Monday, May 21, 2007

It's Official: Ballmer has lost it

I should probably add "completely" since there were signs of increasingly erratic behavior along the way. Starting early, for example, we saw extreme denial as he argued that the company would prevail against the DOJ and be found innocent. That was quickly followed by manic confidence in "emerging bets" which, 5+ years later (actually decades in some cases), are looking more like a disastrous binge in Vegas after failing to take his lithium versus anything remotely approaching a business investment. Then there were the delusional "bet on it" promises that Vista would be "great" and that MSFT would quickly catch and surpass GOOG [Apple, CRM, insert xyz other company kicking MSFT's butt then and still currently]. Thrown into the mix, were the occasional Tourette-like stock-tanking remarks - as in "Surprise! We're going to spend $2-3B more than we let on previously". However, as bad as that is - and it's pretty pathetic - it pales by comparison to news Friday that MSFT is set to acquire aQuantive for the astronomical price of $6B. In Search/Advertising, it would appear, Ballmer has finally wigged out. Either that or he's found a business in which he can lose more money, faster, than even the asinine amounts he's already lost on Xbox, MSN, IPTV, etc. - which is really the same thing.

Recall that just a few weeks ago, it was DoubleClick that was the target of his addled affection. But we know - or at least think we do - what happened there; MSFT offered to outbid GOOG's $3.1B cash deal but DoubleClick backers opted for GOOG anyway. Then 24/7 Real Media became the target of his infatuation, but that went to WPP group for $649M cash (notice how everyone avoids stock these days?). Now suddenly aQuantive is the perfect fit, and all that fiscal responsibility that MSFT has been bragging about with each successive bidding loss these past few months is a thing of the past. Here's how Liddell describes this $6B purchase - the largest acquisition in MSFT history:

We're happy with the price we paid. We believe it's exactly the right company to buy so we're willing to pay the value we are paying today," said Chief Financial Officer Chris Liddell. "We will use the strength of our balance sheet when we think it's necessary to drive growth going forward.

Is aQuantive everyone else's leftover and a poor choice? No, it's an excellent company. Here's an overview of why (nice and timely call btw However, it was also a great company last year, the year before that, the year before that, and the year before that - when incidentally it was trading at a fraction of the current market price and already on the radar of investment forums including MSFT's own Moneycentral (not to mention being right under MS's nose in Seattle). But just like in '00/'01, when Ballmer could and should have been using MSFT's [then] legendary cash pile to make a ton of smart accretive acquisitions for pennies on the dollar, he was too distracted. This time, instead of the DOJ, it was OSS, the Vista screwup, and fantasy delusions that GOOG could be caught any time soon and via an in-house only strategy. Well guess what? The latter has been a failure, as subsequent market share data makes crystal clear. And this expensive and rather desperate acquisition is proof positive that even Ballmer acknowledges it. So, once again, shareholders get to pick up the tab. And not just an already inflated tab (from around $8 several years ago, to <$30 before the DoubleClick deal, to ~$36 before the news Friday) , but a whopping 85% premium to that. As Warren Buffett says, "The best side to be on in a bidding war is the losing side". So why did MSFT management do the unthinkable and not only engage in, but win, a bidding war? Because they once again failed to proactively understand the market and competitive forces and thereby position the company advantageously and cost-effectively. But rather than refocus/regroup after this latest strategic blunder and consider why their largely me-too strategy has been a failure to date, they're just going to "double down" - using our money. And that's going to somehow "change the game". Such is the collective brilliance that we paid $1B in bonuses for.

As you can tell by now, my concern isn't just did MSFT overpay. While you can argue that it equates to less per sales dollar than say, Google paid for DoubleClick - and some supporters of the deal have - I personally have no doubt that MSFT overpaid by any reasonable accounting analysis:

aQuantive generates admirable free cash flow, but everything has a proper price, and Microsoft sure doesn't seem to be paying it here. Discounting likely cash flows, and assuming a huge growth rate of 30% a year for the next half-decade(before some minor cooling), I'd value aQuantive at $45 a share on the very high end. By my math, Microsoft is paying 54% too much, even if things turn out great.

In other words, based on the math alone, this deal might pay for itself sometime in the 2020's - right around the same time that Xbox gets to lifetime breakeven (maybe). Therefore, the critical issue for shareholders imo is having overpaid, can MSFT possibly make it work and how? Beyond the obvious financial obstacles discussed above, there are real business, integration, and strategic, concerns. For example, just this past week, the CEO of AQNT was citing their "independent" position as a core competitive advantage:

We think we can continue to win market share from DoubleClick as we have consistently over the past five years, and now we have the added opportunity of being the only independent player

Hmm, when you throw $6B around it seems that former deeply-held convictions can go out the window. However, for all except the brain-dead, it clearly was and is a major business consideration with unclear implications now that AQNT will no longer be "independent". So how is that going to be resolved and what impact will it have on AQNT's current and expected sales? More importantly, how is this addition going to possibly re-position MSFT's overall money-losing, distant #3 Search and Advertising business in such way that it can recoup that $6B and actually turn a profit on it? Oh, I forgot, current management never concerns themselves with that last part. There's a lot of talk about benefits outside of Search and Advertising for MS. To make it work financially, there almost have to be. But what are they? Is there a play here for Office? Servers? Tools? Will MSFT save some money by say, drop-kicking their current ridiculously bad advertising partners who have brought us the lackluster/non-existent Vista and Zune campaigns, replacing them with AQNT's talent instead? And does it seem odd that a company who's advertising generally sucks (MSFT), especially versus competitors like AAPL, thinks they can "win" in this particular space? Maybe Ballmer can help us out here. Let's look to him for some clarification on the strategy and business justification underpinning MSFT's largest-ever purchase:

The advertising industry is evolving and growing at an incredible pace, moving increasingly toward online and IP-served platforms, which dramatically increases the importance of software for this industry,” he said of today’s deal, adding that it, “represents the next step in the evolution of our ad network from our initial investment in MSN, to the broader Microsoft network including Xbox Live, Windows Live and Office Live, and now to the full capacity of the Internet. Microsoft is intensely committed to creating a thriving advertising business and to partnering closely with all key constituencies in this industry to help maximize the digital advertising opportunity for all.

Have you ever heard more meaningless, content-free, doublespeak in your entire life? This is the "next step" in MSFT's overall unprofitable Online and H&E strategies? Wasn't the next step supposed to be making money - finally? How is an extra $6B of costs going to do that exactly? I mean, is all this just about demonstrating "commitment" to this space? With that kind of reckless financial stupidity it's Ballmer who should be committed - to an asylum. And how will the net result be different from the abject failure to date if we're stuck with the same me-too strategy? As one report noted while discussing why MSFT has lost its innovative edge:

In the old world of technology, Google's ad push might have been met with the announcement of a killer technology, possible for something unrelated, or even more likely for some new online ad-serving technology that lets Microsoft push commercial content simultaneously to online, TV, podcast, radio and for output in various print and display venues. That didn't happen.

I agree. What is the plan? If it's the one evident currently - namely to beat GOOG by copying them only slower - then Ballmer is out of his mind. There is NO hope that is going to happen in the short term. Instead of focusing on a competitor, MSFT should concentrate on a customer niche that it can dominate and then build from there. For example, I have long argued that MSFT should try (directly and in partnership) to position itself as the most-effective vehicle for advertisers. In other words, not necessarily the biggest (duh), but the one who has the deepest market knowledge - at least within some core verticals - and the one who can provide the best effectiveness and tracking for advertisers. Even if the latter means - gasp - placing advertising across competing networks. Right now, online advertising is a free-for-all. But over time advertisers will gravitate - and pay a premium - for those entities who can demonstrate the most bang for their buck. AQNT's deep expertise could help in that, but you need a focused strategy first. Otherwise, whatever they bring to the table will be quickly diffused across too many conflicting efforts - like ignorantly trying a frontal assault against a dominant entrenched competitor like GOOG. Why even continue making this a "we vs GOOG" battle when it's clear MSFT isn't in the same league? If you were relatively new to golf and way down the rankings, would you constantly reiterate your goal to beat Tiger Woods? Does it serve shareholder's interests to have the market constantly compare every misstep or minor victory against the backdrop of GOOG and that goal ? It doesn't. We'd be far better off if management made that clear, stopped blindly responding to everything GOOG does, and focused instead on executing their own strategy with more realistic short-term goals - like becoming a relevant and profitable #3.

Meanwhile, MSFT throws in another re-org for good measure. I guess internecine battles are a nice break for the troops from getting killed by competitors.

BTW, If there's some good financial news relating to the AQNT purchase it's this:

The company said the deal would add revenue and operating expense in fiscal 2008, but said it will not change its outlook for operating income or earnings per share next year.

How that will be accomplished is anyone's guess since the interest lost on the $6B - plus integration costs - should eat up any profit AQNT was set to deliver (assuming customers don't balk at the newfound lack of independence) and/or merger cost savings that can be eked out short-term. Presumably, MSFT will be making cuts elsewhere in order to create that result. That said, expect buybacks to slow or even stop on the back of this - at least for several Q's. Otherwise, unless they sell some of their LT investments to help cover this (like maybe Comcast shares now that the latter dumped MS's TV guide?), cash + ST investments will dip below $20B - which would be contrary to Gates' stated preference to go a year w/o any revenue if need be.

Bottom line, AQNT is a great company and should have been acquired years ago while it was still cheap - and when MSFT had already committed 110% to this area. That's what a smart, proactive, management team would have done. Instead, at this price, the sun, wind, and moon, will have to align in order for it to make financial sense. Translated, the current management team who have a brutal record of successfully integrating acquisitions and have shown no aptitude yet in beating YHOO, far less GOOG, are going to have to do BOTH and then some to make it a wise investment.

However, yours truly has come up with the one way in which this deal can make perfect financial sense. Reviewing this must-read article, it's clear that AQNT's chief executive officer Brian McAndrews is a force to be reckoned with. And since MSFT is desperately in need of a new (non-inbred) CEO-replacement, maybe he's it. After all, not only did he just out-negotiate Ballmer six ways from Sunday, but over the past 5 years he's managed to reward his shareholders with a 2000% increase in share price versus ~14% for MSFT. $6B for aQuantive? Far too much and almost impossible to reconcile financially. On the other hand, $6B for a new (capable) MSFT CEO who can substitute winning strategies and execution for empty bravado, dubious "investments", and irresponsible spending? Priceless.


Articles against the deal:

  • Endless (do a search) - although the market itself is taking it well so far.

Articles for the deal:


Found two more positive articles on the deal - they're proving to be more elusive than MSFT ship dates.

Update #2:

Good thing I said the market was taking it well "so far". Berkowitz spoke at a JP Morgan conference today and got killed during the Q&A. Perhaps that's why the stock was off so visibly. Listen to the linked webcast or check out this for some excerpts:

Wednesday, May 16, 2007

What I'm reading

I plow through a fair bunch of MSFT-related articles every week. Some become the basis for posts, but most don't and end up in my favorites cache. Here's a sampling of what I'm reading currently in case it's of interest (plus, now I can clean up that cache!):




Monday, May 07, 2007

Updating the Record

I know what you're thinking - two posts in one day? That's right - and still the same low subscription price!

Actually, last weekend after mowing my moss lawn, I checked my blog where one of my adoring fans asked:

What do you think about the stock now? How is it possible that you write long notes about how the stock is busted and how you told us so - but when it bounces back and actually outperforms, you are silent. I guess you just move on to the next topic/rant.

I've been working on a response off and on during the week - and here it is. BTW, I'm thinking they're not going to like that recent Microsoft's $6M+ Dollar Man post either. Nevertheless, the commenter is correct that the stock has performed better of late. To be honest, I hadn't really noticed since I was away for several weeks and it had been lagging badly prior to that. But if you check now, recent performance plus a more favorable calendar compare makes for some marked improvement. For example, when I penned the specific post on which that comment came through (March 08/07), MSFT had underperformed the NASDAQ on every standard time frame up to 6 years - a fact that I noted at the time. But if you do the same compare now, it has outperforming on the 5-day, 10-day, 1 month, 3 month and 1 year views. Progress - undeniable. Like most shareholders, I'll take it. However, it has still underperformed YTD, and over 2, 3, 4, 5, and 6 years. For example, see the 6-year chart below using just obvious peers SAP, ORCL, HPQ, DELL, and the NASDAQ index (adding high-fliers like GOOG, AAPL, CRM, YHOO, or even EBAY, etc. would have made it unreadable given their dramatically better performance) - that's MSFT on the bottom btw:

Also, note that this better performance comes after ~$24B in buybacks Q4/06 to present (including $6.7B in the last Q alone), which sadly has reduced shares outstanding by only 553M thanks to ongoing dilution - aka paying insiders. As a result (and combined with dividends), MSFT's cash+st investment budget has dropped from $34.161B to the current $28.23B over this period. In other words, it hasn't been free.

So while I'm encouraged by the recent improvement, it's hardly something I'm going to dedicate a glowing post to. But keep in mind that I'm a long-term holder - so this was just a recovery to me. If, on the other hand, you're a short-term holder who picked MSFT up last year at the lows after Ballmer's latest disappointment, then you should be ecstatic with your return. As a long-term holder, I'm also cognisant of the fact that even MSFT's prodigious cash position is eroding rapidly under the weight of these massive buybacks - and that's fundamentally not sustainable. So while there's $22.5B left in approved purchases, MSFT will soon have to slow the pace substantially or face taking cash+st investments below $20B (which imo is unlikely). Therefore, at some point the management team will run out of stock Viagra and price will go up or down based solely on real market demand and non buyback-massaged EPS. For it to go up materially, the market will want to see earnings acceleration, evidence that previous "investments" are finally paying off, and/or bold new moves that show this company isn't headed to irrelevance. In other words, all the things they haven't seen much of this decade. Otherwise, do the math on expected earnings times a sustainable P/E (hint: 25+ on EPS growth of 12% likely isn't it), hope the general market doesn't implode and/or MSFT miss their EPS targets, and look forward to a best-case scenario of modest annual appreciation from here consistent with that (with the normal gut-wrenching plunges along the way, and for as long as MSFT can keep growing earnings).

Now, if you ask what has impressed me lately? What is worthy of a positive post and gives me some optimism that maybe, just maybe, this ol' dog may have some hunt left in it after all? It's this: Silverlight. Way late, but finally some evidence that MSFT is prepared to embrace and go after the Web opportunity versus ceding it to Open Source, Adobe, etc., while busying themselves defending - not very well - the desktop cash cows.

Alas, others are far better qualified to blog about it than I am. So see sample coverage here:

Or just Google Windows Live it. :-)

Update: Added a 6-year chart and related commentary.

Update 2: Corrected some numbers based on commenter feedback and review of the 10-Q.

Microsoft's $6M+ (Per Year) Man

Okay, you may be too young to remember the TV show The Six Million Dollar Man, starring Lee Majors (former husband of formerly gorgeous Farrah Fawcett - first pin-up for every guy my age). But this post isn't really about old TV series trivia anyway. Instead, the focus is once again on MSFT's Entertainment & Devices Division and its president Robbie Bach.

Readers of this blog already know that I'm not a fan of the Xbox business; Great console, world-class stupid business investment. There was a time when I actually had to justify that opinion. Today, it's the mainstream perception based on results (or, more accurately, lack thereof) and you can find others making the case routinely:

However, what bothers me more than the massive losses to date, likely inability to ever return an overall profit as a result, and missed alternative opportunities, is that Xbox is constantly cited by MSFT management as a "success" and its leadership rewarded with even more responsibility. For example, Ray Ozzie is quoted in a recent Wharton interview (an otherwise thoughtful and highly recommended read btw) calling it "fairly successful", and goes on to say that:

When all was said and done, [these threats] ended up making the company more resilient.[For example,] in the PS2 competitive realm with Sony, our whole entertainment division came out of that one battle.

Er, so shareholders should be happy that Xbox hasn't just lost a ton of money but has also spawned an entire money-losing Entertainment and Devices Division? Um, okay. Even normally level-headed journalist and full-time Microsoft-watcher Mary Jo Foley seems to have bought into this fantasy. Here she is with "Ten lessons the Xbox Team can teach the rest of Microsoft". Hey, I'm sure there's good stuff in there that other teams at MSFT have/could/or should benefit from. But how about the one lesson MSFT's legacy divisions could teach E&D - namely, how to make money?

Meanwhile, Bach keeps right on making promises he has been totally unable to deliver. For example, here's another comically-titled must-read article (right after you read my Repeat After Me, "We're on the cusp of" post):

In it, while Bach waxes poetic about the future, the interviewer manages to slide in "When do you think Xbox will be able to contribute a billion dollars to Microsoft's bottom line, and how?". Hey, good question. After all, at that impressive rate of return it would take just five more years for Xbox to...well, to almost break even since inception. Eight paragraphs later (you gotta read it - it's funny stuff) we get Bach's [effective] answer:

So, it's a business that will be profitable next year—we'll make money next year and that will be the first time, which is pretty exciting. And then the next two or three years are the place where you need to make tracks, and the next two or three years are where you have to make money.

In other words, beyond the vague "2008 will be profitable" assurance (now that the previous 2007 - itself a revision - came and went), he gave no answer at all. But hey, they've only lost $5B+ since 2001. So why would anyone expect or - gasp - demand some greater visibility and accountability at this point?

Bach is on a roll though. Here he is again, this time providing his thoughts on Wii (and PS3):

"It’s a very nice product, but it actually has a relatively specific audience and a fairly specific appeal, frankly, based on one feature, which is the controller itself," he said, as quoted by GoNintendo. "And the rest of the product is actually not a great product—no disrespect, but … the video graphics on it aren’t very strong; the box itself is kind of underpowered; it doesn’t play DVDs; there are a lot of down-line components [that] aren’t actually that interesting."

Don't know about you, but I'm actually starting to feel sorry for Nintendo after reading all that. Hmm...maybe we should review how this sad little product with minimal appeal is doing outside of Bach's mouth - like say, in the marketplace:

Tokyo (Japan) - In one of the most amazing turnarounds in gaming history, Nintendo has seen its net profits grow 77.2% to 174.3bn yen ($1.4bn), beating financial analysts expectations, and its sales grow 90% in the year to March on the back of the runaway success of its DS and Wii gaming systems.

Oh, so they have already achieved what has eluded Bach et al for 6 years? But wait, what about unit sales? I mean, the first person to 10M units (MSFT's Xbox 360) "won" right?:

The Wii has sold 5.84 million units in the year to March, and Nintendo expects to sell around 14 million in the 2007/08 financial year.

Hmm..looks like no one told Nintendo they were meant to give up. Game over. So now they're currently on a much steeper adoption path than Xbox 360, outselling it every month, and are poised to surpass it in total unit sales sometime next year (assuming no change of trend) - all while doing what the Xbox hasn't: be profitable. Perhaps MSFT should have come out with a limited product with limited appeal too? BTW, see the lesson which Nintendo understood and executed brilliantly but which seemingly still eludes Bach (and most of MSFT's current management)? When competing against an entrenched competitor it's not good enough to offer a product that plays just to their weaknesses. The latter can be easily addressed (assuming the competitor isn't destracted or clueless). You need to have a product which plays to the weaknesses inherent in your competitor's strengths. That way, even if they could copy you they likely won't, as it would adversely impact their real or perceived strengths too dramatically.

Bach isn't done though. This time, he's pumping Windows Mobile. Coincidentally, this is occurring just as the iPhone nears market availability and MS "leadership" right up to Ballmer seemingly can't shut up about how it won't take major share - but "may make a lot of money" (isn't that like the goal?). And we know from actual market share data that Mobile is a distant third to Symbian and [much less so] Linux, respectively. But Bach sees an inflection point and it's...well, it's just ahead of course:

After years of struggling to gain momentum, the business is finally at a tipping point, Bach said in an interview."Three years ago, I could walk through Microsoft halls and see Windows Mobile phones. Now, I can walk through any airport in the world and see Windows Mobile phones," said Bach, in Las Vegas to speak at two Microsoft developers' conferences.

Hey, who needs market share data from recognized industry sources when you've got anecdotal evidence like that? He continues:

Bach, who is one of Microsoft's three business presidents, said he expected that figure to more than double to between 10 million and 11 million this year before doubling again to around 20 million handsets in the 2008 business year.

Of course, Bach also famously said (about Xbox) that MSFT doesn't go into new areas "to lose money for years", that Xbox would sell 13-15M units by the end of this year (before revising it down to the current 12M - even that is going to be a challenge based on last Q's sales), and that Zune would be great.

So how much does Bach make for this track record of accomplishment? There's no data available to check back to 2001 - which is unfortunate as it would have made a nice overlay with Xbox's $20B+ invested and $5B+ lost during that period. But in just the past two years since he's been President of the division, Bach has made ~$4M+/year in grant/option sales and what I would estimate to be another $750K/year or so in salary and bonuses. Not up to $6M+/year you say? Well, you need to add in the 328,250 shares he got in August of '06 for doing such a bang-up job. Approximately value at that time: $8M - but it was part of the 3-year SPSA pork barrel and "only" $2.8M of it vested immediately. So there you have it: $6M+/year for an executive who oversees a division that had cost shareholders nearly $2B in losses during the past two years alone. In passing, I see that Bach has a degree in Economics and an MBA. Surely in one of those two he was exposed to the concepts of "opportunity cost" and "net present value"?

Thinking about this and MSFT generally, I'm reminded of the tag line from the Six Million Dollar Man: "Gentlemen, we can rebuild him. We have the technology. We can make him better than he was. Better...stronger...faster." Sounds great - let's start with a new bionic E&D arm...