<THE CASH-KING PORTFOLIO>
Austin, TX (Nov. 17, 1998) -- In Friday's article, Cash-King manager Al Levit suggested that this portfolio should buy more Microsoft when we add new money to our account in February. Even though I expect to be out-voted three to one again, I'm going to spend this week telling everyone why I don't think investing in Microsoft is the most attractive option. I'll start by talking about some of Microsoft's internal problems with its business model and its products. Brace yourself. I know that my fellow managers will disagree with much of what I have to say... but the Internet is all about the First Amendment. So...
Let's begin with what I consider to be the obvious: Microsoft has saturated its market, without having developed what we covet as investors: the repeat-purchase business model. A single copy of their software continues to function indefinitely (barring design flaws), meaning that Microsoft's new-customer growth is linked tightly to the growth rate of the overall computing industry. In my opinion, sales to their new customers won't be enough to maintain Microsoft's current rates of revenue, let alone grow them fast enough to justify this stock price.
Given that, Microsoft has to convince existing customers to regularly purchase additional software. That's their public-market challenge. In order to do so, the Redmond giant must now develop new software that's a significant improvement over what it has already sold its customers. Unfortunately, software development is NOT one of Microsoft's strengths. And lately, PC users -- like you, if you're not a Microsoft shareholder -- have begun to grumble about the upgrade cycle in the computing industry. Another $2,000 for a new computer next year just to run the next heavy iteration of Microsoft-ware? At some point, this model hits consumers in the nose, and they begin to resist low-grade upgrades.
An oft-heard complaint about Microsoft is that their new releases are perpetually late, but far worse than this is that they are getting progressively less meaningful. Three years after Windows95, Microsoft's most recent operating-system release (Windows 98) was widely acknowledged as a fairly pointless incremental upgrade, almost all of which could be downloaded for free from Microsoft's Web site and applied to Windows 95. Even today, the major computer manufacturers still offer Windows 95, due to customer demand. The first set of bug-fixes to Windows 98 (excuse me, a "Multimedia Upgrade") shipped less than a month after the product was released.
If that seems a common complaint by yours truly, consider that the quality of Microsoft's "finished" products has never been very good. A recent White House research report (U.S. Technology Lead Is At Risk) concluded that the "once robust technological edge that the United States has enjoyed over the rest of the world is actually built on an increasingly fragile technological substructure," leading to a "software gap." The Navy recently ran into this problem when it used Windows NT in an experimental program to automate ships like the USS Yorktown to require fewer sailors. When NT blue-screened, the ship was dead in the water for hours before being towed home.
In fact, serious bugs in Microsoft software are becoming so common that news organizations often report them (CNN: Summer spawns cloud of Microsoft bugs). The fact that the "Blue Screen Of Death" or the "Three Finger Salute" or the "Vulcan Neck Pinch" (terms for hitting Ctrl-Alt-Delete) are common enough to have nicknames is probably a bad sign. The difficulty for Microsoft is that it's now just too big to rein in the little slips and fumbles that are part of the development process of every software product. Size, you see, is not limiting their financial power today; it is beginning to seriously restrain the company's productivity edge.
Part of the reason for the slipping schedules and unstable releases is the increasing size of Microsoft's products, trapped now in what was a wonderful intermediate-term business model: Upgrading. Here are some numbers: NT 3.51 consisted of 5 million lines of source code. NT 4.0 had 8 million lines. NT 4.0 with Microsoft's "IIS" web server has 12 million. The first beta of NT 5.0 (now Windows 2000) has 27 million lines; the second beta has an estimated 32 million lines. And the final ship version could well be over 35 million lines. That's 7 times the size of NT 3.51.
And that requires a whole lot more computing speed that individuals and corporations may be willing to pay up for. The increased size of Microsoft's new products doesn't just make them harder to develop and debug. The end products are significantly larger. They require more memory and hard-drive space, and run more slowly as the CPU is forced to churn through more instructions to accomplish a task that hasn't conceptually changed since the Windows 3.1 days. Just as when measuring out the metal used in the construction of an automobile, more is not better. It reduces the efficiency of the finished product in many different ways. This is why the free email website Hotmail is still running under Unix servers over a year after Microsoft purchased the company, because (despite repeated efforts) Hotmail has been unable to get NT servers to handle the load.
Microsoft's biggest problem in all this is its lack of innovation. Without a repeat purchase business model, and with a tendency for each new release of a Microsoft product to be bigger, slower, more resource-hungry, and just as unstable as previous releases, Microsoft's new software must provide users SOMETHING that their current version doesn't. Unless something in their model changes, I don't think it will. Innovation will either be Microsoft's rebirth or it's methodical undoing.
When you consider that the company's only truly original product was something called "Microsoft BOB," a cartoonish user interface launched about the same time as Windows 95, you start getting worried. It was such an embarrassing fiasco that Microsoft is trying hard to pretend it never happened. And the "next great advance" that Microsoft is touting, voice recognition, was shipped by IBM as part of OS/2 4.0 in 1996. This is not innovation at its finest.
Microsoft has, in my opinion, never innovated. It bought DOS and had IBM to help develop it until around 1990. It licensed the Windows interface from Apple. NT was based on IBM's OS/2 source code and later ported to a microkernel architecture. Microsoft missed the Internet completely, touting its proprietary Microsoft Network instead, which (as Al noted Friday) has now been re-launched for the fourth time. Microsoft lacks innovation. It has great business minds, is extremely competitive, and perseveres with the best. But I believe the future in a world of open technology relies on innovation -- and to date, Microsoft can't innovate.
As the company ports from a methodical upgrade cycle that has consumers paying too much for their applications too often, Microsoft now has to put together packages that persuade us to buy more computing power. It has to be more than just an ATM machine for its shareholders. Now that the world is scrutinizing it, now that technology has gone mainstream, Microsoft will have to create and provide estimable value for end users.
I believe that Microsoft's lack of innovation will force it into a greater reliance on partnerships, into working with rather than taking from other software companies. Tomorrow, I'll be talking about Microsoft's problems playing well with others.
- Rob Landley (Oak)
P.S. Have you read the 11 Steps to Cash King Investing? You should. It takes a half hour and explains the Foolish approach in detail: Cash-King Portfolio's 11 Steps.
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Day Month Year History C-K +0.79% 5.75% 17.55% 17.55% S&P: +0.30% 3.70% 13.25% 13.25% NASDAQ: +0.90% 6.05% 12.73% 12.73% Cash-King Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 111.88 42.94% 5/1/98 37 Gap Inc. 51.09 68.00 33.10% 2/3/98 22 Pfizer 82.30 109.50 33.05% 2/13/98 22 Intel 84.67 108.50 28.14% 6/23/98 34 Cisco Syst 58.41 68.75 17.70% 8/21/98 22 Schering-P 95.99 102.00 6.27% 2/6/98 56 T. Rowe Pr 33.67 34.63 2.83% 2/27/98 27 Coca-Cola 69.11 70.19 1.56% 5/26/98 18 AmExpress 104.07 99.38 -4.51% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 63.15 75.25 19.17% 3/12/98 20 Exxon 64.34 70.56 9.68% 3/12/98 17 General Mo 72.41 73.13 0.99% 3/12/98 15 Chevron 83.34 80.75 -3.11% Cash-King Stocks Rec'd # Security In At Value Change 2/3/98 24 Microsoft 1878.45 2685.00 $806.55 5/1/98 37 Gap Inc. 1890.33 2516.00 $625.67 2/3/98 22 Pfizer 1810.58 2409.00 $598.42 2/13/98 22 Intel 1862.83 2387.00 $524.17 6/23/98 34 Cisco Syst 1985.95 2337.50 $351.55 8/21/98 22 Schering-P 2111.7 2244.00 $132.30 2/6/98 56 T. Rowe Pr 1885.70 1939.00 $53.30 2/27/98 27 Coca-Cola 1865.89 1895.06 $29.17 5/26/98 18 AmExpress 1873.20 1788.75 -$84.45 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 1262.95 1505.00 $242.05 3/12/98 20 Exxon 1286.70 1411.25 $124.55 3/12/98 17 General Mo 1230.89 1243.13 $12.23 3/12/98 15 Chevron 1250.14 1211.25 -$38.89 CASH $120.62 TOTAL $25692.56 *Please note: On 8/4/98 $2,000 cash was added to the
</THE CASH-KING PORTFOLIO>