Thursday, July 26, 2007

Like us, or leave us

That's the effective message Ballmer et al delivered at today's Financial Analyst Meeting. BTW, the market decided to go with the "leave us" option, although it's up a bit in after hours:

Before you say, "But hey, the market was down too". It was. However, most stocks rally on presentations to the financial community. After all, the objective of the exercise is to provide that group with greater insight into management's thinking and strategy, thereby making them more confident, not less. I would also remind you that the exact same thing happened last year. Finally, I would point out the large volume (~88M shares) and significant end of day selling (red):

I was originally going to cover the FAM in detail, but on reflection why bother? Most of it was the same tired, old, self-serving drivel we've heard before. And yet the current management team still thinks that maybe, just maybe, someone will buy it.

The stupidity can be summed up in this statement by Ballmer, which came early in his speech:

If you take a look over the last five years, a lot has gone very well from a shareholder perspective.

He went on to discuss revenue and earnings growth over this particular time period, which of course avoids highlighting the rapid ramp in costs during the past three years (the period, incidentally, that he used when referring to shareholders with [implicitly] too short of an expectation time frame). While Ballmer deserves some kudos for top line growth and - much less so - bottom line earnings during this time frame, the ultimate test for investors is how the stock did. As per usual, Ballmer omitted that little gem. So let's fill in the missing data point:

BTW, that's sans dividends. With dividends (including the one-time $3 fiasco), it would be another 14-15% higher. So call it just a 60% under performance versus the NASDAQ (although the QQQQ's, for example, pay dividends as well). Maybe it did better versus its peers? Let's check:

Er, nope (that's MSFT at the very bottom btw).

It boggles the mind that the CEO of a company whose stock has chronically underperformed the index and its peers by that magnitude, and is currently trailing the NASDAQ by almost 7% YTD (in this its major product release year), can actually stand on stage in front of investors/analysts and claim that "a lot has gone very well from a shareholders perspective". Even more incredulous is that not one of them called "bullshit!".

I'll at least give credit to CFO Liddell for doing what no senior MSFT executive has done in recent history, and that's mention the stock proactively:

Probably of more interest at the end of the day is what that looked like from a shareholder point of view, and that translated into the total shareholder return of 28 percent for the year.

Of course, it was also self-serving and primarily reflects how badly MSFT had crashed the year previously following Ballmer's now infamous spending surprise - a point that Liddell semi-acknowledged:

And, obviously, some of you will say, Well, it was at a low point last year, I could have gone back two years, and it would have been around 25 percent.

BTW, my math for the past two years - again, sans dividends - is more like 19% (~22% with). Unfortunately, having won some points by mentioning the stock, Liddell descends into the same self-serving nonsense as everyone else:

But measure it however you like, last year was the best financial year from a shareholder perspective that we've had this decade, at 28 percent.

Again, it's unbelievable to me that Liddell and others can brag about this with a straight face and no one challenges them on it. Seriously, the translation here is: "Forget the fact that this was in large part a rebound after crashing to three-year lows (following our gross incompetence in managing street expectations), that it came at the cost of another $27B of shareholder cash poured into a tender and buybacks, that it was helped by the hope that Vista was going to be a killer release (now dashed btw), and that it came after badly trailing all major indexes so far this decade (along with the largest destruction of shareholder value in corporate history). Isn't it great?".

That said, Liddell's speech is the only one I found any value in. It's worth a read. He also seemed to foreshadow some improvement in the dividend strategy (which has been a total mess so far). Although he still expressed a preference for buybacks vs dividends. Why, exactly, was left unsaid. Except, of course, that dividends actually go to shareholders, whereas buybacks can be claimed as "returned to shareholders" when in actuality a large part historically has gone to offsetting the dilution caused by paying insiders.

Bottom line, unless shareholders finally push back and call for new management, expect the next five years to look like the last five - best case. While others are spending far less on R&D and reporting massive earnings upside:

MSFT management is calling for no earnings acceleration because they're going to keep spending ridiculous sums on suspect "big bets" and failed business models like Xbox, while continuing to under execute wrt delivering core products that actually thrill users and generate word-of-mouth buying excitement. As regards the stock, expect it to continue to under perform. After all, who wants a mature 8-10% grower that's still spending like it's a high-growth company - and rewarding its upper echelon accordingly - because its management is ineffective and in denial?


An interesting round up of analyst impressions coming out of the meeting:

I guess it must be some of the other institutions represented by the 100-odd professionals who follow the stock that are selling :-)

Thursday, July 19, 2007

Q4/07 Earnings

I'm tied up today and don't expect to post much on earnings this time around. The Xbox charge will blow earnings for both the quarter and the year, so that pretty much negates any anticipation for a "blowout". That said, Ballmer's recent public comments have had a certain unmistakable swagger. So expect the rest of the business to have done quite well. No doubt the company - and analysts with buy recommendations and/or investment banking relationships - will do their best to present the results in that light. Specifically, look for numerous references to "excluding the charge, EPS would have been...". While there's some merit to that wrt understanding how the rest of the business did, the reality is that rightly or wrongly (it's clearly wrongly btw) Xbox is part of MSFT's overall business now. In fact it's a significant part, especially for top line revenue and revenue growth. So excluding that charge is a bit like saying "the date went really well except for the part where I got drunk, spilled a glass of red wine all over her new dress, and she slapped me in the face".

The major focus, of course, will be on anything that gives a sense of how Vista is doing (answer: not nearly as well as it should be, all company rhetoric aside) and of course guidance for the year. Again, listening to the swagger coming out of Ballmer, Witts (who incidentally rivals Liddell for B-O-R-I-N-G) and others at the recent partner meeting, they seem to be very optimistic about FY08 - at least for now. So I don't anticipate any negative change to previous guidance. There's even a chance they could raise it slightly.

WRT the stock, it has suddenly reversed course and been surprising strong after tracking near perfectly against my earlier $28's downside forecast. Not sure what to make of that, except possibly that those comments coming out of the partner meeting caused the street to jump the gun and buy heading into earnings. Hopefully, there are enough positives on the conference call - or at least absence of negatives - that we avoid a post earnings selloff like INTC experienced. Of course, INTC had nicely outperformed the NASDAQ on the year heading into that, whereas MSFT - even given the recent strength, and in this, its major new product year - is still lagging it by more than 6%. So we'll see.


Post-earnings and conference call:


  • PC growth was stronger than expected (by a full 1%)
  • Foreign exchange helped revenue (by a full 2%)
  • "Each business grew revenue at double-digit rates at the high-end of our guidance"
  • The Windows premium mix did better than expected (up 17% to 72%)
  • MBD revenue was up 19% versus guidance of 13-14%
  • Enterprise agreement renewals exceeded the historic range of 66-76%
  • Dynamics bookings were up 24% (not great vs, but better than normal)
  • They sold 400K less Xbox consoles (thereby avoiding the loss per unit * 400K)
  • 243M shares were bought back on the Q for $7B+ (thereby boosting EPS)
  • Headcount growth came in lighter than usual (again, should have helped income even though it's still excessive at ~10%)

MSFT only managed to meet street expectations on EPS. Huh? Hey, I only report the stuff. I guess Ballmer's swagger was reserved for top line results only - part of a disturbing trend. BTW, notice how the earnings "caption" always gives away the plot? Last Q, for example, when earnings for a beat were there, the caption was "Microsoft Reports Record Profits". This Q, when it's just a meet, the caption is "Microsoft's Annual Revenue Surpasses $50B".

To determine why EPS weren't higher I reviewed the financials. FWIW, the first thing I always do is take MSFT's efforts to make growth of revenue vs earnings less easy to compare, and rearrange it so that it's clear cut. That yields a table that looks like this:

At first glance - and ignoring the usual losers - the issue would appear to be Client (see red highlight). That failure of earnings growth to match revenue growth is a real concern. But it's been one for a while, and includes such macro items as an increasing percentage of sales coming from emerging markets (where Windows sells for less). Indeed, Client revenue growth (at least) was actually within forecast (14% vs guidance of 14-15%). It's actually Server & Tools that came in light on revenue versus guidance (15% vs the 16-17% forecast). Additionally, they only matched on earnings growth (versus exceeding it as they have on some previous occasions). According to Liddell, some of the top line issue may have been a result of stronger than expected EA renewals. Whether that played any part in the bottom line impact is unclear. Finally, you have MBD coming in way above plan on revenue (19% vs guidance of 13-14%), but only matching that growth on earnings (it too has done better than that in some previous quarters). Bottom line, who knows? It's a $100M-$300M earnings mystery wrapped in an enigma - or maybe I'm just too tired to analyze it further. On the all-important Vista issue, it's clear from comments that adoption is behind expectation. Liddell's actual euphemism was something along the lines of "we're broadly happy with Vista adoption". But in the Q&A, he was forced to concede that MSFT took down expectations for next year from 85% Vista/15% XP to just 78% Vista. What did Ballmer say again? Oh right, "Vista will be great - bet on it". He must have meant "eventually". Rounding things out we have the pre-announced Xbox loss, which came in at $.08 (the high end of the previously given range of course). That took total losses in E&D for just the past two years to a whopping $3.176B. Yup, that's a "strong business" alright. Finally, Online continues to be a financial sinkhole and will lose money again next year (Xbox business plan redux?). Forecast revenue growth of 10-13% for Online in FY08 is also a joke compared to GOOG, YHOO, or the market as a whole.

So overall, revenue came in roughly as I expected. However, bottom line results were weaker (I expected 1-2 cents upside). Guidance for next year is in line with what I anticipated (i.e. a slight increase), which ultimately is good. But the implicit confirmation about Vista sluggishness, combined with the lack of margin and earnings acceleration next year - and guidance to continue hemorrhaging in Online, will likely take the wind out of the sails of the extra bullishness that had been building following management's recent upbeat comments. Some analysts may still take their estimates up slightly following the call (assuming that MSFT was just being conservative as usual). But I doubt we'll see anything like what followed IBM's strong results. BTW, IBM stock has now handily outperformed MSFT over 1, 3, 5 and 10 years. So much for MSFT being the "new IBM" - we should be so lucky.

For its part, MSFT is down in AH trading. Although exactly how much is subject to some debate (NASDAQ reporting last trade @ $30.90, down .61 from the close; MSNmoney and YHOO say $30.83, down .68). It will likely open weak tomorrow as a result (despite the MM's best efforts). It could have been worse though. Just look at GOOG in AH - down $39.06 according to MSNmoney (and it was down forty-something at one point). That should also hurt the market tomorrow.


"For people who think Microsoft is still a growth story, it's disappointing. It's a mature company in a mature industry with declining prices," Chowdhry added. "For people who think Microsoft is a value company, what they delivered today was quite good."

Monday, July 09, 2007

What did they know, and when did they know it?

The focus of my initial post on the latest Xbox fiasco was primarily on the seemingly endless trail of management incompetence. In thinking about the issue further, I'm not sure that's enough. In fact, I'm wondering if this situation isn't potentially far more serious, possibly even actionable. I'm also wondering if my initial inclination to discount calls from commenters for an SEC investigation was right, and whether that may not be a possibility after all - or at least a risk.

It's one thing to stonewall and put a positive spin on bad news. We might disagree on the extent to which that should be condoned, but it's not illegal per se and is unfortunately commonplace. It's another thing entirely, however, for the executive officers of a public corporation to knowingly make false statements to media and analysts, attempt to conceal material information from shareholders and possibly even from reported financials, or remain silent while seeing others engage in that behavior. At best, it is unethical/unacceptable and risks a shareholder lawsuit. At worst, it raises the specter of a full SEC investigation and resulting charges/fines/restatements if found guilty - not to mention shareholder lawsuits.

Determining which we're dealing with here, seemingly hinges on answers to a relatively short list of questions, none which MSFT has addressed publicly, but all of which the Board could easily determine (more on that later). They include:

  1. What is the overall Xbox 360 failure rate due to manufacturing defects/design shortcomings?
  2. When did it first become "unacceptably high"?
  3. What was the "acceptable" threshold and how does it relate to industry norms?
  4. If it is significantly higher, what is the justification for the delta and who authorized it?
  5. To whom was the abnormal failure rate information communicated and when?
  6. What actions were taken to address the problem, by whom, and when?
  7. Were any of the subsequent remedial changes recommended during the initial design and/or manufacturing process? If so, which ones, why were they ignored initially, and who authorized it?
  8. Was proper accelerated life testing done before launch? If not, why not? (FWIW, Bach says it is being done now).
Here's a very cursory and incomplete review of event chronology:

November 2005: Xbox 360 is launched

  • Shortage of available units is blamed on insufficient manufacturing ramp up time. Others later charge that this was a result of - or at least exacerbated by - low yield, which itself should have acted as a warning of future problems.

  • Articles detailing how to fix the overheating problems begin to appear almost immediately.

  • MSFT's own Mini-Microsoft does a post on the topic of overheating and red circles (later called Red Ring(s) of Death or RRoD), which turns out to be rather prophetic.

  • MSFT responds with:
The vast majority of Xbox 360 owners are having an outstanding experience with their new systems.

December 2005

  • Robert Byers, a Chicago man who purchased the Xbox 360, files suit in a federal court accusing Microsoft of selling a defectively designed product.
September 2006

  • September 22, 2006, MSFT admits to problems with some early units, waives the cost for repairs on all Xbox 360 consoles made before January 1, 2006, and refunds any fees already paid.
  • By this point, MSFT has a full page dedicated to the issue on its web site, and RRoD is one of the command prompts on the support line.

June 15, 2007

  • Todd Holmdahl, Microsoft’s corporate vice president of Gaming and Xbox Products Group, does his best to deny there is any abnormal failure rate, claiming the issue is limited to a "vocal minority".

July 5, 2007

  • MSFT admits the problem, calls the number of failing units "unacceptable", changes the warranty for RRoD specifically, and takes the $1B+ financial charge.

  • Peter Moore, Corporate Vice President, Interactive Entertainment Business, Entertainment and Devices Division, indicates that they began investigating this just "weeks ago".

  • Robbie Bach, President, Entertainment and Devices Division, states that:

For a little over the first year this problem, or this set of issues, wasn't visible at all.

  • MSFT adds that:
The majority of Xbox 360 owners are having a great experience with their console...

[Hmm...that last one sounds familiar somehow. Only "vast" got dropped from majority, and "outstanding" is ratcheted down to just "great". Is MSFT legal doing some advance damage control?]

Given the scope of the problem, resulting financial charge, and potential risk of future legal and/or SEC exposure, common sense - not to mention fiduciary responsibility - argues that the Board of Directors get involved to satisfy themselves that appropriate, defensible answers are forthcoming to the questions above. And not wrt word-games about the meaning of "minority", or wasn't visible for "this set of issues". But on the core topic of overall reliability vis a vis industry norms, and MSFT's resulting actions. Specifically, Moore is quoted stating that:

The information that we knew we had a bad box, we kept shipping it. That’s completely wrong.

The Board needs to determine if that is accurate, using generally accepted industry standards for failure rates as the hurdle. If it is, great. Although by way of full disclosure, I should add that I'm beginning to seriously doubt that is the case. Even if it is, there seems to be no interpretation under which Holmdahl isn't guilty of being hopelessly deceitful when he made his statements defending Xbox reliability three week ago. As such, he needs to be severely reprimanded or fired.

If, on the other hand, those acceptable answers aren't forthcoming, then it's very serious. Under that scenario, imo, every senior manager who knowingly tried to conceal the problem, made false and misleading statements, and/or stood by while they were aware of others doing so, should be fired - period. If that includes Ballmer, he should step down. If charges should have been taken earlier, or shouldn't now be taken as special one-time ones, then bite the bullet and restate/change future guidance accordingly.

Shareholders deserve a clear assurance that management acted appropriately in this matter and can be trusted. The current leadership word-games, unwillingness to detail the specific nature of the issues, and refusal to confirm whether overall failure rates are at or below industry norms, is not providing that. Will the Board act to fill the gap?

: Related.

Update #2:

Thursday, July 05, 2007

What's another $1B among friends?

The train wreck that is the current leadership team of Microsoft, continued their winning ways today. For months they have been stonewalling and denying that Xbox 360 had reliability problems despite widespread reports indicating otherwise. The latter had reached a crecendo recently, but have plagued the unit since its introduction. Today, they admitted the obvious: there is a problem and they are going to fix it. In other words, they finally did what most ethical, customer-focused, and intelligent management teams would have done from the start - told the truth and committed to making it right. But this is Microsoft, so honesty and fixing mistakes often takes longer and only occurs after massive external pressure is applied.

As someone who posted about how ridiculous it was for MSFT to continue ignoring this issue, I'm glad to see them finally step up. However, even I am amazed at the extent of the problem and the resulting price tag: $1.05B-$1.15B. No, that's not a typo. That's what MSFT says it's going to take to fix it. Oh well, what's another $1B+ when you've already invested some $24B to generate $5B+ in cumulative losses so far? Meanwhile, having crashed and burned in Xbox, blowing upcoming quarterly earnings and EPS for the year company-wide in the process, management decided they might as well air all the dirty laundry. So CFO Liddell slipped in that oops, they also missed their already downwardly revised guidance for Xbox 360 unit shipments - well, after an analyst noted the differential and asked him point blank about whether that was confirmation of a miss. Excellent. Combining the above, scratch one of the last remaining areas where MSFT's current leadership was still considered competent: conservative forecasting.

Returning to Xbox 360 failure rates, what are they exactly? MSFT still isn't saying. Here was the answer from Todd Holmdahl, Microsoft’s corporate vice president of Gaming and Xbox Products Group, three week ago:

I would go back and say the vast majority of people love their experience. We continue to go back and address all of these issues on a case by case basis. There is a vocal minority out there. We go off and try to address their issues as quickly and as pain free as possible.

Here it is today from Robbie Bach, president of Microsoft's entertainment and devices unit:

"It's a meaningful number and it's got our attention,'' Bach said. "When you look at the financial implication, obviously it's not a small number."

Todd and Robbie work in the same division and talk to each other, right? FYI, the MSFT press release calls the number "unacceptable". Directions on Microsoft analyst Matt Rosoff is quoted stating that the charge is sufficient to fix 2.5M units. Doing quick math, 2.5M on 11.6M total shipped would suggest a failure rate in excess of 21.5%. But there are numerous unkowns which could skew it higher or lower. Bottom line, it's far above the 3-5% rates considered "normal" for the industry. It's also MSFT's fault apparently (read inadequate design, not poor manufacturing):

Flextronics International Ltd. manufactures the Xbox 360. Bach said Microsoft takes responsibility for the problems and won't be seeking to replace Flextronics.

So what does Bach have to say overall? He'd like you to know that:

the issue was the result of a "complex set of factors'' and it would have been difficult to predict the problem in advance. The failures cropped up in the past few months and weren't apparent in the first year the machine was on sale, he said.

In other words, don't blame him even though he's in charge and gets paid $10M's per year - shit happens. Oh, and that teeny weeny fact that they've known about this for at least "the past few months" (if not 8-18) but were vehemently denying it as recently as three weeks ago? Well, er... did I mention that shit happens? But wait, he's not finished making a fool of himself:

"Our goal has been to have Xbox profitable in the coming fiscal year 2008," said Robbie Bach, president of Microsoft's entertainment and devices unit. "We don't think this changes that in any way."

Doesn't change that in any way? Is Bach retarded? First, they missed their already revised unit forecast for the year and took a massive unexpected charge. As a result, they blew what remaining credibility they had left - which after years of failures, losses, and missed profitability targets, admittedly wasn't much. On top of that, the runaway success of the Wii (and resulting need for MSFT to do something more aggressive on price) was already calling the validity of this '08 forecast into question. Second, the media and competitive fallout from this, including the fact that they may have sat on 20%+ failure rates w/o doing anything about it (except try to aggressively deny it), is going to be huge. It will undoubtedly have a negative impact on unit sales vs previous forecasts. Third, announcing on July 5th that you're retroactively taking a $1B+ charge for last fiscal, and then acting like this fiscal's results are unaffected, is simply comical - and disingenuous. Fourth, even if the division does show a profit on the year, what difference does it make now that Xbox (as an overall investment) goes from $5B+ in the hole to $6B+?

How many more similar fiascoes, obvious management lies, sales misses, financial hits, company credibility blows, and massive failed "investments" is it going to take before MSFT's Board of Directors steps in and demands real accountability and change on behalf of shareholders whose interests they are legally chartered with protecting?

Update: Related: