What Microsoft and Other IT Companies Are Telling Us

| About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) announced that its board has approved a 22 percent increase in the company's quarterly dividend. In addition, the board agreed to a new $40 billion stock buyback program. The buyback program is replacing another buyback program of $40 billion that expires on September 30. Microsoft has repurchased $110 billion of its Microsoft shares over the past nine years.

Shares outstanding in Microsoft have declined by 22 percent over this time period. The dividend increase this year compares with a 15 percent increase in dividends last year.

The price of Microsoft stock has been basically flat for the past ten years or so. For the last five years, the stock has risen from about $25 per share to around $33 per share as of yesterday. And, what about returns?

I, especially, like to focus on a company's return on equity. I am looking for a return on equity in excess of 15 percent because research seems to indicate that a return on equity of 15 percent or more indicates that a company might have achieved a competitive advantage over competition in the marketplace. And, if the company can earn a return on equity for five years or more, then one can say that the company has a sustainable competitive advantage.

What about Microsoft? Well, it meets all the criteria I look for. This year, so far, it is earning just under 25 percent on total shareholder equity. The five previous years: the lowest return on equity has been just above 33 percent and the highest, in 2008, was near the 50 percent level.

So, one can argue that Microsoft has achieved a competitive advantage in its marketplace and, in fact, it has achieved a sustainable competitive advantage according to the criteria I set out above. Why, then, has the price of Microsoft stock remained flat for the past ten years?

The basic response to this argument is that the company achieved a monopoly position in the industry through scale and network effects, which have created sufficient barriers to entry to keep other companies out so that the "monopoly" returns cannot be competed away.

The problem is that through insufficient management leadership, Microsoft has basically gone nowhere even with such a powerful position. As a consequence, it has built up "cash balances." And, it has even gone through two debt issues … which it had never done before … to build up even greater cash balances.

Since these debt issues came after the U.S. economy started to recover, one assumed … at least, I certainly did … that the cash balances were going to be used for acquisitions as the economy picked up steam and a company with "tons" of cash could basically have the choice of any weaker or smaller organizations it wished to absorb.

One such attempt to do this was Microsoft's acquisition of the handset business of Nokia (NYSE:NOK). But, this, within the scheme of things, was pretty weak.

Microsoft has missed the arenas that are most vibrant now: smartphones and tablets. (For a discussion of arenas, see my review of the book by Rita Gunther McGrath, "The End of Competitive Advantage".) Instead, Microsoft has seemingly decided to concentrate on software, supporting services and devices, enabling technologies.

But, as stated above, Microsoft seems to be going basically going nowhere. And, they seem to be doing all the things that company's going nowhere seem to do. They announced a reorganization in July. Then Steve Ballmer, the company President and CEO announced his retirement in August. Following this we were told about the uninteresting acquisition from Nokia. Now, we have an increase in dividends and a new stock buyback program.

All these are signs that Microsoft has no place to really use its "cash balances". It is just rested on its monopoly position, raking in the cash … and is incapable of finding any real use for the money. Microsoft is not alone, however.

International Business Machines (NYSE:IBM) has acquired its own stock over the past nine fiscal years … $100 billion worth. The growth rate of its earnings per share rose from 16 percent to 53 percent. By the way, IBM has earned a minimum return on total shareholder equity of just over 31 percent in the last five years. Its maximum return in this time period was almost 40 percent.

Cisco Systems (NASDAQ:CSCO) is another company that has repurchased stock. In recent years it has obtained $63 billion of its stock helping to goose up the growth rate of its earnings per share from 10 percent to 40 percent. Cisco has not performed in terms of return on equity the way these other companies have: its minimum return on total shareholders' equity over the past five years was just under 13 percent; its highest return was just over 20 percent.

Oracle (NASDAQ:ORCL) only began to buy back its stock over the last couple of years. But, the timing is interesting. Oracle has plenty of cash and the economy is recovering. The company must have little or nothing to do with the cash and so it has started to buy back stock in the effort to bump up earnings per share to get a better stock price. Over the past five years Oracle has earned a return on total shareholder capital that has ranged between 21 percent and just under 23 percent.

The point is that these hulking giants of the computer world all seem to be languishing and their stock prices are tending to underperform. There is little or no indication that they are going anywhere. Their cash inflows need to be returned to shareholders in one way or another because these companies don't seem to have a vision for what the future is going to look like.

One thing these companies need to avoid is making acquisitions just because it makes them look like they are "doing something" and because they have all this cash around. It just shows that the managements are desperate!

In fact, this is the worst thing they can do with the cash. Microsoft may be signaling to us that they realize this fact. I sure hope so.

The final takeaway from this information is that the "old" information technology companies are living off of the good decisions they made earlier in their lives. They have not yet found a way to break into the new arenas and develop new competitive advantages for the future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.