Microsoft (MSFT): Hidden in Plain Sight?
Overview:
Microsoft (MSFT) was founded by Bill Gates and Paul G. Allen in 1975 after the pair converted the programming language BASIC for use on an early personal computer (PC), the Altair. MSFT was established with the intent of selling BASIC interpreters, which generated a stream of fees and royalties, but proved insufficient to cover the firm’s overhead. Gates would later admit that the few individuals who used BASIC in the Altair actually paid for MSFT’s software — commonplace practice among the primarily hobbyist crowd of the early PC era, but a practice Gates considered to be mere stealing.
As computers grew in popularity, companies such as Apple and IBM set their focus primarily on the sale of hardware whereas Gates and MSFT stood firm on the merits of software. (A view that Apple would eventually, at least partially, adopt in the form of its “services” business.) In 1980, therefore, IBM selected MSFT to develop the software to operate its upcoming PC. In partnering with MSFT, IBM had hoped to purchase the software outright upon completion, but Gates insisted the IBM simply license the software from MSFT for a fee — a fee paid for every IBM PC sold with MSFT’s operating system attached.
Gates’ insistence would prove a prescient move. The company’s agreement with IBM allowed MSFT to license the MS-DOS software to other PC manufacturers, which would form the basis for MSFT’s dominance in personal computing for decades to come. Indeed, by 1983 an estimated 30 percent of the world’s computers ran on MSFT’s operating system and over 70 percent do today. (Technically, as of 2017.)
Expanding upon its dominance in PC operating systems, MSFT launched its Office product in 1989. By bundling office productivity software such as Microsoft Word and Excel into an offering compatible with all Windows-enabled devices, MSFT leveraged and deepened its ecosystem of services. Office, in other words, was not — or at least less — compatible with other operating systems such as IBM’s OS/2 and Apple’s Macintosh.
It was this resulting dominance that led MSFT into a string of legal issues. The FTC and Justice Department repeatedly investigated MSFT during the 1990s, and, at one point, MSFT faced a possible breakup of its two divisions — operating systems and software development. Monopoly or not, MSFT was able to escape rising antitrust sentiment relatively unscathed.
MSFT’s success, charted on a graph against time on the x-axis, would not simply appear “up and to the right.” From the stock’s peak in early 2000, MSFT would go sideways for 15 years before returning to breakeven. This illustrates the dangers of overvaluation, to be certain, but it also reflects the market’s dislike of former CEO Steve Ballmer and MSFT’s supposed lack of innovation.
Perhaps it was because of its dominance in personal computing that MSFT failed to capitalize upon subsequent developments in the technology space. From search, to social networking, to the secular shift to mobile devices, MSFT missed it all. (Does anyone recall the Zune, Windows Phone, Bing, and Internet Explorer?) Each of these categories alone created tech giants — Facebook, Google, and Apple — worth hundreds of billions of dollars.
Therefore, even with the launch of other successful product lines such as gaming (Xbox), MSFT remained reliant on its operating systems and productivity software. Greater competition in operating systems from Mac OS as well as Linux at the low-cost end, coupled with a string of lackluster product releases in the form of Windows Vista, 7, and 8, didn’t help MSFT’s situation. MSFT remained the dominant supplier of operating systems throughout, but it would have to compete against Google on this second front of software and search.
Needless to say, Microsoft’s search engine and internet browser attempts were no match for Google’s expertise. Yet thanks to this competition, MSFT moved into cloud computing (now under Azure) — where MSFT provides the data storage and application software infrastructure for other businesses.
Under Ballmer, the narrative goes, not only did MSFT’s innovation flounder, but the company failed to recognize even what it specialized in. After 15 years of sideways stock movement and repeated, failed attempts to dominate various new technology categories, perhaps Ballmer was truly at fault.
Naming Satya Nadella, former head of MSFT’s cloud division, as CEO has been perhaps the most critical piece of the stock’s narrative shift. No longer would MSFT make attempts in categories it simply could not compete effectively in with the likes of Google and Apple, but would pivot to services rather than hardware.
As tech analyst Benedict Evans puts its, MSFT’s release of Windows 95 was the company’s peak, as it came at just the moment the internet began to take off — without MSFT as a relevant force. The company invested tens of billions of dollars in the space to no avail.
To be fair, MSFT’s failures in “new-era” technologies did not matter much, for the relevance of PCs did not suddenly crash to zero, nor did the company’s deep moat in the PC space erode. Yet Ballmer’s final years at MSFT indeed saw the tech giant become less relevant on the tech stage, if you will, as a whole.
Nadella, in contrast to Ballmer, recognized that MSFT’s future would not be in a device-centered business model (or even Windows-centric). Rather, MSFT ought to become a services business regardless of platform, emphasizing the development of Azure and adapting Office for Apple’s iOS.
Only with this background can we understand Nadella’s 2018 reorganization — or perhaps better recognized as “splitting”— of MSFT’s Windows division. For the first time since the 1980s, the company was left without a division entirely dedicated to PC operating systems.
Nadella’s strategy is all about meeting customers where they are rather than limiting MSFT’s offerings to PCs. In his first memo to employees as CEO, he acknowledged that the company operates in mobile-first and cloud-first world. Quite the pivot away from the Ballmer era of “devices and services”.
Financials:
(As of June 2021): MSFT breaks out its revenue and operating income (or EBIT) into three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. First, the Productivity and Business Processes (“PBP”) segment is primarily comprised of Office 365 (subscription model), LinkedIn (subscription and advertising), and Dynamics.
The Intelligent Cloud segment consists of MSFT’s public, private, and hybrid cloud services that together provide the infrastructure enabling modern (read: internet) businesses and developers. MSFT does not break out revenues and operating income for Azure alone, so it is critical to note that this segment also includes GitHub, SQL Server, Windows Server, and enterprise services.
MSFT’s third and final segment is More Personal Computing (“MPC”), and primarily consists of Windows (licensing), devices, gaming, and search.
[Note on Intelligent Cloud:] MSFT’s Azure is currently second in cloud computing to AMZN’s AWS, and ahead of third-place Google Cloud Platform (“GCP”). Azure has a few notable advantages over AWS and GCP, including its emphasis on “hybrid” adoption, whereby longtime MSFT enterprise customers can experiment and move select workloads into the cloud. Since MSFT customers remain in the same ecosystem with Azure, applications and data are more easily transferred.
For FY ’20, revenue increased by 14%, or $17.2 billion, as compared to FY ’19 YoY growth of 14%. MSFT’s gross margin percentage also expanded in FY ’20, driven by the sales mix shift to higher-margin businesses, presumably Intelligent Cloud and PBP. In other words, cloud and software.
Operating income for FY ’20 advanced by 23%, driven primarily by operating income growth in Intelligent Cloud (32%) , followed by MPC (24%), and lastly, PBP (15%). Revenue increases tell a somewhat different story, with Intelligent Cloud leading once more (24%), this time trailed by PBP (13%), and lastly, MPC (65).
The underlying shift to cloud and software is encouraging from the investor’s perspective. Not only has it benefitted gross margin percentages (see above), but these are higher-growth areas and, relatedly, have larger TAMs than MSFT’s Windows-and-gaming-centric MPC division.
MSFT does not break out financial metrics for Azure on a standalone basis, though it noted that the product grew revenue by 56% in FY ‘20.
MSFT’s cash and short-term investments, as of March 2021, equal approximately $125 billion. Thus, when COVID struck, investors could quite literally rest assured that the company would face minimal financial stress — over the medium to short-term, at least. All else equal, investors should prize assets that show little exposure to extrinsic factors outside of the company’s control, such as interest rates, geopolitics, and inflation. MSFT not only has the wherewithal to absorb a crisis approximate in magnitude and scope to COVID-19, but significant pricing power in the case of inflation.
Bear Case and Investment Risks:
1: Momentum is slowing in the ongoing shift to subscriptions, as Office is a mature product: This bear case goes hand-in-hand with the supposed disruption of Office by companies with a singular focus (i.e. Zoom, Slack, Okta, etc). Slowing subscription momentum, which in turn influences customer LTV, is a real and valid concern. Yet COVID-19 has played an important role in getting individuals to rethink how they work and interact with MSFT’s offerings. As working from home becomes ubiquitous, individuals and enterprises will become increasingly reliant on Office and, luckily for investors, MSFT has the pricing power to ensure that it captures its fair share of consumer surplus.
Additionally, some believe that Office is being disrupted by high-profile, highly-focused competitors such as Zoom and Slack — to make little mention of Google’s own suite. Indeed, Slack and Zoom are superior products to their Office equivalents, but the reality is that Office is often purchased in addition to these products. Office is a bundle, after all. What it lacks and videoconferencing and communication platforms it makes up for with Word, Excel, PowerPoint, and others. The real competition, therefore, is Google Suite. Yet let us not forget that Office is protected by switching costs and network effects in the productivity space.
2: MSFT lacks a meaningful mobile presence: A longtime worry that extends back to the Ballmer era (see above). MSFT has admittedly lost the competition for mobile dominance, and accepts this outcome wholeheartedly. Nadella’s strategy is in both software and cloud computing, which makes mobile rather irrelevant to the company’s future ambitions.
3: MSFT is not the leading cloud provider: The critical question is not whether MSFT can gain more market share than AWS, but rather whether cloud computing is a winner-take-all market. In short, it would appear this way. Over the past four-to-five years, both Azure and AWS have increased their markets shares substantially while GCP has lagged and “other” cloud competitors bled share. Azure has grown faster than AWS recently, but this growth has not come at the expense of the latter platform; let us remember, once more, that cloud computing is growing rapidly and has a large TAM, to say the least.
Admittedly, this investment risk concerns me both. I will be watching cloud metrics closely over the short- to medium-term. Such is a requisite for investing in high-technology.
Summary:
MSFT is a stock that requires very little “variant perception”. It has a long growth runway, owing to its continued shift towards software and cloud computing, is priced rather fairly, and critically, is relatively insulated from regulation “headline risks”. As one investor commented on Twitter, the MSFT thesis can be encapsulated by the following: it is the only Big Tech firm allowed to undertake acquisitions; for all the talk on Capitol Hill about regulating the tech giants, MSFT’s seems to attract the least amount of attention, if any. It’s days of regulatory scrutiny appear long gone.
Furthermore, at a modest 32x forward earnings — approximate to FCF — MSFT is unlikely to undergo significant multiple compression owing to its strong growth and long duration of cash flows. (See COST and MCD P/E for reference.) If the multiple indeed compresses, I will be a buyer all the way down. Moreover, growth in earnings and FCF will provide significant cushion for any multiple compression — making MSFT a difficult stock to lose money on.
Lastly on multiples, as so many tech bears fixate on the subject, MSFT is a far superior company to its former self even one year, two years, or five years back. Satya Nadella has executed brilliantly on his emphasis on MSFT’s cloud operations, helping to shift the narrative around the company, while greatly extending its growth runway. Such analysis makes 32x forward P/E seem fair, if not very close to it.
MSFT will continue to execute in the years ahead in both software and cloud computing, underpinned by the stream of cash flows from its personal computing segment and large pile of cash on its balance sheet. Together, this means MSFT can allocate significant sums to R&D while funding a dividend and share repurchases. Certainly a favorable position for MSFT to be in, and with a visionary leader at the helm, there is ample opportunity for market narratives to continue to shift in MSFT’s favor.
