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SEATTLE (Reuters) - Every July, Microsoft Corp invites a sizable Wall Street crowd to its leafy, low-rise campus outside Seattle. Chief Executive Steve Ballmer and his top managers take a half-day to explain where the world's biggest software company is going, to a generally friendly audience.
This year things didn't go quite according to plan.
Ballmer, CEO since 2000, talked excitedly of Windows 7, its new Bing search engine, new Phone software and the Xbox game system. But he was skimpy with details of how Microsoft would counter Apple's hugely popular iPad, a question that has been vexing investors.
At the end of the presentations, Sarah Friar, the influential Goldman Sachs analyst and a long-term bull on Microsoft's stock, seemed unconvinced. She wanted Ballmer to take another stab at explaining the iPad counter-attack. "It feels like right now you are not completely clear," said Friar. "I just want to give you another chance to give a succinct ... response."
Always an energetic presence on stage, Ballmer raised his voice even louder than usual, and with a resounding slap of his hands, repeated his main points methodically. Slates and tablet computers are coming soon. They will have Intel chips. They will run Windows. "We're going to sell like crazy. We're going to market like crazy," he boomed.
Three months later, Microsoft and its hardware partners have unveiled only one Windows tablet, which does not seem to be an iPad contender, much less a killer, as Apple's nifty gadget heads toward 8 million sales, eating away at the lower end of Microsoft's core PC market.
Partly because of this, Microsoft's stock has drifted lower, and is now down 16 percent for the year, despite a surge in tech stocks that has pushed the Nasdaq up 10 percent in the same time. The shares remain resolutely stuck at the same level as 2002.
At the beginning of October, Goldman's Friar threw in the towel, pitching Microsoft out of her bank's Americas Buy List and downgrading it to "neutral" -- Wall Street's euphemism for "dead money." One of her complaints was the lack of a "coherent consumer strategy," the very thing which Microsoft and Ballmer took such pains to lay out at the July meeting.
The downgrade by Goldman, the company that led its initial public offering in 1986, was an unexpected knock for Microsoft, which has no shortage of cheerleaders on Wall Street, given the potential fees it represents for mergers and corporate bond issues.
Coming only four months after Apple surpassed Microsoft in market value -- until recently an unthinkable event -- the downgrade brought into focus questions about Microsoft that are increasingly being asked by customers, investors and even some employees. Why hasn't the stock moved in eight years, despite more than doubling profit and sales in that time? Is Microsoft really at the forefront of technology? Why can't it invent popular gadgets like Google or Apple? Is Ballmer still the right person to lead the firm?
From the other side, Wall Street may have missed a subtle answer from Ballmer. The company is not Apple and can't promise stellar growth or a rocketing share price any more. It is learning how to be a mature, fiscally responsible company that will return as much as it can to shareholders in other ways.
In this fashion, Microsoft may point the way for rising companies like Google, which one day will also face the issue of how to keep growth going beyond its initial success.
On paper, Microsoft is still a strong and growing company. It notched record sales of $62.5 billion last fiscal year, up 7 percent from the year before, and its highest ever net profit of $18.8 billion. The 70 percent operating profit margin on its core Windows business is the envy of companies the world over.
The new Windows 7 operating system is a hit -- selling 240 million licenses in the first year and erasing most of the stink of Vista -- and looks set to continue Microsoft's 90 percent-plus hold on the operating system market. Its new Office suite of applications -- containing Outlook e-mail, Excel spreadsheets and PowerPoint presentation programs -- will likely remain the gold standard in the workplace.
Those two units underpin Microsoft's steady success, accounting for about 60 percent of sales and the vast majority of operating profit in the last fiscal year.
On top of that, its server and tools business, which sells the software and services that run companies' computing systems, is now a giant in its own right, although the profit margins are about half of those in the Windows unit.
With more than $36 billion in cash and short-term investments on its balance sheet, it is one of the handful of U.S. companies to hold AAA credit ratings. Bond buyers have faith in the company's long-term success, recently buying its 30-year debt at the lowest interest rates on record, according to Thomson Reuters data going back to 1970.
And yet, its shares remain tethered to the $25 mark, which they have revolved around for at least eight years. If you reinvested dividends over that time, you would actually have lost money, according to Goldman Sachs. By contrast, Apple shares have grown 25-fold in the same time.
As Microsoft's earnings rise but its shares don't, the ratio between the stock's price and expected earnings has shrunk to around 10 times. That is well below the software industry average of 16 times and Microsoft's 10-year median of about 19 times, according to StarMine data.
For some, that's a signal to buy. The current share price is "insanely cheap for a company of this caliber and market position," says renowned value investor Whitney Tilson, managing partner at T2 Partners LLC and the Tilson Mutual Funds, a holder and recent buyer of Microsoft shares.
In the second quarter, top hedge fund managers like Dinakar Singh at TPG Axon and David Einhorn at Greenlight Capital also scooped up Microsoft shares, according to Thomson Reuters data.
"The stock price is not necessarily an accurate barometer of the business," said Dan Hanson, a portfolio manager at BlackRock, which is one of the biggest investors in Microsoft, through various active and index funds, owning about 3.3 percent of the company. "They (Microsoft) have not gotten everything right, but the stock is priced that they are getting everything wrong."
"The underlying business has been performing extremely well," said Hanson. "That's a disconnect, and a real opportunity in the stock today."
The problem is partly perception, suggests Patrick Becker Jr. at Becker Capital Management, a value-oriented fund manager. "They don't get very much credit for what they do on the business side. For whatever reason, you do well with the consumer, and you get a higher multiple on your stock."
On the downside, Microsoft's entertainment and devices unit, which includes the hit Xbox game system and the less successful phone operation, is much less profitable. The online services business, including the Bing search engine and MSN internet portal, is a perennial loss-maker, leaking almost $6 billion out of the company in the last five years alone.
More broadly, there is concern that Microsoft has not prepared well enough for the shift toward mobile computing.
Some major holders have been selling. Fund firms Fidelity and T. Rowe Price cut their holdings by almost one-fourth in the second quarter, according to Thomson Reuters data.
"Tablets -- the iPad in particular -- and the smartphone market are major overhangs and discounted heavily in the stock," said Ken Allen, portfolio manager of T. Rowe Price's Science and Technology Fund, although he is still positive on the company's growth prospects. "There is huge investor fear around those two areas, especially with the iPad being successful so far."
It's too early to say whether Microsoft's new phone software -- its last ditch attempt to catch up with Apple and Google in the burgeoning smartphone market -- will be a success. The phones, with glossy touchscreens and 'live tiles' to quickly access e-mail, the internet and applications, go on sale in the United States in November.
There is a growing feeling that the $9 billion a year Microsoft is now spending on research and development -- totaling almost $69 billion over the last decade -- has not brought the breakthroughs it should.
"Comparing Microsoft to Apple over the past 10 years in terms of innovation, new products and completely new businesses, the differences are pretty obvious," said Don Dodge, a former 'startup evangelist' at Microsoft, who now works for Google. "What did Microsoft investors get in return for their investment of over $75 billion in R&D and acquisitions?"
That view is shared by another former high-ranking Microsoft executive, still active in the technology sector, who asked not to be identified. "There probably isn't another company in the world that has the same amount of raw talent and smart people," he said. "Then you look at the results over the last 10 years and they're not so impressive. How do you explain that gap?"
One explanation is that Microsoft has been hampered by what's known as the innovator's dilemma. After revolutionizing the world with computer software, the company's priority has been to protect its core markets rather than commit itself to anything that may pose a serious threat to that.
"Microsoft's been playing defense for the last 10 years," said the former executive. "They are trying to protect existing revenue streams rather than taking risks. New revenue streams put the old ones at risk, and those old ones support thousands of people in the company. It's a difficult situation to be in."
Microsoft was touting tablet computers 10 years ago. It was one of the first to see the smartphone market and even the potential of web search as a business. But a failure to put the right resources on the right projects at the right time means that it now lags Apple and Google in all those important markets.
"Once (Microsoft) felt the Internet threat had been disposed of, it retrenched back into retrograde behavior protecting Windows," said the anonymous former executive. "The rest of the world didn't stand still, it moved ahead quite fast and left Microsoft in the position it is today."
Some pin the blame for Microsoft's failures on its leader. Ballmer, 54, has been CEO since January 2000, although he has been thrust more into the spotlight since co-founder and Chairman Bill Gates retired from day-to-day duties in the summer of 2008 to focus on philanthropy.
A friend of Gates from Harvard University, Ballmer was the first business manager hired by Microsoft in 1980, five years after the company was founded. At the height of Microsoft's power in the 1990s, a software rival referred to the two as Pearly Gates and the Embalmer.
Ballmer's passionate, sometimes sweat-soaked, public performances have made him a YouTube celebrity. His loud and gregarious persona is the stylistic opposite of Apple CEO Steve Jobs. Ballmer tends to delegate hands-on demonstrations of new products to lower managers, whereas Jobs delights in his.
Ballmer has a habit of retreating into corporate-speak, or saying "bleh, bleh bleh, bleh bleh" at important moments. His frequent public appearances don't generate excitement outside the tech world, whereas Jobs says little but still manages to captivate the mainstream media.
"If they (Microsoft) are not successful with their consumer product launches that are coming in the next year, I think all of us will stop listening to him period," says Becker at Becker Capital. "And that's coming from a supporter." It may be time for a change, Becker says, if Ballmer cannot deliver that success.
Such talk is not new. Throughout Ballmer's 10-year stint as CEO, he has faced doubters. But some detect a heightened urgency. An anonymously sourced report in The Daily Beast blog this summer claimed a cabal of Microsoft executives was plotting to overthrow Ballmer, although it provided no evidence.
Insiders dismissed the report as implausible. "Steve brings a unique set of capabilities to running a very broad and complex set of businesses," said Frank Shaw, in charge of Microsoft's corporate communications. "The company is well positioned for growth and I'm excited for everything we are delivering this fall."
Ballmer was not available for an interview. But he did make it clear at a conference last week that he still has a passion for the job and has no plans to step down soon. "If I ever thought there was a day where the company would be better off without me, I'd leave that day," he told the audience. "The day I think somebody else can do it better would probably be the day I would decide to move."
But dissatisfaction among investors and employees about Ballmer's reign appears to be growing stronger. "The market in general is not positive on Ballmer, and some of that is not appropriate, but it is present in the stock price," said Allen at T. Rowe Price.
Part of the friction may spring from Ballmer's inherently long-term view after 30 years at the company. "His time horizon is much longer than investors' time horizon," said Allen. "If his time horizon is 10 years, investors' is six-to-12 months. So decisions he's made, in a lot of cases, investors would have preferred otherwise."
Consensus among insiders and company-watchers is that Ballmer is not going anywhere until his old friend and business partner Gates wants him to.
"As long as Bill wants Steve to be CEO, Steve will be CEO, it's as simple as that," said Brad Silverberg, a former Microsoft executive who co-founded venture capital firm Ignition Partners.
There's no evidence that Gates -- still the company's largest shareholder with 7.2 percent -- is any less confident in Ballmer now than at any other time, said Silverberg, who ran Microsoft's Windows business between 1990 and 1995 and went on to lead the company's Internet efforts and its Office business.
Other former executives say Ballmer has carried out his mandate of protecting the company's main businesses, and there is still no one better to run Microsoft. "I have seen Steve Ballmer first hand -- he knows this business better than anyone alive," said Dodge at Google. "His blind spots are very minor compared to what he does know and see. Everyone who meets Steve comes away impressed with his passion, knowledge, and honesty."
At this point, Ballmer is not in it for the cash. He was paid only $1.35 million last fiscal year, well below the $7.5 million mid-point for CEOs of the Standard & Poor's 500, according to executive compensation research firm Equilar. He only got half his available bonus this year, mostly because of failures in the phone and tablet market, according to the firm's latest proxy filing.
Microsoft stopped issuing stock options in 2003, and Ballmer gets no stock awards at his own request. Not that he needs them. Ballmer is the second largest shareholder in Microsoft, owning 4.75 percent of the company, making him the world's 33rd richest person, according to Forbes.
If not Ballmer, then who would run Microsoft? Some entertain the idea that Gates will emulate Jobs at Apple and return to usher in a magnificent revival. But people close to Gates say there is "zero" chance of that happening, as Gates is consumed with fighting killer diseases and improving education through the $33 billion Bill & Melinda Gates Foundation.
The latest favorite in a long line of executives tipped to succeed Ballmer is Steven Sinofsky, the 45-year old who runs Microsoft's Windows unit, but he is not regarded as the anointed heir. Microsoft says it has a succession plan but will not talk about it publicly.
The problem in finding a worthy successor is that Microsoft executives tend to be either software experts -- a "Bill guy" -- or financial and sales oriented -- a "Steve guy". (Only two of Microsoft's 18 senior leaders are women.)
Microsoft's five operating divisions don't act as fully standalone businesses, which some argue means no executive is getting the ideal training to be CEO, where you must combine knowledge of software and sales.
"They need to take more of a Hewlett-Packard model, or a General Electric model, where they partition the company into some small number of semi-independent businesses," said one former executive, who asked not to be named. "Then you get very senior CEO-quality people running those businesses. That's what Microsoft needs to do and that's how you find a successor to Steve."
That's exactly what some have been advocating for years. Break the company into smaller units that must survive on their own merits. "Jack Welch at GE would fix this in a New York minute," said Dodge at Google. "Any business must be number one or two in the market or get out."
Breaking up the company is what a federal judge ordered in 2000 after concluding Microsoft had abused its monopoly position with Windows, although his judgment was subsequently overturned and the case was settled two years later with no changes to the company's structure.
The company resisted that idea, hoping to leverage its huge scale across different businesses, but it could have been a benefit, some former workers say. "Maybe it would have been better for the company to be broken up," said Mike Koss, who worked at Microsoft between 1983 and 2002 and now works with a number of startups in Seattle. "I've always been in favor of having individual business units that would actually focus on their individual markets."
Koss said fear of "stepping on somebody else's toes" -- essentially the behemoths of Windows and Office -- constrained innovation at Microsoft: "When I would try to start new things, I'd be spending 80 percent of my time just trying to beat back all the other teams that are trying to kill what I'm doing."
Friar at Goldman Sachs suggests a break-up of the consumer businesses could unlock some value, perhaps letting the Xbox operation stand alone. The status quo cannot continue, she says, of Microsoft trying to focus simultaneously on business customers and consumers.
"In many ways, Windows 7's success is a long-term curse, not a blessing, because it masks Microsoft's vulnerability and delays the reckoning that's coming," said another former employee, who asked not to be identified. "It needs to either accept that it's an enterprise company, or if it wants to compete in these new businesses -- mobile, social, internet -- it needs to make more fundamental changes."
Microsoft still shows no public interest in breaking into smaller autonomous units. Ballmer himself called Friar's break-up plan "nutty" and "next to crazy". Company insiders say the new line of phones -- featuring Office applications, Bing, Xbox games, Internet Explorer browser, Hotmail and Outlook e-mail and Zune music player -- is a perfect example of the company's disparate parts working together on one product, which would have been much harder if they were separated.
Some say the innovation issue is a red herring, arguing that Microsoft was never a true innovator, just very good at getting its own version of existing technology to a mass market. "I don't think the proposition buying the stock is that they are going to be the innovator in a visionary way," said Hanson at BlackRock. "(But) they are going to be a disciplined integrator and remain relevant to the competing ecosystem."
If you ask Microsoft executives what the future holds, they will talk about "cloud computing," a broad phrase describing the provision of software, services and data storage over the Internet.
This sea-change is a potential threat to Microsoft as it represents a shift away from software installed on computers toward a more fluid scenario. Why pay for and install Microsoft Office when you can use Google Docs over the Internet for free?
After some initial skepticism, the company says it is now fully committing itself to the cloud, with a strategy of "software plus services" -- essentially banking that the future will be a combination of installed software that is connected to the web.
The move toward the cloud was championed by chief software architect Ray Ozzie -- the intellectual heir of Bill Gates -- who is retiring in the next few months, feeling that his job at Microsoft has been done. Bob Muglia, the head of the server and tools business, is charged with putting Ozzie's vision into effect.
Muglia, whose unit sells the server software and runs the data centers that keep the cloud running, says the shift toward cloud computing is as big a revolution as the PC and the Internet. "We're in the middle of this incredibly interesting transition," he said in an interview at Microsoft's campus. "There is some risk associated with that and yet I view this as this massive opportunity for us."
Muglia says the shift to providing cloud services -- which involves investment in hardware and a new way of selling to customers -- will likely shrink Microsoft's profit margins, but he hopes that the new sources of revenue will make up for that, as more computing is done via the cloud.
This is how Microsoft is answering the innovator's dilemma, insiders say, by moving lucrative services like Exchange e-mail and Office applications into a web-delivery format, and betting that customers will end up spending more with Microsoft rather than less in the long run, as Microsoft looks after more of the back-end systems.
Microsoft talked a lot about the cloud at the gathering with analysts in July, but it stressed how it was moving existing businesses in that direction -- especially creating a 'personal cloud' to link up all kinds of data and services -- rather than billing it as a huge new and separate avenue of growth.
This was a quiet but significant step, said Matt Rosoff, an analyst and journalist who has covered Microsoft for more than a decade. "The investment community seems to have missed it, but Microsoft's pitch about the cloud was an admission that it's no longer trying to recapture the go-go growth of its early years," wrote Rosoff in a recent piece for the Silicon Alley Insider blog. He recalled that at past meetings, Microsoft would throw out lofty estimates on how much money it could make in grand new business areas, none of which quite panned out.
The company's recent fiscal behavior backs up the theory that it no longer sees itself as a fast-growth company, but a steady achiever. In September Microsoft hiked its quarterly dividend 23 percent to 16 cents per share. That will give it a dividend yield of about 2.5 percent, putting it in the top third of the S&P 500. Why stop there, asks Friar at Goldman, who thinks the dividend yield should be twice as much to make the shares more attractive.
All told, Microsoft has returned nearly $170 billion to shareholders through dividends and share repurchases over the past 10 years. The company started paying a dividend in 2003, and surprised the market with a special dividend of $3 per share the year after, dispersing more than $30 billion to investors in one go.
The company is quietly closing businesses and unpromising projects. This year it killed off the Kin phone, the Vine emergency social networking tool and video-game ad operation Massive. Last year it closed digital encyclopedia Encarta. A "slow and unannounced" pullback from other non-core businesses could be ahead, said Rosoff.
There is always the possibility that Microsoft will attempt to buy its way to growth, as software rival Oracle Corp has successfully done. The company tends to make dozens of small deals each year, generally under $250 million, but has slowed significantly this year. Although Microsoft is mentioned as a potential buyer in almost every tech M&A situation, CFO Peter Klein told Reuters earlier this year that it is unlikely to go for a "mega-acquisition."
Its largest deal to date, the $6 billion purchase of web ad firm aQuantive in 2007, has not been a great success. And shareholders are generally relieved that its $47.5 billion offer for Yahoo Inc in 2008 was rebuffed, paving the way for a web-search agreement which gives Microsoft most of what it wanted anyway. Its most important deal may yet turn out to be the $240 million it paid for a 1.6 percent share in Facebook in 2007.
Microsoft has made moves to tighten its belt financially, another sign of a cost-conscious culture rather than a growth-at-any-price approach. Last year it had its first ever job cuts, getting rid of 5,800 people, or 6 percent of its staff. In October it announced that workers would have to start paying a portion of their health insurance for the first time in 2013.
That may be common practice at other companies, but it could be a stinging financial penalty to Microsoft workers, who no longer get rich on stock options and have seen no real increase in the value of any stock they hold.
"There's zero tolerance now for major money screw-ups like Kin and Massive," wrote Mini-Microsoft, an anonymous inside blogger. "The bumbling flushing away of millions or billions of dollars is going to be compared directly to the reduction in benefits."
As for those iPad killers, industry-watchers expect to see manufacturers like Acer, Dell and Toshiba to bring out devices after Intel's low-power 'Oak Trail' chip is available next year. Although there is some concern that they will merely be small PCs with touch screens, there is hope they will grab a slice of the burgeoning tablet market, which technology research firm Gartner forecasts will almost treble to 55 million units next year.
If Microsoft can do that, while maintaining focus and cost discipline, then maybe the company and its investors will have a clearer understanding of each other.
"Microsoft has grown up. It's a mature, entrenched, leading provider of technology," said Hanson at BlackRock. "It's not what it was 15 years ago. It's not what Apple is today in terms of a high-growth trajectory. But I don't know if the stock market has graduated to that maturity of perspective."
Editing by Jim Impoco and Claudia Parsons