Microsoft & Standard Oil
by Tom Gardner
ALEXANDRIA, VA (Oct. 1, 1998) -- A few weeks back I promised to review some thoughts about Microsoft, about monopolies, and about whether investors can expect long-term reward from such companies. Over the past few years, arguments have broken out across the technology industry about Microsoft (Nasdaq: MSFT). Does its dominant position in providing the PC operating system give it an unfair advantage in the sale of the high-margin applications that neatly integrate back into that operating system? The debate has spread into the halls of justice this past year as Janet Reno and the Justice Department have carried out a grueling search for more information about Microsoft's business practices.
Unfortunately, I can offer few guarantees about the future direction of the DOJ's case, a subject that falls far outside of my tiny circle of expertise. The only thing I can offer with any certainty is that interaction with the Justice Department will be a permanent feature of Microsoft's development over the next decade. Beyond that, numerics do suggest to me that over the next ten to fifteen years, Microsoft will have to be heavily regulated or broken out into smaller entities -- in much the same way that Standard Oil was back in 1911. The mathematics of its growth rate, even as it necessarily slows, indicate to me that, over the next decade, Microsoft will occupy a position that destroys the economics of competition. The DOJ and anti-trust law won't permit it.
But is that such a bad thing for investors? Let's look to history.
First of all, in very general terms, Microsoft is blessed with a number of the same qualities as Standard Oil: 1) extraordinary demand for its products; 2) a product that fuels a new economic age; 3) spectacularly high profit margins; and 4) superior and far-sighted financial management. In these ways, Microsoft is much more analogous to Standard Oil than to IBM. The oil and software titans were committed to a narrow focus on being a high-profit monopoly rather than on the sort of market-control monopoly (with vertical integration through all product lines) that IBM sought.
Both Rockefeller and Gates wanted to deliver fuel for the machines that would take the world into its next stage of development. An eye for mathematics and a flair for commercial competition, not technical expertise, drove both men toward these ends. Rockefeller was not an expert in oil refining. In 1863, at the age of twenty-four, he was prodded into an investment in oil and pressed forward with a lot of skepticism. Gates has never been considered a master software programmer and, along the way, he's been credited with dramatically underrating the need for computing memory and, more recently, overlooking the importance of the Internet.
No, both men proved to be enterprising mathematicians. They found a cookie jar of profit, spent the early parts of their career expanding it by putting their "fuel" into every machine, then dedicated the next stage of their careers to defending their profit jar. They followed that along with endless negotiation with the trustbusters, then -- in Rockefeller's case -- spent the remaining stage engaged in philanthropic endeavor. The commercial pictures of these two so resemble one another, the basic mathematics of their games are so similar, that my petty, Foolish speculation that the two companies will meet similar ends isn't farfetched.
What does it mean for investors?
For investors, the end of Standard Oil just meant a new beginning. Broken out into 34 separate companies, the Standard Oil machine kept churning out extraordinary investment returns for decades, right up until today. Exxon, Mobil, Chevron, Arco, Amoco, and Pennzoil -- these are all children of Standard Oil. Because the business model was light, because the product could be delivered into a wide range of machines, and because the financial managers were committed to a rigorously honest depiction of their progress, Standard Oil as a whole and in parts survived as a market-beating entity for a century.
I believe Microsoft will prove much the same.
It's only fair that I be forced to share a few simple numerics to support this claim. Here are a few simple equations that I use to track the level of control that a company has in its markets. I encourage you to add or subtract from these elements as you draw up your own approach. For the first four, I compare one company to its lead competition -- defined as the leading competitor to its core business. This can be a difficult task, as large businesses can grow diverse. But you can always compare them individually to the top three threats in their market.
Here are the five expectations that I set for companies ascending toward a monopoly:
1. Gross margins 5 percentage points ahead of its lead competitor.
Companies that have a significant gross-margin advantage are able to knock back their competition, virtually at will. Examples are Intel undermining Advanced Micro Devices on pricing at every turn or Coca-Cola converting Pepsi's bottlers. The manufacturing efficiencies and pricing authority that light-product monopolies carry with them gives them an extraordinary advantage.
2. Net margins 5 percentage points ahead of its lead competitor.
Down on the bottom line, a 5 percentage-point lead for a business translates into a whole lot more cash flowing into its coffers than toward its competitors. Our entire Cash-King portfolio is built upon the notion that we should not underestimate the value of cash, the oxygen of the public business. Apparently, others have agreed. In his excellent recent book on Rockefeller's life, Ron Chernow writes:
"It is impossible to comprehend Rockefeller's breathtaking ascent without realizing that he always moved into battle backed by abundant cash. Whether riding out downturns or coasting on booms, he kept plentiful reserves and won many bidding contests simple because his war chest was deeper."
Poker players also know that among four perfectly equal competitors, the one that starts with the most cash will always win.
3. A Flow Ratio under 0.75.
The three key variables in the Flow Ratio -- inventories, accounts receivable, and accounts payable -- are critical drivers to market dominance. The company that gets greedy for sales and sloppy with its inventories is in trouble. The company that gets greedy for rich valuation and excuses rising levels of receivables is in trouble. The company that is forced to pay down its payables instantly is in a weakened position in its industry.
Invert all three, and you have a business that is more methodical than maniacal, concerned more with creating enduring value than immediate valuation, and one that can play more offense than defense.
4. Namebrand victory through convenience.
The final two characteristics rely on your ability to make judgment calls. The first is an inclusion of some assessment of the company's brand. What I look for is the brand that stands for the greatest convenience in its industry. History shows that in virtually every industry, there is almost no way to underrate the value of being the leader in convenience for customers. Whether it's buying mid-level shelf space in a supermarket, or placing the gas station closer to the exit ramp, or delivering books right to the doorstep, or selling coffee on the corner, or pre-loading software on a computer -- convenience for the customer is crucial to long-term success.
In measuring monopoly status, I try to determine if a given company provides the most accessible products or services in its industry.
5. Ongoing lawsuits from competitors.
A curious one, yep. But you won't find many ascending monopolies that aren't being sued by their lead competitor or an assemblage of their competitors.
As I add to this list, I will certainly include cash reserves relative to the competition as well as expectations for sales growth rates relative to those who covet the crown. These first handful of measurements, though, provide some clues to how powerful a business is in its industry, whether it is sustaining that authority, and what we might expect from it as investors in the years ahead. If you run these numbers on Microsoft, for instance, you'll wonder why Netscape ever sold a browser. It was like fighting the dragon with a wooden sword or playing the San Francisco 49ers when suited up in a Washington Redskins uniform.
Tomorrow, I'll switch gears and write a short report on a baseball pitcher who, I think, taught us a lot about how to invest, and more about the game of life. Until then, Fool on!
Day Month Year History C-K (4.40%) (4.40%) 0.98% 0.98% S&P 500 (3.01%) (3.01%) (1.95%) (1.95%) Nasdaq (4.81%) (4.81%) (3.24%) (3.24%) Cash-King Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 104.06 32.96% 2/3/98 22 Pfizer 82.30 99.38 20.75% 8/21/98 22 Schering-P 95.99 100.63 4.83% 6/23/98 34.5 Cisco Syst 57.56 57.25 -0.55% 2/13/98 22 Intel 84.67 83.44 -1.46% 5/1/98 37 Gap Inc. 51.09 48.19 -5.68% 2/27/98 27 Coca-Cola 69.11 56.25 -18.60% 2/6/98 56 T. Rowe Pr 33.67 27.31 -18.89% 5/26/98 18 AmExpress 104.07 73.50 -29.37% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 63.15 74.75 18.37% 3/12/98 20 Exxon 64.34 71.04 10.42% 3/12/98 15 Chevron 83.34 84.00 0.79% 3/12/98 17 General Mo 72.41 53.88 -25.59% Cash-King Stocks Rec'd # Security In At Value Change 2/3/98 24 Microsoft 1878.45 2497.50 $619.05 2/3/98 22 Pfizer 1810.58 2186.25 $375.67 8/21/98 22 Schering-P 2111.7 2213.75 $102.05 6/23/98 34.5 Cisco Syst 1985.95 1975.13 -$10.83 2/13/98 22 Intel 1862.83 1835.63 -$27.20 5/1/98 37 Gap Inc. 1890.33 1782.94 -$107.39 2/27/98 27 Coca-Cola 1865.89 1518.75 -$347.14 2/6/98 56 T. Rowe Pr 1885.70 1529.50 -$356.20 5/26/98 18 AmExpress 1873.20 1323.00 -$550.20 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 1262.95 1495.00 $232.05 3/12/98 20 Exxon 1286.70 1420.78 $134.08 3/12/98 15 Chevron 1250.14 1260.00 $9.86 3/12/98 17 General Mo 1230.89 915.88 -$315.02 CASH $48.07 TOTAL $22002.16 *Please note: On 8/4/98 $2,000 cash was added to the