Adam Bryant's interview with Microsoft's new CEO has just appeared in the New York Times with the headline "Microsoft's New Chief Says It's Time to Create."
Unfortunately, most of the interview concentrates on "What leadership lessons have you learned from your predecessor, Steve Ballmer?" "And what about Bill Gates?" "What is going to be the role of Bill Gates?" "Tell me about your management approach in your new role?" "How do you hire?" and so on and so forth.
The last question asked is "Any final big-picture thoughts on how you're going to approach your new role?"
The answer: "Longevity in this business is about being able to reinvent yourself or invent the future…"
Microsoft (NASDAQ:MSFT) has a problem. Basically, the price of Microsoft stock has remained within a narrow band since the Spring of 2000, several months after Steve Ballmer, Mr. Nadella's predecessor, took over the office of CEO from Bill Gates.
Even though Microsoft earned a return on shareholders' equity in excess of 15 percent every year after Mr. Ballmer took over the leadership of the company, the stock price basically went nowhere.
In essence, the franchise value of Microsoft was determined by the end of the last decade of the twentieth century and that value has not changed since. In terms of the creation of an information good, Microsoft had created a platform, scaled the platform to the point where it was (almost) a monopoly, and then with the existence of network effects and high switching costs, maintained that franchise up until the present.
The problem with this is that Microsoft, according to the financial market, basically created no additional value since then.
Even though it was earning a return on equity in excess of its opportunity cost of capital and generating "tons" of cash every quarter, Microsoft could not create any more value.
Microsoft did not know how to use its retained earnings very well. To Warren Buffett, this is one of the major things to look for in an incumbent management - how does the management team use the retained earnings that a firm might be generating.
Looking at this in a little more technical way, we can look at the performance of the Microsoft stock from the standpoint of value investing. To do this I turn to the classic work by Bruce Greenwald, Judd Kahn, Paul Sonkin and Michael van Biema titled "Value Investing: From Graham to Buffett and Beyond" (John Wiley & Sons, Inc.: 2001).
Two major elements in their methodology are the Earnings Power Value (EPV) of the firm and the Value of Growth. Basically, the "firm's intrinsic value" is "the value of (the firm's) current earnings…." Basically, the current earnings of the firm boils down to "sustainable levels of distributable cash flow." In essence, this "earnings level remains constant for the indefinite future."
If the EPV of the firm includes the excess earnings that are achieved from the existence of sustainable competitive advantages, then, the authors argue, the firm has a franchise value.
I don't believe that anyone doubts that Microsoft has "franchise value" due to the existence of its software platform that achieved a (almost) monopoly position in the market…and has sustained it.
The problem about producing more value is the problem of how the firm uses its retained earnings. The firm must invest and reinvest in order to attain growth in value. If the return on the investments the firm makes just about equals the firm's opportunity cost of capital, then no more value is being created. The worth of the company remains the same.
Microsoft, for example, has a lot of "cash" on hand. It has not used it. One could certainly argue that the return on this investment is not covering the firm's opportunity cost of capital.
The authors of the book add "we know that in many-if not most-situations, the value is zero (no franchise) or even less (competitive advantages)."
"Only franchise value creates growth value. Thus, judging the existence and sustainability of a company's franchise/competitive advantages/barriers to entry, is central to assessing the value of future growth."
Microsoft established its "franchise" value by the end of the 1990s. Since then it has done little or nothing to build additional franchise value or establish further competitive advantages or build barriers to entry in the spaces it has entered with its retained earnings.
This, to me, is the problem that Microsoft has.
Mr. Nadella's interview with Adam Bryant has done little to give me confidence that he is the one to lead Microsoft forward in this quest.
What did Mr. Nadella learn from his predecessor? To "stay grounded and to be brutally honest with yourself on where you stand."
From Bill Gates? To push and to let others push back on you. People like Bill Gates…"They pressure-test you. They test your convictions."
And, the big picture? "Longevity…is about being able to reinvent yourself or invent the future…"
Mr. Nadella appears to me to be an engineer…which is what he is. I have seen very little of what it takes to be a leader and to truly use your resources, including your retained earnings, in a way that will create value.
I am all for Mr. Nadella. I hope he succeeds. I hope he is very successful. But, I look at things from the standpoint of finance…not from the standpoint of an engineer. I believe that Microsoft needs something more at this time than just the viewpoint of an engineer.