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One of the most controversial debates going on today is over what place Microsoft (NASDAQ:MSFT) will have in the technology sector in the years ahead.

It is something that everyone is wondering about, including users, employees, analysts, and investors (for purposes of disclosure, we have an indirect stake in Microsoft via the Fidelity Growth Company Fund). In particular, investors want to know if Microsoft's best days are behind it. Can the company reclaim leadership of the technology sector? Or will Microsoft remain stuck in the doldrums?

In our view, Microsoft's best days are behind it. Although our last article on Microsoft struck a somewhat positive tone regarding Microsoft's server business and its margins, it contained several caveats, including the need for Steve Ballmer to be ousted as CEO. We continue to believe that in the coming years, Microsoft will not see the success it has in the past, even if its server business is growing and its margins may not shrink as much as expected.

Microsoft is a frustrating company for investors to categorize. Is it a growth company? Is it a value company? Nobody has a definitive answer, least of all Microsoft. In our view, Microsoft is in fact a value stock, and we explain our thinking below. We think that to move it stock firmly out of the doldrums, Microsoft needs to stop gyrating back and forth between growth and value strategies and firmly embrace its status as a value company.

Reviewing Past Performance

Microsoft has had a relatively banner year, with the stock rising over 21% over the past 12 months, outperforming the S&P 500 and almost keeping pace with the NASDAQ. For Microsoft, that is notable.

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And yet, Microsoft's performance over the past 5 years, as well as the past 10 years, leaves much to be desired. Microsoft still outperforms the S&P 500 over a 5-year period, but its under-performance relative to the Nasdaq becomes much more pronounced, as the main technology index rose over 19% during the past 5 years, while Microsoft rose just over 6%.

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Microsoft's under-performance becomes truly pronounced over the past 10 years. While it has risen over 17% over the past decade, the S&P 500 has risen nearly 50%, and the Nasdaq is up by well over 100%.

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By now, the reasons for Microsoft's relative under-performance are well known to most investors. A lack of focus, a bloated R&D budget (more on those later), and questions over Steve Ballmer's tenure as CEO are just some of the reasons for how Microsoft's stock has done over the past decade, to say nothing of the external competitive pressures that the company faces. But, we believe that there is another factor that has contributed to how Microsoft's stock has performed: its seemingly schizophrenic attitude to deploying capital.

Which Capital Deployment Strategy is the Fairest of them All?

Microsoft says it is committed to returning cash to shareholders. And its dividend (the stock currently yields 2.62%; on the higher end for the technology sector) has been steadily increasing, with another increase expected this fall. Microsoft has bought back billions in stock. Microsoft's return of cash to shareholders is very much in line with what "value" companies do. And yet, Microsoft seems unable to accept this. The company spends billions on R&D projects that go nowhere, pours billions down the drain via Bing and its Online Services division, and has a habit of making expensive acquisitions (Microsoft's Q4 2012 results included a $6.2 billion write-down of virtually its entire acquisition of aQuantive).

Microsoft's sprawling ambitions are costing the company and its investors billions of dollars. The Online Services division lost $8.121 billion in fiscal 2012, and $1.921 billion excluding the impact of the aQuantive write-down. One silver lining is that the division's loss narrowed from the $2.657 billion lost in fiscal 2011. Since the unit's inception and the creation and launch of the Bing search engine, Microsoft as lost billions by trying to compete with Google (NASDAQ:GOOG) in search and advertising. Trying to compete with Google may be a noble effort, but there are limits to how far Microsoft should push things, and those limits were crossed long ago. Bing may be gaining share (it held 15.6% of the search market in June), but that means little when it is bleeding red ink by the billions. Microsoft's R&D budget also lays bare the company's weakness in deploying capital. In fiscal 2012, Microsoft spent $9.811 billion on R&D, an 8.49% boost from fiscal 2011. By comparison, Apple (NASDAQ:AAPL) has spent $3.12 billion on R&D in the past 12 months (Apple's fiscal year is different than that of Microsoft), a boost of 36.922% from the previous 12 months. We feel it is unnecessary to explain which company's R&D investments in the past 12 months have paid off more. Microsoft may be producing upgrades to Windows and Office, as well as the Xbox, but that is not what the company needs to be doing. Microsoft needs to take a different approach to developing the next generation of computing technology (more on that later).

Despite Microsoft's continued spending, its balance sheet keeps expanding, as more and more cash is added. Microsoft ended fiscal 2012 with $51.096 billion in net cash & investments, and that does not take into account $9.776 billion in equity investments that the company holds on its balance sheet. On the company's Q4 conference call, Microsoft did not break down its percentage of onshore cash. However, during the Q1 2012 conference call, CFO Peter Klein stated that Microsoft had $51 billion of its cash offshore, which comprised about 88.85% of its Q1 cash balance. It is highly probable that this ratio has been maintained through the end of fiscal 2012. We will discuss this dilemma a bit later in the article.

Lessons from Aesop's Fables: Trying to Please Everyone, But Pleasing No One

There is a reason that Aesop's fables have stood the test of time: despite their relative simplicity, they offer valuable lessons, and in this case, one fable in particular offers a valuable lesson for Microsoft.

The story of The Man and His Two Wives is a fable tells the tale of a man who has two wives: one young, and one old. His hair is graying, and his young wife did not like that, for she wanted him to be younger. So, every night she would pluck his graying hairs. His older wife, however, loved his graying hair, for she did not want to be mistaken for his mother. So, every night she would pluck his black hairs. Soon, the man had no hair. The fable ends by saying that if you "yield to all and you will soon have nothing to yield."

This fable does, in fact, offer lessons for Microsoft. Microsoft is suffering from an identity crisis, and it goes beyond whether or not it is a value or growth company, Microsoft seems unable to figure out whether or not it is a consumer or enterprise company, and the end result is that no one is truly pleased. Microsoft designs its products for both the enterprise and consumer markets, and the results show. This identity crisis extends to how the company interacts with its investors as well. Microsoft's inability to figure out whether or not it is a growth or value company means that it is pleasing neither camp. But, we believe, that Microsoft can rectify these issues, and we outline our proposed solutions below.

Embracing Value to Create Value for Investors

Microsoft needs to embrace the fact that it is a value company, for we believe that it is the best way to create value for investors. Below, we offer 3 different steps that Microsoft should to take in order to drive value for its investors, and truly move into the direction of a value company.

  1. Shut down Bing & Online Services: Microsoft has lost billions trying to compete in search and advertising, and we see little reason to believe that the losses will stop. Rather than pouring billions down the drain in an attempt to compete with Google, Microsoft should shut down its online divisions and return that cash to its shareholders.
  2. Slash its R&D spending & focus on acquiring startups: Microsoft spends far more on R&D than it receives in return, especially when compared to what Apple spends. Instead of wasting billions on internal research, Microsoft should turn its focus to searching for the next disruptive startup. No one can say that Microsoft does not employ diligent and intelligent people, and we believe that with the proper focus, Microsoft will have little trouble in finding which startups warrant the company's attention. And given that Microsoft has a solid balance sheet, it would be difficult for a startup to refuse Microsoft if the software company truly wanted to gain control (there is a difference between paying a premium and overpaying; the aQuantive is a prime example of overpaying for an acquisition). The biggest threat to Microsoft's future will almost certainly be developed at a startup somewhere in Silicon Valley (or another technology hub). And Microsoft needs to be able to identify those threats. In our view, that is much cheaper than investing billions into unwarranted R&D. That is cash that could be returned to shareholders as a dividend, or if the price is right, buybacks.
  3. Increase leverage: As we noted earlier, the vast majority of Microsoft's cash is held outside the United States, restricting its use for dividend and buybacks that benefit the company's American investors. But, Microsoft is one of the last few remaining AAA rated companies, and with $11.944 billion in debt, Microsoft has ample ability to increase its leverage and boost payouts to shareholders. Microsoft's dividend payouts for fiscal 2012 amount to 37.607% of its net income, but just 20.189% of its operating cash flow (buybacks equal 29.621% of net income and 15.901% of operating cash flow). Microsoft's payout ratio is low for a value company, and while Microsoft is likely to increase its dividend slightly in the fall, we feel the company needs to make a much more meaningful gesture. Microsoft, in our view, needs to yield, at a minimum, 3.93%, which would represent a 50% increase in its dividend (the company currently pays out 20 cents per share each quarter) to $1.20 in annual payouts.

Conclusions

We would like to own Microsoft stock, in theory. The valuations are unassuming (the company, as of this writing, trades at just 10.119x earnings), and Microsoft's financials are strong. But, Microsoft's growth rates leave a lot to be desired, and we simply cannot buy shares directly until Microsoft begins returning much more cash to investors. For the record, earnings are set to grow by 10.62% in fiscal 2013, and growth is set to slow to 9.93% in fiscal 2014. Those are not exactly the kind of growth rates most technology investors are accustomed to seeing (for the record, this data is sourced from Reuters consensus estimates)

(click to enlarge)In our view, Microsoft needs embrace the fact that it is a value company, and stop chasing growth. Those days are behind it, and there is nothing wrong with that. In trying to please every kind of investor, Microsoft is pleasing none of them. But by embracing its status as a value company, Microsoft can create a great deal of shareholder value. There is nothing wrong with being a value company, and once Microsoft accepts that fact, we believe that the company's stock will see solid gains.

Source: To Create Value For Investors, Microsoft Needs To Embrace Its Status As A Value Company

Additional disclosure: We own shares of all 3 companies via the Fidelity Growth Company Fund, and hold shares of Apple directly as well.