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| Microsoft (MSFT) by Geoff Gannon
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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 each of the first two businesses is wide. The
Windows moat is huge.
The business model in operating systems is good. 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 problems.
Games
Eventually, this will be a big business for Microsoft (at least
that's my guess). 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 dominant console business are launching first and
getting good games on your platform. We'll see how Sony 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 or
Google.
I also think we might see a couple other (largely unknown)
search engines gain some share.
I think Google's strength is the 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 more generic, more 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, 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 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.
But, 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.
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About The Author
Geoff Gannon is a full time investment writer. He writes a (print) quarterly investment newsletter and a daily value investing blog. He also produces a twice weekly (half hour) value investing podcast at:
http://www.gannononinvesting.com.
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