| Microsoft CEO Satya Nadella (Bloomberg) |
Jeffrey Ubben and Mason Morfit at ValueAct Capital Partners wanted to see a change in direction at Microsoft, and now they’re getting glimpse of what change might mean under CEO Satya Nadella. The new chief executive, who has been in the job for just five months, sounded fired up when he said “we’re going to change the world” during the quarterly earnings call this week. That’s standard patter for a technology executive, but to bring on long-term value he will have to truly change the world, at least from a technology perspective, not to mention Microsoft’s corporate culture. So far ValueAct and the 100-some-odd other hedge funds holding Microsoft stock still have the same thing they bought in the first place. It’s a company that has hefty cash reserves and strong earnings overall in spite of a dip in the last quarter, but in need of a very clear vision. As activist investors, Ubben — the founder and CEO of the $12 billion ValueAct in San Francisco — and Morfit, the president of the firm, have an agreement with Microsoft that stipulates holding regular meetings to discuss business issues, and Morfit joined the board at the end of 2013. The corporate vision is beyond the job description of activist hedge fund managers, however, which is why all eyes are now on Nadella.
“It’s swim or die time out there at Microsoft,” says Merv Adrian, a vice president at the technology research firm Gartner in Pleasanton, California. Adrian says the company needs to come up with innovation that re-establishes it as the kind of leader it was when Bill Gates started out in the 1980s with a plan to put a personal computer on every desk in the world – or else become irrelevant, which in the technology business often means defunct.
Microsoft now makes up more than 22 percent of ValueAct’s portfolio, with shares worth upwards $3 billion, and the stock has become a hedge fund favorite. Although ValueAct is the only hedge fund conducting an activist campaign, other funds with holdings of more than 5 percent of their total portfolio in Microsoft, according to first quarter 2014 13F filings, include Sandy Nairn’s Edinburgh Partners in Edinburgh, David Abrams’ Abrams Capital Management in New York and Patrick Wolff’s Grandmaster Capital Management in San Francisco. Stanley Druckenmiller, the founder of Duquesne Capital, also had holdings comprising nearly 8 percent of his portfolio as of the end of the third quarter.
Adrian thinks Nadella seemed in command in the earnings call. “His answers to analyst questions showed a more technologically visionary sense that I would have expected of [previous CEO] Steve Ballmer. You could hear his enthusiasm and passion.”
Among other things Nadella talked about “an aggressive move to the cloud,” a strategy that Ubben and Morfit have urged. The company reported revenue of $23.38 billion for the quarter that ended June 30, up 17.5 percent over the same period last year, but earnings per share, at 55 cents, were down from 59 cents last year and below analyst expectations. Last week Microsoft announced it would eliminate some 18,000 jobs, mostly in the Nokia division, and change the work terms for its 71,000 contract vendors and temporary workers, many of whom are former fulltime employees. All of this was an indication that Nadella is making good on his promises to steer the company away from lower-end consumer devices and focus on mobile software, cloud computing and business customers.
This bad news for Microsoft employees in the Seattle area and the Nokia facilities in Finland has been good news for Microsoft investors. The company’s stock began to rise early last week in anticipation of a big announcement, and after the earnings call it went just above $45, its highest level since the technology bubble of 1999-2000.
Ubben has said he doesn’t like seeing a company’s stock go up based on the news of his involvement as an activist. But Steven Ballmer himself, who was CEO from 2000 to February of this year, credited ValueAct with putting Microsoft back on investors’ radar. Ubben disclosed his $2 billion activist stake in Microsoft at an investor conference in New York in April 2013, and the stock rose 3.6 percent that day — bringing a stock that had hovered mostly in the $20-29 range for five years into the $30-39 range. At the time Ubben said that investors didn’t fully appreciate Microsoft’s corporate software, which it sells for use in servers and databases and has begun moving into cloud computing. “In the long term it will win out,” Ubben said of the software.
For Josh Mangoubi, a portfolio manager at Sanborn Kilcollin Partners in Chicago, a $198 million value-oriented hedge fund, investing in Microsoft has been an exercise in long-term patience. The earnings have been strong even while the price has been relatively static, and he figures that eventually the share price will have to start moving. Sanborn Kilcollin made money from short positions in Microsoft in 2001, then didn’t go back in until it started buying the stock long in 2011. Mangoubi has been pleased at the activist pressure, which he says “reduces the risk of management misappropriating their resources.” He’s been concerned that Microsoft hasn’t always used its excess cash wisely and has made some bad acquisitions in the past.
Wolff at Grandmaster told ValueWalk earlier this month that investors should view Microsoft as “the world’s best enterprise software company combined with a somewhat dysfunctional consumer software company.”
Nadella comes from the enterprise side of the business, and that has been heartening to Wolff and the managers at ValueAct. But to really turn this company around, the new CEO is going to have to change the culture, say analysts and former employees. Sid Parakh, an analyst at the brokerage firm McAdams Wright Ragen in Seattle, is keeping a close watch on recent discussions about trimming the layers of mid-level managers, which he says should be another part of the cutbacks. “They’re now trying to streamline the decision-making process, so that ideas that originate at the engineering level can come to fruition faster,” says Parakh.
Two ex-employees who did not want their names to be used for legal reasons both say the company has stifled innovation in all kinds of ways. A prime example is Microsoft Office software, which could have been available on iPad years ago, but the corporate decision was that selling Office to Apple would cannibalize Windows sales. That kind of thinking is changing, but it remains to be seen if Nadella can turn around a company for which employees have a widely circulated quote: “When Bill Gates left, Microsoft lost its direction, when [chief operating officer] Kevin Turner came, the company lost its soul.”
