Microsoft: A dependable investment in bull and bear markets

The business

Microsoft is one of the world’s leading technology companies and sells some of the world's most widely used software products. At the time of writing it has a market capitalisation of over $1 trillion.

 Its business is split into three reportable segments:

• Productivity and business processes
• Intelligent cloud
• More personal computing

Its $134bn of annual revenues came from the following sources in the year to December 2019.

Productivity and business processes

This business is based around many familiar products and services used by large numbers of people and businesses around the world. It is currently Microsoft’s biggest source of operating profit and contributed $18.3bn of its $49.3bn of total profit in the year to December 2019.

The key product is the Microsoft Office suite of productivity software. This includes Word, Excel and PowerPoint, as well as Skype video conferencing, Outlook email and One Drive cloud storage.

Office used to be something that got installed once on a computer and was left there for years before maybe getting upgraded. Today it forms part of Microsoft’s changed approach to business, whereby it has moved away from selling software licences to annual subscriptions.

Microsoft Office 365 subscriptions are sold to businesses and individuals and provide a more regular and reliable source of income, which has been growing strongly in recent years. 

Skype earns money from advertising and the sale of minutes to users whereas Outlook is also a source of advertising revenue. One Drive earns money from selling subscriptions for cloud storage.

Microsoft also owns Linkedin, the world’s biggest professional network. It earns revenue from job advertisers and news feed adverts. This business has seen significant revenue growth in recent years as user engagement with the network has increased.

Microsoft Dynamics is a software service that helps companies manage their businesses better in areas such as their finances, strategy, customer relationships and supply chains. This software is cloud-based and sold as a subscription through Microsoft Dynamics 365.

Intelligent cloud

This is Microsoft’s second biggest source of operating profit ($16.1bn in the year to December 2019) and its fastest growing.

The business is based around providing servers (a big computer that processes data requests and sends them over the internet or local network) and related services such as Microsoft SQL database management. It also provides cloud computing services under the Microsoft Azure brand.

The server and SQL business has been a steady grower over many years, but the significant growth in revenues is coming from cloud computing services.

Cloud computing provides companies with computing services and processing power over the internet. Instead of buying and owning their own IT infrastructure, they rent it from companies such as Microsoft, which means they don’t have to worry about maintaining it or upgrading it. They pay Microsoft fees to use its cloud services based on how much they use them.

Cloud services range from data storage, networks and the processing power required to run applications, to things such as artificial intelligence and machine learning.

The biggest part of the cloud market is software as a service (Saas), whereby software companies provide their products to their customers over the internet using the cloud and sell them as a subscription rather than a licence. This means users can work remotely on different devices providing they have an internet connection.

Microsoft has arguably the biggest footprint across the global cloud computing market at the moment. Not only is it a provider of cloud services with Azure, but it is also a huge Saas provider with products such as Office 365 and Dynamics 365 (reported in productivity and business processes).

The company was a lot slower off the mark than its main cloud rival, Amazon, but has been catching up rapidly. It does not separately report the revenue that comes from Azure but does give a figure for its commercial cloud revenues, which also include sales from Office 365, Dynamics 365 and the commercial portion of revenues from Linkedin. These have seen stunning levels of growth in recent years, increasing from just over £5bn in the year to June 2015 to over $44bn in the year to December 2019.

The cloud computing market is changing quickly and is very competitive, but it does have one very desirable characteristic. Once a company has chosen a cloud provider and has lots of its business on its cloud it tends to stay with it, which makes cloud revenues very sticky and reliable.

More personal computing

This division currently contributes $14.9bn of annual operating profits. The business is underpinned by the Windows computer operating system, which still dominates the personal computer (PC) market. Windows’ revenues come from the sale of licences, mainly to PC manufacturers who pre-install it on their computers.

Having given up on trying to make mobile phones and portable music players, Microsoft has focused its devices business on selling its Surface brand, which combines the flexibility of a laptop and a tablet computer.

The Microsoft XBox is the company’s gaming console. As well as making money from selling consoles, revenue is generated from software sales and subscriptions.

The other main source of revenue for this division comes from search advertising through the Bing search engine.

Competition and risks

Microsoft operates in very competitive markets across all its businesses. In productivity and business process, its Office 365 has to compete against the pre-installed office and productivity suite that comes with Apple’s Mac computers and Google’s free office products and G suite.

Skype has to compete with rivals such as Zoom, whereas Dynamics competes with several Saas providers such as Oracle, Salesforce.com, SAP and Sage.

Yet, Microsoft has a brand that is deeply entrenched across businesses and has a lot of trust built up over many years. It’s not impossible, but moving files and data for a business that has been using Office to another provider such as Google is a lot of hassle. The fact that Office is increasingly purchased on a subscription and in the cloud also means that customers can use it anywhere and across devices and receive regular upgrades. The growth in Office 365 users and revenues in recent years has been impressive and suggests that Microsoft is more than holding its own here.

Cloud computing is set to get more competitive as the market changes and matures. Microsoft is in a battle for supremacy in this market with Amazon and to a lesser extent Google as they try to win big contracts from businesses, governments and healthcare providers.

Demands from customers are increasing. Many don’t want to have all their data in the cloud as it is commercially sensitive or have all their cloud services with one provider. This is fuelling demand for hybrid cloud (on-site servers and cloud) and multi-cloud services as well. On top of this, technology changes in areas such as 5G networks, artificial intelligence, machine learning and the internet of things (where any connected device can store and send data) is creating more demand and challenges for cloud providers.

Barriers to entry in this business are significant and include huge global investments in data centres and communications infrastructure to provide a comprehensive service. 

Microsoft has the scale and reach to compete very effectively. It pitches its Azure products to customers on their performance capability, low cost of ownership, product offerings, range of applications, ease of use and, importantly, security.

Amazon is a fierce competitor on price and is also looking to ramp up its server business. It is not slow to point out to customers that many Microsoft applications work just fine on its cloud platform. It is also challenging the award of a $10bn US government cloud contract to Microsoft and there has to be some risk that the latter could lose this contract.

Microsoft no longer bases its business around Windows, but it is still a significant earner for the company. Windows faces competition from Apple’s operating system and Google Chrome, as well as Linux, but these have not inflicted much damage. Windows 10 is proving to be very popular and system upgrades from older versions mean that Microsoft’s operating system has been doing quite well and growing faster than the PC market.

Gaming consoles have a long lifecycle (five to 10 years) which means that sales can dip between new versions, but users stick with them. Microsoft faces considerable competition here from Sony and Nintendo as well as gaming services from Apple and Google.

Bing has failed to become a major player in search and its online advertising revenue is up against two fierce rivals in the form of Google and Facebook.

Microsoft has not yet said that the coronavirus is having a big impact on its revenues and profits. However, the fact that a large chunk of its revenues are on subscription gives it a degree of protection.

It still faces a risk from big increases in unemployment. This could see fewer Office 365 and Dynamics subscriptions from businesses, as well as lower cloud pay-as-you-go revenues.

A reduction in hiring could see job advertising revenue on Linkedin fall as well as search advertising from Bing. PC sales and Windows installations could also see a fall. 

Business performance

Microsoft provides a lot of products and services that it has built up to a huge scale that makes it hard to compete against. It also benefits from the huge profitability that comes from software sales, which add large profits for little cost with each additional sale once all fixed costs have been paid for.

These characteristics are shown in the very high profit margins that the company earns across its three divisions.

Microsoft: revenues, profits and margins

Source: Microsoft/Investors Chronicle

Its operating margins for the company as a whole have been moving upwards over the past few years. This is not its only attractive financial performance number. It makes very respectable returns on capital employed (ROCE) – even given its substantial cash balance – and is very good at turning its profits into free cash flow with high free cash flow margins.

Most of the company’s free cash flow has gone back to shareholders in the form of higher dividends and lots of share repurchases. These have turbo-charged total shareholder returns in addition to its strong and growing business performance

Microsoft: Key financial performance metrics

Source: Microsoft/Investors Chronicle

What the future might bring

This is difficult to answer for many businesses right now. In the case of Microsoft, it does not seem unreasonable to think that when the economy and business conditions get back to normal it should continue to do well.

Cloud computing is set to remain the main area of growth. Gartner, a US research and advisory company, recently predicted that global spending on cloud computing would increase from $217bn in 2019 to $266m in 2020 and $355m in 2022. Covid-19 means these forecasts are likely to be revised down, but if Microsoft continues to grab a decent chunk of new business its cloud revenues and profits should still grow nicely.

Its subscription products Office 365 and Dynamics 365 as well as Windows (which is currently producing annual revenues of $21.6bn) give an attractive base of predictable, growing and cash-generative revenues.

How much profit the company might make in the years ahead is uncertain, but nowhere near as uncertain as a great many businesses out there. Its revenue stability and predictability – along with its ability to grow –  is one of the reasons it has become a firm favourite with investors.

Current Wall Street consensus forecasts are for Microsoft to make net income of $43.5bn in the year to June 2020. These forecasts, like so many out there at the moment, have yet to be revised significantly in response to the economic shock caused by the response to the coronavirus.

Microsoft actually made $44.3bn of net income in the year to December 2019. While there have undoubtedly been some reductions in revenues and profits in the past month – particularly those related to advertising – and are likely to be in the months ahead, it would not surprise me if Microsoft got quite close to meeting current forecasts.

At a share price of $136, this would put its shares on a 2020F price/earnings (PE) ratio of 23.8 times or an earnings yield of 4.2 per cent. Not so long ago, investors were happy to pay a higher valuation for the growth and predictability they felt Microsoft offered them. We are in a different world now and this can no longer be taken for granted.

Microsoft is undoubtedly an excellent business, but the valuation of its shares remains rich. Shareholders have benefited from a large degree of outperformance in a falling stock market in recent weeks, but buying Microsoft shares now only makes sense if you believe forecasts will not come down and that the shares will continue to trade on the current high PE multiple. There may yet be a better entry point, but this is a share that is worthy of joining most quality investors’ watchlists at the very least.