Microsoft was the bright light in the tech firmament in the 1980s and ’90s. Then it got too successful, overconfident, lazy and uncreative, and started making bad products and wasteful acquisitions. Worthy competition eventually emerged from the likes of Apple (AAPL) and Google (GOOG), and Microsoft had to fight for its existence and relevance.
Despite doubling its earnings in the past five years, Microsoft has seen its stock go sideways as the market has viewed it for what it is: a sleepy, often arrogant monopolist that is being beaten up by the agile, paranoid and equally financially well-off competition. Microsoft’s price-earnings ratio—which ended the ’90s at a bubbly valuation of 50—has fallen to a level most of us never thought we’d see, recently trading at less than 7 times earnings if you take out the $6 a share in cash on the company’s balance sheet.
Apple (and more recently Google with its Android operating system) has attacked Microsoft on the Windows front. The iPhone and iPad showed everyone what cell phones and tablets should look like. The iPhone killed Windows phones, while the iPad killed netbooks (low-powered, cheap laptops) as a product category and caused a first-time-ever decline in the sales of Windows.
Even a company with Microsoft’s thick skin can take only so much before it starts to fight back. The upcoming launch of Windows 8 indicates that the software giant is waking up. Windows Vista was a horrible product made by a lazy monopoly. Windows 7 was really just the Vista-fixed edition. But when I watched the demo for Windows 8 a couple of months ago, I caught myself saying, “Wow!” Windows 8 is an uncharacteristically innovative operating system made for PCs and tablets. (Microsoft is making a separate version for phones.)
But an exciting operating system needs to be married to great hardware. Apart from the Xbox, Microsoft has never made hardware; its partners have. In the world of PCs and laptops, that setup did not hinder Microsoft, but it does now.
This brings us to Nokia Corp. The Finnish company used to own the cell phone market, but it too got fat and lazy. In contrast to Microsoft, Nokia was great at hardware but not at software.
In September 2010, Nokia hired a new CEO, Stephen Elop, who joined from Microsoft. Elop killed Nokia’s effort to develop its own operating system and signed a deal with Microsoft in which Nokia committed to make phones that would run exclusively on Windows. Like conquistador Hernán Cortés, who in 1519 ordered his troops to burn all their ships when they invaded Mexico to ensure that they had to conquer the Aztecs to capture their boats and get back to Spain, Nokia has burned all its boats.
Microsoft could have done something stupid and tried to buy Nokia. Taking the Cortés analogy further, instead of burning their boats, Nokia employees would have felt that if they failed, there would be a huge cruise ship with an all-you-can-eat buffet waiting for them (a fat severance package backed by $60 billion in Microsoft cash).
The Nokia-Microsoft alliance will extend beyond cell phones to tablets; after all, as Apple taught us, a tablet is a big cell phone, not a small laptop. Despite dropping the ball on the operating system front, Nokia is the king of cell phone hardware. Working very closely with Nokia will provide Microsoft with a more holistic software-hardware design platform and give it a fair chance of creating an iPad-quality tablet. In addition, Microsoft will benefit from Nokia’s still-strong brand name and tremendous global distribution network.
Before Windows 8 hits the market in 2012, Microsoft will benefit from ultrabooks—powerful, light and thin Windows-running laptops that were inspired by Apple’s MacBook Air and envisioned by Intel Corp. Windows’ sales will likely accelerate for another reason: Microsoft will discontinue support for Windows XP in 2014, forcing upgrades by businesses that were still using it because of their disgust with Vista.
Many Microsoft shareholders are fatigued. I am too. But despite the market’s pessimism, the company’s earnings power should rise over the next decade. Its depressed valuation offers a significant margin of safety, and P/E expansion should become a significant source of returns. Considering the high quality of its business, 40 percent return on capital and cash-rich balance sheet, Microsoft should trade at a significant premium to the market, not at a discount.