Microsoft's Capital Allocation Strategy is Highly Suspect

Microsoft's (MSFT) latest investments (Facebook), acquisitions (aQuantive, Fast) and propositions for mergers (Yahoo!) inspired me to think about the role of management in public companies.

Managers and executives of a public company are paid by the shareholders of the company to provide the shareholder an expected rate of return on their investment. The best way to achieve this is to increase the intrinsic value of the company.

The Executives of a public company are usually paid the lion's share of their compensation in the form of stock options. This was designed to make sure that the shareholders' interests are aligned with those of management's. Alas this form of compensation hasn't had the desired impact. With CEOs changing jobs frequently, the only interest they have is in maximizing their compensation instead of increasing the intrinsic value of the companies.

There are three main criteria that Warren Buffet has applied in picking stocks.

1. Nature of Business: Buy a business that is so basic that it is not prone to technological disruption. Furthermore it should be so simple that even a bozo can run it because ultimately, a bozo will in fact be running that company.

2. Margin of safety: Buy businesses with an adequate margin of safety. Warren Buffet does not apply this principle as strictly as Ben Graham has recommended.

3. Management: Warren Buffet likes to do business with people he likes. Beyond the fundamentals of the company, it's the management that can make or break a company. Wrong moves taken by CEOs out of greed, ego or thrill have caused massive companies like Enron and Worldcom to sink. Enough has been said about the other two principles so in this post, I will concentrate on the third.

My recommendation is that one should not buy the stocks of a company whose CEO you can not trust. How can you find whether you can or can not trust the CEO of the company, you may ask. I will give some of the examples and insight that I have learned from experience.

Buybacks vs. Dividends

No other instrument has been abused as much as the stock buyback. CEOs declare huge buybacks and the stock price takes off. In the mean time, the CEO dumps his stock options and the stock buyback never takes place. Would you be surprised to know that a large percentage of declared stock buybacks never take place? Can you trust such a CEO? Furthermore, sometimes buybacks take place when the stock price of the company is way higher than the intrinsic value. But these actions increase the value of the stock options of the CEO. These actions erode the intrinsic value of the company in long term.

Stock dividends on the other hand are a better way to pay back the stock holders. Since stock options holders do not benefit from the dividend as much they do from stock buybacks, this is a better way to pay back excess cash to the shareholders. Since qualified dividend are taxed at the capital gains tax rate, there is no huge tax hit. Furthermore, with cash in his pocket, the shareholders can buy the shares of any company they like, including the one that paid the dividend.

Capital Allocation

CEOs are not always blinded by greed. Sometimes it is ego, legacy and the rush to make a big deal. Some of these factors cause them to make stupid acquisitions. The list of such acquisitions is endless. Nothing destroys shareholder value faster than a trigger happy CEO on a buying spree on shareholders money.

Lets take an example that has bothered me a lot lately - Microsoft.

After refusing to pay $3B to acquire double click, Microsoft thought it was a great idea to buy Aquantive for $6B. Paying $2B for Norwegian search company Fast was also hailed by both Microsoft executives and analysts alike. The same Microsoft that implied its Youtube acquisition for $1.6B was not a long term investment, somehow discovered that valuing facebook for $15B is a very smart move. And now their bid to buy Yahoo (YHOO) for $45B, which could well cost them around $55B (considering the price raise, Yahoo employee severance package poison pill, Yahoo employee retention bonuses, investment bank fees and legal fee), makes me wonder how are they going to get a reasonable rate of return.

Imagine Microsoft succeeds in buying Yahoo for $50B. To get 10% ROI, Yahoo will have to generate $5B in profit, Aquantive will have to generate about $600M and Fast will have to chip in $200M. That's almost $6B in profit per year. Currently they are creating less than $1B in profit. So unless Aquantive, Fast and Yahoo are just pieces of a jigsaw puzzle that when combined, create a very rosy picture, I can't help but wish good luck to Ballmer, Ozzie et al.

A great CEO should be a great allocator of capital. Having said that, I believe it is better to have a CEO who knows that he is not too bright and returns the excess cash in the form of dividends, compared to the one who values himself much higher than his intrinsic value and destroys shareholders money to fulfill his whims.

When purchasing stocks, look for the above signs and try to fathom whether management thinks like the owner of the company, whether management's actions are based on business sense or based on greed or ego. If you have found a CEO who truly cares about his company, you have got a winner.

Disclosure: None

Comments

[Gigm_pumper:]

I did find that kind of company---Gigamedia (GIGM)

2008 Feb 26 10:35 AM

[User 156150:]

It is easy for people to say that Microsoft is wasting shareholder money when they don't run the company. The reality at Microsoft is quite different. The company sees the competetive threat Google poses in an industry that is rapidly turning into a monopoly (i.e. Internet advertising). Microsoft seems to be among the few that see both sides of the coin. On the one side internet advertising will be a huge market and if they develop a second place spot to Google then the acqusitions will pay for themselves. Most people see this as accurate, but don't think Microsoft can accomplish that. On the other side (and most people don't seem to be grasping this) Google has developed a new revenue model for the software industry which is based on advertising. It is now conceivable that this model will eat away at the fabric of Microsoft unless the company is able to transition over to this model. I do not own Microsoft and I think Google is a better bet long term, but for Microsoft this is a very very expensive insurance policy. We will probably never know whether it made sense, but this company is not run by idiots. Bill Gates (who really still runs the place via Balmer) knows this is a calculated bet in a very high stakes game. Anyone who doesn't like high stakes games can go buy railroads (like both Buffet and Gates). No one can tell me whether Google or Microsoft will be around in 20-50 years, but we all know the railroads will...

2008 Feb 26 10:48 AM

[vbatura:]

remember in the nineties when US news published CEO salaries and the public protested at the 5-6 million salary.The smart CEO figured out a less obtrusive ,more lucrative way to shaft the common shareholder.They agreed to drop their salary and in turn started reimbursing themselves with mammoth amounts of stock options.
The common shareholder got shafted doubly,cash was spent to buy back shares and these shares were awarded to the chosen few as stock options.No attempt was made to pay a dividend as the available cash had been spent buying back the shares.

2008 Feb 26 12:24 PM

[Football Geek:]

I own Home Depot shares and it's a good example of stock buybacks really hurting a company. While they sold their supply business, which was doing pretty well, and applied that money to their massive stock buy back, they also went deeper into debt to finance it.
Time will tell whether this was a good move. They turfed the old ceo out the door, but he did one thing well while being in charge. He had a good record of dividend increases. Did anyone else notice HD did'nt bump up their dividend in 2007?
I don't want to single out HD, but they are a good example of why
a growing dividend beats stock buybacks most of the time. The problem is that after the buy backs, and employees stock options that are given to them, the share "float" remains about the same. It's almost like the government, they give with one hand, and take with the other.

2008 Feb 26 10:27 PM

[red5:]

Just as investors speculate rather than invest, corporations do the same. They're looking for the big "synergy" or big payoff. Sometimes it hits IE EMC bought VMWare for around 600 million and it now has a market cap in the tens of billions. But for each VMWare there must be dozens flops yet the corporations still can't resists the prospects for quick growth or a stellar return. Most of them are clearly not statisticians.

2008 Feb 27 09:51 AM