Corporate 'Miserliness' In The United States: The Case Of Microsoft

| About: Microsoft Corporation (MSFT)
This article is now exclusive for PRO subscribers.

John Plender writes in the Financial Times that "Apple, Google and Facebook Are Latter-Day Scrooges." His point: "All across the world companies have in recent years been hoarding cash, nowhere more so than in the US. For at least a decade and a half, cash has progressively increased its share of the American corporate balance sheet, to the point where US quoted companies have turned in the Scrooges of the global economy."

Going further, he writes,

...corporate miserliness in the US is driven by the technology sector. I calculate that the combined cash and liquid investments of Apple, Microsoft, Google, Cisco, Oracle, Qualcomm, and Facebook now top $340 billion, a near-fivefold increase since the start of the millennium.

What differentiates these tech companies from most of the other businesses that contributed to the American corporate cash nest egg is that they have little or no borrowings.

That is, all this "cash" has been produced internally from depreciation and retained earnings.

Plender questions why this must be the case. He asks "Why are the most successful and innovative companies on the planet acting like misers in a Balzac novel during a dramatic technological revolution that is leading to the digitization of virtually everything?"

In trying to understand this behavior he comes up with what he calls "the most plausible reason." He argues, "that since information technology, social networks, and the rest are driven by human, not financial, capital. Those such as Google or LinkedIn are the very opposite of capital intensive and the parts of the industrial process that are capital intensive at Apple and Microsoft are substantially outsourced. This chimes with the fact that the biggest cash hoarders are large research and development spenders."

Let's stay with those companies that work in "information technology, social networks, and the rest" and concentrate just on Microsoft (NASDAQ:MSFT) and the foundation of the Microsoft franchise. The Windows system is the heart and soul of the Microsoft franchise. It is the classic example of an "Information Good."

Carl Shapiro and Hal Varian, in their book "Information Rules," define an information good in this way. Information is anything that can be digitized…encoded as a stream of bits. Information goods, therefore, are "baseball scores, books, databases, magazines, movies, music, stock prices and Web pages…."

They go on: "Information is costly to produce but cheap to reproduce," therefore "Economists say that production of an information good involves high fixed costs but low marginal costs."

Information goods can be built into platforms that can serve as networks in which individuals that purchase the platform face switching costs that can keep them "locked-in" to a specific network. The value of a network grows as the number of endpoints associated with the network grows.

And, this is exactly what Microsoft accomplished with its Windows system. It created a network with a vast number of users that were locked-into the Microsoft product because of the high switching costs associated with leaving that system. This system grew as many different valuable applications were created that only worked on the Microsoft network.

The cash flows coming from this huge system were gigantic because of the "low marginal costs" of reproducing the product because price was related to "consumer value."

All that the producer of an information good had to do was to make sure that updates to the system and new "timely" applications appeared on a regular basis to keep the switching costs high. Research and development of new generations of the system and "new" products were problematic because of the dynamics of the industry and the vast space of "new" innovations that were constantly being produced almost anywhere.

The producers of information goods could create their innovations from scratch and pay for the result from the start to finish internally. Most of these producers however took on a "real options" approach to product develop and created their own private equity wings to invest small amounts of capital here and there in small start ups that were producing viable products or applications of interest to the major company. Thus, Microsoft did not have to do all of its own "R&D" but could oversee developments and acquire promising "options" as the concepts matured.

Cash was a vital component of this strategy. Right from the start, most of these producers of information goods did not go into debt. The high fixed costs to produce information goods were funded by families or by venture funds that were paid off as companies went public. The low marginal costs were easily covered by the prices that consumers were willing to pay for the products and huge amounts of cash were accumulated for the acquisition of firms that had products that supported or augmented existing platforms. No debt was really needed.

Companies, like Microsoft, produced amazing amounts of cash flow and the return on equity at Microsoft was well above the 15 percent hurdle that is usually associated with firms that possessed competitive advantages in the marketplace. Because of the network created by Microsoft, the competitive advantage was a sustainable competitive advantage as Microsoft has earned returns on equity in excess of 15 percent throughout its history right up to the present time. It's return on equity for 2013 is somewhere between 25 percent and 30 percent.

Having cash on hand and little or no debt to deal with is a real benefit to a firm with a lot of options and opportunities. However, it can be a very heavy burden to a firm that doesn't have good options or opportunities, or, is unable to execute an investment plan to take advantage of the good options and opportunities that are available to it.

Warren Buffett likes to invest in companies that have a competitive advantage and that are underpriced. However, one more thing that Buffet looks for in a company is how the management of that company uses its cash flow. Having a strong cash flow is not enough. How that cash flow is used is crucial if the value of the investment is to rise. Just having a competitive advantage is not enough to produce a rising stock price if the management of the firm doesn't seem to know how to use the cash flow it is retaining in the firm.

And, investors in the Microsoft company seem to believe that this has been a problem with the outgoing CEO, Steve Ballmer. Microsoft stock has recently been trading in the $37-$38 range.

When Ballmer became the leader at Microsoft thirteen years ago, the stock was roughly around the same level. Furthermore, the price of Microsoft stock did not vary much during Ballmer's tenure. And, over the past three years, Ballmer's Microsoft issued debt…something not done before. This just added more cash to the cash already on hand…for acquisitions?

The judgment of investors? Although Microsoft had a competitive advantage in its main product space generating lots and lots of cash flow…the company failed in one of Buffet's primary criteria for investing…management did little or nothing of value with its retained earnings. The stock price did not go up. And, many would argue, that is why Ballmer had to go.

What about the rest of the technology companies and as well as other companies piling up lots of cash in the past fifteen years or so? Well, buying back the company stock is one way to use the cash. The other way Mr. Plender offers, "in this brave new world America's technology wizards will still be condemned to spew out cash that they cannot absorb in business investment. It is a novel quirk in the workings of late capitalism." Such is life!

Disclosure: I am long MSFT, . 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.