On January 22nd, news broke that Microsoft (MSFT) has now entered into the fray to help take Dell (DELL) private with Silver Lake Partners. While I believe that if Dell is taken private below $14 per share, the buyers will get quite a deal over the long-term, I find myself constantly disappointed by Steve Ballmer and Microsoft's capital allocation. Honestly, the technology sector as a whole has some of the worst capital allocation habits, and it is amazing the opportunity cost that these companies are willing to pay to maintain these bastions of tens of billions of dollars in search of the next Autonomy or aQuantive time-bomb. To put my argument in perspective I wanted to look back at my previous article, "How Microsoft Can Win," that was written in November. In the prior article I made four recommendations to Microsoft and Steve Ballmer, that I admit are quite controversial, but that I truly believe could help get Microsoft going in the right direction. Below I am going to rehash them and update changes that have occurred since the time of the previous article.
1) When Research in Motion (RIMM) had a market capitalization of $5 billion, I recommended that Microsoft attempt to buy the company for a maximum of $15 per share. Currently RIMM has a market cap of roughly $9.4 billion and trades at $17.90 a share on optimism for the BB10 release. While I'm optimistic on both the BB10 and Windows, I don't believe there is realistically room for four major mobile operating systems so consolidation of the two accomplished over a longer-term period would greatly increase the combined entity's viability. BB10 looks great but imagine the excitement if consumers and enterprises knew that Microsoft's financial muscle was behind RIMM's technological skill. This deal would have been great for the Bing Search engine to expand in mobile as well and would add to the scale that Microsoft has with its relationship with Nokia (NOK).
2) I recommended Microsoft partner with Facebook pertaining to the Search business. The utilization of Bing's algorithms, which often test quite well in comparison to Google, with Facebook's social information about its consumers could create an extremely powerful competitor to Yelp (YELP) and eventually Google (GOOG). Facebook recently announced its Graph Search features, which are obviously independent of Microsoft, but to ultimately combat Google on Search a wider partnership with Microsoft's Bing could really help both companies. This is particularly true if Bing can win enough market share in mobile where the key Search battle is taking place.
3) I recommended that Microsoft issue an additional $10 billion of long-term, fixed rate debt for the purpose of buying back its undervalued stock. The interest on the debt would be tax deductible and the reduction on dividends paid on the common stock that is retired would lessen the cost of the debt even further. At current prices, Microsoft has earnings and free cash flow yields well in excess of 10% so buying back stock makes a lot of sense, and would be highly accretive to earnings per share. Look at the stock performance of IBM, which has less revenue growth than Microsoft, as it serves as the ultimate positive example of large cap technology capital allocation. I don't think it is surprising that the man who has eschewed technology concerns, Warren Buffett has built a huge position in IBM (IBM), as I believe he understands the company's strategy and trusts that excess free cash flows will be returned to shareholders.
4) The last thing I suggested was for Microsoft to support some of its key suppliers, more so for the reason that their stocks were absurdly undervalued, than anything necessarily strategic, as Hewlett Packard (HPQ) and Dell already are big supporters of Windows 8. At the time of the previous writing, a 5% stake in Dell could have been acquired for a cost of roughly $790MM and 5% of HPQ could have been bought for about $1.3 billion. Microsoft could have bought much more of these companies than 5% due to the ample liquidity in both stocks. Both stocks had dividend yields in excess of 3% and free cash flow yields greater than 10%, which is well beyond what Microsoft is earning on its cash holdings. Currently a 5% stake in Dell would now cost at minimum $1.15 billion and 5% of HPQ would cost roughly $1.68 billion. There is no reason why Microsoft can't buy these stakes in the open market, as opposed to only acquiring it once the price has been jacked up due to M&A speculation. Think how much stronger Microsoft's negotiating position would be if it already owned 5% of Dell at the much cheaper price.
Intel (INTC) is betting big on ultrabooks and tablets with keyboard optionality, and I believe they are right-on over the long-term. Ultimately the tablet technology will converge but I do believe the ultrabooks need to get a little bit lighter. When this happens, I believe Dell and HPQ will be much more competitive in putting out high quality devices that can compete with Apple (AAPL) and Android products. If HPQ and Dell end up failing into obscurity, I highly doubt that Microsoft will work out as a great investment, so I believe that supporting each other is the right move to make during this time of uncertainty. If PCs are really becoming tablets and hybrid tablet/PCs then there is absolutely no reason why Windows 8 should not be able to garner an extremely large market share. The edge that Apple had on tablets has been whittled away at this point from a technology perspective, and the marginal buyer interested in functionality and compatibility now has quite a few options without becoming a slave to the iOS eco-system.
Steve Ballmer paid ridiculous prices for aQuanitive, Skype and his career was saved by Jerry Yang & Co. rejecting his horrible bid for Yahoo (YHOO). There is a huge cost to waiting to make bold and decisive moves only when the business prospects looks brighter because as Warren Buffett says "You pay a high price for a cheery consensus."
Buying out of favor businesses that can improve Microsoft's competitive position makes a lot more sense than paying outrageous prices for companies that may or may not add to non-GAAP revenue growth, let alone actual earnings. There is no reason whatsoever for Microsoft to be sitting on in-excess of $66 billion in cash and investments. It is pure arrogance and lacks any business sense whatsoever. The beauty of Microsoft's business is that it isn't cash intensive. The amount of cash from operations that the company has generated over the last decade is astounding to think about. While business performance has been pretty good, I have no confidence in Ballmer's decision making pertaining to spending on M&A. I would also like to see a closer examination of what the return on investment on the company's vast R&D expenditures has been. Microsoft clearly isn't alone in its willingness to hoard cash at the expense of shareholders, as Apple is another example of a company that has no real need to sit on such a vast amount of cash. Unless they are saving up to buy a company the size of Citigroup (C) or something, what could possibly justify earning a few cents per dollar, versus returning a good portion of that money to the owners of the business? I have no idea what Microsoft will end up doing with Dell in this deal or if it will fall apart, but what is clear is that the company needs to make changes in how it is allocating capital.
I believe Microsoft has the opportunity to be a really tremendous investment over the next decade. Not all of Ballmer's move have been bad but he was given a stacked hand to begin with. If you are managing a public company, excess cash that can't be reinvested into the business at a reasonable rate of return should be paid back to shareholders via dividends, buybacks if the stock is reasonably valued, or M&A only if the acquisition makes strategic and financial sense. I believe the steps I outlined would have increased Microsoft's competitive position tremendously at a very reasonable cost. It is not too late to make some of these moves, but obviously the prices are quite a bit higher. As Peter Lynch says "Go for a business that any idiot can run - because sooner or later, any idiot is probably going to run it." I'm not interested in calling anyone a name, but I'm invested in Microsoft because it qualifies as one of those businesses and if management changes for the better the stock could go materially higher.