Friday, May 13, 2011

Microsoft’s Acquisition of Skype

Microsoft’s acquisition of Skype this week has given me cause to revisit my thinking on why I own this nine year flat liner. To provide a frame of reference, I look for companies that are dominate in their businesses, abnormally profitable, and will likely continue both while expanding revenues and earnings through unit sales growth. In order to justify investment, the entry price must be attractive based on free cash flow. And lastly, good management would be an added plus.

Dominate, profitable, growing, inexpensive and well-managed, Microsoft passes the first four hurdles with ease while face-planting on the last. This latest purchase of Skype adds to the legacy of poor capital allocation by management of the company.

There are few companies that control their core businesses as totally as Microsoft does. In PC operating systems and productivity software the company has the vast majority of the market share and has fought off all comers, such as Amiga OS, Linux, NetWare, OS/2, UNIX and VMS over the decades. The future is clouded by the likes of Apple, with mobile operating systems running iPads and Mac OS, and Google developed Android and Chrome. But it is possible these will be additive to the market and not cut directly into Microsoft’s sales.

In terms of profitability, Microsoft reigns supreme. Due to operational leverage (the ability to sell more product without incurring increased costs), as well as the growth and size of the end market, the company has operating margins over 60% in its main businesses. And very little capital is required in the process, so the return on invested capital is at the top of all industries.

Revenues and earnings at Microsoft have grown over 15% annually for the last five years and are projected by Valueline to advance at 10% annually for the next five years. The global PC market continues to expand while the company gets to sell upgrades and replacement units to existing customers.

For an investment, the price paid for an asset is the difference between a winner and a loser. There are plenty of stocks that are trading at a lower price now than a decade ago even though the business is 2-3 times larger or more profitable. In fact, Microsoft fits that description to a tee. That said, Microsoft could pay out a 10% annual dividend and continue to grow nicely in the future, if management decided to. This is extremely attractive pricing for any asset in today’s market, not to mention the safety inherent in Microsoft’s balance sheet, over $25 billion in net cash.

That brings us to the problem with Microsoft; management. Steve Ballmer has taken too much of the cash generated and invested it in businesses that have terrible returns. Billions has been invested over the years in entertainment systems such as Zune and Xbox that are collectively just now profitable. Company management has also expended billions more to create an online business in web sites and search that lost more than total sales last year. Fortunately, Yahoo’s management is even more challenged than Microsoft’s; rejecting a deal that would have saddled MSFT with a $40 billion fading business.

Management has also purchased shares of Microsoft in the open market over that last decade, unfortunately, most at above the current price. This latest purchase of Skype cost shareholders $1 per share, hardly something to ruin one’s life over. However, it is $8.5 billion spent on a business with no profit, and since the service is mostly free, unlikely to generate one in the future.
So, what are the reasons to hold this stock? The first four items, a 2.5% dividend and the hope that management learns about capital allocation, resigns or is replaced. The stock is just too cheap to sell! To paraphrase Warren Buffett, “I want to own businesses that even an idiot could run, because some day one will”. Please see the following articles for more info.


NEW YORK (Bill Rigby) - Microsoft Corp's move to buy money-losing Internet phone service Skype for $8.5 billion was immediately skewered by critics and investors, who questioned the logic of the deal and suggested the software giant is paying far too much.

The price is about double the expected value of Skype if it had gone ahead with its planned initial public offering, leaving investors puzzled over how Microsoft will make the deal pay for itself.

"I wish they had not done it," said Whitney Tilson, founder and a managing partner of T2 Partners LLC, which owns Microsoft shares.

"Initially when I first read about it, I hated the deal. Now, I don't like it," said Tilson, who is a long-term buyer of Microsoft shares and still sees them as a great cash-generating business and an undervalued stock.

"Everybody I know uses it and I am glad Microsoft owns it. They just probably paid too much for it," said Tilson, who did not buy or sell Microsoft stock on Tuesday.

Shares of the world's largest software company fell 1.4 percent, anchored at the same level they have been for 10 years.

The latest deal was a fresh reminder that Microsoft has no record of making acquisitions pay off. Its 2007 deal to buy online ad firm aQuantive for $6 billion was a flat-out failure.

"They really have to do some explaining as to how this company merited that price and how they'll return the value to shareholders," said Kim Caughey Forrest, senior analyst at Fort Pitt Capital Group, which holds Microsoft shares.

"We have to see the path to profitability. It smacks of that 1999, 2000 time period when valuations were granted on eyeballs, not revenue and earnings."

Skype made a net loss of $7 million last year on revenue of $860 million, even as its user base grew nearly 40 percent to 145 million.

Microsoft Chief Executive Steve Ballmer said the deal would add to the company's profits from the first year, preferring to focus on the $264 million Skype made last year, excluding interest, tax, depreciation and amortization.

He stressed that Skype, which will be a separate unit within Microsoft, will help sales of its other products such as Xbox game console and Kinect motion-sensing system, and add luster to its Office suite of applications.

"Will we sell a few more Kinects when we get these things hooked up? Yeah, I think so. Skype can help where we are in the enterprise by getting those customer bases to work well together," said Ballmer in a phone interview.

"I think there's a lot of value in here that we can drive -- we've just got to go get it done when we get through the regulatory (approval)," he added. Microsoft aims to complete the deal this year.

Microsoft is hoping that more business users would be willing to pay for Skype if it is integrated with Outlook e-mail, which hundreds of millions of people already use, or that more gamers will pay to join the Xbox Live network if real-time video and voice services are added.

It should also allow its new Windows Phones to compete directly with Apple Inc and Google Inc smartphones, which already feature video chat.

But some investors carped that Microsoft already had the technology to do this, or should have developed it itself, and may soon be overtaken.

"They paid a headscratcher of a valuation," said Patrick Becker Jr., a principal at Becker Capital Management, which owns 1.5 million Microsoft shares.

"One of my big fears is that by the time they design this into Outlook, Xbox and their phone software it's going to be overtaken by Google and Apple from a capability standpoint," he said.

Becker said buying a software company should cost more like a multiple of five times revenue, which would imply a valuation closer to $4.3 billion based on the company's 2010 revenue.

"It points to them playing follow the leader, which is a very difficult game to play," said Becker. "My disappointment is that I thought this was an area (in which) they had a fair amount of expertise. To go out and spend $8.5 billion makes me wonder about internal execution. They obviously felt they didn't have the product in house to compete with Skype, Google and Apple."

One factor in favor of Microsoft: it is using cash from overseas to buy Luxembourg-based Skype, which means it won't have to pay U.S. tax on that money, as it would if it had repatriated the money to the United States.

The majority of Microsoft's $50 billion cash and short-term investments are held overseas, where most of its revenue is generated.

"They can't return their offshore cash to shareholders so this might be reasonable use of that," acknowledged Tilson. But even that could not persuade investors that the deal was a bargain.

"It does strike me that by almost any dimension Microsoft is overpaying," said Andrew Bartels, an analyst at Forrester Research.

"There's some strategic benefits but I have a hard time seeing them being anywhere close to what they're paying," he said. "I'm sure shareholders are saying that Microsoft should have given a dividend to shareholders rather than spend it on this."

(Additional reporting by Jennifer Ablan and Sinead Carew; Editing by Richard Chang)
Copyright 2011 Thomson Reuters.

Microsoft Just Pulled Another “Microsoft” with its Purchase of Skype

When I wake up in the morning and check news for the companies I own, I worry. I don't worry that my companies missed their quarterly guidance by a few pennies – running a business is an art, and things don't usually work out in a precise, linear fashion. The companies that have a "deliver the quarter" culture often just play their financial statements as a musical instrument. No, I am not worried about that. What worries me is that a company in my portfolio will pull a "Microsoft" – announce a stupendous, "transformative" acquisition, like the $48 billion takeover of Yahoo! that Microsoft announced in 2008, but that Yahoo!'s management was too ... (fill in the blank) to accept. (I spent some time looking at Yahoo! last week. Its stock is at $18, almost half the price that Microsoft offered, and I find the company only mildly undervalued if you give a significant value to the assets and Alibaba Group that Yahoo! acquired in 2006 and which were not worth nearly as much in 2008.)

Today, while in NYC still playing catchup with the jet lag from the European trip, I read a headline: "Microsoft is near a deal to buy Skype for $8.5 billion." Microsoft is pulling another "Microsoft", though this time it may actually succeed. Private equity and eBay, which still owns 30% of Skype, may actually sell, unless Google or someone else rushes in with a competitive bid.

Microsoft had the chance to buy Skype for a long, long time. eBay would have parted with Skype for a fraction of $8.5 billion as recently as 2009; in fact it did, it sold 70% of it to private equity, valuing Skype at $2.8 billion, a third of what Microsoft is offering today. Skype only generates $800 million in revenues, putting today's price tag at over 10x revenues and some much, much larger multiple of earnings – a very lofty valuation.

Microsoft falls into the broad category of high-quality stocks that were incredibly expensive in 1999 and have not gone anywhere since (and have often declined, as is the case with Microsoft). But most stocks in that category – take Wal-Mart, Cisco, Medtronic, etc. – have seen their earnings and revenues triple and P/E’s collapse. So before we run to crucify the management of these companies and call them "value traps," we should actually take a careful look at their fundamental performance. Management did what it was hired to do: it increased shareholder value by growing the business while maintaining or increasing the moat. It is the shareholders who overpaid for those stocks in the ’90s. Management is not at fault for that, human greed is.

However, ten years ago Microsoft was an icon, it was a star, it was the company that any self-respecting software engineer wanted to work for. Today, with current management's help, it is slowly becoming a has-been. In fact, when I think of Microsoft I often think of a quote from Warren Buffett (Bill Gates’ best friend), who said he wants to own a company whose business is so good and whose moat (competitive advantage) is so wide that it could be run by a monkey, because someday it will be. Buffett, though he’s the Oracle of Omaha and all, probably did not know at the time that he was talking about Microsoft (bing it: "Steve Ballmer Monkey").

Today Microsoft is suffering from the too-successful company syndrome: it was too successful for too long, and the success corrupted management thinking into a belief in entitlement. Management started to forget what made them successful in the first place –hard work, paranoia about competition, and a little bit of luck (which is random; one could hope for it but never depend on it).

I vividly remember in 2007 Apple was introducing its iPhone, a touch phone, and Microsoft was introducing a touch table (see it for yourself). Steve Ballmer publicly dismissed the iPhone as a very expensive gadget. Today, after Microsoft's market share in cell phones went from respectable to nonexistent, and with the iPad (a device that is a barely a year old) killing netbook sales, Microsoft is a shadow of its former self. The number of consumer gadgets that have the Apple insignia is rising at a much faster rate than Microsoft's (my family has two iPhones, two iPods, one iPad – I am writing this on it – one Mac mini, and two Windows PCs).

The moat is still there; Microsoft still dominates in desktops, servers, productivity (office), and even gaming; and that is why, despite Mr. Ballmer antics, earnings are much higher today than they were 10 years ago. But when a company is run by a proverbial Buffett's monkey, no matter how good the business is, the moat will grow shallow and then cease to exist. Even five years ago one would have been fairly comfortable projecting rising Microsoft cash flows ten, fifteen years out. That confidence is much lower today.

From my conversations, people who work for Microsoft love the company but hate the environment. Microsoft has become a highly bureacratic, extremely political timeocracy. (A timeocracy is the opposite of a meritocracy: people get promoted not based on their talent or performance (merit), but on the time they've been at the company. This type of environment is great for Google and Apple, as it creates a fertile ground from which to cherry-pick talent. It is very difficult to fire a person at Microsoft who doesn't perform (I've heard it takes a year to dump someone). This is good if you a nonperformer but horrible for the company, as it creates an undynamic, zombie-state working environment with horrible productivity. Managers are afraid to hire full-time workers and thus hire temps. In other words, to some degree Microsoft is becoming the un-unionized GM of the West Coast (though in all fairness, due to its moat, it still produces a 30% return on capital, high margins, and a healthy balance sheet).

Microsoft's past success, $40 billion net-cash balance sheet, and the $20-plus billion in cash it generates each year gives management a false sense of security. But success has it side effects. It takes away the need to be paranoid, competition is dismissed, focus is lost – there is no project (even the touch table) that is not off limits when you think you have limitless resources. Steve Jobs once said that focus is not what you choose to do, it is often what you choose not to do. Cisco's three-decade success also went to management's head; however, CEO John Chambers woke up to that a few weeks ago and wrote a memo to employees admitting his mistakes and outlining steps to refocus the company.

It is difficult for management to admit their mistakes (they are human, and we are not good at that), and for the board to fire current management while the company is increasing its revenues and earnings. A company needs to hit the proverbial wall for that to happen. Microsoft is far from that wall.

Instead, Microsoft is making another acquisition, and Skype will likely be as wasteful as the ones it did in the past. I am fairly sure, a few years down the road, Microsoft will take a "one"-time charge to write down the goodwill for this acquisition, not unlike eBay a few years ago, after their purchase of Skype.

Skype has a terrific product, which I use a lot. My son plays chess with my father on Skype daily (despite my father living only seven miles away). But unless I use Skype to make phone calls (which I do when I travel outside of the US), Skype makes no money on me as a customer. I find that I use Skype as a VoIP product less and less when I travel outside of the US, because almost everyone I want to talk to has Skype on their phone or computer (this is how I communicate with my partner Mike when I am outside the US). The minute Skype decides to start charging for video-to-video service I'll switch to another free provider and so will my friends and relatives (ironically, we've been conditioned that video-to-video communication should be free).

So why, after everything I wrote, do I masochistically own shares of Microsoft? Because the business is still too good and the stock is incredibly cheap. Microsoft is trading at about eight times next year's earnings if you take out cash. However, as I write this I pause. What if Microsoft (Steve Ballmer, to be exact) keeps pulling "Microsofts" and continues to buy the Skypes of the world? With the Skype acquisition Ballmer will likely destroy 60 cents of Microsoft’s value. ($8.5 billion roughly equates to $1 per share for Microsoft. Skype is worth closer to $3 billion, 40 cents a share.). In our estimate Microsoft is worth around the mid-30s, so with this upside we can tolerate a few Skypes, but not many. I truly hope that other shareholders and employees start a jasmine revolution in Microsoft and vote Steve Ballmer out of office. But that is only a dream.

P.S. Despite my being critical of Steve Ballmer, the deal Microsoft signed with Nokia was brilliant. Microsoft is a software company and doesn't make hardware; its partners do. Though in the bulky world of PCs and laptops that setup did not hinder Microsoft, it does now. Apple's control of both hardware and software allows the iPad to have a 10-hour battery life. On my flight from Prague to NYC my Dell ran out of juice in less than 2 hours, and I had to use the iPad for the rest of the trip (an external keyboard helps a lot).

Nokia's new CEO came from Microsoft. My friend Tero Kuittenen described him as a Manchurian candidate: it appears almost as if he was implanted into Nokia by Microsoft – the Microsoft-Nokia deal is by far more favorable to Microsoft than Nokia. The new CEO looked at Nokia's operating systems (Symbian and MeGo) in development and realized he didn’t have many options other than creating an alliance with Microsoft. (Go figure!) Nokia could have used Google's Android, which is free, but it is difficult to differentiate in that crowded space. So Nokia hung its future on the Windows operating system. And it makes logical sense that the alliance will go beyond cell phones to tablets; after all, as Apple taught us, a tablet is a big cell phone, not a small laptop. Despite dropping the ball on the operating system front, Nokia is the king of cell phone hardware. Working very closely with Nokia will provide Microsoft a more holistic software-hardware design platform and give Microsoft a fair chance to come up with a decent, iPad-level tablet.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.

Vitaliy N. Katsenelson, CFA│ Chief Investment Officer
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