Microsoft Questionably Entering Digital Music Biz

Microsoft (MSFT) bulls hoping that Windows Vista and a splash into the digital music industry with "Zune" branded mp3 players and music downloads will boost the company's fortunes are set up for disappointment. Does anyone really think consumer electronic buffs are going to get excited to replace their iPod with a Zune player? Having a closed system architecture will make it even harder for Microsoft to take meaningful market share. And why are Ballmer and Co. targeting the overcrowded, low-margin digital download business?

The bigger potential boon to Microsoft's financial results in 2007 relates to an upgrade cycle centered around Windows Vista. I can't get too excited about the prospects for Vista either. I don't know anyone who is running Windows XP today thinking "Man, I sure wish Microsoft would upgrade their operating system." There just is no reason for most people to go out and buy a new system or even upgrade an existing one to Vista. All of our favorite computer tasks (email, web surfing, document management, digital music and photos, etc) work just fine on XP.

Microsoft stock is not expensive, and you will get some dividend payments here and there, but significant capital appreciation is pretty much unlikely. The company reminds me a lot of IBM, a tech giant that has been dead money for a long time, with no resurgence on the horizon.

Revisiting the Google/Yahoo Paired Trade

I've been experimenting with more and more paired trades in my personal accounts lately as the market overall hasn't looked all that enticing to me over the last year or two. Yesterday I decided to take a position in the Google/Yahoo! trade that I have mentioned before on this blog.

At 42 times 2006 estimates, simply going long Google (GOOG) no longer has the risk-reward scenario that intrigues me. That said, Yahoo! (YHOO) stock at 62 times this year's estimates looks even less compelling. There is little doubt that Google has been taking some market share from Yahoo! and many of the company's recent quarterly reports have been lackluster as a result.

I decided to implement the long Google/short Yahoo! paired trade (at $403 and $32 per share, respectively) prior to both companies reporting their numbers this week (Google is due to release results on Thursday). YHOO's second quarter reported last night looks unimpressive once again, but assuming that Google's results will be equally as bad might very well be an overreaction.

I would expect that the P/E ratios of the two Internet search giants will eventually converge, which would yield a solid return from this trade. As always, opinions are welcome.

Post-IPO, Investment Banks Bash Vonage

"Many investors forget that most IPOs utterly fail to live up to their promise after they are issued. A study by Tim Loughran and Jay Ritter followed every operating company (almost 5,000) that went public between 1970 and 1990. Those who bought at the market price on the first day of trading and held the stock for 5 years reaped an average annual return of 11 percent. Those who invested in companies of the same size on the same days that the IPOs were purchased gave investors a 14 percent annual return. And these data do not include the IPO price collapse in 2001."

[Source: "Stocks for the Long Run," Jeremy Siegel, 2002]

The fact is often ignored, but IPOs are bad investments on the whole. The real money is made only on the hottest deals, but only an investment bank's best clients get shares at the offering price for those stocks. With hype and exposure at a peak, the sellers can usually succeed in getting top dollar, leaving individual investors set up for below-average returns.

Vonage (VG) is one recent example. The underwriters valued the firm at $17 per share when the company went public. Now only weeks later, the same banks' analysts have initiated coverage of the stock with neutral ratings and price targets between $9 and $11 per share. Aside from some bad publicity, nothing about the business has changed.

The Vonage example just goes to show you that, like most things where money is involved, people selling you something have inherent conflicts of interest. They are trying to maximize their cut. The only way to ensure you get a good price is to do your homework. I'd guess that at least 90% of the people who bought the Vonage IPO at $17 did no valuation analysis whatsoever.

Those that did were correct in avoiding the deal, as the current $7 share price shows. If the stock was really worth far more than $17, don't you think they would have sold it for more than that? Retail investors need to be careful with IPOs, as history is not on their side.

Is an IPO in MySpace's Future?

I was shocked to hear that MySpace.com was the most visited U.S. web site last week. I am well aware of the site's popularity (and even have an account on the site), but still, finishing ahead of Yahoo! Mail and Google Search is pretty darn impressive. It appears that News Corporation (NWS-A) got the deal of the year when it purchased MySpace for $580 million in 2005.Should investors go out and buy News Corp stock at $19 per share? Maybe. The only problem with that idea is that NWS has a market cap of $60 billion, so MySpace still is only a small fraction of its business. How much is MySpace worth? I really don't know, but it would not shock me in the least if it could get a $5-$10 billion market value on the public market.

If I were running News Corp, I would probably strongly consider spinning it out in an IPO to monetize the asset and boost shareholder value, especially since the site is really coming into its own right now. Will an IPO happen? I haven't heard anyone mention the idea yet, but would not be surprised if we do soon. Meanwhile, kudos to Rupert Murdoch for such a great move.

Market Curbs Enthusiasm for AMD

On March 8th I wrote that the disparity between Advanced Micro Devices (AMD) and Intel (INTC) shares (AMD significantly outperforming) is not a new phenomenon, but rarely prolongs for any meaningful amount of time. Oftentimes AMD gets a lead only to see Intel close the gap, usually via massive price cutting. Below is the historical chart I provided, comparing the two computer chip makers.

The majority of feedback I got from that post was from technically-focused investors who were bullish on AMD based on their superior technology. Given I don't have a computer background, I was basing my opinions on historical evidence, as well as valuation metrics, not product specifications. Over the last four months, the trade I recommended (short AMD, long Intel to play a closing of the gap) has proved very profitable. Intel has dropped less than 10% while AMD is down more than 40%, as this chart shows.

I would be tempted to close out the trade here. Once again steep price cuts from Intel are hurting AMD, as their profit warning late last week indicated. After a huge move in a short amount of time, booking the profit and moving on seems prudent. If the AMD bulls out there are right, and the company will continue to gain market share from Intel, perhaps AMD stock in the low $20's is a good buy, as it's much cheaper now than it was in the 40's earlier this year. I, however, think that call is much tougher than the paired arbitrage trade, so I am going to move to the sidelines.

Best Buy Test Marketing Macs Should Boost Apple

Electronics retailer Best Buy (BBY) announced yesterday that they have begun test marketing Macintosh computers in some of its stores. A potential distribution deal with one of the largest retailers of computers, combined with new software that can run Windows, sure bodes well for Apple's Mac division. You have to like the odds that people buy Macs over Gateways at retail.

Investors seem to be focusing on iPod sales right now, as the stock is down significantly to $57 and change. While not inexpensive, shares of AAPL seem to have more room to run than most tech stocks.

An iPod from Microsoft?

Evidently Microsoft (MSFT) is developing a digital music device and download service to compete with the iPod and iTunes from Apple (AAPL). Headlines like these show that Microsoft is feeling the heat and believes it must reinvent itself. I would agree completely with that assessment, but I also disagree with their apparent strategy.

Merely copying successful products that have already attracted scores of competition is not going to reinvigorate growth at Microsoft. They need to play offense, and by that I mean, develop new technologies and products. They should aim to be first to market, and force others to play defense by copying them.

Adding another video game system to the market is not very innovative. Adding another mp3 player to the market is not innovative. Ditto for a music download service. The companies that are taking aim at them today aren't doing so by copying. They are doing so by innovating. Google changed the online advertising market, has the best product out there, and now dominates.

Google's beta of a new, free, online spreadsheet program isn't merely an imitation of Excel. You can see where Google is going with this. Low end computers nowadays can cost as little as $300 with a monitor included. However, if you want to put a copy of Microsoft Office on your new home machine in order to do work on weekends, the software package could easily double your system's cost to $600.

Large corporations have big pockets, so they will likely continue to equip all new systems with the full version of Office. Consumers though, hate paying hundreds of dollars for software that is oftentimes essential to do anything productive on their computer. Microsoft may have a monopoly on desktop software, but their dominance has nowhere to go but down the drain as other companies innovate. An online spreadsheet program complete with free storage space on Google's own servers could ultimately dent Microsoft's Office business, though it will take time.

Selling video game consoles and imitation iPods might make up for some of the business Microsoft will undoubtedly lose to companies such as Google, but the margins will be so much lower that it will never completely make up for it. Right now Microsoft gets nearly all of their operating income from Windows and Office. Those businesses are under attack, but do you really think the way to reinvent the largest software company on the planet is to go after the iPod?

Note to Microsoft: Fire Steve Ballmer

It made perfect sense for Bill Gates to be replaced as CEO of Microsoft (MSFT), and renamed Chief Software Architect. Gates is a technology guy, not a traditional business executive. When you surpass General Electric (GE) as the most valuable U.S. company, as Microsoft did back in the technology stock hey day, you should have people focusing on their core competencies. For Gates, that was software.

In stepped Steve Ballmer to take over as CEO. How is he doing? Horribly, if you ask me. Now I don't own Microsoft stock (thank goodness), but if I did I would be infuriated. The shares have done nothing in 8 years. They trade in the low 20's, same level they were in 1998. Any investor will tell you that shareholders can share in the success of a public company in two ways, through share price appreciation, or through the return of capital.

For some reason, however, Ballmer does not particularly like either one of these forms of building shareholder wealth. Microsoft has nearly $35 billion in the bank and another $10 billion or so in investments just sitting on their balance sheet collecting dust. It's like he doesn't care about the shareholders one bit, despite the fact that they own the company and he works for them.

And that is why I think he should be fired. That doesn't mean he needs to leave Redmond entirely. Rather, orchestrate a similar migration to the one Gates embarked on several years ago. Ballmer's core competency clearly isn't working for the shareholders as CEO, so he should be working for someone else, his successor.

Not only has Ballmer been completely unfriendly to shareholders since he took over, he doesn't seem to care that they are upset with Microsoft's huge cash balance. When asked about the issue Ballmer told investors and analysts "It is likely I will continue to have to discuss with you for many years why we have as much cash as we do."

That quote says two things. One, we will continue to treat shareholders like crap. And two, he obviously thinks that it is a chore to "have to" have these discussions, proof that has no idea who he is working for or what his objectives should be.

Ballmer will likely try to make the case that they need all of that cash to invest heavily in R&D. Anyone who has paid attention to Microsoft in recent years knows that they are not doing much innovating at all compared with their competitors. The majority of their income still comes from Windows and Office. Their other ventures, like XBox for example, are losing money.

Most of what is going on in Redmond seems to lack strategic sense. Why are they in the video game business anyway? Why do they own billions in Comcast stock? Why do they have a bank account with $35 billion in it? It's no wonder Microsoft stock has done nothing for 8 years. If shareholders ever want to make decent money on their MSFT stock, they are going to have to fire Steve Ballmer.

Another Twist to the Failed Vonage Deal

Now we are hearing that Vonage customers who took the company up on its offer of IPO shares at $17 each are planning on backing out and not paying after the stock cratered upon issuance. Vonage's response? They'll reimburse their underwriters for any shares not paid for by their customers. Wait, what?

I don't care how desperate you are to keep your customers happy. If they refuse to pay for their stock, you go after them. Now I have not seen the agreement that went along with the IPO offer. I am simply assuming that they had to sign something that bound them to purchase shares. If there is indeed some sort of contract, how can you simply say, "you know what, you were stupid for thinking $17 was a fair price for our stock, so don't worry about paying us."

When are individuals going to take responsibility for their actions? Rather than pay consequences for bad decisions (like paying $17 for Vonage), Americans now blame others first, opt for lawsuits, or in this case they simply try and stop payments on their checks. I don't know what's worse, Vonage pricing their IPO so ridiculously high, or allowing (and supporting) their customers to act in such an irresponsible way. Either way, I wonder if there are any shares out there to short yet.

Broad Appeal for Broadcom

It's tough to find good, cheap technology stocks these days. I've been underweight the sector for many months due to a lack of good ideas. However, the recent market decline has given the Nasdaq a 9% haircut over the last few weeks.

Earlier this week I saw Broadcom (BRCM) cross my screen at $33 per share. That quote surprised me a bit. Broadcom is a very good chip company but its stock usually reflects that. Growth investors have traditionally been perfectly willing to fork over 30 times earnings for the stock. That's fine, but rarely will I pay up that much for something. In fact, I don't think I've ever owned Broadcom.

My instincts told me that BRCM hadn't traded at $33 for a while, which is why the price alone got my attention even though the stock is not really on my radar screen, so I took a closer look. It last closed there during the first week of the year, so it's been more than 5 months.

Looking at current estimates ($1.47 in EPS for 2006 and $1.66 for 2007) along with the company's pristine balance sheet ($4 per share in cash and no debt), Broadcom trades at an enterprise value to earnings ratio of only 20x for 2006. That seems very reasonable for a 15% long term grower that serves some of the best markets within technology.

I still think the market as a whole goes lower, and tech will get whacked more as well. That said, Broadcom at $33 looks like an opportunity that I'll strongly consider despite a market that has not yet gotten the 10% correction that I'm looking for.

And just in case readers might think I purposely failed to mention the options backdating issue (Broadcom's name has been mentioned as being "at risk"), that is not so. I plan on talking about the issue more broadly (no pun intended), so look for that sometime next week.