Tag Archives: MSFT

initial thoughts on Microsoft/Skype

May 11, 2011 By in Current Market Thoughts, Industry Analysis, internet, Private equity, Recent Market Action, Stock ideas, Technology Tags: , , , , , , Leave a comment

the purchase

Yesterday, May 10th, MSFT announced it had agreed to buy Skype from its private equity owners for $8.5 billion in cash.

a little history

If you recall, e-Bay bought Skype from its founders–who opened up for business in 2003–for a total of $3.1 billion ($2.6 billion up front, an additional $500 million in incentive payments) in 2005.  The idea was that free phone calls between seller and bidder would somehow boost e-Bay’s online auction business.  That didn’t work.  In 2009, after Meg Whitman was ushered out of the company and new management began to clean up, e-Bay tried to sell Skype.  Only then did it learn that Ms. Whitman had neglected to secure the basic intellectual property behind the internet phone service (whoops!).   But e-Bay eventually managed to sell roughly 70% to Silver Lake for a price that valued the whole company at $2.8 billion (Silver Lake did manage to acquire the IP from Skype’s founders).

After freeing itself from the “bureaucratic mess” of e-Bay, as the New York Times reported, quoting a Skype blogger, the company dusted itself off, filed for an IPO about eight months later and simultaneously began exploring the possibility of a private sale.

Enter MSFT, which intends to link Skype to its e-mail, X-Box and office collaboration offerings on the idea that this will make them all more attractive.

This will be the largest purchase for MSFT ever, though not its highest-ever offer.  Remember, MSFT made an unsuccessful $44+ billion bid for YHOO in 2008.  In that instance, the YHOO board (strangely, given the firm’s operational difficulties) rejected the $31 a share offer, which was at about a 60% premium to the pre-bid price.  The S&P 500 is about flat since that time.  YHOO has  new CEO and is now trading at just under $19.

why Skype?

Skype is probably not the purchase you or I would make if we had a loose $8.5 billion lying around.  I don’t think it’s one that GOOG would make  …or AAPL   …or WMT.  In addition, as far as I can see, MSFT had no interest in Skype when it was in the process of being sold for less than $3 billion a year and a half ago–which for me is the most troubling part of the deal.

But the acquisition may not be as bad as it looks on the surface.  It also gives you insight, I think, into what MSFT sees as its best viable investment options.  To elaborate:

foreign earnings

1.  Like many US-based international companies, MSFT has a ton of profits it has earned overseas that are lying around in low-yielding offshore bank accounts.  There are two reasons for this:

—economically, repatriating these earnings to the US would subject them to federal income tax at a rate of 35% minus any foreign tax paid.  Since the funds are presumably in low- or no-tax jurisdictions, a company returning the funds to the US would have to fork over a third of the money to Uncle Sam. Why do it without a clear domestic need for the money?  Suppose you repatriated a large amount, paid tax and then figured out you wanted to use it for an acquisition abroad?  Better to keep your options open.

—financially, unrepatriated funds can’t be used to pay dividends to US shareholders.  So in some sense, this money is not worth 100 cents on the dollar to US shareholders.  A generation ago Wall Street would have worried about this and applied a discount PE multiple to low-tax foreign earnings.  No more.  Today’s investors seem to me to be indifferent to the tax rate a company pays.  They capitalize all after-tax earnings at the same rate.  So in today’s world, repatriating funds, which lowers reported eps, lowers the stock price as well.   …another reason not to do it.

If we assume MSFT will pay for Skype with money marooned in a zero tax rate jurisdiction, then paying $8.5 billion for Skype in Luxumburg is like paying $5.5 billion in the US.

a quick-and-dirty payback analysis

2.  In an interview with Forbes, Silver Lake says that if MSFT manages Skype well, it could eventually be worth $25 billion-$30 billion.  (Huh?  If this is the case, why in the world are they selling 100% of what they own?)

Let’s assume, just for the sake of argument, that Skype, which is around breakeven in its seventh year of operation and has only 8 million paid users, somehow grows profits in a linear fashion to $500 million five years from now and $1 billion in ten years, before earnings flatten out but continue at the $1 billion a year level.  Let’s also assume that MSFT doesn’t spend a penny integrating Skype into its software offerings.  How long does it take MSFT to recover its $8.5 billion?

The answer is 13.5 years.

That’s a looong time, especially in the fast-changing world of the internet.  In fact, if we were calculating a present value and not just a simple payback, or if we were assuming the MSFT has to spend money to integrate Skype (which it will have to, I think), recovery would be even loooooonger.

What makes Skype an attractive investment for MSFT, then?  The simple answer is that this is the highest-return investment the company can find that’s within its core competence.  Yes, it could buy something in an unrelated field, like a department store or a circus or a mining company, as Big Oil did when it was flush with cash in the mid-Seventies.  But ideas like those are always disasters.  In other words, the Skype deal underlines how mature a company MSFT is.

from growth to value: a life cycle progression

May 4, 2011 By in from growth to value: the life cycle, growth vs value, Industry Analysis, Stock ideas, Technology Tags: , , , , , , , , , , Leave a comment

going ex-growth

What happens when a growth stock goes ex-growth.  Nothing good.

Owners of a stock like this face two issues:

–the share is doubtless trading at a very high relative price-earnings multiple, based on Wall Street expectations that its superior track record of profit expansion will continue.  Not only that, growth stocks often experience a kind of buying frenzy at the peak of their popularity that pushes the multiple way above the level the stock would deserve, even if investor expectations could be met.

–growth investors lose interest, leaving value investors as the only possible buyers.  But, as we saw yesterday, value investors are attracted only to issues that have been all beaten up and tossed onto Wall Street’s scrap heap.  Like famous relief pitcher Sparky Lyle, former growth stocks must go “from Cy Young to sayonara” –or from living in the penthouse to sleeping in a doorway in the alley–before they attract much investor support.

This process of price earnings multiple “compression” or “derating” normally takes a very long time.  I don’t understand why.  Maybe it’s confirmation bias–that people see only what they want to see.  In any event, it happens.  The first half of the 1970s, before I entered the market, were characterized by the rise of a small number of stocks, like Xerox, Polaroid or (my favorite) National Lead, that were believed to be able to grow at high rates forever.  They were called “one decision” stocks–no need to sell ever.  Many of these issues traded at 90x-100x earnings in an overall market that was selling at around 12x.

In the case of the “Nifty Fifty”, it took from 1975 to 1984 for the excesses to be wrung out of the majority of these stocks.  Of course, we need only to look at the aftermath of the Internet bubble of a decade ago to see the same process play out again, although this time it “only” took 2 1/2 years.

INTC and MSFT–APPL, too

…which brings us to the topic of INTC and MSFT, two titans of the personal computer era, and how to evaluate them today.  I’m tossing in AAPL, as well, although that firm was doomed by a series of strategic missteps by a younger Steve Jobs, to remain a bit player in the PC world.

the performance record

All three stocks hit a peak in early 2000.  From April of that year to now, their stock performance is as follows:

S&P 500          +.5%

MSFT          -41.8%

INTC          -66.2%

AAPL          +963%

From the market bottom in early 2003:

S&P 500          +55.9%

MSFT          +23.8%

INTC          +36.6%

AAPL          +2007%

From the market bottom in March 2009:

S&P 500          +98.5%

MSFT          +68.9%

INTC          87.2%  (including a 15% rise in the past couple of weeks)

AAPL          +308%.

valuations:  2000 vs. now

At the top in 2000, the S&P 500 traded at 27x earnings of $56.18; now it is trading at 13x earnings of $100.  eps growth, 2000-2011 = 78%.

At the top in 2000, INTC traded at 36x earnings of 1.53;  now it is trading at 9x earnings of $2.50.  eps growth = 63%.

At the top in 2000, MSFT traded at 68x earnings of $.85;  now it is trading at 10x earnings of $2.50.  eps growth = 194%.

At the top in 2000, AAPL traded at 30x earnings of $.85; now it is trading at 14x earnings of $25.  eps growth = 28x.

Looking at MSFT and INTC shares:

MSFT:  the obvious factor is that the stock’s relative PE has been crushed.  During much of the 1990s, the company was growing earnings at a 50% annual clip.  During the past decade, it has barely managed to get into double digits.  That’s better than the overall US economy and the S&P did over the same period, but still represents a sharp departure from the past.  One might also argue that MSFT’s numbers are flattered by the recent launches of Windows 7 and Office 2010, which together have added about $1 a share to eps.  What comes next?

INTC:  it took INTC until 2010 to surpass its earnings peak of 2000.  Yes, the PE has been flattened and the company trades at at about 2/3 of the market multiple, but earnings growth has been sub-par until recently.  The big change for INTC, to my mind, is new management that is focused on building what customers want rather than on what its engineers can create.

which to buy?

Here’s where ideology comes in.

On a PE basis, INTC is a little cheaper.

But, to my mind, MSFT has a far superior operating model.  Relative earnings growth vs. INTC over any time period shows this.  MSFT has had a stranglehold on the personal computer operating system and productivity program businesses for over two decades.  There are few signs of this changing, since so many corporate IT systems are built on MSFT products.  Unlike INTC, MSFT has little need for capital.  And, again to my mind, because AAPL’s Office-like products are so bad, MSFT faces less competition in this arena than INTC does vs. AMD.

On the other hand, MSFT appears rudderless.  It hasn’t had a new product success in at least a decade.  And I see no signs MSFT is wiling to adapt itself to a changing environment.

INTC, in contrast, faces serious competition from ARMH.  But INTC seems to me to understand the need to recast the way it operates and is changing itself as quickly as it can.

If I could choose one of the two to own 100% of myself, there’s no question I’d pick MSFT.   So it seems to me that if I were a “no catalyst” value investor, that’s the stock I’d choose.

But, as it turns out, I’m a catalyst-for-change kind of guy.   I own INTC and not MSFT.  Why?  It isn’t the lower PE.  It’s the catalyst that I see in the current INTC management and that I don’t detect with MSFT.

a footnote on AAPL

How does AAPL fit into this discussion?  In a sense, it doesn’t, because AAPL is clearly a growth stock.  Over the past two years, however, the AAPL PE has contracted from about 30 to the current 14.  In fact, if you subtract AAPL’s $50+ billion in cash from the market capitalization, AAPL is trading at a sub-market multiple of under 12.  The stock is being priced almost as if the company had already gone ex-growth, which it clearly has not.  I can’t recall ever having seen a true growth stock act this way.

the two (possibly three) flavors of value: with and without a catalyst for change

May 3, 2011 By in book value, cash flow/share vs. earnings/share, growth vs value, two flavors of value Tags: , , , , , , , , , , , 1 Comment

As you know if you’ve been reading this blog for a while, I’m a growth investor.  But I started out my career as a value investor and spent over half my working years in shops that had either a value orientation or a substantial value presence.  For an outsider, then, I think I have a reasonable grasp of what value investors think and do.  I’m also laying the groundwork in this post for writing tomorrow about the titans of the personal computer industry, AAPL, INTC and MSFT.

how all value investors operate

Value investors like to invest in companies whose stocks are trading at very low ratios of price to book value (shareholders’ equity), price to cash flow, price to earnings and/or price to assets.  Many times such companies have gotten to low valuations because their managements have made strategic missteps.  Sometimes, though, the environment in which they work is highly cyclical and the cycle has turned against them.  Or it may just be that the industry in which the company operates is boring and seldom catches investors’ eyes.

In their pursuit of very cheap companies, value investors hold to two ground-level beliefs, namely:

–you can’t fall off the floor, and

–everything reverts to the mean, sooner or later (but mostly sooner).

The first dictum suggests that if a company’s stock is already all beaten up, at some point it just won’t go any lower.  So if buyers can locate and act at around this level, they have limited downside risk.

The second idea is that the company will eventually overcome the mistakes it has made–either with present management, new leadership, or as a division of a larger company.  In any of these events, the stock will go up …or the business cycle will turn in the company’s favor …or investors may just spontaneously wake up one morning and find the company’s industry much more fascinating (maybe as the first market entrant is taken over).

In any of these cases, the severe negative market emotion that has driven the stock to extremely low levels will dissipate and the stock will return to a more normal valuation–that is, one more in line with its past trading and with what companies with similar financial characteristics in other industries sell at.

All value investors believe this.

What sets them apart from one another?

For one thing, different investors may use somewhat different metrics.  One may be deeply convinced that he should only pay attention to price/book.  Another may be equally committed to price/cash flow.  A third may want to have another company in the same industry that’s very well run, whose (higher) margins may give a strong clue as to how good things might one day get.

In the final analysis, however, I don’t think these differences mean all that much.  Where I see the big divide for value practitioners is between those who want to see some catalyst that will encourage/force favorable change in the firm being analyzed before they’ll buy it, and those who don’t.

no catalyst

I understand the argument that the “no catalyst needed” camp makes.  They say that when things start to go bad for a company, investors can (and usually do) have a violent negative reaction that far exceeds anything that the (deteriorating) fundamentals justify.  The stock gets battered in a way it never will again, once the sellers are able regain a bit of their self-control.  Therefore, by buying when the blood is flowing the thickest in the streets, you get by far the best prices. You’re more than compensated for the risk early buying entails.

I understand the argument, but temperamentally I could never just look at the price/book (or whatever other metric) screens and jump in.  What if the stock turned out to be GM, or Enron, or Global Crossing?  As a result, I’ve never tried to investigate whether the approach works.  Unfortunately, I have seen it fail, though.

catalyst required, please

The second camp of value investors are those who insist on being able to see some sign, or catalyst, that convinces them that change for the better is under way.  It may not have to be much.  The retirement of a CEO and the appointment of a more capable successor might be enough   …or an activist investor approaching another laggard in the same industry   …or indications that the business cycle is changing in the company’s favor.  Although I’m not that interested in a regular diet of value names, I’m much more comfortable with this second approach.  But that’s just me.

where does GARP stand?

There is a third style that stands on the border between growth and value.  It’s called Growth at a Reasonable Price, or GARP.  I’ve often had colleagues describe me as a GARP investor, mostly, I think, because I don’t see a compelling reason to live exclusively on the bleeding edge of growth (with emphasis on bleeding).  But I’m not a GARP investor in the way value players would understand it.

As growth, GARP means having a forward PE that’s equal to or lower than the forward growth rate.  As value, in contrast, being a GARP investor means that you determine a forward PE level, say, 15x, above which you refuse to make a purchase, no matter what you think the forward growth rate will likely be.

For example, I have no problem paying 22x earnings for a company that will grow earnings at a 28% annual rate for at least the next few years.  In fact, I’d consider myself lucky to have discovered the stock before the PE rose further. I’d also be happy to pay 40x for a company that could grow at a 50% rate.

A value-oriented GARP investor, in contrast, would have drawn a line in the sign in the sand, probably between 15x-20x–certainly no higher, and would refuse to buy either.

That’s it for today.  Tomorrow, let’s apply this to INTC and MSFT.


MSFT’s 3Q11: signs of Windows weakness

May 2, 2011 By in earnings conference calls, growth vs value, Industry Analysis, internet, Stock ideas, Technology, Video games Tags: , , , , , , , , , , , , Leave a comment

the results

After the close of the market in New York on Thursday April 28th, MSFT reported its 3Q11 (MSFT’s fiscal year ends in June) results.  The company earned $.56 per share for the three months (+24% year on year), on revenue of $16.4 billion (+13%).  A non-recurring tax benefit raised the final per share tally by $.05, to $.61.  This compares with the Wall Street consensus estimate of $.56.

MSFT shares dropped by 3% in Friday trading, in a flat market for IT.  INTC, the second member of the “Wintel alliance,” whose shares tend to  trade more or less in line with those of MSFT, rose, in contrast, by 1.5%.

the details

picky points (symptoms of analyst’s disease)

–MSFT continues to show impressive control of operating expenses.  Despite this, operating income for the quarter was up by only 10.3% year on year.  That’s less than the rate of increase in revenue–not what you’d expect from a software company.

–The company spent $10.3 billion, or a tad less than 60% of net income, over the first nine months of fiscal 2011 buying back its own stock.  That’s far above the $2.2 billion in new issuance (presumably from exercise of employee stock options) over the same period.  Outstanding shares are down by about 4% year on year–meaning around 4% of the advance in per share income comes, not from an increase in the bottom line, but from shrinkage of the denominator used in the calculation.

more important things

MSFT has five divisions, two big ones, one medium-sized and two that you can safely ignore if you just want a general picture of where growth is likely to come from.  In size order, giving the percent of operating income each represented in fiscal 2011 to date, and year on year growth for 3Q11, the divisions are:

Business (meaning MS Office and related productivity tools)      43.5% of operating earnings, 24.5% year on year growth in 3Q

Windows (the PC operating system)          38.7% of operating earnings, 10% year on year decline

Server and Tools          20% of operating income, 11.7% year on year growth

Entertainment + Devices (X-Box, cellphones…)          5.4% of operating income, 50% year on year growth

Online Services          -7.6% of operating income (a loss of $1.8 billion), a 10.% increase in the year on year loss.

the numbers need a bit of tweaking

Windows 7  launched in late October 2009.  So year-ago sales were flattered by the rush to buy the new product (and ditch Vista).  Office 2010 debuted in June 2010.  Anyone who bought Office 2007 in the runup to launch of the new version got a free upgrade.  Revenue was booked when the upgrade was redeemed, not when the sale was made–meaning that revenues in the Business segment during the year-ago quarter were unusually weak.

MSFT thinks the true rate of the Business segment revenue growth was 13%, not the 20% reported.  Conversely, it believes the decline in the PC market it saw in 3Q11 was 1%-3%, less than the 4.5% drop in sales it posted.

MSFT’s take on the PC market…

According to the company, netbook sales were down 40% year on year, business PCs were up 9% and consumer PCs were down 8%.  MSFT thinks that emerging markets represent “nearly half” of global PC shipments.

…vs. INTC’s

In simple terms, INTC (see my latest post on the company) is saying that the lion’s share of PC growth is coming in the emerging world, where consultants like Gartner or IDS, who are projecting lackluster growth in the PC market this year, have limited ability to collect data.  The two consultants are mistakenly extrapolating the present weakness in the US and Europe to include the developing world.  As a result their unit sales projections are too low.  INTC, which does over half its business in developing countries, says it has a much better look at demand through its warehouse and sales staffs–and business is better than the consultants think.

In a nutshell, MSFT sees the same picture the consultants do.

my thoughts

I don’t think netbooks are an important factor.  If they comprised 5% of the total PC market a year ago and that’s been cut in half, the resulting unit volume decline is 2.5%.  But they use low-cost Atom processors and Windows 7 Starter, which does little more than start the machine.  So they’re not a commensurate revenue loss.  Also,  to some degree buyers have switched to low-end laptops, which carry higher revenue and profits for both MSFT and INTC.

Macs are a factor, but not the key one, in my opinion.  Macs are growing much faster than the overall PC industry.  They use INTC chips but the AAPL operating system.  However, although Macs represent over 10% of the PCs sold in the US, they’re less than 4% of the world’s unit purchases.  Yes, they’ve been gaining half a point to a point of market share per year, but that probably means less than a 1% unit volume increase for INTC.

The MSFT management didn’t respond to an analyst’s question about piracy, which, in my experience, is rampant in the Pacific.  My guess is that non-branded “white box” computers with unauthorized copies of Windows software are a big part of the difference between MSFT’s experience and INTC’s.  There’s no way of knowing for sure, though, so MSFT’s judgment not to broach the topic is probably its best tack.

One other interesting MSFT management comment about INTC:  The MSFT CFO suggested that maybe the biggest reason for INTC’s good results was its ability to raise prices.  Although he didn’t say this, what seemed to me to be implied is that INTC can raise prices in a way MSFT can’t.  In other words, through constant innovation in chip size, speed, power consumption, INTC has a better value proposition for customers than MSFT does.  I think that’s right, but it’s funny to hear it from the lips of MSFT.

the stock

MSFT is guiding to a 4Q11 about in line with results from 3Q11.  This would bring full-year results to about $2.60 a share.  I think we’ve already seen the crest of the current product cycle with the launches of Windows 7 and Office 2010.  So fiscal 2012 will likely show eps growth at a much slower pace than the likely 24% gain this year.  Let’s pencil in 12%.

If so, the stock is trading at about 9X forward earnings, has net cash of around $4.50 a share, generates free cash flow and yields about 2.5%.  That looks cheap to me.  It’s hard to figure where the upside is going to come from, though.  Certainly, there are isolated interesting products, but I’m not sure there’s anything big or dramatic enough to move the needle for a giant like MSFT and engage investors’ imaginations. So value-oriented investors, the prime potential buyers of MSFT, may well worry that the stock will remain the “value trap” it has been for the last decade.




“search neutrality” –Google’s newest challenge? the ITA acquisition

July 19, 2010 By in Current Market Thoughts, Industry Analysis, internet, Stock ideas Tags: , , , , , , , , , , Leave a comment

Everybody is by now familiar with the topic of net neutrality.  This is the question of whether the owners of high-speed transmission networks for internet traffic have the right to regulate the flow of data, assigning some information to what is in effect the slow lane while allowing other content to barrel ahead in express.

This issue still hasn’t been fully dealt with.  As I posted in April, the FCC ordered Comcast to stop interfering with traffic through BitTorrent, a peer-to-peer file-sharing service that the ISP claimed was using up too much bandwidth.  Comcast sued, on grounds that the FCC didn’t have the authority to issue it such an order–and won.

The FCC responded by moving to reclassify Comcast as a public utility, like phone companies ATT or Verizon, so that it would have the regulatory authority it needed.  This opens a whole political can of worms, however, so it’s still not clear where matters stand.

GOOG’s ITA purchase

The wheel of competition has recently taken a turn in a different, but related, direction with Google’s agreement to buy ITA Software, founded by MIT scientists and now held by private equity, for $700 million.  ITA makes the airline database search software that powers the air part of travel sites for online agencies like Kayak and Orbitz, as well as for the online sales sites of Continental Air.

GOOG’s isn’t the first purchase of this type.  Two years ago, MSFT paid $115 million for the smaller private company Farecast, which is at the heart of MSFT’s Bing Travel service.  But ITA is bigger and already services significant third-party customers.

unhappy campers

Not everyone is happy with this development–especially not Barry Diller, CEO of online travel agent (and former MSFT subsidiary) Expedia.  He’s worried that if/when it acquires ITA, GOOG will promote its own services over those of EXPE.

This assumes, of course, that GOOG will follow MSFT’s lead and create a travel site similar to Bing Travel.  That may well happen.  In paid search, a prospective GOOG Travel could outbid everyone else for keywords, since this would just be transferring revenue from one GOOG pocket (travel) to another (search).  It’s not so clear that would happen in any unfair manner in unpaid search.  The reputational, and legal, risk to GOOG is too high, I think, for that to occur.

EXPE isn’t out of the woods by any means, however–in my opinion.  It’s possible that the combination of GOOG and ITA professionals will produce new travel software that’s significantly better than anything on the market today.  Maybe ITA can do this alone, with GOOG financial support.

Suppose that instead of using ITA software itself  GOOG offers it for free to any travel site that is willing to allow GOOG advertising on it. This is basically what it did with cellphone operating system software.   That would give any takers a 10%-15% cost advantage over sites which either develop their own travel software or buy it from third parties.  It would also make it easier for new firms to enter the market.  Any way you look at is, GOOG offering ITA for free would  lower the value of any database technology that a company like EXPE holds.

That’s Mr. Diller’s real problem, I think.  If so, he can’t just say this–that there’s something wrong with a new market entrant turning up with better, lower-cost technology.  Search neutrality may be the best weapon he has to fight with.