In Search of the Perfect Investment

It’s all about excitement. Get excited, stocks go up. Get bored or uncertain, stocks flatten and go down.

Right now we have lots of unceertainty.

Apple is an example. No new products are rumored. Steve is away on definite sick leave. The stock is squirrely. The tech industry is buzzing with stories on why it’s flattened and when it will go up. Earnings are strong, in fact, superb. But frankly, my wife’s Android (Google) Thunderbolt is a better phone than my  iPhone4.

Think about Microsoft. Here’s a really miserable stock chart.

Now I want tyou to read this. This is the second excerpted half  of David Einhorn’s recent peech at the Ira Sohn (Hedge Fund) Conference. It was transcribed by Insider Monkey:

The title today is Two Longs, Two Different Types of Overhangs.

But let’s in the meantime, close out by going back and revisiting my idea from five years ago, which was to buy Microsoft. Many of you will remember that at that time, I argued that Microsoft was the stock market equivalent of A-Rod, the best player of baseball in his prime. I argued that the stock was a bargain because it had a great market position, great prospects, and was available at the league average for a market multiple.

So let’s see what’s happened to that recommendation. First, from an operating perspective, Microsoft has made clear progress. Revenues, profits and earnings have all grown at a decent rate. Microsoft has also repurchased enough stock to make a noticeable impact on the share count. Earnings per share have more than doubled.

Looking at it by segment, four of the segments have shown growth and improvement, the servers and tools growing the fastest. Windows 7 is the fastest selling operating system in the company’s history, with 350M licenses sold and still has the opportunity with a large portion of the installed PC base yet to upgrade. Office products are now used by about 1B people. Newer offerings like Dynamics and SharePoint have consistently grown at double-digit rates, and Window’s share in the server market has also grown from 65-70%, according to Gartner.

Entertainment and devices driven by X-Box and X-Box live has turned from an operating loss to over $1B in operating profits. On the other hand, online services segment has grown mostly in the size of its losses as Microsoft has increased spending on search in an expensive effort to belatedly take on Google.

Five years ago we thought Microsoft could become the dominant provider for software for smart phones and could displace research in motion. We were right that RIM would be displaced, but it has been Apple and now Google Android that has done the job. Microsoft has one more shot at a role in smart phone software through its deployment on Nokia phones. Nokia is still the global market share leader in cell phones. Maybe it will work out, but this is hard to envision great success in the area coming on the heels of so much disappointment in missed opportunity in this important and visible category.

Certainly success is not linked into the stock price.

Microsoft’s business has been much stronger than the average company in the S&P over the last 5 years. Revenues have grown nearly 4 times faster at Microsoft, EPS has more than doubled, while S&P’s have grown only a few percent. Microsoft has also almost doubled its dividends.

While I thought Microsoft was a bargain at a small discount to the S&P, it now trades at a remarkable discount.

Even as the business is out performing average S&P 500 companies by a wide margin, the advancement has been barely above average. While the S&P multiple has gone from 16 to 15, Microsoft’s multiple, net of cash, has contracted from 16 to 7. The question at hand is why. Certainly Microsoft isn’t getting credit for some of its achievements and prospects.

Today cloud computing companies that make no profits trade at 10x revenue. In April, Computer Reseller News named Microsoft the cloud computing applications champion ahead of Salesforce.com. And now with the rollout of Office 365, Microsoft is positioned to be the leading software service company in the world.

Separately Microsoft has a strong position in application hosting, making Microsoft uniquely positioned to lead in both revenue areas in cloud computing. Morgan Stanley estimates that Microsoft already has $5B in software as a service in cloud revenues, making it roughly 2.5x larger in this segment than SalesForce.com

Microsoft has made some other good innovations. Kinect is a terrific product with capabilities that should go far beyond video games. SharePoint looks like another significant opportunity to win content management systems, document management systems, and collaboration.

One could make the argument that Windows Office franchises face bigger risks. Five years ago, the worry was about open source software. Some suggested that Microsoft might have to give away Office in order to compete with Google free offering. Those fears were grounded in reality at the time, though they now appear to have been overblown. Google docs has captured less than 1% of the Enterprise market. Today the worries that tablets are taking share from PCs and notebooks. Time will tell whether that concern will prove problematic or whether Microsoft has a good response.

But I think that the bigger problem is that I got the analogy wrong. Microsoft is not A-Rod. The better analogy is that the best parts of the Microsoft product portfolio, particularly the dominant Windows Office and Enterprise server franchises, are A-Rod. Put simply, they are some of the most valuable products ever developed in technology. They are record-setters and hall of famers. But they are only part, albeit a large part, of Microsoft. And having A-Rod by himself does not win championships.

Before the 2001 season, the Texas Rangers signed A-Rod to a record 10-year $250M contract. He spent the three years in Texas and did not disappoint, hitting 156 homers and batting over .300, but the team never won more than 73 games, and the Rangers management and overall resource allocation decisions were more Charlie Brown than Sandy Alderson.

That’s not only precluded them from winning despite A-Rod’s heroism, it eventually pushed them into bankruptcy. Now Microsoft suffers from Charlie Brown management, as evidenced by its miserable capital allocation plan. It makes no sense to invest the terrific cash flows in pricey acquisitions, losing businesses, and mostly unproductive R&D, particularly in a corporate culture where even when the team does develop a product, Microsoft is unlikely to bring it to market if it conflicts with Windows.

In the five years since I first spoke about Microsoft, the most common question I’m asked is what about Ballmer? My initial reaction was to say Ballmer does not care what Wall Street thinks, and maybe that’s a good thing. Wall Street has lots of bad ideas, and people can get rich by ignoring them. It’s more important that he does a good job running the company.

But having now owned Microsoft for half a decade, and having watched the company carefully, I can say that the problem with Ballmer isn’t his attitude toward Wall Street. While the financial results have been good compared to other companies, I believe this reflects an incredibly strong market position that Ballmer inherited rather than his skill as a manager.

Ballmer’s problem is that he is stuck in the past, and is at best a caretaker in an industry demanding constant innovation. He’s allowed competitors to beat Microsoft in huge areas including search, mobile communication software, tablet computing, and social networking. But even worse, his response to these failures has been to pour tremendous resources into efforts to either buy or develop his way out of these holes.

The best example of this behavior was his 2008 attempt to throw several years of Microsoft profits into premium priced purchases deteriorating Yahoo! business. Here Microsoft was only saved by Yahoo!’s then management, which proved by to be even crazier by rebuffing the offer. But the risk that on any given day we could wake up with the announcement of another bad and very expensive acquisition has an ongoing dampening impact on Microsoft’s PE ratio.

For another example, let’s consider this quote from a 2006 interview withFortune.

Q: “Do you have an iPad?”

A: “No I do not. Nor do my children. I’ve got my kids brainwashed. You don’t use Google and you don’t use an iPod.“

Or this quote from a 2007 interview in USA Today:

“People get passionate when Apple comes out with something new. The iPhone of course, the iPad, the iPod. Is that something you’d like people to feel about Microsoft?”

Ballmer says, “It’s sort of a funny question. Would I trade 96% of the market for 4% of the market?” And he laughs to himself. “I want to have products that appeal to everybody. There’s no chance that the iPhone is going to get any significant market share, no chance. It’s a $500 subsidized item. They make a lot of money. But if you actually take a look, the 1.3B that get sold, I prefer to have software in 60% or 70% or 80% of them. I’d rather have that than the 2-3%, which is what Apple might get.”

Now the Pincher came for me in a Fortune article this March. It began with a description of what happened to Microsoft’s development of a tablet computer that they called the Courier. According to Fortune, the Microsoft team working on Courier was equally jazzed.

“We had a breakout product that had the potential to really delight the user,” says Rebecca Norlander, a star programmer inside Microsoft who quit last June after 19 years with the company.

So when Robbie Bach, who led the company’s entertainment and devices division at the time, presented his idea to CEO Steve Ballmer and Microsoft’s senior leadership, he expected enthusiasm and additional funding for the project. There was just one problem: The

Courier prototype borrowed from Windows, Microsoft’s vaunted computer operating systems, but had an operating system all its own.

Bach learned the hard lesson about the power of Windows within Microsoft. Not only would Bach not receive the extra funding he sought, said Ballmer, who personally delivered the blow, but there would be no Courier because it was unnecessary

Every year Microsoft invests $9B in shareholder money and R&D. Much of it is wasted on product that will never see the daylight, or worse, is spent on products like the Kin, which was pulled from the market after just 48 days.

But a good chunk of that goes to developing future generations of Windows and Office. Perhaps if Ballmer eased up on brainwashing and let his kids play with the most popular devices, he would see the opportunity in making available a version of Office for the iPad and the Android devices.

The search business is another sinkhole. On pace to generate $2.5B or more in operating losses this fiscal year, the sixth year of operating losses. Even for Microsoft, these losses at 25% per share, matter, especially when the losses are growing over time. (I’m going to use Bill Ackman’s 2.5 minutes.)

Microsoft’s dogged determination to be successful in this field by investing as much money as necessary for as long as necessary is a result of having the high margins of Windows and Office to subsidize the losses. At the very least it’s time for Microsoft to consider strategic alternatives for its search business.

One possibility would be to strengthen the existing strategic relationship it has with Facebook, where my cousin Sheryl has worked as the COO since 2008. Since search is a scale business, and scale comes from traffic, currently Microsoft spends heavily to drive users to Bing. Facebook could help Bing achieve scale and reduce Microsoft’s need to pay for traffic.

Likewise, paid search at scale is one of the most proven high margin businesses on the internet. Microsoft could help Facebook with one of the biggest challenges, namely monetizing its traffic without reducing the user’s experience. It’s obvious that Microsoft needs traffic and Facebook needs search. As the cost to create a new search engine of its own is prohibitive, the revenues paid search through Bing would be capitalized in a much higher multiple on Facebook’s income statement than on Microsoft’s.

With the JV, or perhaps even an outright sale, Microsoft can contribute Bing in exchange for a sizeable minority interest in Facebook. This would be a win-win for both companies and their customers.

But for my final thoughts on Microsoft’s future, I’d like to revisit one last Ballmer interview from Business Week in 2005. In it he saysGreat companies and the way they work start with great leaders. You have to say, do you have great leaders? All companies of any size have to continue to push to make sure they get the right leaders, the right team, the right people to be fast-acting and fast-moving in the marketplace. We’ve got great leaders, and we continue to add and attract and promote great new leaders. And he later added, we’ve bought on fantastic new talent, people like Ray Ozzie, Gary Flake, and Li Gong.

Well Ray Ozzie, Gary Flake and Li Gong have all left Microsoft, along with Robbie Bach, and J Allard, who were largely responsible for the success of X-Box. Four other division presidents have left Microsoft since 2008 as well as former CFO Chris Liddell. Good grief!
Perhaps the question is not do you have great leaders, but rather do you have a great leader?

During my freshman year at Cornell, I joined my dorm’s intramural football team. At the first practice, upper classmen pointed out I was tall, so I should try playing QB. Well half an hour later, it was abundantly clear that I should not be the QB. I remember how kind the upper classman was when he said,David, we’ve seen what you can do, let’s give so-and-so a chance.

As I recall, Charlie Brown had about as much success on the baseball field as he did with Lucy and her football. I think it’s fair to say that almost everyone except Steve Ballmer understands it’s time for Microsoft’s board to tell Steve Ballmer after ten years as CEO, alright, we’ve seen what you can do. Let’s give so-and-so a chance.

This continued presence is the biggest overhang on Microsoft’s stock. Thank you.

When I published magazines and ran rade shows, Microsoft’s bill Gates  was on the cover of our magazines. I wrote a seven-page cover story. Microsoft exhibited at our trade shows. And their poeple delivered keynote speeches.

These days, Microsoft doesn’t respond to my letters and emails. Under Ballmer, fear reigns.

What’s with Greece? I stole this chart off CNBC yesterday. Thnk of  Greece as a deadbeat person. It borrowed so much that it has to pay 50 billions euros each year in interest, but it only earns $46 billion.

So, what are the solutions?

1. Declare bankruptcy and cut  the interest to 10 billion euros a year.

2. Borrow more money to pay the interest.

Solutions that don’t make any sense:

1. Cut government spending.

2. Raise taxes on your major (but dwindling) tourism businesses — like hotels and restaurants.

If Greek defaults, many English, French and German banks will be in trouble. They own Greek debt. (Real smart banking decision that one). Some will go broke. So what? Some of my ventures went broke. I moved on. They can too.

What’s killing the world’s financial markets is not the magnitude of the problem — but the lingering uncertainty. Will they? Won’t they?

So where’s the world economy going? While the politicians dither, uncertainty remains. This weekend’s Economist leads with this piece.

The world economy: Sticky patch or meltdown?

How politicians could carelessly turn a temporary softening of the global recovery into something worse

SUMMER is at hand in the world’s big financial centres, but the mood is hardly bright. Stock prices have been sliding for weeks in response to gloomy economic news. Factory output has slowed across the globe. Consumers have become more cautious. In America virtually every statistic, from house prices to job growth, has weakened. There was some respite earlier this week, but only because a few figures-on American retail sales and Chinese factory production-were not as dire as feared.

Globally, growth is at its weakest since the recovery began almost two years ago. Is today’s softness just a sticky patch, or is the global recovery beginning to melt away?

The reasons for the lull suggest it should be temporary. First, the tsunami in Japan sent its GDP tumbling and disrupted supply chains, and thus industrial output, around the world, particularly in April. But just as that slump shows up in the economic statistics, more forward-looking evidence points to a rebound. The summer production schedules of American car firms, for instance, indicate that the pace of annualised GDP growth there will accelerate by at least a percentage point.

Second, demand was dented by a sudden surge in oil prices earlier this year. More income is being shifted from cash-strapped consumers in oil-importing countries to producers who tend to sit on their treasures. Costlier fuel has knocked consumer confidence, particularly in gas-guzzling America. And there is still an uncomfortable possibility that further instability in the Arab world will send prices soaring again. Nonetheless, at least for now, the pressure is waning. America’s average petrol price, though still 21% higher than at the beginning of the year, has started to fall. That should boost shoppers’ morale (and their spending).

Third, many emerging economies have tightened monetary policy in response to high inflation. China’s consumer-price inflation accelerated to 5.5% in the year to May. India’s wholesale prices leapt by 9.1%. Slower growth is, in part, a welcome sign that their central banks have taken action, and that those measures are beginning to work. There is no evidence that they have gone too far, even in China, where the worries about bringing the economy down with a bump are loudest. The bigger risk is that nervousness about a weakening world economy leads to a premature pause in the tightening. With monetary conditions still extraordinarily loose, such a loss of resolve would make higher inflation and an eventual crash far more likely.

A growth lull may be just what most emerging markets need, but it is the last thing that any advanced economy wants at the moment. The recovery in the rich world is weak and vulnerable, as recoveries tend to be after balance-sheet recessions. This lull is particularly dangerous because it coincides both with a move away from fiscal and monetary stimulus and with an outbreak of risky political brinkmanship on both sides of the Atlantic.

The shift from stimulus is well under way. Faced with a similar sluggishness last year, America’s Federal Reserve promised to jolt the economy with a second round of quantitative easing: printing money to buy government bonds. But the latest spell of quantitative easing comes to an end this month and the Fed has made clear it has no desire to add to it. The European Central Bank (ECB), meanwhile, is set to raise its policy rate again in July. The budget squeeze around Europe is intensifying, and even in America fiscal stimulus may give way to austerity (see article).

Some of these policy decisions are right. With America’s underlying inflation rate no longer uncomfortably low and declining, it makes sense for the Fed to refrain, for now, from another round of loosening; and, on the fiscal side, the country can probably get by without further stimulus. Some are not. In the euro area, where there is scant evidence of wage inflation and extreme weakness in the periphery economies, the ECB should not raise rates. In America, the big danger is that the row between the political parties over the country’s medium-term deficit leads to short-term spending cuts that are just what the country does not need right now.

The current battle over raising the federal government’s debt ceiling is driven not by careful consideration of the economics but by ideology and brinkmanship. Democrats refuse to consider serious spending reform. Republicans reject higher taxes. Many tea-party types would rather see America’s government default than compromise on spending. The result is a perilous stand-off-and a growing danger that America will have to make drastic short-term spending cuts, or even find itself forced into a technical default.

A parallel dynamic is playing out in the euro zone, where the debate about how to deal with Greece’s debt crisis has descended into a high-stakes stand-off between Germany, which wants the maturities on Greek bonds to be extended, and the ECB, which resists any debt restructuring (see article). The hope is still that Europe’s leaders will come up with a face-saving compromise at their summit on June 23rd-24th. But the longer the confrontation continues, the greater the risk of an accident: a chaotic Greek default and exit from the euro.

This dangerous political brinkmanship could also have a damaging effect by creating uncertainty. Companies are currently sitting on piles of cash because they are wondering how strong economic growth will be. Politics gives them more reason to sit on their hands rather than investing and hiring immediately, providing a boost the world economy sorely needs.

There is a real risk that the politicians’ pig-headedness could lead to disaster. The odds of a catastrophe-harsh fiscal tightening in America, or a crash in the euro zone-may not be high, but neither are they negligible. Though economic logic suggests that the world economy is just going through a sticky patch, squabbling politicians could all too easily turn it into a meltdown.

Today’s aphorism. Never irritate a woman who can operate a backhoe.

Today’s best logic:

A confused  counterfeiter spends all his days making funny money. At the end one day he realizes he’s been  making $15 bills.

The only way he’s going to get anything from his money is to find a place where the people aren’t too bright and will change his phony money for real money.

He travels to a small town in West Virginia.  He walks into a small Mom and Pop grocery store. He  asks the old man behind the counter;  him, “Do you have change for a $15 bill?”

The old man replies, “Sure do. How would you like it? An 8 and a 7 or two 6s and a three?”

Harry Newton who wonders why Rosie has chosen the Wee-Wee pad under my desk  to become her favorite place to pooh on?

I need to buy stock in Wee-Wee Pad, Inc.

Meantime, here’s Rosie, when she’s sleeping (thank god for small mercies), not poohing:

Have a great weekend. I know Rosie will, especially with all the attention that’s being fawned on her.