When I wake up in the morning and check news for the companies I own, I worry. I don’t worry that my companies missed their quarterly guidance by a few pennies – running a business is an art, and things don’t usually work out in a precise, linear fashion. The companies that have a “deliver the quarter” culture often just play their financial statements as a musical instrument. No, I am not worried about that. What worries me is that a company in my portfolio will pull a “Microsoft” – announce a stupendous, “transformative” acquisition, like the $48 billion takeover of Yahoo! that Microsoft announced in 2008, but that Yahoo!’s management was too … (fill in the blank) to accept. (I spent some time looking at Yahoo! last week. Its stock is at $18, almost half the price that Microsoft offered, and I find the company only mildly undervalued if you give a significant value to the assets 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.
Coho Capital 2Q20 Commentary: Podcasts, The New Talk Radio
Coho Capital commentary for the second quarter ended June 30, 2020. Q2 2020 hedge fund letters, conferences and more Dear Partners, Coho Capital returned 46.6% during the first half of the year compared to a loss of 3.1% in the S&P 500. Many of our holdings, such as Netflix, Amazon, and Spotify, were perceived beneficiaries Read More
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.
Instead, Microsoft is making another acquisition, and Skype will likely be as wasteful as the ones it did in the past. I am fairly sure, a few years down the road, Microsoft will take a “one”-time charge to write down the goodwill for this acquisition, not unlike eBay a few years ago, after their purchase of Skype.
Skype has a terrific product, which I use a lot. My son plays chess with my father on Skype daily (despite my father living only seven miles away). But unless I use Skype to make phone calls (which I do when I travel outside of the US), Skype makes no money on me as a customer. I find that I use Skype as a VoIP product less and less when I travel outside of the US, because almost everyone I want to talk to has Skype on their phone or computer (this is how I communicate with my partner Mike when I am outside the US). The minute Skype decides to start charging for video-to-video service I’ll switch to another free provider and so will my friends and relatives (ironically, we’ve been conditioned that video-to-video communication should be free).
So why, after everything I wrote, do I masochistically own shares of Microsoft? Because the business is still too good and the stock is incredibly cheap. Microsoft is trading at about eight times next year’s earnings if you take out cash. However, as I write this I pause. What if Microsoft (Steve Ballmer, to be exact) keeps pulling “Microsofts” and continues to buy the Skypes of the world? With the Skype acquisition Ballmer will likely destroy 60 cents of Microsoft’s value. ($8.5 billion roughly equates to $1 per share for Microsoft. Skype is worth closer to $3 billion, 40 cents a share.). In our estimate Microsoft is worth around the mid-30s, so with this upside we can tolerate a few Skypes, but not many. I truly hope that other shareholders and employees start a jasmine revolution in Microsoft and vote Steve Ballmer out of office. But that is only a dream.
P.S. Despite my being critical of Steve Ballmer, the deal Microsoft signed with Nokia was brilliant. Microsoft is a software company and doesn’t make hardware; its partners do. Though in the bulky world of PCs and laptops that setup did not hinder Microsoft, it does now. Apple’s control of both hardware and software allows the iPad to have a 10-hour battery life. On my flight from Prague to NYC my Dell ran out of juice in less than 2 hours, and I had to use the iPad for the rest of the trip (an external keyboard helps a lot).
Nokia’s new CEO came from Microsoft. My friend Tero Kuittenen described him as a Manchurian candidate: it appears almost as if he was implanted into Nokia by Microsoft – the Microsoft-Nokia deal is by far more favorable to Microsoft than Nokia. The new CEO looked at Nokia’s operating systems (Symbian and MeGo) in development and realized he didn’t have many options other than creating an alliance with Microsoft. (Go figure!) Nokia could have used Google’s Android, which is free, but it is difficult to differentiate in that crowded space. So Nokia hung its future on the Windows operating system. And it makes logical sense that the alliance will go 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 a more holistic software-hardware design platform and give Microsoft a fair chance to come up with a decent, iPad-level tablet.
Vitaliy N. Katsenelson, CFA? Chief Investment Officer