To be fair, Microsoft is far larger than it was when Gates ceded the CEO seat to Steve Ballmer back in 2000. In fact, since then Microsoft revenues, profits, and free cash flow have risen 86% to $42.6 billion (in the most recent 12 months), 44% to $13.5 billion, and 8% to $14 billion, respectively.
Unfortunately for Microsoft shareholders, the stock price has gone in a different direction. Since hitting its $59 peak in 1999, the stock has dropped 63%. Its stock market capitalization has declined a stunning $383 billion to $225 billion. And the stock market values Microsoft's earnings prospects at a level far lower than its competitors' – assigning Microsoft a Price/Earnings (P/E) ratio on current earnings of 17.6, which is 72%, 74%, 87% and 39% lower than Red Hat, Google, Salesforce.com, and Apple respectively.
If Gates wishes to get Microsoft's stock price back up, he should follow the WSJ's suggestion and consider breaking up the company into autonomous units that can react more quickly to industry changes once they are untethered from the creativity-sapping committees that Microsoft requires of them so its new products will work with previous versions.
Based on the assumptions detailed below, a breakup of Microsoft would create as many as six autonomous units which could be worth a combined $32.81 a share. Here's how I estimated the worth of the component parts:
- Operating systems. Microsoft's PC and network operating systems businesses generated combined revenues and operating income of $21.2 billion and $12.3 billion respectively for Microsoft's fiscal year ending June 2005. As an independent company it might be worth $23.96 a share assuming it continues to grow at 10% this year, earns a net margin of 35%, and is valued at a P/E of 30 -- below that of open source operating system service provider Red Hat whose P/E is 63 and whose earnings per share (EPS) are forecast to grow 30.7% over the next five years;
Applications. Microsoft's office applications generated revenues and operating income of $11.5 billion and $8.6 billion respectively for Microsoft's fiscal year ending June 2005. As an independent company it might be worth $6.36 a share assuming it continues to grow at 7% this year, it earns a net margin of 35%, and is valued at a P/E of 15 -- below Google which has a P/E of 69 and EPS which are forecast to grow 35.2% over the next five years; - Microsoft Network. Microsoft's web portal generated combined revenues and operating income of $2.4 billion and $469 million respectively for Microsoft's fiscal year ending June 2005. As an independent company it might be worth $1.90 a share assuming it continues to grow at 22% this year, it generates a net margin of 32.8% (same as Yahoo's), and is valued at a P/E of 20 -- below Yahoo whose P/E is 24.3 and whose EPS are forecast to grow 27.9% over the next five years.
Microsoft's three other businesses – Home Entertainment (Xbox), Business Solutions (small business accounting and CRM), and Mobile Devices (mobile software) are losing money but might fetch an additional 60 cents a share – 43, 14, and 3 cents/share respectively -- if they were fixed up and earned margins as high as comparable companies – Nintendo, Salesforce.com, and Palm -- respectively.
Microserfs of the world spinoff! You have nothing to lose but your crumbling stock price.
I am neither long nor short shares of Microsoft, Yahoo, Red Hat, Palm, Nintendo, Google, or Salesforce.com. For more about me, click here.
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Reader Comments (Page 1 of 1)
6-19-2006 @ 9:18AM
douglas mcintyre said...
Microsoft At The Rubicon
Stocks: (MSFT)(VIA)(CBS)(GE)(UTX)(GOOG)
A writer for the Wall Street Journal recently suggested blithely that Microsoft should consider breaking itself into three pieces as a way to unlock shareholder value. The program is not unlike the one the government looked at when Microsoft was facing antitrust issues with the U.S. government several years ago.
But, will making one public company into three, really help shareholders? Alternatively, will it simply create fees for the people who engineer the split? This seems to have been the case when Viacom was broken into two public companies, Viacom and CBS, Inc. CBS’s stock has gone nowhere, moving from a high of $27.45 in January to its current price of $25.99. The other part of the entity, Viacom, has seen its stock drop from above $44 in late 2005 and early 2006 to its current value of $36.15.
So, breaking enterprises into pieces that may be easier for institutional investors to understand, does not create value per se. This is especially true if the new companies do not perform well financially.
Part of the argument about breaking Microsoft into pieces is that it is too large to manage, In other words, it is no longer the simple operating system company that Gates and Ballmer were running a decade and more ago. The problem with this line of thought is that there are a number of larger companies that are well run. GE has revenue of $150 billion, and several complex divisions. Even United Technologies has revenue of over $40 billion coming from several divisions, and its stock trades near the high end of its 52-week range.
Microsoft’s stock price has not been anywhere near as strong. The stock, at $22.10, is at a 52-week low, and has not been this low since 2002.
Microsoft’s major problem, which is well understood, will not be solved by breaking the company into parts. Microsoft’s operating systems and related software, which have shipped with PCs and servers for years, are now competing with web-based and open source solutions which customers find increasingly more economic.
Microsoft’s OS and Office software throw off billions of dollars of cash per year, as the WSJ pointed out. However, much of this money is consumed by losses at newer businesses like the Xbox gaming platform or the cell phone and IP television software. Building and marketing the new software products, search technology, and operations like MSN, would be nearly impossible without the cash flow from the older businesses and the ubiquity of the operating system. A break-up of the company would orphan the divisions that the company is counting on for future growth.
What might get Microsoft back on track? Perhaps nothing. But, the conventional wisdom is that the company has to train its really big guns on the marketing of its OS, Office and server products using the internet as the delivery mechanism. This same line of reasoning argues that companies like Google have taken the lead in this form of delivery with products like their date-base search and spreadsheet software.
Microsoft has the marketing dollars and muscle to get its “Live” and so-called Web 2.0 products widely distributed. However, the financial model is extremely difficult for a corporation that is used to huge margins on its products. Google has a number of products which are delivered on the web, from Google Earth to its Google Pack of internet search, photo organizer, and Google video player. It is unlikely that Google makes any money on these products.
It appears that Google is as much a prisoner of its advertising key-word model as Microsoft is of its OS. Both have established, large, and seemingly, insurmountable leads in their fields. Both still struggle to find additional, large businesses. Google may only be different in that it began its diversification long after Microsoft did. What both have in common is that they have not found that unusually large second business, one that will deliver high market share and substantial margins.
The common thread between Google and Microsoft is that consumers, whether they are corporate or individual, now get a great deal of the software that they use on computers and servers either free or at very little cost. Virtually all search technology is free, despite its tremendous value. Advertisers offer a revenue stream for this model. But, with applications like blogging software, photo-sharing, free voice over IP, text chat, e-mail, video, and even some classifieds (craigslist), there is no consistent way to get significant financial yield. As spreadsheet software comes online at no charge and Linux improves as an alternate to Microsoft OS and server applications, the options for making money on Web 2.0 fade.
Breaking up Microsoft will not answer the shareholder question about the value of Microsoft’s stock. Delivering software over the internet that can command a price at volume, along with large margins, may. Microsoft has as good a chance as any company in the world to unlock the door to this online software opportunity, but it is possible that it is a business that has slipped through everyone’s hands. “Free” is not a model that allows companies to make up low margins with volume.
Douglas A. McIntyre can be reached at douglasamcintyre@gmail.com. He does not own securities in companies he writes about.