Money Matters - Simplified

Why Microsoft Will Never Be Great Again

In a sobering move, Goldman Sachs is downgrading shares of Microsoft (Nasdaq: MSFT) -- from "buy" to "neutral" -- with analyst Sarah Friar lowering her target on the stock from $32 to $28.

Friar is also talking down her profit estimates over the next three years, as the latest former believer to realize that the world's largest software company is a shell of what it used to be.

After all, many pros will downgrade a stock after a heady run-up. That's not Microsoft. The shares are essentially where they were -- favorably adjusted for dividends -- five and 10 years ago. If you look up "lost decade" in a dictionary, you'll probably find the mug shots of Steve Ballmer and Bill Gates -- and you should probably go out and buy a dictionary for grown-ups that doesn't include any pictures.

Friar's roast
Illustrating Microsoft's ineptitude as an investment, Friar offers up three steps that the company must take to regain its swagger.

The saddest part in all of this is that three suggestions aren't feasible and in some cases mutually exclusive. Oh, and even if Ballmer was able to pull them all off, it still wouldn't resolve the company's fading relevance.

Let's go over Friar's three points:

  • Microsoft needs a bigger boost to its quarterly payouts than last month's 23% upgrade. The stock is currently yielding 2.6% -- certainly better than a lot of short-term fixed income paper out there -- but Friar believes that Microsoft needs to be one of the 20 highest-yielding stocks in the S&P 500.
  • There's a need for what Friar calls a "coherent consumer strategy" that will require scaling back on investments and even selling off or spinning off some of its divisions -- primarily its Xbox gaming arm.
  • Despite Azure and porting its Office functionality into a server-stored solution, Friar feels that Microsoft should be a bigger force in cloud computing.

Let's go over the push for chunkier yields first. Returning money to its shareholders hasn't really worked for Microsoft. The stock has been a sorry market laggard since it began its distribution policy seven years ago. How will digging deeper into pockets help? Is replacing burned investors with income chasers that are about to get singed any better? The tech stocks that have bucked the meandering returns since earlier last decade -- led by Apple (Nasdaq: AAPL) and Google (Nasdaq: GOOG) -- don't pay out a dividend at all.

As for divesting, dumping its gaming division would be crazy. Xbox and Microsoft's niche-leading Xbox Live are some of the few things working for the rudderless giant these days. If Microsoft has any street cred among the youth, you can bet on Xbox being a big part of that. The Xbox brand is being cast in a major role in Microsoft's effort to keep Zune alive and give its upcoming Windows Phone 7 upgrade an advantage over the already entrenched Apple, Google, and Research in Motion (Nasdaq: RIMM).

Mattering in cloud computing is no easy task. It's easy to see why Microsoft would be a better investment if its cloud-crowning achievements were better publicized. The valuations in this niche are insane, with salesforce.com (NYSE: CRM) and SuccessFactors (Nasdaq: SFSF) fetching 73 and 230 times next year's projected earnings, respectively.

Unfortunately, it's not as easy as one would think. For starters, mattering in the cloud would mean paying a premium to acquire speedsters that are already richly valued. If Microsoft chooses to go the organic route, it would likely mean pushing Office further into the cloud to compete against the freebies and cheapies put out by Google and Oracle's (Nasdaq: ORCL) Sun. In other words, it would come at the expense of slashing its existing cash -- and potentially sacred -- cow.

Hard times for Microsoft
Friar's suggestions are as flawed as they are unrealistic.

It's clear to nearly everyone that Microsoft will never be the juggernaut it used to be. Its operating system stronghold will be challenged by Apple's iOS and Google's Android in tablets and smartphones, and it won't be long before it trickles higher to ram Microsoft in a way that Linux and other platforms were never able to accomplish.

Software will get cheaper and more accessible. Microsoft will unearth new revenue streams, but they will simply be aiming to fill the voids widening elsewhere.

I can't offer three suggestions myself, but not because I'm stupid or cruel. I've thought this through for years, and I have yet to stumble on the scenario where Microsoft is more relevant in three to five years than it is today. Give it some thought, and you'll bang your head into the same dented walls that I once frequented.

My solution is to stay away -- just as Friar is advising her clients this morning.

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