Microsoft Overview

In fiscal year 2007, total MSFT (Microsoft) revenues were $51.12 billion, up 15% over 2006. Broken down: sales of the operating systems (Vista, XP, NT, etc) represented $15 billion, sales of Windows Server & SQL server were $11.2 billion, and Microsoft Office was $16 billion. The Entertainment & Devices division (Xbox 360 & Zune MP3 player) was a loss leader with $6.1 billion in revenues leading to a division loss of $1.9 billion in 2007 (loss would have been “only” 800 million if it weren’t for the extended warranty program on the 360 gaming console).

MSFT also returned $31 billion in cash to shareholders through stock buybacks and dividends. They spent $7.12 billion in research & development (R&D) and bought aQuantive (global digital marketing company) for roughly $6 billion. Microsoft is a huge company that generates mountains of cash each year, and this leads us to our first checklist item.

Quality of Management

What is MSFT management’s track record of adequately reinvesting their profits back into further profitable investments? To put it lightly, MSFT is at a loss as to how to reinvest in their business. Over the last five years, MSFT has returned $100 billion back to shareholders. If you were to translate this $100 billion “giveback”, essentially management is saying, “We can’t invest this much money profitably in our business, so we will give it back to our shareholders.” Another less cynical translation might be, “We think we will make more by investing directly in our stock as opposed to new lines of businesses because we think the stock is cheap.”

The Windows Vista operating system represented several years of concentrated R&D spending for MSFT. The problem with Vista as an investment for Microsoft is that there was no real breakthrough from XP to Vista. Vista makes Windows more secure, adds more of the “cool factor”, and allows Microsoft to maintain the Windows line of business. To some observers, Vista seems to be a wasted investment for MSFT because its features do not compel its users to upgrade from XP to Vista. An interesting tidbit, MSFT originally planned to halt all sales of Windows XP as of January 2008 (and force everyone to buy Vista), but they extended that deadline by 6 months… due to popular demand for XP.

The Microsoft management also seems to be struggling to keep up with Google. They see that Google’s business model can be very lucrative, but they are playing a game of catch-up. MSFT lost out to Google in bidding for DoubleClick (an Internet ad serving service). Google paid $3.1 billion for DoubleClick in April 2007. MSFT paid $6 billion for aQuantive in May 2007 (one month later) (aQuantive’s 2006 profit was $54 million, so MSFT paid more than 100 Price-to-Earnings). It appears that Microsoft’s investments have been reactionary to moves that Google has made or is making.

As an investor, if you believe that quality of management at a company is poor, then this aspect can actually be an investing opportunity. Recently, Dell and Sun Microsystems each replaced their CEOs and the stocks rebounded instantly and both companies are starting to improve their performance. Unfortunately for MSFT shareholders, CEO Steve Ballmer and other founders are fairly entrenched at MSFT, so it wouldn’t make much sense to buy MSFT on hopes that Ballmer is ousted.

In All Fairness

In all fairness, if you were presented with a mountain of cash that is larger than the annual sales of many combined industries and told to go invest it in profitable business lines and products, then it would be quite a difficult task. This is precisely the task that Microsoft is faced with. Luckily, they can return cash back to shareholders; however, the cash that they do invest better be invested profitably or MSFT will continue to tread water.

This column has looked at only my opinion of quality of management at MSFT. This would not be a reason by itself to either invest or divest of MSFT stock, but it is something to keep in mind. As an investor, quality of management at MSFT represents a headwind or a reason to not invest in the stock.

In paradoxical contrast, if company management of the hypothetical XYZ Inc. has historically made all the right moves at all the right times, then you would think that quality of management is very high. In some of those cases, you have to wonder whether management performance has been due to luck or superior skill. You have to temper expectations and stay rational and not think that XYZ management is genius and can do no wrong. “Past performance is no guarantee of future returns.” If XYZ management has been perfect in the past, and if the stock market thinks they will be perfect in the future, and a project doesn’t work out perfectly, then XYZ stock is generally going to under perform when the future doesn’t turn out to be perfect.

Post Script

Microsoft has a really cool hardware product that may be released in 2008. It is called Surface and while its applications will be limited to swanky businesses and the rich, it is very cool indeed. Check out the videos of it in action here. Don’t get too carried away in thinking this will be sold in a mass market fashion. We don’t know its price tag or how easy it will be to program/use for various functions.