Kevin Rose, in our fledgling New York Office, explains why the International Fund doesn't own Microsoft.
History is not kind to the titans of the technological marketplace. Even the mightiest seem to fall: IBM, Kodak, Sony, Research in Motion – all once dominant leaders eventually undone. That is a tired cliché, but relevant to the case of Microsoft.
By most traditional measures, Microsoft’s stock trades at an inexpensive valuation. It still has an incredible franchise and produces prodigious profits. But one does not invest based on historical profits. In the long term, stock prices will always reflect the market’s expectation of future profits. And it is those profits that worry me when I look at Mister Softee.
The death of the PC is an easy drum for the business press to beat, but there is no doubt that the introduction of smartphones and tablets has brought about a profound change in our everyday use of technology. Once computing power was put in our hands, the world started to tilt away from Microsoft. Currently I own an iPhone, an iPad, and a PC laptop that, since I bought my iPad, I use only for work. I don’t see any reason to own a PC (or a Mac) for personal use. Now that file storage has shifted to the cloud via Google Drive, iCloud, Skydrive, etc, I can surf, email, save and access all of my music, photos, videos and documents, and read books with my tablet. I seriously doubt I will ever buy another PC for personal use again – and I’m not alone. Five years ago I couldn’t have fathomed making such a statement.
Microsoft operates in five businesses, but relies on only three of those for most of its profit: Windows, Office and Server. Of those three, Windows is driven almost entirely by PC demand while Office is exclusive to Windows. Windows 8 and Microsoft’s Surface tablet have been real disappointments – their announcement yesterday of the Windows Blue update is a tacit admission. The most significant evolution in the hardware market since the commoditisation of the personal computer, and Microsoft is looking more and more like a passenger, not the conductor. Android has basically replicated the 1980s Microsoft playbook: license out your software to any equipment manufacturer that wants it, and create a valuable software ecosystem to encourage mass adoption. For a long time, Microsoft issued a new version of Windows every few years. Today, Apple and Google release multiple versions of their mobile software per year. The pace of change has accelerated, and that doesn’t bode well for anyone.
I mentioned that Microsoft looked cheap. There is a cogent, plausible argument popular among bulls that if you break the company apart and value each of its main business lines separately, you reach an intrinsic value in excess of today’s price. If I apply premium multiples to the Server and Office segments, I reach values for those businesses of $9 and $22 per share respectively. Given my concerns over the PC market, I would discount the Windows business meaningfully, resulting in a $7 per share value. The Online and Entertainment divisions are lousy businesses that have produced negative profits for years – worth zero at best to anyone except, perhaps, one of its competitors. The only remaining piece is a corporate overhead cost center that subtracts $5 of value. Microsoft's cash balance is domiciled largely outside of the US, so the after-tax value is circa $5.50. Putting all of that together, you arrive at an estimated per share value of $38.50, 14% above today’s closing price
But what chance you ever realise that value?
This is a company that has dominated the tech sector like no other, with unmatched resources, yet whose only real innovation in the last 20 years is a video gaming platform. The Server business is an attractive business, but one largely built through acquisitions. Meanwhile, they have missed the boat on search, social media, smartphones, and tablets. And then there’s the Balmer/Yahoo issue. He has failed to accomplish anything in his time as CEO, and almost pissed away the company’s considerable cash balance on another dying tech wannabe. More damningly, Microsoft is not an employer of choice amongst tech’s up-and-comers. What is the long term cost of that brain drain? I am not saying Microsoft won’t succeed in the future, but I feel ill positioned to make that judgment. There are just too many risks and uphill battles left to face, and their track record is uninspiring. Microsoft is another for the “too hard” bucket.