At a minimum, I appreciate Microsoft's (Nasdaq: MSFT) honesty. Last week, CEO Steve Ballmer told reporters the company has no intention of changing its policy on expensing stock options, though he disagrees that doing so would have disastrous consequences for entrepreneurial enterprises in America.
Just so we're clear, let me repeat this. Microsoft thinks doomsday scenarios painted by tech industry mouthpieces on stock options expensing are silly. I'm with 'em so far. They also say Microsoft, being what it is, ought to show leadership among its peers. Yep, I completely agree. But because many of its peers are afraid of the effects of stock option accounting, Microsoft won't rock the boat? That's not leadership. At best, it's leadership from the school of "I'm in charge here... which way did they go?"
Microsoft's right about a few things. The company does need to show leadership. Sometimes, leaders must do what they believe to be right and moral, albeit unpleasant or unpopular. Sometimes, leaders must make a few enemies for the long-term benefit of the group. Funny, I've never thought of Microsoft as a company fearful of making enemies. Leadership with its root in making people happy is not leadership at all.
Due to Microsoft's position in the fight to keep options from being expensed, the Rule Maker Portfolio will exit its position in the stock in the next five days.
A fond farewell, but farewell nonetheless
Now, I'm not saying Microsoft is the root of all evil. Some may think so, but I don't. I'm quite fond of the company. I think it's got wonderful prospects. Web-based service framework .NET is far ahead of its competitors, not to mention Microsoft's continued dominance over computer operating platforms. And I'd put a "strong buy" on the prospect of increased whining from competitors about Microsoft's dominance of yet another operating system category.
And certainly, one can look at the past performance of Microsoft's stock and say that if shareowners have been harmed by Microsoft's financial decisions, the vast majority of them have yet to notice. Even with the stock down two-thirds from its peak, the returns enjoyed by long-term Microsoft shareowners are extraordinary. Sublime. Staggering. I don't know if it's true anymore, but at one time, Microsoft stock was one of the top five millionaire-makers in the United States. If you want to talk about companies that have created net positives in the U.S., I'd put Microsoft near the top of the list.
But it's easy to be sanguine about poor decisions when everything else is going well. Let's not forget that one can't eat "historic returns" unless one actually benefited from that history. Future returns are a very different thing and companies I own must offer informative disclosures; avoid expensive buybacks; treat shareholders as proportionate business owners; refrain from expanding in the name of anything but extending long-term shareholder value; and be faithful to accounting rules. Anything less, and I feel like I'm trading away the confidence of a good decision in place of the hope of a good outcome.
We've known for years that Microsoft was a serial user of various accounting tricks to "groom" earnings, including delaying revenues for use in later quarters. It agreed to stop this practice in a settlement with the Securities and Exchange Commission in May. However, this doesn't excuse using such practices in the first place, as they distort shareowners' views of the company.
When times are great, sandbagging doesn't particularly hurt. Under Jack Welch, General Electric (NYSE: GE) perfected it with massive discretion that came along with its operations and GE Capital. But shareowners don't deserve dolled-up investor reports. They deserve faithful reporting of a company's quarterly and annual results. Bending generally accepted accounting principles (GAAP) to meet your needs doesn't sit well with me.
Speaking of appearances, Microsoft's capital deployment policies are abominable. The company annually buys back stock to cover up the dilution stock options grants would create. In 1999, Microsoft spent $2.9 billion in stock buybacks; in 2000, $4.9 billion; and last year, a whopping $6.1 billion, all of which intended to hide the dilution from stock option grants.
Now, if Microsoft's management were convinced the company's stock was underpriced, this would be a pretty good use of capital. Stock buybacks at $40, when management computes it to be worth $50, is a good thing. But in late '99, Steve Ballmer caused furor when he stated that the overvaluation of tech stocks was "absurd," adding, "and I'd put my company's stock in that category." Again, love the honesty.
Within 24 months of that comment, Microsoft spent nearly $9 billion of its existing shareholders' money to buy back that very same, absurdly overpriced stock. That's a miserable use of capital. It shows a contemptuous lack of concern toward minority-shareholder interests. This at a time when it had $24 billion in liquid assets (and has yet to pay out a dividend to existing shareholders). It has never been the hallmark of good management to hoard cash, unless it's for something really important. Buying back admittedly overpriced stock to hide options dilution doesn't qualify, in my opinion.
Interestingly enough, even after those stock buybacks, Microsoft's share count rose from 5 billion to 5.3 billion in the last two years. By using any form of standard valuation measure, such as P/E, one could claim the company has been overvalued from the day it went public. But such measures are just that: measurements, or functions of value. P/E is not, was not, and never will be a determinant of value. There has never been, and may never be again, a better (legal) value creator than Microsoft during its first two decades of existence.
Why sell now? Why unload when Microsoft is at its lows? That's a great question. In the Rule Maker's last review of Microsoft more than a year ago, we said it did a good job of identifying new growth markets as its core business matured. From these efforts sprang Xbox, .NET, and other initiatives.
But past success doesn't guarantee future results, and Microsoft's future performance is not assured, as the company moves outside of its core competency. Over perhaps any other company, I'd be willing to take the risk with Microsoft. But I have to expect compensation for taking that risk, and more importantly, that management will make the necessary effort to treat my investment decision with the gravity it deserves.
Perhaps I'm punishing the company for the much more egregious sins of those it could influence, those who pay executives in the millions with options, only to threaten to remove broad-based grants if they are forced to expense. Microsoft had the opportunity to show true leadership, and it declined. Therefore, so do I. Sayonara, Gates.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
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Bill Mann finds it wonderful that -- even if just for a while -- nine coal miners from southwestern Pennsylvania are among the most treasured people in the country. He does not hold beneficial interest in any company mentioned in this article -- but check for yourself. Please consult The Motley Fool's disclosure policy.
The Rule Maker completed its announced transactions, selling 182 shares of Cisco at $12.81 per share, buying 20 shares of Johnson & Johnson at $49.10, and buying 41 shares of Costco at $35.89.
The Rule Maker closed on July 29 with a cash value of $26,852.34, down 15.25% since the beginning of the year. This compares to a loss of 32.1% for the Nasdaq Composite, 21.7% for the S&P 500, and a loss of 13.7% for the Dow Jones Industrial Average. Its internal rate of return (IRR) since its launch in 1998 has been -9.8% annually.
