As a stockholder, you are a part owner in a business, and it is your responsibility to keep a close eye on that business to make sure that it still belongs in your portfolio and to ensure that you are holding a stock for the right reasons, and not because of emotional attachment.
Before I buy a stock, I write down the reasons I have chosen to be a part owner of a business, the risks to that business and some predictions about the business. Every year or so I revisit that list and update it. I find this helps me manage emotional connections to stocks and portfolio inertia.
Nine Months Ago - What Things Could Have Been
I am using Microsoft's (MSFT) purchase of Nokia's (NOK) phone business this month as an opportunity to revisit my list and to take a look at whether my reasons for staying invested in the company a year ago still apply. Here are my reasons for investing from nine months ago, which was right after Windows 8 was publicly released:
- Microsoft's enterprise businesses, including Windows and Office, Windows Server, Lync, Exchange, Dynamics, SharePoint, SQL Server, Hyper-V, etc. These businesses are (1) entrenched, with high switching costs, that provide large barriers to entry; (2) gaining market share, particularly with Lync and in virtualization where they are the low-cost alternative to VMware (VMW); and (3) provide Microsoft the best cross-selling opportunities in the industry. These businesses are safe over the long-term with the possible exception of cloud services encroaching on Windows Server sales. Azure is a promising business, although in part it will cannibalize some of the other lines.
- Windows 8 was designed for tablets and hybrids, and consumers will have no reason to buy Google (GOOG) Android tablets (which at the time did not have many tablet-optimized apps available) after Windows 8 is released. Windows 8, even if it sells poorly, will have a huge user base very soon. That user base will be sufficient to drive a thriving app ecosystem. Developers will develop Metro apps because of the hundreds of millions of Windows 8 users. The tablet market will therefore be divided between the iPad and Windows tablets and hybrids.
- Over time, consumers will become familiar with the Windows 8 Metro UI on desktops, laptops and tablets/hybrids. This familiarity will drive sales of Windows Phone. While Windows Phone will not sell more than iPhone or Android, it will have enough market share to have a healthy ecosystem, particularly with enterprise applications.
- Over time, Microsoft will be able to position itself to offer phones that, when docked, can run a productivity operating system, which is something only it can do well, and which will allow it to market to take enterprise share from Blackberry (BBY).
- Without the legacy anti-trust restrictions, Microsoft can begin to extract more value out of its huge user base by integrating its products into Windows in ways that have not been permitted before, including by integrating Bing, Skype, SkyDrive, etc directly into Windows and by establishing an exclusive Windows app store for Metro apps.
- In conclusion, Microsoft will not control the consumer platform like it has in the past, but the enterprise businesses in point (1) are so strong, with such high barriers to entry, that as long as it can keep its head above water (points (2)-(5)), the stock in the high $20s is a great value.
At the time, that all sounded pretty reasonable, and a lot of it still is. But my, how things can change in less than a year.
Where I Was Wrong
The first point still stands; the enterprise businesses are fantastic businesses. There is still no real threat that office workers stop using Windows and Office, or, with some exceptions, that the other enterprise businesses are at risk.
Where I was wrong was on the other five points. Although Windows 8 has had disappointing sales, consumer sales were never one of my concerns. But for various reasons, which can be debated, several things that I expected to happen did not.
First, I thought that the hundreds of millions of Windows 8 users would almost instantly provide a critical mass of users sufficient to spur development of Metro apps. That still has not happened. There still is not an official Metro Facebook app. There simply are not enough apps. One of the reasons is that many users (myself included) do not even use Metro and stay on the familiar desktop. Whatever the reason, no apps means Microsoft has not been able to push Android out of the tablet/hybrid market. Android has a foothold in the tablet market now, and that foothold will not go away given the incredibly strong position Android has in the phone market.
Second, consumers still have not embraced Metro, and Windows Metro certainly has not had much of a halo effect on Windows Phone sales. Again, as a shareholder, I was never concerned about consumer sales, but was concerned about Microsoft's ability to create a viable mobile ecosystem. With market share around 4%, this is simply not a viable ecosystem yet.
A year ago, it was reasonable to think that at this point Microsoft would have pushed Android out of the tablet market and developed a viable phone ecosystem that would allow it to at least tread water in the consumer market while it grows its fantastic enterprise businesses. Instead, today Android has a strong foothold in the tablet market that is not going away and Microsoft still has not developed a viable mobile ecosystem.
What does this mean? It means Microsoft is desperate, and it is going to take on a lot of risk and waste a lot of money. That's where the Nokia acquisition comes in.
The Nokia Deal and the "Go-It-Alone" Strategy
Buying Nokia for $7 billion is not in itself a lot of money for a company as big as Microsoft. But Nokia comes along with 32,000 employees (Microsoft itself only has 99,000 employees). That's a 30% plus increase in employee count. Nokia is also a hardware company, which is an incredibly difficult business, as Microsoft itself found out when it had to write off $900 million on its Surface line of tablets. With the exception of Apple, no other computer hardware company has ever been consistently and highly profitable, and Apple's success is arguably only the result of being years ahead on several major hardware trends. Microsoft is instead years behind. The hardware business ties up capital, has large labor costs, and often produces losses. The acquisition also makes it much more likely that the other Windows Phone partners like Samsung and HTC fully abandon the platform in favor of Android, which will make Microsoft's challenge here even more difficult. All of these reasons make you wonder whether the rumors are true that the deal was driven by Nokia threatening to make Android phones.
So now Microsoft and Nokia will have to wait until early next year to close the deal, then will have to integrate operations and start co-developing products. Don't expect the fruits of this deal to come until late next year, at the earliest.
In the meantime, Android will continue to dominate the phone market, and will continue to add functionality that will keep it relevant in the tablet market. Most Windows Phone partners will likely abandon the platform and focus exclusively on Android. These are some of the same manufacturers that have announced new Chromebook models, which also shows signs of life.
A New Money Pit
It has been clear for years that Microsoft will no longer control all access points to the internet. Consumers will increasingly utilize mobile devices that are outside of Microsoft's reach. That in itself does not put Microsoft's enterprise businesses at risk, and those businesses will continue to perform well. The failures of Windows 8 and Windows Phone have, however, made Microsoft desperate, and in its desperation, it has acquired Nokia and is diving head first into the hardware business, with all of its associated costs and risks.
If Windows 8 and, by extension, Windows Phone, had been as modestly successful as was expected a year ago, these risks would not be as serious. Instead, going forward, it is clear that Microsoft will now throw an unlimited amount of money at these platforms and devices. They have a very steep hill to climb, which means many billions will be spent on advertising blitzes, hardware production and subsidies. By going it alone, they can no longer rely on their partners to take risks and invest the capital. Instead, Android will derive those benefits from its partners.
Just like Bing has been a money pit, so too will consumer mobile devices, but on a much larger scale. Microsoft still has fantastic enterprise businesses, but its shares are no longer a compelling value, because of the risks and costs inherent in a go-it-alone mobile device strategy with a desperate and cash-rich management team that has proven it will not hesitate to throw good money after bad.