Monday, January 29, 2007

Q2/07 Earnings

Sorry for the delay - I was flat on my back for most of the past week with the worst flu of my life. You know things are bad, when you're munching extra-strength Tylenol like they're bar peanuts and yet your head still feels like it's going to explode.

Getting back to the quarterly report, it was a pretty good one. In fact, from a top-line perspective, it was very good. Sure, the adjustment from the technology guarantee program did a pretty masterful job of obscuring that fact. But that was expected. And yes, operating costs also came in hot - which hurt earnings. But that shouldn't have surprised anyone given that we knew Xbox 360 sales would figure prominently in the mix (although I'm less quick to ignore the 23% increase in General and Administrative expenses which, imo, simply underscores MSFT's out-of-control spending). Other's seem to have a different take on the quarter. For example, Joe Wilcox in his summary characterizes it as a "minus". That strikes me as uncharacteristically simplistic and inaccurate of him. But then, of late, he and Ziff Davis seem to be on a personal jihad to alienate their historical reader base. Joe, here's your first big hint: it's not that the $ weren't booked during the quarter, they just weren't recognized. That's a non-trivial distinction. Adding back the deferred $ from the guarantee program, MSFT revenue was up 20% on the quarter. That's the best top-line growth MSFT has had in years. Better yet, the subsequent conference call showed strength across all "core" segments, with uber-successful Servers finally getting a helping hand from better than expected take up in Client and Business.

Of course, it wouldn't be a MSFT earnings call without some disappointments. These came in the form of downward guidance for Xbox console sales through year-end (12M from 13-15M), and downward guidance for Online (from 11% growth on the year to 3-8%. Gee, I wonder if it will be closer to 3 or 8?). Hard to say what to make of the former. No doubt they stuffed the channel over Xmas and are now looking at considerable inventory that needs to be bled off. But perhaps they're finally getting smart and rather than cutting the price post-Xmas and losing every more $, are prepared to stick to their price and simply run out the timeline. Since I'm no particular fan of the Xbox business plan (oxymoron?), anything that reduces the losses here is okay by me. Moving over to Online/Search, what can I say? Unexpected? Absolutely not. Brutal? Yup, with a capital "B". Indeed, it was SO bad, that we even got an [almost never heard in the wild] executive admission of failure and dissatisfaction from CFO Liddell, following a question from Sandford Bernstein's Charlie Dibona (one of the few analysts who consistently dares to ask tough questions):

On the search side, you are correct that we lost market share certainly relative to the independent assessment during the quarter, and are clearly not happy with that.

I'm not a search expert, but it's hard to see how MSFT's efforts since they supposedly "got serious" about Search, have been anything other than a dismal failure. Sure, their actual search capability has improved - markedly so - but who cares when they continue to lose share hand over fist and grow at fractions of even the market? And this isn't just vis a vis GOOG or YHOO. I mean, when can grow nicely and gain share and you can't, that should be a pretty big clue that you're on the wrong track. I'm also wondering when we should expect to see some results from former Ask CEO Steve Berkowitz, who MSFT hired? It was very uncharacteristic of MSFT to go outside the company and get someone with knowledge and a track record of success. Normally, they seem to prefer in-bred incompetents. As such, I applauded it. But shouldn't we be starting to see some positive results by now? Or is Steve likely nearing his frustration point at no being able to move the ship faster? Meanwhile, you'll be glad to know that MSFT is "taking a long-term view", which you should recognize by now as MSFT speak for "we intend to continue on our chosen path, no matter how unsuccessful or financially-retarded that appears to be". To that end, MSFT is building yet another $500M data center to keep up with rival GOOG. Given that GOOG can actually monetize its "investments" whereas MSFT seemingly can't, I'm sure they're quite content to let MSFT match them data center for data center. At some point, although [sadly] no time soon, MSFT is going to figure out that it can't buy its way to success in Search - or any other business - and is going to have to earn it instead.

Anyway, that's about it for the quarter. The issue for the stock is that the recent run doesn't leave much immediate upside given current earnings. MSFT's biggest problem continues to be the lack of acceleration in the latter. Current management wants you to believe that this year's massive costs are an anomaly, which will eventually subside leaving a clear path to drive the bottom line. That hasn't been true since '00, and I'm not at all convinced we're going to see it now. Indeed, where earlier I got a sense that, post-launch, MSFT would finally take a chainsaw to its bloated headcount, I didn't get that sense AT ALL from the conference call. So, do the math. With consensus EPS next year of $1.67 and a market P/E of say 20, you get a stock price of $33.40. That's not exactly a return that's going to bring tons more money off the sidelines. Could EPS go up? Sure, some analysts are saying there's .10-.15 of potential upside. So that's $36.40. Could the market decide to award MSFT a higher PE now that its massive Vista screwup is behind it? Possible (in fact the current P/E is ahead of the market), but the failures in Search are likely to remain front and center, thereby keeping the P/E multiple in check. Bottom line, based on the numbers, we shouldn't expect much more upside until such time as MSFT gets serious about driving earnings. Of course, leaving aside the numbers, there's always this savvy investing premise - offered by a portfolio manager no less:

Microsoft underperformed the market for so long, now that it's moving, it's like an oil tanker -- hard to stop," says Alan Lowenstein, a portfolio manager with American Fund Advisers.

LOL, an "oil-tanker"? Now, I'll admit that for much of the past few years, MSFT has looked like the Exxon Valdez, complete with incapacitated leadership. But somehow, I think I speak for most investors when I say that we need a "Great White Shark" not an "oil-tanker".

Friday, January 19, 2007

Growing Shareholder Value? Yeah, not so much.

I came across this presentation, by MSFT CFO Chris Liddell, while doing some unrelated research. Here's the transcript and webcast. Given the subject matter, I'm not sure why I missed it at the time (directly or via the media). Nevertheless, it's worth a read/review.

Liddell starts out on a scary note:

I also like to think about that I've helped bring the investor perspective into the company, and talk about perspectives like shareholder value.

You mean that up until a couple of years ago, it didn't exist? That won't come as a complete surprise to many holders since '00, but it's yet another data point supporting how disconnected MSFT's leadership team is from their actual core mandate of running the company to increase shareholder (i.e. owner) value. Luckily, Liddell gets back on track and moves to the heart of the matter:

I talk to people about how we can drive revenue growth, both in the short and the long term, how we can translate that revenue growth into operating income growth, so what's our margin structure and what are the investments we're making in order to drive income growth; how we drive earnings per share growth, so how do we take our income growth and drive it to the bottom line, and the number that you would be most interested; and then lastly, what can we do from a cash flow point of view and in terms of managing some of the other levers that we have to impact earnings per share growth over the long term to drive shareholder value.

Unfortunately, he goes on to largely ignore answering those critical bottom line issues adequately.

The early part of the presentation is self-congratulation for the job done on growing the "core" businesses these past years. That's deserved imo, but mostly because of the failure to get Vista out (which makes the growth achieved with mostly the same ol', same ol', more impressive). There's also some reasonable detail on how MSFT hopes to grow these businesses longer term. Then comes mostly fluff on how they plan to grow their emerging businesses in Entertainment and Online. For example, you gotta love the detailed strategic thinking captured in this slide:

Somehow, I don't think this was crafted by a Wharton MBA. I also doubt that it instills fear in competitors like GOOG/YHOO or, more importantly, convinces investors that MSFT has a well thought out, winning, strategy here. Of course, simple though the plan may be, that Online and Entertainment business goodness (?) requires lots of investment, which comes at a steep price:

However, Chris et al think "a combination of all of those factors are the ones that we believe in the future will drive a revenue base in the online area". Ah, at least there might eventually be a "revenue base". Sadly, there's no mention of profits - but I'm sure that must be an oversight. Net net, how very reassuring. NOT!

Inexplicably, Chris wants to remind you that, had they not made these investments, overall margins would have been better:

Um, is that meant to inspire investor confidence in the leadership team and their investment choices? After all, why is it that GOOG, Apple, Nintendo, [insert pretty much any other top-tier tech company here], can consistently invest far less, and yet monetize it via significant revenue and profit increases far faster?

The slide-deck "pièce de résistance" though, is this one, meant to capture the glowing history of issuances vs repurchases, and setting the stage for the subsequent "money returned to shareholders" finale:

That's a beautiful thing, right? After all, buybacks are trending higher while issuances are trending lower. Er...not quite so fast. While the trend is decidedly positive, do the rolling math - which MSFT conveniently avoided: Total issuances: 1,815M, total repurchases 1,972M. So, the staggering amount of shareholder cash spent on buybacks over this 7 year period ($43B since '02 alone) has reduced shares outstanding by a whopping 157M shares.

In other words, the vast majority of buybacks to date didn't benefit shareholders directly. Instead, they merely avoided the additional dilution that would have occurred had these massive payments to insiders been allowed to further increase shares outstanding. Meanwhile, the stock grossly underperformed all major indexes, thereby negating the excuse that that payout was justified by results on behalf of shareholders. It is an absolute embarassment - not to mention insult to shareholder intelligence - that MSFT continues to grossly misrepresent the true nature, impact, and principal beneficiary of the buybacks done to date using what was/is, after all, our cash to begin with.

The presentation ends with a review of historical dividends paid, while omitting the fact that MSFT's dividend badly lags even the S&P average, far less the DOW 30 (of which MSFT is a member). Finally, nowhere in the ENTIRE presentation is a chart showing the performance of MSFT's stock over this period (for reasons all too obvious to shareholders). After all, why would a discussion entitled "Growing Shareholder Value" want to focus on that?

Liddell appears to be sincere in his focus on shareholders, and this isn't aimed at him directly. However, MSFT's current leadership team needs to stop playing hide-the-pea shell games with investors and misrepresenting money "returned" to them that in fact went to insiders (with a disproportinately large share of that going to senior management). Instead, they need to be honest with shareholders, and start delivering meaningful bottom line earnings acceleration (not just talking about or promising it) that will drive the stock and create realizable shareholder value (i.e. share price appreciation). You know, like they've been paying themselves as if they were doing, while the lesser-paid teams at Apple, Google, etc., have actually been doing it?

Tuesday, January 09, 2007

If they sold sashimi, they'd call it cold dead fish

That was the criticism leveled at Hewlett-Packard back in the mid-80's. Personally, I think they would have called it "the best engineered cold dead fish", but the point is the same - their marketing sucked (btw, I'm using the broad definition of marketing which consists of the four P's: Product, Price, Place and Promotion). As a result, HP was routinely being handed their ass by Digital Equipment in the mid-range and IBM at the high-end. Flash forward to today, and many argue that MSFT has assumed that dubious marketing distinction. Okay, some might say that MSFT's is "Polonium-laced cold dead fish", but let's ignore the ABM whackers and OSS zealots for the moment and concentrate on the core charge. Is it accurate? Is MSFT's marketing really that bad?

I'm not sure that it is, but I do think that MSFT's marketing execution is hopelessly inconsistent and rarely gets the four P's lined up effectively. For example, a hugely successful viral marketing campaign like Origami, is followed up with a decidedly underwhelming UMPC that costs too much and has too little value-add. Similarly, we see amazing hype leading up to the Zune, only to have it come crashing down when a less-than-complete product was rushed to market. In other cases, such as Media Center, we see a very good product at a decent price that seemingly gets almost no direct advertising. Why? Or we see Office, another generally good product (albeit that there were too many marginal releases until recently), marketed with the now infamous "dinosaur" ads - it's always smart to insult your customers (NOT!). Even the Xbox, which has generally been a good product and reasonably well marketed (albeit still unprofitable), has suffered [at times] from chronic supply problems (e.g. Xbox 360 launch) and variable advertising. On the latter, who was the bozo who thought kids skipping rope outdoors was a good way to promote a gaming console - which is almost the antithesis of outdoor enjoyment? The recent Gears of War/Xbox spots are significantly better, but again - across products and across the company - where's the overall marketing consistency that typifies, say, Apple?

All of which brings me to CES - the Consumer Electronics Show currently going on in Las Vegas - and this week's developments. So far, in reading various reports, MSFT has seemingly managed to underwhelm. Sure, there's been some interesting announcements, but nothing much seems to have really captured the imagination of attendees or the media - well, except another mind-numbingly boring keynote by Gates and interview comments where he apparently joked that the Longhorn/Vista fiasco was "the best $6B I ever spent" - yeah, we shareholders found it a real gut-splitter. Meanwhile, compare and contrast to Apple - a company that lately seems to manage the four P's extremely well. They're having their Macworld event in San Francisco, and Apple's CEO Steve Jobs literally blew people away with today's announcements which included the very impressive iPhone (an impossible-to-miss reminder of what the Zune could/should have been) and the iTV. Indeed, just take a quick look at the "CES coverage" on Engadget for a hint at who's capturing early-adopter interest. Meanwhile, MSFT, with tons more R&D and resources, once again seems to be coming up short and is left promising games on Zune by "2008" - I shit you not - and trotting out executives live Robbie Bach to impotently trash talk Apple. Here's an idea: maybe you should keep your mouth shut and let your actions speak for you? Oh...that's right, they are - which is the problem. Seems to me that the "best management team" in MSFT's history would be focused on improving what's clearly wrong with MSFT's marketing rather than wasting cycles jealously mouthing off about those who seemingly have their act together. But hey, that's just me. And how's the market reacting to all this? Currently, MSFT is up $.03 and Apple is up $7.10. Go figure.

Update: Related - an earlier piece in which Joe Wilcox tries to make the case that MSFT's low-key marketing approach (including the painful Gates/Jobs mismatch) is actually a good thing (LOL!). He also predicted disappointment over the iPhone at CES this week (Oops! Bet he wishes he could rewrite that one.) and Gates' keynote not wowing the crowd (okay, that one was a gimme):