Microsoft At $40

Mar.23.14 | About: Microsoft Corporation (MSFT)


Microsoft stock hit $40 per share for the first time since early 2000.

Investors are looking for positive results from Satya Nadella, the new Microsoft boss.

Microsoft's future still depends upon Nadella developing an adequate reinvestment policy for Microsoft's earnings.

The stock price of Microsoft Corp. (NASDAQ:MSFT) has finally hit $40 again!

It has been a long time in coming. The last time the Microsoft stock price hit $40 was in early 2000 and Steve Ballmer was the new CEO.

Perhaps the worst market response that can occur to a retiring CEO is to have the stock price rise upon your retirement. The day before Ballmer's retirement was announced, Microsoft's stock closed at $34.15.

Since the announcement, Microsoft's stock price has risen just about 18 percent.

Since the announcement of his replacement, Satya Nadella, Microsoft's stock price has risen by about 13 percent.

Well, you can say that the whole stock market has risen since the day that Mr. Ballmer's retirement was released. The S&P 500 index has risen about 13 percent since that day in late August. But, Microsoft's stock has risen by more than that since late August… and Microsoft's stock is not that sensitive to movements in the whole market. For example, Microsoft's Beta coefficient is 0.85. Furthermore, the stock market achieved two major peaks while Ballmer was the CEO and Microsoft's stock price hardly moved at all during those major upswings.

Anyhow, Microsoft's stock price closed the week above $40 per share. Positive Nadella… negative Ballmer.

The only major thing that Mr. Nadella has done during this time is make some executive changes. The direction he will be heading in, the strategy he will devise, and the culture he will attempt to create will all slowly evolve.

The most that Mr. Nadella has said in this area is that a company must be able to "reinvent itself" or "invent the future."

We can all agree with that. But, what does this mean?

Microsoft came up with two major market-dominating innovations. First was the Windows operating system, an OS that has dominated the market and established an earnings performance second to very few. Microsoft led the market here.

The other major product that Microsoft delivered was the Explorer browser. Microsoft was not the first in this area, but created a browser that overtook the earlier mover and came to dominate the market.

These two advancements got Microsoft the position it is still in today. And, it produced a return on equity for the company that exceeded 15 percent for well over a decade.

But, there was a problem. As John Mihaljevic writes in his book "The Manual of Ideas" (published by John Wiley & Sons in 2013), "High returns on existing capital-the capital already employed in a business-are almost meaningless without an ability to invest new capital at above-average returns. Returns on existing capital, whether high or low, are already reflected in a company's operating income."

Microsoft was behind in the creation of a browser but was able to pull a remarkable comeback that is now industry lore, but ever since this triumph, Microsoft has been a follower… and followers do not produce "above-average returns" on its new investments.

Mihaljevic writes that a value-creating machine "could include proprietary business processes, copyrights and patents, carefully nurtured consumer brand preferences, deliberately heightened customer switching costs, and other factors…" that allow a company to generate abnormal returns.

This, however, gets built into stock prices and the stock price goes nowhere unless a management can reinvest the cash flow being generated by this comparative advantage at above-average returns.

"In a scenario without reinvestment, the only other driver of return will be whether management returns cash to shareholders or whether it insists on putting cash back into the business despite an absence of high-return projects."

In the first choice, repurchasing the company's stock or paying higher dividends are the only choices. The second can include acquisitions, but the history of buying other companies is "typically a less favorable way of allocating excess capital."

Mihaljevic goes to write "While it is difficult for outside shareholders to judge in real time whether a company's reinvestment levels are appropriate, management's attempts to expand into new businesses or launch new product categories may be warning signs that the company is venturing into potentially high-risk, low-return projects."

He concludes that investors should "avoid companies with virtually no opportunity for high-return reinvestment of capital."

This is what Mr. Nadella faces and what he must address and communicate to the investment community. I believe that thirteen years of failure to reinvest capital into high-return opportunities has been long enough to convince the investors that Mr. Ballmer was not the one to extend the Microsoft's competitive advantage into other fields… like tablets and mobile devices.

Now, investors are hopefully looking to Mr. Nadella to change this culture. This hope, however, is what is driving the Microsoft stock price.

Mr. Nadella has not addressed the reinvestment issue yet. Unfortunately, it is a very difficult task and will only be observed over time as the reinvestment takes place. The people that are able to achieve very good results in this task are in the minority. But, it is what the future of Microsoft depends upon.

Mr. Nadella cannot control the price of the Microsoft stock, but he is responsible for the process of reinvestment within Microsoft. Investor perception of the success or failure of this process of reinvestment will be the ultimate factor that will influence the future value of Microsoft stock.

Disclosure: I am long MSFT. 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.