Monday, May 9, 2011

What To Do About Microsoft?

I went to go hear analyst Brent Thill last week. Brent follows the enterprise software group for the brokerage firm UBS, which includes Microsoft (ticker: MSFT).

Brent is one of the better analysts in the space, in my opinion, but his "buy" recommendation on Microsoft has not worked out particularly well, as he noted with some frustration.

Over the last year, for example, Microsoft has declined by -11% while the S&P 500 is up +19%.

It's also been the same story for the last few years: despite a very attractive valuation; a decent dividend; and monopoly pricing power over products that nearly all of us use on a daily basis, the company has been struggling to figure out it way in the new world of cloud computing, and so its stock has lagged the broader market indices.

In some ways, the company is typical of many other "big tech" stocks. In the 1990's, if you didn't own tech stocks like Microsoft, Oracle, IBM, etc., you risked lagging the market significantly.

Lately it has been the opposite for investors in technology stocks. While the larger technology stocks have languished, volatile stocks like Salesforce. com; VMWare; and Red Hat have soared.

Microsoft today offers investors a 2.5% dividend yield, and a free cash flow yield of 13%. It's price/earnings is less than 10x, and sits on more than $40 billion of cash. For the patient investor, it would seem an opportunity, but, boy, it's been painful to sit with the stock.

About a year ago there was an interesting piece in the New York Times written by a former Microsoft executive named Dick Brass. Mr. Brass discussed the innovation and cultural problems at the company that are contributing to its problems (tip of the hat to columnist Luke Johnson of the Financial Times). Here's an excerpt, with the full link below:

Microsoft’s huge profits...come almost entirely from Windows and Office programs first developed decades ago. Like G.M. with its trucks and S.U.V.’s, Microsoft can’t count on these venerable products to sustain it forever. Perhaps worst of all, Microsoft is no longer considered the cool or cutting-edge place to work. There has been a steady exit of its best and brightest.

What happened? Unlike other companies, Microsoft never developed a true system for innovation. Some of my former colleagues argue that it actually developed a system to thwart innovation. Despite having one of the largest and best corporate laboratories in the world, and the luxury of not one but three chief technology officers, the company routinely manages to frustrate the efforts of its visionary thinkers.