Wed, Oct 27, 2010, 2:22PM EDT - U.S. Markets close in 1 hr 38 mins
Microsoft CEO Steve Ballmer is seen after the Windows Phone 7 launch in New York, October 11, 2010. REUTERS/Jessica Rinaldi
By Bill Rigby
SEATTLE (Reuters) - Every July, Microsoft Corp invites a sizable Wall Street crowd to its leafy, low-rise campus outside Seattle. Chief Executive Steve Ballmer and his top managers take a half-day to explain where the world's biggest software company is going, to a generally friendly audience.
This year things didn't go quite according to plan.
Ballmer, CEO since 2000, talked excitedly of Windows 7, its new Bing search engine, new Phone software and the Xbox game system. But he was skimpy with details of how Microsoft would counter Apple's hugely popular iPad, a question that has been vexing investors.
At the end of the presentations, Sarah Friar, the influential Goldman Sachs analyst and a long-term bull on Microsoft's stock, seemed unconvinced. She wanted Ballmer to take another stab at explaining the iPad counter-attack. "It feels like right now you are not completely clear," said Friar. "I just want to give you another chance to give a succinct ... response."
Always an energetic presence on stage, Ballmer raised his voice even louder than usual, and with a resounding slap of his hands, repeated his main points methodically. Slates and tablet computers are coming soon. They will have Intel chips. They will run Windows. "We're going to sell like crazy. We're going to market like crazy," he boomed.
Three months later, Microsoft and its hardware partners have unveiled only one Windows tablet, which does not seem to be an iPad contender, much less a killer, as Apple's nifty gadget heads toward 8 million sales, eating away at the lower end of Microsoft's core PC market.
Partly because of this, Microsoft's stock has drifted lower, and is now down 16 percent for the year, despite a surge in tech stocks that has pushed the Nasdaq up 10 percent in the same time. The shares remain resolutely stuck at the same level as 2002.
At the beginning of October, Goldman's Friar threw in the towel, pitching Microsoft out of her bank's Americas Buy List and downgrading it to "neutral" -- Wall Street's euphemism for "dead money." One of her complaints was the lack of a "coherent consumer strategy," the very thing which Microsoft and Ballmer took such pains to lay out at the July meeting.
The downgrade by Goldman, the company that led its initial public offering in 1986, was an unexpected knock for Microsoft, which has no shortage of cheerleaders on Wall Street, given the potential fees it represents for mergers and corporate bond issues.
Coming only four months after Apple surpassed Microsoft in market value -- until recently an unthinkable event -- the downgrade brought into focus questions about Microsoft that are increasingly being asked by customers, investors and even some employees. Why hasn't the stock moved in eight years, despite more than doubling profit and sales in that time? Is Microsoft really at the forefront of technology? Why can't it invent popular gadgets like Google or Apple? Is Ballmer still the right person to lead the firm?
From the other side, Wall Street may have missed a subtle answer from Ballmer. The company is not Apple and can't promise stellar growth or a rocketing share price any more. It is learning how to be a mature, fiscally responsible company that will return as much as it can to shareholders in other ways.
In this fashion, Microsoft may point the way for rising companies like Google, which one day will also face the issue of how to keep growth going beyond its initial success.
THE BRIGHT SIDE
On paper, Microsoft is still a strong and growing company. It notched record sales of $62.5 billion last fiscal year, up 7 percent from the year before, and its highest ever net profit of $18.8 billion. The 70 percent operating profit margin on its core Windows business is the envy of companies the world over.
The new Windows 7 operating system is a hit -- selling 240 million licenses in the first year and erasing most of the stink of Vista -- and looks set to continue Microsoft's 90 percent-plus hold on the operating system market. Its new Office suite of applications -- containing Outlook e-mail, Excel spreadsheets and PowerPoint presentation programs -- will likely remain the gold standard in the workplace.
Those two units underpin Microsoft's steady success, accounting for about 60 percent of sales and the vast majority of operating profit in the last fiscal year.
On top of that, its server and tools business, which sells the software and services that run companies' computing systems, is now a giant in its own right, although the profit margins are about half of those in the Windows unit.
With more than $36 billion in cash and short-term investments on its balance sheet, it is one of the handful of U.S. companies to hold AAA credit ratings. Bond buyers have faith in the company's long-term success, recently buying its 30-year debt at the lowest interest rates on record, according to Thomson Reuters data going back to 1970.
And yet, its shares remain tethered to the $25 mark, which they have revolved around for at least eight years. If you reinvested dividends over that time, you would actually have lost money, according to Goldman Sachs. By contrast, Apple shares have grown 25-fold in the same time.
As Microsoft's earnings rise but its shares don't, the ratio between the stock's price and expected earnings has shrunk to around 10 times. That is well below the software industry average of 16 times and Microsoft's 10-year median of about 19 times, according to StarMine data.
For some, that's a signal to buy. The current share price is "insanely cheap for a company of this caliber and market position," says renowned value investor Whitney Tilson, managing partner at T2 Partners LLC and the Tilson Mutual Funds, a holder and recent buyer of Microsoft shares.
In the second quarter, top hedge fund managers like Dinakar Singh at TPG Axon and David Einhorn at Greenlight Capital also scooped up Microsoft shares, according to Thomson Reuters data.
"The stock price is not necessarily an accurate barometer of the business," said Dan Hanson, a portfolio manager at BlackRock, which is one of the biggest investors in Microsoft, through various active and index funds, owning about 3.3 percent of the company. "They (Microsoft) have not gotten everything right, but the stock is priced that they are getting everything wrong."
"The underlying business has been performing extremely well," said Hanson. "That's a disconnect, and a real opportunity in the stock today."
The problem is partly perception, suggests Patrick Becker Jr. at Becker Capital Management, a value-oriented fund manager. "They don't get very much credit for what they do on the business side. For whatever reason, you do well with the consumer, and you get a higher multiple on your stock."
DIGITAL DOUBTS
On the downside, Microsoft's entertainment and devices unit, which includes the hit Xbox game system and the less successful phone operation, is much less profitable. The online services business, including the Bing search engine and MSN internet portal, is a perennial loss-maker, leaking almost $6 billion out of the company in the last five years alone.
More broadly, there is concern that Microsoft has not prepared well enough for the shift toward mobile computing.
Some major holders have been selling. Fund firms Fidelity and T. Rowe Price cut their holdings by almost one-fourth in the second quarter, according to Thomson Reuters data.
"Tablets -- the iPad in particular -- and the smartphone market are major overhangs and discounted heavily in the stock," said Ken Allen, portfolio manager of T. Rowe Price's Science and Technology Fund, although he is still positive on the company's growth prospects. "There is huge investor fear around those two areas, especially with the iPad being successful so far."
It's too early to say whether Microsoft's new phone software -- its last ditch attempt to catch up with Apple and Google in the burgeoning smartphone market -- will be a success. The phones, with glossy touchscreens and 'live tiles' to quickly access e-mail, the internet and applications, go on sale in the United States in November.
There is a growing feeling that the $9 billion a year Microsoft is now spending on research and development -- totaling almost $69 billion over the last decade -- has not brought the breakthroughs it should.
"Comparing Microsoft to Apple over the past 10 years in terms of innovation, new products and completely new businesses, the differences are pretty obvious," said Don Dodge, a former 'startup evangelist' at Microsoft, who now works for Google. "What did Microsoft investors get in return for their investment of over $75 billion in R&D and acquisitions?"
That view is shared by another former high-ranking Microsoft executive, still active in the technology sector, who asked not to be identified. "There probably isn't another company in the world that has the same amount of raw talent and smart people," he said. "Then you look at the results over the last 10 years and they're not so impressive. How do you explain that gap?"
One explanation is that Microsoft has been hampered by what's known as the innovator's dilemma. After revolutionizing the world with computer software, the company's priority has been to protect its core markets rather than commit itself to anything that may pose a serious threat to that.
"Microsoft's been playing defense for the last 10 years," said the former executive. "They are trying to protect existing revenue streams rather than taking risks. New revenue streams put the old ones at risk, and those old ones support thousands of people in the company. It's a difficult situation to be in."
Microsoft was touting tablet computers 10 years ago. It was one of the first to see the smartphone market and even the potential of web search as a business. But a failure to put the right resources on the right projects at the right time means that it now lags Apple and Google in all those important markets.
"Once (Microsoft) felt the Internet threat had been disposed of, it retrenched back into retrograde behavior protecting Windows," said the anonymous former executive. "The rest of the world didn't stand still, it moved ahead quite fast and left Microsoft in the position it is today."
BALLMER PROBLEM
Some pin the blame for Microsoft's failures on its leader. Ballmer, 54, has been CEO since January 2000, although he has been thrust more into the spotlight since co-founder and Chairman Bill Gates retired from day-to-day duties in the summer of 2008 to focus on philanthropy.
A friend of Gates from Harvard University, Ballmer was the first business manager hired by Microsoft in 1980, five years after the company was founded. At the height of Microsoft's power in the 1990s, a software rival referred to the two as Pearly Gates and the Embalmer.
Ballmer's passionate, sometimes sweat-soaked, public performances have made him a YouTube celebrity. His loud and gregarious persona is the stylistic opposite of Apple CEO Steve Jobs. Ballmer tends to delegate hands-on demonstrations of new products to lower managers, whereas Jobs delights in his.
Ballmer has a habit of retreating into corporate-speak, or saying "bleh, bleh bleh, bleh bleh" at important moments. His frequent public appearances don't generate excitement outside the tech world, whereas Jobs says little but still manages to captivate the mainstream media.
"If they (Microsoft) are not successful with their consumer product launches that are coming in the next year, I think all of us will stop listening to him period," says Becker at Becker Capital. "And that's coming from a supporter." It may be time for a change, Becker says, if Ballmer cannot deliver that success.
Such talk is not new. Throughout Ballmer's 10-year stint as CEO, he has faced doubters. But some detect a heightened urgency. An anonymously sourced report in The Daily Beast blog this summer claimed a cabal of Microsoft executives was plotting to overthrow Ballmer, although it provided no evidence.
Insiders dismissed the report as implausible. "Steve brings a unique set of capabilities to running a very broad and complex set of businesses," said Frank Shaw, in charge of Microsoft's corporate communications. "The company is well positioned for growth and I'm excited for everything we are delivering this fall."
Ballmer was not available for an interview. But he did make it clear at a conference last week that he still has a passion for the job and has no plans to step down soon. "If I ever thought there was a day where the company would be better off without me, I'd leave that day," he told the audience. "The day I think somebody else can do it better would probably be the day I would decide to move."
But dissatisfaction among investors and employees about Ballmer's reign appears to be growing stronger. "The market in general is not positive on Ballmer, and some of that is not appropriate, but it is present in the stock price," said Allen at T. Rowe Price.
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