Longtime Fools won't be surprised that I have a few comments on Judge Thomas Penfield Jackson's now-official ruling to break up Microsoft (Nasdaq: MSFT). More on that ahead. But before galloping down that rabbit trail, here's an update (plus an extra surprise) on where we stand so far in our polls to identify our candidates for the next $2000 Rule Maker investment. (And remember, the polls don't close until noon ET Friday, so there's still time to vote. Also, you can click on the "vote" links below in order to view the most up-to-date tabulations.)
- Networking -- Vote
- Cisco Systems (Nasdaq: CSCO) --> Leader (72%)
- Lucent Technologies (NYSE: LU)
- Nortel Networks (NYSE: NT)
- Internet Media -- Vote
- Pharmaceuticals -- Vote
- Computer Hardware -- Vote
- Diversified Media -- Vote
- Walt Disney Co. (NYSE: DIS) --> Leader (60%)
- News Corp. (NYSE: NWS)
- The New York Times Co. (NYSE: NYT)
In case you missed yesterday's report, here's a quick summary of what's happening. In July, we'll begin a four-week Rule Maker Seminar, at the end of which the attendees will vote upon and choose our next investment. But the process begins right now in your choosing of our company focus group. That brings us to the surprise I alluded to earlier. You asked for it, so here 'tis. We're expanding our candidate list from five to six slots. Please submit your vote for a software candidate to be included in our seminar focus group:
- Software -- Vote
If you're interested in signing up or learning more about our upcoming seminar, the Rule Maker Seminar page has all the details.
Another announcement that Matt forgot to include in yesterday's report is that we've updated the Rule Maker Ranker spreadsheet. New features include:
- Works on any version of Excel.
- Calculates the Cash King Margin as a data point, but scoring remains unchanged.
- Scoring criteria are in a more print-friendly format.
See our Rule Maker Spreadsheets page for free download information.
All right, let's finally get to the meat of tonight's report. As you know, the judge's ruling is official now: Break Microsoft in two. One part has the Windows monopoly, the other gets everything else. The Web browser Microsoft refused to uninstall at the start of the trial goes in the "everything else" category. What a surprise.
If the Supreme Court agrees to hear the case next, it could be argued as early as the end of this year, with a verdict rendered sometime next year. In the meantime, Microsoft's abuse of monopoly status is a fact of law, and until it is not just appealed but successfully appealed and overturned, it may be treated as fact in other courts. Over a hundred miscellaneous civil lawsuits against Microsoft have already been filed awaiting this verdict, with more coming out of the woodwork every day. And all because Microsoft was too arrogant to provide an uninstall option for its Web browser a year ago.
I could say bad things about Microsoft for days without repeating myself, and if you're curious what I have to say on that subject go read the Dueling Fools I did with Matt recently. Instead, I'm going to talk about why I wouldn't be at all surprised to see the stock go up in the short-term. There are two reasons, and both have to do with why the stock went down in the first place.
First, the stock declined because of uncertainty about its future. Now that the other shoe has dropped, the company's future is more predictable. The farther into the future investors can reliably project, the more future earnings they can include in calculations like discounted cash flow analysis. Because of this, even bad news can come as a relief when it reveals more of the future of the company. Stability and certainty command a premium, which is one reason shares of our stable, predictable Rule Makers are so expensive.
Secondly -- and more importantly, in my opinion -- Microsoft's share buyback program will be allowed to resume next month. Microsoft has been forbidden to repurchase its shares since January shortly before the stock started its 50% drop, for reasons detailed in this excellent New York Times article (free registration required): For Now, Microsoft Can't Save Itself. (Do note that this article has a mistake in the time at which Microsoft will be allowed to begin repurchasing its own shares again -- the date is July, not June.)
For years, Microsoft has vacuumed up billions of dollars worth of loose Microsoft stock from the market. Then in January, Microsoft purchased another software company called Visio for $1.5 billion and pooled the other company's financial statements with its own. This at least partially compensated for the slowing revenue growth Microsoft's investors were complaining about at the time (or at least the pooling of financial statements disguised it a bit), but the pooling also triggered SEC accounting regulations prohibiting Microsoft from buying back its own stock for six months after the acquisition.
Since Microsoft's option program not only causes billions of dollars worth of dilution per year, but also virtually forces about a third of the freshly issued stock to be sold on the open market immediately (to cover the income taxes the employees have to pay on the stock they receive), employees exercising options can cause a serious downward drag on the company's stock price in the absence of a stock buyback program.
The "float" is important here, rather than the total shares outstanding. If a billion shares are locked up in accounts around the world, but only a million offers to buy exist out in the market against two million offers to sell, the price goes down with only 3% of the shares in play. Large price swings on low volume are what Microsoft has experienced over the past six months, and the trend has been consistently downward to the point where the going price for Microsoft shares dropped by half even though most of the shares out there haven't changed hands since January. That's the market for you.
Interestingly, the taxes Microsoft's employees pay get refunded into Microsoft's own coffers as a "Stock Option Income Tax Benefit," recorded in the financing section of the cash flow statement. This may be a contributing factor to Microsoft's decision to double its outstanding employee option grants to make up for the stock price decline. If Microsoft can't generate enough taxable income for its employees, the federal government might wind up keeping some of the corporate income tax money Microsoft pays instead of refunding it.
Then again, Microsoft truly appears to be having employee retention problems, as evidenced by Bill Gates' appearance before Congress earlier this week lobbying for more of the H1-B visas that allow high-tech workers into the U.S., and events like Microsoft Chief Technology Officer Nathan Myrvhold's announcement that he will not be returning to Microsoft.
The long term is what counts to an investor rather than a trader, and in the long term, I'm still not a fan of Microsoft. Although I've said in the past that breaking up the company would be as good a thing for Microsoft shareholders as was the breakup of AT&T (NYSE: T) or Standard Oil for their shareholders, a breakup into only two pieces is not the kind of bureacracy-busting, fat-trimming, sink-or-swim revitalization I had in mind.
Microsoft still has no friends in the industry, as evidenced by the fact that the DOJ witnesses at the antitrust trial included executives from Intel (Nasdaq: INTC), IBM (NYSE: IBM), Compaq (NYSE: CPQ), Oracle (Nasdaq: ORCL), America Online (NYSE: AOL), Sun Microsystems (Nasdaq: SUNW), Intuit (Nasdaq: INTU), Apple (Nasdaq: AAPL), Gateway (NYSE: GTW). The DOJ even snuck in videotape from an executive at Boeing (NYSE: BA); they had testimony coming out of their ears! But Microsoft couldn't even come up with 12 friends to call as witnesses; it had to call itself to the witness stand NINE TIMES. That's just sad.
Intel and AMD (NYSE: AMD) are both pumping out chips as fast as they can but have a backlog of orders. They literally can't manufacture hardware fast enough to meet demand. While Microsoft is warning investors of slowing growth, PC manufacturers like Dell (Nasdaq: DELL) are experiencing record quarters. Where's the disconnect here? Perhaps it's the fact that study after study shows Linux shipments literally doubling each year, or perhaps it's the profusion of 'Net access devices like the Palm Pilot or the new partnership between AOL, Gateway, and Transmeta. "Microsoft-free" is virtually a marketing phrase for an increasingly large segment of the market. Talk about negative brand equity.
I realize I stand alone on this issue among the Rule Maker Portfolio managers. They tend to see the situation more along the lines presented in Tuesday's Post of the Day. Nevertheless, my convictions on the subject are pretty firm. In my opinion, the inevitable shift toward commodity software is well underway and accelerating. The antitrust trial merely provides an opportunity for a gentler transition to a future where software is as much a commodity as the PC hardware it runs on. Such a transition must force Microsoft's current monopoly position to go the way of the proprietary hardware monopolies that the PC undermined 20 years ago.
Whether Microsoft will go the way of Digital Equipment Corporation or will reinvent itself like IBM did remains to be seen.
For more on the Microsoft judgment, check out this week's Foolish Special.