Microsoft Offers a Solid Opportunity

 | Aug 29, 2013 | 10:00 AM EDT  | Comments
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The surprise announcement of the early retirement of Steve Ballmer, Microsoft's (MSFT) long-time CEO, has generated much discussion in the past week as to MSFT's future direction and prospects.

While we were hopeful that ValueAct's discussions with the board might result in some changes that would enhance shareholder value, we had feared that Ballmer would remain at MSFT for years to come.  

As long-term MSFT shareholders, we think the announcement is a positive and will provide for a needed and welcome change. On the positive side, current management and the MSFT board have succeeded in building a dominant technology franchise, despite many missteps and missed opportunities along the way. More importantly, they have done a poor job transitioning the core legacy software franchise to smartphones and tablets.  

Ballmer and the board also have done a poor job through the years of running the company to increase shareholder value. They have done little to assist the stock price through capital allocation, or to employ other means in which to reward shareholders. The result has been a flat share price for over a decade even in the face of substantially higher earnings, revenues and cash flow. 

There is much discussion about the many challenges a new CEO will have at MSFT, particularly in trying to revitalize the Windows franchise. Lost in discussion, however, is a focus on a number of often overlooked corporate strengths and available levers that the new CEO can use to significantly enhance profitability, as well as shareholder value. Here are some key considerations:

Strengths: 

  • MSFT still has a dominant software franchise that generates huge cash flows and earnings.  The core Office (Microsoft Business Division) and growing Server & Tools units are particularly strong franchise.
  • Move to the Cloud:  MSFT is a leader with its Windows Server, SQL Server, Azure and Office 365 product lines.
  • Over $61 billion in net cash, or $7.30 per share, on the balance sheet.

 Levers: 

  • A bloated cost structure:  some analysts believe that operating margins could rise 300 to 500 basis points, adding over 30 cents to earnings, with more disciplined investing and prudent cost controls.  We think a focus on profitability, including not accepting ongoing losses in certain divisions, would result in an even larger increase.
  • Making more of Xbox: focusing on making Xbox a meaningful earnings contributor vs. a break-even to marginally profitable business today.
  • Search:  partnering to make it a profitable business vs. losing -$1.5 billion per year. Partnering with Facebook or selling the business to Yahoo would make sense.
  • Culture shift: by all accounts, Microsoft's emphasis on protecting its incumbent positions has stifled pursuit of real and meaningful innovation.  Selecting an authentic change agent as CEO can shake up a stagnant organization and allow more good creative ideas to be explored without reservation.

Despite its many challenges, MSFT has more than ample cash resources and a strong enough competitive posture to enable it to continue as a leader in computer and internet software. Simultaneously, there is no reason why new leadership cannot enhance shareholder value along the way.

A simple, yet compelling, proposal to improve shareholder value would entail (1) increasing the dividend yield to 4% based on the current stock price; (2) retiring 5% of the stock each year for the next few years, in order to help manage and to grow earnings; and (3) allocating those same aggregate dollars for dividends, which combined with share buyback results in an additional increase in the per-share dividend over time. 

Implementing these reasonable proposals, combined with a strong focus on cost cutting and returning capital to shareholders, should result in more consistent returns to shareholders, faster earnings per share  growth, and lead to a $40 plus stock price. 

Beyond that, if the new CEO is also successful in breathing life into the organization, there should be further upside from those realistically higher levels.      

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