Lee Ainslie of Maverick Capital recently pitched Microsoft (MSFT) as a good investment at the Value Investing Congress. Unless Whitney Tilson has changed the name of the conference to the Value Trap Congress, I can’t imagine why you would be enamored with the stock right now.
In Texas Hold’em, when you have a leading hand on the flop but don’t play your cards right you can often be “counterfeited.” For instance, if you hold 9-10 and the board flops 5-9-10 you will be leading against even a pair of A-A. However, if you don’t protect your hand and get your opponent to fold with a big bet, you might end up losing. If a 5 falls on the turn, your winning hand will have turned into a losing one. You will now be holding middle two pair vs top two pair.
Microsoft let its winning hand, Windows, become counterfeited because of its poor management. The only two business lessons Bill Gates preaches are
1) always hire the best lawyers you can afford (a reference to the contract which gave Microsoft control of the operating system it wrote for IBM personal computers in the 1980s) and
2) always control the ‘choke’ point of a system. The choke point in the computing world is the operating system. Hardware is a commodity because it is worthless without an operating system to run it.
When Bill Gates ran Microsoft, the company owned the choke point of the computing world with Windows. Gates was ruthless in defending his turf. When Netscape threatened to own the internet access choke point with its browser, Microsoft dropped everything to destroy its upstart competitor. When PDAs became all the rage in the late 1990s, Gates created an operating system for PDAs to combat Palm OS. Palm never recovered after Microsoft entered the PDA market because Microsoft always had the best hand – the company owned the PC and the PDA had to integrate with the PC to be useful. When Sony threatened to invade people’s living rooms with Playstation and control their entertainment flow, Microsoft backed the Xbox.
But now, under the leadership of Steve Ballmer, Microsoft has lost the choke point. The choke point has moved from the PC to mobile devices. Microsoft’s winning hand has been counterfeited by both Apple (AAPL) and Google (GOOG).
Apple has been a thorn in Microsoft’s side for the better part of the past decade but never a huge threat because most businesses and many consumers would never dump their PCs to buy slower, more expensive Apple computers, no matter how good the user interface. Steve Jobs was selling Lexus compared to Microsoft’s Camry. It was basically two different markets.
The iPhone, however, was a direct threat to Microsoft’s control of the ‘choke’ point. The iPhone was revolutionary not because of it’s interface, which was brilliantly designed, but because Apple opened up the code to allow third party developers to create new applications outside of the traditional Windows platform. Microsoft should have seen the threat immediately because it was a direct copy of the threat Palm posed with its operating system. Yet Microsoft’s response was slow and disorganized. It didn’t introduce a phone until 2010 and the KIN was a weak response to Palm’s phone, not to the threat Apple was posing.
So weak, in fact, that it allowed the unimaginable to happen. It allowed another dominant competitor into the market: Google (GOOG). The Android operating system, which was introduced in late 2007, should never have gained as much traction as it has. Android was open design developed by a consortium of companies specifically aimed at combating both the iPhone and any future Microsoft entry. However, Microsoft should have been able to use its clout, cash war-chest and expertise to muscle into the market, just as it had with its PDA operating system.
Both the iPhone OS 4.0 and the Android are now working themselves backward to the PC from the newly introduced tablet computers. Both allow third party developers to create applications that basically mimic the dominant Windows Office environment. Not only that, but in many cases, the targeted applications are easier to use than Microsoft’s increasingly bloated software.
Microsoft is now running behind with the introduction of Windows Mobile 7.0. To continue the poker analogy, while Ballmer was trying to beat Google’s hand in search with his pursuite of Yahoo, Google hit an set on the turn with Android. Microsoft didn’t bet big enough and fast enough on Mobile and Google stole the pot from under its nose.
This is clearly management’s fault. Allocating resources and putting in place the correct division managers are strategic decisions that need to come from the CEO. While KIN management was clearly incompetent, Ballmer should have realized this much earlier than 2008, when work on Windows Mobile 7.0 began.
Unless the Board replaces Ballmer with more competent management, I believe Microsoft’s stock will always trade at a discount to its competitors. On paper, Microsoft looks like a value investors dream. The company trades at a steep discount to Google and Apple, even though Microsoft’s margins and growth stack up equally or better.
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In addition, Microsoft’s earnings have been growing steadily over the past two years. In the chart below, you can see that the forward estimates indicated by the dotted line have been rising even though the stock has been stuck in the mud.
And the stock’s Price/Earnings ratio is basically at the lowest level ever.
Since the introduction of Windows 7.0 and the resultant earnings boost from it the stock has basically gone nowhere. I believe the market realizes that Microsoft has lost its dominant hand. It no longer owns the choke point since that point has moved from the PC to mobile devices.
If the introduction of the biggest software upgrade since Windows XP in 2001 can’t move the stock higher, what will? Will it be Windows Mobile 7.0, a hopelessly late, fourth-place entry into the wireless market? Will it be the rise of Bing, which costs Microsoft about $1 billion in losses every year to operate? Will it be the Xbox which saw no growth and represents only 12% of Microsoft’s revenues? Will it be the corporate upgrade cycle in PCs, which is being cannibalized by the introduction of tablet computers?
My answer is none of these will make the stock move higher. Microsoft has relegated itself to a dying utility through its slow and inept management. They have lost their dominating starting hand of pocket aces to a couple of upstart players that were playing a much weaker cards. I believe much like IBM, which lost the operating system to Microsoft in the 1990s, Microsoft’s stock will trade at a forward P/E of the mid to low teens for the foreseeable futures. The stock is, in my opinion, a value trap. There’s no doubt the stock is cheap at 11x earnings and could move back to the high $20s. And an increase in the dividend could make it more attractive to yield hungry investors. However, I don’t see a sustainable advance back to $30 or higher until the Board cuts its losses and replaces the CEO who played his cards so poorly.
Disclosure: Contrahour is long Microsoft (MSFT) but for the life of it can’t figure out why.