Recent activity surrounding Microsoft (Nasdaq: MSFT) makes it seem increasingly possible that it will be split up into several operating businesses by the Justice Department. There have been hundreds of opinions and blatherings as to whether this is justified, so I'm purposely not going to add to this argument. But some of the more interesting utterances have been from shareholders and pundits who believe that either a) Microsoft actually wants to be broken up (the Brer Rabbit solution), or b) that the enormous appreciation of AT&T (NYSE: T) and its spin-offs following its forced divestiture shows that Microsoft will be better off in the long run.

I wrote a comprehensive look at the valuation of AT&T and its hatchlings last October (linked at bottom), in which I calculated that 100 shares of AT&T bought in 1984 (purchase price $6500) were worth just over $70,000 by the end of 1999. Read this, and look at the roster of companies that have been created from Ma Bell, and you get an idea of why some people are actually pretty excited to have Microsoft thrown in the proverbial briar patch of a breakup.

This train of thought is very, very wrong.

The circumstances of AT&T's break up were entirely different from those surrounding a potential breakup of Microsoft. So while there may be some values that could be unlocked by breaking up Microsoft, AT&T in 1984 was a beast that was begging for a diet.

Prior to its break up, AT&T was not a virtual monopoly. Rather, it was a company that had been granted monopoly power by the government in most parts of the country. As a regulated monopoly, AT&T had some restrictions as well as some advantages. For example, AT&T had a margin built into its regulated long distance rates. This meant that AT&T totted up its cost of service and capital expenditures, submitted them to the FCC and state regulators, and had its approved rates for interstate and intrastate long distance assigned to it.

This meant two things: 1) AT&T had every incentive to "gold plate" its network, as it could be assured of recouping whatever capital expenses it incurred; and 2) it had very little reason to innovate. This is because if an R&D expenditure paid off, AT&T would still be assured the same margin of return, but if it failed and had to be written down, the regulators were in no way required to allow AT&T to pass these expenses through to customers.

Anyone who is old enough to remember what phone service was like before 1984 will know exactly what I mean. Phone service changed hardly at all between the 1950s and 1980, as the only innovations were ones adding efficiency to the network itself. Remember those big ugly telephones that we rented from AT&T? There was a reason that they were completely indestructible -- because AT&T could pass the production cost for each of them on to consumers. It is thought that the only thing that would survive a nuclear war would be cockroaches, but I contend that the cockroaches would have had an awfully nice phone system left behind, courtesy of AT&T.

Think again to the rates you paid for long distance in the 1970s. Five cents a minute across the country? Fat chance, a rate five times that high would have been low enough to bring a tear to many a consumer's eye. Why? Because AT&T had no incentive whatsoever to be efficient.

It was only after the break up of AT&T, the deregulation of long distance, and the allowance for local telephone providers to charge for auxiliary services that true innovation began in telecommunications. Deregulation caused AT&T and the Baby Bells to work to bring prices down, to provide value-added services, essentially to look at users as "customers" rather than "rate base."

Throw in the efficiency created by the spin-off of Lucent (NYSE: LU) in the mid-'90s -- allowing AT&T to buy equipment from whomever it wanted, and for Lucent to sell to whomever it wanted -- and you have the formula in a growth business to create huge chunks of value.

Microsoft has none of these advantages, which has a great deal to do with the fact that it is already extremely lean. Microsoft, for any other perceived sins it has, does not overcharge its customers for the right to use Windows, which costs consumers in the range of $65 per unit pre-installed. It does not have a government-regulated price structure, nor does it have inefficiencies created by government mandating of its pricing structure. In other words, Microsoft is currently succeeding where AT&T had failed -- it provides a reasonably priced product that had been developed in an environment that is already entrepreneurial in nature, even if the practitioners seem to have taken their guidance more from Sun Tzu or Nicollo Machiavelli than Sam Walton.

The massive amounts of shareholder value created since the breakup of AT&T have by and large come about due to market limitations and disincentives for innovation being stripped away, to be replaced with competition and rapid evolution in the market. Software? Well, call that market and Microsoft's effect on it what you will, but it is already as competitive and innovative an industry as exists.

And since there is no government-mandated tariff for purchase or usage of Windows, there has been no resultant fat built into Microsoft's operations. AT&T and its babies blossomed in value when the government got its nose out of telecommunications. What we have in software at this point is quite the opposite. In fact, the government is more involved now than it has been at any point before. In other words, the efficiencies available to AT&T by virtue of the change in rules are simply not going to be available to Microsoft should it be split up.

Steve Ballmer knows this, so does Bill Gates, and so do the people at Justice and all of Microsoft's competitors. A break up of Microsoft would not be accompanied by a sea change of regulatory philosophy. As a result, neither Microsoft nor its competitors will have a new environment in which they can streamline themselves to compete in the same way that AT&T, MCI (Nasdaq: WCOM) and Sprint (NYSE: FON) had in '84.

This is why the thought that Ballmer is secretly salivating at the prospect of the government forcing him to break his company up into several hyper-competitive units is simply ludicrous. Ballmer knows that Microsoft will gain nothing from being broken up, and so that is one briar patch he does not want to be tossed into. For where Brer Rabbit saw home, Ballmer sees only a big thorny problem.

On a final note, we want to clarify from last night's report that the Rule Maker Portfolio will indeed be purchasing an additional $500 worth of Yahoo! (Nasdaq: YHOO) shares in the next five trading days. No trade was made today in light of the fact that we didn't state our intention outright last night. We apologize for any miscommunication on our part.
Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Related Links:

  • AT&T's Offspring: A Motley Fool Special Report, 10/19/99