Large Cap Technology - Break It Up, Baby

by: Yale Bock

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Investors in large-cap technology companies Microsoft (NASDAQ:MSFT), Cisco Systems (NASDAQ:CSCO), Hewlett-Packard (NYSE:HPQ), and Dell (DELL) own pieces of businesses, which are large and consistently profitable. However, shareholders in all of these enterprises have underperformed the S&P 500 over the last 10 years. The smallest of these companies is Cisco Systems, with annual revenue of just under $50 billion.

As stewards of shareholder capital, management has a fiduciary responsibility to try and create shareholder value in a legal way. The purpose of this article is to propose the idea of breaking up these large technology companies into smaller more focused companies to generate better returns for shareholders over the next 10 years. Let's take a look at these four companies' most recent results and how to possibly restructure each enterprise.


'Mr. Softee' is one of the world's most recognized brands, and the reason is because of its dominance in personal computing operating systems and software over the last 20 years. In the most recent quarter ended June 30, 2012, Microsoft posted these results:

Microsoft Financial Results Quarter Ended 6/30/2012
All Figures in Millions 2011 2012 GAAP Earnings 2012 Non-GAAP Earnings
Revenues 17,367 18,059 18,599
Operating Income 6,171 192 6,925
Earnings Per Share .69 (.06) .73

(Please note, all figures provided from Microsoft)

These results give a company-wide performance indicator, however, they do not break out the detail necessary to analyze how each business unit is performing from a growth and margin perspective. For that, we need to dig further into Microsoft's individual segments.

Microsoft Segment Revenues ($ in Millions)
Revenues 3 Months Ended 6/30/2012 3 Months Ended 6/30/2011 12 Months Ended 6/30/2012 12 Months Ended 6/30/2011
Windows/Windows Live 4,145 4,743 18,373 19,033
Server/Tools 5,092 4,524 18,686 16,680
Online Services 735 680 2,867 2,607
Microsoft Business 6,291 5,873 23,991 22,514
Entertainment/Devices 1,779 1,487 9,593 8,915
Unallocated/Other 17 60 213 194
Consolidated Total 18,059 17,367 73,723 69,943
Microsoft Operating Income ($ in Millions)
3 Months Ended 6/30/2012 3 Months Ended 6/30/2011 12 Months Ended 6/30/2012 12 Months Ended 6/30/2011
Windows & Windows Live 2,397 2,908 11,460 12,211
Server & Tools 2,095 1,686 7,431 6,290
Online Services (6,672) (745) (8,121) (2,657)
Microsoft Business 4,100 3761 15,719 14,657
Entertainment/Devices (263) 13 364 1257
Corporate Level Activity (1,465) (1,452) (5,090) (4,597)
Consolidated Total 192 6,171 21,763 27,161

Clearly the three largest divisions are Windows, Servers and Business. In sum, they account for almost 83% of all revenue and all of the operating profits at MSFT. All are large on their own merit, exceeding or almost reaching $20 billion in annual revenue at minimum, and the lowest operating income total for any of these three units is nearly $7.5 billion. I would make each of these segments a new company, with their own management groups and stock, as well as stock incentives. Each of these enterprises would be given the task of growing on their own merit, and each could borrow freely, as well as using their own stock as a currency to make acquisitions, which would support their growth prospects.

The leftover divisions could either be sold or combined into a separate company as well. Investors may disagree with how the break up might be structured, and certainly different configurations are all possible. I would imagine the investment bankers would salivate at such a prospect. Microsoft faces an interesting future in that it has several cash cows as business units, but with the decline of growth in personal computers, some believe the company faces an uphill battle in the key markets of tablets and smartphones. All of the investment in research and development over the last 10 years has yet to produce much of a competitive offering in the on line segment, and shareholders have clearly seen their returns suffer as a result of the mis-investment. Hopefully, management at Mr. Softee will start to think differently about how best to use capital.

Cisco Systems

Cisco Systems has a large and very profitable business. In fact, I believe the reason why stockholders in Cisco have endured substandard returns is because of slower growth rates in revenue, operating income, and net income over the last decade. Certainly, Cisco grew very quickly for a long time before the last 10 years, and management deserves a great deal of credit for building such a powerful company. However, as the enterprise grows larger and larger, it has become much more difficult to maintain those high growth rates, and when growth slows, multiples contract. Let's take a look at the most recent results from Cisco to see how to possibly reorganize the networking behemoth.

Cisco Systems Financial Results ($ In Millions)
2011 Qtr 4 2012 Qtr 3 2012 Qtr 4
Total Sales 11,195

11,588 (7% yr/yr growth)

11,690 (4% yr/yr growth)
Products 8,921 9,106 9,150
Services 2,274 2,482 2,540
Operating margin Percentage 13.0 23.7 20.3
Net Income 1,232 2,165 1,917
GAAP Earnings Per Share .22 .40 .36
Non-GAAP Net Income (Growth rate after figure) 2,195 (12%) 2,605 (11%) 2,527 15%
Non-GAAP EPS .40 .48 .47

(All figures supplied by Cisco Systems)

Again, it is more important to look at results broken out by individual business segments so we dig deeper. However, we will only look at revenue and growth rates as those are the pertinent issues. Cisco has very good operating margins on a company wide level.

Cisco Segment Revenues and Growth Rates ($ In Millions)
Business Segment 2012 Q 4 Revenues Segment Revenue Y/Y Growth Percentage of Total Revenues
Switching 3,605 0 31%
Next Generation Network (Cloud Services) 2,097 4% 18%
Collaborative 992 -8% 8%
Service Provider Video 962 -2% 8%
Wireless 494 22% 4%
Security 350 8% 3%
Data Centers 415 90% 4%
Other Products 235 -15% 2%
Services 2540 12% 22%

In looking at these segments, the major reason the company is not growing as quickly is because nearly two segments, switching and the cloud comprise nearly 50% of the total revenue, and those categories are large and showing minimal growth. The largest division to have good growth is the services business.

My belief is the two think about the answer in one of two ways. First, a simple answer is to have two companies, one with all the fast growing divisions, and one with the areas which have minimal or no growth. So, Switching, NGN, Video, and Other Products would be in one company and everything else in another.

Another approach would be to group those with natural synergies with one another. Under this kind of arrangement, one company might consist of NGN, services, wireless, and other products. The other company would be switching, data centers, and video. Again, each investor can come up with his or her own structure for a break up, but the reality at Cisco is it is a $50 billion dollar a year company and growing quickly is just going to be very difficult. In smaller companies however, growth could be much more readily achieved.

Thank you for reading the first part of the article; next we will look at Hewlett Packard and Dell.

Disclosure: I am long MSFT, CSCO, HPQ. 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.