Sunday, July 30, 2006

FAM - Ante up, up the ante, or just plain bluffing?

A presentation to financial analysts is normally a positive catalyst for a stock. In MSFT's case, the occasion of the FAM (Financial Analysts Meeting) coincided with the stock selling off 2% on the day - albeit that it participated marginally in the broader market rally that occured the following session. What explains this phenomenon? According to several sources, it was MSFT's inability to confirm that Vista will ship on even the latest revised timeline:

That corresponds with the trading action, which saw the stock tank almost immediately after Kevin Johnson failed to rule out a further delay - although it's hard to believe that supposedly smart people were counting on MSFT to do otherwise given the numerous slips so far and months of development work still left. Of course, even if Johnson had backed the ship date 100% (and he actually came closer than I expected), it's unclear that the content/tone of the FAM would have inspired a buying frenzy. That's unfortunate, because when Ballmer opened with this slide, I was initially optimistic that he was going to deal with matters head on:

These are exactly the concerns that exist and the questions MSFT needs to answer especially re: the stock. And it's the first time I've heard Ballmer even acknowledge many of them. Unfortunately, despite raising them and promising they would be addressed by day's end, most weren't - except indirectly.

Other slides that caught my eye in a mostly negative way, included:

This was the culmination of Jeff Raikes' extended effort to discuss adjacent markets into which the Information Worker segment can expand. While that's obviously what MSFT should be focused on doing (in addition to building a product that more existing users want to upgrade to), Raikes never explained whether MSFT's entry into these fields could be expected to yield the market growth rate, something more, or less. That's obviously critical since as you can see from the chart above, most are growing at less than 10% - which would appear to put a cap on what can be expected from IW, MSFT's second-largest source of profits. Indeed, this clumsy presentation has already led to at least one media report incorrectly quoting Raikes as saying that MSFT's IW group would have a CAGR of just 7% over the next 3 years - whereas that was his forecast for that entire segment of the overall market.

This was Robbie Bach's attempt to show that E&D isn't the complete sinkhole that it appears to be. That's a point worth making, but the main concern here are the massive losses being generated by Xbox. And while it's nice to see that acknowledged via a larger red circle today (clearly not drawn to scale), the real question for investors is "What is the magnitude of the eventual payoff (i.e. the black dots in '08 and beyond)?". Many investors, myself included, are sick and tired of hearing that it'll be "worth it", just trust us. We want to see the actual business case even if it's just in the broadest of terms. Ballmer actually acknowledged that feedback in his opening comments - but still the company refuses to lay out the business case. This continuing evasion strikes me as having two possible explanations: either MSFT doesn't know the answer, or MSFT knows the answer is insufficient to support the massive outlays being made. Neither are good options (obviously). For the record, I believe the answer is the latter and that while Xbox may someday be profitable YOY, it is unlikely to ever be so as an overall investment.

This was CFO Chris Liddell's contribution to show what a great job of forecasting MSFT did in '06. Arguably, it doesn't do a very good job of that at all. More importantly, the takeaway for me is that that while business was much better than expected, MSFT only managed to come in at the lowest end of its EPS guidance. Indeed, Liddell confirmed that given the heavier investments, the latter was only made possible via the increased pace of the buybacks. In other words, w/o the buybacks, MSFT would have missed. Gee, that makes me want to run right out and buy more stock. Not!

What can I say about this slide besides the fact that it burns my butt every time I see MSFT referring to all this money supposedly "returned" to me that never actually was? The reality is this: most of that $43B of buybacks went to avoid dilution caused by insider selling. In other words, it was [shareholder-owned] cash that was hijacked to pay insiders - not money "returned" to shareholders. The $33B special dividend, possibly the stupidest use of funds in corporate history, did accrue to shareholders but tanked the stock $5 before it was all over and took more than a year to recover from. In other words, it mostly benefitted traders not long-term holders. The ongoing dividend does accrue to shareholders, but is below market and far below the DOW 30 average of which MSFT is a member - so hardly praiseworthy. Most important of all, in 2002 the stock was as high as $35. Today, it sits at $24.25. At the end of the day, that's where the rubber hits the road - and MSFT's track record in that regard is simply abysmal.

This was seemingly the slide "du jour" and variations appeared in several presentations. If I wasn't a shareholder, it would be comical to see MSFT explaining their unique business investment strategy with what most will recognize as the standard Economics or Business 001 investing chart. As stated above, everyone's aware that MSFT is losing money in various areas and that this is often necessary when making new investments - we don't need a grade-school refresher. The concern is that for MSFT, the curve is the opposite: losses are massive and go on indefinitely, whereas returns are either totally unclear or modest and short-lived. Several presenters suggested that no, MSFT views all investments over a 3-7 years timeframe. But with MSN and Xbox in particular, that's either already been negated or is a contention that seriously strains credibility.

This was one of Ballmer's final slides in his end-of-day wrap up. While he tried to sell it as a positive, I think even a casual review raises immediate concerns. First off, it's worth noting that this is operating income and not net income. In and of itself, that's pretty misleading/deceptive. For example, in '00, net income was $9.4B. In '06, it was $12.56B. In other words, it grew about 33%. The only problem? Revenue over that time almost doubled. Finally, even from this slide, it's obvious that operating income growth is slowing to a crawl. Income and income growth rates ultimately drive stock prices. Which is why for MSFT investors, this significant failure to leverage top line revenue growth into bottom line results is a very alarming trend. Although I can find no record of it on the webcasts, Greg Parker, head of Equity Trading at Pacific Crest Securities, supposedly summarized it this way:

Explain why I'm paying 20 times for a stock that is growing at 10 with a whole lot of investments that are not really going anywhere

That, in a nutshell, is Ballmer's challenge. If MSFT can't find a way to grow faster than 10%, and continues the ridiculous current level of headcount increases and money-losing "big bets" such that income trails even that anemic growth, then MSFT is eventually going to trend to a P/E nearer to 10 than the current 20. For his part, Ballmer took pains to tell us that 85-90% of his investment portfolio is in MSFT. Somehow, that doesn't reassure me.

On a brighter note, Bob Muglia's presentation was right on target - Server & Tools has long struck me as the best run division in MSFT. Kevin Turner's and Craig Mundie's presentations were also okay/informative. Ray Ozzie's was good albeit a little obvious and therefore dull - but seems to have been well received by others. Maybe the fact that someone at the top is now prepared to state the obvious is a positive alone. Frankly, I need to see results versus just words before I can conclude similarly. Finally, while I had some concerns, Liddell's presentation did at least try to deal with some issues head on, and he generally came across stronger than I've seen him on previous occasions - which is a plus. Bottom line, is MSFT anteing up, upping the ante (as they contend) or just bluffing? I don't think the FAM answered that, so only time will tell.

Friday, July 21, 2006

4th Q Financials

Looks like MSFT finally managed to avoid screwing up an earnings call. It's been quite a while since we could say that, and it's interesting that it comes on a quarter which saw a 24% decrease in YOY net income. Still, in reviewing the results, it was a decent quarter - not great, but decent. Ditto, guidance for next year. Of course, there were concerns. For example, Business Solutions - the subject of some of my previous rants - continued to underperform with only 16% license growth. How many years has MSFT been at this now and it's still not growing even at the market rate far less taking share from its main competitors? And let's not even talk about contribution to overall profitability, albeit that it did manage to notch a slight positive profit on the quarter and for the year. You just know someone got really creative with that +$38M profit on the quarter which magically put the division at +$24M for the year just as they get swallowed into the broader IW division for future reporting purposes - how convenient. And then there's MSN. What can I say about this perpetual laggard and decade-long investment failure? I think I'll leave it to Charlie Dibona, analyst for Sandford Bernstein, who posed this question during the conference call Q&A:

...when can we see you start to turn the corner and at least track towards the aggregate overall search market?

He went on to point out that MSFT's guidance for the division could have been accomplished just via the expected lessening impact of access business declines and the display business tracking the market. In other words, where the heck is the search advertising upside? That of course got a long-winded non-answer from MSFT CFO Chris Lidell. Apparently, '07 is yet another "transition" year for search - just like '06, '05...well, you get the picture.

Last, we have Home and Entertainment which was barely referred to at all in the earnings report or subsequent conference call. They did say that Xbox 360 shipments managed to meet the 5M units previously forecast (though shipments don't necessarily equal sell-through we should note). Oh, and they doubled the loss on almost double the revenue - nice to know that they managed to keep that linear. But beyond that, nada. Call me jaded, but when MSFT stops talking about its heretofore bragging poster child, that suggests there's trouble - which I take as sales being weaker than expected. Hopefully, there will be some more color at the upcoming analyst's meeting. At this point, it's totally unclear to me how Xbox will ever return the funds invested to date far less be a wise business investment. Of course, that doesn't stop Ballmer from calling it "one of the greatest creations of shareholders value ever". Perhaps it's just me, but what good is latent shareholder value creation that isn't reflected in the company's market cap, isn't driving earnings but is detracting from them? I guess you could argue that without Xbox, MSFT's top line growth would be even more anemic - which is true. But what good is profitless growth? Unfortunately, of late, Ballmer has been repeatedly quoted talking about "revenue, revenue, revenue". As an investor, I'm interested in healthy revenue growth. But I'm a lot more interested in driving earnings - something MSFT has lagged badly at for 5+ years.

Finally, for fun I looked at headcount stats since they were broken out in the earnings press release. Company-wide, headcount was up a whopping 16% despite % change revenue growth of just 11% and % change operating income of just 13%. Here are the relevant numbers by segment:

Client: 13% headcount growth on 9% and 8% respectively.
Server: 11% headcount growth on 15% and 31% respectively.
IW: 18% headcount growth on 5% and 3% respectively.
BSol: 10% headcount growth on 17% and 114% respectively.
MSN: 44% headcount growth on -2% and -119% respectively.
Mobile: 24% headcount growth on 44% and 103% respectively.
H&E: 19% headcount growth on 36% and -160% respectively.

Tell me, how many companies have the luxury of growing headcount faster than their growth rates and irrespective of whether they're even making a profit? And this is on top of the unprecented headcount increases since '00. Well, in the Alice-in-Wonderland world that is MSFT business management and accountability, apparently the answer is most. And note that the worst sink holes are also some of the biggest % headcount abusers. No wonder income continues to lag revenue growth badly, as it has for more than 5 years now, and the stock continues to flat-line along with it.

FYI - I'm still reviewing the buyback announcements and will post on them when I have a better understanding. For now, the Dutch auction seems about as useful as RPN on a calculator - but I know some swear by the latter so I'll dig into the former before commenting further.

Thursday, July 13, 2006

Finally - someone from Europe speaks out!

As the MS/EU situation has unfolded over the past several years, one thing noticeable by its absence, has been the dearth of folks prepared to come to Microsoft's defense. Indeed, one reader of this blog highlighted that fact when they left this comment:

While the EU is MASSIVELY flawed in their logic and you make some good points...Microsoft has a major customer relations problem in Europe. I put this squarely at the feet of the executives in the EMEA sub. If our "good" partners like Siemens and SAP (for example) were to go to the EU and tell them to lay off, if our big customers like Citibank, like AXA (France), like BT or BP, like alliance or Zurich Insurance were to go to the EU and say, "gee, Microsoft is a strategic platform for us and we need you to lay off"...I have a feeling that the EU would back off. The same goes for the individual country governments to which we sell. That's what we call a customer relationship strategy issue and takes executive love, attention and leadership. Something we're in sore need of. So while the EU is wrong, we've done nothing on the enterprise customer front to make this easier for us to get out of.

Media commentary - at least what I've seen of it - has also generally taken either a "here's the facts" approach, or adopted the MSFT-bashing tone that is so du jour these days. Perhaps most interesting of all, even companies who could be adversely impacted in the future by the precedent potentially being set with MSFT currently (and that includes a broad swath of companies including European ones), have stayed on the sidelines.

All of this, is a rather long-winded way of explaining why the following article caught my attention:

In it, David Mitchell, Software Practice Leader and Gary Barnett, Research Director, of UK-based research group Ovum, are quoted as follows:

Many in the analyst community, the media and the blogosphere have continued to repeat the mantra "Microsoft is bad, the EU is good!" without bothering to subject the conduct of the EU to any form of real analysis. The, perhaps unpalatable, truth is that the EU deserves its share of the blame for the long delay in Microsoft's compliance with the 2004 decision, and as a result it is wholly inappropriate for the EU to fine the company for non-compliance at this point in time.

The timing of this fine is bizarre and unhelpful in resolving the dispute. In the last three to four months there has been genuine progress towards resolving the substantive issue around documentation of Windows protocols. Agreement has been reached between the EU's monitoring trustee and Microsoft on the form and substance of documentation. A series of seven milestones were agreed upon and the first six have been achieved already, with scrutiny of the revised documentation showing signs of a positive reaction. Waiting until the final milestone, due on 24 July, had been reached and those deliverables examined before confirming this fine would have been much more logical.

Microsoft is appealing against this decision and the saga will stretch on - this latest extension is down to the EU, not Microsoft. The EU should not rely on spending the money that Microsoft will hand over as there is a significant chance that they will need to give it back after the full flush of the appeals process.

This case hangs like a pall over the European software industry, acting as a general market depressant. The case will set wider and very significant precedents that will affect many aspects of the European industry. By taking the stick to Microsoft the EU could inadvertently end up beating other companies too, thereby damaging the industry. Engineers and scientists have more chance of producing a rapid resolution to the case than the civil servants and lawyers - the EU should allow the current technical work to complete, and call off the legal and bureaucratic dogs for a while.

Microsoft is not blameless in this case, but the blame equation has more weight on the EU side than most recognise.

Wow - kudos to them!. Oh, and in case you were wondering, according to this related piece:

MSFT doesn't appear to be paying them to say this - go figure:

We've done consulting work for the EU in a number of areas, and we've advised Microsoft on a number of things but none of our work had to do with the problems between the two.

Tuesday, July 11, 2006

Stupid is as stupid does

I haven't posted for a while because frankly, there wasn't much of interest to post about. But now we have the mother of all issues - the EU court case - set to take its next step. According to reports, tomorrow MSFT can expect to be fined as much as $2.5M/day backdated to December of 2005 for failure to comply with the EU Commission's demands. That would also give MSFT the dubious distinction of being the first company to ever be fined by the EU Commission for failure to comply. Additionally, it looks like the EUC may ratchet up the fines to $3M/day moving forward if MSFT continues to disobey.

For the record, I think the EU Commission's original charges were even weaker than the DOJ's, and I hope that the European Court of First Instance restores what little faith I still have in European justice (not to mention common sense) by finding against the EUC when they ultimately hand down their verdict on MSFT's appeal. That said, we have the current mess to deal with and one of the best summaries of that imo, is this one by David Hunter at HunterStrat:

I particularly like this line, talking about the European Union’s Competition Commissioner Neelie Kroes :

...she runs an interminable process that makes a sieve look tight with her as the head blabbermouth.

That's a fact: the EUC has been a sieve of leaks from day one, which should be totally unacceptable. Like me though, Hunter is left scratching his head as to why compliance by MSFT has been so problematic. The EUC and most MSFT detractors seem to back the theory that "MSFT management tried to play chicken with us and failed". That's certainly possible and if so, I think MSFT's board of directors have no choice but to ask for Ballmer's resignation - seriously. MSFT on the other hand, is going with the "we tried our best to comply, but the EUC kept changing the ground rules" defense. This argument would have had a lot more credibility if MSFT had made it two years ago versus just over the past 6 months. However, the EUC's apparent expansion of scope while simultaneously refusing to document said, does raise some concerns which, along with their leaks, mean that I can't discount this scenario entirely. Finally, there's the possibility that MSFT decided early on that providing the requested documentation in full was not in the company's best interests, and has been stalling all along hoping to close the gap to where the appeal could be heard.

If I had to guess, I'd say there are elements of truth in both scenario #1 and #2, but that #3 seems to explain what we've seen best. If so, it's a very dangerous strategy. First of all, MSFT is not guaranteed to win the appeal, whereas their shoe-dragging to date is guaranteed to have pissed off the EUC and made them less amenable moving forward - not exactly what you want if the Court of First Instance ends up backing the EUC 100%. Second, I wonder whether the cost/benefit analysis that might have gone into such a decision, included the further damage to MSFT's credibility amongst Governments, customers and investors as this extended saga has played out in the press worldwide? In any event, I guess we'll know more tomorrow. Meanwhile, MSFT is doing their usual clumsy job of trying to deflect attention from this impending bad news:

And of course the stock is taking another major hit...