What Wall Street Doesn't Get About Microsoft

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The software giant's chief is serious about making it a major player in mobile communications and consumer products. Value investors should be warned.
David Einhorn's bet on Microsoft is unlikely to pay off any quicker than his investment in the New York Mets.

The hedge-fund investor's recent recommendation of the stock helped push Microsoft (ticker: MSFT) shares about 3% higher the next day, near 25. There is a lot for a value investor like Einhorn to admire in the stock. The shares trade at less than 10 times fiscal year 2011 earnings of $2.58 a share, compared with 15 for rival Google (GOOG). And it's generated stellar earnings, despite more than a billion in losses on its Internet business. If $5.78 a share in net cash and investments were factored in, the price/earnings ratio would be closer to seven. What's more, Microsoft is sitting on $50 billion in cash that could be used to boost its 2.6% dividend or to buy back more shares.

But, like many potential positives for Microsoft shares over the years, the Einhorn effect didn't linger. The shares, in an admittedly weak market, drifted back down to 24.76 by Friday. The one-time growth stock has been flat for nearly a decade now.

Investors' enthusiasm for change underscores some of the tensions between the company and Wall Street. Microsoft, for instance, spends about $9 billion a year to develop new and better products, money that could be used to reward shareholders. Critics like to point out that investor darling Apple (AAPL) spends about $2 billion a year on R&D, yet it's the undisputed champ of new-product launches. Microsoft supporters counter that the vast majority of its R&D goes toward writing new iterations of its Windows operating system, a hugely expensive endeavor that is the source of much of the company's profit.

Microsoft isn't expected to dramatically shift its priorities so long as Steve Ballmer is CEO. As a result, there's little chance of more than a standoff with investors. Veterans of the high-tech business contend that Ballmer's much more interested in regaining the company's tech leadership and growth profile than in ramping up the small annual dividend hikes the company tends to offer. (Microsoft is in the midst of a $40 billion buyback program, too.) The software giant has totally missed two game-changing trends: Internet search and mobile phones. Aware of just how quickly a technology asset can disappear, Microsoft is trying a Hail Mary pass with handset maker Nokia (NOK), partnering for yet another stab at wireless with another version of a Windows mobile-operating system. "In technology, if you miss one wave you are in trouble," says Google Chairman Eric Schmidt.

The shares have paid for Microsoft's missteps, as growth investors and tech specialists have pared positions or liquidated them, leaving the field to value players. But Microsoft "has been an absolute value trap" to date, says portfolio manager David Readerman of Forward Management in San Francisco, who tracked Microsoft as an analyst for 25 years.

Einhorn, who also recently bought a $200 million stake in the long-suffering Mets, called for Ballmer's removal as a way to unlock the value in the stock. (Einhorn declined to speak with Barron's.) There are some persuasive reasons to think Ballmer will be around awhile. Since he took the reins from Chairman Bill Gates in 2000, Ballmer has tripled revenue, expected to increase by 11% to $70 billion this year, and earnings per share. The Windows and Office software franchises continue to be cash machines despite slower personal-computer growth generally and significant obstacles, such as piracy in what's soon to be the world's largest PC market, China. The company's Azure cloud-computing initiatives show promise. Operating cash flow of $8.7 billion for the most recent quarter was up 17% from a year ago.

"There are lots of concerns about the future, [but] it would be tough to say he hasn't been performing based on past results," says Bill Koefoed, Microsoft's investor-relations general manager. Ballmer, like Gates, runs Microsoft for the long haul and isn't interested in making short-term decisions that can bump shares, he adds.

TO CATCH UP TO SOME of his rivals in these markets, Ballmer has tried to use cash and shares to make acquisitions. He paid $6 billion, an 85% premium, to buy Internet-ad network aQuantive in 2007, as another step in trying to catch Google in search. In 2008, Ballmer made a $33 a share offer for Yahoo! (YHOO), only to be turned down. Based on Yahoo!'s subsequent share performance, the market thinks the company is worth just half what he offered. A partnership deal reached with a new Yahoo management team has thus far not lived up to expectations. The result is that Microsoft is No. 3 in the U.S. market, well behind Google.

Just recently Ballmer agreed to pay a steep price of $8.5 billion for online video and voice specialist Skype, four times what eBay sold its 70% stake for in 2009 to private-equity investors. Skype could help Microsoft in many of its businesses, from videoconferencing in its enterprise unit to voice communication for videogames. The deal "makes strategic sense given Skype's large customer base of 170 million active monthly users, high growth rate and potential to enhance other Microsoft products and services," says Cowen analyst Gregg Moskowitz. Still, it's going to take time to see how it works out.

And then there is the partnership with Nokia, a world-class handset maker that's fallen on tough times. The only problem is that the twosome is vying to become the No. 3 phone outfit, behind Apple and Google.

Creating new products on its own has also been a problem, as Microsoft continues to grapple with the cultural effects of gigantism. The bureaucracy needed to run it is a deterrent to innovation. The Microsoft campus in Redmond, Wash., and the surrounding Seattle area now has more than 100 buildings, and the company employs almost 90,000 people.

Beyond that, the company is understandably reluctant to stray from a Windows-obsessed strategy. New products, whether for search, music or mobile, are all tethered to the Windows operating system. That means that Windows engineers get involved in virtually every new idea to make sure it's compatible with the operating system. That isn't the best way to build a new business from the ground up. The one exception to that rule in consumer products: the Xbox computer game system, one of Microsoft's few successes.

SO WHAT MIGHT REBOOT the stock? Some think Microsoft shares could rise this fall if the company offers a credible new mobile game plan at its analyst meeting in Anaheim, Calif. "The short-term catalyst has to be a believable strategy in mobile for both phones and tablets," says Bill Whyman of ISI Group. But that's still months away and mere speculation, he cautions.

Aside from that, there's little on the horizon to produce big changes in Microsoft's strategy—or its share price. With such a huge market capitalization, it would take a very, very deep-pocketed shareholder activist to stir the pot. Ballmer and Gates together still hold more than 10% of the shares.

Ballmer, 55, has said he wants to remain CEO until his youngest child enters college, which is still eight years away. Gates, who is intensely loyal to Ballmer, isn't likely to urge his friend to step aside, say those familiar with the co-founder's thinking.

When the time does come, expect an orderly changing of the guard. "Steve and Bill aren't going to do something that is unnatural for a short-term benefit," Koefoed said.

One possibility to unlock some shareholder value would be to spin off the consumer divisions. That would give investors a stake in fledgling businesses and free these units from the engineering and bureaucratic constraints they face. The highly profitable Windows division, the server and tools group and the business unit, which includes the Office software franchise, would make up the core Microsoft entity. It would retain controlling positions in the others. Spun out would be online services and the entertainment-and-devices division, which is moderately profitable and includes Xbox.

To date, Microsoft has opposed any divestitures. "The synergies across the various business divisions give us a competitive advantage," says Koefoed. But not much comfort to investors like Einhorn.