By Vitaly Katsenelson, CFA, author of The Little Book of Sideways Markets. Vitaly’s website is alibaba.com and Alibaba Group that Yahoo! acquired in 2006 and which were not worth nearly as much in 2008.)
Today, while in NYC still playing catchup with the jet lag from the European trip, I read a headline: “Microsoft is near a deal to buy Skype for $8.5 billion.” Microsoft is pulling another “Microsoft”, though this time it may actually succeed. Private equity and eBay, which still owns 30% of Skype, may actually sell, unless Google or someone else rushes in with a competitive bid.
Microsoft had the chance to buy Skype for a long, long time. eBay would have parted with Skype for a fraction of $8.5 billion as recently as 2009; in fact it did, it sold 70% of it to private equity, valuing Skype at $2.8 billion, a third of what Microsoft is offering today. Skype only generates $800 million in revenues, putting today’s price tag at over 10x revenues and some much, much larger multiple of earnings – a very lofty valuation.
Microsoft falls into the broad category of high-quality stocks that were incredibly expensive in 1999 and have not gone anywhere since (and have often declined, as is the case with Microsoft). But most stocks in that category – take Wal-Mart, Cisco, Medtronic, etc. – have seen their earnings and revenues triple and P/E’s collapse. So before we run to crucify the management of these companies and call them “value traps,” we should actually take a careful look at their fundamental performance. Management did what it was hired to do: it increased shareholder value by growing the business while maintaining or increasing the moat. It is the shareholders who overpaid for those stocks in the ’90s. Management is not at fault for that, human greed is.
However, ten years ago Microsoft was an icon, it was a star, it was the company that any self-respecting software engineer wanted to work for. Today, with current management’s help, it is slowly becoming a has-been. In fact, when I think of Microsoft I often think of a quote from Warren Buffett (Bill Gates’ best friend), who said he wants to own a company whose business is so good and whose moat (competitive advantage) is so wide that it could be run by a monkey, because someday it will be. Buffett, though he’s the Oracle of Omaha and all, probably did not know at the time that he was talking about Microsoft (bing it: “Steve Ballmer Monkey“).
Today Microsoft is suffering from the too-successful company syndrome: it was too successful for too long, and the success corrupted management thinking into a belief in entitlement. Management started to forget what made them successful in the first place –hard work, paranoia about competition, and a little bit of luck (which is random; one could hope for it but never depend on it).
I vividly remember in 2007 Apple was introducing its iPhone, a touch phone, and Microsoft was introducing a touch table (see it for yourself). Steve Ballmer publicly dismissed the iPhone as a very expensive gadget. Today, after Microsoft’s market share in cell phones went from respectable to nonexistent, and with the iPad (a device that is a barely a year old) killing netbook sales, Microsoft is a shadow of its former self. The number of consumer gadgets that have the Apple insignia is rising at a much faster rate than Microsoft’s (my family has two iPhones, two iPods, one iPad – I am writing this on it – one Mac mini, and two Windows PCs).
The moat is still there; Microsoft still dominates in desktops, servers, productivity (office), and even gaming; and that is why, despite Mr. Ballmer antics, earnings are much higher today than they were 10 years ago. But when a company is run by a proverbial Buffett’s monkey, no matter how good the business is, the moat will grow shallow and then cease to exist. Even five years ago one would have been fairly comfortable projecting rising Microsoft cash flows ten, fifteen years out. That confidence is much lower today.
From my conversations, people who work for Microsoft love the company but hate the environment. Microsoft has become a highly bureacratic, extremely political timeocracy. (A timeocracy is the opposite of a meritocracy: people get promoted not based on their talent or performance (merit), but on the time they’ve been at the company. This type of environment is great for Google and Apple, as it creates a fertile ground from which to cherry-pick talent. It is very difficult to fire a person at Microsoft who doesn’t perform (I’ve heard it takes a year to dump someone). This is good if you a nonperformer but horrible for the company, as it creates an undynamic, zombie-state working environment with horrible productivity. Managers are afraid to hire full-time workers and thus hire temps. In other words, to some degree Microsoft is becoming the un-unionized GM of the West Coast (though in all fairness, due to its moat, it still produces a 30% return on capital, high margins, and a healthy balance sheet).
Microsoft’s past success, $40 billion net-cash balance sheet, and the $20-plus billion in cash it generates each year gives management a false sense of security. But success has it side effects. It takes away the need to be paranoid, competition is dismissed, focus is lost – there is no project (even the touch table) that is not off limits when you think you have limitless resources. Steve Jobs once said that focus is not what you choose to do, it is often what you choose not to do. Cisco’s three-decade success also went to management’s head; however, CEO John Chambers woke up to that a few weeks ago and wrote a memo to employees admitting his mistakes and outlining steps to refocus the company.
It is difficult for management to admit their mistakes (they are human, and we are not good at that), and for the board to fire current management while the company is increasing its revenues and earnings. A company needs to hit the proverbial wall for that to happen. Microsoft is far from that wall.