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“An idea that is not dangerous is unworthy of being called an idea at all”- Oscar Wilde

I believe the trade of trades, well actually it’s more like an investment, (if you have a 6 to 15 month horizon) will be to take the other side of the Google (GOOG) Trade I just did. When I first contemplated buying Google calls five weeks ago the thing that jumped out at me was the visual representation of its position in the world of publicly traded technology companies. Forget the fact that there was a "cloud" mania going on, and that in my mind Google was the definition of “cloud"; its position in the global market cap rankings made no sense. Going into earnings, which was after a solid rally of 8% over 4-5 weeks (I have used these numbers as I don't remember what they were the first day I looked at it and opened the position), the company had a market cap of 171 billion. That put them a full 103bln behind Apple (AAPL), 50 billion behind Microsoft (MSFT), and 6 billion behind IBM. This was shocking, and that was before I had even taken a close look at the last three quarterly reports and what the sell-side was expecting and obsessing about with respect to Google.

See, I was familiar with the China issue as I have traded (BIDU) pretty consistently over the past couple of years. I also understood the sell-side obsession with the spending concerns. In fact, I had actually been burned on that in July in both Amazon (AMZN) and Netflix (NFLX) when a miss due to a jump in expenses was shrugged off and then steadily and eventually aggressively bought. I'd been short. The market psyche had shifted to growth, and this meant that companies that were experiencing margin pressure because of excessive investment or hiring were now attractive. The logic was simple. One or two quarters of disappointing bottom lines were to be disregarded, and replaced with rapid multiple expansion.

What I didn't realize was that such a meaningful disparity had developed. Then I looked at the options and discovered they were cheap. When I noticed that Google was scheduled to report on the 14th with options expiration on the 16th of October, I got a little excited. I also knew they had a Google TV "Apple style" launch event on the 12th as well as industry market share data being released the week before (hype never hurts). Put this all together and throw in that the 520 Oct calls were at 4.5 dollars, and you have the making of a trade.

But this had more to do with Microsoft than Google. See, I had printed up Microsoft's 10ks a few months ago as I was exploring how I could maximize my exposure to a massive downwards rerating of their business. What I had picked up after perusing their 10-k was that Microsoft generates 28% of revenues from the Windows operating system division. But what really caught my eye was that operating profits for the Windows OS division account for 51% of total operating income. And in this division OEM sales are about 80%. This means that the biz with the original equipment guys, like Dell (DELL) or HP (HPQ), is virtually everything to this company. When you consider that these players have been watching pc margins collapse while the Microsoft ‘monopoly’ retained pricing power, you start to appreciate exactly where things are heading.

But let’s be honest this is not news to most, but for some reason it doesn’t really factor into many discussions on the stock. Those conversations usually center around the dividend yield, cash hoard and rock solid balance sheet, and the metrics that reflect the historical money minting machine of soon to be long ago.

But times they are a changing.

Apple the new Super Integrator -

Apple has slowly but surely perfected ‘the closed model.’ Steve Jobs calls it integration and the ultimate user experience; I call it super integration because there is nothing like it out there. They control everything themselves, and odds are that model (as long as Jobs is alive) is not changing anytime soon. Apple will continue to sell IOS devices that are miles ahead of the Wintel devices. I used to say compete, but the reality is they are killing them. Listening to Jobs on the conference call Monday (see transcript here) should have told you all you needed to know about the future of Windows. He barely mentioned Microsoft. He spent all his time going after Android and Research In Motion (RIMM). In the hyper competitive world of Steve Jobs, Windows is irrelevant.

Research in Motion - The other integrator

Research In Motion comes in a step below Apple. They also are running an integrated model, but just not as sharp as Apple. They have a huge and quickly growing installed base of users, but they seem to have hit a bump in the road. Their OS has been criticzed and they have lagged Apple in applications. Users have also had a hard time with their attempts at touch interfaces. They are moving beyond simple Smartphones and into tablets with the launch of their new device ‘the RIMM Playbook’.

Google - The Disruptive Monetizer

I think when you talk about Apple and RIMM most investors recognize what those companies are doing to Microsoft already. Some readers might even be confused by my argument as both are Smartphone companies and thus not a true threat to the PC space that Windows dominates. Isn’t that the point of the new Windows Mobile? Aren’t you missing the whole picture? Not exactly.

Enter Android. At the total other end of the business model spectrum you have Google which is running a pure monetization model. They are giving away software, namely, the OS and the browser, with the intention of monetizing the platform themselves. They have done this in mobile and it has taken off, and now they are moving to tablets (Android) and notebooks (running Chrome OS). Interesting right? Well, Steve Jobs doesn’t think so. According to him this open model isn’t truly open, and it will run into problems. First, before I even go there, let’s acknowledge the fact that by attacking Android Jobs is validating the threat. See what Jobs is missing is the relationship with the OEMs that Android offers, that is to say, the least hard to pass up.

Here is where you can start to appreciate my argument. Apple and RIMM and the likes have succeeded because MSFT has failed to provide anything to their OEMs that could significantly boost their business. But the OEMs have been stuck on this model with no alternatives, and Microsoft has had an incentive to milk the 70% plus op margins that comes with it. Now, that is about to suddenly and most likely very rapidly change. Android and Chrome OS are a genuine option for any OEM looking to compete with RIMM and Apple. If Google is going to provide a free new platform, the OEMs will embrace it. They also have a huge incentive to work on shifting this platform over to their full suite of devices. Let the crazy monetizer figure out how to make money of search and display while we save on margins and provide a fresh new product to consumers. As long as the consumer is willing to embrace this shift, it is a no brainer. Recent market share data and the explosion of HTC would suggest that they are.

And that’s not all….

HP has picked up on this shift and is now following suit by launching a line of devices using Palm's Web Os in an effort to replicate the Apple and RIMM models. They realize they have distribution and scale and that an integrated OS at this juncture makes perfect sense. And what about the Meego devices from Intel (INTC) slated for 2011…or a Mozilla based netbook?

So who’s the big loser?

Well ask yourself this:

Can you imagine what happens to your pricing power when you go from being a software licenser with virtually no competition for twenty years to one with two to three integrated competitors as well as an additional competitor that has perfected back end monetization and could wipe out the licensing OS model all together?

I can.

Microsoft is in serious trouble. Sometime in the very immediate future the operational metrics will fall off a cliff.

I think this is a no brainer when you look at how strong their market share position still is. (Yes, I am taking the 'a lot to lose' approach here over the ‘look at how strong they still are' approach.)

Despite falling behind the pack and letting Apple steadily gain share for years, they still pretty much dominate the OS space.

But that’s why this is such a great trade from a risk/reward standpoint. If you think we have hit an inflection point, this is where you want to get short.

Are there risks?

Of course there are. Windows Phone 7 looks brilliant. But then again, it has to be brilliant, and even then we will still see a significant decline in the stock. Why? Competition. Microsoft mobile, no matter how good it is, will be a choice amongst several successful platforms. That equals less market share no matter what, and much weaker pricing. This is because pure web-enabled is taking share in the total device space and changing the economics of the OS. Consider what happens in the traditional WINTEL space when an OEM holds discussions in a world with multiple OS options competitive devices.

I can just picture the conversations between the Microsoft account manager and the OEM counterpart....

OEM: Umm, we are going to need to make some changes

MSFT Employee: sure

OEM: big changes

MSFT Employee: well, we can only go so far

OEM: you really have no choice...Google is giving it away and it's great and only getting better...and there are three other vendors selling hardware integrated with OS' now that dominate the market.


So where could I go wrong?

A person in this trade/investment has tremendous conviction that the Windows division is going to experience rapid margin erosion, and that this will be the equivalent of an earthquake for the shares.

That’s a bold prediction and one I have tremendous conviction in, but others may disagree.

But that aside, I am aware of certain risks to my thesis.

1) Facebook Integration - I do see a bigger risk if they can monetize a healthy relationship with Facebook fast. But all that does is soften the blow.

2) Microsoft Buys RIMM - I have suggested this before, and so have many others. It is now a NO BRAINER. These are two companies that desperately need each other and would be much more competitive together. Microsoft would get an installed user base that is very hooked to their devices and could use RIMM to start building on a socially based mobile OS approach. Such an approach has a very good chance of succeeding while going it alone may result in Windows Mobile 7 going down as another great technology that just came along at the wrong time.

What to buy?

I like a combination of 2/6/15/30 month puts depending on your target return and risk profile. I expect the stock to decline at least 20% over 15 months. That's still a 175 billion company. You make 49% on your investment over 15 months or a 39% annualized return if you go the "conservative route".

There is of course a risk that all equities rise in this environment, and that this issue causes some headwinds for this trade. I for one am not bothering with this as I personally think MSFT will experience a much more drastic decline, but I do realize it is a concern for some. If that is the case hedge by pairing this position with some long calls on Google and the likes or the broader indices. You could also buy gold...short the DXY...or just don't do the trade.

Note: The value guys love this stock. It lights up every single valuation metric, and on a rear view mirror basis looks UNBELIEVABLY cheap. That is a trap (maybe one of the greatest ones in history), and why this is going to be such a great trade.

By the Way -

Some will say this thesis makes sense but the timing is too soon. I disagree. All you need is a whisper of weakness in the Windows division over the coming year. You will get it. In fact, I think sentiment has turned on this name already. The mobile launch has supported the stock. That effect will wear off. And the street now has one or two skeptics who will probably remain bearish till MSFT does "something big".

Oh, one more thing -

Anecdotally, I thought I would add that I have three PCs at home. I don't use them anymore. I surf and read on the iPad. That's after six months and a great deal of Anti-Apple based resistance on my part. Give me Flash/HTML access, some storage, a solid browser, and I could care less what the OS is now. Touch interface, super battery life, and display are huge leaps forward. That is what I think it took to convert me. So, Windows' market share in my life has fallen off a cliff. I only use Windows based devices because that’s what is typically loaded on devices that I need to access the net that are not a smart phone. Change that, and I could care less what it is running on as long as it turns on instantly, lasts for 12 hours, is conveniently portable, and ultimately visually pleasant.

Disclosure: Holding puts on MSFT.

Source: Microsoft: The Big Short