We have written at length about Microsoft (MSFT) in the past, and have repeatedly stated that one of, if not the key reason, why we have hesitated to buy shares of the company is the continued presence of Steve Ballmer as CEO. Our criticism of Ballmer stems not from a collapse in revenue or profits under his tenure, but largely from his presiding over a corporate culture that promotes vicious infighting and corporate politics that lead to an inability to innovate in truly meaningful ways. That, combined with Ballmer's track record of firing subordinates that he sees as a threat to his power, has led to a persistent inability to craft truly meaningful commercial breakthroughs that go beyond incremental updates to Windows, Office or the Xbox. There is a difference between research and development and commercial innovation, a distinction Microsoft has for years failed to grasp. As we have written previously, Microsoft employs many intelligent and qualified engineers and scientists, and the company spends far more on R&D than Apple (AAPL) or Google (GOOG). But Microsoft's billions in R&D spending have led to a myriad of projects that have either failed to see the light of day or, in the case of the Zune or the Kin, have been commercial failures. And at the end of the day, there is only one person responsible for this: Steve Ballmer.
Refuting the Ballmer Defense
The duty of a chief executive officer is made clear in the title: they have a duty to execute the company's strategy, to generate profits and revenues, and grow those profits and revenues over time. And over the long run, this continued growth in profits and revenues should lead to continued growth in the company's stock price. But what if it does not? What if a company's share price remains stagnant, or even drops over the tenure of a particular CEO? Who should be held accountable? In our view, it is the CEO who bears ultimate responsibility for this failure.
On paper, Steve Ballmer's tenure as CEO of Microsoft has been a successful one. Steve Ballmer was appointed CEO of Microsoft on January 13, 2000, and in fiscal 2001, Microsoft generated $25.296 billion in revenue and profits of $7.346 billion. In fiscal 2012, revenues came in at $73.723 billion and profits reached $23.171 billion (excluding the aQuantive writedown). Surely Steve Ballmer should be commended for such success. Even in the face of weakness in the PC market, Microsoft has remained relatively healthy compared to peers such as Dell (DELL). But what of Microsoft's stock price? Logically, if Microsoft's revenues and profits have both grown over Steve Ballmer's tenure, then its stock price should as well. However, the truth is far different, as the table below shows (results are presented on both a price and total return basis).
Microsoft vs. the Markets
S&P 500 (SPY)
January 13, 2000 Close
January 13, 2000 Adjusted Close
May 8, 2013 Close
% Change (Price)
% Change (Total Return)
*Adjusted to exclude dividends, but to include splits that have occurred since January 13, 2000
Even when dividends are included, shares of Microsoft have lost nearly 19% of their value since Steve Ballmer was appointed CEO, and without Microsoft's decision to initiate dividend payments, its shares would have lost almost 40%, far exceeding the losses of the NASDAQ and the NASDAQ-100, to say nothing of Apple (up 1,845.64%) and Google (up 770.67% since its August 2004 IPO). Defenders of Microsoft will likely point to the performance of the NASDAQ and NASDAQ-100, arguing that underperformance of a few percentage points is hardly grounds for such levels of criticism. However, the performance of Microsoft has suppressed the true performance of the NASDAQ. Even now, Microsoft accounts for over 8% of the NASDAQ-100, and during the early years of Steve Ballmer's tenure as CEO, its weighting was far higher, and as Microsoft's stock continued to slide, it had a disproportionate effect on these indices.
Compared to the S&P 500, Microsoft has dramatically underperformed. It would be one thing if this were Steve Ballmer's first year as CEO. In our view, it is certainly valid to argue that the market is not giving a CEO enough credit, or enough time to execute the business strategy. For Microsoft, that argument may have been valid in 2001, 2002 or even later in the decade. But not in 2013. Steve Ballmer has been at the helm of Microsoft for over 13 years, and in our view, that is more than enough time for the market to pass judgment. But perhaps more importantly, defenders of Steve Ballmer that point to Microsoft's continued profitability fail to see a crucial distinction in the business world: Profitability does not always equal success.
Microsoft Under Ballmer: 13 Years of Leaving Money on the Table
For most companies, posting billions in net income every year would be a feat worthy of envy. For Microsoft, however, it serves as a reminder of the billions left on the table. Success at Microsoft, or any publicly traded company for that matter, should not be measured simply by the dollar amount of profit it can generate. It should be measured by how closely the company is coming to achieving maximum profitability. And on that front, Microsoft has fallen far short of its goals. Over the past 13 years, Microsoft has left billions on the table in its attempts to compete with a variety of companies, most notably Google. The issue is not that Microsoft is attempting to remain competitive in an era of technological change. Such efforts are worthy of praise, and Microsoft should certainly be investing to retain its market position. The issues stem from how Microsoft is attempting to remain competitive, and that by focusing much of its competitive efforts on Google, the company is missing the forest for the trees.
The billions that Microsoft has left on the table can be best summed up in one simple chart: a display of the profitability of its online services division.
Since 2005, Microsoft's online division has lost billions in an attempt to compete with Google in search and advertising. Notably, this chart excludes the $6.2 billion writedown of aQuantive, which represents a near total loss on the $6.3 billion Microsoft (and by extension its investors) paid for the advertising company in 2007. Microsoft has spent years attempting to compete with Google, even as cloud, mobile and tablet computing present a far bigger threat than online advertising and search. While it is true that Google is levered to all 3 of these trends, Microsoft has spent years competing with the wrong divisions of Google, and in the process, has cost its shareholders billions. The issue that Microsoft's online losses highlight is not weak financials, for Microsoft's balance sheet is still strong, but a weak corporate culture. Had Steve Ballmer chose to shut down Microsoft's search and advertising business even a few years ago, Microsoft shareholders would be several billion dollars wealthier. The fact that Microsoft is now losing less than $300 million per quarter in its online division is seen by many as a sign of progress. We, however, see it as a stark reminder of Microsoft's missteps, and the billions that this has cost shareholders. Online services, however, is not the only division where Microsoft has left billions on the table. Microsoft's research and development budget, among the largest in the technology industry (and indeed corporate America), has produced little in the way of groundbreaking innovation under Steve Ballmer's tenure other than a case study in the "innovator's dilemma."
Between 2000 and 2010, Microsoft spent $69 billion on research and development, and since then, billions more have been spent on research and development. And what does Microsoft have to show for this level of spending? Other than incremental updates to existing product lines, there has been precious little in the way of true groundbreaking, commercialized innovation. As we stated above, Microsoft employs many talented and intelligent scientists and engineers, and they can easily rival the talent employed by Apple and Google. But that is where the similarities end.
Apple and Google take far different approaches to R&D, despite spending far less than Microsoft. Apple's R&D budget is focused on not simply crafting new products such as the iPhone or iPad, but on new products that will be commercial successes. At Apple, there is no R&D for the sake of R&D. Every dollar is geared towards crafting either new versions of existing products, or on creating new product lines. Defenders of Microsoft and Steve Ballmer will likely point to Google, arguing that if Microsoft is an example of wasteful R&D, then surely Google is as well. What do things such as self-driving cars or Google Glasses have to do with search and advertising?
At Google, there are 2 key factors that serve to make its R&D practices different. 1) Although some of Google's R&D projects may be considered extravagant or unnecessary, the majority of its projects are designed to do one thing, and one thing only: boost Internet usage, and by extension, the use of Google services. If Google Glass becomes a commercial success, then Google will likely have a major foothold into what many see as the next key era of computing: wearable computers. Projects such as this are designed to strengthen the Google ecosystem, and even if they are unprofitable today, they help ensure that Google's ecosystem and advertising reach continue to grow. 2) At Google, voting control of the company rests with Larry Page, Sergey Brin, and Eric Schmidt. From the very beginning, Google's investors knew that when they invested in Google, they invested in the vision of its founders (and eventually, that of its chairman as well), and that this vision was not focused on any particular quarter.
However, Google's vision ensures that it does not fall into the trap of the innovator's dilemma. The company's top executives are aware that there are many challengers to Google's market leading position in search and advertising, and even if these challengers are largely unsuccessful today, that does not mean they will be unsuccessful tomorrow, which is why Google must constantly remain at the forefront of Internet innovation. Microsoft, on the other hand, has fallen into the trap of the innovator's dilemma, a view shared by many former executives of the company. Under the leadership of Steve Ballmer, the company views everything through the prism of defending its Windows and Office franchises, seemingly refusing to accept that if the company does not cannibalize these franchises on its own, then another company will. Much has been written about the challenges facing Windows and Office, and we will not spend additional time discussing them. What matters is that these franchises are under pressure, and without a truly innovative and disruptive mobile and tablet strategy, Microsoft's financial future is likely to be far less comfortable than its financial present.
Then Why Buy Microsoft?
If we are doubtful of Microsoft's prospects, given the internal rot that has taken hold under the leadership of Steve Ballmer, then why have we bought shares of Microsoft, and by extension, recommend that others do as well? It is because we have come to the belief that 2013 will be the definitive year that determines whether or not Steve Ballmer has a future at Microsoft. In our view, the 2013 holiday season will be most important in Microsoft's history. Windows 8 will have been out for over a year by the time the season begins, and with Windows Blue set to be released by the end of the year, Microsoft and its OEM partners will likely have a new lineup of PCs and tablets to sell, and by the 2013 holiday season, Windows Phone 8 will have also been on the market for a full year (having been released in October 2012, the 2012 holiday season may not have been fully representative of its potential), and rumors indicate that the next version of Windows Phone will be released in time for the 2013 holiday season.
How these new operating systems fare in the face of refreshed devices from Apple (a new iPhone is certain to be released by the start of the holiday season) and Samsung (the Galaxy S IV will certainly see a successful holiday season as well) is likely to play a key role in framing Microsoft's ability to compete in the smartphone and tablet space. Steve Ballmer's bonus for fiscal 2012 was cut due to weakness in the company's mobile and online divisions, and when the company releases its proxy for fiscal 2013 in October, we believe that Ballmer's bonus will be cut again, due to what we see as continued failure in these divisions.
Microsoft's performance in the 2013 holiday shopping season, and the results it reports for the holiday quarter will, in our view, play an instrumental role in determining whether or not Steve Ballmer remains as CEO. The company will likely go into the season with a fully refreshed lineup of products across PC's, tablets and smartphones, and if Microsoft fails to deliver a solid holiday quarter, the pressure on Steve Ballmer, both outside and inside Microsoft, will grow. Already, the markets have indicated that any headlines suggesting a removal of Steve Ballmer are a positive for Microsoft's stock price. Shares rose in 2011 when David Einhorn called for his ouster, and they rose in late April when activist investor ValueAct took a $2 billion stake in the company. Given that ValueAct has a track record of pressing for change at the companies it invests in (albeit in private), there is potential for increased pressure on Microsoft's board of directors, especially if other, emboldened investors join ValueAct.
We bought shares of Microsoft based on our belief that this year, especially the holiday shopping season, will play a key role in determining whether or not Steve Ballmer remains CEO of Microsoft, and believe that both a strong and weak holiday season will bode well for shares of Microsoft. If the holiday season is strong, then Microsoft will have made clear that it has the ability to remain a viable competitor in an increasingly mobile world. And if the holiday season is weak, then pressure on Steve Ballmer will increase, both internally and externally, and as the markets have shown several times before, any rumors or developments that suggest that Steve Ballmer will no longer be the CEO of Microsoft are a positive for the company's stock price.