Microsoft (MSFT) has experienced an impressive turnaround over the last few years. The company’s top-line growth has been fueled by its cloud computing solutions. Demand for cloud computing has been on the rise and has seen acceleration post COVID-19 due to a global push for business digitalization. More recently, Microsoft has been in the news after announcing that it (along with Walmart (WMT)) is in talks with ByteDance to acquire social media app TikTok’s business in certain countries including the US. In this report, we analyze Microsoft’s business model, its market opportunities including the potential TikTok transaction, competitive positioning, valuations, risks, and finally conclude with whether an investment in the company’s stock offers an attractive balance between risks and rewards.
Overview:
Microsoft offers a variety of software and hardware solutions for both commercial and personal use. Co-founded by Bill Gates and Paul Allen in 1975 as an operating system developer, Microsoft was listed as a publicly traded company in 1986 and has grown to become one of the largest tech companies with a market cap of over $1.6 trillion. Since the 1990s, Microsoft has cemented its position as the market leader in the operating systems space with its Windows OS and has also diversified into other business segments via LinkedIn, Xbox devices, and its Azure platform. More recently, Microsoft (and Walmart) entered into talks with ByteDance and to acquire its TikTok app business in the US and a few other countries to further expand the company’s social media business.
Microsoft conducts its business through three operating segments: -
Productivity and Business Processes: This segment primarily consists of productivity, communication, and information services solutions offered by Microsoft. Revenue in this segment is generated from commercial or consumer subscriptions to Office 365, as well as licensing of its suite of productivity and cloud solutions such as Teams, SharePoint, Exchange, Skype, Office 365 security, outlook.com, and OneDrive. This segment also includes Microsoft’s social media platform LinkedIn along with cloud-based ERP and CRM solutions. The segment contributes 32% to the overall top-line of the company and generates an operating margin of 40%.
Intelligent Cloud: This segment consists of all server products and cloud solutions offered by the company, which include Azure, SQL server, Windows Server, Visual Studio, System Center, GitHub, etc. This is the fastest growing segment for Microsoft and accounts for 34% of total revenue. Operating margin of this segment stands at 38%.
More Personal Computing: This segment houses products and services that deliver personal user experience. The products include the Windows operating system, Surface and Xbox. This segment also contributes 34% to total revenue of the company but generates relatively speaking lower operating margin of 33% as it includes more hardware-based solutions.
In terms of product exposure, server products account for 29%, followed by Microsoft office products which contribute 25% to the topline.
Although all the segments have shown impressive performance in recent years, a significant portion of the growth has been driven by the Intelligent cloud segment which houses Microsoft’s cloud computing Azure business. As business digitalization and cloud-based solutions expand globally, there has been an increasing demand for cloud computing platforms such as Azure, which provide analytics, virtual computing, storage, networking, and other solutions without the need for costly, inflexible on-premise server infrastructure.
Industry leading position in business productivity software and operating system segments
Microsoft has consistently maintained a dominant position in the PC operating system segment since the launch of its first IBM compatible DOS version in 1980s and is continuing to cement its near monopolistic position in the desktop/laptop userbase. While the company has observed a slight loss of market share to Apple’s macOS, WindowsOS still remains the leader with a global market share of over 85% as per netmarketshare.com. MacOS stands at a distant second position with a share of just 8%. Windows 10, which is the latest OS version released by Microsoft is now used by approximately 60% of the global Desktop/Laptop users. Once a user adapts to an operating system, it becomes an integral part of computer workflows, and switching to alternatives may not be viable given additional effort required to learn new functions. Given these dynamics, we believe the company’s dominance in the PC/Laptop operating system segment is secure in the near to medium term.
Having said that, it is important to note that Microsoft significantly lags its counterparts in the fast-growing mobile operating system market. Smartphones have seen significantly faster growth than desktop/laptops in recent years and Google Android has emerged as the clear winner in the handheld devices O/S space with a market share of over 70%. Apple’s iOS which functions on iPhone and iPad hardware has a market share of around 29%. Microsoft entered the smartphone OS business with a tie-up with Nokia and later went on to acquire Nokia’s mobile division in 2013 for around $8 billion. However, this business acquisition turned out to be a failed experiment. Later in 2015, Microsoft announced discontinuance of its mobile OS segment as it was unable to get mobile app developers on board.
While the company’s mobile O/S business has been weak, it has made solid progress on making its productivity suite cloud friendly. With increased demand for cloud-based software solutions, the company released Office 365. Besides several new features, Office 365 also includes cloud computing integration that allows users to easily share, collaborate, and co-author work through files centrally stored in the cloud. Apart from improved efficiency, Office 365 also provides improved security and is cost effective, especially for enterprise customers. Also, Office 365 is offered through a subscription-based business model that provides sticky and recurring cash flows to the company. Revenue from Office 365 overtook the on-premise Office suite back in 2017 and it has become the most used enterprise cloud software solution globally. One quarter of Microsoft’s top-line is made up of Office products and revenue is increasing at a growth rate of 13% with expanding user adoption. The company faces competition from G-Suite which is Google’s cloud friendly version of Office. However, through constant innovation and upgradation to its Office suite, Microsoft still occupies a significant share of the business productivity solutions market.
Gaining share in the cloud computing market
Microsoft offers its cloud computing services through its Azure platform. Azure is the fastest growing product segment for the company and has remained the driving force behind Microsoft’s impressive financial performance in recent years. Azure is a cloud computing service which provides a platform for creating, testing, deploying, storing, and managing applications and services through its managed data centers located all over the globe. It is a flexible platform in that users can scale computing resources as per their needs.
Cloud computing is a rapidly growing technology market segment. The primary driver behind this strong growth is the push towards business digitalization along with efficiency. Cloud allows organizations to access software, computing power, and other applications without the need for in-house hardware infrastructure, thus leading to reduction in large scale capital expenditure investments and maintenance. As per Statista, the global cloud services market size currently stands at $258 billion and is expected to expand to over $364 billion by 2022, translating into a CAGR of around 15%. Please note that Azure is not only growing at a fast pace in absolute terms, it is also significantly outperforming its peers.
Amazon Web Service (AWS) is the largest player in the cloud computing space with 33% of worldwide market share. It enjoys the first mover advantage and was launched in 2006 whereas Microsoft played catch up by launching Azure in 2010. Despite that initial disadvantage, as evident in the chart below, Azure has been slowly taking market share from AWS. Although AWS and Azure provide almost the same service specifications, Azure provides better hybrid cloud capabilities i.e. users can easily move between on-premise data centers and Azure’s public cloud infrastructure. Also, since most of the organizations already have agreements with Microsoft for use of software such as Office suite or Windows OS, they are entitled to receive loyalty discounts for availing Azure services. Additionally, the cloud infrastructure market segment has been undergoing consolidation. The market share of top 3 vendors has increased from 51% in 2017 to 60% by Q2 2020. This market share movement highlights that scalability is important in cloud IaaS business and service providers that can consistently invest capital in building an increasing number of data centers will continue to garner additional market share.
Source: Statista
More recently, the COVID-19 pandemic has accelerated the need for Cloud solutions as global organizations are pushing for digital transformation and see cloud platforms as a logical solution to achieve business continuity in the post pandemic new normal of social distancing and work from home. During Microsoft’s most recent Q3 earnings call, CEO Satya Nadella had this to say:
“As COVID-19 impacts every aspect of our work and life, we have seen two years’ worth of digital transformation in two months. From remote teamwork and learning to sales and customer service, to critical cloud infrastructure and security, we are working alongside customers every day to help them stay open for business in a world of remote everything. There is both immediate surge demand, and systemic, structural changes across all of our solution areas that will define the way we live and work going forward.”
TikTok - A potential window into the digital video social media space
Social media app TikTok has been ordered to sell-off its US business by President Trump over national security concerns by November, post which it will be banned from operating in the U.S. Understandably, Bytedance and its investors are looking to monetize the assets before they are compelled to shut shop in the US. Microsoft is in advanced talks to buy TikTok’s US, Canada, Australia, and New Zealand assets from ByteDance. If the acquisition goes through, TikTok’s U.S. business would provide Microsoft with a head start in the video social media industry and would also add to its advertising revenue. TikTok has over 50 million active users in the US and is ranked one of the most downloaded apps on both Android and iOS platforms. TikTok users have more than doubled in the past year showing impressive growth and user acceptance, especially among teens.
The acquisition would add several elements to Microsoft that it presently doesn’t have in abundance namely a) access to a younger crowd b) huge advertising potential. Additionally, Microsoft would most likely replace other cloud providers for TikTok with Azure leading to synergies. Having said that, TikTok’s competition with Facebook (FB) and Snapchat (SNAP) is heating up. Instagram has recently introduced Reels with TikTok-like features. Moreover, Facebook and Snap Inc. have also expressed interest in acquiring Dubsmash which is a TikTok like platform. Nevertheless, TikTok’s acquisition would be a game changer for Microsoft.
The acquisition will also be impactful for other service providers in the ecosystem. For example, TikTok is the largest customer of Fastly (FSLY). If TikTok can find a home at Microsoft, FSLY wouldn’t have to face significant loss of revenue. In the latest, according to a Wall Street Journal article, Microsoft may team with Walmart (WMT) to acquire TikTok.
Strong operating performance despite COVID led challenges
Microsoft reported revenue of $38 billion in FY Q4 2020, which represents a constant currency growth of 15% on a YoY basis. Growth in Office suite license purchases remained suppressed in Q4 because of reduced purchases by small and medium sized enterprises as they curbed operational expenditures. Slow growth in the productivity and business processes segment was offset by strong expansion in the personal computing segment because of increased demand for gaming consoles and surface devices as people stayed at home during the pandemic. The slated release of Xbox Series X and Surface devices later this year is expected to provide a further boost to this segment in the coming quarters.
Intelligent cloud continued to remain the fastest growing segment for Microsoft as the Azure business saw a YoY increase of 50%. Investors must note that this was the weakest growth Azure has reported since its launch which suggests that Microsoft’s cloud computing business has started to mature. Having said that, we believe that a 50% top-line increase on such large base is commendable. Azure is still growing at a faster rate than both Google cloud and AWS implying that Azure continues to take market share. The strong push for business digitalization in the post-pandemic world and rise in demand for cloud infrastructure will provide enough ammunition to Azure in near to medium term.
On the profitability front, Microsoft continues to expand its operating margins as it grows its higher margin businesses such as Intelligent cloud and business productivity solutions. Its operating margin has expanded from just 25% in FY 17 to 37% in FY 20. Besides, it is a cash rich company and generates a significant amount of cash flows. In FY 20, Microsoft generated free cash flow of $43 billion which represents a YoY increase of 20%. Please note that the company has been consistent in returning cash back to the shareholders. In FY 20, Microsoft distributed $38 billion to its shareholders in the form of dividends and share buybacks, which translates into a payout ratio of 89% in terms of free cash flow. The company ended the year with a net cash position of $73 billion which we believe puts Microsoft in a robust position as far as financial stability is concerned. It has enough sources to fund the acquisition of TikTok without impacting the quality of its balance sheet in a meaningful way.
Shift to SaaS based business leading to expansion of valuation multiples
Microsoft’s valuation multiples have been consistently expanding over the last few years. The stock is currently trading at a Price to Sales multiple of over 11.4x and EV to EBITDA of 23.5x which is at the higher end of its valuation range. This is primarily because under the leadership of Satya Nadella, Microsoft has transformed itself from a boxed product seller to a subscription-based Software-as-a-service (“SaaS”) provider through its several cloud-based applications including Office 365 and Azure. Apart from rekindling top-line growth, this shift has helped the company achieve higher margins and more predictable cash flows. Therefore, while Microsoft’s valuation has expanded over the years, it is for justifiable reasons and relative to peers (NOW) (ADBE) (CRM) (SAP) (ORCL) it is still trading at reasonable multiples.
Risks
Competition: Microsoft faces significant competition from Amazon and Alphabet in the cloud computing space. Intensifying competition may force all players, including Microsoft, to reduce pricing for their services in order to maintain market share which will impact segment margins.
Prolonged business spend slowdown. A deep and protracted slowdown in corporate spending will impact the company’s growth momentum despite strong digital transformation tailwinds. Having said that, we believe any slowdown is likely to be temporary and the company’s strong balance sheet provides it with enough staying power.
Valuation: As mentioned, Microsoft’s valuation is near the higher end of its historical range. However, this is primarily because it has wisely transformed itself from a boxed product seller to a subscription-based SaaS provider, thereby warranting a higher multiple. Furthermore, relative to peers, Microsoft is relatively less expensive, especially considering its strong growth trajectory.
Conclusion
Microsoft is one of the largest technology companies in the world. It has been consistently delivering strong top and bottom line growth for the past few years primarily through the success of its SaaS and public cloud solutions. The company has ample growth opportunities as it rides on the cloud trend over the foreseeable future. Additionally, acquisition of TikTok will add another massive growth driver to this growth engine. We believe the stock offers strong upside to long term-oriented investors from a 3-5 year perspective. We are currently long shares of Microsoft, and have zero intention of selling anytime soon.