Why Sarah Friar is Wrong About Microsoft’s 2011 Growth Prospects

Goldman Sachs’ analyst Sara Friar is at it again. In her latest research note she declares that Microsoft will face a very tough 2011. She projects that top line revenue growth will slip to seven percent from twelve percent this year.

I’m not in the market valuation guessing game so her projections may end up being correct. However, if that’s the case then it will be a matter of pure luck on her part. Friar’s analysis of what ‘ails’ Microsoft demonstrates such a fundamental lack of understanding about the core drives of Microsoft’s business that it borders on the incompetent. Even that would be OK if her analysis did not influence millions, if not billions, of dollars of investment in Microsoft stock. Joe Wilcox, a frequent critic of Microsoft strategy, has a lengthy piece on why Friar is wrong so I’m not going to cover the same ground.

Disclosure: After December 31st I will have no personal financial interest in Microsoft. In a very real sense I have no vested interest in what happens to the company in 2011 and beyond except in wanting the company to remain successful for the sake of my friends who still work for the company. However, no matter what my loyalties are on the subject, in my opinion Friar is just plain wrong in her analysis and needs to be called on it.

Here’s where I think Friar’s analysis is materially incorrect:

1. Friar seems not to understand that Microsoft is an enterprise software company -As I wrote here, here, here, here and here – and not a consumer products company. Microsoft’s 2011 growth prospects hinge on continuation of the corporate upgrade cycle, re-platforming and general investment in business IT. The economy is hopefully emerging from the bottom of an economic cycle and corporate profits are at record highs. The combination of those two facts creates a very healthy outlook for corporate IT investment and, as a consequence, for Microsoft.
2. Friar is correct that Microsoft’s strategic failure to have an competitive entry in the nascent tablet market hurts growth prospects: Microsoft has lost the ability to drive incremental growth by tapping a new market opportunity. That is not the same as prognosticating that tablets will reduce growth in Microsoft existing markets. They will not, in 2011 anyway.
3. There is no evidence that tablets are cannibalizing traditional PC or laptop sales. That may change in 2011 but as it stands today Microsoft’s core business does not grow less because of tablets. Tablets, and by that we mean the iPad – because everyone else still has to prove they can compete – are a NEW category. My iPad does not replace my MacBook Pro, it adds value to it. Tablets will remain an add-on purchase to an individuals desktop or laptop needs. That may change as tablet functionality and features improve in 2012 and beyond but that will have very little impact on Microsoft in 2011. Hopefully by 2012 the company and it partners, will have their tablet act together.
4. Friar’s conclusions about Microsoft and the cloud demonstrate her most egregious lack of understanding of either the technology, market or Microsoft. Maybe she’s been reading too many Google press releases. By all independent evaluation, Microsoft has the most complete and comprehensive set of Cloud offerings in the market today. Google can only dream of the opportunity facing Microsoft as it moves its current installed base of enterprise customers to the cloud. In doing so Microsoft secures a higher more stable and sustainable revenue stream than it could ever have dreamed of in the packaged software business. It is true that the margins for cloud service provision are less obscene than those realized when shipping a customer a DVD. However, that will change as the next generation of Microsoft’s cloud service infrastructure comes online. If Microsoft has a track record on anything it is squeezing cost out of its operations. Margin reductions is also offset by the huge portfolio expansion opportunities presented when a customer migrates to the cloud – when the cost of upgrading falls to zero customer feel a lot more comfortable buying more and more of your product. The latest win at USDA proves just how powerful a position Microsoft has as the incumbent and what a roadblock that is to Google’s ambitions.

Friar is correct about one thing – It is time for Microsoft to start handing out a much larger dividend. There are few potential acquisitions that would increase shareholder value – Twitter aside – that would eat into the growing horde of cash. Add to that the company’s senior executive obsession with flushing money down the toilet, trying to prove their consumer credentials – Windows Phone 7 anyone – and you have every justification for shareholders to demand more of those profits be returned to their wallets.

As I have already written my holiday wish is for SteveB to realize its time to break the company up and start focusing – without distraction – on the enterprise business upon which Microsoft’s long-term future and growth depends. In this regard, Friar and I probably agree but it’s only a wish and I don’t believe in Santa or the Tooth Fairy.