On Microsoft (MSFT)

Copyright 2006 Geoff Gannon Microsoft is a difficult situation for me to evaluate. I think the company still has a lot of growth ahead in some areas. But, that depends on where management wants to take it. There are three core businesses that are already well developed: Windows, Office, and Servers. The moat in the first two are wide. The Windows moat is huge. The business model in operating systems is great. You keep upgrading every few years; the hardware needn't progress for you to find things to tweak and get people to buy the next step up. It's insanely profitable. I think the new launch (Vista) will be bigger than people expect (eventually) in how it allows for cross selling other Microsoft products (but we'll see about that). I expect the press to be very negative at least until well after the launch, because there will always be some bugs and delays. Games Eventually, video games will be a big business for Microsoft. I hate the economics of the console business, but love the economics of the publishing (and development) side of things. I'm sorry to see that Microsoft didn't use its cash pile to buy up an established business here (publishers were cheap in the market a few years ago; an all cash deal would have worked well. Now, everyone thinks video games will be the next big thing). The console wars are going well for Microsoft. The two keys to establishing a dominant console are launching first and getting good games on your platform. We'll see how Sony (SNE) does this round, but I expect them to be the big loser. Nintendo may surprise here. I think the Xbox 360 and Nintendo's new console (Wii) will do very well. It'll be interesting to see the breakdown of the consoles in both the domestic and foreign markets. I think Sony may still be strong overseas, but could be in a much poorer position at the end of this round than they were with the PS2. Search Long-term I am optimistic about search. I think Google's position is much weaker than most people think. I don't think Microsoft will be the only one to benefit here. Search is a very natural cross sell with Windows. That's the direction everything seems to be headed in (combining online and desktop search). For future growth in terms of market share I think Microsoft is in a better position than either Yahoo (YHOO) or Google (GOOG). I also think we might see a couple other (largely unknown) search engines gain some share. I think Google's strength is its brand. Its dominance helps with advertisers more than users. I don't think it has a lock on users. Also, I think Google has been poorly positioned for doing much of anything outside of keyword search. I expect to see a lot more in the way of intelligent, social search inspired stuff. Years from now, much of search will have to be helping you find what you didn't know you wanted to find. Google is dominant in a different business: helping you find what you know you want to find (but don't know the name / location). The two types of search are very different. Both will be important, but the growth in other forms of search will be coming off a smaller base and will likely integrate with keyword search. Google has the most to lose here. Other Devices Microsoft wants to perform well on mobile devices and on your TV. Compared to competitors it is very strong in these respects. The strategy seems to be the one I would favor - to control the point of initial contact wherever software is used and then to only venture into the actual application or content side of the business where it is highly profitable to do so. In video games it will be highly profitable. In other areas it is less likely to be very profitable. I expect to see more generic, web-based applications. These will be less profitable for everyone. Office should hold up well, but not as well as Windows. Basically, Microsoft needs to take what it has in PCs and import that to TVs, Handheld Devices, Consoles, and the Web. That should be the strategy. I think that is the strategy. These aren't unrelated businesses that need to be broken up to unlock creativity (as some have suggested). Rather, the profit potential for each is greatly enhanced by being part of Microsoft. If you take these pieces apart they are worth very little. There would only be the three businesses I started off talking about and the console / games business. Internationally, there is going to be natural growth for Microsoft's dominant businesses. It won't be a tremendous growth rate, but it will be strong and will require virtually no additional investment to secure. Obsolescence Issues Overall, I like the future for software a lot more than hardware, because the marginal gains in the quality of hardware will slow greatly in the years ahead. The question isn't what can be done mathematically in terms of increasing specs; it's what that translates to for the user. We are reaching a point where the individual user will not directly see the benefits of increased hardware performance as clearly as he did in the past. Much of the research that goes in to this area will only serve to bring down prices and benefit memory intensive businesses - it will not provide as much of a "wow" factor for the user anymore. This is especially true in games. The situation in desktop applications is already such that improving the software design is where most gains will come from. Computing power is simply not a scarce resource for most individuals sitting at home or in a cubicle. Advances will benefit some users a lot and will trickle down to the end user (often via the web) through fast responses and cheap services. But, that's a barely noticeable change. You'll see something here akin to the kind of thing you see in the brokerage business. It won't be obvious, because price competition will never be as great in software. Generally, you'll just see the prices for doing anything electronically come down. That's very different from what we've seen over the last few decades, where you also had advancements that attracted new users, because they allowed developers to do something differently, not just more cheaply. This is a very long-term trend I'm worried about. It could weigh heavily on a business like Dell (DELL), because PCs are actually quite durable; once the rate of obsolescence slows, sales will have to slow as the cycle lengthens. Management I think Microsoft's management is absolutely the best in the business. In fact, I think it's one of the best in any business. It would be hard for me to find more than a handful of people I'd rather have managing a business I was part owner of. I also think the current arrangement is a good one. There is enough of a line between current operations and future investments in the Chairman / CEO split that investors will probably get the greatest benefit from the brilliance of the Chairman this way. Everyone underestimates Bill Gates. It's easy, because his great triumph came some time ago now. But, he's interested in building something lasting. I trust him more than anyone in tech without a question. He always impresses me whether he's talking about his own industry or some other topic. He has exactly the right kind of mind for someone running a business where the long-run is such a concern. Qualitatively, I think Microsoft scores close to perfectly. I could cite the profitability stats, but I won't, because you know they're better than almost any other business on the planet – and that's with a huge siphoning off of resources to investments in the future that aren't required to maintain the cash cow, wide-moat Windows franchise. Valuation Valuation is a bit more troubling. Microsoft is not at the point on an EV/EBIT basis where I'd be buying the stock if there was a risk of no extraordinarily profitable growth in the future. In other words, at the current price, it clearly makes for a bad bond. The key is earnings growth. I think you have to believe MSFT will have a real future in search, games, and non-PC devices that will fuel future, highly profitable growth. I think that future is there. As far as a truly large cap stock (say $10 billion or more) it's about as attractive as anything on the planet right now - and certainly it's the most attractive stock of any very large U.S. business. Even though Intel (INTC) and Dell are cheap looking, I don't like them nearly as much. Dell is an interesting situation, but I don't understand the business well enough. I have a better idea of where MSFT is headed – and I like it. Conclusion I don't own shares of MSFT. I won't be buying any either. I don't normally own such large stocks. I prefer much smaller businesses, because the mispricings tend to get more out of whack. You aren't going to see MSFT trade at an EV/EBIT of 7.5 or something like that, but you do sometimes get those chances in small (high quality) businesses. There are a lot of chances to find wild mispricings without much of the future being a concern. Those are the situations I prefer to invest in, because businesses like MSFT have an awfully large anchor with the amount of capital they've got – plus, they tend to be less likely to be wildly mispriced. However, if I had to own one business with a market cap of more than $10 billion and hold it for a lifetime I would buy Microsoft here without hesitation.

The Danger of Inflexible Enterprises

Copyright 2006 Geoff Gannon Whenever a large investment has been made in a particular area, whenever there is a lot capital, people, and ego tied up with some operation, the transition away from that operation is apt to be far slower than what an objective observer would have expected. As an investor, it’s easy to look at a corporation from afar and see the business the way a rational capital allocator would see it. But, very few people within the organization are able to take such a farsighted view. They are not able to asses the matter dispassionately. There are jobs at stake. There is the admission of defeat. And there is the question of identity. Just as importantly, these problems hang over the managers every day. Staying too long in a dying business is rarely the result of one major misstep – rather, it is the result of a series of seemingly innocent steps that merely serve to delay the inevitable. Recognizing the terrible importance of the inflexibility of an enterprise that is tied to a particular line of business, mode of production, or labor force is a difficult task. Many value investors have been caught in this trap. Some business appears to offer excellent value today; but, if it should cling too long to its old ways, that value will be destroyed. It’s tempting to think that managers will see the obvious danger, act to remedy the problem, and forever change the organization, before the inevitable occurs. But, that kind of thinking requires a leap of faith. It is too easy for the investor to believe what he wants to believe – to assume that somehow tomorrow will take care of itself. Even Warren Buffett, a man who has been ever vigilant in his efforts to avoid prolonged entanglements in businesses with poor economics, has suffered from delusions of an easy transition. There are probably three good examples of such delusions from Buffett’s career. Discussing only two will be sufficient (the third would be Baltimore department store Hochschild-Kohn). Buffett suffered from his most recent delusion in late 1993. That’s when Berkshire Hathaway acquired Dexter Shoe. Buffett now realizes that deal was a mistake. In the 2001 annual letter to shareholders he wrote: “I've made three decisions relating to Dexter that have hurt you in a major way: (1) buying it in the first place; (2) paying for it with stock and (3) procrastinating when the need for changes in its operations was obvious…Dexter, prior to our purchase - and indeed for a few years after - prospered despite low-cost foreign competition that was brutal. I concluded that Dexter could continue to cope with that problem, and I was wrong.” Buffett lists three separate decisions. I don’t think the way he presents the Dexter Shoe debacle is simply a thoughtless arrangement. Buffett is admitting he shouldn’t have bought Dexter Shoe at all. He shouldn’t have bought it with stock or cash. His purchase was based on a false premise. It wasn’t simply a matter of overpaying (by using stock). It’s also interesting to note the third decision he describes: “procrastinating when the need for changes in its operations was obvious”. That’s a pretty harsh admission. Buffett refers to procrastinating as a decision. No doubt it was a daily decision, not a one-time choice between two separate paths; nevertheless, it was a costly decision. Excusing inaction as being somehow a lesser offense than an incorrect action is a common occurrence in business; but, it is not a productive way to learn from one’s own mistakes. Especially in investing, inaction must be judged just as harshly as action. The most interesting part of all this is the fact that Buffett separates the purchase itself from his failure to push for change at Dexter Shoe. He does not suggest that buying the business and then trying to change it would have worked well. Buffett seems to be saying the best course would have been not to buy the business in the first place. I think he’s right. The risks involved in purchasing an inflexible business are difficult to quantify. However, they are real. These risks are frequently large enough to destroy any apparent value that comes in the form of a bargain price relative to high current earnings (or cash flow). A business that is purchased because it can throw off cash can quickly become a money pit. Often, the buyer is well aware of this possibility. However, he manages to convince himself that the necessary transition will be made with the speed demanded by a rational assessment of the facts and a desire to put capital to its best possible use. Operating managers rarely see things so clearly. Even when the road ahead is clear, the will is often lacking. It is easy to rationalize decisions that seem to offer a middle course. A gradual transition is always a tempting possibility. Who wouldn’t want to convince themself that a retreat is really a fighting withdrawal? In the 1985 annual letter to shareholders, Buffett gave Berkshire’s reasons for remaining in the textile business as long as it did: “(1) Our textile businesses are very important employers in their communities, (2) management has been straightforward in reporting on problems and energetic in attacking them, (3) labor has been cooperative and understanding in facing our common problems, and (4) the business should average modest cash returns relative to investment.” “It turned out I was very wrong about (4)…I won’t close down a business of sub-normal profitability merely to add a fraction of a point to out corporate rate of return. However, I also feel it is inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect.” The delusion Buffett suffered under was only in regard to his fourth reason for remaining in the textile business. The belief that modest returns will be realized from a sub-par business is an attractive one. A rational assessment of the facts would have lead to the opposing conclusion. Past experience demonstrated that apparent possibilities of future profitability based on greater efficiencies and improved conditions within the industry rarely lead to any actual profits. There was always hope. But, there was rarely any proof that such hope was justified. “Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses…But the promised benefits from these textile investments were illusory.” An objective observer would have seen the flaw in the arguments offered in support of such investments. The industry was plagued by an overabundance of capacity. In the past, there had been a terrible misinvestment of capital that diverted a great flood of money into a seemingly attractive industry. Unfortunately, that capital did not go into easy to recoup investments. It went into massive expenditures that saddled the owners with high fixed costs. A factory that produces nothing is worse less than nothing. It’s a money pit. The owner has only two choices: exit the business or attempt to obtain the most favorable variable costs by any means necessary. If enough players opt for the latter the game is no fun for anyone. “Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.” The image of a crowd of parade watchers on tiptoes is a good one for investors to keep in mind. This is what a bad business looks like. This is the kind of investment you want to avoid. A corporation rarely exits a business on economically beneficial terms. It does so in its own time – long after the unending decline becomes obvious. An inflexible enterprise is one that is tied to a particular line of business, mode of production, or labor force. Most businesses are not as closely tied to these things as you might think. A few are. Xerox and Kodak (EK) are two examples from the recent past. General Motors (GM) is still tied to a labor force from a bygone era. GM is an example of a business that is so inflexible it is tied not only to a particular industry but to a particular position within the industry. The company was not structured in a way that allowed it to slim down in the event of a loss of market share. For some businesses, a shift in the structure of their market can be as disastrous as a shift in technology. The consequences of such shifts can be dire. The good news is that it is not difficult to see which companies are exposed to these future threats. General Motors was a huge, unionized enterprise. It held a very large share of the U.S. market. It obviously had to maintain its market share. That may not have on the mind of investors a few decades ago, because the idea that GM would lose market share might have seemed absurd. But, if they had considered the matter, they would have seen that GM’s survival was largely dependent upon maintaining a very large share of the U.S. market. Likewise, if Intel (INTC) or Microsoft (MSFT) lost much market share, they’d have to make huge changes very quickly. The current structure of those companies can’t be supported by a small share of the market. Of course, it would be much easier for these businesses to shed tens of thousands of employees than it is for General Motors. At the same time, no sane investor is buying shares of Intel or Microsoft unless he expects them to maintain roughly the same share of the market for their products that they currently control. Future market share is a key consideration at both these firms, because the weight of the expenses they have taken on would crush any company that is not the biggest player in the industry. The companies literally employ small armies. In fact, the combined workforce of these two companies is no less than the number of U.S. troops in Iraq. So, clearly both companies have made rather large commitments predicated upon their continued dominance. Without that dominance, these commitments would become crushing burdens. You need to give some thought to the flexibility of any business you invest in. The greatest risk facing a large enterprise is a decrease in revenues that can not (or will not) be offset by a similar decrease in expenses. The “will not” part is important, because I’ve learned that it is easy to put too much faith in management. No one likes to make tough decisions. The fact that a problem is obvious does not mean those who understand the problem will necessarily seek to solve it. I have no doubt that many in Congress recognize that the national debt is a problem. I also have no doubt that they recognize it is not in their interest to address the problem. They would like to see someone else address it at a later date. Everyone would. It is too easy to rationalize a thousand small steps. Then, you never have to admit your one big mistake. It may be that no one consciously chooses to tie a business to an inflexible and potentially perilous position. Likewise, it may be that no one consciously chooses to continue down that path. But, that is often precisely what happens. If the problem is not addressed until it must be addressed, it is too late for the owners. The losses in both time and money are already too great. Therefore, it may be best to look for businesses where managers will not be required to make tough decisions. An investment based upon the belief that managers will make tough decisions is always a risky investment – regardless of the fundamentals.