 1/3 of the cost of Macbook Pro.

Not many people know how essential some MSFT products are. What does Netflix run on, on both PCs and Macs? That's right, Microsoft Silverlight. I could go on.

That Win 7 is not selling as quickly as it should is a testament to how good win XP actually was. After 3 service packs, it is a lean, mean productive machine. But as MSFT withdraws support, windows 7 will catch on. Emerging markets pirating? Good! I think that's MSFT's strategy. Let pirates learn Windows for free; then when they get jobs that's what they'll use.

Bing is now on all blackberries by default... Have you tried Bing lately? It's great!

I am feeling lazy at the moment, but I would counter Adam with the following margin of safety calculation: tax all of MSFT's cash as if repatriated, then back it out. Multiply earnings from windows et al by HALF, then assume it won't grow. Project growth of remaining earnings as they are. There should be at least 30% margin of safety left.

noblepaladin
Noblepaladin - 2 years ago
I don't think people understand Microsoft's moat that well. For retail tech savvy people, the moat is not that strong. I can switch to Ubuntu. Then again, I have a Master's degree from MIT. But for most people, it is not that easy. I was with many Harvard Business School students the other day and they were trying to install Ubuntu and 80% of them could not do it in 3 hours. They are not dumb, they are simply not tech people. They can figure it out in a few hours. However, how much does a few hours cost a corporation?

I get paid $50/hr. It actually costs my company about $150/hr (they must pay taxes, insurance, rent office space, lease furniture, etc). So if they switch operating systems, and it takes me more than 2 or 3 hours to familiarize myself with the new operating system, the company is losing money already! Companies are willing to pay a few hundred dollars to Microsoft every couple of years to get a new Windows license. And the truth is that the mean (or median) age of workers are in their mid-40s. These people tend not to be tech gurus (especially if they are not in a computer software related field). Most of the older engineers I know are not that familiar with computers. They can do all the math, all the theory, and all the technical stuff, but they are not very quick on the computer. Switching operating systems will decrease the productivity of these guys significantly for a few months, and that cost is way too big. For non-engineers, the cost of switching is even greater because it will take them a longer time to learn the new system. The same is true with the Office products.

The cost of using Microsoft products is very low from most companies' standpoints. They won't save much money from switching. Microsoft makes money because a lot of people use their products, not because they obscenely overcharge corporations. If you want to know about obscenely overcharging, I use a really crappy, old HP computer at work which costs $20,000 because I work in the Defense industry and this ancient computer is approved to store classified information. When companies have costs like that, they don't care about cutting a $100/computer on Windows.

Some people think that "The Cloud" will kill Microsoft. This may be true for some retail applications. However, is a company really going to store all their information on "The Cloud"? What if the network goes down for 1 day. How much money will the company lose by paying 2000 employees to sit at the desk and cannot work? Without the cloud, a company's infrastructure can only fail locally in their internal network. When using the cloud, the internet connection can fail and the cloud can fail, along with the local network. It will at least triple the amount of possible downtime. And what about the security implications? "The Cloud" is great for consumers, people want to stream video and media instead of carry DVDs with them. But it is not so great for enterprise.

All the new stuff is great for growth in the media consumption and retail consumer world. However, Microsoft still holds a very strong monopoly in the corporate world. A lot of people think that the moat is gone. I think it is a bit weaker than it was 10 years ago, but it is still a very wide moat.
jim.falbe
Jim.falbe - 2 years ago
Ok, too many ultra-long comments here. End-game:

Alex is correct. The stock is priced at a cash backed-out P/E of about 9. It is priced for everything to fail.

PC's and Laptops are "content creation" devices. They aren't going anywhere, unless people are going to stop working.

Tablets and Phones are "content consuming" devices. Yes, people don't want to lug a laptop through the airport. Of course, but are you going to write a 15-page term paper on a tablet. Get real. PC's aren't going anywhere, neither is Microsoft.

If we take in the dividend and share buybacks, the company is paying us over 5% to just sit around and make money.
energywonk
Energywonk - 2 years ago
cathedral v bazaar arguments. monopoly v open source/decentralised approach.

1. monopolies nearly always fail (either via anti trust or via innovation/low labour costs)

2. apple is making same mistakes microsoft has made (captivity argument)

3. content creation v content consumption is not valid argument it depends on peripherals/apps

4. tech is poor investment long investment long term unless you can shift capital with the trends. (warren teaches us this)

5. microsoft is being attacked on all fronts no matter what arguments are presented, they really dont have a widening moat in anything anymore.

6. short this stock, it will be far more lucrative.
Sivaram
Sivaram - 2 years ago


Good post LakesideB (props to a few others as well). I think you touched on the key element that created Microsoft's moat. Namely, customer lock-in, or what you call captivity.

It remains to be seen how the applications for tablets (and mobile phones) end up being. A lot of them are (or are likely to be) web services (i.e. app available through the internet e.g. Facebook, Netflix, and in the future, office applications) and that is completely different from what it was on the desktop/laptop/minicomputer/mainframe enironments. I suspect the captivity is with the software company and not the platform/OS/hardware company, which is unlike what it has been for the last 30 or 40 years.
Sivaram
Sivaram - 2 years ago


---QUOTE---

PC's and Laptops are "content creation" devices. They aren't going anywhere, unless people are going to stop working.

Tablets and Phones are "content consuming" devices. Yes, people don't want to lug a laptop through the airport. Of course, but are you going to write a 15-page term paper on a tablet. Get real. PC's aren't going anywhere, neither is Microsoft.

--------END QUOTE---

I don't think this is likely to be true going forward. Tablets can easily kill desktops (in addition to laptops). All you need is a "docking station" (likely wireless) with a keyboard and monitor that hooks up to your tablet -- you use the tablet alone on the road but use a normal keyboard/etc when at the office/home. Technology isn't quite there right now but I can easily see it going that route in a few years.

In terms of processing power, tablets (and smartphones to some degree as well) have sufficient CPU processing power and memory to carry out the vast majority of consumer and business applications. Specialized engineering, architecture, scientific, multimedia, gaming, etc applications still need powerful machines but the vast majority of consumers and office users can probably get away with a tablet or smartphone in a few years.

If Microsoft's operating system doesn't successfully compete in the smartphone or tablet space, they will likely lose all the revenue and profit from that division since I anticipate nearly all PCs and laptops will be replaced by tablets or smartphones within the decade. However, Microsoft will still have its Office and various non-operating-system divisions that can survive.

buynhold
Buynhold - 2 years ago
"Microsoft Near Deal to Acquire Skype"

http://online.wsj.com/article/SB10001424052748703730804576313932659388852.html

There goes $8 billion out of that $40 billion that investors were counting as cash in hand. Reinforces my belief that ego comes in the way of smart capital allocation way too often.
energywonk
Energywonk - 2 years ago
tech is not oil production or minerals production, or some other durable competitive advantage.the nature of tech is erosion of moat and creative destruction etc. i believe gates was well aware of the decline in microsofts fortunes. it is rumoured he had a single picture on his wall in his office of henry ford to remind him that monopolies always fail/beaten by competitors etc. he also stepped down as CEO coincidentally when iPhone was released. now the batten has shifted. apple is attempting to mimic MSFT strategy via captivity etc. microsoft is absolutely doomed. there is no doubt in my mind.
Lothario
Lothario premium member - 2 years ago
Seems like a waste of shareholder value.

It certainly wouldn't cost them anywhere near $8.5 billion for them to build their own Skype/Google Voice alternative.

This reminds me of why I hate most tech companies in general. Overpriced acquisitions that I cannot for the life of me understand.

Microsoft should just stick to Windows & Office and paying dividends since almost every other business they've gotten into outside of those seems to be a failure.

I should add that MSFT does indeed look cheap, but this Skype acquisition they paid for, along with their proposed $45 billion acquisition of Yahoo a few years ago just leaves a sour taste in my mouth.

"Microsoft Near Deal to Acquire Skype"

http://online.wsj.com/article/SB10001424052748703730804576313932659388852.html

There goes $8 billion out of that $40 billion that investors were counting as cash in hand. Reinforces my belief that ego comes in the way of smart capital allocation way too often.


energywonk
Energywonk - 2 years ago
alex thanks for link. however there is nothing to learn there. its obvious to many reasonably informed consumers where pcs/IT is heading. there is saying that "the science of tomorrow is the pulp of today". watch any good sci-fi movie (admittedly 95%) are crap, but you will get an idea of form factors, desktop/holographic interfaces etc.

what is at issue here is whether microsoft is being underpriced or whether value investment framework can help us to see a clearer picture. microsoft will survive (and perhaps in multiple niches), however it will shrink until every part of it its core business is replicated/cloned/eroded and the company becomes largely irrelevant.

many will disagree, but time will will tell i guess. , i am just a reasonably informed consumer whos partner has an apple, i have android, i use skype, i use google voice i have pcs at home and at work, i have an xbox and a Wiii. i am not short nor long any tech at all except a small australian 3rd gen solar player (its less than 1% of my aussie portfolio because tech is generally a punt until a clear paradigm is established. then you can ride the trend and get short at the right time with a little bit of luck). but what i do know is that there are better companies out there for my capital and i would suggest many others.
jim.falbe
Jim.falbe - 2 years ago
Alex,

At the end of the day, I totally agree with you. ANY COMPANY, can be a great deal if it is priced accordingly. Do I think Microsoft will be stronger 10 years from now than it is today? No, but maybe the boys in Redmond will surprise us. All I care about is how insanely cheap it is right now.

This is my own take on it:

http://bit.ly/lHMKmo
DoubleDrop
DoubleDrop - 2 years ago


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