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Leading Digital Transformation

Microsoft Corporation (“Microsoft”) is a technology company that is perhaps best known for its presence in the market as an operating system and productivity tool provider. However, Microsoft is far more than just Excel, Word, and Windows. The company is an innovator with operations across cloud services, artificial intelligence (“AI”) and machine learning (“ML”), video games and consoles, hardware, and even advertising tools and services.

Microsoft is leading the world’s digital transformation, helping thousands of organizations however big and small migrate their data onto the cloud, streamline their operations, and modernize their digital processes to save time, money, and other resources. Corporate technology spending as a percentage of global GDP is set to double this decade – Microsoft has what it needs with its 40+ years of experience in everything about computers to lead this secular trend and transform the working world as we know it.

Growth

48

Valuation

71

Quality

93
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Where Are We Now

Updated on: 11/7/2021

Conviction Score

9

Microsoft is everywhere and grows with each one of us throughout our lives – it has products that we use directly (and indirectly!) almost all the time, anywhere. We like Microsoft for its obvious brand name advantages and deep integration in our working and personal lives. We think Microsoft is still a buy despite it hitting all time highs.

  • An important business will have solid growth rates. That’s exactly what we’re seeing today – Microsoft is growing revenues above 20% and Azure (cloud) is growing over 50%.

  • Even Microsoft’s dreaded LinkedIn platform is growing rapidly to a tune of 46% per year based on latest numbers from Microsoft. The company is growing in all places and we think it will continue innovating for decades to come.

Investment Thesis

  1. Microsoft is a massive company with its foot in just about every major technology business line – operating systems, productivity tools, operating systems, productivity tools, cloud services, AI and ML, video games and consoles, hardware, and advertising tools and services.

  2. Microsoft products and services are found in most people’s homes and businesses around the world. Microsoft benefits from a reputable brand name due to customers facing high switching costs for competing services, the products having seamless integration with thousands of devices and other software, and Microsoft keeping pricing reasonable because of scaled economies.

  3. Azure is growing at rapid rates and may outpace AWS at some point this decade. This growth can be attributed to Azure’s good pricing, integration with software found across thousands of organizations, leadership in hybrid cloud, and neutral business model that does not directly compete with customers.

  4. Microsoft can exercise optionality using its corporate relationships, data, and strong presence in the gaming market. AI, ML, the creator economy, and Xbox Game Pass present potentially ground-breaking opportunities this decade, particularly in the latter half.

  5. Microsoft is an innovator – just five to ten years ago, nobody could have seen today’s breadth of products and services coming. Its management team is highly competent, and the company can attract top talent well to continue this momentum.

The Basics

Microsoft is a technology company that provides and delivers operating systems and productivity, cloud, video game, hardware, and advertising tools and services for individuals, businesses, and other organizations.

Microsoft’s operations can be grouped into three main segments:

  • Productivity and Businesses Processes

  • Intelligent Cloud

  • More Personal Computing

Productivity and Businesses Processes

  • Office Commercial (i.e., Office, Exchange, Sharepoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business)

  • Office Consumer (i.e., Microsoft 365 Consumer subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive)

  • LinkedIn (including Talent, Marketing, Sales, and Learning Solutions and Premium Subscriptions)

  • Dynamics business solutions (i.e., Dynamics 365 and on-premises ERP and CRM applications)

Intelligent Cloud

  • Server products and cloud services (i.e., Azure, SQL Server, Windows Server, Visual Studio, System Center, related Client Access Licenses, and GitHub)

  • Enterprise Services (i.e., Premier Support Services and Microsoft Consulting Services)

More Personal Computing

  • Windows (i.e., Windows OEM, Windows Commercial, Windows cloud services, patent licensing, Windows Internet of Things, MSN Advertising)

  • Devices (i.e., Surface and PC accessories)

  • Gaming (i.e., Xbox hardware, content, and services, Xbox Game Pass, subscriptions, video games, video game royalties from third parties, cloud services, advertising)

These platforms and tools form a powerful suite of hardware and services that boost productivity, increase competitiveness, modernize operations, improve business and organizational outcomes, and promote innovation.

Microsoft Revenue Sources (Q1 2022)

Source: Microsoft Investor Relations

Revenues have grown at a respectable double-digit CAGR despite slow growth between 2012 and 2017, when Microsoft was coming out of an innovative slump with few foreseen business catalysts. Over the past five years, revenue growth has picked up with the help of the rapid growth of Azure.

Microsoft Historical Revenues ($M) (Q1 2022)

Microsoft is an efficient and high-margin business. Net margins closely resemble operating margins mainly due to low interest costs and modest tax provisions in recent years. The growth of high-margin businesses, namely Intelligent Cloud, is helping raise overall margins.

Microsoft also converts a large proportion of its net income into free cash flow. Free cash flow margins have been steadily rising since the 2015 trough. The company has also been growing free cash flow at a rate greater than its revenues while also buying back tons of stock - a sign of a strong business with great products and profits that show for it.

Microsoft Historical Free Cash Flow per Diluted Share ($M) (Q1 2022)

"Micro-Soft"

In April 1975, Bill Gates and Paul Allen founded Microsoft (originally stylized as “Micro-Soft”, “microcomputer” and “software” combined) in Albuquerque, New Mexico. 

The company had been started to create software for an early personal computer (“PC”), the Altair. To pursue the perceived opportunity that is now worth trillions, Gates dropped out of Harvard University and Allen quit his day job.

Shortly thereafter, Gates and Allen worked on refining BASIC and developing other programming languages. IBM later approached the two to create an operating system for the IBM PC, the company’s first PC. Microsoft’s first operating system was born – the MS-DOS, a modified version of an operating system purchased by Microsoft prior to its release in 1981. 

Microsoft gained momentum quickly, outpacing sales of CP/M, a competing operating system in the 1980s. By 1990, Microsoft released its third version of Windows and throughout the 1990s, Windows was selling millions of copies each month and held over 90% of market share.

The momentum in the 1980s and 1990s set the stage for the rest of Microsoft’s more recent history. Xbox was released in 2001, Microsoft Azure (originally Windows Azure) was launched in 2008, Office 365 was released in 2011, Skype was purchased in 2011, and LinkedIn was acquired in 2016. 

Today, the company dominates across numerous verticals in operating systems, productivity tools, cloud services, AI and ML, video games and consoles, hardware, and advertising tools and services.

Competitive Advantages

Switching Costs

Microsoft Office is so deeply ingrained into society that millions of job descriptions and resumes ranging across many professions would need to change. Additionally, the re-training and re-learning costs and time spent to learn another set of productivity tools and ensure widespread compatibility across platforms would likely be too large an obstacle for the world to overcome.

Microsoft Azure is similar in this regard – it is used by virtually every major company in the world, having been integrated into 95% of the Fortune 500’s business processes. A Microsoft product will find its way into an individual’s or an organization’s property at some point, whether they like it or not.

Brand Name

Microsoft has been creating computer products and services for almost 50 years, gaining a strong reputation for quality, innovation, and governance along the way.

Microsoft products are found on hundreds of millions of computers today, and the number and variety of product offerings continue to expand with incredible customer uptake. Microsoft is a name customers appear to always believe in given the relevance its products have in our lives.

Deep Integration

Microsoft has access to tons of customer data across its vast stack of product and service offerings. The company has direct insight into its customers' needs throughout different personal and business functions. It uses data to innovate and develop new products and services that allow individuals and businesses to be more productive and more effective in their daily tasks.

A world of optionality is also open to Microsoft, who can use the data to innovate in areas beyond its current suite of products and services.

Economies of Scale

Microsoft’s fast-growing cloud business benefits from huge economies of scale.

Microsoft’s large data centres can deploy computing power at a lower cost per unit and allocate computing resources more effectively than smaller data centres.

There are also scaled economies inherent in the multi-tenancy location structure, in which new capability rollouts can be applied to multiple tenants at once and infrastructure costs are shared among many tenants.

As Microsoft Azure expands, so will its margins.

Core Microsoft Doesn't Miss

Microsoft is likely best known for the Windows operating system and Microsoft Office (i.e., Excel, Word, PowerPoint, Outlook, etc.) productivity tools that are found on almost every desktop in existence.

Windows captures about 73% of the world’s operating system market and Office 365 dominates the productivity tools market with almost 90% of market share.

Despite having massive market share in both areas, Microsoft continues to innovate to increase its value proposition to its customers. 

For example, Microsoft Teams was launched in early 2017 and currently sees almost 250 monthly active users. Put another way, over 120 organizations around the globe have more than 100,000 users of Teams, and another 3,000 organizations have over 10,000 users. Slack, a major competitor of Teams, has only a fraction of the user base that Teams enjoys – there are roughly 20 to 30 million monthly active Slack users worldwide.

Windows 10 dominated the operating system scene since its launch in 2015. In June 2021, Microsoft announced that Windows 11 is on its way and should launch in late 2021.

Microsoft 365 and Windows both make up a substantial portion of revenues at Microsoft, but most of their value is derived from the “land-and-expand” strategy.

Microsoft maintains its strong brand name by continuing to deliver staple productivity tools that every individual and organization is familiar with. As enterprises migrate to cloud-based productivity tools and seek to modernize their operations, Microsoft is mainly sought to digitally transform their operations and shift to cloud-based databases and tools. Since Office 365 is so deeply ingrained in corporate culture, using Microsoft products for digital transformation is a no-brainer – it is simply the suite of tools with the greatest level of compatibility and integration for most organizations. 

This is precisely where Microsoft wins. A great suite of products with high switching costs means Microsoft “lands” across thousands of organizations in which millions of people work. Once it “lands”, it becomes easier and perhaps more intuitive for the customer to “expand” on its services as its business and digital operations become more complex, opting for Azure’s cloud services, Dynamics 365, Exchange, AI solutions and services, and Sharepoint, among many others. 

The uptake of Microsoft’s productivity apps is a clear indicator of the strength and seemingly impenetrable positioning within a corporation’s digital and productivity tool stack. As a result, we believe Microsoft should grow at above-average rates when it comes to digitalization. 

Satya Nadella, the CEO of Microsoft, expects global technology spend to increase to 10% of world GDP within 10 years from 5% today. Microsoft will (almost) undoubtedly emerge out of this decade as a leader of digital transformation.

Azure, For Sure

Azure, Microsoft’s suite of cloud platforms and services, poses a real threat to Amazon’s AWS, the industry’s largest cloud provider. Although AWS leads in the infrastructure- and platform-as-a-service (“IaaS” and “PaaS”) markets with almost 60% market share, Microsoft is the clear winner when commercial software-as-a-service (“SaaS”) is included in the formula, dominating with 50% of market share. Microsoft’s Commercial Cloud grouping includes Azure and the commercial portions of Office 365, LinkedIn, Dynamics 365, and several other software offerings.

Azure is the fastest growing cloud platform of the three major cloud platforms – AWS, Azure, and Google Cloud Platform (“GCP”). AWS is consistently growing at mid-30% rates while Azure can maintain year-over-year growth rates of around 50% despite only being launched two years after AWS (AWS – 2006; Azure – 2008). GCP, the “younger brother” of AWS and Azure, is growing at similar rates to Azure but off a smaller base – GCP was commercially launched in 2011 and captures only a small piece of the IaaS and PaaS pie.

Microsoft’s Commercial Cloud revenues grew at a 49% five-year CAGR between the 2016 and 2021 fiscal years, only slightly below the Azure-only cloud growth rates.

IaaS / PaaS Market Share

Sources: IDC, Evercore ISI Research

Overall Cloud Market Share

Sources: IDC, Evercore ISI Research

Microsoft Commercial Cloud Historical Revenues ($M) (Q1 2022)

Source: Microsoft Investor Relations

Public Cloud Revenue Forecast

Microsoft does not disclose operating income related to Commercial Cloud, however, the Intelligent Cloud and Productivity and Business Processes segments have high operating margins around 40%. We believe it is safe to assume that both Intelligent Cloud and Commercial Cloud have operating margins in line with these figures – around 40%. In contrast, AWS has operating margins around 30%, meaning that Azure and Microsoft’s full SaaS / PaaS / IaaS stack both appear to operate more efficiently than AWS.

Azure has several advantages over AWS (and GCP) that could propel it upwards into a leading position later this decade. Some of the main differentiators include, but are not limited to, the following:

  • Azure is the leader in hybrid cloud, a concept that is gaining prominence over fully outsourced cloud services or keeping data entirely on-premises (i.e., in private data centres). Hybrid cloud is important for edge computing – another major trend in the 2020s – to work to its full potential. It also allows enterprises to better control security, performance, and costs rather than subscribing to multiple cloud environments to meet business needs. Microsoft has a broad portfolio of identity and security solutions to curb the security concerns and operates on a global scale. Although AWS is larger, Azure competes in many of the same markets – as Azure continues to grow, it may also capture greater incremental market share than AWS.

  • Microsoft software, products, and services hold together the corporate world, and will continue to do so as companies modernize operations to include collaboration tools like Sharepoint and Teams. This powerful integration of software offerings, especially Microsoft 365, with cloud services, brand name and reputation, and strong corporate relationships are compelling reasons as to why corporate executives may opt for Azure over AWS.

  • Microsoft does not directly compete with many other companies anywhere around the world. While AWS is unpopular amongst retail brands, Microsoft has an edge over AWS in this regard by being able to pick up customers that may be concerned about handing their data over to a large competitor.

  • Azure beats AWS on pricing.

Azure has made a name for itself in the corporate world, and it still has a long runway before momentum slows. Considering that over 95% of Fortune 500 companies use Azure, growth rates surpass AWS, and Azure having many key benefits over AWS, we believe Azure will be a force to be reckoned with in the cloud industry.

The Data Empire

With great data comes great responsibility (and optionality). Microsoft has one of the most comprehensive and durable technology stacks spanning SaaS, PaaS, and IaaS. The land-and-expand model enables Microsoft to work with thousands of organizations of all sizes, industries, and regions around the world.

Microsoft’s wide and vast customer base gives the company direct insight into what organizations are looking for and swaths of data across virtually every digital aspect of an organization. Microsoft can then use this knowledge to develop the next best technological advances in hardware, software, cloud, and even AI.

Microsoft currently leads in enterprise AI, which helps financial services, healthcare, government, manufacturing, and retail organizations streamline operations by avoiding redundancies, improve decision-making, and find critical information quicker. Microsoft is betting big on the AI front – it announced the acquisition of Nuance Communications, a voice technology solution company with the aim to reduce the need for doctor note-taking and better predict patient needs, to bulk up its healthcare AI portfolio and research.

ML is another major opportunity for Microsoft with tons of optionality as use cases are set to boom this decade. Azure ML is Microsoft’s cloud-based ML service that gets “smarter” and more efficient at performing its set tasks over time. ML has many important uses today, especially in predictive analysis, which can be used to understand, control, and protect data, models, and operational and digital processes. 

Microsoft can improve its current product offerings and create new services in the future using advances in AI and ML. AI and ML will be increasingly ingrained into business functions throughout this decade as organizations modernize their operations, inevitably boosting use cases down the line as organizations grow and learn using AI and ML and realize all their capabilities.

Outside of enterprise technology, Microsoft is also investing heavily into gaming and the creator economy. 

Xbox is the second-most popular gaming console in the world, behind only the Sony Playstation, and Xbox Game Pass – a video game subscription service launched in 2017 that allows users to access a rotating catalogue of game and other content – recently surpassed 23 million subscribers. Game Pass subscribers reportedly play 40% more games and spend about 50% more than non-members, presenting a major recurring revenue opportunity in gaming as subscriptions increase.

Creators are also earning more in Microsoft’s gaming ecosystem by creating new games, challenges, and maps within popular games, like Minecraft, Forza Horizon 5, and Flight Simulator. Powerful network effects can ensue if Game Pass subscribers increase, which would raise the demand for new games and challenges, and ultimately boost the monetization ability of creators within the Microsoft gaming creator economy.

Microsoft theoretically has no shortage of opportunities, and we believe it will continue to expand its offerings outside of what it's known for today. Gaming, AI and ML, and digitalization are the themes of today that will lead to the next innovations of tomorrow. If Microsoft maintains large market share in each of these areas, Microsoft will continue to innovate and outpace other technology companies for as long as the earth remains.

Risks

Speed Kills

Microsoft is growing revenues at rapid rates, especially its cloud segment. When a business is growing at a high run rate, its share price is more susceptible to whipsaws.

If the cloud or productivity tool markets slow, Microsoft loses share to competitors, or guidance is lowered, shares of Microsoft could drop substantially. Microsoft is not particularly cheap – there is room for downside if the business faces challenges.

General Competitive Risks

Windows market share has been steadily declining from 95% market share in 2009 to 73% today due to the growth in Apple’s OS X; Google Workspace is an attractive alternative to Microsoft 365; Sony’s Playstation is still the global console leader; AWS is larger and currently more popular than Azure and controls the IaaS and PaaS market; Google and Facebook advertising are powerful tools for marketers and Amazon Advertising is a fast-growing segment.

Microsoft faces intense competition in virtually all segments which may impair their ability to emerge as leaders or capture enough incremental market share to grow as expected.

Antitrust Concerns

Microsoft holds high market share in Windows, productivity tools and services, and cloud, naturally attracting regulatory probes and antitrust complaints. US President Joe Biden recently issued an executive order that directs the Federal Trade Commission (“FTC”) to make anti-competition rules more stringent.

The FTC launched a probe last year of the acquisitions made by large technology companies, including Microsoft and Amazon, between 2010 and 2019. Microsoft, being a company worth over $2 trillion, will also attract antitrust attention if its “big tech” peer group comprised of Amazon, Facebook, Google, Apple, Netflix, and others, face antitrust scrutiny. Heightened regulatory oversight and stricter rules could make it more difficult to do business and grow.

Bottom Line

Microsoft is a force that is gaining momentum as organizations digitally transform their operations and seek ways to save money, time, and other resources. The company has an ever-growing stack of software, infrastructure, and platforms that facilitate this change and outperform large competitors. 

Despite its hiatus in the early 2010s, the business is back on the innovation train, rolling out new products and services across AI, ML, software, operating systems, gaming, the creator economy, and the cloud. The truth is that we could be understating Microsoft’s opportunities throughout this decade.

If Microsoft continues to innovate and roll out new products and services, we believe Microsoft is a name to consider for your portfolio. It rarely releases subpar products and services that do not perform as expected – the company gets its high reputation from rolling out quality products time and again.

Microsoft has ample growth opportunities and possible verticals it can tackle. The Microsoft we know today may not be the Microsoft we know tomorrow. Although Office and Windows will be with us for years to come, the image of Microsoft may morph into something entirely different as it explores and penetrates new markets, geographies, and concepts.

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