Summary
- Microsoft established themselves as a trusted name for PC operating systems.
- The company is achieving growth in all business segments.
- Microsoft is capitalizing on strong growth in the cloud business.
Microsoft (MSFT) really doesn’t need an introduction since they’ve established themselves as a leader in software and cloud services. The company established themselves as a household name with the success of their Windows OS, MS Office, and XBox gaming products. Microsoft’s move into the cloud over a decade ago opened up a new source of growing revenue.
Microsoft’s Productivity & Business Process segment comprises 32% of total revenue and 37% of operating income. This segment increased revenue 20% in 2018 over the prior year. This segment offers the Office products, Office 365 subscriptions, Skype, LinkedIn, Outlook, and Dynamics.
The Intelligent Cloud segment comprises 29% of total revenue and 33% of operating income. IC achieved a revenue increase of 17.5% in 2018. Intelligent Cloud handles the server products, Azure cloud services, and enterprise services.
source: Microsoft Q2 FY19 slides
The More Personal Computing segment comprises 38% of total revenue and 30% of operating income. However, this segment experienced the slowest growth as compared to the other segments as revenue increased 7.7% in 2018. This segment offers the Windows OS and related licensing, and the MSN advertising business.
Microsoft can drive future growth by continually improving the products in each segment and expand their reach to more customers in new and existing regions.
Strengths
Microsoft has dominate positions for certain products, which gives them brand strength that they can build upon for long-term growth.
- Strong brand recognition: Microsoft is a household name, which consumers can trust for quality products/services. The company is a global leader for their Windows OS and software.
- High customer retention: Most PCs have Microsoft’s Windows pre-installed as a part of OEM licensing agreements. Unless its a MAC, chances are that Windows was installed on your PC. Since many non-MAC PCs are less expensive than their Apple (AAPL) competitors, Microsoft has a large market for customer retention.
- Strong sales distribution system: Microsoft has distribution agreements with almost all international OEM’s. This provides the company with consistent repeat business.
- Microsoft has a strong growing market share for the Azure cloud business – competing with Amazon’s (AMZN) AWS and Google (GOOG) Cloud.
- The company’s profitability is higher than the sector median.
| Microsoft | Sector Median | |
| Gross Margin | 65% | 47% |
| ROE | 40% | 7% |
| ROIC | 14.7% | 5% |
| EBITDA Margin | 42.4% | 12.6% |
source: seekingalpha.com
- Microsoft has strong above average growth. This starts with double-digit revenue growth. The company’s high margins lead to strong double-digit earnings growth on the bottom line.
source: Microsoft Q2 FY19 Earnings Slides
Weaknesses
Although Microsoft has many strengths, they also have some weaknesses that they can improve upon
- The company struggled with the smartphone OS business. The Windows OS for smartphones didn’t gain traction as the market is dominated by Apple’s iOS and Google’s Android OS.
- Failure to gain market share in the hardware side of smartphones: Microsoft paid $7 billion for Nokia in a deal that closed in 2014. However, the company lost market share in the smartphone market in 2 years following the acquisition. As a result, Microsoft sold Nokia in 2016.
- Microsoft has weak market share of only 5.4% for their Internet Explorer web browser. Chrome has a strong lead with 69.5% market share. This is followed by Firefox with 9.6% and Safari with 6.5%.
- Poor history of securing good acquisitions: failures include: Nokia, Navision, Tellme Networks, and aQuantive. Microsoft did acquire some good companies, but they need to be more consistent with the good acquisitions since they wasted billions on the poor ones.
- The company’s software has been exposed to viruses and security hacks.
Opportunities
Microsoft has room for improvement in strengthening and rounding out the company to grow successfully in the future.
- Microsoft has a good opportunity to grow the Azure cloud business. This can help drive global growth over the long-term.
- Continue to improve the Productivity & Business segment with new differentiating features that can help individuals and business become more efficient.
- Given multiple past failures, Microsoft needs to be more diligent in evaluating future acquisitions. They had success with LinkedIn and Skype. So, they need to get a better grasp on which companies they can integrate and grow successfully for future M&A.
- Although Microsoft struggled with their mobile OS in the past, there is still an opportunity to develop differentiating features in their own mobile OS that could capture certain niche markets.
- Hardware: If they do find success with mobile OS, they could integrate that into a more successful mobile hardware smartphone device. The company could also improve upon and expand the Surface hardware business.
- Incorporate new technology such as artificial intelligence [AI] into their products to create richer experiences for end users.
- There is an opportunity to grow the mobile advertising business via mobile OS. This could provide a steady stream of income if successful.
Threats
Microsoft faces various external threats in each segment, which can eat into their market share.
- Competition in each segment threatens to take market share away. The Productivity & Business segment faces competition from Google, Apple (AAPL), Cisco (CSCO), Facebook (FB), IBM, and Slack. Competition comes from Amazon’s AWS, Google Cloud, IBM, Oracle, Linux, etc. for the Intelligent Cloud segment. The company competes primarily with Apple and Google in the Personal Computing segment. Microsoft needs to continually improve and differentiate their offerings to retain and grow market share.
- Cyber crime, hacking, and viruses threaten to hurt Microsoft’s reputation. Widespread and highly publicized incidents could lead consumers and businesses to use products/services from other companies.
- Government regulations regarding personal data, trade protection, competition rules, etc. could negatively affect how Microsoft designs and markets their products. The company faces regulations in various regions, which can have different implications country to country.
- Microsoft would likely be negatively impacted from a slowdown in economic activity, which could reduce demand for the company’s products/services.
Long-term Microsoft Outlook
Overall, Microsoft’s strengths should outweigh their weaknesses. Although the company struggled to successfully enter certain markets such as mobile OS and hardware, Microsoft could be successful in this area with a new strategy of targeting untapped niche markets.
Microsoft’s existing business segments are all growing at a healthy pace. Microsoft’s licensing deals with OEMs gives the company a strong competitive advantage and repeat business for the Windows OS. This provides a good foundation to build further growth upon.
For the future, expect Microsoft to continue to innovate and improve their products while they take advantage of their economies of scale. The Productivity/Business and Intelligent Cloud segments are likely to drive the biggest growth for Microsoft over the next few years.
Disclosure: I am/we are long AAPL, FB.
Business relationship disclosure: This article was written by David Zanoni for Kirk Spano’s Margin of Safety Investing service.
Additional disclosure: The article is for informational purposes only (not a solicitation to buy or sell stocks). David is not a registered investment adviser. Kirk Spano is an RIA. Investors should do their own research or consult a financial adviser to determine what investments are appropriate for their individual situation. This article expresses my opinions and I cannot guarantee that the information/results will be accurate. Investing in stocks involves risk and could result in losses.
