A couple of weeks ago Forbes had given Microsoft (MSFT) CEO Steve Ballmer the title as the worst CEO of a large publicly traded American company today. Based on the article, he outranked John Chambers of Cisco (CSCO), General Electric's (GE) Jeffery Immelt, Walmart's (WMT) Mike Duke and Sears' (SHLD) Edward Lampert. There is a common factor among these CEO's: multi-year underperformance of its stock price.
The Forbes article said that Mr. Ballmer has steered Microsoft away from the fastest growing and lucrative markets. The roll out of new products were constantly delayed and ended up with mediocre products that do not add any value. After dumping its music player, new Windows product and other mobile products, it seems that Microsoft is the same company that it was a decade before. In the cutthroat technology space, incumbent leaders should not be complacent. They should create new products that would generate the fastest cash flows the way Apple (AAPL) did.
Last year, hedge fund manager and activist David Einhorn has openly called for the resignation of Ballmer. He said that he no longer believes that Ballmer is adding value to Microsoft after major missteps. These include lackluster investments and questionable acquisitions, as well as blunder in the tablet business. Obviously, Microsoft did not heed to his call.
Looking at Microsoft's capital allocation
Warren Buffett said that he likes that the management of the companies he own to allocate its capital very well. This is important as good capital allocation decisions translate to shareholder gains.
Over the last 5 years, the company has increased its free cash flow 1.59 times bringing it to $24 billion over the last 5 years. This is actually due to higher profitability. Operating cash flow has grown into a steady 10% growth a year during the same period. Moving forward its growth hinges on its ability to roll out new products that customers would love.
It has spent over $12 billion of capital expenditure over the last 5 years. This brings to an average capital expenditure of $1.5 to $2 billion a year. This does not include the acquisitions, which average to 6 transactions a year since its first acquisition in 1987. Under the helm of Ballmer, the company has acquired more than a hundred companies. Relative to its closest competitor, Apple, it spent 6 times more in terms of research and development. From this we can conclude that there is indeed a lack of the spirit of innovation in the company. The creativity flow to create a product that customers love is not present.
The recent acquisition of Skype has cast doubts on the capital allocation abilities of Ballmer. Many pundits have said that it was an expensive deal at $8.5 billion for a business that has yet to make money and with substantial debt.
Over the 5 year period, incremental cash flow from investing and acquisition is at $9 billion. Excluding acquisitions, the company is getting 70 cents for every dollar invested. This does not immediately erode shareholder's value. If Microsoft continues to make non-accretive capital allocation decisions, it would either run out of cash (due to expensive acquisitions) or run into debt. Eventually the stock price will remain flat for the rest of the decade.
Making progress fundamentally?
In the recent third quarter results, it reported quarterly revenue of $17 billion, an increase of 6% over prior year's results. Operating income was also up by 12% to $6 billion. This translates to a net profit of $5 billion for the quarter.
If you look at the major business segments, it seems that the company is doing a lot of progress. The Servers & Tools business have posted growth of 14% driven by SQL server. Its business division reported a 9% revenue growth reflecting continued strength in Office 2010 with corporate clients. The Online Services division posted a 6% increase and has narrowed its operating loss. Only its Entertainment and Devices division posted a decline of 16% over prior year levels. This is due to the soft gaming console market.
Going forward, the company will report better than expected earnings this year. However, investors are concerned that the company can no longer return to the same growth rates we have seen in the past. Based on the consensus estimates, earnings are expected to grow 11% lower than the average 5-year growth rate of 17%. This is also lower than the industry's growth rate of 26%.
In fact, other technology stalwarts have better growth prospects than Microsoft. Apple is expected to grow its earnings by 40% this year. On the other hand, Google has earning growth rates of 16% next year, higher than the estimated growth of Microsoft.
Cheap by Any Measure
The stock is currently trading at 10 times 2012 earnings. Adjusting for net cash of $3.98 per share, the stock will trade at 9 times. It also has a dividend yield of 2.70%. This seems cheap considering that the company could grow its earnings by 17% a year. Also its net profit margin is at 29% higher than the industry average of 18%.
Conversely, other technology stocks are valued higher. Apple is trading at 12 times 2012 earnings and pays no dividends. [[IBM]] is valued at 13 times earnings and has a dividend yield of 1.70%. On the other hand, Google (GOOG) and Oracle (ORCL) both trades at 14 times next year's earnings.
The undervaluation is undeserved. In terms of returning cash to its shareholders, it has done a good job. It has bought back its own shares for $22 billion for the last 5 years. Also, it has paid dividends of $56 billion for the same period.
The overhang is the notion that Microsoft will never recover its golden age. This is due to the lack of the spirit of innovation. The late Steve Jobs said that Microsoft will not change as long as Ballmer is calling the shots. The focus has been less on the products and more on selling the products. The market seems to agree.