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If I ran Nokia , I would probably do two things:
I would set upon transforming the company into a retail financial services powerhouse, focusing in particular on developing markets like India and Brazil; and
I would buy Skype .
I don’t have time to articulate the whole thesis here (and besides, if they want the whole thesis they can hire me!) There are some hints in my …
I’m going to keep this short, mainly because I’m not an expert by any stretch of the imagination. So discount this as a layman’s viewpoint as needed.
The most common, almost Pavlovian, stock response I hear from (both IT and senior management) financial services firms with respect to why they don’t see cloud computing as relevant to their high-level business strategy (ie ok around the edges but really just an IT cost/benefit thing..) is:
Of course you know, our business is different, it needs to be secure. The hardware needs to be sitting under my desk.
Ok, fine I made the last bit up, but you know they’re thinking as much. So without digressing into a debate as to just how secure most financial services IT is, the question I always respond with is this: does your organization know how to run a more secure data centre than Amazon or Google (or any other present or future specialist cloud infrastructure supplier)??? Really think about it. Do you make your own hardware? Perhaps you can make banking microchips better than Intel… (From Appirio’s CIO Guide to On-demand: )
On-premise does not equal secure: the biggest driver towards private clouds has been fear, uncertainty, and doubt about security. For many, it just feels more secure to have your data in a data center that you control. But is it? Unless your company spends more money and energy thinking about security than Amazon, Google, and Salesforce, the answer is probably “no.”
VPN-Cubed® is the first commercial solution that enables customer control in a cloud, across multiple clouds, and between private infrastructure and the clouds.
VPN-Cubed provides an overlay network that allows YOU control of addressing, topology, protocols, and encrypted communications for YOUR devices deployed to virtual infrastructure or cloud computing centers. When using public clouds your corporate assets are going into 3rd party controlled infrastructure. Enterprise checks and balances require you to exhibit control over your computing infrastructure. VPN-Cubed gives you flexibility with control in 3rd party environments.
The other myth to dispell is that no one is suggesting migrating any or all infrastructure to a cloud environment overnight, or even as soon as possible. The decision whether or not to move existing infrastructure to a cloud (private or public) and when is indeed probably more of a ‘routine’ (but big) question for IT (although management should be interested in the answer.) The point I’m trying to make, the point that is relevant for the executive committee is:
How does the nature of my business – what products and services I provide to my customers and how – potentially change because of this new technological substrate?
This is the question that should animate the weekend executive strategy retreat. In order to answer that question, you need to have some understanding of the technology but not how it works so much as what it can do. I don’t need to know how the microchip works in a digital camera to think about how I can use that camera. The question management should be brainstorming is:
If we were to start with a blank page, with the technology that exists today (and will likely exist in the next 5-10 years) how would you best build a company to serve our customers, present and future? What does FaaS (Finance as a Service) look like?
This isn’t going to happen overnight so the suggestion is not to ‘throw the cards up in the air’ and panic. And incumbents have many advantages on their side (customer inertia being the most valuable). But it will happen. And quickly in the geological timescale of large organizations so they need to start moving, start mapping out this future. And – here is a shameless plug for Nauiokas Park – one facet of that should be placing a lot of small bets on emerging, disruptive start-ups that have the luxury of moving more quickly, experimenting more radically, with faster evolutionary cycles. (Like a genomics company experimenting using fruit-flies and mice first to isolate winning adaptations.) While at the same time preparing their supertankers for a significant change in direction.
Maybe we should offer to moderate these strategic retreats. Do you think we would get any takers? If you work in a financial services company, ask your CEO and let us know.
Update:
If you are looking for a good (albeit long) explanation of what VPN-Cubed does and why it really is a “game-changer” read this post from Mark Masterson who sums it up as follows:
So, let’s sum up. Enterprise cloud computing is a type of cloud computing that is suited to the specific requirements of existing companies, and allows them to leverage resources in the Cloud to provide economical ways of adding capacity to their existing environments. First, their existing data centre (or some portion of it) is virtualised. Once this is accomplished, capacity from external cloud providers can be added (and dropped) dynamically, using technologies like VPN-Cubed, allowing enterprises to use the cloud to elastically (and transparently) scale out to the cloud. And because all network traffic is securely encrypted, enterprises can effectively make use of public, cloud infrastructure as if it was part of their internal datacentre — entirely behind the (virtual) firewall. Moreover, the same technology can be leveraged to allow the use of multiple, disparate cloud providers, effectively solving the ‘eggs in one basket’ problem. Different cloud providers can be leveraged to allow for failover redundancy, load balancing, even the leveraging of different providers on a dynamic basis, using metrics such as SLA compliance, or changes in cost. And an enterprise might want to do this not because it will reduce costs, or allow a switch from capital to operating expenditures (although both of those things might be true or not, depending on the context), but because it will increase their overall agility.
GigaOm writes today on the growing divide between the leading and lagging companies on the web:
The web is entering a period of intense creativity. Companies like Google and Apple are positioned to ride, if not generate, the momentum driving that creativity. The laggards are at risk of being stuck in perpetual catch-up mode. If that happens, the bluebirds will have flown for good — and the landscape of Internet companies will soon look dramatically different.
And yet this is nothing compared to the ‘creativity gulf’ that is emerging between leaders and laggards in other sectors of the economy, including in banking, insurance and finance generally. Only here, the leaders are still small and just starting to emerge. Further, GigaOm points out that even once this creativity divide is created and continues to grow, the deleterious effects of being on the wrong side of this divide can take many years to really start to bite:
Other Internet names seem mired even further in the past. Yahoo’s interest in a deal with Microsoft for “boatloads of money” is a headline that belongs in 2008. eBay keeps trying to recapture the magic it had five years ago. And MySpace is still trying to renew its lifeline to Google.
None of these laggards will see a quick end. They’ll be able to endure for years serving the people who haven’t taken to Facebook or maybe tried and then abandoned Twitter, people who are comfortable with a simpler, more familiar experience on the web. But it’s an ever-shrinking crowd. A decade ago, AOL chose a complacent path by maintaining its gated online community, shunning the migration of content and services to the web itself. And look where AOL is today.
Substitute ‘financial’ for ‘internet’ in the analysis above and the parallels are obvious. The big difference of course is that the analogs for Google, Facebook, Apple and Twitter in finance are not yet obvious and indeed probably don’t yet exist (or are at the very early stages of their development.) However, the environment supporting the emergence of new digital leaders in finance has never been more fertile. This is one of the main reasons I created Nauiokas Park with Amy: in order to discover, support and develop the next generation of leading companies delivering financial services and products from the right side of the digital divide. The next several years promise to be exceptional vintages in our opinion.
If I had a billion dollars. (If I had a billion dollars.)
Well I would buy you a Skype. (I would buy you a Skype.)
I would buy a Twitter for your Skype (so you could tweet and chat and call all your friends.)
The news has left many in the industry wondering if eBay will put Skype, which it paid a hefty $2.6 billion to buy in 2005, on the auction block. Donahoe had said last year that eBay would consider selling the business unit if it couldn’t be integrated with its auction or PayPal payment system.
And according to statements made during the conference call, it looks like Donahoe doesn’t think there is much the Skype technology can do to help eBay’s other businesses. When asked what eBay was doing to add shareholder value to Skype, Donahoe admitted that “the synergies between Skype and the other parts of our portfolio are minimal,” the paper said.
Well if it were up to me, I’d sell eBay – maybe Ken Lewis at BoA might be interested, would look innovative and might distract the federales from the Afghanistan that is the Merrill acquisition – and keep Skype. eBay could have been the Betfair of consumer goods, instead it became the Microsoft of marketplaces…
Anyhow, I’d buy Skype. Maybe not for $2 billion, but I think it is potentially a very valuable asset and I’m convinced that it is not even scratching the surface of its potential. The problem is that they seem to be trapped in linear thinking with respect to their business model. Selling minutes and add-value telco services. A telco. An alternative and innovative telco. But a telco. Nothing wrong (well you know what I mean…) with telcos but if you want to buy a telco, buy BT – its a lot cheaper. And its not just management (that can’t think out of the box) – it’s the press, analysts etc:
So an acquirer would likely be buying Skype for its 370 million registered users, which is nothing to sneeze at. But the big question is how much money can be made from these users? Sure, people love using Skype’s free services, but most of its revenue is made from a small portion of its users. Skype generates most of its revenue from its SkypeOut service, which charges users to make calls from the Skype service to regular landline phones and cell phones.
The SkypeOut revenue stream is sufficient to sustain Skype’s business model today, but as IP networks are deployed throughout the world and all communications becomes IP-enabled, there will be fewer opportunities to make money from connecting Skype calls to the regular phone network. What’s more, as Skype adds more subscribers, those users are more likely to talk to one another over the free Skype-to-Skype network rather than paying to call these friends and family on regular phones. Of course, it will likely take years for this scenario to play out, but this fact could color a potential acquirer’s willingness to pay a premium for the service.
“As more people adopt Skype, there’s potential for the asset to peak in value,” Friedland said. “It won’t likely happen for another five to eight years. And unless Skype comes up with a new meaningful revenue driver, it could start to decline.”
370 million registered users. Three hundred and freakin’ seventy million. And growing. Fast. And more people joining is a bad thing?!?
Let’s just pause here for a moment. So Mr. Friedland, if Skype ended up having say one or two billion – BILLION – registered users and so like became the de facto communications substrate for the vast majority of the connected citizens of the planet, that would be…ummmm…bad?
There are a hundred and one ways to bootstrap amazing, profitable, cash generative businesses off of Skype’s brilliant platform and installed base, and they are all in my new book: Managing Skype for Dummies. Actually, I didn’t write it. And it’s usual title is the Cluetrain Manifesto but still…
1. Markets are conversations.
I don’t know what Meg was thinking (those of you who listened to the eBay analyst webcast and pored over the accompanying presentation the day eBay announced it was buying Skype will surely remember that at the end of both you were even more confused than at the beginning…) But even if it was by accident, she was on to something (admittedly she did get a bit punchy with the pricing, although if she had paid in paper instead of cash…) It’s just that that something wasn’t being able to call EvilRabbit467 and haggle over the price of an iPod nano to ‘close the deal’…
Seriously if I was the captain of some vast private investment capital pool, I would be sitting around with my partners and a handful of clever young associates and putting together a plan for Skype. But if I were Donahoe, I’d spin Skype out to my shareholders as a separate listing, this would create value and possibly more importantly, especially in these interesting times, give Skype an explicit valuation and an acquisition currency. Then it gets interesting.
There is strong demand for technologies that do the same for less money, rather than more for the same price.
The focus of the article is on computing and software – obvious and direct beneficiaries of Moore’s Law:
The “good enough” approach also works with software. Supplying “software as a service”, via the web, as done by Salesforce.com, NetSuite and Google, among others, usually means sacrificing the bells and whistles that are offered by conventional software. Google Docs lacks the fancy features of Microsoft Word, for example. But hardly anyone uses all those features anyway, and Google Docs is free. Once again, many users are happy to eschew higher performance in order to save money.
But this is one of the key foundation pillars we look for in the business models of companies we look at in the financial services space as well; ie can you give the same (or better) service at a paradigm-shifting price point. A (successful) mainstream example of this would be ING Direct. However – even in a recession – price is rarely the only, sometimes not even the main driver in a purchase decision. This is especially true when it comes to (many) financial services; often the key driver is trust. And “trust” provided a significant barrier to entry, protecting incumbents irrespective of how anachronistic their business model may have been. How ironic then that it would seem that most large financial institutions played loose and fast with what ultimately was their one true differentiating asset, and largely trashed the trust they had built up (often over decades or even centuries) potentially opening the door for much better adapted new competitors to compete in their markets for their customers.
Yet again, Microsoft strikes buying a very interesting private company with excellent potential: Powerset, who describe the deal thus:
Powerset has always been a small company with big dreams, with the ultimate goal of changing the way humans interact with computers through language. We set out to improve search by indexing Web pages based on the meaning expressed in them rather than just the literal words. Powerset licensed breakthrough technology from PARC, hired world-renowned computational linguists and search engineers, and recently released a search and discovery experience for Wikipedia articles. Our technology helps to improve search results and also makes new features possible, such as Factz, which aggregates information from many articles to summarize a topic.
With any startup, the challenge is to take the seeds of an idea and grow it into a viable company. At Powerset, we transformed our idea into a world-class semantic search platform, demonstrating the future of search with our Wikipedia search experience. But building a large-scale semantic search engine is expensive, requiring an engineering effort and computing resources beyond what most start-ups could ever imagine. Because our goals around improving search align so well, Powerset has decided to team up with Microsoft. We believe that this is the fastest way to bring our technology to market at a large scale.
I have been following Powerset closely for approximately 15 months, ever since I first learned of the company and had I been up and running with my new venture at that time I certainly would have tried hard to learn more with the goal of becoming involved as an investor. Ex-colleagues can attest to my long-standing belief that search – and in particular semantic search – lay at the very heart of the core value proposition of a modern investment bank. Further, intelligent search is key to creating robust markets in just about anything. Indeed, a few years ago I tried to interest my former employers in doing what I thought was a very low risk and potentially highly valuable (strategically and financially) deal with Fast Search & Transfer (which btw was acquired for $1+ bn by Microsoft(!) in January.) Suffice to say that my views did not command a consensus amongst management at the time…
For me the value of intelligent search in financial services and markets is self-evident and so I’m not inclined to waste your time elaborating. With this in mind, despite having no ‘skin in the game’ I have to admit to feeling a certain disappointment upon hearing the news that Powerset was selling up to Microsoft. And given the valuation as guessed by TechCrunch, the investors certainly haven’t hit a home run (c. 2-3x would be my guess), so why did they do it?
The answer seems to be in a nutshell: the very significant capital costs of building the computing and storage infrastructure needed to scale up Powerset to the entire web. This certainly seems reasonable, and I get the impression that both sides are very keen to ‘over-communicate’ (see for example this great interview on TechCrunch) in order to counter the expected ‘default’ view that here is yet another great emerging company about to get swallowed then crushed by the Borg… I hope I’m wrong and “Powerset: A Microsoft Company” really does turn out to be a win-win. Still even if it does, I remained convinced that it will only be an exception that proves the rule.
The Economist framed it well in their recent article titled “After Bill”:
Mr Gates’s reply to Mr O’Reilly was not entirely reassuring. The firm, he said, now has dozens of “quests”—revolutionising television, automating data centres and creating software ten times faster. Perhaps this fragmentation of Microsoft’s ambition is only natural. In its 33 hectic years the company has swollen to nearly 90,000 employees (see charts); revenues this year should exceed $60 billion and net income reach almost $18 billion. Even Microsoft’s own senior executives struggle to grasp its growing empire. The firm now sells 75 different products, many of them in lots of versions.
I’m sorry but 90,000 employees? In a business that is wholly reliant on human creativity, initiative and in a market that demands resilience and near real-time reactions to a fast-changing environment? 90,000 employees? 75 different business lines? Too complex. Too much complexity.
In this, Citigroup and Microsoft are highly analogous: their core ‘innovation roll-up’ strategies should work a charm but in reality don’t seem to work at all. This comes down to the drag from increased complexity and bureaucracy, more than offsetting the gains from new and innovative technologies and business opportunities. Many companies fall into this trap. And yet the only time we see even the potential for breaking up these behemoths into more optimal pieces is either in situations of distress (and even rarely then) or through vigorous ‘activist’ outside shareholder pressure. It’s a mystery to me why more CEO’s don’t have ‘cell division’ on the top of their corporate agenda. Too much testosterone? (A derivative of the ‘power corrupts’ rule?) It mystifies me because if they did this, it would almost certainly bring them success and more importantly a giant ego boost: just imagine the powerful wave of growth and innovation that would be unleashed if these corporate giants divided into more manageable elements and released their excess capital in the bargain?
Scanning through my newsfeeds this morning, a couple seemingly unrelated posts on Google caught my eye. The first over at Silicon Alley Insider picked up on the recently published Fortune list of ‘Most Desirable MBA Employers’ highlighting the remarkable fact that almost a quarter of graduating MBA students say they want to work at Google. First red light flashing.
The second was a post over at Technosailor taking issue with Jeff Jarvis’ view that the current problems of Twitter could be solved were they to be acquired by YahooMicrosoft Google. Second red light flashing.
Call me a cynic, but my first reaction to the MBA poll is that it is a giant contrarian indicator – if MBA’s are dying to go work somewhere, you can bet you are at or close to a top. (At this point, I’d love to have a couple of eager analysts that I could send off to complile a regression analysis of Fortune’s MBA poll results vs stock market returns over the last 25 years or so. I don’t so I can’t but having read Fortune regularly for the last 15 years or so, my gut and addled memory tells me it is so. Any MBA’s out there want to dig up the data and prove me right or wrong? Perhaps I should try the Mechanical Turk, but can’t be bothered…)
I don’t know enough about the examples Technosailor gives, but assuming they are correct (they seem plausible given my limited knowledge), this is starting to sound an awful lot like traditional big company disease (of which Microsoft is just one of many examples across every industry.) Given Google’s enormous growth in every metric including importantly number of employees, one has to wonder if they – no matter how smart they are – can escape the laws of corporate physics.
I know it has been asked a million times before but is Google the next Microsoft? (At least from a financial point of view…) At the start of 1996, MSFT traded at c. $6/share. Four years later they peaked at almost $60/share. GOOG IPO’ed at c. $85/share in 2004, and just over three years later peaked at over $700/share. Both moves of approximately 10x. Since 2000, MSFT has been more or less range bound at around $30/share, despite continuing to grow it’s top and bottom lines and produce prodigious amounts of cash. I’m not suggesting history will repeat itself exactly – perhaps we have not yet seen the peak in GOOG’s share price (sell at $850?), and I’m certain they will continue to grow their top and bottom lines and produce prodigious amounts of cast in the next 5-10 years. But…will the stock eventually settle at around $500 – 600/share…? Is it conceivable that Google, like Microsoft before it, will become the place where good companies are bought only to disappear?
Acquisitions are hard. As Anand points out in the comments to my recent post on financial sector M&A, most companies are bad at it. The few exceptions to this are companies that make integrating acquisitions a (if not the) core competency of the company. And by the way, it’s even harder when you are talking about service companies and the only real assets are people and their work culture. I would guess that there is no way that a company as successful and fast growing as Google could have the corporate infrastructure, let alone the corporate DNA to effectively manage serial acquisitions of growth companies and their dynamic founders.
So what should they do? I don’t know. But I think the answer probably lies less down the path of making acquistions and more towards the idea of either returning more and more cash to shareholders (to squander as they like) or if they/shareholders are convinced that Google’s leaders have a competitive advantage in identifying new business opportunities, they should set up some sort of strategic fund structure to get the financial (and many of the strategic) benefits of being able to identify talented teams and promising businesses, without the pain of having to manage exponentially increasing corporate complexity.
They should think like some of the more enlightened oil-producing states (think Norway’s Oil Fund) – the gusher of cash they produce carries with it risks. If they don’t want their share price to stagnate going forward, it might come down to avoiding the corporate variant of Dutch Disease…
And to finish, a trip down memory lane: a Fortune article from July 2000. Try reading it replacing “Microsoft” with “Google” throughout. Spooky. The headline:
I Remember Microsoft: Once computing’s red-hot center, Microsoft now has a tough time retaining its best and brightest employees. Here, some who left reflect on what they learned–and why they find life on the outside so much more alluring.
I have to admit I am not exactly shocked that the Park Paradigm isn’t required reading in Redmond. In fact I’m not even sure it renders in IE. (Do you get fired – or worse – if caught using Firefox at Microsoft?) But obviously Steve B. and his non-exec boss Bill G. have either not read my back-of-the-envelope suggestion on what to do with the company, or have chosen to ignore it. Perhaps they had a look, called up a couple of their favorite bankers, and were put off by the fact they hung up when asked to price up a $100bn term acquisition facility… (Fair enough, December 2007 was always going to be a tough month to cobble this kind of deal together. )
So instead of making the company leaner, more focused, less complex, easier to manage and more appropriately capitalized, they decided to go a different way. More bloat, less focus, more complex, harder to manage and inefficiently capitalized. Hey why not? It’s a plan.
Since writing my suggestion in October, Microsoft has announced the acquisitions of Multimap, Fast Search and now Yahoo. The first two of these three fit the typical Redmond acquisition m.o. :
…Microsoft’s problem isn’t that they have bought bad companies with bad technologies at bad prices. Mostly just the opposite. There are a lot of very smart people at Microsoft, starting at the top. They have bought many really interesting companies with really neat technologies and incredibly smart people. And then they kill them. They don’t mean to. But it is unavoidable. The corporate antibodies in a giant like Microsoft inevitably end up overwhelming the acquisitions (which especially given that by the nature of the industry, most are very young and very fast growing, innovation-driven companies that have not had time to evolve any defenses against mature mega-corporation antibodies. Don’t feel bad Bill, it’s not a Microsoft thing, it’s a Fortune 100 thing. The nature of your business (technology) just exposes you more is all.
The Yahoo acquisition is a bit different, both in scale (ie needle moving, not just a couple weeks free cash flow) and in the sense that it is a mature, struggling big(gish) company (as opposed to a fast growing entrepreneurial start-up); in many respects similar to Microsoft (with the small difference of not having a Windows/Office cash cow equivalent puking money week in week out.)
So is the Yahoo deal fundamentally dumb? Not necessarily. Indeed it isn’t by any means a complete surprise given previous approaches and widespread speculation and commentary on the idea. (I admit to having traded small amounts of Yahoo from the long side over the past 9 months or so basically looking to bet on this deal. I am somewhat pissed off that I was not in the trade when it actually happened.) The logic in this merger is less typical Silicon Valley and more Rust Belt in the sense that it is two mature ex-growth companies with leading market positions looking to rationalize – combine cost centres, share customers, extract “synergies” of course – and to generally give management something to keep busy with for a few quarters so they don’t have time to worry about strategy. Clearly Microsoft and Yahoo have many complimentary, overlapping and duplicative products and technologies so the scope to do some worthwhile and value producing old fashioned consolidation and restructuring is definitely there. For instance, I suspect it would make a lot of sense to use Fast technology for all of their search products going forward.
So fine buy Yahoo. My previous advice stands. In fact it becomes even more pressing – more complexity to unwind, more assets to regroup intelligently and spin off before they are completely absorbed in the giant corporate goo. That said, the numbers won’t look as good (except to the lucky Yahoo shareholders who have been bailed out.) But hey that’s what happens when you pay $45bn for $700mn of earnings and crummy operating cash flow. Which is of course what happens when you have money burning a hole in your proverbial corporate pocket because of a ridiculously under-leveraged capital structure…
One of the reasons I think the Microsoft situation is so interesting is that it is a particularly good metaphor for the “paradox of growth” facing many (most? all?) giant mega-corporations, including – and perhaps more relevant to many of this blog’s readership – the world’s financial services giants (banks, insurance companies, securities firms, exchanges, etc….) Citigroup may be the current poster child for this but this should be cold comfort for many of their peers and competitors. The single-minded pursuit of growth eventually always runs up against the law of large numbers. I figure it boils down to two fundamental limiting factors – diminishing returns on scale and exponentially increasing management complexity.
The optimal size (past which these limiting factors start reducing value faster than growth adds value) will of course be different by industry and activity and even by firm, but will exist all the same. Once this point is reached, it behooves management – and I would say especially the non-executives who are by definition supposed to be able to see the forest for the trees – to react and adjust accordingly. This could be by divestitures, de-mergers, recapitalisations, etc. Unfortunately for many reasons, the management of public large-cap companies typically are geared only to “go forward” and this type of behavior is too often an anathema. Indeed some of the great successes of private equity have imo been due to their ability to manage without concern for growing any line except the return-on-capital-employed line, and so to dispassionately dismantle overly complex and wrong-sized companies.
So should I buy Microsoft shares? If there was a chance that Bill & Co. would implement some variation or other on my suggestion, I would say yes. If they continue with business as usual? No way. Probably a reasonable short. Maybe the right position is short the underlying share and long OTM calls? Is this the right position to have in [fill in favorite large financial institution here] as well?
Someone close to Bill Gates – someone he trusts, but also someone who can be objective (Warren???) – needs to have a heart to heart with him and make him see that his baby is grown up now. It’s time to let go. The alternative is to keep pissing money down rat holes: damned if you do, damned if you don’t.
I’ve been meaning to write this post for about a year now, just never had the time; I had planned to pull out the old spreadsheets and do some good old fashioned financial modeling (ie from the days I was an indentured analyst, not a coddled managing director) but I’ll probably never get around to that and yesterday’s announcement of Microsoft’s new investment in Facebook has prodded me to just get on with it (at the risk – please I encourage it – of some smart private equity number cruncher telling me my numbers are all wrong, and my trade doesn’t work.)
Now Facebook is an exciting opportunity, and I won’t pretend to know whether $15bn is too high (although I’m pretty sure it’s not a screaming bargain) but Microsoft’s problem isn’t that they have bought bad companies with bad technologies at bad prices. Mostly just the opposite. There are a lot of very smart people at Microsoft, starting at the top. They have bought many really interesting companies with really neat technologies and incredibly smart people. And then they kill them. They don’t mean to. But it is unavoidable. The corporate antibodies in a giant like Microsoft inevitably end up overwhelming the acquisitions (which especially given that by the nature of the industry, most are very young and very fast growing, innovation-driven companies that have not had time to evolve any defenses against mature mega-corporation antibodies. Don’t feel bad Bill, it’s not a Microsoft thing, it’s a Fortune 100 thing. The nature of your business (technology) just exposes you more is all.
Worse still – given that acquisitions are doomed to failure – is the glaring inability to (profitably) innovate in-house. Now to be fair, this again is not surprising. Microsoft is too big and worse – too rich – to have much chance of driving bottom-line boosting innovation from within. They face the traditional bugbear of big firms, which is no one ever got fired for not putting their neck out; no matter how smart and visionary the people at the top, the vast armies of the middle see (personal) risk, not opportunity, in change and innovation. And so (as rational economic beings) they resist. Usually passively, but given their sheer numbers, that is more than enough to suffocate even the most promising new products or services. Additionally, Microsoft has the problem of having too much money (burning a hole in their pockets…) and so even when they do come up with something interesting (say Xbox for example), they spend too much money and time building it which ultimately leads to financial failure accompanying these rare commercial successes.
So what should be done? This is after all a $300bn company with tens of thousands of employees and hundreds of millions of customers. In my opinion, it’s pretty obvious: you take it private and restructure the hell out of it, give it an appropriate capital structure and in so doing release significant amounts of human and financial capital to redeploy in creating and growing the next generation of innovative technology companies. Microsoft is a quintessential fifth paradigm company, founded at the dawn of the information and telecommunications revolution ushered in by the microchip. It’s time to take the enormous wealth created by Bill and his colleagues and turn it towards the opportunities that will arise out of the sixth paradigm.
The current market cap is just under $300bn, I figure you’d need to pay a 20% premium to get a deal which in any event would be less about price and more about convincing Bill it was the right thing to do. So that would mean $360bn (or just €250mn or £175bn…) Sounds like a lot – especially in these post-credit-bubble-bursting times. But forget for a moment about the headline number and look at the underlying numbers (any help from a good MSFT analyst in correcting / debugging these back-of-the-envelope thoughts is welcomed!) In 2007, Microsoft had revenues of $51bn and an EBITD of c. $20bn. They have c. $30bn of cash/investments on their balance sheet and generated c. $18bn of free operating cash flow, another $5bn from investments, and spent $24bn buying back stock. They spend around $7bn a year in R&D (not sure what their depreciation policy is on this.) These are big numbers. Now, most of the bottom line comes from Windows and Office. Split these off and run them like the cash cows that they are: cut R&D, cut operating expenses – good old fashioned private equity pruning. Microsoft has no debt. How dumb is that?!? Give Windows/Office an efficient capital structure: you can probably even securitize a lot of their blue chip corporate licence revenues. In any event, you should be able to finance at least 6x EBITD. I don’t have the divisional breakdowns (the Annual report download from Microsoft’s site doesn’t work! I’m not making this up…maybe it only works with IE?!) but I wouldn’t be surprised if the lion’s share of FCF comes from these products. I figure – post restructuring – you should be able to get at least $22bn out of these alone, and so probably justify an enterprise value of $250mn+, with $125-140bn of debt (which could easily be serviced with the cash generated.) All of Microsoft’s other businesses would need to be sold (either back to their founders, trade sales or IPOs) or shut down. So are they worth $100bn or so? I don’t know. However it seems entirely plausible. Especially, unshackled from Microsoft, they would have much more chance of being successful.
So who could buy it? Who has c. $70-100bn of equity capital available (and the credibility to get the debt financing and spin-offs underwritten?) Clearly there are the usual suspects – the giant private equity players: Blackstone, KKR, Goldman Sachs, Silver Lake, TPG, etc. and the enormous sovereign wealth funds. (You want China to get serious about protecting software licences – give them a stake in Windows/Office…) And what about Cascade (Bill’s private investment management firm)? They might be interested (both financially and emotionally) in recycling $10 or $20bn of the proceeds back into the deal. (Not to mention all the other MSFT billionaires.) Also you have to think alot of the big institutional holders of MSFT would much rather hold a lean and efficient Windows/Office company and so might well be interested in recycling their payouts into a sidecar or 144a structure to participate in the deal. And then of course there is Warren. A lean, run-for-cash Windows/Office is a company that would be right down Berkshire Hathaway’s alley, no? Basically – and even if my maths/numbers above are a bit shaky, my gut feeling is that it would stack up. It’s fundable. And the banks will fall over themselves to get it done. Think of the fees!!! (In this instance, the ‘absolute’ numbers matter more than the ratios!)
So coming back to the start, the key is convincing Bill it is in the best interests of the company, his foundation (he can really focus), the employees, and the economy. It’s a win/win/win/win so to speak. And instead of punting a quarter of a billion dollars on a tiny stake in Facebook – you engineer a more robust and interesting trade like having Facebook buy MS Live (with stock) as part of the buyout. I don’t know, but I’m sure there are smarter things to do with their cash than the corporate equivalent of chasing rainbows (which seems to be the governing framework of Microsoft’s acquisition policy.)
If somebody does want to take a run at this, I hope they’ll think of giving me a small finders fee, and get me on the tombstone for bringing the idea. I wouldn’t expect alot. One basis point would be just fine.
The two things (in finance) that interest me most are market structure and capital structure. To date, the discussion on the Park Paradigm has centred far far more around the former. I’ve been meaning for some time now to redress that balance but two (well three if you count procrastination) things have got in the way. Firstly I’m still not sure at exactly what assumed level of knowledge I should pitch the discussion; discussion of capital structure can be somewhat daunting for non-specialists. Not so much because it is intrinsically difficult to grasp but more just in terms of knowing the jargon and having spent the time to learn some basics in terms of the building blocks of finance and what makes up a balance sheet. Secondly because as an “approved person”, regulated by the FSA and working for a large financial institution, I need to be cautious about providing anything that might vaguely be perceived as “investment advice” even though this blog is clearly written in a personal capacity and does not reflect the views or opinions of the firm I work for and nothing I write should be construed as investment advice and these are just my personal opinions and ask your mom before doing anything anyways and I didn’t want to have to append a 3 page disclaimer to every post. Phew…
So to tackle the first issue, I’m going to assume a basic introductory university level knowledge of finance and perhaps lean on wikipedia a bit more than usual to link to definitions, so as not to turn this into a tutorial on basic finance. As for the second point I will emphasize that any reference I might make to specific companies or industries should not be regarded as anything other than personal opinion and that no one should infer any explicit or implicit advice is contained therein.
So disclaimers aside, what was the spark that got me (finally) to have a go? Microsoft. As you all know a company that has been – even more than usually – in the news recently. Specifically I’ll draw your attention to two items: their announced share buyback and an editorial by David Kirkpatrick on Microsoft’s new approach to competition and openess.
David opens with:
In the early years of the U.S. Justice Department’s antitrust assault on Microsoft in the 1990s, I occasionally opined that, for better or worse, Microsoft (Charts) was likely to end up as some sort of regulated utility. I saw Microsoft’s Windows as central to modern life, and believed that something so critical would inevitably come under governmental oversight.
Rob Cox of breakingviews.com sums up the logic behind the buyback thus:
Microsoft has shocked the market with its plans to buy back $20bn worth of its stock in a tender offer next month. The software giant has already returned $23bn to shareholders through dividends and stock buybacks over the past 12 months. And one can’t forget its $32bn special dividend two years ago. It’s pretty clear even the group itself now realises it is ex-growth.
I first started writing this post in July (!) , in the mean time John Plender actually wrote in the FT (with a different spin – ie private equity – but similar underlying logic imo) something similar to what I was going to write (apologies, stupid FT behind a firewall stuff):
Private equity folk could do wonders with Microsoft By John Plender
Published: August 17 2006 18:54 | Last updated: August 17 2006 18:54
As leveraged buy-outs go, the recently announced $33bn deal to buy HCA, the US hospitals group, is rated the biggest ever. Now, NTL, the heavily indebted European cable group, looks set to go the same way for an eye-popping $20bn. With private equity investors gobbling up bigger and bigger chunks of the corporate world, fuddy-duddies worry that quoted equity will shortly become extinct. The usual party-poopers see a bubble and warn that hubris will soon lead to nemesis. For them, over-ambitious private equity folk deserve their status, shared with hedge funds, as the new bogeymen of the western world.
Anyhow… where was I? What these various commentators are getting at is the following: Microsoft’s capital structure is completely innappropriate for it’s underlying business. It still has the balance sheet (ok slightly less with the buybacks and dividend but still…) of a risky fast growing knowledge-based services company: ie large (enormous) cash balances and equity-only financing. Against this however is a mature and robust (granular and stochastic) business throwing off gigantic and regular cashflows. Corporate finance 101 question: ‘How should such a company be financed?’ Answer: With debt! Now whether that is via on balance sheet leverage (a la Plender’s private equity LBO) or off-balance sheet (securitised – a la bank securitizing the regular cashflows of mortgage or credit card repayments) is a second order question.
Indeed this is the case for any ‘utility’-like business. The problem is I think that there seems to be an irrational aversion to being labelled as a utility…mature. It’s as if the business establishment only values growth companies (and their management.) Obviously this is changing and is (part of) the giant opportunity that folks like KKR and Blackstone and the other giants of private equity discovered and have been feasting on for the past 20 years to the benefit of their investors and the economy alike. But the importance of getting this right goes beyond – in some industries – just having the optimal and most efficient (thus profitable) capital structure. It can fundamentally alter the competitive behavior, for better or worse, of companies.
Indeed I was prodded into finishing this post by reading Gordon’s post on the behavior of US telcos. Here is an example of an industry who’s capital structure is driving nonsensical (at an economy-wide level) behavior. As network providers, even better – regulated – network providers, they should be funded by debt. Indeed, the core infrastructure should be securitized and spun out of the vertically integrated groups. As Gordon points out their rabidly defensive and rent-seeking behavior is a natural if cynical reponse to their business environment and – I would add – their capital structure. With all that equity sloshing around on their balance sheets needing to be fed, they have to extract monopoly type rents via rationing. There is no way to isolate the true cost of the infrastructure from the rest of the balance sheet. The optimal solution is to have a separate network company funded by debt with open-access and – where natural monopolies exist – a regulator to set prices (based on ensuring a decent economic return and continuing investment and innovation.) If that sounds complicated, the UK has been quite successful in implementing this kind of model, for instance in water services. So the question is, when is Guy Hands going to bid for at&t and break it up?
(Comments and criticism welcome, but can I just say up front that I acknowledge my analysis – as presented in this short blog post – is oversimplified and incomplete; basically I ask you to indulge the somewhat shoddy exposition and attack (or endorse) the fundamental idea, for which in contrast I have complete confidence and stand behind fully.)
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