For years, Microsoft (MSFT) has been a favorite of value investing gurus citing the big cash position and the huge captivated user base. But so far, Microsoft has managed to disappoint most of them. Now Microsoft is following Apple’s footsteps into devices. But can Microsoft transform itself from a relentless follower into a device leader when Apple itself is struggling?
Microsoft's stock price fell 12 percent on July 19 after the disappointing fourth quarter earnings released one day earlier. The last two weeks have been tough for Microsoft. Things looked bad enough: a long-anticipated reshuffle, allegation associated with the FBI and NSA, and the massive, controversial operating system change, all of which added to the stock price decline.
The problem is quite simple: People are moving from PCs into low-price mobile devices. Businesses are moving into cheaper cloud software alternatives. Mobile apps are much cheaper than traditional software. The PC and software revenue drop is pounding IBM, Oracle and now Microsoft.
The growth in Microsoft's cloud-based products and services is likely to weigh on margins over the long term. Consolidated operating margins are under the weather. Windows OS business is facing further decline due to a variety of factors including alternative devices, alternative operating systems and the mix shift toward lower-priced, lower-margin emerging market sales.
The tide is sinking on software giants. That’s perhaps why Steve Ballmer recently started the company’s biggest restructuring effort in history: “One Microsoft.”
“One Microsoft” Plans to Move Quickly Towards Devices and Services
In the past few years, major Microsoft old guards like Windows OS and Office, in their efforts to protect their own turf, have missed the explosive growth in mobile devices and apps. Now Steve Ballmer realized that Microsoft’s push to become a “devices and services” company would only succeed if it worked together as “One Microsoft.” But the recent announcement of One Microsoft, a plan to transform Microsoft's current structure into one that would encourage greater collaboration, was met with both enthusiasm and skepticism by other industry leaders and academic gurus.
“First thing, I will quickly and efficiently write a nimble and concise memo to all employees.” Steve Ballmer, the chairman and CEO of Microsoft said at a board meeting. Then, Ballmer wrote in a 2700-word memo to employees posted on Microsoft's website saying, “To advance our strategy and execute more quickly, more efficiently, and with greater excellence we need to transform how we organize, how we plan and how we work.”
MSFT was down 0.87% after Ballmer announced on July 11 the One Microsoft approach. The approach aims to cut down on political infighting and turf wars that stifled innovation. His memo on the company restructuring laid out the usual goals: speed, efficiency, innovation and the ability to compete in a fast-changing world. “Technology moves fast so it needs to reorganize its workforce, its priorities and senior executives reporting to the CEO.”
As we know, companies have to balance culture and leadership because the culture is there and it is longstanding, and this limits what the management can do. Particularly, tech companies need to innovate quickly with restructuring. Microsoft's R&D budget is among the largest in the technology industry but lags behind Google which constantly remains at the forefront of innovation. Microsoft's operating system (OS) and business software divisions account for 80 per cent of operating profits. The PC category, the core products of these divisions, accounts for most of its OS application profits. While investors are worrying about the decline of the PC market, former Intel chairman and CEO Craig Barrett supported the PC and Ballmer in an interview with Bloomberg: “The PC is not dead. It is still alive and well. Microsoft's new structure reflects a better focus on its strengths.”
However, not everyone is so optimistic about the new restructuring. “Microsoft is a rich and undisciplined company. Reorganization does not help much on the stock price,” Professor Bruce Greenwald of Columbia Business School said recently before its stock price declined substantially on July 19. Greenwald believes Microsoft needs to develop its own apps instead of changing its operating system.
According to Lex Column of the Financial Times, while Microsoft's overarching strategy has never been clear, its reporting structure has at least made it clear that, regarding profit, one product effort (server software) has been a smashing success while three others (online services, Xbox, phones) have been failures. Lex also warned that investors deserve a clearer view of the strategy for a restructuring. Any new structure must deliver at least that much clarity. If Microsoft is committed to devices, investors should get systematic unit volume reporting. If software sales are becoming services sales, they should be told how the license sales/subscription sales mix is shifting one quarter to the next. Failing this, they should assume the patient is unlikely to recover.
Mr. Market Giving Microsoft a Wakeup Call
Whether the restructuring will create a sea change is unclear despite a strategic plan following the reshuffling. According to the Wall Street Journal, Microsoft began to shift its identity from being a producer of operating systems and application software to being known for devices — designed by Microsoft itself or by partners — and services that are closely tailored to work with that hardware. The strategy shift about a year ago still relies heavily on software development. Similarly, its competitors, Apple Inc. and Google Inc., have approached development of products such as smart phones and tablets.
According to the memo, Ballmer used a sports analogy to describe Microsoft's transition from a corporate culture with great autonomy and into great collaboration. Microsoft's old structure was more like a baseball team, in which players independently make many decisions. The new structure is more like football, in which a huddle of the team is required and individuals get specific instructions to follow. Back in 2005, greater autonomy was expected to allow product groups to make decisions more quickly. Now, Ballmer argued that greater collaboration was a more pressing priority, as devices and online, or "cloud" services, must work better together.
“We will pull together disparate engineering efforts today into a coherent set of our high-value activities,” he wrote in the memo. “We will see our product line holistically, not as a set of islands.” Analysts and former Microsoft executives noted that the change will require more discussions and negotiations among managers, neither of which are necessarily conducive to speedy action. To help keep such slowdowns a minimum, Microsoft said individual products will have designated “champions” to help marshal resources from separate groups, like research and development and marketing.
A Software Giant Entering Uncharted Water
Despite of recent disappointments, Microsoft’s balance sheet and cash flow remains strong. Some analysts see silver lining in the upcoming changes including the launch of the Windows 8 new version attempt to remain competitive in an era of technological change. Bulls expect that the Windows 8 launch provides a more cohesive strategy for its Windows OS franchise to compete with tablet and mobile devices. Microsoft's strong product refresh cycle shows in the operating segment forecast. On the other hand, bears claim that the Windows OS business is declining due to a variety of factors including alternative devices, alternative operating systems, and the mix shift toward lower-priced, lower-margin emerging market sales.
Some bulls argue that the Azure platform has the potential to develop into a significant contributor alongside the company's other cash cows. The already strong server and tools business continue gaining share in an expanding market.
Upcoming changes also entail partnerships with Oracle and Best Buy despite the fact that the Nokia-Microsoft partnership collapsed over the deal price. According to The Wall Street Journal last month, Microsoft was in “advanced talks” to purchase Nokia's handset business and the Microsoft-Nokia alliance has been a failure. Microsoft is known for a political corporate culture that gets in the way of its ability to innovate as quick as it should. Its R&D hasn’t produced blockbuster innovations which should be the backbone of any tech product company. Microsoft is now following Apple into the devices market when Apple itself is in trouble. Many analysts doubt Steve Ballmer’s ability to innovate with devices that wow users.
It is the 13th, not the first, year of Ballmer as CEO. The market has given him enough time to execute. While Microsoft’s revenue and cash flow climbs higher, its shareholders are getting lower and lower multiples.
A special focus of Microsoft’s restructuring is on engineering. One Microsoft will be composed of four areas: OS, Apps, Cloud and Devices. The reorganization may signal which executives could be chosen to succeed Ballmer.
Microsoft board members were in talks with activist investor ValueAct over the firm's demand for a board seat, according to Reuters. Sources say Microsoft's lack of CEO succession planning is a prominent issue in the discussions. Steve Ballmer, who has plenty of critics, has previously suggested he'll leave in the 2017 to 2018 timeframe. Nomura suggested that Microsoft's poorly received fiscal fourth quarter results and fiscal first quarter guidance could lead to an activist push.
(Disclosure: Brian Zen has positions in Microsoft and Oracle.)