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Microsoft (NasdaqGS: MSFT): Desperate, Shrewd or Stupid Strategic Planning?

Let us start by crediting the pullouts and data to Paul McDougall at InformationWeek who published a piece back on 7/13/09. It seems everyone’s original “evil empire” is going to the web and free (kind of) model, perhaps seeking to offer bonus online features and gaining more users.

Microsoft on Monday outlined a host of new features that will be included in its forthcoming Office 2010 home and business productivity suite. Not surprisingly, many are geared toward users steeped in Facebook, YouTube, Twitter, and other popular Web 2.0 tools.

For starters, Microsoft revealed that the Office 2010 release, slated for the first half of next year, will include free Web versions of Excel, PowerPoint, Office, and Notepad. The move is in keeping with the "Work anywhere" theme the company has attached to its new offering.

The company has thought through the standard user base.

Under the plan, users will be able to tap Office Web—as the online version of Office is called—through Microsoft's Windows Live Portal. After editing and saving work, users can store their documents on Microsoft's existing SkyDrive service.

So far nothing is that new. Is Microsoft letting the cat and its software out of the bag and Windows and onto the web, Facebook, Twitter, etc – you bet.

Microsoft has also added a host of collaboration features to the Web and client-based versions of Office under its "Better collaborate" theme. For instance, new co-authoring tools will allow easier document sharing across teams and workgroups. Instead of passing a Word, Excel, or PowerPoint document around through e-mail, users can simply e-mail colleagues a link to a document that's viewable and editable in Sharepoint or Windows Live.

The email reference below will save them a few bucks, but also their rivals like Google (NasdaqGS: GOOG) and AOL.

230 million Office documents are attached to Hotmail each month. Many of those will go away because we've added multi-user authoring." Meanwhile, the Web-based version of Office will allow users to more easily tag content from within their documents and post it to blogs and social networking sites.

Google is not showing a profit with its online version of Office-like products and there is no light at the end of that tunnel. Form Microsoft’s perspective collaboration smells like a key tool for business if anyone can learn how to use it. Empowering and enticing the web 2.0 crowd is also a good thing as long as there is a Mac version quickly for them to use.

As an investor I want to see increased scale and the revenue that goes along with it. The earnings will follow swiftly. The on-line version of Office only comes with a paid desk-top license. I get it. This is a slippery road to travel and MSFT should have the brain trust to figure this out: how to leap frog the competition and regain “restart growth mode.”

I am pleased with this stepped approach. It should keep them in charge of the desktop and office-like software for the next few years. However, the way to selling 100 million copies of a new program is not through incremental improvements market tested by competitors.

The path the firm needs to take and copy is leading through innovation. Through learning, taking risks and throwing some of its formidable power investing in and testing game changing ideas. The firm needs to find the big need and solve it. I didn’t even know I needed a phone to watch movies on, take my pictures to Facebook and have an app store with thousands of scratches to my potential itch. Leave it to Apple (NasdaqGS: AAPL) alone? I hope not.

The firm needs its bravado back and a stealth team of non-corporate types who don’t care what is happening down the street or in the valley.

I screen every public company ever market day – Steve, Bill, I am waiting!

Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Through various equity strategies under his supervision he is long MSFT, GOOG, and AAPL.

Can Money Buy Healthcare Innovation?

In previous posts, I cited several reasons for optimism regarding the U.S. healthcare industry. This includes new major revenue sources such as the expansion of coverage to the uninsured and aging baby boomers. We also export our expertise and the global population is swelling.

Although these developments remain strong indicators of a robust demand for the healthcare industry, they also paint a macabre picture of the future of our country, and its economic condition. In short, what is good for healthcare providers may not be good for America. Healthcare expenditures in the U.S. currently consume roughly 16-17% of our GDP and are rising at an alarming rate. From a 2008 study by the U.S. Department for Health and Human Services:

Over the full projection period (2008-2018), average annual health spending growth is anticipated to outpace average annual growth in the overall economy (4.1 percent) by 2.1 percentage points per year. By 2018, national health spending is expected to reach $4.4 trillion and comprise just over one-fifth (20.3 percent) of Gross Domestic Product (GDP).

In 1789, Thomas Malthus predicted that the exponential growth of the human population would overwhelm our arithmetically growing food stores, returning us to subsistence-level conditions. (His gloomy predictions led historian Thomas Carlyle to dub economics; the dismal science.) Lucky for all of us, he was wrong. The Industrial Revolution provided us with efficiency-enhancing technology, enabling us to produce food at a faster pace. 

Today the situation in healthcare is not much different. Left unchecked, healthcare expenditures will continue to sap economic productivity and output, not to mention fiscally bankrupt the U.S. government. The disquieting projections of the DHHS present us with a Malthusian situation. Although healthcare is decidedly more complex than agricultural production, the solution is no different than it was two centuries ago: disruptive innovation.

The case for disruptive innovation in healthcare is most effectively championed by Clayton Christensen, a former Rhodes scholar and professor at Harvard Business School. In The Innovators Prescription, Christenson and his co-authors (both MDs) diagnose the industry with a lack of innovation, both in terms of its technological progress and its outdated business models. They argue that in order to keep healthcare providers and insurers off government provided life support, new technologies need to be developed in order to increase efficiency, while simultaneously improving the overall quality of care. In turn, these technologies must be applied to business models that align the interests of patients, practitioners, insurers and policymakers. 

Examples of technologies that have simultaneously reduced costs while increasing quality of care include those used to treat atherosclerosis, or fatty buildup in blood vessels. In the past, bypass surgery was used to divert blood flow around the obstruction. Then angioplasty procedures were developed, enabling surgeons to widen the blocked vessels using tiny balloons. Nowadays, doctors often prescribe cholesterol-lowering statins, both as an ex-ante and ex-post treatment for cardiovascular disease, making more risky and expensive bypass surgery less common.

Unfortunately, innovation does not come cheap and throughout the recent financial crisis, financing sources for entrepreneurs have effectively flat lined. Venture capital funding, the preferred source of backing for fledgling enterprises, fell a staggering 37 percent between the first quarter of 2008 and the first quarter of 2009. A primary reason for the lack of funding is that the traditional exits for VC firms through acquisitions or IPOs have been blocked. But there is a light at the end of the tunnel for healthcare startups. Recent reports show that venture funding in the biopharmaceutical field jumped 72 percent in the second quarter of 2009 and overall VC investment in healthcare surpassed the IT sector traditionally a stalwart leader in venture capital investment. 

A confluence of factors has contributed to the recent improvements. First and foremost, economic stability seems to be returning, making the foreseeable future more, well, foreseeable. Improvements in the credit markets reduce the financing risk for new ventures, allaying fears that VC investors would need to continue pouring cash into their investments to keep them afloat through the recession. Additionally, in response to the previous dearth of available funding, startups are now seeking the lowest valuations from VC investors since 2003. Most importantly, though, large healthcare and pharmaceutical companies are becoming more acquisitive, providing profitable exit opportunities for early investors. 

Bristol-Myers Squibb Co. (NYSE: BMY) announced the purchase of already public (founded 1987 during a healthcare start up boom cycle) Medarex, Inc. (NasdaqGM: MEDX) for a major premium, potentially launching a rush to launch more biotech firms and innovation. Human Genome Sciences, Inc. (NasdaqGM: HGSI) is gaining additional commercial traction and could attract a buyer with a market cap under $2 billion. The majors such as Pfizer Inc. (NYSE: PFE), Merck & Co. Inc. (NYSE: MRK) Johnson & Johnson (NYSE: JNJ) have strategic planning departments seeking where the future of their firms will be two, five and ten years from now. None may be looking at HGSI, but be sure, they are seeking innovation to thrive in an ever changing world.

Regardless of the results of the Obama plan, innovation will be necessary to revitalize the U.S. healthcare industry. As such, the increase in venture capital funding for this sector is a welcome development. If a stone is dropped in a pool of water, the size of the wave created depends on the mass of the stone. By choosing to support or not support promising startups, venture capital investors, and the majors effectively determine the size of the ripples that lead to innovation, entrepreneurism, and ultimately, new procedures and cures for humankind, and benchmark beating returns for investors.

Shout out: to intern Colin Sloand for herculean assistance with this post.

Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Through various equity strategies under his supervision he is long BMY, MRK, PFE and JNJ.

Vulnerability and Opportunity in the Healthcare Sector

In March 2008, the U.S. Food and Drug Administration was forced to recall the drug Heparin after a number of deaths were linked to the product’s use.   According to the agency, the root of the problem was traced to contaminated Chinese factories that supplied the raw materials needed to manufacture the popular blood thinner.  By the time the recall ended, the Heparin contamination had claimed at least 81 lives and affected more than 700 patients.  Fortunately, such healthcare product deficiencies are uncommon.  This was major headline news and Baxter International Inc. (NYSE: BAX) saw its stock drop significantly as well as all the additional ramifications of this event.

While the FDA insists that it’s underfunded and insufficiently staffed to be able to police such potential problems, both the responsibility for monitoring these products and the blame for any errors lie at the agency’s door.  All too often, though, it is companies and their investors that take the blame.  In the case of the heparin contamination, Baxter International was vilified for their role in outsourcing production of the drug’s inputs to Chinese factories and it’s been a public relations nightmare for the company ever since.  Was it Baxter’s fault? Could they have supervised their vendor more carefully, chosen a different supplier? In the healthcare industry, and for those who suffered, from the sick and their families to investors, it hardly matters.  In dealing with life and death, healthcare companies play a risky - albeit important - role.  In no other industry are the stakes so high or the expectations so stringent. Perfection is imperative and mistakes are intolerable.  In the business of saving lives, there’s no wiggle room.  

Public relations disasters and product recalls are not the only risks that face healthcare companies.  Government intervention is ever-present, as no other industry on the planet is as heavily regulated as the healthcare industry.  Pharmaceutical companies and others are forced to navigate a regulatory maze that affects all their activities, ranging from manufacturing processes to sales practices.  I acknowledge, that many firms have stretched the law as far as they can when it comes to sales.

Currently, the Obama administration is wrestling with its universal healthcare plan, which promises to impose a new suite of rules and restrictions on the industry’s players.  Already, the U.S. pharmaceutical industry has been coerced into offering $80 billion in cost reductions over the next ten years.  They may also be forced to compete with generic imports, which would effectively put a cap on domestic drug prices.  Any new regulations pose the threat of cutting into profits and reducing international competitiveness.

With these new rules may bring innovation to a crawl as the risk/reward scale of discovery tilts the wrong way. Or perhaps innovation will be the best route to success. The world has a lot riding on the new legislation.

Despite all its risks and drawbacks, though, healthcare is still a very good business.  Aside from helping people and saving lives (no small feat), there are notable benefits to being part of the industry.  As discussed in my last post, healthcare is a quintessential defensive sector.  People still get sick during recessions and they will often continue paying for medicine and treatment even when they cut back on other things. 

We are pleased to own share of innovative firms such as Bristol-Myers Squibb Co. (NYSE: BMY), Pfizer INC(NYSE: PFE) and Intuitive Surgical, Inc. (NasdaqGS: ISRG) which is the company behind the da Vinci surgical system.

While profits for the S&P 500 have dropped roughly 30% in the past quarter, healthcare earnings have barely moved. Not bad for the worst recession in sixty years.  Additionally, the same regulations that sometimes threaten the industry’s global competitiveness often serve as a barrier to entry and an impediment to potential competitors.  Blockbuster drugs have historically provided a consistent earnings flow throughout the entire twenty-year lives of their patents. Lastly, U.S. healthcare expenditures are massive, consuming roughly 16% of the country’s economic output. The Obama administration seems set on mandating universal healthcare, which will extend health coverage to the 49 million Americans that are currently excluded.  That effectively means 49 million new customers and a host of other benefits (along with its costs). 

Additionally, although frightening from a fiscal point of view, America’s ageing population may provide an additional engine for industry growth. Demand for healthcare is tremendously robust and will only continue to grow as the baby boomers age. 

While it’s easy to be cynical about the industry’s prospects in the face of product recalls and pending regulatory reform, the advantages in the healthcare sector are significant. 

Aside from being an ideal way station in the midst of recession, the healthcare sector could be poised for considerable growth and profitability.

Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Through various equity strategies under his supervision he is long (BMY), (PFE) and (ISRG).

Special footnote: As a society we need to balance human risk and the advancement of treatments and therapies for the betterment of humankind. I am sensitive to all life and for this blog which focuses on stocks, deaths are viewed as statistics. I understand fully there are real people and families behind the statistics, and I wish them the best while hoping the industry does well and helps bring new cures to the world.

 

Drug Discovery: Each Phase of the Value Chain Counts

I recently did an interview with the FT discussing the healthcare sector as a good defensive sector play. I answered of course, that healthcare along with utilities and consumer staples are the classic defensive sectors. The stocks in those sectors tend to be lower beta and many are mature companies with good cash flow that pay dividends. We own many companies within the sector.

We watch the sector closely as the head winds to growth are many, here are a few:

·         The Obama health plan(s)

·         The new FDA approval process coming with our new administration

·         Patents coming off protection

·         Generics in prescription, OTC and consumer product markets

·         The risk of a drug, device etc killing a patient, and other headline risk

·         The cost of developing manufacturing, marketing and sales

The industry is finding many ways to sail through these winds. Today, VC-backed Portola Pharmaceuticals entered into an agreement with Merck & Co. Inc. (NYSE: MRK) to an incentive laden deal potentially worth up to $420 million. Merck will pay Portola $50 million up front for the exclusive licensing rights to the anticoagulation drug, Betrixaban.

Merck’s $50 million investment in Portola is a promising investment for a private company. If Betrixaban gets FDA approval, it could offer a major improvement over the incumbent Warfarin, and billions in annual sales. 

As the Obama administration overhauls the healthcare system, pharmaceutical companies face the increasing threat of reduced profits. Unlike years ago, many drug companies are no longer willing to invest the millions required to get a drug from concept to patient. Major pharmaceutical companies frequently rely on smaller companies to undertake the costly and risky R&D and preliminary stages. 

Have smaller, nimble firms willing to take risks for potentially exponential rewards works well for an industry in need of new (and patients in need of) improved drugs. The smaller companies can “hit the big-time” receiving millions for a drug that may never succeed and larger companies can buy the rights to a drug that could be worth billions. For years major pharmaceutical companies have relied on this tactic making it increasingly likely that major advancements can be made continuing an entrepreneurial and scientific discovery process. Each new discovery enhances a challenged industry and an aging world population.

Stem cell research is growing with recent changes by the Obama administration potentially sparking more ideas and discovery for the health care industry. The uses for stem cells are near limitless and so are the potential profits.

Whichever companies can get stem cell therapies off the ground stand to make billions. The bigger winners though, will most likely be the major pharmaceutical who will buy the rights to the drugs, or gobble up the smaller firms in this future trillion dollar industry. 

The big pharmaceutical firms such as Merck, Johnson & Johnson (NYSE: JNJ) and Pfizer Inc. (NYSE: PFE) have the cash, manufacturing capability, marketing and detail (sales) staff to create the next multi-billion success that also may improve the lives of millions of people.

Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Through various equity strategies under his supervision he is long MRK, PFE and JNJ.