Wednesday, July 25, 2012

Microsoft - Value or Not (Part 2)?

Here is the response I got from the fellow investor whom I wrote my original response.  I believe other's will find this interesting.  Enjoy.


Thanks Kevin: I respect contrary views and learn from them, so please keep them coming.

I agree the financial metrics for MSFT are impressive-- as they were for RIMM, HPQ and NOK. Look how quickly that can change. Many highly respected (by me) value investors own all those companies too. The crowd isn't necessarily correct, even amongst the elites-- thank God for that or we'd never have a chance getting an edge in the market.

My view is that the technology sector is a tough neighborhood these days such that once a company loses its momentum, it is very difficult to restore it-- particularly when you are a giant like MSFT. History has borne this theme out. How many *thriving* companies in the tech sector can you name that have existed longer than 10 years? By thriving, I mean gaining market share and growing both the top line and bottom line. A handful, and some of the few that do qualify have questionable prospects, like MSFT and CSCO. 10 years from now, I wouldn't be shocked if MSFT, CSCO, GOOG and even AAPL (gasp!) no longer existed or were irrelevant. That's my opinion, for what it's worth.

Some of the other woes MSFT faces (I'm sure there are more, but I'm not an expert on MSFT):

1. MSFT has entered a gigantic partnership with NOK (!!!) to launch their phone platform. That's not exactly a blue sky situation and MSFT expects billions of dollars of revenue from the venture. NOK is in the ICU on life support with the crash cart by the bedside. Doesn't look too good....


2. PC sales growth these days is mostly sourced from emerging markets where piracy rates are high and IP protection is a low priority. Morningstar forecasts margin compression due to these very important unfavourable effects.

3. The HTML 5.0 web standard should accelerate cloud computing adoption by the same businesses that could not change over to other OS's in the past. There's no reason to believe that MSFT can transition to a cloud based SAAS enterprise easily, efficiently or effectively.

4. MSFT's size has made it a ongoing target for adverse political interventions worldwide. This has adversely affected the corporate culture as you can see from one employee review taken from Glassdoor.com:

While Microsoft always tried to avoid being become large and bureacratic that's exactly what we've become. Our fear was always that we would become IBM after the DOJ settlement. Ballmer swore up and down that we would never fall into that trap, but the reality is with our size and the constant scrutiny be governments around the world we have become this generations IBM. Everything we do is scrutinzed by lawyers first, we all have to go through training to understand what we can't and can do for customers and partners, while our smaller nimbler competitors can react much more quickly than us.

I noticed that Bill Gates has sold $60MM worth of stock in late 2011 and 2012. I originally thought this was due to the funding requirement for his Foundation as part of an orderly liquidation of his portfolio; however, I see he's been buying Diamond Foods, Ecomotors and Tripadvisor in the same time period, so he may well not be a MSFT bull either.

L

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Here is my lastest response:

I enjoy the discussion too. I was just getting tired with the comparisons to RIMM, HP and NOK that you continue to make. Let's start there.

First you said.

I agree the financial metrics for MSFT are impressive-- as they were for RIMM, HPQ and NOK.

This is hardly an accurate comparison. MSFT hasn't stumbled at all from a financial standpoint while all the rest have. Unless you can predict the future, I believe you are giving opinion and not fact. I don't have a problem with opinion, they are needed in investing. But to compare MSFT to these companies is a stretch, but is widely believed by many. That is my point. Many investors look at the chart and conclude the underlying business is struggling. MSFT hasn't struggled over the past 5 years, but instead have doubled earnings.

You also said (not in the above message):

Even more interesting is that I couldn't find a single bear case write up for MSFT on any of the investing websites I frequent (and I frequent most of them)-- not a single one. Talk about a rosy consensus.

What about your original email? Does that one count? Isn't the author a CFA? I really don't get the "not a single one" comment, in light of the article you sent.

Back in 2000 MSFT was selling for 50x earnings. That was a rosy consensus. Today they are devoid of a rosy consensus and sell for 7x earnings (net of cash). They have grown EPS 3.3x over that period.

Anyway, I agree that the tech sector is a difficult neighbourhood these day but that is mainly a function of market sentiment. Technology will continue to change our lives. I agree it is difficult to predict the future, but my argument is different. It's that MSFT is so cheap and generates so much cash that your getting a *free* wild card on the future. I'm not paying up for a rosy consensus, I'm getting any future upside for free.

1. Nokia's partnership. If Nokia fails this will have little bearing on MSFT. It will suffer a blow to MSFT in the phone market but they don't exactly have anything to lose, do they? Again this offers upside and I don't have high hopes but who really knows. You believe that it will be negative, I don't know.

2. PC sales. This has been a headline story for some time. The only problem is that it really hasn't impacted the financial results all that much. I understand PC sales are flat and the trends are moving toward cloud computing, but MSFT does have a strategy for cloud computing.

On the topic of PC's, I am in some training this week with some staff from Intel. I have been quizzing them up on the ultrabook, among other things. The have a strong belief that the laptop won't be going away for some time. I would tend to agree.

3. HTML 5 and cloud computing. I don't understand the sector well enough to make a call on how this will play out. Office 365 is being utilized by many large companies such as Lowe's, Quantas, Japan Airlines and Hallmark Cards. The biggest adoption of Office 365 will likely come from small businesses, which is a huge market.

4. Political risk has been around for decades. The business has grown through it anyway. Company culture may very well suck. I hope it does suck. That is something that can always be changed and improved. Just ask IBM or read the book "Who Says Elephant's Can't Dance."

I find it amazing that a business that enjoys 80% gross margins is a business that people think is a poor one. It's not like they have huge competitors in many of their lines of business. Once competition shows up you will see this needle move significantly... just ask RIMM. And RIMM didn't have anywhere near those types of gross margins. Apple's gross margins are less than 50% for pete's sake.

As for Apple, that is a stock where I would have concern. It's purely a consumer show and sales can rise and fall much quicker than expected. The quarter released today is evidence of that. Despite the headline nonsense, revenue and profits were up nicely. The problem is the forecast doesn't look good. The sales of the ipad and iphone can rise and fall as quickly as the ipod has. What are the entrenched advantage of AAPL? Consumer loyalty? That can change overnight as we saw with RIMM. All it takes is the next "cool" device, crackberry's were the rage before the iphone. MSFT has much stronger ties to business and that doesn't tend to change very much. It's too costly to change and re-train everyone. In some cases it's nearly impossible to change.

As for RIMM I don't have high hopes for the future but QNX (the wholly owned software company) does have a strangle hold on vehicle software market. Something like 65% of new vehicles use their software. If RIMM can leverage that they may have a hope. That said, they also better have good devices going forward.

Anyway I should probably quit with the comments on tech. I'm no expert.

Maybe I should just stay away from MSFT but the math is just too good for me. I also believe I have a margin of safety.


Later,
Kevin
 
 
Thriving 10 year tech companies: MSFT, IBM, ORCL, CSCO, INTC, ADBE, ANSS, SAP... to name a few. 
 
 
Disclosure:  Long MSFT

2 comments:

  1. Hey Kevin i like your blog. I was also considering buying msft but i stayed away from it. The problem i have with msft is that they have an image issue. The licensing bussiness is being doing done for free it is not very consumer friendly but they Will be. If msft would have strong brandpower than it wont be a problem but they dont. But in all fairness you are gonna get paid off most likely but i think their is a 20% chance of it failing

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