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Why Microsoft Will Never Be Great Again

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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 (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.

Has Microsoft peaked or is the best yet to come? Share your tips in the comment box below.

Google and Microsoft are Motley Fool Inside Value selections. and Google are Motley Fool Rule Breakers picks. Apple is a Motley Fool Stock Advisor recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Apple, Google, Microsoft, and Oracle. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Longtime Fool contributor Rick Munarriz remembers having a picture dictionary as a child. He outgrew it. He does not own shares in any of the stocks in this story. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (15)

Comments from our Foolish Readers

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  • Report this Comment On October 04, 2010, at 2:44 PM, PhoolishPhilip wrote:

    "The shares are essentially where they were -- favorably adjusted for dividends -- five and ten 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."

    Revenues in 2000 = $23 billion

    Revenues in 2005 = $39.8 billion

    Revenues in 2010 = $62.5 billion

    Earnings in 2000 = $9.4 billion

    Earnings in 2005 = $12.7 billion

    Earnings in 2010 = $18.8 billion

    Share count in 2000 = 10.2 billion

    Share count in 2005 = 10.7 billion

    Share count in 2010 = 8.7 billion

    EPS in 2000 = $0.85

    EPS in 2005 = $1.16

    EPS in 2010 = $2.10

    So in 2005 you could have bought all of MSFT for $268 billion @ $25/sh. They had $34 billion in cash and securities at the time, so the net cost would have been $234 billion. Since then they have payed out $20 billion in dividends and bought back $65 billion in stock (after accounting for options) for a total of $85 billion returned to investors. A private buyer of MSFT in 2005 would have recouped over a third of their invested capital in five years and would be pocketing $18-20 billion in fcf per year for the forseeable future.

    So, we have a company that is returning capital to shareholders while growing both top and bottom line in the face of its ever imminant collapse. A collapse that has been predicted in each and every of the past ten years, never mind the fact that they have grown revenues and earnings by 272% and 199% respectively over that time period.

    Yeah, only an idiot would buy MSFT at a current fcf yield on EV of 12% in the face of such horrific facts.

  • Report this Comment On October 04, 2010, at 3:26 PM, hudsondusters wrote:

    Phoolishphilip is spot on.

  • Report this Comment On October 04, 2010, at 4:33 PM, financeguy85 wrote:

    Well done PhoolishPhillip. A site that supposedly touts sophisticated authors should understand the difference between a company's success and its stock price. Yes, MSFT's stock hasn't gone anywhere in the last 12 years. But that has nothing, I repeat, nothing to do with the success or failure of Microsoft the company. Quite the contrary--Microsoft has grown earnings by roughly 10 percent annually over that period. The fact that shares dropped was because of the insane valuations seen during the tech boom of the late 90's, and that wasn't Microsoft's fault, that was the market's fault.

  • Report this Comment On October 04, 2010, at 6:35 PM, Borbality wrote:

    2 hours later there's an MF story titled "MSFT is a buy at current levels."

    This site always has content saying what a great stock MSFT is. It might not be the future and it might not lead software or hardware innovation anymore but it seems hard to doubt their profitability.

  • Report this Comment On October 04, 2010, at 6:57 PM, TheDumbMoney wrote:

    Borbality, important to remember the Fool is essentially a bunch of freelancers, as far as I can work out. Or at least it's totally agnostic and inconsistent as to viewpoint. So it's not surprising this article would appear with one saying MSFT is a buy. Phoolish, I've said similar things on other posts, and based on your comments above I'll be following you from now on. It's not that I'm ga-ga for MSFT, it's just that the company is NOT on death's door. It is growing and thriving. There is a difference between being sexy and being a media darling and making money. As hard as it may be to believe in our media-obsessed world, the amount of 'buzz' about a company does not always equal a company's true worth. Doing a simplified (and therefore not totally inaccurate) DCF, assuming a discount rate of 12%, the market is pricing MSFT to grow a little over 5% annually for ten years, and 1% thereafter in perpetuity. MSFT has, for perspective, growth earnings (not cash flow) at 9.45% annually for the last ten years. Do the math.

  • Report this Comment On October 06, 2010, at 12:09 AM, ilovesumm wrote:

    MSFT is living on yesterday in a industry that is today and tomorrow. Since windows XP there has not been any significant change to windows, minor tweaking and functions don't count. Remember Vista?

    Windows 7 is ok but are there lineups to get it?

    Once the antitrust lawsuits started flying MSFT stopped flying.

    Why does Bill Gates spend more time away from MSFT then with? He knows their days are dwindling.

    Who and what have they been leaders of in the last 10 years?

    Why does Apple have a larger market cap?

    Steve Jobs , although somewhat old is still very innovative, Steve Balmer and Bill Gates aren't.

    All the buzz is about Apple not Microsoft.

    How long can they continue to be second, third or worse place for innovation?

    They continue to have so so products not smash hits anymore.

  • Report this Comment On October 06, 2010, at 12:37 AM, lctycoon wrote:

    ilovesumm, Windows 7 has sold 175 million copies since its release in March and still has millions of eager buyers.

    APPL will not be big in the enterprise market. MSFT still has that market locked in and APPL will not be embraced by CIOs until they get rid of their closed infrastructure which they won't do. They don't need to, either.

    Hype doesn't matter - take a look at the numbers. MSFT may not be in the news 24/7, but they are a buy at this level.

  • Report this Comment On February 05, 2013, at 7:42 AM, barackBIGNUTS wrote:

    What has happened to the Motley Fool? I just clicked a link called "the steve jobs betrayal" and was subjected to a rambling spiel about how you can make money by investing in a secret company....whose name I'm not going to tell you unless you listen to some more rambling in a video that doesn't even tell you how long it is

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