The Market Sees Microsoft Losing Its Grip

Last Friday's article on Steve Ballmer being bad for Microsoft (MSFT) generated a lot of reader commentary.

Jack wrote:

I disagree with your position on Ballmer. The reasons being:

• Ballmer took control over Microsoft whilst it was at a huge premium to intrinsic value. Despite improving value of the business it was not enough to substantiate the large equity premium on top of intrinsic value. At current prices, this may not be the case.
• Ballmer has grown the company considerably over the last few years (earnings + revenue wise), drawing attention to many value investors as you mentioned in your article. If you look at this website, it shows that Einhorn, Tweedy Browne, etc. have large holdings in the company. These investors are not to be underestimated.
• After eight or so years with Ballmer at the helm of Microsoft, there seems to be no significant erosion of Microsoft's economic moat. In fact their dominance in operating system software has extended to Mac, as I for one, like many others, install Windows on my Mac. Products such as Vista and Office are continuing to be a "necessity" on one's computer. Although OpenOffice and Google Docs have their merits, they are not very compatible with Office (sometimes the fonts get mucked up, etc.), further...try loading an ODS file on Office! Although Firefox has cut down Internet Explorer market share, that in turn has never been a material source of Microsoft revenue.
• Microsoft gaming is experiencing huge growth. It currently makes up 11% of revenue, yet grew 68% last quarter. By next year I'm guessing that this division will grow up to 16% of revenue. Vista is experiencing large growth as well.

At a forward P/E of 13 and with significant levels of cash (they special dividended a fair bit!), the company may be undervalued. Ballmer has undoubtedly built up the intrinsic value of the business and for a true value investor, that is what it is all about.

Jack raises excellent points, some of which I hinted at last week. It's true that both revenue and earnings have grown on Mr. Ballmer's watch. Gaming has also flourished while he's been at the helm.

The question is: Why haven't rising earnings and revenue translated into a higher share price? The lack of capital appreciation means that investors dislike something at Microsoft.

Jack and others pointed out that it may not be fair to compare the price of MSFT in early 2000 with its price today because the early 2000 price came at the tail end of the internet bubble and all technology stocks were overinflated. However, even if we start examining the stock from the beginning of 2003 when the crash was over, it fails to impress. MSFT began 2003 at around $28 and closed Monday at $27.71.

It paid dividends, true, but that's hardly a compelling reason to own the stock. Its dividend yield is 1.6%. There are better stocks for dividend income, such as Pfizer (PFE) with a yield of 7%.

In any event, it's clear that the market has paid a lower multiple on Microsoft's growing earnings, resulting in a flat stock over the past five years, during which time Mr. Ballmer has been in charge. Again, why is that?

My take is that investors are finding better futures elsewhere. Outside of gaming, what new territory has Microsoft claimed? It still puts out Windows and Office, and has improved their capabilities in marginal ways. Jack pointed out that he installs Windows on his Mac. That's not much of a growth story, though.

What I think Microsoft needs is another huge market to call its own. Per its usual approach, it has refused to invent anything or revolutionize any process. It's finding that its usual mode of copying and outmarketing the creator is not working online. Google (GOOG) has used the network effect to nullify Microsoft's strategy. Microsoft can copy Google all it wants, but there's no compelling reason for people to switch from Google to Microsoft, so the copycat sits lonely while the pioneer is overrun with users.

The ample cash that Microsoft has is apparently earmarked to buy Yahoo (YHOO) in a last ditch attempt to catch up with Google. Here again, what a head shaker. Buying Yahoo is Microsoft's internet strategy? That's some visionary leadership from Mr. Ballmer. It was not this kind of behind-the-curve reactive management that made Microsoft the wealth machine that it used to be.

In retrospect, it seems that making internet search faster and more accurate was an easy goal to have seen back around 2000. You may feel that rearview analysis is easy, but remember that Microsoft takes every opportunity to boast about its technology gurus and skillful team. Well, if they're such gurus and so skillful, why didn't they come up with something we've needed in the past eight years? It's a fair question. I haven't needed even one upgrade from Microsoft. Have you? I don't use Office to create new documents, and when somebody sends me an Office document I open it with an old version of the software. I never even considered upgrading to Vista. Did you?

Meanwhile, my personal life and business are increasingly run with Web 2.0 applications accessed by Firefox. Our next office upgrade will be to all Apple (AAPL) products, not because they bring capabilities that we can't live without but because it finally doesn't matter what machines and local software we use. Everything happens online anyway, so any machine can do the job, so why not go with the best ones? In our opinion, the best computers are made by Apple.

When we work with a new organization, we suggest that they coordinate with us easily by using Google Docs. Most are now already familiar with it -- which is pretty impressive in itself -- and those who are not have no trouble getting up to speed. Once they see that sharing information is as easy as logging into Google Docs and checking the file that we can all access, there's never a complaint. "Sure beats email attachments," is a typical comment.

In short, I think the market sees Microsoft losing its grip on computer users and having nothing to take its place when those users start leaving. Jack's right that they haven't started leaving in droves yet, but the market is a forward looking mechanism and senses that at Microsoft there's a greater chance of ramping down than ramping up.

If that's not what's going on, then what else? A long-term stock chart shows Microsoft stock forming a plateau after Mr. Ballmer took over. Something caused its stock to lose relative appeal. The above reason is my best guess.

I've looked just at the stock's performance when pointing a finger at Mr. Ballmer. Other readers have looked more closely at the man. Charles sent the following clips and wrote that it's "scary" to think how many people are depending on this guy:

Comments

[RK:]

MSFT looks and acts like the IBM in the mid 1990s. Still very big and influential, but the market that it dominates is less relevant every day. The Windows and Office franchise will be a lot less important in 10 years. MSFT's position in other businesses vis-a-vis Google, other gaming companies, Apple, Nokia is far less dominant. MSFT's aborted purchase of Yahoo reminds me very much of the IBM's Lotus acquisition as a way to jump start a lackluster competitive position. Mr. Ballmer is a caretaker CEO; he won't ruin the franchise, but he won't re-vitalize the company either.

2008 Jun 10 09:37 AM

[MothyJohn:]

Why haven't rising earnings and revenue translated into a higher share price?
I think it might be the enormous size of the float. Translate earnings and revenue growth into earnings and revenue growth *per share* and I suspect it would be diluted down to nothing.

2008 Jun 10 10:37 AM

[Depressedal...:]

I came across an article on the internet that stated that in the year 2004 Microsoft was the fourth biggest company in the world. Now, as of 2008 Microsoft has dropped down to the 59th position. Portents of things to come? I believe so! All the money this man has made, is still making, is being eroded by three primary trends. These ongoing trends are: 1. Consumer dissatifaction with Microsoft's treatment of consumers, their needs and their wishes i.e. stopping technical support for Windows XP and then telling customers/consumers that Windows XP will "expire" by 2009! 2. Increased prices for internet protection which can be breached by "hackers" 3. Increased threat of "identity theft" along with that the exponential and growing problem(s) of "malware", tool kits (can now be purchased on the internet!), computer bots, etc. But the biggest problem Bill Gates is facing is the loss of "complete trust of the consumer.!" People are being "TOLD" what they can have and what they cannot have by Microsoft and the pricing of upgrades at a clip of $150.00 per year is WHAT people are rebelling against! Enter the emegence and biggest threat of Microsoft, which they are not commenting about but actively fighting, and that is OPEN SOUCE SOFTWARE, ie. LINUX. For around $35.00-$40.00 a person can purchase Linux software such as Ubuntu, or Fedora 8, then a firewall for your computer and a firewall for the network. Also, an individual can purchase excellent graphics, video/audio software. Extra software can be downloaded and burned for free or ordered on CDs for a minimal cost of anywhere from $2.00 to $6.00 per CD! Software is either free or minimal in cost and what more, the security is right up there along with Mac computers! Linux has come a long way and is relatively easy to install, even for newbies! Microsoft also fears "Open Source Software", ie. Linux because it is now taking over Low cost computers. Schools within this country and especially overseas are opting to replace Microsoft for Linux! Because Linux is Open Source Microsoft is unable to prosecute them in the US Courts! They still keep on threatening Linux with threats of suits but NOT ONE suit by Microsoft has gone to court! IBM supports Linux 100%. The European Courts have found Microsoft of violating anti-trust laws and must pay the European Union 60 million dollars for one lawsuit and 160 billion dollars for the other lawsuit, which they also lost in court! There are at least two more court cases against MIcrosoft in the European Union Courts! Yes, Microsoft is loosing their edge because their ruthless business practices against their competitors and their "arrogance" towards computer owners and new customers! The bullying tactics shown towards their competitors, and their arrogant attitudes shown to the consumers en large has provoked many to "look elsewhere" to look for "other, or alternative solutions" such as Linux or Mac computers! The first step is loosing the market is to become arrogant, to dictate towards consumers/business what they can have or not have! If you don't think this is possible, remember that GM, Ford, Chrysler were number one for car sales and now it is Toyota! There are two sayings that are applicable to Microsoft now and as predictors for Microsoft......"what goes around, comes around" and "Pride comes before the fall.)

2008 Jun 10 10:51 AM

[RLLH:]

Interesting comment about Microsoft now being like IBM in the 90's. I had $75,000 worth of IBM stock then. It's worth a bit more than $950,000 now. Now a bad prospect for Microsoft if a similar trend develops for them.

2008 Jun 10 12:09 PM

[Alex Filonov:]

Well, I can only repeat my position: Microsoft is a sell. If it manages to buy Yahoo!, it's sell short.

Disclosure: Long AAPL and GOOG, no position in MSFT.

2008 Jun 10 12:17 PM

[nicedude:]

For around $35.00-$40.00 a person can purchase Linux software such as Ubuntu, or Fedora 8, then a firewall for your computer and a firewall for the network.

Uhhh - While Fedora might cost money Ubuntu costs $0 dollars, Always has and always will. Also most linux distributions use IPtables which is a built in firewall, now while that is command line based there are several GUI frontends for it so you can control the firewall more easily. Why anyone would buy Vista for up to $300 when in Ubuntu for $0 you can have the same functionality and more. Then throw in that all the same stuff is available Firefox web browser, Flash player ( for you tube etc ), Open Office ( the free MS office clone ), Gimp ( a free photoshop type graphics design application ), PDF viewer support ( for electronic books ), VLC Player ( DVD & AVI MPEG and many more video formats playback ), Skype (VOIP) & Several instant messengers compatible with yahoo, msn etc.

So why on earth would someone need to pay MS a ton of money for their products especially knowing that they could care less about their customers and worship only the almighty dollar.

to just get Vista Ultimate and MS Office for a business would be close to $1000 when they could get the same functionality in Ubuntu for $0.

To anyone that wants to try Ubuntu PM me "nicedude" in the Ubuntu forums ( you need to sign up but it is 100% free ) and I will try my best to help & advise you about how you can accomplish this for $0 dollars as well.

2008 Sep 01 12:44 AM

[nicedude:]

PS and Steven Balmer needs to lay off the ritalin or whatever he is taking as he looks all coked up and rants like a lunatic. Really not the kind of CEO behavior I would want to see in a company I had stock in. Remember Howard Dean's career ending Beyaa!! well Balmer makes that look both reasonable and tame.

2008 Sep 01 12:54 AM