Wednesday, June 11, 2008

Eight Years of Wrongness

Warren Buffett is quoted saying that his favorite holding period for a stock is "forever". I'm not ready to go quite that far - and in practice neither does he - but I do subscribe to a long term investing philosophy generally. For example, I bought my first MSFT shares back in the early 90's. Like most holders that decade, I did very well. Then came this one, which has been an absolute disaster.
It's sobering to realize that during Ballmer's term as CEO, MSFT has underperformed almost all of its top tech peers (including AAPL, IBM, HPQ, SAP, INTC, CSCO, SYMC, NOK, ORCL, ADBE, RIMM, QCOM, Ebay, and AMZN), and badly lagged the major averages. We may even see our third plunge to test the 2000 lows during his watch. Unbelievable. There may be another major technology CEO with an equivalent or worse track record who is still in power, but a name doesn't come readily to mind. Indeed, it’s instructive to note the four companies who didn’t make my list above: DELL, YHOO, Sony and Sun. In other words, four well-publicized flameouts/turnaround stories (depending on your perspective), all of which have new CEOs. Go figure.

That performance record would be embarrassing enough on its own, but it comes in spite of going through an unprecedented amount of our cash on buybacks (nearly $43 billion worth in just the past three fiscal years) and other schemes that were supposed to drive the stock. It's also despite spending more on R&D than virtually anyone in the industry, and more than GOOG and AAPL combined (nearly $20 billion in the past three fiscal years alone). Meanwhile MSFT's senior leadership have collectively been paid billions over this period, while leading the industry in insider selling every year (net of purchases, almost 350 million shares sold over just the past 5 years). You are expected to be patient and wait for returns over the "long term" (still undefined, but has already exceeded 10 years - think Jim Carrey in Ace Ventura and “If I am not back in 5 minutes….just wait longer”.), but they want their return up front.

Against that backdrop, it should come as no surprise that a shareholder was recently driven to write about "Microsoft - A Decade of Gross Corporate Negligence and Destroyed Shareholder Value." It’s a good read, and kudos to Bishop for publishing it – that probably didn’t earn him any brownie points with management.

FakeSteveJobs (aka Dan Lyons of Forbes) also said something worth reading here:

There's something really scary in the voices here. It's in the tone. You know what I'm hearing? It's disgust. Nobody comes out and says it, but these guys are fed up with Microsoft. They're not even angry. They're just fed up. They've had it. They stuck by the company during the DOJ trial and the antitrust mess, because hey, what investor doesn't love a monopoly. The guys on Wall Street don't care if you lie, or cheat, or bully your rivals -- as long as you're winning, and making money, and as long as the stock keeps going up.

What they won't stand for is fuck-ups. Incompetence. Mistakes. And the Borg has been nothing but fuck-ups for what -- three years? Listening to these investor dudes talk I'm reminded of a time in the late 1980s when Wall Street guys began ranting about Digital Equipment Corp. For years DEC had been their darling. Ken Olsen walked on water. But suddenly Ken Olsen was a doofus, an idiot. The company which once had been so powerful and so admired almost overnight came to be seen as a loser that couldn't adapt and change.

His site is offered as humor, obviously, but he often weaves in good insight. That’s an example, imo. Certainly, there has been another major negative sentiment shift since the YHOO offer and the latest quarterly results. I've been a shareholder for a long time and I have never seen the stock as weak as it has been these past months. Down some ~14% more than the market on the year, fifth worst DOW 30 performer YTD, and trading at [just] 14.8x forward earnings. Looking at the chart, the uptrend line from February has been obliterated, and major support has been broken as well. We’re seeing a little relative strength these past few days, but even that looks tenuous.

Some readers may be surprised that I was initially a Ballmer supporter. Not for CEO necessarily (I felt that he and Gates should have resigned after losing the DOJ case), but generally. I admired his tenacity and positive outlook. I still do. I'm even happy to give him credit operationally where it's deserved. For example, a good job has been done against traditional competitors in legacy markets (with the exception of Apple). On balance, after a rocky start and some noteworthy exceptions (e.g. Firefox), he has done a decent job of responding to the newer threat posed by free and open source software. Broadening MSFT's worldwide presence with foreign R&D centers is another positive on his watch, though the company is still too Redmond-centric. The addition of ERP/CRM made sense, though it’s been botched badly imo. Maybe in the fullness of MSFT-time (i.e. decades) it will live up to its potential. Gaming, well…I guess you could credibly say that it has been the only source of “cool”. It has also contributed to revenue growth, which overall has been solid under Ballmer (though the company wasn’t exactly on life-support when he took over). On the personal side, I respect him for not bailing on his shares to the degree that say Bill has (the latter will be out of the stock completely within 10 years based on his current pace of selling). And I admire his work ethic. He may well be the world's hardest-working billionaire. Also, the most passionate. My concern is whether or not the company has been effective under his leadership. Rightly or wrongly, the buck stops with the CEO. And when I look at the totality of MSFT’s performance under his reign, it's not a pretty picture. In fact, it's an epic fail.

There are too many issues to mention, but let’s review some of the real lowlights:

  • Losing the DOJ and EU cases, which has resulted in $10B’s in fines and (more importantly) permanently damaged MSFT's reputation.
  • Failing to aggressively leverage MSFT's cash horde buying promising companies at the bottom of the dotbomb for pennies on the dollar (btw, not 20:20 hindsight on my part – I posted that MSFT should do this in real-time back then).
  • The Longhorn clusterf!*k. The long-term damage of which continues to this day, will never be fully quantifiable, really began the process of confidence erosion in both the management team and company more generally, and may prove to be a decisive turning point from which the company never recovers.
  • Allowing Xbox to dig a $6B hole in the ground.
  • The "emerging bets" which collectively have been a bust.
  • Allowing IE to stagnate after risking the company and paying $B’s in fines primarily to beat Netscape and become the browser leader.
  • The major opportunities that were missed while leadership was otherwise preoccupied/distracted (Search, Advertising, Web 2.0/SaaS, etc.).
  • Losing digital media to AAPL.
  • The financially-retarded one-time dividend and the ongoing stock buyback games.
  • The sorry performance of the stock (which has resulted in part from all of the above).

Current management tell us that the company is “stronger and better positioned today” than it was in 2000. They may even believe that, but the market clearly doesn't. And available facts support an alternate conclusion. Some examples:

1) "Vista is a success".


Management can claim it “sold” 150M licenses and call that “success”. But in virtually every other way – versus expectations, given a ridiculous 5 year gestation period and reported $5-$6B price tag, media reaction, corporate adoption, FPP retail sales, the company’s own expectations, and most important the competitive need – it’s a disappointment. Leadership are also blasé about the future implications that this underwhelming release may represent. I’m not. How many who have downgraded to XP - a significant number by all reports – will be harder to sell to next time? How many have switched or will consider switching to a competitor as a result? How many OEMs are pissed off and will now embrace other options like Acer is doing with Linux, or make comments like this from Intel’s Ottelini? And what about current impact? Windows marketshare, while still above 90%, has fallen to its lowest level ever. And others, particularly AAPL, have been steadily gaining share. More importantly, MSFT has arguably ceded undisputed technical leadership in desktop OSes - the core of what the company does - to Apple. It pretty hard to underscore how much of a strategic blunder that is.

The hope here is that Windows 7 will be the must-have product that Vista wasn’t, and the company is busy touting that promise regardless. While I’m optimistic that Sinofsky will prove more effective than his predecessor, and actually support the cone-of-silence approach he’s getting crucified for in the media currently, he doesn’t have carte blanche to make major changes - or five years to do it in - like Allchin did. I’ve long argued that MSFT needs to dump some backwards compatibility and come to market with a leaner OS to have any chance of keeping up with OS X and Linux. It should have been done with Vista, at least for a consumer version which could act as a showcase for innovation (assuming any was forthcoming). But that’s not in the cards on this iteration. So Sinofsky is going to have to focus on a few new killer features, addressing some of the major issues that still plague the Vista code base on which it will be riding, and perhaps work on the fit and finish that was so sloppy in Vista (inexcusable given the development timeframe). Bottom line? “Success” for Windows 7 will be stopping share erosion at whatever level it has dropped to by then.

See two additional pieces here:

“The inescapable conclusion” of the survey, he writes, is that “support for Vista has been battered across all enterprise sizes and corporate constituencies.” He finds that “the Vista cycle looks likely to be materially less robust than indicated in our prior survey.”

Until now, I've been advising Vista fence-sitters to wait for Windows 7. However, last week's "big reveal," in which Microsoft finally confessed that Windows 7 will be nothing more than "Vista warmed over," has forced me to reconsider my position. I'm now more convinced than ever that Windows is doomed - at least on the enterprise desktop.

2) "We have a solid strategy in Online".


MSFT's Online efforts have been a disaster. Indeed, the company's performance has been the worst of the four major players - and they all managed to turn a profit versus lose billions.

It has become clear the plan hasn't worked -- which is the main reason Microsoft tried to buy its way into competitiveness by acquiring Yahoo, a deal that died May 3, when Microsoft withdrew its bid for the Internet company.

WSJ May 17, 2008

More bad news here:

3) "We are winning this generation of gaming".


Xbox, while more successful than Online on a comparative basis, has been a financial sinkhole of epic proportions. More than twenty billion dollars “invested” over nearly a decade, not to mention countless amounts of management’s time and “talent”, for what? If it wasn’t for creative accounting this fiscal, Xbox would still be unprofitable some 6-7 years and $6B-$7B in losses later. Speaking of the warranty charge that was retroactively buried into a previous fiscal, here’s a report on what was really to blame. Short form: to save perhaps $10M’s, MSFT designed the graphics chip in-house rather than using an outside expert – eventually resulting in the $1B+ warranty/recall charge. Smart. And remember that hasty and breathless PR release a few weeks ago about being “first to reach 10M units in the US” and this metric historically determining the winner? Well, that was because Nintendo was set to reach that figure and surpass MSFT a few weeks later. Bottom line, in all likelihood MSFT will finish this console round dead last of three:

4) "We can reach 40% share in smartphones".


Microsoft has been pursuing mobile in some form or other for nearly a decade. The result? A distant 3rd to 5th place depending on whose figures you use. And while there has been better success in the smartphone sub-segment, Apple has surpassed MSFT there in less than one year, at least for North America (MSFT still holds a lead worldwide, though I will be surprised if that holds up through 2010).

And with the $500M Danger acquisition, we can assume that Mobile would join the stable of unprofitable MSFT “investments” if costs actually got apportioned properly. Unfortunately they don’t (gotta love those inter-group transfers and that convenient “Corporate Activity” slop bucket for everything else), and MSFT doesn’t break out the detail for Mobile anymore regardless (or ERP/ CRM).

More here:

Considering this set of competitors, I don't think Microsoft has a snowball's chance in hell of reaching 40% of the global market for smartphones. Not in four years, not ever.

5) “We have the best browser”


I’m not sure what leadership means by best. Fastest? Not on most benchmarks I’ve seen. Most standard? No, although the team is at least trying to catch up. Smallest/fastest install? Um, no. Best mobile experience? Not according to most reviewers. While I’m on it, how did AAPL get to market with a better mobile browser than Microsoft, the browser leader? Additionally, why hasn’t Microsoft bought and incorporated IE7 Prothe must have add-on for IE? Right now, the average IE user has to do without this functionality or, if they hear about IE7 Pro and go to download it, they get prompted to select GOOG as their search engine. Brilliant.

Meanwhile, Firefox closes in on 20% share.

6) “Zune is succeeding”


Okay, you get the picture. I won’t go into detail on all of the rest like IPTV (10 years, $10B invested, still no material return), etc.

What do you think current perception of MSFT would be like if:

  • Vista had been the must-have upgrade it should have been?
  • The company had embraced the internet and led the move to SaaS versus resisting both?
  • Online had managed to at least turn a profit, if not hold share?
  • Xbox was leading this round of gaming and was actually profitable versus just creatively so?
  • Windows Mobile had generated even half the excitement that the iPhone has?

Do you think that maybe the annual P/E chart wouldn’t show this clear downtrend, which keeps negating the positive impact on share price that otherwise might be expected from what little earnings gains have occurred?:

Meanwhile, look at some other critically important metrics:


Back in 2000, MSFT was one of the industry leaders in both revenue and profit per employee. Now look. While it’s still above average in income, revenue per employee is actually below the S&P average. Compare that to AAPL, who matches the S&P figure for revenue/employee – and they don’t have the leverage of the OEM model that MSFT does.


When you trail IBM, you know you have a problem.


As I’ve noted before, Microsoft’s marketing is an embarrassment. Their PR is too, but that’s another matter. Perhaps the most glaring example of this is the failure to respond to Apple’s PC/Mac TV ads, something that Gates denied is having a negative impact as recently as the D conference a few weeks ago. Huh? Earth to Bill, come in. This is the same company that wants to be a leader in advertising, right? And the one spending $300 million to makeover its image?

"Nobody messes with anyone in the tech industry the way Apple has messed with Microsoft," says Enderle. "It's the first time I've ever seen a major national campaign that disparages a competitor, and the competitor just sits back and takes it. If somebody tried to do that to Oracle, you wouldn't be able to find the body."

Help may be on the way, but why did it take so long? Why has the company allowed AAPL to effectively define MSFT’s own brand in a negative fashion? Why was it Lenovo, not MSFT, who came up with a smart counter ad? How come MSFT’s Vista marketing team hasn’t been able to come up with something compelling like this (albeit a little rough), even though Robert McLaws was able to do so by simply offering readers of his blog a chance to win a PC?


Like many, I have been holding out hope that MSFT would gets its act together. In the first two fiscal quarters that looked like it might be happening. But then the wheels came off the wagon and it’s been down hill ever since. I’m not just talking about the ill-advised and poorly handled YHOO bid. I think a lot of folks, myself included, reassessed after Q3 and wondered how others (AAPL, GOOG, less so HPQ, etc.) have been able to sustain successive growth and earnings surprises for years in some cases on the back of modest R&D expenditures and new product/service offerings, and yet the largest R&D spend and product line up in MSFT's history wasn't able to deliver even three consecutive quarters of the same.

As a stock, MSFT is done - stick a fork in it. And not just past and present, which has seen the terrible performance mentioned and is the reason, for example, that the QQQQ underweights MSFT in favor of overweighting AAPL and others (despite its mandate to track the index). I mean moving forward. If you want dividends, there are far better plays. And if want equity appreciation instead, make a list of MSFT’s top competitors, throw a dart at it, and invest in whoever you hit. More rationally, buy the index or one of the technology-specific ETFs. Either way, you’ll likely do much better over the next 5 years and have less volatility.

As a company, MSFT will obviously continue on for some time. But I will be surprised if 3-5 years from now (maximum), growth in the cash cows hasn’t come to a screeching halt and the company hasn’t been forced to layoff at least 10% of its employees.

All of this assumes Ballmer is still at the helm of course, which sadly is a good bet:

Don’t misunderstand, he isn’t the source of all that’s wrong. But he is the enabler that allows it to continue (with the acquiescence of our do nothing Board of Directors).

So under a Ballmer-led administration, expect more of the same. Specifically, a general lack of accountability and urgency within the senior management ranks, a myopic strategic focus on protecting the cash cows while paradoxically paying inadequate attention to the actual products themselves, a related failure to spot new trends and get out in front of them (invariably resulting in a desperate, expensive, and often unsuccessful attempt to play catch up later), a staggering annual R&D spend that produces lots of research papers but a shockingly small number of promising technologies and even fewer successful new products, variable execution that runs from great to poor but is on average weak, a marketing effort that is simply atrocious, a bunch of very expensive "investments" that have best-case paybacks measured in decades and appear to be almost totally focused on driving revenue not income, and of course the ever-present maniacal focus on the latest competitor du jour, whose market the company currently covets or feels threatened by.

Meanwhile, OSS, AAPL, and others, will continue chipping away at the legacy cash cows, gaining share and driving down margins even where share is retained. So in addition to continued PE compression, there’s a good chance that “E” itself may start to decline as well.

So it's time for me to listen to the fat lady who has been singing for years now, and finally pull the plug. I can't keep waiting another 11 years for MSFT's leadership to deliver the returns that say AAPL's have in just the past 12 months, despite struggling (and that's on top of 2000+% this decade). I'm also increasingly concerned that under this leadership team the long-term flatline will eventually be resolved to the downside versus the up, with all the implications for additional shareholder value destruction that implies. As one pundit summarized it:

In short, I think the market sees Microsoft losing its grip on computer users and having nothing to take its place when those users start leaving. Jack's right that they haven't started leaving in droves yet, but the market is a forward looking mechanism and senses that at Microsoft there's a greater chance of ramping down than ramping up.

So with that, I announce the end of my MSFTextrememakeover blogging career. The timing seems right as this is my 100th post. Good luck to all those who continue to hold MSFT. I also wish the very best to MSFT's employees, especially folks like Mini-Microsoft, Dare Obasanjo, and others who have pushed for change from the bottom up at some considerable risk to their careers. Ditto folks on product teams like Live Writer, etc. who somehow managed to get something great out the door despite the obvious organizational dysfunction. Finally, thanks to media folks like Todd Bishop, David Hunter, and others who cited me from time to time and got others to read my input for whatever it was worth - which apparently wasn't much.

Anyway, best wishes to all. Extreme out.



Update #2:


Yahoo destroyed itself to save itself. Microsoft tried to get stronger, but only ended up exposing its own weakness. Somehow Google emerged triumphant, effectively neutralizing its two biggest competitors.


Buying international properties outright may be tricky, but buying up minority stakes in overseas leaders such as (Nasdaq: BIDU) in China, or Russia's Yandex, will give you a toehold in faster-growing markets abroad.

Ya think?:


Here’s his four-part plan for energizing the company:

  • Innovate! “Multi-year investor concerns about the company’s ability to innovate have only increased in recent times,” he writes. “Outside of the “Surface” product, we have seen little from the company that could be labeled as being truly innovative. Innovation is key in boosting opportunities for Microsoft and in its battle against threats from Open Source software, SaaS, Online Advertising, Apple, Google, etc.”
  • Stop taking the iterative approach to product development. He asserts that “the ‘Hey, that was only Version 1′ approach to building software and products is ancient and creates a flood of unwanted negative publicity – Zune 1.0, Vista/SP1 are just some examples.” Parakh says that a key here is “a flawless user experience the first time any product is launched.”
  • They need a new branding strategy. “The use of Microsoft and Windows for corporate products is fine,” he writes. “However, anecdotal conversations with multiple individuals reveals that the use of Microsoft or Windows while branding consumer focused products increases the likelihood of a negative perception of the product (even if unwarranted), thanks to the immense negative publicity (news media, Mac/PC ads) received over the last several months and years.”
  • 20% time? “Microsoft also needs to be nimbler in responding to the competitive environment and provide increased latitude for employees seeking to innovate.”