Google and Microsoft are abandoning their Roots as they embrace hardware. Will investors come to regret their choice?
There is a great deal to be said for a company knowing what it is and what it is not. Over time this can change, but a clear vision that is communicated to all stakeholders is a key part of creating a thriving company.
Given that fact, it is reasonable to ask what exactly Google (GOOG) and Microsoft (MSFT) are thinking with their push into hardware. These are two companies that, at their core, are software companies. Google developed a better search algorithm and then settled on a model to monetize those search results, allowing marketers to carefully target their advertising. Microsoft rose to prominence riding the success of its Windows operating system and Office suite of productivity software. At their core neither is a hardware company, but they have both recently made significant, arguably transformational, pushes into the hardware business.
I think the reason for this change is the same for both: Apple (AAPL) has them terrified.
Fear is generally not the best reason to embark on a costly effort to remake a company, especially when the effort involves taking a company from an area of historic strength to one of weakness (or, more charitably, ignorance).
Google and Microsoft have given themselves over to a level of strategic drift which could result in nothing but tears for investors. Buzz is nice, but delivering value for shareholders over the long-term is better.
Both companies are now trapped in a strategy that has them competing against natural allies. Google is now in the business of selling its Android smartphone operating system while also, through its acquisition of Motorola Mobility, selling smartphones. Microsoft, apparently having lost patience with its long-time hardware partners Dell (DELL) and Hewlett-Packard (HPQ), among others, has launched the Surface, its own tablet device, and hence put itself in direct competition with those companies.
In moving into hardware, both Google and Microsoft have turned away from a much more proven means of delivering value to shareholders: Tightening operations.
Let's take a look at where these two companies are now and what they offer for investors:
Google has always been an ambitious company, and that ambition did little to slow it down in its first decade. While its attempts to dominate all aspects of consumer internet experience did little to arrest Google from achieving search dominance, there was always a considerable disconnect between the root of Google's success and the breadth of its efforts.
Heart of the Business: Make no mistake: Google sells ads against its search results. In a nutshell, that is the story of the company. In 2011, 96% of the company's revenue comes from advertising, a % that has held steady for three years even as total revenue has increased by more than $14 billion. During this period gross margins have declined from 37.4% in 2009 to 34.8% in 2011. Worryingly, this happened at a time that traffic acquisition costs as a percentage of advertising revenue declined from 29.0% to 24.1% from 2009 to 2011
Research and Development: Spending is increasing not only in nominal terms but also as a percentage of sales. R&D was at $2.8 billion and 12.0% of sales in 2009, and rose to nearly $5.2 billion and 13.6% of sales in 2011. A reasonable question given this increase would be just what the anticipated return on this spending is.
Sales and Marketing: This expense category has exploded both in nominal and percentage of sales terms. In 2009, spending was approximately $2 billion and 8.4% of sales; by 2011 it was nearly $4.6 billion and 12.1% of sales.
Cash and Marketable Securities: Google ended 2011 with $44.6 billion in cash and marketable securities, an increase of nearly $10 billion over the level at the end of 2010.
A $12.5 billion Ulcer: For shareholders wondering just what might be in store for Google now that Motorola Mobility is its problem, the Q3 earnings release was sobering. The division delivered a $500 million operating loss (good for a -20% operating margin). In August, Google announced that it would layoff 4,000 workers in the division (one-fifth of Motorola Mobility's global workforce), as it seeks to contain costs and somehow realize value on its acquisition.
Savings Opportunities: Rather than an ill-conceived move into hardware, Google could have focused on cost discipline and generated considerable value for investors. If R&D and Sales and Marketing spending had been held at the 2009 percentage of sales level, Google would have generated an additional $2 billion in EBITDA. At the 12.0x the multiple the company is currently trading at, those savings represent $24 billion in market value.
Microsoft
Microsoft has been accused, with some fairness, as being a mess. The company has struggled to retain its strategic focus as competitors have risen and its own product development efforts have been hamstrung by an increasingly sclerotic bureaucracy.
Unless otherwise noted, all numbers from the 2011 annual report.
Revenue Breakdown: A look at Microsoft's various segments reveals that it has done a good job broadening its revenue base over the years. In the 2011 revenue breakdown was as follows:
Microsoft Business (31.4%)
Windows & Windows Live (26.8%)
Server and Tools (24.5%)
Entertainment and Devices (12.5%)
Online Services (3.6%)
Other (1.2%)
Research and Development: Nominal spending is basically flat since 2009, at $9 billion. However, as a percentage of sales, spending in this area has declined from 15.4% in 2009 to 12.9% in 2011.
Sales and Marketing: This category has seen a modest nominal increase ($13.9 billion in 2011, compared to $12.9 billion in 2009. As a percentage of sales this expense also declined, from 22.0% in 2009 to 19.9% in 2011.
Cash and Marketable Securities: Microsoft ended 2011 with $52.8 billion in cash and marketable securities, an increase of $14 billion over the level at the end of 2010.
Profitability: Management is doing a good job of maximizing profitability, as operating income has increased to $27.2 billion in 2011 from $20.4 billion in 2009. Operating margin has jumped four percentage points, to 38.8% in 2011, compared to 34.8% in 2009.
Valuation: This company is a steal at its current valuation. Regardless of its strategic drift, the fact that investors can get in at less than 6.5x Enterprise Value / EBITDA (TM) is too attractive to pass up.
Conclusion
Both Google and Microsoft are drifting into hardware in a way that does not make a lot of sense, but only one has demonstrated a commitment to maximizing profitability from its core offerings. Microsoft, perhaps because it has been out of favor in the tech world longer, has shown a focus on increasing the value of its shareholders' investment. At the moment the market is not rewarding those efforts, but that will change eventually. Buy Microsoft and wait for Google to get cheaper.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
