Will Microsoft Inject Trademark Mediocrity Into Promise 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 as a rule 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.

The chance to buy Skype for a long

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; as a matter of 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 earnings, putting today’s price tag at over 10x earnings and some much, much larger multiple of revenues - 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.  However most stocks in that category - take Wal-Mart, Cisco, Medtronic, etc. - have seen their revenues and earnings triple and P/E's collapse.  So previously we run to crucify the management of these companies and call them “value traps,” we should in fact take a careful look at their fundamental performance.  Management did what it was hired to do: it increased shareholder value by growing the business during 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, and 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.  To tell the truth, when I think of Microsoft I often think of a quote from Warren Buffett, who said he wants to own a company whose business is so good and whose moat is so wide that it could be run by a monkey, because someday it will be.  Buffett, even though he's the Oracle of Omaha and all, probably did not know at that time that he was talking about Microsoft.

I vividly remember in 2007 Apple was introducing its iPhone, a touch phone, and Microsoft was introducing a touch table.  Steve Ballmer openly dismissed the iPhone as a very expensive gadget.  Today, afterwards Microsoft’s market share in cell phones went from respectable to nonexistent, and with the iPad 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.

The moat is all in all there

The moat is all in all there; Microsoft everything considered dominates in desktops, servers, productivity, and even gaming; and in other words why, in spite of Mr. Ballmer's antics, revenues are much higher today than they were 10 years ago.  Nevertheless when a company is run by a proverbial Buffett’s monkey, no matter how good the business is, the moat will grow shallow and at the time 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 nevertheless hate the environment.  Microsoft has become a highly bureaucratic, in the extreme political timeocracy. , yet on the time they’ve been at the company.  This type of environment is great for Google and Apple, as it creates fertile ground from which to cherry-pick talent.  It is very difficult to fire a person at Microsoft who doesn’t perform.  This is good if you are a nonperformer nevertheless 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 along these lines hire temps.  That is, to some degree Microsoft is becoming the un-unionized GM of the West Coast.

It is difficult for management to admit their mistakes, and for the board to fire current management during the company is increasing its earnings and revenues.  A company needs to hit the proverbial wall for that to happen.  Microsoft is far from that wall.

Terrific product

Skype has a terrific product, which I use a lot.  My son plays chess with my father on Skype daily.  Nevertheless unless I use Skype to make phone calls, Skype makes no money on me as a customer.  I find that I use Skype as a VoIP (Voice over Internet Protocol) product less and less when I travel outside of the US, because nearly everyone I want to talk to has Skype on their phone or computer.  The minute Skype decides to start charging for video-to-video service I’ll switch to another free provider to cut a long story short will my friends and relatives.

So why, afterwards everything I wrote, do I masochistically own shares of Microsoft?  Because the business is even so too good and the stock is incredibly cheap.  Microsoft is trading at about eight times at once year’s revenues if you take out cash.  Nevertheless, as I write this I pause.  What if Microsoft 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. .  In our estimate Microsoft is worth around the mid-30s, so with this upside we can tolerate a few Skypes, nevertheless not many.  I really hope that other shareholders and employees start a jasmine revolution in Microsoft and vote Steve Ballmer out of office. But in other words only a dream.

P.S. In spite of 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.  Although 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.

Nokia’s new CEO came from Microsoft.  My friend Tero Kuittenen described him as a Manchurian candidate: it appears nearly as if he was implanted into Nokia by Microsoft - the Microsoft-Nokia deal is by a long way more favorable to Microsoft than Nokia.  The new CEO looked at Nokia’s operating systems in development and realized he didn't have many options other than creating an alliance with Microsoft.  Nokia could have used Google’s Android, which is free, nevertheless 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; in short, as Apple taught us, a tablet is a big cell phone, not a small laptop.  In spite of 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.