Microsoft’s Write-offs: What Lessons Can We Learn?

Microsoft Takes $6.2 Billion Charge, Slows Internet Hopes

Published: Monday, 2 Jul 2012 |

By: Reuters

I was shocked: http://www.youtube.com/watch?v=HqVBKO_QM3o

Lessons to be learned

There are several lessons:

  • First, this is an example of why you must discount/haircut the value of the EXCESS CASH on Microsoft’s balance sheet.
  • Second, the importance of the ability of management to invest outside their circle of competence; in other words, how management allocates capital.
  • Finally, what strategic logic did Microsoft violate? Hint: Google has 65% of the search market.

Hint: If I wanted a job at Microsoft or an investment bank servicing technology companies, I would do an intensive analysis showing why there would almost always be failure due to faulty strategic logic. You may not get the job, but I guarantee you would do better than submitting countless resumes.  Say you saved MSFT $6 billion plus the money that could have been earned on that amount–what percentage would be fair compensation? Not a bad payday.

Microsoft admitted its largest acquisition in the Internet sector was effectively worthless and wiped out any profit for the last quarter, as it announced a $6.2 billion charge to write down the value of an online advertising agency it bought five years ago.

The announcement came as a surprise, but did not shock investors, who had largely forgotten Microsoft’s [MSFT30.56 -0.03(-0.1%) ] purchase of aQuantive in 2007, which was initially expected to boost Microsoft’s online advertising revenue and rival Google Inc’s [GOOG580.47 0.40(+0.07%)] purchase of DoubleClick.

The company’s shares dipped slightly to $30.35 in after-hours trading, after closing at $30.56 in regular Nasdaq trading.

Microsoft said in a statement that “the acquisition did not accelerate growth to the degree anticipated, contributing to the write-down.”  

Editor: Discuss MSFT’s flawed strategic logic.

The world’s largest software company bought aQuantive for $6.3 billion in cash in an attempt to catch rival Google Inc. in the race for revenues from search-related advertising. It was Microsoft’s biggest acquisition at the time, exceeded only by its purchase of Skype for $8.5 billion last year. But it never proved a success and aQuantive’s top executives soon left Microsoft.

As a result of its annual assessment of goodwill – the amount paid for a company above its net assets – Microsoft said on Monday it would take a non-cash charge of $6.2 billion, indicating the aQuantive acquisition is now worthless.

The charge will likely wipe out any profit for the company’s fiscal fourth quarter. Wall Street was expecting Microsoft to report fiscal fourth-quarter net profit of about $5.25 billion, or 62 cents a share, on July 19.

In addition to the write-down, Microsoft said its expectations for future growth and profitability at its online services unit – which includes the Bing search engine and MSN Internet portal – are “lower than previous estimates.” 

Again, through your lens of strategic logic what obvious flaw did management make and WILL make again if it doesn’t understand what?

The company did not say what those previous estimates were, as it does not publish financial forecasts.

Microsoft’s online services division is the biggest drag on its earnings, currently losing about $500 million a quarter as the company invests heavily in Bing in an attempt to catch market leader Google. The unit has lost more than $5 billion in the last three years alone. Even though its market share has been rising, Bing has not reached critical mass required to make the product profitable.

Before rolling out Bing in June 2009, Microsoft’s Windows search engine had 8 percent of the U.S. Internet search market, compared with Yahoo’s 20 percent and Google’s 65 percent.     

In the three years since then, Bing has almost doubled its market share to 15 percent, but that has been mostly at the expense of Yahoo, which has had its share whittled down to 13 percent. Google now has almost 67 percent, according to research firm Comscore.

Another article:

http://www.montrealgazette.com/business/Microsoft+writes+admits+aQuantive+acquisition+worthless/6873661/story.html

14 responses to “Microsoft’s Write-offs: What Lessons Can We Learn?

  1. Microsoft is focusing on growing revenue instead of revenue and profits (and profits are what really matter). It’s apparent that in the online services business, the company has no competitive advantage (they’ve almost doubled market share, but at what cost? — $5 billion in the last 3 years alone). In fact, they are at a competitive disadvantage in this business compared to Google. By continuing to invest in the online services business (where the company has no competitive advantage) the best Microsoft can hope for is to earn its cost of capital. Based on the evidence presented, Microsoft is actually destroying shareholder value by overpaying for acquisitions and making unprofitable growth “investments.”

    The company should consider shutting down the online services business and focus on maintaining its OS and Office franchises. Excess cash should be returned to shareholders tax efficiently through share buybacks (at the right prices) or increased dividends.

    • Agreed – I get the feeling that focusing on the search engine market might take away from their focus on the OS and Office businesses. I worry that as more and more applications/services are operated through the web browser, the tie into a specific OS will become less over time decreasing the barrier to entry into the OS business.

    • Good post. The next step is to show examples of repeated failure like Ebay trying to compete against the equivalent of Ebay Japan.

      Hidden failures are found in WDFC. It has a great business (oil in a can under the sink) to buy other businesses like soap where they have no advantages. The great business subs. the bad or breakeven–diluting returns. Note that WDFC does not break out in detail their different businesses? Oh boy!

      I am not saying that at the right price WDFC isn’t a good investment, but realize what is going on and adjust your valuation accordingly. WDFC earns slightly over its cost of capital, but the stock would double if management sold off the poor businesses then buy back shares until one share is left. A tontine.

  2. A number of comments:

    1) This specific deal turned out to be very bad, but if others that they did worked out better, then maybe the odds are in their favor and it was okay to do. That said, I don’t think they make acquisitions of this magnitude very often and so I don’t believe it can be argued that their expected return justified it. (If you pay 10 drug research firms with a 10% chance of a 20x return, it’ll pay off despite 9 of them going broke)

    2) Regarding investment banks… the description I’ve been given is that they aren’t there to tell companies what they should or shouldn’t be buying, but rather to facilitate a smooth transaction and provide the information that the company wants in their decision making. This means ensuring the legal/regulatory items are taken care of, items that need researching are dug into, experts are brought in where needed, and so on. When they issue a rating on a stock, maybe it’s just a “rating” and the real value is in the research. If someone goes out and buys stock on just a single world of what an analyst says, they need to recheck their premise. I’m not convinced giving them any strategic insight will go anywhere – we have to think for ourselves as investors.

    3) This is what scares me in general. You can have an amazing business, but if management blows through money on acquisitions that don’t create value, then my money is being squandered away. In physics, we have this concept of potential energy and kinetic energy. If I raise a weight 10 feet above the ground and hold it there, the weight has potential energy. It isn’t converted into kinetic until it drops. In business, a free cash flow producing machine has potential energy, but until the cash is released, there’s no kinetic energy. We have to ultimately realize the cash from what they do. I think too many executives see the stock market as a place to sell stock and create an exit. They don’t focus enough on returning the cash to ultimately justify the value that was given to it. In some ways, I think the stock market harms our returns as investors because it’s far easier to sell stock than it is to release cash needed to realize that same value. If CEO’s could never sell the stock they own in a company, I bet the decisions they would make would be very different.

    • Dear Ankit:

      It is easy to point out AFTER the fact that their venture was a failure. How would you know a priori that their venture was almost distined for disaster? What would you have written the Board of Directors the moment MSFT said that they would develop Bing?

      Using Strategic Logic, MSFT was an entrant against Google that had 65% market share. Google had economies of scale, network effects and customer captivity. Note the power of habit in search. So MSFT has an entrant strategy but they went head to head against Google without any advantage–in fact, a huge disadvantage, because how would they take customers from Google? They would have to offer a service multiples of benefit better to get people to switch. What are the odds of a Pee Wee hockey team beating the Los Angeles Kings. It could POSSIBLY happen but the odds are 99.99999999999999999999999999999999999999999999999999% against it.

      Gee, why is competitive advantage important? MSFT did the equivalent of burning $6 billion dollars in a garbage can. Image ten dump trucks bringing paper money to the bonfire. Can anyone calculate the wieght of $6 billion in one dollar bills.

      Point 2: I think you are a bit niave on what Investment banks do. Their job is not only to facilitate the transaction but also to GENERATE the transaction. So if you were the banker to write that this attempt was doomed gues you would get fired? Even though you would provide a huge benefit to MSFT’s shareholders.

      The research is just to JUSTIFY–go look at merger proxies–the transaction. Asking a banker about doing a deal is like asking the barber if you need a haircut. I did that one day–I had a haircut then walked two blocks to another barber and asked him if I NEEDED one. The benefit of merger proxies is the industry stats in them.

      point 3: Yes, if MSFT returned money to shareholders and didn’t flush it down the toilet, the stock would be over $40. In fact, these humiliations may be BULLISH for the stock.

      But MSFT was cheap enough for me last year to buy even knowing their other business were worth $0.

  3. I believe that one should look at MSFT’s acquisitions as a form of cap-ex. If you go back and look at how numerous these have been throughout the years, it has actually been a fairly successful strategy . aQuantive and the yahoo debacle {where they were saved by yahoo rather than themselves} are two of the blazing individual failures of that strategy of course. Mr Softie has TTM Net Inc + depr./amort of $26 Bil. If one takes the last 7 years of acquisitions which include skype (no revenue) and this aQuantive and every other in between…add in the actual cap ex…you get $5.4Bil per year on average. So, $20.5B Free Cash on an EV of $213 B is a 9.6% free cash flow yield AFTER the crappy capital allocation strategy they are so often knocked for. In those last 7 years, Revenue has grown by about that same 9.5%-10% and EBIT has grown even faster. So invert and ask yourself where does the variant view really hide . (??) Happy Co-dependece Day.
    Cheers, Peter

  4. Hey Peter:

    That is an EXCELLENT post and analysis. Your analysis is exactly how an intelligent investor would look at it. You could look at many companies like Cisco, etc. that way.

    Despite the bad investments and some have worked out, the company gushes cash–think if they gave that excess cash to Buffett to invest for them or just returned to shareholders.

    PRIZE will be sent via email.

  5. Excellent post, Peter. I think John was heading in the same direction above when he said that you have to discount the cash on the MSFT balance sheet for the crappy capital allocation history. You don’t have to write-off the company altogether because of the bad M&A. The company is attractive at the current EV because Windows and Office are cash cows and gush FCF. Even an idiot could run this business. But, when calculating EV or asset value, you can’t simply deduct 100% of cash on the balance sheet because of the tendency of Ballmer et al to blow it.

  6. It seems like we moved from trying to figure out MSFT’s strategic logic flaw to talking about whether it’s an attractive long position at the current price (great idea on including acquisitions in CapEx).

    Getting back to flaws, how do we know what theirs was w/o being privy to their internal meetings before the acquisition? Presumably they had SOME idea of what their edge might be.

    If Larry & Sergey had failed, I could imagine my postmortem detailing how crazy it was for two grad students to think they could hack together something better than what established, profitable companies with much larger R&D budgets were turning out. Even if they KNEW their mojo was better, wouldn’t they get quickly copied and leapfrogged?

    I never understood Google’s moat until I switched to Bing for a while to see what it was like. For most searches it seemed identical! But for those rare searches, when you’re not finding what you’re looking for, you always wonder if Google could find it, so you end up trying Google too. After this happens 8 or 9 times, you just set your default back to Google (regardless of whether it actually did help). That’s mindshare, I guess.

    • Good thoughts. I am sure there was a HUGE INSTITUTIONAL IMPERATIVE (Read in Buffett Essays (http://www.investinternals.com/2008/01/warren-buffett-on-institutional.html) Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press. – Warren Buffett

      One of the big shocks that Buffett got when he left business school was just how irrational many managers really are. In school he was taught that the experienced managers of leading companies were honest and intelligent, and automatically made rational business decisions. When Buffett actually got out into the real world, he found that rather than rationality and wisdom, there is a much stronger force that operates in business.

      This force, which drives managers with the most excellent credentials to invest capital in bizarre ways and adopt silly approaches purely because it seems to be what everyone else is doing is what Buffett calls the “institutional imperative”.

      The institutional imperative manifests itself in four ways:

      * The organisation resists any change whatsoever in its current direction, and will seize upon any evidence that they are doing the right thing while fastidiously ignoring evidence to the contrary.

      * Just as work expands to fill time, and waistlines expand to fill belts, projects and acquisitions will materialise to soak up all available capital.

      * Any business plan of the CEO, however stupid it may be, will receive immediate support from a legion of lackeys who will produce copious data and detailed rate of return and strategic studies to support the boss’s thesis.

      * The behaviour of peer companies, irrespective of differences in circumstances, whether they are acquiring, expanding, setting dividend policy, downsizing, putting the troops through customer service training or setting executive compensation will be immediately and thoughtlessly copied. The most typical examples of this sort of self-destructive me-too behaviour include commodity businesses having price wars to preserve market share even if it means selling at below the cost of doing business, share buyback schemes just because everyone else is doing them, moving in blocs to structure remuneration for top management, the rise and fall in takeover activity on a seasonal basis and the adoption of sales strategies as an industry standard, without anyone really stopping to consider if it is even worth while and most particularly in the adoption of strategies that may boost short term earnings but harm long term growth, such as certain measures that may require high initial expenses but lead to massive long term cost savings.

      Buffett finds it is not the owners who are at the greatest risk of being blinded by the institutional imperative, but the managers themselves in their inability to accept fundamental change.

      Buffett notes that even when managers do accept that change is needed or the company could face shutting down, carrying out the plan is so difficult that many managers choose instead to try to buy their way out of the doldrums by buying a new company rather rather than execute potentially far cheaper measures to change the direction of the existing company.

      Why do managers act like this? Buffett notes three reasons: most managers cannot control their lust for hyper-activity, preferring instead to go out and buy something, they are constantly comparing themselves to companies inside and outside of their own industry, making changes to reflect the “new ways of thinking”, which are in fact only the old ways with new fads inserted and most managers tend to have an exaggerated sense of their own abilities.

      Other reasons include poor capital management skills. Most CEOs rise to that rank from within other areas of the company like information technology, engineering or marketing. When they do reach the top they lack the necessary skills to make decisions on the allocation of capital. What occurs then is that CEOs turn to their staff, consultants and investment bankers and the institutional imperative enters the process.

      The biggest reason for the institutional imperative though is just mindless imitation of other companies. Every company is different and can not be run to a standard formula, however with managers spending as much time watching their rivals and adopting what they see as normal for other companies as actually running their own business, many companies can all go down the same tube by making the same mistakes.

      Management’s pressure to “spend” or invest their huge cash pile and arrogance or perhaps politics caused them to not use COMMON SENSE or better–STRATEGIC LOGIC. Google ALREADY had 60% or more of the search market. They had network effects/economies of scale and a huge BTE. How was MSFT going to develop a product MULTIPLES of levels better to CHANGE people’s habits. MSFT could have spent $50 billion to no effect. Who would be successful taking away Facebook’s business. An entry strategy would be a FACEBOOK for one-eyed drawrfs–very niche.

      Try taking $150 billion to put Coke out of business.

      Logic is logic. Let’s take OBAMACARE–forget politics–what will cause its collapse? Could you show by mathematical formula the inevitable collapse?

  7. I demo’d MSFT’s windows phone on the Nokia Lumina Tuesday and its a very good product. Superior in many ways to my HTC thunderbolt. It will be very interesting to see if people can be swayed to try another MSFT phone product. What has been described here re: Facebook and google competitive advantage may infact keep people from bothering to try it and MSFT may face another long uphill battle to catch up no matter how good the product is.
    How difficult are the switching costs really? In my business, they would be very high and cumbersome to switch pc’s and servers to mac’s. On another related note, I started using gmail in 2006 after a friend rec’d it for searching old emails…Which was horrible in outlook. I was also happy to get my gmail right on my phone via the android system/HTC. HOWEVER, now that bing has been imbedded in outlook, I find gmail very cumbersome and would like to have Outlook on my phone. I won’t switch yet because it is not available on Verizon..but I would try it when it is available and even though I am long MSFT, I would not bother to do that if I thought it would be a hassle or inferior. So the lead AAPL has in tablets and phones may not have the kind of near permantcy that MSFT has had in enterprise. No major point here other than things are not black and white across all mediums of tech and one thing is for sure….The converged mobile device (aka: smartphone and tablets) is the most competitive space on earth in my view. MSFT’s products here look surprisingly good and this was never part of my long thesis.

    Final note: It is not easy to watch smart investors whom I admire such as Klarman and Einhorn sell down their positions in MSFT while I ride on…but as John has so aptly pointed out, one has to think independently. Emerson puts it best:
    “There is a time in every man’s education when he arrives at the conviction that envy is ignorance; that imitation is suicide; that he must take himself for better, for worse, as his portion; that though the wide universe is full of good, no kernel of nourishing corn can come to him but through his toil bestowed on that plot of ground which is given to him to till. The power which resides in him is new in nature, and none but he knows what that is which he can do, nor does he know until he has tried”

  8. I think there is a big difference between hardware (smartphones) and Internet search. There are no switching costs in changing from Google to Bing, but there is a powerful habit associated with Google. Why do people drink Coke and not Pepsi despite the fact Pepsi wins blind taste tests?

    Here is a good article on the battle AAPL faces in trying to maintain market share in hardware in the consumer space: http://www.slate.com/articles/technology/technology/2012/07/iphone_google_glass_apple_s_tech_innovation_has_gotten_boring_it_s_time_for_something_new_.html

    • “There are no switching costs in changing from Google to Bing, but there is a powerful habit associated with Google. ”

      Indeed. But there are ways and means … Internet Explorer automatically taps into Bing, and there’s always the possibility of corporate sponsorship of browsers like Firefox that could swing things in their favour. Possibly, if MS is going to win the war, what it needs is complacency at Google. Google has come in for some criticism as to the quality of its search results, some say as it got a little sloppy and perhaps arrogant in the kind of results it displayed through its dominant position. If MS is genuinely committed to making Bing better (and not the risible attempts to elevate Microsoft products in the search results), and Google started frustrating users, then it’s a chink that MS could exploit. And you don’t want to go around having chinks in your offering when you’ve got MS as a competitor.

      I’m not saying that it’s likely, I’m just saying that it’s possible.

  9. One thing I’d say is that tech is very difficult to predict, and I think it’s too easy to learn the wrong lessons.

    Where MS (Microsoft) scores is in its Windows monopoly. That’s its fortress.

    A lot of where it has fallen down is to pay absurdly large sums for dubious businesses. MS probably has Ballmer to thank for that. Consider its failed bid for Yahoo. Anyone could have told you that MS was willing to pay too much for Yahoo. Fortunately for MS, Yahoo was too greedy, and the talks failed. That was one of the best things to have happened to MS.

    In other areas, successes and failures are mixed. For example, its phones and games consoles seem only to be so-so. There’s a level playing field.

    But consider some of MS’s other successes and failures. It basically failed in accounting software. The grip of Quicken was too strong. Contrast that with MS Office. Wordperfect was a strong incumbent. MS bought up Office, and released a shoddy but cheap product. It then went on to gradually improve it, and as we know today, is the dominant office package. No other package comes close. Open Office doesn’t come close, even though it’s free.

    Thinking of the commonality of MS’s successes, it releases cheaper somewhat shoddier goods than its competitors, but which usually has a “hook” in it. For example, IIRC, DOS was worse than competitor’s offerings, but it was cheaper, and possibly quite importantly, it was faster. These positive characteristics were good enough to outweigh any deficiencies.

    Perhaps I may be tempted to say that MS didn’t make strategic errors, it just made errors. I’m thinking here of Nassim Taleb, where he often talks about being “fooled by randomness”. The trick to success is buying cheap options. A lot will expire worthless, but you never know, one of them could be the winning lottery ticket.

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