“Man can see things that are far off but is blind to what is near," Sophocles wrote.
There I was sitting on the couch flipping through the channels when I came across Bill Miller and Brian Rogers on CNBC. Half way around the world in Dubai, and I still can’t escape my Baltimore roots. Two titans of finance and two hometown legends on the air at the same time. Suffice it to say I stopped flipping and stopped to watch. I was curious to hear what these two guys thought of the equity markets. Unfortunately for me, I was a little late to the interview as CNBC was already harping on Bill Miller to talk individual names with them, and the name that came up was none another than Microsoft (NASDAQ:MSFT). When I heard Miller say “we like Microsoft”, I quickly turned to my friend and said "watch, he will cite the fact that it’s got a lower P/E than the market, a better ROE, and a great balance sheet to support his case.” I couldn’t have scripted it any better.
Miller, the consummate value guy cited exactly those points and nothing else. Rogers, another value maven, agreed. As for me, well let’s just say I was a little bit irked. How can you talk about Microsoft, a company that generated 56% of its revenues and 88% of its operating profits from selling Windows, Office, and Exchange licenses over the past six months, and not discuss Apple’s (NASDAQ:AAPL) thriving integrated ecosystem or Google’s (NASDAQ:GOOG) booming software monetization platform. To me this is tantamount to celebrating your investment in the world’s leading horse and buggy maker while your neighbor is zooming around at 35hp in his DMG automobile. When it comes to 'softy' (Microsoft), investors need to stop looking in the rearview mirror or they might end up missing the giant value trap in front of them.
So, while it hasn’t been a year yet since my MSFT Big Short piece; I thought this little occurrence warranted revisiting this story.
The Value Trap Case
- 'Softy' generated a 44% ROE over the past 6 months. How can you not like that???
Who cares. The company that achieved this sold operating systems and productivity suite software licenses to both the enterprise and consumer in legacy monopolistic fashion. That business is dying. Windows 7 is considered to be a success after the failure that was Vista. I don’t see it that way. If you ask me XP was the last time people and businesses were dying to upgrade their OS. The reason Vista failed was because the upgrade cycle got stretched out because the hardware was still serviceable. Windows 7 didn’t sell because it was so great; it sold because it was the de facto operating system available at a time when a delayed hardware replacement cycle took off. So for the last two generations of Windows, people have not actually cared about the OS.
Now, think about what has happened since Windows 7 launched. We are on generation II of the iPad, Macbook Airs are flying off the shelf, Android devices are everywhere and Chrome OS is on the way. Anyone who saw HP’s (NYSE:HPQ) EVP Todd Bradley at the Touchpad launch, flipping through slides of HP PC’s and laptops with web-OS on the display, knows which direction the world’s largest computer maker is heading in.
Suffice it to say, the computing world Windows 8 is born into is going to be very different from the one Windows 7 launched into. Darwinian evolution might just get this baby. That is not to say there haven’t always been alternatives to the Windows monopoly. There have been several, and they have always failed, but this time around it’s a different story.
When Windows 8 launches there will be thriving ecosystems that have almost no MSFT software inside of them, and that is going to make for a very interesting couple of quarters. See, I can’t help but wonder what happens to the Windows division, which is 75% OEM, when the OEM’s start selling their own OS or accepting the free OS’ of MSFT competitors. And these will have models that can monetize the software without needing to sell a license.
- 'Softy' has a fortress balance sheet with $40 billion in cash
Who cares. If you ask me this is now more of a liability than an asset. 'Softy' will eventually have to make a sizeable outlay to either acquire a hardware manufacturer, a gaming software company, a cloud software company (CRM?) or a major internet piece of real estate in social networking or pure display. It has no choice. I’d say the odds are stacked against it. Whatever acquisition Microsoft makes is going to be about making a major business model shift and thus will no doubt be viewed as something that is more likely to fail than succeed.
- 'Softy' is so entrenched, shorting it is an uphill climb
Who cares. This is a $200 billion dollar + company you are betting against and not some $1 billion name. The market still gives the company #2 status in all of technology, when it has fallen much further in the eyes of consumers and industry onlookers. Look at how quickly Cisco (NASDAQ:CSCO) turned into a panic-- and I can easily argue Cisco is in strategically in better shape. If you believe licensing of the OS is going the way of the dinosaur, then you will have no problem betting against this stock. Yes MSFT can adjust, but no matter what it does, the shock of losing a pure licensing cash printing press will more than offset for any solid execution on its part.
I opened this post with a quote from Sophocles because every time I make a bearish Microsoft argument I get at least several responses saying that I am right but that it will take so long that it isn’t worth putting the trade on at these levels. Yes, MSFT has a moat, particularly in the enterprise, but believe you me, it won’t take long to hammer its margins as every potential partner will be looking for concessions.
Bulls don’t really have an argument to be long this stock other than mostly weak attempts to justify the anomalous value screener output that is 'softy' shares. This stock is pure torture for the value guys because they just can’t believe how such a well known name can light up the screens as it does. I think it ironic that the argument used to be to buy MSFT because it was a monopoly, and now it is filing an antitrust complaint against Google.
Last week I read a bullish article on Seeking Alpha that basically said buy MSFT shares because the company will be buying back stock in a nice little cap structure play. Sorry, I don’t buy $200 billion tech stocks to take advantage of an underleveraged balance sheet; I imagine I am more likely to run into trouble with that philosophy.
Disclosure: I am short MSFT.