Microsoft is one of the blue-chip companies that are trading today at extremely attractive prices. By any measure, Microsoft is an impressive business machine; the economics of its business allow it to achieve ROAs in excess of 20%, ROE's in excess of 40%, and net margins in excess of 20%. To top if off, Microsoft has managed to grow its revenue and earnings per share at a CAGR > 10% over the last ten years. By the numbers, this looks like a growing company with excellent financial characteristics.
Yet its share price has gone nowhere over the last ten years. With its EPS increasing over the years, its PE ratio has dropped to approximately 11 times 2011 forward earnings.
This stunning dichotomy simply demands a closer look by any investor worth his salt. This is either an unprecedented buying opportunity, or Microsoft's business is about to enter a rapid descent, which is what its current valuation suggests the herd is thinking. The latter also demands the attention of any serious investor, as a case study of how a wide moat business can lose its edge and fall into the abyss in a blink of an eye.
Microsoft's earnings streams
Microsoft is really a combination 4 separate earnings streams: (1) its profitable and well established Windows Operating System and Microsoft Office earnings stream, and (2) earnings from its server software division, where it is a competent player, and (3) earnings from its online and games division, a new area which the company is trying to break into, and (4) its nascent Azure application development cloud its Office and Exchange cloud businesses.
The bulk of Microsoft's earnings come from its Windows and Office product lines. These earnings stem from its dominance of the operating system and office productive software markets for the PC (and PC server) space. They make up the bulk of its earnings and revenue, and enjoy enviable margins.
-----------------------------------------------------------------------------
Sidebar: Here's how margins(net income/revenue) stack up in the software industry:
NOVL: 0% CSC: 5% RHAT: 12% SAP:15% CA: 10-16%
ADBE: 20-22% ORCL: 22-24% MSFT: 27-29%
MSFT Operating income/Revenue: Server and Tools = 33%
MSFT Operating income/Revenue: Business Division = 61%
MSFT Operating income/Revenue: Windows And Windows Live = 67%
-----------------------------------------------------------------------------
Valuing Microsoft broadly boils down to thing things: (1) valuing its established Windows and Office franchise, and (2) valuing its cloud, gaming and online initiatives. The first requires an analysis of the moat and sustainability of its PC based ecological niche, while the latter requires a Venture Capital type assessment of a startup's prospects. Its server software business, while competent and well executed, is not large enough to move the needle on valuing the Microsoft behemoth.
Assessing Microsoft's prospects in its new initiatives is a challenging task. As any business historian can attest, the track record of established companies successfully remaking themselves in new ecological niches is dismal. It is exceedingly difficult for established companies to innovate and enter new market spaces. A look at the history of capitalism suggests that groundbreaking innovations are usually brought to market success by startups. Established businesses have rarely been able to create, innovate and enter fundamentally new market spaces. Where they have done so, it's typically by acquiring upcoming startups.
How businesses evolve in Ecological niches, and the challenges dominant firms face in evolving with changes in the Ecology (Business Anthropology)
Most established companies are the survivors of the ecological market niche that a particular confluence of technology, fashion or the zeitgeist that happened at point in history. For example, P&G and Unilever are the dominant survivors of the ecological niche brought into existence by the advent of chemical manufacturing, mass communications, and logistics. Similarly, Coca Cola, Kraft, Nestle and Heinz are the dominant survivors of the intersection of mass manufacturing, agricultural logistics and mass communications.
The same is true in the technology industry, except that ecological niches exist for much shorter time spans. IBM was the dominant survivor of the mainframe era, but that ecological space shrank precipitously in the 70s. Digital Equipment Corporation dominated in the minicomputer space, an ecological niche which all but disappeared by the 90s with the coming of the microcomputer ecology. Microsoft and Intel are in turn, the dominant survivors of the microcomputer ecological niche.
Few large companies manage to recreate their success in new ecological spaces when their original ecological spaces expire. Polaroid and Kodak declined when their spaces declined; Newspapers, print media (and likely cable companies) are starting their decline as their ecological space is eroded by digital technology. Those that succeed in surviving the decline of their niche typically lose their dominant franchises. IBM managed to plant itself in the new ecological niche of IT services, but it no longer enjoys the franchise economics that it enjoyed during the OS/360 mainframe era. It's economics today are more of a competent well-executed business, as opposed to one enjoying franchise economics.
There are many reasons why large companies fail to do this. Clayton Christensen's The Innovators Dilemma presents one reason. I believe the primary reason is that what made them large dominant companies also makes them bad at the core innovation and flexibility needed to experiment and succeed in a new ecology. In their nascent stages, these companies were nimble startups that worked out the core value proposition and play books for their ecological niches. In any new industry in a competitive economy, thousands of startups will try their hand. Only a few find the sweet spot which consumers are willing to pay for. Of those, the dominant survivors are those who can execute the business best; with the best planning, resource allocation, logistics, and discipline to allow it to marshal resources and deliver the value best to consumers. They out sold, out delivered, and generally out planned their competition. These companies have built their measurement systems and social proof by these lines, allowing them to execute a business play book successfully.
Unfortunately this is also the type of environment that is the complete opposite of a startup. As a result, fundamental innovation is rare in dominant firms. The employees and the firm primarily excel and are measured at executing the delivery of a value proposition, a value proposition that was defined early on in the company's history and around which the entire business' hard and soft infrastructure is constructed. This isn't to say that they are completely devoid of innovation; often they excel at incremental innovation (for example Toyota), or have established systems to acquire or compete companies in in adjacent ecologies where other pathfinders have established that a market exists (for example Nestle).
Microsoft seems to exhibit the same characteristics of large dominant companies. In spite of Microsoft's enormous war chest and extremely farsighted (some would say paranoid) management who have demonstrated more vision and nimble thinking that many, its forays into the online, gaming, and non-PC niches have not been spectacular.
- The four horseman of the Internet (Ebay, Amazon, Google and Facebook) have firmly established dominant positions in the recently evolved Internet ecological niche.
- In the emerging mobile form-factor ecological niche (PDAs, mobile phones, tablets) Google and Apple have run away with the lead.
- It is an open question whether Microsoft's cloud gambit will pan out. Already Google, Amazon and Force.com have already made forays into the productivity and applications hosting cloud platforms, albeit with different value propositions. (The applications cloud space is not a new one, companies like ADP have been hosting applications for decades - Before "Cloud Computing" became the buzzword of the day, applications clouds vendors were known as Application Service Providers. What has changed is that there are now a much larger range of applications which are now being delivered in this way; partly because technology now allows for it, and partly because a critical mass of software use-cases have evolved to a steady state, allowing companies to make the large capital investments needed to build cloud-delivered versions of the software without worrying so much about whether the features built will be accepted).
Valuing Microsoft
Given the dismal track record of dominant companies surviving the demise of their ecological niches, it would not be prudent when valuing MSFT, to bet that the company will be able to transform itself and dominate an upcoming ecological space. Rather, the question when valuing MSFT is:
- whether the PC space will continue to coexist with new ecological spaces, or whether we are at the transition between the eclipse of one space and the rise of another, and
- the source of MSFT's strength, and what can destroy MSFT's moat in the PC space.
Sustainability of the PC ecological space
The computing industry has been progressively shrinking the size of computers, from the mainframes to todays' PCs and mobile computers (PDAs, cell phones, netbooks). From requiring teams of people to operate a mainframe system, to allowing individuals to own and use computing. It has been about a continuous reduction in the form factor of a Turing computing unit, and removing the accidental difficulties in programming and software.
The question now is whether the PC (desktop or netbook) species is in a punctuated equilibrium within the computing ecological space - in other words, whether it is a form factor that will continue to coexist with whatever else may come along. I suspect the answer is yes. It is likely that the PC form factor is the most suitable form factor for many types of Information-based work built around the keyboard-monitor combination. This is a spectrum of work that requires textual input and concentration on the display, and the PC (desktop or laptop) is the culmination of the various evolutionary experiments of what type of machine form factor is best suited to it. The PC is likely to become another office fixture or household appliance, like a household refrigerator that coexists with wine coolers and other appliances.
This doesn't mean that the market size for this form factor will remain what it is today:
- There are likely to be many people who are using this form factor today who would be better served by something else that comes along. These are likely to be persons whose work with the computer is less intense, or is primarily information consuming in nature. Many people who typically just browse and surf will switch away from PCs to tablets and other information consumption devices. They are now using PCs simply because there is no better option.
- As the desktop computing usage pattern enters punctuated equilibrium, we may see the desktop replacement cycle approaching the once every 10-years replacement cycle of refrigerators - people only replace them when they break down.
Microsoft's moat in the PC ecological niche
The question then becomes how sustainable Microsoft's Windows and Office position is in the PC space. Windows and Office's wide moat is primarily because these 2 types of software have Platform Economics, and Microsoft has a play-book that successfully made the most of this economic effect. A secondary factor is that Microsoft has a well-run and well-staffed software development organization that has been able to continually respond to changing customer needs, by adding new features/releases and supporting its existing software.
Platform economics is a term I use to describe an economic effect seen in certain industries. A product enjoys platform economics when it has gravitational mass. As its gravitational mass grows, it attracts more matter to it, causing it grow even more. In a platform, this gravitational mass is conferred by the product enjoying 2 or more of the following economic effects:
- it enjoys a network effect, and
- it enjoys economies of scale in a positive feedback loop, and
- it guarantees an optimal solution to the "prisoner's dilemma" or "tragedy of the unregulated commons" for all persons using the product
The Microsoft Windows operating system enjoys this economic effect. In the era before interoperability technologies and standards were common, it was the case that as more people used Windows, each user benefited because he/she was able to exchange files with an ever larger community of people. The larger community also made it more cost-effective for software vendors to write software for the Windows operating system, increasing the number of applications available to Windows customers, further increasing the value of the operating system to its existing and potential customers.
The Windows operating system also provided software programmers and hardware manufacturers the promise of breaking the prisoner's dilemma. In the early days of desktop computing there was a proliferation of hardware devices and software programming platforms. Individual software vendors had to write their software to support the multitude of hardware devices out there. Software programs like WordPerfect 5.1 distinguished themselves by having the code to support a large number of printer hardware devices. Printer manufacturers like Epson distinguished themselves by canvassing as many software vendors as possible to support their printers. While this was an environment that worked for each party, it was far from optimal. (The system had settled into local optima instead of the global optima) Microsoft played the role of a global optima guarantor through the Windows operating system. It created a common device programming model, so that all software vendors only had to write to support the (one) Microsoft programming model, and all hardware vendors similarly only had to support the (one) Microsoft device driver model. All participants in this scheme stood to benefit, but only if everyone participated. A software vendor could support all possible hardware versions, and vice versa. Microsoft succeeded in delivering on this value, and Windows became the prisoner's dilemma global optima guarantor.
To a lesser extent, the Microsoft Office software also enjoyed platform economics. As a productivity software suite, it's users needed to exchange its files with other users (exchanging Word documents, Excel spreadsheets and so on). The more people who used Office, the larger the community of people its customers could exchange files with. The more people using it also made it more attractive for software developers to build productivity add-ons like macros and formulae in its Excel software and templates and fonts for its Word software.
Microsoft's playbook, which integrated its software products and allowed them to exchange information with each other, as well as its cultivation of the software developer community, fully exploited the platform economics characteristics of its products and created a wide moat. Customers who bought Microsoft products entered an ecosystem of benefits that only the Microsoft family of products could provide.
Supporting Microsoft's play-book was a solid software development team. There are 2 unique characteristics of software that make it different from analyzing other industries:
- Software is all about design. The source of competitive advantage is in having a business model that supports a team of developers who can keep updating software to keep pace with changes in the way customers work, or the way information is being processed. Constantly designing and redesigning software to meet changing usage patterns and needs is the key to sustaining a competitive advantage. There is no manufacturing economies of scale in software, because software is an information good with zero marginal cost of production.
- The way to get an edge in software development is to hire the best people. As primarily a design activity, hiring the best developers in the industry brings you much closer to having the best software development capabilities.
On both counts, Microsoft was firing on all cylinders throughout the 90s and early 2000s. The early PC era was like the Cambrian explosion, as people tried many different ways of processing information, use-cases, usage patterns and different types of software. Microsoft was able to build an organization that supported constant software adaptation to new and evolving usage patterns and needs. It was also seen as the most attractive place to work for bright software engineers, and it had a business model to fund its software development talent and organization. It built a market-to-lab feedback loop that allowed it to come up with continuous software design changes (upgrades and releases) to meet evolving customer needs.
Threats to Microsoft's moat
As computing evolves, we are now at a juncture which presents the following threats to Microsoft's moat and earnings stream:
- Software Cambrian explosion tapering off. The evolution of software use-cases and PC usage patterns are reaching a punctuated equilibrium. This is readily observable to both practitioners and customers. Think about how much Word Processing has changed for you in the last 2 years? Not likely to be much. For practitioners, how much has relational database or core operating system technology changed over the last 2 years? This relative stasis has the following effects:
(a) It makes it possible for the bazaar model of software development to become practical. (See The Cathedral and the Bazaar). When software patterns stabilize, it is less of a necessity to have a paid team of developers constantly tinkering with the design to meet rapidly changing needs. Because software is all about design and has zero marginal cost of production, it allows startups and loose coalitions of developers to also develop competing software. The evidence for this is in the encroachment of open source software development in areas like operating systems, databases and web servers, where software evolution stasis is setting in. This is a threat to all software businesses, including Microsoft. It is especially threatening to Microsoft because operating systems and productivity software appear to be reaching punctuated equilibrium. What works in Microsoft's favor on the desktop side is that there is still some evolution in the types of hardware devices used and end-user programs, which keeps Linux and open-source competitors at bay. The bazaar model is more suited to point, less dynamic, software which changes less and has arrived at some emergent pattern. In comparison, the bazaar model likely to hit Office first, because it is more of a point solution and doesn't have to deal with as many integration and complexity variation points. The productivity suite space (Microsoft Office) is the canary in the coal mine to watch for the bazaar approach'es encroachment onto Microsoft's moat.
(b) Punctuated equilibrium also allows open standards to come into existence. During periods of rapid software design evolution, it is difficult for open (interchange) standards to be maintained because too many parties need to sign-off on each change. But when categories of software reach evolutionary stasis, it becomes far more likely that open standards can be negotiated and maintained. Upstart competitors are likely to be strong advocates of standards, since it gives them the means to enter the market against Microsoft. Open (interchange) standards have the effect of breaking the closed ecosystem and platform economics of Microsoft software. With open standards, you no longer need to buy Microsoft software to exchange information with other people. The computing community as a whole enjoys the network effect as more users compute, instead of a world where network effect only exists within software platforms (Microsoft's or otherwise).
(c) It reduces the value of software having development platforms for 3rd party software plug-ins, which is a core driver of platform economics. There is less value to Windows or Office providing an platform for 3rd parties to build applications on top of it. In the old world, more developers building more applications increased the value of the platform. But in a punctuated equilibrium, a single vendor can identify what is needed by the bulk of users and build it in an integrated stack/device. For example, Apple is doing that with its consumer devices - it has identified the core applications and use-cases for the bulk of users, and built it into one well executed device. This reduces the value of having a platform like Windows or Office. - Interchange standards are becoming entrenched, fueled by the Internet and the Proliferation of non-PC devices. Interchange standards remove a key pillar of the platform economics that Microsoft has enjoyed to date. If the world were such that Microsoft software existed on all types of computing devices, then the defacto standard would be Microsoft's and Microsoft would still enjoy the benefits of platform economics. However, this isn't the case, and the probability of Microsoft reasserting itself across all computing devices is low. The proliferation of other non-windows devices accessing information (over the net) accelerates the adoption of standards and provides the environment and incentives for all players to work out mechanisms to share data and standardize formats. The cat has been let out of the bag, and there is no going back.
Not that Microsoft didn't try. Bill Gates famously recognized the threat of the Internet very early on in 1995, as seen in his "Internet Tidal Wave" memo to employees. But even with this prescience, Microsoft failed to fend off the threat. It tried shaping the Internet conversation with IE, for example by only allowing IE to access hotmail, and getting website to use ActiveX controls which only PCs with Windows would be able to access. If they had succeeded, we could today be conceivably living in a world where all websites and browsers needed ActiveX technology and by proxy windows clients. With 20/20 hindsight Microsoft could have won the browser battle, but only if they had run it lean and mean. It could have won in this new ecology albeit with less of moat, because this ecology doesn't allow it. But it was playing by the play-book of the PC era ecology, which required complete domination. Its browser grew bloated, and mis-steps on standards (by trying to freeze other players/java/etc out too early ) and fundamentally failing to create a good user experience lost it the war. Firefox and Chrome took market share because they out executed and were leaner, and Internet standards are well entrenched today.
Microsoft also failed to create compelling experiences on tablets, PDAs and Smart phones. It is likely it failed because it was playing by the PC playbook, and didn't recognize that a new user interface and usage model was at play. Apple and Google realized this when they looked at the market with a fresh pair of eyes. Apple and Google out competed by creating compelling user experiences that were suited to the new form factor.
The proliferation of other devices and standards also presents a negative feedback loop for Microsoft. For example, as more people buy iPhones, they may decide to buy Apple computers to sync up with those phones. Because of the punctuated equilibrium and interchange standards, they may find they are able to do most of their work on the Apple computers. This would further reduce the moat Microsoft has around its Windows operating system. - Technology evolution is shifting the battle has shifted to a new arena. As the industry evolves away the accidental difficulties in computing, Cloud Computing has become a viable architecture and software delivery model. Cloud Computing, more accurately defined as "presentation layer on the client, everything else running on a server somewhere else" has reduced the raison d'etre for the various features in PC operating systems like Windows.
It also fundamentally changes the battlefield from the PC operating system and PC applications to the applications tier (which is increasingly residing on the server). It has changed the arena "playing field" where battles are fought from the PCs in our home and office to the servers and applications running on them. In a Cloud Architecture, the ecosystem is less important on the client side, especially if you only use cloud applications. However platform economics exist on the server application side. In this new arena, the battle is to get as many users onto your cloud application as possible, so that they can enjoy the interchange and platform economics amongst themselves. Microsoft will have to try to get the bulk of its users onto the web version of office, while trying to keep Google Apps at bay. Platform and Information economics work to benefit and build a moat around the dominant Cloud platform. So Microsoft's Azure and Office 365 cloud initiatives are critical plays for Microsoft.
The paradigm shift from PC era computing to Cloud Architecture cannot be understated. It is akin to the point where people change from installing their own power generators to using centrally generated power. But we should not overstate the case either, it is unlikely that all software is suitable for a Cloud Architecture. But for users who only need applications which are Cloud-able, the value of the PC ecosystem to them is greatly diminished.
This type of major technology disruption is what allows upstarts to destroy dominant firms. It exposes a new front for a competitor to come in, much like KMart's failure to serve second tier cities allow WalMart to build up its momentum and eventually displace it. As a new software architecture and delivery mechanism, it erodes the need to install software on PCs. It may allow new innovations like Google's Chrome based laptop to take share, and allow Force.com and Google Apps to take share.
Summary
It is likely that the ecological niche which sustains Microsoft will continue to exist for some time (a decade or more). It is probably an exaggeration to say that all software will shift to a Cloud Architecture, or that PCs will disappear from the face of the earth. It is also probably an exaggeration to say that Open Source software will destroy all commercial software companies. For many types of software, software will never fully stabilize into a punctuated equilibrium, because the software is built around how humans work in the real world. And that always changes. For example, in Enterprise Resource Planning and Accounting software will have to constantly evolve to meet changes in the business and regulatory environment.
On balance, a valuation of Microsoft relies on two things:
- your assessment of the qualitative issues discussed here, and how much they will (a) reduce the size of PC ecological space, and (b) reduce Microsoft's pricing power; and
- your assessment of Microsoft's prospects with its Cloud Computing efforts. That is the emerging threat and new ecology in which it appears to still be in a position to set the agenda.
By any measure, this is not an easy investment case to work out; there are many elements which require Venture Capital type thinking. Here are some other investors' thoughts on Microsoft as an investment:
- Whitney Tilson on MSFT: http://www.tilsonfunds.com/Julypres.pdf
- Arnold Van Den Berg on MSFT: http://www.centman.com/PDF/2010/Newsletters/Nov2010ValueInvestorNewsletter.pdf
- David Einhorn on MSFT: http://seekingalpha.com/article/11531-value-investor-david-einhorn-on-microsoft-msft
- And a general blog on happenings in Microsoft: http://minimsft.blogspot.com/
Posts
