The end of Microsoft

Anybody using Windows 8 should realize it is a disaster for Microsoft. Possibly even worse than Windows Vista. Just ask the question of whether you will be seeing corporate clients (the major money-makers for Microsoft) upgrading to the new operating system.

The whole corporate strategy of Microsoft after they crushed IBM’s competitor, OS/2, has been to put a ringed gate around all software users and make it as difficult as possible to port outside of Microsoft DOS/Windows as possible. This worked for the most part for about 20 years before mobile and internet platforms started to become prevalent and relevant. Now, Microsoft’s strategy is simply about salvaging what is left inside the ringed gate with their Office and Exchange Server suites, where they still have a decent amount of entrenchment.

A chart is fairly instructive in terms of what the market is sensing is the reception to the Windows 8 launch:

Realize that institutional investors have much more powerful access to various data (e.g. channel sales data) than the everyday joe retail investor and you can easily see they have been betting significantly against Windows 8 being a material impact on Microsoft’s bottom line.

In terms of valuation, while Microsoft is more attractive than purchasing long term government debt, all of the growth should be discounted from the company’s valuation and instead a financial salvaging model should be applied to the company’s equity – eventually their domination of the office and exchange server market is going to erode to the point where they will completely lose pricing power.

I am not even going to get into the topic of their totally failed mobile phone market strategy, which has been even more of a disaster than Windows 8.

It is also not surprising as well to see the associated corporations, Dell and Intel being equivalent hammered by the marketplace.

All three companies will survive, but they are going to be shadows of the titans they used to be. I will give a bit of an exception for Intel, whom seem to somewhat still have their competitive act still together.

Microsoft vs. Google

I’m not interested in investing in large cap companies, but they are interesting to look at a superficial level. Sometimes this superficial analysis gets me very close to actually purchasing large cap companies (e.g. I thought Starbucks was a good purchase around $12/share back in late 2008/early 2009 when it was going through its coffee crisis during the economic crisis – I never did purchase them simply because there were so many other alluring securities trading at dirt cheap prices at this time).

Getting back to the original topic, looking at trailing 12 month P/Es (after subtracting net cash balances of both companies), Microsoft is at 12.1 and Google is at 15.9. So Microsoft is about a quarter cheaper than Google, just based on past earnings values.

Intuitively, Google looks like a much cheaper investment than Microsoft when you plug the question into your mind “Which company will be more relevant five years from now?”, or you can also use the more direct variant “Which company will grow its earnings more in five years from now?”. Both companies are in the revenue range ($74 billion for Microsoft and $43 billion for Google) where the law of large numbers is evoked – long gone are the days of 40% growth.

This is a fairly elementary analysis, but a hypothetical decision to invest a dollar in Google vs. a dollar in Microsoft is an easy decision. Google is probably the better medium term play.

However, I wouldn’t discount Microsoft’s chances too heavily – when I look at my own computing habits, I still see myself using a Microsoft operating system most of the time, and also Microsoft Office.

On this note of stickiness, as long as Yahoo doesn’t screw up their finance portal by adding in features which are utterly useless (e.g. how their news services are not filterable by content provider), I still find it to be my main “standby” webpage for just getting quick metrics on companies. I don’t know how they were able to be so sticky, but they way they present public information is a touch better than the others, including Google. If it wasn’t for Yahoo Finance, I’d find them to be completely useless.

Kevin Graham on Microsoft

Kevin Graham writes about why he is long on Microsoft (Nasdaq: MSFT) despite quoting reviewers’ ominous warnings about the usability of the new Windows 8 interface.

Certainly from historical financial measures, Microsoft is a cash machine and he does illustrate this.

Does anybody remember the release of Office 2007, with its new ribbon interface? Here is a reminder:

Almost everybody that I talk to said that this new interface required many, many painful hours of re-learning to find out where the functional equivalents were in the older pull-down menus from Office XP and before. It is one reason why I still run Office XP today – I find that the ribbon makes it about three times as difficult to remember where the function is that you are looking for and memory retention is significantly worse.

Windows 8 is going to be a similar analogy to the difference between Office 2003 to 2007. It is throwing away a lot of the “intuition” people have built up using the Windows interface, which will result in increased training time to acclimatize to the new operating system.

While the “Windows and Windows Live” division of Microsoft is responsible for about 40% of its profits, the office (business) division is just over 50%. Businesses have very little choice but to keep with office because of the fact that most staff you can hire will already know it (including the ribbon interface). Microsoft did not lose relevant business for the interface change, albeit, I do not think they were doing themselves any favours.

Windows 8 is probably going to be another incarnation of Windows Vista. With the “appletization” of computing being the new wave of software, the operating system is continuing to be less and less relevant. It is why you still have about a quarter of the population still using Windows XP, while Windows Vista users have gone below 1%. Basically people that had Vista went and upgraded to Windows 7 as soon as it was available, while those that have Windows XP machines are keeping them until they purchase new hardware with the newer version of Windows (and I am of that type – using my old and trusty Windows XP notebook that I purchased over 3 years ago).

This is the primary reason why Microsoft-centric hardware vendors like Dell (Nasdaq: DELL) are taking it in the chin.

This upgrade cycle – upgrading your software when you purchase a new computer system – is likely extending from an upgrade every two years to an upgrade every three, four, five or even more. The new features of the upgraded systems are becoming less and less relevant to actually getting work done and as a result, Microsoft’s business metrics should also slow down, albeit still gushing cash.

At a glance, if Microsoft gave out a $6 dividend tomorrow and promised not to blow money on stupid acquisitions (including their own stock, or buying out Yahoo), you still have a company that is generating roughly 15% of its value in cash a year, which is a fairly decent return when compared against the bond market. The remaining risk is how long companies and consumers will put up purchasing licenses of Windows and Office. Even if Windows 8 is a user interface disaster, I still don’t see people migrating from Office for a long time.

I do not see the stock itself, however, becoming a quick “double” or anything radical like that. If anything you will see some P/EV compression as the cash continues rolling into the bank account.

The dangers of technology investing

Shareholders of Research in Motion (TSX: RIM) are likely feeling a lot lighter in the pocket from three months ago. I don’t have any comments on the valuation of the company other than that the market weights future performance than past performance – RIM over the past reported about $6/share in earnings and when combined with their $27 share price makes the company look like a spectacular value. Even when looking at the analyst estimates, most are projecting they will make $6/share for the next couple years.

The truth, however, is not so simple – the company is facing intense competition through a couple channels – Apple with their iPhone/iPad and Google’s Android operating system embedded on a myriad of devices that are chipping away at Blackberry. As shareholders of Nokia (NYSE: NOK) might know, when you give up a lead in technology, it may be permanent or at least very long.

In the “social networking” domain, Friendster was trumped by Myspace, and now Myspace has been trounced by Facebook. Predicting the evolution of technology is not easy.

In the “search” domain (i.e. online advertising), Google so far is the winner, with old players such as Lycos, Excite, Infoseek, Altavista and Yahoo left behind.

Microsoft, for the most part, appears relatively insulated from the change in technological trends, mainly due to people’s acclimatization to the Windows and Office suites. Linux’s various permutations has failed to permeate into the client marketplace to a significant degree while OpenOffice and its derivation (including Google Docs) has not penetrated Microsoft Office to any extent. However, a bet on Microsoft relies on the fact that these two core assumptions are true. While Microsoft does have a financially viable video game division, this is not the primary bet a Microsoft shareholder implicitly makes – rather, it is that they are able to maintain monopoly-level pricing on Windows and Office.

Apple shareholders also received adverse treatment from Microsoft back in the 1990’s and nearly faded into oblivion until they revamped their product marketing with the iMac. The question of 2012 is: Will Apple or Google shareholders receive the same treatment from some other upstart company?

Finally, with RIM, if you anticipate that people will be using Blackberries (or other RIM devices) in the future, RIM might be a good bet. Investors with clairvoyant abilities to predict future technological trends will be handsomely rewarded with either gains, or the ability to sell out of a stock before the rest of the market realizes that the technology trend has changed.

Skype – Another kick at the can

The news is making the rounds that Microsoft is paying a large amount of money for Skype, approximately $8.5 billion in cash.

It is virtually guaranteed the acquisition will lose money. EBay tried their hand with Skype back in late 2005 and they only had to pay $2.6 billion for the privilege before they threw up their hands in late 2007 when they dumped the company for a loss.

Now Skype has found a bigger sucker to sell itself to, which in this case is Microsoft.

All of these value investors that have their money in Microsoft have to be wondering what Steve Ballmer is thinking, and how much more money Microsoft will run themselves through before realizing that it has gotten to the size where it is unable to compete effectively outside of its Windows/Office monopoly.

Quick review of some large cap technology stocks

I am continuing to look at the US large cap sector, just for personal review rather than serious consideration. I am continued to be surprised by relatively good valuations, around the 10% yield levels. Most of these are in the first-generation “old-school” technology sector. Very well-known companies include the following, with some very anecdotal remarks on my behalf:

Microsoft (MSFT) – Trading at 9.3x FY2012 projected earnings, with $30B net cash on balance sheet, Windows/Office empire continued to be chipped away at with competition;
Intel (INTC) – Trading at 9.5x FY2012 projected earnings, $20B net cash on balance sheet, likely to be around for a long time, competition in mobile processors, but nothing in really ‘large scale’ CPUs except AMD;
Dell (DELL) – Trading at 8.6x FY2012 projected earnings, $8B net cash, well-known customer support/service issues, but otherwise entrenched in computer/IT market;
Hewlett-Packard (HPQ) – Trading at 7.3x FY2012 projected earnings, $10B net debt, along with Dell, entrenched in computer/IT market;
Lexmark (LMK) – Trading at 7.7x FY2012 projected earnings, $600M net cash, major supplier in printer/imaging market;
Xerox (XRX) – Trading at 8.3x FY2012 projected earnings, $8B net debt, in a similar domain as Lexmark;
Seagate (STX) – Trading at 7.2x FY2012 projected earnings, $0 net cash/debt, hard drive/storage manufacturer;
Western Digital (WDC) – Trading at 9.3x FY2012 projected earnings, $3B net cash, in a similar domain as Seagate;
Micron Technology (MU) – Trading at 8.4x FY2012 projected earnings, $600M net cash, memory manufacturer;

One would think that diversifying a position into these nine companies and calling it the “Old-school technology fund” would probably be considered a relatively safe alternative over the next 10 years, compared to the 3.4% you would achieve with a 10-year US treasury bond.

My gut instinct would suggest that these companies would still be around in 10 years, especially Intel, which has the biggest competitive advantage out of the nine listed above.

I am also assuming that smarter eyeballs than my own have looked at these companies, which is why I suspect there isn’t much extraordinary value here other than receiving a nominal 10% return on equity, which is pretty good for zero research.