Q3 FY08 Earnings

I may or may not be covering this in detail today. To be honest, I'm close to packing it in wrt both MSFT and this blog. However, for those who wandered over here looking for the usual review, expectations are as follows:

The Street is looking for revenue of $14.5 billion and EPS of 44 cents. The company’s guidance was for revenue of $14.3 billion to $14.6 billion, with EPS of 43-45 cents.

With the YHOO thing still hanging over us, reaction to strong results are likely to be muted. And with GOOG and AAPL having already posted blowout results, anything from MSFT will seem average by comparison - which of course it is. On the other hand, negative results and/or weak guidance will be punished severely. Personally, I expect a strong report given higher than expected PC sales. However, I think guidance will be on the modest side given the declining macro economic picture and MSFT's typical conservatism. So tomorrow, the stock may be $1 or so higher best case, or $1-$2 lower worst case. Then we'll drift along some more until the YHOO thing finally gets resolved. If that's a merger, then the stock will take a hit and be dead money for two more years. And if it's walk away, then maybe the stock goes up $2-$3 until worries about how MSFT can curb GOOG's growth without YHOO take over and drive the price back down $2-$3. In other words, yawn.

Results:

On first blush it's not great and the stock is off 5% to $1.62 in the after hours session presently. At $14.45 billion, revenue is in the middle (exactly) of company guidance but light versus consensus. Considering how much further the US$ fell during the Q, that's particularly weak. EPS at .47 looks to be a solid beat, but there's some noise there wrt charges and I haven't detailed what was in/out yet. The item that jumps out is that expenses came in very hot. In particular "Cost of revenue" and "General and administrative". As a result, net income fell off a cliff. Again, I haven't detailed what's behind that yet, although a billion of it looks to be accounting for the EC fine. There's a note in the .ppt that says "Operating income" would have been $5.8 billion ex the fine, which would have exceeded company guidance of $5.6-$5.7 billion. Not that investors apparently care about the distinction.

Results by segment are as follows (technology guarantee impact making compares difficult):

Again looking quickly, Client sucked. And it seems to be not just the technology guarantee impact but also anemic OEM growth. The .ppt brags about the same 140M Vista licenses sold that we've been hearing about for a while now. So clearly there's been no acceleration wrt installed base upgrades either. Surprise! Not. MBD was also weak. I haven't delved further to figure out why. Server put in a strong showing as per usual. Kudos to that group at least. And E&D managed to eke out a paper profit (as long as you ignore intra-group transfers and the convenient "Corporate-level activity" bucket).

Guidance for Q4 is $15.5-$15.8 billion. The street was expecting $15.6 billion, so nothing too negative there. But EPS guidance is .45 -.48, whereas consensus was .48. So that's a guide down.

Of course, since next fiscal provides lots of time for things to change, to beg forgiveness, or for a YHOO merger to screw up compares enough to make burying a subsequent miss easy, and since having the stock drop too far currently isn't ideal given the pending YHOO merger, the company is able to look past Q4's set back and be unreservedly bullish for FY09:

• Revenue is expected to be in the range of $66.9 billion to $68.0 billion.
  
• Operating income is expected to be in the range of $26.7 billion to $27.4 billion.
  
• Diluted earnings per share are expected to be in the range of $2.13 to $2.19.

Wall Street analysts were forecasting EPS of $2.00 to $2.20 per share ($2.10 consensus), on revenue of $66.5 billion.

Buybacks during the quarter were unsurprisingly light at around $1 billion.

Sample media reaction:

• Microsoft's Revenue, 4Q Outlook Disappoint the Street
• Microsoft quarter view disappoints, bullish on '09
• LIVE ANALYSIS: Microsoft FQ3 Weaker Than Expected

And:

• Microsoft: FY Q3 Windows Demand Falls Short Of Forecast

Excerpts:

Tracy notes that revenues from the Client division - the Windows business - had been expected to be down 18%-20% year over year, but actually fell 24%. He notes that Microsoft believes PC market growth was 8%-10% in the quarter, below the company’s previous estimate of 9%-11%. I would note here that other estimates of Q1 PC unit growth are higher: IDC says units grew 12.3%; Gartner says growth was 14.6%.

Minimum 20% miss versus forecast on a business this large? Not good. Who is getting fired? Kidding, we know no one will be. And who to believe wrt actual PC shipments? FWIW, I'm going with IDC and guessing a mix shift back to lower priced/lower margin XP and towards Linux in UMPCs and emerging markets is what is really responsible for the miss - which is even more concerning.
 

Tracy notes that the Microsoft Business Division’s revenues came in about $20 million to $30 million below expectations. He says the server and online businesses were in line with expectations. He says the entertainment and devices segment was ahead of plan, driven by strong Xbox 360 sales

You know it's a weak report overall when MSFT is reduced to playing up E&D's results.

 

Update:

Thank God for the last minute "surge" today, or the maximum $2 downside target that I postulated yesterday would have been exceeded on a closing basis. As it was, the stock was down more than $2 during the session. But it managed to end the day down a mere $1.97. Hopefully you appreciate the psychologically important distinction there, because I'll bet dollars to donuts a bunch more of our cash got spent in order to ensure that result. So, let's call it $18 billion of shareholder wealth destruction. Not bad for one day's work.

Having listened again to the fifty something minute excuse-fest that passed for a conference call last night, I can see why investors were dumping. If I had a dollar for every "woulda, coulda, shoulda" that was uttered, I'd be rich today instead of just poorer like most shareholders. Liddell's attempt to blame the Client shortfall in part on some mysterious piracy problem with a Chinese distributor and their "market dynamics" (which when coupled with the recent MSFT/Novell/China announcement is probably really about Linux competition), while comically maintaining that there is no Vista problem (even though the "sold" counter is moving slower than Zimbabwe's national election results), just shows how much contempt this management team has for the truth and the intelligence of its shareholders. Most companies bend the truth. That's expected. But MSFT's current management team just dispense with it entirely.

I especially got a kick out of their self-congratulations for the wise "investments" made and diversification achieved, how good they feel about the way the business is performing, and how much they will have increased EPS by - assuming they make their targets -  over the past three years or so (which conveniently have now morphed from the biggest product lineup in company history being well received by customers as recently as last Q, to "one of the most difficult economic environments we've seen". Huh?). Pop quiz: What has all this supposed goodness meant for the people they have a fiduciary obligation to - shareholders? Answer: Effectively squat. Had you simply invested in the indexes over the same period, you would have had a better return with much less volatility. Extending that to 5 years, you would have outperformed MSFT by approximately 34% to 50% ex-dividends (depending on whether you chose the S&P or the NASDAQ). And let's not even bother comparing returns to companies that have actually performed for shareholders like AAPL, GOOG, HPQ, or even IBM of all people.

I wonder if I'm unique among shareholders in that I'm only ever half-listening to their tired self-serving bullshit. Meanwhile, a virtual ticker tape of MSFT's moribund stock price this decade is scrolling along in my mind, serving to negate much of what they're saying and underscoring just how out of touch with reality they are. Based on market reaction today, it looks like at least some others reached similar conclusions.

Anyway, this piece includes analysts reactions following last night's results:

• Microsoft Shares Stumble; Earnings A Mix Bag; Xbox Strong, But Windows Disappoints; Waiting For Yahoo

There's also some additional color on the financial sinkhole that is Online in this piece:

• Microsoft Cuts Outlook for MSN, Online Display Ads Weakening

Again, Ballmer must have a really low opinion of the average investor's IQ if he thinks we can review data like this and still believe him that MSFT has a "solid" strategy here with or without YHOO. They don't. They have another financial clusterfuck that rivals Xbox, and investors are more than smart enough to see that - which partially explains the stock action.

Is the Sleeping Giant Finally Waking Up, or Just Rolling Over?

In the movie Tora! Tora! Tora!, when Japanese Vice-Admiral Isoroku Yamamoto is presented with the news that Pearl Harbor has successfully been attacked, he doesn't gloat. Instead, he shows great prescience and says:

I fear all we have done is to awaken a sleeping giant and fill him with a terrible resolve.

For several months now, I've been trying to determine whether the increasing successful attacks of competitors are finally waking MSFT up and relighting the fire, or whether the company is just putting more pillows over its head so that it can keep dreaming about the good ol' days of the late 90's - the corporate equivalent of a child's "can't hear you".

Support for the latter proposition is nearly endless, and I'll return to that in a bit. In fact, it's so abundant that my willingness to consider an alternate reality is itself ipso facto evidence of possible self-delusion. Holding the stock will do that to you. Nevertheless, there is some support for that view, albeit that it's much harder to come by. Case in point, this ZDNet article by Dana Gardner, who interestingly isn't much of a MSFT fan - which gives it all the more credibility:

• It’s good news, bad news: Microsoft gets its Internet act together

Excerpt: (bolding mine):

The Google fear on the business model disruption, the Apple fear on the client disruption, and the Amazon fear on the cloud disruption, seems to be making Microsoft do what anti-trust regulators, Java, open source developers, Linux, Firefox, OpenDocument, IBM/Eclipse, Novell, and a chorus of Microsoft bashers like myself have been trying for many years. And that is ultimately to save Microsoft from itself.

Halllalulah on that last one. The piece contains several great links that are also worth a read, including this one by former softie Robert Scoble.

Unfortunately, there's the flip side that I mentioned earlier. Let's skip over the usual stuff like an Excel bug, a Word bug to keep that one company, a long-ignored Jet bug, and embarrassing IE performance scores (btw, can someone also tell me why IE - both 7 and 8 - choke on a large number of favorites when Opera, Firefox, and even Safari do not? Or why Safari can come to market with better standards support and a better mobile experience in less time than IE, and - at the risk of answering my own question - why MSFT hasn't ripped the browser out of the OS where it should never have been put in the first place?). I'm not even specifically focused on news of all the drivers that are still problematic for Vista SP1 along with failed install stories. After all, that was true of XP SP2 initially too, and God forbid that MSFT would improve over time - especially when this version of the OS is struggling so visibly.

No, the things that really concern me are reports of declining reputation and other branding issues:

Microsoft also came out on top when customers were asked to choose which company to rebrand. "It's gone from innovative and bold to stodgy and a follower," said one respondent. "But rebranding is only one step since it really needs a major shift in how it thinks."

Or how much additional share the MAC is picking up - here's a further nice quote to ponder on that score:

Huberty notes that a recent higher education survey shows Apple’s mind share tracks well ahead of the current market share - 40% of college students plan to buy a Mac, while just 15% actually have one so far.

Mary Jo Foley has a timely piece quoting Forrester and saying forget the noise, "Windows still totally and completely rules the enterprise roost". That may be true, but it's a very shortsighted view of things. IMO, if MSFT continues to sit back and let Apple lead technically (or at least from a user experience perspective - the phrase every convert I know uses to describe it is simply "I love it") and clobber the Windows brand from a marketing standpoint, then it's only a matter of time before consumer success for AAPL translates into business success as well.

Then you have the recent trend towards low cost portables, like the Asus Eee, with Linux as the default (and where Vista is a non-starter both price-wise and especially resource-wise). And the very concerning possibility that with the iPhone, Apple may have given birth to an entire new platform - taking a page right out of Microsoft's own Windows play book.

Another concern, though unsurprising, is Ballmer's absence from Barron's list of the world's best CEOs. Was it the failure to "deliver for shareholders", or the inability to be seen as an "excellent manager", that kiboshed his inclusion? Guilty on both charges would be my own input. Is the Board really so out of touch that it doesn't recognize the connection between confidence in the CEO and bullishness in the stock? Maybe they need a more concrete example - like the top holdings of the QQQQ as a percentage of net assets? Hmm...that is meant to be the tracking stock of a marketcap weighted index right? So, er, shouldn't MSFT be weighted higher than AAPL?

And finally we have the whopper, the YHOO bid, now rumored to be going to $34 - or maybe $36 - despite the already ridiculous premium of the current offer, ongoing executive and senior sales departures (the latter apparently coinciding with the annual bonus being paid out in March - go figure), comScore data showing continued search share erosion, the Alibaba folks wanting to trigger a contract clause that allows them to buyout YHOO's stake in the event of a takeover (particularly concerning since the Asian holdings are perhaps YHOO's strongest asset), childish anti-MSFT antics, and fantasy growth projections like this:

Take a look at the data below, and ask yourself whether pursuing the same "me too, just worse" strategy that has failed dismally so far, only in a super-sized and even more shareholder-hostile version via Microhoo, is likely to yield a different result?

Anyway, in trying to answer the subject question of this piece, I went back and reread an earlier post where I laid out what MSFT needed to do imo to turn itself around (lest you thought all I did was complain). It has been just over one year since I wrote that piece and two things struck me after reviewing it: 1) It stands up pretty well despite the passage of time (read: I would change very little, though I'm of course biased) and 2) There has been progress in some areas (implicit as well as explicit). That's a positive. But complicating the analysis - and one of the main problems - is that MSFT (the company) never appears to be on one singular path. Instead, you have to divine the direction of the whole by assembling various often conflicting crumbs of information from the constituent parts. As this article notes:

"Microsoft's left hand and right hand don't ever talk to each other -- but if they did? Whoa, watch out," he said.

How does the leadership of a company this disorganized and literally tripping over itself with respect to its go-to-market messages, branding, advertising, etc. (think Live, for example), convince itself that it can be the leader in helping others hone their image and advertising online? Maybe back in the 90's, companies would have sidled up for some insight from the master. Today, that master would be Apple, or less so GOOG, and the value of getting strategy/marketing advice from MSFT is pretty unclear - except possibly so you can do the exact opposite. For example, consider the following from this article:

"We are working with a broad cross section of our product groups," he said, adding that evangelizing Silverlight across the company is still a challenge, even though CEO Steve Ballmer has highlighted the technology as key to its future. "It's a big ship to start turning around."

Huh? Is the captain in charge and running the "ship", or is this the Exxon Valdez? Or how about a quote from this one:

That's all I'll say, but you can easily imagine how we can take those things -- music, some of the things we do with Zune; games, with what we do with Xbox and Xbox Live; things that we would do with the PC and the Web, with Windows Vista and Windows Live; what people do in business with Exchange, with Office -- and how we'll make those things really come to life on mobile devices, in the right way for a mobile device.

Imagining that requires no effort whatsoever. What's difficult to understand is why it hasn't been done already? Was someone actually content with being a distant #3 (or having say a whopping 1% marketshare in China) before Apple came along and kicked everyone's butt? Predictably, now that the latter has occurred, the company is finally mobilizing (sorry for the pun there) and spending vast sums to acquire Danger, license Flash from Adobe, and doing whatever else comes to mind - including playing for time by making forward looking announcements and even creating fictitious and misleading UI shots - to try and get back in the game. And the PR machine is pumping out "Mobile momentum" pieces almost daily, while Mr. Credibility himself, Robbie Bach, assures us that MSFT will gain more share. Recall what that normally means in Bachspeak - more $$$ going the wrong way.

Anyway, all of this is a rather long way of saying that after looking at the data for and against, I think the giant is awakening. That's something, and potentially constructive. However, my concern is that the breadth of that change is still too limited and the overall pace of change is grossly inadequate. Like Nero fiddling while Rome burned, Ballmer seems to be preoccupied with GOOG while MSFT melts down - or at least while the first embers, which had already been apparent for years, now threaten to turn into something much more serious. Hence the recent ill-advised and fiscally irresponsible YHOO bid.

Barring a leadership change (which sadly isn't in the cards), MSFT's best bet is seemingly that emerging market growth bails the company out long enough to get its act together (a tall order given the competition there from Linux, along with heavily discounted MS pricing). Because at this rate, it's going to take current management at least several more years that they don't have to get there - assuming they ever do. Meanwhile, AAPL, GOOG, and others (Firefox, etc.) are going to continue to grab significant additional share in their respective markets - much of it at MSFT's expense - based on current momentum alone (not to mention their generally better strategy, agility, efficiency and execution). Against that backdrop, don't expect the stock to cease its now five-year plus flatline.

 

Update: Related developments...

• Real threat or tactic? Yahoo’s stock plummets on threat of Microsoft pulling bid. (I'll guess "tactic", unfortunately, but at least it suggests MSFT may finally be prepared to play hardball)
• Microsoft's Savvy Open Source Move (this is smart)
• Killing XP: Microsoft's Fatal Error (this one not so much)
• Who uses MS Live Search? (scary if correct)
• Microsoft Announces Extended Availability of Windows XP Home for ULCPCs (surprise! not)
• With Yahoo deal off, what next for Microsoft? (talk about premature, but still a good read). Excerpt:

Michael Gartenberg, vice president and research director at Jupiter Research, suggested that rather than acquire or partner another company to gain ground on Google, Microsoft should turn inward and focus on execution of its own online strategy. The company has developed innovative online services behind the scenes but has been slow getting those out to users, he said.

FWIW, while I agree with Gartenberg that MSFT has some innovative online services that need to get out the door faster, focusing internally on the current strategy isn't the answer. That's what the company has been doing for the past several years and it has been an abject failure. MSFT needs to quit the "me too, just worse" strategy. Instead, it needs to go back to basics. Forget the envious dreams about GOOG's $ signs. What customer isn't currently being well served? What are their needs that aren't being met? What unique core competencies does MSFT have that it can bring to the table? What partners exist who, for their own reasons, would want to align with MSFT and could be leveraged? Execute on that, and while MSFT many not ever dislodge GOOG, it could at least start to grow share - which is more than it has been able to do so far, despite years spent and billions lost.

Breaking News: CVP Will Poole Certifies Another Laptop as Vista "Capable"

Granted, you may not get the "full" experience - though some might argue that the difference will be marginal. However, it will mean another chip sale for INTC. And isn't that all that matters?

Seriously, what an embarrassment. See the story that Todd Bishop broke here:

• Full text: Microsoft execs on Vista problems

Additional coverage everywhere else including:

• Microsoft Changed Vista Rules for Intel, E-Mail Says
• Microsoft Combined With Intel For A Vista Logo Disaster
  
• Why Did Microsoft Favor Intel Over Users?

I suppose there's some way to spin this in a positive direction - and no doubt MSFT leadership will try. Here's their first lame attempt:

Throughout this process, Microsoft employees raised concerns and addressed issues with the intent to make this program better for our business partners and valuable for consumers. That's the sort of exchange we want to encourage. And in the end, we believe we succeeded in achieving both objectives.

Unfortunately, the record appears to show that while employees raised the concerns (to their credit), they were overruled by senior leadership. In other words, there was a willful decision to screw over customers and even OEM partners in order to placate INTC. Great judgement call if that's the case.

At least the Sinofsky summation shows there's hope for Windows - and the company more generally - under his leadership.

I'm not a lawyer, but these revelations would appear to be more than sufficient for the plaintiffs to win their pending class action lawsuit. So expect another $500M+ eventual judgement. Which makes the following all the more prescient:

In a February 2006 e-mail, Robin Leonard, a Microsoft employee, wrote that Wal-Mart officials were "extremely disappointed in the fact that the standards were lowered and feel like customer confusion will ensue."

She added later, "Please give this some consideration; it would be a lot less costly to do the right thing for the customer than to spend dollars on the back end trying to fix the problem."

"Do the right thing for the customer". Now there's a concept. So will anyone senior get fired for having seemingly done the wrong thing for customers, thereby damaging perceptions of Microsoft and its most important product in the process? Of course not.

Not coincidentally, MSFT is dropping Vista prices for retail skus; A move that is long overdue since the pricing there is ridiculous and sales have been abysmal.

All in all, a nice cap to a rotten week of news and stock action for MSFT.

Awooga, Awooga... Abandon Ship!

What do you do when you find yourself aboard the USS Caine and unable to locate enough fellow deckhands willing to stage a mutiny? Why, abandon ship of course. And that's what MSFT shareholders have been doing - in droves. I wonder if Ballmer is holed up somewhere right now, in front of the Board of Directors, with a scene like this playing out? Okay, maybe not. Must be my excitement over the upcoming Academy Awards talking. Reality is probably more like Alfred E. Neuman's "What, Me Worry?" anyway.

Meanwhile, MSFT shareholders are paying the price - a $73,000,000,000 tab in just the past three months ($85B if you go back to the peak in Oct.). Of course, some of that was the mysterious inability of the stock to hold its rally coming out of the strong earnings report - something that had already gotten my spidey senses tingling and waiting for the inevitable "bad news" shoe to drop. No way anyone knew something was up in advance, right? Like say, YHOO's and MSFT's M&A advisors from Wall Street? But if you want to explain that away as just market related, compare and contrast how HPQ fared in an equally bad environment following their strong report (I'll come back to them later). Then you have the market meltdown itself, which is responsible for a good chunk of the loss. And finally you have the massive fallout from the YHOO deal. A few billion here, another few billion there, $40B+ on top of that, and pretty soon you're talking serious money.

Consider the implications, for a moment, that if I left you with just two clues: "MSFT" and "$27.68" (it actually hit $27.20 intraday), I could be talking about 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, or now 2008. That's right, the stock has hit that level at some point during each of those years. How can anyone still be a CEO with a track record like that?  Ballmer is like a small child who, having been told not to put their hand on a hot element, continues to do so anyway. Only in this case, it's our hand that repeatedly gets burned. Or - at the risk of belaboring the point and overextending the child analogy - maybe he's like the teenager who wants money for a home recording studio because he decided on a whim that he's the next Ray, or for a boxing ring in the back yard because he's convinced he's the next Rocky, or for a big-ticket plane to park in the driveway because he watched Top Gun and figures he could be the next Maverick. All of which end up going to waste, due to the subsequent half-assed dedication and limited attention span.

Funnily, this post was originally going to be about how maybe, just maybe, Microsoft was finally getting past the denial stage it has been in for most of this decade, and starting to acknowledge - and even get serious about attempting to fix - its many obvious problems. Now admittedly, you had to make like Andy Dufresne in The Shawshank Redemption and swim through a river of [MSFT executive and pr] crap to get there - truth still being anathema to current management. But there had been a series of moves recently that struck me as atypical: the YHOO bid - no matter how ill-advised (confirming that MSFT's Online efforts have failed miserably), the Danger acquisition - no matter how costly (acknowledging that Windows Mobile is being clobbered by the iPhone in the consumer space and is now at risk to even stay an also-ran in the business market, despite nearly a decade of investment), Ballmer admitting to having had "fits and starts" in the Xbox business (translation: it has been one ginourmous clusterf$k, which looks to be getting worse not better), several executive departures in areas that are all clearly struggling - dare I say some long overdue executive accountability? (I would even have entertained right-sizing the exec ranks, if it wasn't for the fact that they promptly turned around and minted even more VPs via promotions. Gotta keep that agility-sucking "top 500", er... "top 800", er... "top 1000", 1200?, in tact), and finally - gasp! - Ballmer acknowledging that AAPL is kicking MSFT's butt and that they need to do "more to market Windows" (wow, and that only took a few years of AAPL bombarding the public with Windows-bashing ads and increasing their marketshare at MSFT's expense).

FWIW, I attributed all of this to either fear (i.e. MSFT has seen the future and doesn't like the view) or MSFT management finally getting sick of being a punch line for most of this decade - the edge going to the former (not that it much matters if the end result was achieved). But somewhere along the way I started to doubt my entire premise. Maybe I just saw what I wanted to? Which is why you're getting this post instead. After all, what right-thinking management team with problems like those below, would turn around and make a huge offer to buy someone even more screwed up?:

Windows

• Vista SP1: The hits just keep coming
• Windows Vista SP1 To Break Apps Just Like Vista Did!
• Wave goodbye to Microsoft’s Windows Anytime Upgrade
• 50 Reasons to Switch from Microsoft Windows to Apple’s Mac OS X
• Microsoft class action suit over Vista approved

Home Server

• Windows Home Server Still Crippled By Corruption Issues

Live

• Why Ray Ozzie can't save Microsoft

Office/CRM

• Document format battle takes shape ahead of meeting
• Microsoft: IBM masterminded OOXML failure
• The Smartest Unknown Indian Entrepreneur

Xbox

• Sony's PS3 overtakes Xbox 360 in US sales
• Microsoft Offers 'Mea Culpa' For XBox Market Share Loss(copping to incompetence in forecasting, apparently being preferable to admitting lack of competitiveness)
• PS3 Outsold Xbox 360 In First 14 Months
• EA predicts 2008 hardware sales, expects PS3 to be on top
• Gaming Consoles: Wii To Dominate Sales This Year, PS3 Next Year
• Xbox failure rate is around 16 per cent and rising
• Lessons from the Death of HD-DVD

Zune

• Apple iPod Sales To Take Off Again? (AAPL)

Online

• Search Trends: Google Advances in Latest Search Data

Mobile

• Apple beats Microsoft, Motorola in Q4 phone sales
• Screw Windows Mobile, I'm Getting an iPhone
• For Microsoft: Danger, indeed
• The Spectacular Failure of WinCE and Windows Mobile

Marketing

• Microsoft rebrands healthcare software as Amalga (Amazing that they didn't go with "Phlegm" instead)

Legal

• Microsoft move doesn't solve product-tying issue - EU
• U.K. will investigate Microsoft for consumer rights violations

And that - believe it or not - is just a quick sampling. Wouldn't it be an idea to maybe get your own clearly dysfunctional and threatened house in order first, before embarking on trying to clean up someone else's? Is there any doubt that management's credibility would be higher, and the market would be responding more favorably to the proposed deal currently, if that had been true?

Ballmer, imo, has one opportunity to get things back on track. Given the hostility of the YHOO Board to the offer, the list of good people jumping ship or being pushed, the severance programs being put in place that would add billions more to the cost of this already insanely valued deal, its declining share in search, recession risk in this space broadly, and the clear message being sent by MSFT shareholders, Ballmer should revoke the proposal. Just sail away. Chalk it up as a somewhat successful ramming of an enemy cruiser (even if you had to disable, at least temporarily, a few of your aircraft carriers to do it), and leave them to sink via additional shareholders lawsuits and customer/employee defections. Maybe buy just the parts you really wanted at some future date - for ten cents on the dollar versus a 60% premium -  when they're on the block and being sold as scrap. And yes, give up your dreams of blowing up the GOOG battleship anytime soon. Like the Bismark, you let that one get built and sail out of port right under your nose. But instead of chasing it recklessly now, maybe see if you can manage to successfully maneuver your own little destroyer-minesweeper for a change, without taking on water continuously and using shareholder cash to fuel the bilge pumps. Perhaps - and I'm just spit-balling here, like Jack Nicholson in A Few Good Men - use some of those $10B's in R&D every year to actually innovate and say, eventually make battleships obsolete? Oh, and do a mea culpa to all shareholders and set about making the current MSFT the best fighting vessel it can be. 'Cause it sure ain't there currently.

Meanwhile, accepting the Oscar for best CEO is... envelope please - HPQ's Mark Hurd:

• Hewlett-Packard CEO: We can do even better

Excerpts:

It's just that the CEO who may be the best big-company operator in the country is all about making uncomfortable observations that so far have ended up being the right call for his company: Market share isn't the best goal to shoot for; even good businesses need to be examined carefully (especially their cost structures); and strategy and execution trump vision any day of the week.

(Take special note of the "cost structures" and "strategy and execution" parts)

And,

Hurd doesn't talk about the competition.

How refreshing.

He boils down the CEO's responsibilities to three tasks: setting strategy (not offering a vision); aligning operations and modeling ways to execute on the strategy; get the best team to help the CEO. "There are a thousand distractions that keep you from doing that," he says. But that's where the focus needs to be.

Pretty clearly, Ballmer has too many "distractions" as it is. The last thing he needs is another super-sized one. That said, will he be smart enough to recognize that and disengage? Sadly, I doubt it. Egos are now involved. So the silver lining is that this decision is big enough and reckless enough that if/when it goes forward, he'll either rule the ocean if it succeeds or be scuttled when it fails. And since we've seen this movie before, odds heavily favor the latter. Let's hope there's enough of the ship left by then to resurrect. Maybe Captain Hurd will be looking for a new berth by then...

Reprieve, Or Just Haggling On Final Price?

Word over the weekend (from various sources) is that YHOO's Board is set to reject MSFT's bid on Monday:

• Yahoo Board to Reject Microsoft Bid

If true, you have to wonder what YHOO leadership's real intention is here. Could they possibly be even less concerned about their shareholder's welfare than say, our management, and stupid enough to flat out reject an offer this lucrative? I guess it's possible, but they'd better have one hell of a consolation prize waiting behind door #2 for their owners. If it's just a zonk, a massive shareholder lawsuit will soon follow, and the current management and BOD would be well advised to start updating their resumes. If a prize is in the offing, how will it be financed? Outsourcing search ads to GOOG, as has been rumored, doesn't seem sufficient to generate the short-term funds required to pay holders a significant one-time dividend or equivalent. In fact, any hook up with GOOG is going to face a tough time passing regulatory muster.  So will YHOO take on debt to do something like that? Sell a partial ownership stake to someone else? Other? Unclear, but interesting.

Of course, this could be - and mostly likely is - just a negotiation ploy. YHOO's Board may well be resigned to being MSFT's Valentine in the final analysis, but figure they might as well hold out for chocolates and roses in addition to that $44.6B dinner originally offered (now subsequently devalued as the price of MSFT shares has dropped). If that's the case, common sense would suggest dialing down the "they're trying to steal us" rhetoric  - especially in light of a 60% premium to market bid that several pundits have described as "insane", and which MSFT holders liked so much they promptly chopped $40B+ off the company's marketcap.

And what's Ballmer's next move upon a formal rejection? Now that he has opened this veritable Pandora's box, in the process destroying that aforementioned MSFT shareholder value, is he going to simply shut the lid and walk away? Sorry folks, early April Fools' joke? While that's likely best for MSFT holders, certainly short-term, it's not likely to enhance his credibility - and he isn't exactly swimming in an abundance to begin with. Will he choose to turn it upside down and shake it instead, bypassing YHOO management altogether and going directly to shareholders - a true hostile takeover that drags on for months? That'll help the stock price. Not! Or will he try to appease the evil spirits, order up those chocolates and roses (and, at the rumored $40 price, dessert wine, a fur stole, a diamond ring, etc.), and just add it to our tab? Capital Research no doubt had something to say about that one - thank God. But I suspect that Ballmer will still bring the offer back up to the at least the original $31 valuation, and will probably go another 10-15% above that.

As a sanity check - or more accurately insanity check - if he ends up going all the way to $40, the deal would now be worth ~$53.6B. Not counting the additional billions here or there in advisor fees and other miscellaneous transaction costs, that would result in the originally envisioned (and abusively dilutive) "600M" of newly minted MSFT shares swelling to ~938M+ - or almost a 10% overall dilution. And we didn't even get the chocolates, roses and dinner first...

I have a better idea. Let's get someone to see the value in MSFT that Ballmer has kept so well hidden these past 8 years, and offer us a 60% premium. Given Friday's close, that would put us at $45.69 - or just about 20% down from where we were when Ballmer first took over as CEO in '00. Surely someone would like us to be their Valentine? We aren't cheap, but we have redeeming virtues. And we won't be ungrateful and accuse you of trying to "steal" us.

 

Update:

It's official, YHOO has rejected the offer as too low:

• Yahoo Rejects Microsoft Bid, Leaves Room for Further Talks

(though they did dial down the rhetoric from that used in the weekend's convenient advance leak).

Some numbers and background on what YHOO is really worth courtesy of Henry Blodget:

• Sorry, But $31 Does Not "Massively Undervalue" Yahoo

(The range btw is $21-$26, and that's using optimistic numbers and assumptions. It's also on a standalone basis. As part of MSFT, YHOO's results would enjoy MSFT's multiple. For example, "35X 2009 estimated EPS = $26", would become "16* 2009 estimated EPS = $11.88" using MSFT's current multiple - give or take any "synergies", of course. Recall what I said in an earlier post about an eventual $1-$2/share goodwill write down for MSFT if this deal goes through? Now you see how that could result)

Not surprisingly, MSFT is selling off further on the news. Consensus expectation appears to be that MSFT will make a higher counter offer - at least before trying other more aggressive measures. In other words, dig in - it's going to be a while, and  the stock is going lower before it's done.

 

Update #2:

MSFT officially responds:

• Microsoft Responds to Yahoo! Announcement

("Good" news? Not upping the original offer, despite the subsequent devaluation - to around $29 and change for each share of YHOO. Bad news? Still want the deal. Read: will likely do so eventually)

Also worth a read:

• Microsoft: Yahoo’s Response To Offer Is “Unfortunate;” Warns It Could Take Other Steps; No New Bid

Excerpt:

Concludes Havens: “It’s not a question of whether they will be acquired, but at what price, and how long will it take.”

Media Roundup

1) Mark Cuban wades in:

• Why Yahoo should say Yes to MicroSoft
  
  

(I respect Cuban, but he must not own MSFT shares)

2) Review of various integration scenarios:

• How To Put Together MicroHoo
  
  

(#1 role model: HP/Compaq. Um, didn't that one initially screw up so badly that the stock nosedived and the original CEO got the boot? On second thought...)

3) Others, besides YHOO's owners, who stand to make a killing:

• Microsoft, Yahoo bankers eye $1 billion payday
  
  

(MSFT shareholders get to supply the blood)

4) An absolutely scathing review of MSFT:

• No joy for Microsoft shareholders in Yahoo
  
  

Excerpt (bolding mine):

Ask investors what they think of Microsoft's innovative juices. The company's stock market value is huge – $280-billion (U.S.) – but it goes for 15 times earnings. Compare that to a far less profitable information company like Thomson Corp., which has no true monopolies (and is a part-owner of this newspaper). At a 10th the market cap, Thomson changes hands for 21 times forward earnings.

Why? We would argue that it's at least in part because Thomson is much more careful with shareholders' money. Thomson investors are rarely diluted by acquisitions or by squandered investments. It's hard to argue with millions of investors.

(Hmm..less "careful with shareholder money"? √ Constantly diluting us by "acquisitions or by squandered investments"? √√ Arguing with millions of investors? √√√).

5) The most succinct but insightful comment I've seen yet on this market space. Ballmer would be well advised to pay attention to the same input:

• Yahoo Vet Millard: Microsoft Deal Was "Inevitable" (MSFT, YHOO, MSO)
  
  

Excerpt (bolding mine):

Yahoo lost sight of who they are and who their customers are. Yahoo's perception is that their only competitor is Google. But 95 percent of their revenue comes from advertising -- so their competitors are really the broadcast TV networks. They think they're in the search game,when they should really be in the brand advertising game.

(Oh, and hire this person)

6) Analyst Trip Chowdry provides some comic relief with a fantasy conspiracy theory worthy of Oliver Stone:

• Analyst: Microsoft's Yahoo bid may be fake
  
  

(If only Ballmer were that strategic and cunning. He's neither.)

7) The sad reality:

• Analyst: 70% Chance For MSFT-YHOO Deal
  
  

(Near 100% chance MSFT shareholders lose money either way though)

8) Finally, the no-brainer trade now that MSFT management have effectively told us they've revisited the future and that what appeared to be incredibly bright initially, turned out to be just the approaching headlights of a Mack truck traveling full tilt with glamour tags reading:

• GOOG
  
  

(Cue sound of air horn)

Meanwhile, another selloff for MSFT on 2X average daily volume:

 

Update:

Worth a read...

• An Open Letter to Steve Ballmer

Excerpt:

I know you want to make your mark on Microsoft, but you should stop trying to be all things to all people. Take a tip on focus from that other Steve.

Dear Steve,

 

Let's talk over this Yahoo! (YHOO) thing before you move ahead. It's a profoundly bad idea.

Also:

• Another Reason MSFT Won't Raise YHOO Offer: Capital Research

(Some possibly good news here. Especially since Capital Research is the largest institutional shareholder of both companies, and therefore has much more potentially at risk on the MSFT side)

Update #2:

More... um, "praise" for the deal:

• Would buying Yahoo be a mistake for Microsoft?

Excerpt:

He is especially frustrated by Gates's pursuit of his white whale when Microsoft has bigger fish to fry, like parrying the challenge from free operating systems like Linux; adapting to the migration of computing from the desktop to the cloud, and competing with Apple as it insinuates its hardware and software into people's living rooms, cars and telephones....

 

"Just now, when they've got momentum, they're going to crush it with this terrible deal," Mowrey said. "I think Microsoft is worth a lot less today than I thought it was worth yesterday."

• Shareholders Want Microsoft-Yahoo Deal Done -- Pronto

Excerpt:

"This is totally insane," says Shareholder Value Management analyst Jeff Embersits. "There's no way Yahoo's worth $44 billion. Period. [Yahoo Management] should fall on their knees, kiss the ground and go home and buy Porsches."

("Insane" seems to be popping up a lot when describing this deal.)

Having Fun Yet?

I know I'm not. And if you think the market is getting it wrong, consider that MSFT was previously expected to make $2.09 per share in FY09. At a semi-reasonable 18X multiple, that would have generated a target price for the stock of around $37.62. Now, consider that some - notably Bernstein - think the YHOO deal could be .32 dilutive to that FY09 EPS target alone. In other words, it could drop to $1.77. If the multiple stayed the same, that would take the target down to $31.86. Which, not coincidentally, is virtually identical to what Canaccord provided today as they downgraded MSFT:

Canaccord Adams downgraded MSFT as they believe shares will come under pressure if the company raises its bid for YHOO. Note that the firm upgraded YHOO to Buy from Hold. Target to $32.00 from $40.00.

But wait, it gets worse. See, with all the extra risk and uncertainty, there's no particular reason to think the market will still award an 18X multiple. I'll leave you to do the math if it dropped to say 16X, or - God forbid - 12X. Additionally, no one knows exactly how dilutive this deal will be. That's because it's half cash, half stock. Now in theory, as MSFT shares continue to decline, so too does the value of the offer. There's just one problem: even if YHOO management decide to accept the deal (and their options are pretty limited), they're very likely to insist that MSFT get it back up to at least the original $31/share level (some are saying $36-$40 might even be required).

Since Ballmer appears to be intent on doing this deal (irrespective of the strong feedback shareholders whom he is meant to represent and work for are giving him), that would leave two choices: adjust the share multiplier higher (from its current .9509 of a MSFT share) - thereby resulting in even more shares being minted, further dilution for us, more downward pressure on future EPS, and a larger ongoing dividend obligation for the company - or change the 50:50 cash/stock balance to favor more cash which, since MSFT doesn't have it, would require taking on even more debt. And the more MSFT shareholders bail, the lower the stock goes, and the worse this non-virtuous failure loop becomes. Neat, huh?

Then there's the fact that while Dumb and Dumber say this deal will be breakeven or better within two full fiscal years after the deal closes, they also said that was excluding various charges. In other words, don't count on EPS after charges - or final EPS - to be breakeven, even through FY10. Related, there is no way that YHOO on paper is going to be worth this price. So at some future point, MSFT is going to have to take a huge charge to write down the "goodwill" difference between what they paid, versus what YHOO was actually worth. I guesstimate that that charge will be at least $1/share, and it could easily be $2 or more depending on what the final price is, how the integration goes, etc.. Needless to say, a $1-2 charge in some future fiscal will have the effect of wiping out a large part of MSFT's overall earnings for that entire year.

As I said in the last post, if you're a MSFT shareholder you should be hoping this deal gets kiboshed by either YHOO or regulators (however unlikely). Alternatively, you should hope that MSFT and YHOO come to some other accommodation. The best option there would be a standalone entity (either under the YHOO listing or a new one), into which both YHOO and MSFT contribute and MSFT shareholders get stock.

 

Update:

• Is Microsoft Desperately Seeking Yahoo?

Our case-in-point arrived today when Canaccord Adams cut Microsoft from "buy" to "hold." Prior to today's activity, MSFT sported 14 "buy" or better ratings, compared to just 4 "holds." If this line of thinking begins to take hold on Wall Street, the shares could be looking at additional declines over the next few months. Additional fuel for the fire could come from the options pits, as the stock's Schaeffer's put/call open interest ratio (SOIR) of 0.44 ranks below 72% of all those taken during the past year. While we can sit and debate the desperation and necessity of Microsoft's bid for weeks, it is investor sentiment that will ultimately vindicate or scuttle the company's shares. And right now, investors appear to be leaning heavily toward the "scuttle" end of the spectrum.