Tag Archives: Portfolio Companies

Microsoft 2024 Q4 Earnings Call: Microsoft strains to meet AI Datacenter Demand, AI Product Usage Ramping.

Leave a reply

August 15, 2024. In the current tech company earnings season, a pressing concern in the investment community is that AI related applications may be exacting more capital investment than is justified by their usefulness and profitability to businesses.

Businesses are beginning to depend on AI. But indeed it may not be possible to clearly foresee the many ways it will actually be used, even as it becomes integrated into daily business functions.  And this normal uncertainty, arouses concern, given the very high level of investment required to build the computation resources required for AI.  The investment community has become concerned that AI related capital investment may strain the corporate balance sheet, reducing cash flow and increasing debt. 

One of the core traits of MSFT culture of operations is that it seeks to adapt and exploit its competitive advantage in a profitable way. The company has never commoditized its products and has avoided being vulnerable to the boom/bust cycle of some tech hardware companies. It has a differentiation strategy and strong competitive advantages of switching costs, largely based on software application usage and platforms.

In the webcast of its 4th Quarter of 2024 Earnings, Microsoft CEO Satya Nadella and CFO Amy Hood explicitly articulated that they are conservative in spending on building infrastructure needed for AI workloads, and that in fact demand by their customers for AI computation is outstripping the company’s ability to supply the computing infrastructure.  The deficit in available AI computation is partly relieved by leasing datacenters from companies which maintain large datacenter assets such as Oracle. These have the advantage of being relatively short term leases, purportedly until Microsoft can establish its own new datacenters, and this helps avoid overinvesting.

CEO Nadella emphasized, as one of two corporate goals in navigating the platform shift of AI, that they are using “customer demand signal and time to value to manage our cost structure dynamically and generate durable, long-term operating leverage. “

(The first strategic goal was, no surprise, driving innovation in infrastructure and applications products, while continuing to scale the cloud business, and prioritizing security.)

As per Nadella, AI was central in MSFT progress this quarter. Azure share gains were driven by AI.  Azure growth included 8 points from AI services where demand remained higher than their available capacity.

Despite the incipient growth of the AI business, cloud margins remain extremely strong.  As CFO Amy Hood stated, Microsoft Cloud gross margin declined from 72% to a still excellent 69%, driven by sales mix shift to Azure, partially offset by improvement in Azure even with the impact of scaling AI infrastructure. Microsoft Cloud includes Azure and other cloud services, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365 and other cloud properties.

To get a high level view of the ability of Microsoft to lay out Capital Expenditure (Capex) needed to grow its business, including AI, we can compare the growth of capex, net income,  free cash flow (FCF), and revenue, over say, a decade. 

Based on review of the relevant Annual Reports, in the decade from 2015 to 2024, Revenue increased 2.6X from  $93.580B to $245.122B.  Net income to common shares rose 7.2X from $12.193B to $88.136B, as operating and nonoperating expenses rose less than income.  Capex rose 7.5X from $5.944B to $44.477B.  Capex accelerated throughout the decade, and ramped up sharply in 2024.  Of the rise in capex between 2024 and 2015, 42% of this rise took place in 2024 relative to 2023.

Microsoft businesses generate enough cash to fund Capex needs and more.  Even with accelerating Capex, Free Cash Flow (FCF) still increased 3.1X from $23.724B to $74.071B. IN 2024, debt interest coverage is still over 20x, and Debt/Equity ratio at end of 2024 was at the lowest level in the decade. 

Remember that FCF is primarily cash remaining after capex expenditure has been subtracted from the cash flow from operations.

Therefore, Microsoft has shown it can generate the cash required to supply capex to adapt and grow its business as cloud computing and AI shape its markets.  Given its historical record extending back decades, I think it is safe to assume it will continue to do so.

The company outlook forecast for 2025 capex was that it would be larger than 2024.  Let’s hypothetically assume capex doubles from the 2024 level of $44.477 billion to $88.954B (note that annual doubling of capex is unprecedented in the history of Microsoft). Given that operating cash flow has increased at an average annual rate of 14.47% for past decade. Assuming operating cash flow in 2025 increases at this same rate over that of 2024, making $135.144 billion. Then hypothetically FCF in 2025 would be $135.144B – capex of $88.954B = $46.190B.  This is a significant decrease from the 2024 level of FCF, of $74.071B.

Should the company be faced with persistent jumps in Capex requirements, we might be concerned to estimate when the resulting datacenters will produce revenue to maintain cash flow at its accustomed growth level. In this, we can look to clues which the leadership team gave at the earnings conference. 

Just taking two instances of AI related products, we see signs of AI-induced growth in usage and revenue which are promising.

Copilot for Microsoft 365.

Copilot for Microsoft 365 is becoming a daily habit for knowledge workers as it transforms workflow.  The number of people who use Copilot daily at work nearly doubled quarter-over-quarter, as they use it to complete tasks faster, hold more effective meetings, and automate business workflows and processes.  Copilot customers increased more than 60% quarter-over-quarter.

Feedback has been positive, with majority of enterprise customers coming back to purchase more seats.  The number of customers with more than 10,000 seats more than doubled quarter-over-quarter. 

With Copilot Studio, customers can extend Copilot for Microsoft 365 and build custom copilots that proactively respond to data and events using their own first and third-party business data.  To date, 50,000 organizations – from Carnival Corp., Cognizant, and Eaton, to KPMG, Majesco, and McKinsey – have used Copilot Studio, up over 70% quarter-over-quarter.

 Copilot is being extended to specific verticals, including healthcare, with DAX Copilot.  More than 400 healthcare organizations – including Community Health Network, Intermountain, Northwestern Memorial Healthcare, and Ohio State University Wexner Medical Center – have purchased DAX Copilot to date, up over 40% quarter-over-quarter.

Github copilot

GitHub Copilot is by far the most widely adopted AI-powered developer tool.

Just over two years since its general availability, more than 77,000 organizations – from BBVA, FedEx, and H&M, to Infosys and Paytm – have adopted Copilot, up 180% year-over-year. “Copilot accounted for over 40% of GitHub’s revenue growth this year, and is already a larger business than all of GitHub was when we acquired it. “.  I assume that means revenue from Github Copilot is larger than Github revenue was, when acquired by Microsoft for $7.5B in 2018.  And Github has a current annual revenue run rate of $2B.  So, not only is its usage growing, but this has been turbocharged by Copilot AI.

In summary, based on review of relevant past financial disclosures including Annual Reports, the Q4 2024 earnings conference, and understanding of Microsoft business culture as it has operated historically, Microsoft should be able to continue to spend as required for Capex to build out AI and cloud computation.  Growth in usage of AI-related products should lead to continued earnings growth. Most importantly, over the long run, the novel AI-related features will become indispensable tools for knowledge workers and will confer the strong competitive advantages of switching costs which enable Microsoft to keep dominating its markets.

Amateur Investor Beats S&P performance at 1y, 5y and 10y at end of 2023

Leave a reply
 1y(%)3y (%)5y (%)10y (%)
Amateur Investor43.2821.220.1
VOO26.339.9715.6612
Brk-b15.4615.4312.7611.64
VBIAX17.583.739.617.73
Performance of Amateur Investor portfolio compared with Vanguard S&P500 index ETF VOO, Berkshire Hathaway Brk-b, Vanguard Balanced Index Fund VBIAX.

January 4, 2024. Annualized Performance of Amateur Investor portfolio at 1y, 3y, 5y and 10y (%), as of the last trading day of 2023, December 29.  Performance is compared with those of various securities of interest.  The S&P500 broad US market index is represented by the Vanguard S&P 500 ETF (VOO).  Brkb-b is the affordable Class B share of Berkshire Hathaway Inc. (Warren Buffet, Chairman, CEO and President).  The conservative, traditional 60/40 stock/bond allocation strategy is represented by the Vanguard Balanced Index Fund (VBIAX).

1-3-2024. 2023 was an eventful year, including predictions of recession; the failure of China growth to happen after the Communist regime decided to loosen up on draconian covid related lock downs; a liquidity scare in the US related to devaluation of bank assets caused by rapid rise in treasury bond rates.  Portfolio performance was poor in the first quarter. In response, I found a new investment in a sector I had hitherto avoided, but decided to reallocate some funds into United Healthcare Group (UNH). While the reallocation, as it turned out, was poorly timed in the sense that the current holdings of V, MSFT ADBE subsequently recovered wonderfully. However, UNH has a strong competitive advantage and management culture has proven itself over time, generating a top flight total shareholder return since IPO in 1984.  I will describe my approach to UNH in a separate article. This involved an innovation of the eternal company criteria.

MSFT:41%
UNH21.5%
V20%
ADBE16.28%
MELI1.17%
Cash0.02%
Amateur Investor portfolio holdings, by proportion %

Microsoft continues to grow its Azure cloud revenue and usage and gradually take market share from Amazon;s AWS.  It has become a leader in AI application for developers, and in workflows for information workers, using AI presented as a “copilot”.  These are reportedly increasing worker productivity significantly.  The addition of AI capabilities into the repertoire of Microsoft productivity products could produce a hockey stick increase in revenue.

Adobe is integrating generative AI capabilities (Adobe Firefly) into its flagship Creative Cloud, Document Cloud and Experience Cloud applications and has created an AI-first online suite of applications in Adobe Express.  AI integration in Experience Cloud makes personalized and real time marketing more facile and efficient, exposing more, non-professional users to creativity and sophisticated digital marketing. The freemium Adobe Express suite too, introducers a greater number of non-professional creatives to digital creative applications. As the market of potential Adobe application users expands, Adobe management plans over time, to leverage use of generative AI into price increases according to the value added. As a leading digital marketing software provider for enterprises, Adobe enables companies to build custom AI large language models in which no alien copyrighted material is used, and the company branded content is for their exclusive use.  

Visa continues to expand its network into novel areas such as B2B payments (Visa Direct), cross border payments. Where potentially competing networks are used, such as RTP (such as Zelle), Visa is still required to provide services needed to bring the payment service up to expectations regarding security and other features.  Visa continues to partner with leading novel fintech companies to give them access to global markets in payments.

UNH continues to acquire relevant healthcare services companies and develop its value based care coverage and provider network, as it evolves as a diversified healthcare company, providing healthcare insurance,  healthcare services,  ancillary services, pharmacy benefits and digital information applications. UNH products are indispensable and must be paid for, whether by individuals, or more likely by third parties such as employers, unions, government. The diversified array of healthcare services combined with market dominating insurance creates network effects and cost advantages.

Mercado Libre continues to build its ecommerce ecosystem, with ecommerce, Mercado Libre; fintech: digital payment, Mercado Pago, credit, Mercado Credito; logistics, Mercado Envios; and advertising, Mercado Ads. The logistics network reaches from distribution centers to neighborhood stores that serve as service centers for delivery and returns, as well as for local SMB sellers supplying into the ecosystem. As delivery efficiency has resulted in speed and reliability greater than normally available otherwise, this is an important pillar of MELI competitive advantage, bringing sellers and buyers into the ecosystem, where each component is advantaged by combination with the other.

While we continue to pray for the world’s people in their difficulties, I feel these companies will continue to adapt and thrive, while enabling people to accomplish more.

Competitive Advantage is at the intersection of Market Need and the Company’s Unique Ability Supply It.

Leave a reply

Oct. 22, 2014.  Focus is crucial In order for a company to build a competitive advantage (the same might be said for a person). A company must first recognize the potential advantage, and focus in order to capitalize on it. A competitive advantage is at the intersection of the most urgent market need and the unique ability of the company to uniquely supply that need. Efforts are focused on developing that ability, and ignoring other less rewarding aspects of the company.

Adapting to focus on meeting the current market needs therefore builds the company’s competitive advantage. But the market does not remain static. In order to continue dominating markets that change, the company will need to develop new strengths. The source of strength at one stage can be used to build new sources of strength. Hence, the company must adapt again. Over time, evolution occurs and the degree and nature of change can be striking.

The story of the early Microsoft is a good example of this. In 1975, Bill Gates and Paul Allen had a competitive advantage in that they had high IQ’s and had worked extremely hard to develop their programming skills, devoting most of their time to that end since the age of 13. At that time, the most practical computers available were termed minicomputers. These were smaller, more physically more practical than the mainframes which had hitherto dominated computing. Minicomputers were pioneered by companies like Digital Equipment Corporation. The programmer communicated with using a keyboard, generally remotely. Different users would book on the remotely located minicomputer. Bill and Allen had spent essentially all their otherwise unoccupied time learning use mini-computers since high school and had faced a constant battle to find time on a shared minicomputer. They realized that computing power would be valuable if it was available on computers conveniently located at the user’s location, whether home or office. Processors were becoming cheaper, smaller and more powerful, so in theory it seemed computers would follow to make this vision possible, although the established computer hardware companies were sticking to more developed markets. So they were aware of a possible new market opportunity which would match their strengths.

In 1975, Ed Roberts in Albuquerque NM had a company called Micro Instrumentation and Telemetry Systems (MITS), selling electronic equipment. In 1969 he moved it out of his garage and focused on selling kits to build calculators. He was wiped out by Texas Instruments’ and others’ entry into the market in early 1970s. Roberts shifted to using the new micro-processors, introduced in 1971 by Intel, to create computers that were small and cheap enough to be used by a single hobbyist. This new chips enabled the entire CPU to be contained on the single small chip. Roberts sold a kit to make a portable computer using the 1974 8080 Intel chip. The computer was called the Altair, the term “personal computer “, was coined by Roberts.

It was the Altair that appeared on the cover of Popular Electronics Magazine in January 1975. Paul Allen spotted it at the newspaper kiosk in Harvard Square while visiting Bill. They realized this was an opportunity to apply their programming abilities with a future market.

Their first task in seizing this opportunity was to promise Ed Roberts they would create a version of basic that would run on the 8080 chip and be able to run calculations. Roberts did not take them seriously. Many enthusiasts had phoned him and made similar claims, hoping to score a contract. He told them all that whoever produced a working product first would get the deal.

The young men did what was required to overcome the obstacles involved. No one had ever written a version of BASIC for a personal computer like this one, since this was indeed the first one. They did so, with the help of fellow student Monte Davidoff. The young men did not even have an Altair to program on. Allen located a manual for the 8080 chip, and created basically an emulator on the PDP-10 microcomputer they used at Harvard. He saw this could be done because of previous work he had done with Gates in high school. Gates wrote the required version of BASIC that would run on the 256bytes of memory it contained. Davidoff wrote the portion that worked with mathematical calculations. Allen flew to Albuquerque at the end of Feb 1975 to show (to everyone’s amazement) that they had written software that could perform on the Altair.

The next step was follow through to turn this creation into a product that would sell. They wrote versions of BASIC that used more memory, and debugged. This required continuous work. Allen joined MITS as software director. Allen’s work colleagues at Honeywell, where he wrote “assembly code for a niche market machine” made clear they thought he was embarking on a foolish distraction, and assured him his job would be waiting for him when he regained his senses. Gates moved at the end of his sophomore year and eventually dropped out of College. They brought Davidoff and an old colleague Chris Larson.

Thus, the partners’ strength in terms of programming skill and agility, and extreme commitment to the task, combined with their focus on the one opportunity to feed a new market which they and apparently no one else were willing to pursue, gave them the start of a competitive advantage.

Demand for the relatively new personal computers was red hot on the part of hobbyists and amateurs. While no established computer related companies initially planned to create PCs using the new microchips, demand for the Altair was huge and MITS quickly became profitable. Micro-Soft, as it was initially called, was clearly supplying an urgent market need by writing versions of BASIC, the most practical and widely used programming language for everyday computer applications, for the Altair in its various models as well as other personal computers as they appeared.

What did Allen and Gates focus on in their new company? Software had hitherto been written by hardware companies for use in their computers. Now, Allen and Gates were writing BASIC and selling it to be used on computers made by someone else. Allen and Gates signed a contract with MITS whereby MITS would pay them per copy royalties for BASIC. In addition, 50% of software sold without hardware, and of software sold to other hardware makers (OEMs). The concept of selling software for people to use in this way was novel, many users copied the Altair BASIC without paying and revenues were initially poor. Gates, the more ebullient of the two, worked to establish the precedent of expecting to get paid for the hard work of writing software partly by writing hard hitting editorials in new magazines devoted to the novel computers. The custom of buying software took hold, without which the Micro-Soft business plan would not be viable.

Within a year of the emergence of Altair, MITS began to be superseded in the market by other companies building superior hardware, and soon new personal computers were being introduced each month. Eventually established companies such as GE and NCR came in. Micro-Soft (Paul Allen came up with this name) wrote versions of BASIC for each new OEM. Their strategy was to sell it cheaply enough to discourage OEMs from developing their own software. Micro-Soft became the software developer for the PC industry, and they continued making sure to provide BASIC for every new microcomputer on the market. In 1977 they added Fortran, a language used in scientific research and engineering, and then others such as COBOL.

In October 1976, Micro-Soft was registered as Microsoft Inc. in New Mexico, and moved into modest offices on Central Avenue, a humdrum low rent commercial neighborhood. Here is a plaque at the sight of the original Microsoft office. The building they originally occupied has since been replaced.

WP_20140804_029

In 1977, prominent brand name companies entered the personal computer market. The TRS-80, Commodore PET and Apple II arrived. These were altogether more usable, with keyboards, monitors and graphics. MITS did not grow and adapt quickly enough to compete with these larger corporations. Microsoft parted ways with MITS after enduring an arbitration process, and proceeded to establish the standard software tools for PC’s. Microsoft provided BASIC for RadioShack’s TRS-80, the most popular PC that year. Apple could not produce an acceptable BASIC tool and licensed a 12Kbyte version from Microsoft. Computers became steadily cheaper and more powerful.

One weakness with this business plan, was that significant work was required to produce a software language for a specific new PC. The development of CP/M, an operating system developed by Gary Kildall of Digital Research, meant that if hardware providers could make their machines support the OS, then software tool providers could write for the OS instead of having to reengineer a programming language version for every single new processor or machine.

In time, 1980 to be precise, the then king of computer companies, IBM, would ask little Microsoft, as the provider of the most widely used programming language tools (while IBM had a version of BASIC, they knew Microsoft’s version was more popular with programmers), to provide programming languages for the new IBM PC they were secretly planning. Oh, and Microsoft was expected to provide an operating system as well to go along with the package. But that is part of another chapter, which occurred after the company had moved from desert Albuquerque to the Pacific Northwest, home for the founders.

Microsoft: leveraging and extending its competitive advantage into the future

Leave a reply

September 14, 2014.

My approach to investing in individual companies starts with identifying the rare companies with a sustainable competitive advantage.  While the existence of a durable competitive advantage is manifested in quantifiable features of the financial statement, the ultimate judgment of whether the current competitive advantage will last for the foreseeable future is qualitative, relying on an understanding of the nature, competitive environment and history of the business.

To adapt to an ever changing future, vigilant companies make trial investments in new related markets. The longest lasting companies are those who finally invest only in those areas in which they can maintain a competitive advantage, and hence continue to earn better than average returns on investment for the foreseeable future.   Many companies watch their once impregnable advantage decline as events shape history’s final judgment.  For example, Kodak was dominant in photographic film and in the 1970s had a 90% market share.  It then participated in the invention of digital photography and had the opportunity to integrate its own digital photo technology into PCs in the 1980s.  But Kodak did not pro-actively build a new basis for market dominance in the new markets.  Competitors caught up and passed, Kodak faded and finally filed for Chapter 11 Bankruptcy in 2012. It turns out that rare companies do the work to create bridges to future franchises, using their current market dominance to shape and outcompete in new markets.  Microsoft (MSFT) is such a company.

For the past 10 or 12 years, Microsoft has frankly been unloved by the fashionable tech media, and increasingly by the professional investing crowd.  Under this surface air of decayed greatness is an irrepressible, tenacious organism that adapts by thrusting into new territories, taking root only in areas in which it may extend its competitive advantage, and then proceeding to compete as if its life depended on it.

Recently, MSFT has put in motion a few approaches to increase its competitiveness, and these are now beginning to bear fruit.  These include low balling the price of its Windows OS;  developing its applications for cross platform markets;  partnering with 3rd party software/platform providers that may be competitors; and transitioning its market dominance to the cloud.

MSFT has used these strategies before. For example, in the early 1980’s Multiplan, the predecessor of Excel, was coded for a software emulator that would be interpreted for different OEM PCs. Thus it was sold to more than a hundred different OEMs selling to businesses, in an ultimately successful end run around Visicalc, which had locked up the retail market.  When MS-DOS was released in 1981, it was virtually given away to OEMs building IBM PC clones for a flat fee.  Clearly, MSFT viewed this as a race to sell applications (also including the programming languages that comprised its main business) as opposed to the OS.

For a vivid account of early Microsoft history and the tale of how a couple of intelligent, determined youngsters, who thought out of the box and had the courage to act on their convictions, created what would become one of the most formidable companies in history, read the splendid Hard Drive: Bill Gates and the Making of the Microsoft Empire
by James Wallace and Jim Erickson.

As announced in April at Build 2014 conference, Windows is now free to OEMs for smartphones and devices of screen size 9 inches or less, and windows now has lower processor and storage requirements. While Windows still has roughly 90% market share in PCs, the overall variegated market of computing devices has vastly increased in the last 10 years, so that Windows has less than 20% market share of that wider universe.  There are large markets for MSFT software.

OEMs have responded vigorously to this overture. For example, more than 11 (up from 3) signed up for Windows phone in the first quarter of this year.  It is important to note that since android OEMS must still pay license fees to MSFT, a $0 Windows Phone license costs them less than Android.

A lower cost Windows opens up markets on devices, as in the past, to Microsoft apps. These include both consumer oriented apps such as Xbox music, video and games, productivity apps including office 365, and services to manage devices for businesses. Over 2 years ago MSFT began writing a version of Office for iOS. When finally released in late March, it was  downloaded almost 30 million times in less than two months.  CEO Satya Nadella has articulated the vision of “Cloud First, Mobile First”, and that Microsoft will focus on “platforms and services”.  From the vantage point of BYOD, this means that businesses will use MSFT productivity applications on popular devices, on the respective different platforms, and manage mobile devices with MSFT Cloud based subscription services such as Microsoft Intune.

A third way MSFT is increasing competitiveness is by partnering with competing software service and platform providers. For the past 2 years, because there is demand for services from other providers in the public cloud, Windows Azure has increasingly accommodated services on 3rd party platforms running on Linux or from other providers such as Salesforce, SAP, Oracle and many, many others. This has produced a hockey stick upshift in Azure revenue growth.  See here for more on how Microsoft is levering its market dominance in productivity applications and services to gain market share in the Cloud, from which it wields the Cloud First, Mobile First strategy.

Microsoft: Extending its Competitive Advantage into the Cloud

1 Reply

September 11, 2014. The public cloud offers unprecedented scale, low cost, and global distribution. Other than Microsoft Azure, there are two other hyper scale cloud competitors, Amazon Web Services (AWS) and Google (Google Cloud). Google Cloud is distinguished in that unlike the others, it primarily does not provide infrastructure as a Service (IaaS), that is, software running on Google Cloud must use the Google platforms. Azure represents a long term competitive campaign by MSFT that goes much further than simply matching competitors’ array of 3rd party service availability on their cloud. Compared to the other hyper scale providers, MSFT has several competitive advantages in the current watershed event of computing history, the move to the cloud. I will be discussing MSFT’s position chiefly relative to the two other hyper scale cloud companies.

  1. As Scott Guthrie, Executive Vice President, Microsoft Cloud and Enterprise group (Chief of Microsoft Azure) reiterated most recently at the September 3rd Citi Global Technology Conference, the MSFT public cloud preeminently enables computing at hyper scale. Today, clusters of datacenters are positioned in 17 regions globally including People’s Republic of China, where it is the first and so far only public cloud provider. Each region contains up to 600,000 servers housed in up to 16 data center buildings each the size of a football field. MSFT, AWS and Google Cloud are the providers of public cloud services at so called hyper scale. That being said, according to Mr. Guthrie, MSFT has datacenters located in twice the number of geographical regions as AWS and 5X that of Google Cloud. Is Amazon cutting prices to compete? This scale allows MSFT to cut prices “continually” in order to compete back.

2. MSFT operates in the hybrid cloud, running applications or services both in on premises datacenters and in the public cloud. For example, Windows Server runs in a private datacenter server, or on a server on Azure. In the hybrid cloud, on premises datacenters (the private cloud) connect with public cloud to optionally extend capacity or enjoy capability of specific public cloud computing advantages or business applications or services which reside on the cloud while preserving the private control of data and resources.

The hybrid model provides advantages because businesses that have been operating historically, are approaching the cloud from the on premises starting point and are not ready to move proprietary and otherwise sensitive data and applications to the cloud all at once and irrevocably. They do not want to be locked in.

Examples of hybrid cloud advantage include enabling services run on Azure to communicate with software and data that is still controlled within the on premises datacenter. Easyjet (largest airline carrier in the UK) keeps reservations data with passenger identities in on premises mainframes. However passengers book flights on the web site, which runs on Azure to accommodate global distribution. The hybrid application makes use of on premises and cloud data.

On premises datacenter workloads or data can be extended to platforms in the public cloud as an option. Azure provides disaster recovery solutions whereby the on premises data center is automatically backed up to Azure. This is available for physical or virtual servers on Windows or Linux, competitor VMware and others. Storage of specific subsections (tiers) of data can be optionally moved from on premises to the cloud, reducing storage costs roughly 50%. The data is moved on dedicated cables and is encrypted on site before moving to the cloud (Microsoft’s acquisition of storage companies StorSimple in 2012 and just recently InMage, play a role in these capabilities).

3. MSFT enjoys an advantage in its dominant market share in the on premises datacenters from which businesses are shifting to the hybrid cloud. Windows Server has 75% market share in business servers. Currently, 95% of businesses globally run on Windows Server Active Directory. Businesses want to use the same software on the cloud. When a virtualized Windows Server runs on AWS, MSFT receives revenue from Amazon (In fact, AWS advertises 750 free hours of virtual windows server instance per month when signing up for EC2. Thank you Amazon!). Perhaps this is contributing to growth in Hyper-V (virtual Windows Server machines) share, which is now at 30.6% and has helped grow datacenter additions, the Windows Server and System Center both up more than 40% for the year (2014 (Q4 earnings call). Here, MSFT wins through growth of either AWS or Azure.

4. Another advantage is MSFT’s dominant share in commonly used productivity applications. Purchasing Office and related productivity applications as a service running on Azure (Office 365) relieves businesses of the cost of maintaining datacenters, gaining the agility to increase or decrease usage with work load fluctuation, while increasing security and availability globally. Moreover, this move to software as a service is more profitable for MSFT. The reduction in revenue to datacenter IT service provider is replaced by new revenue to MSFT. Obviously, AWS does not compete in widely used business productivity apps and Google is competing from well behind.

Recently MSFT has made a concerted effort to make its productivity apps available on other mobile platforms such as Android and iOS, increasing market share of the MSFT apps. For instance, two years ago development of Office for IOS began, finally released in late March and downloaded almost 30 million times in less than two months. Once a business moves to Office 365, its users are managed via Active Directory and the devices are efficiently and securely managed using Windows Intune (for which there are over 10,000 paying corporate customers since release in late April 2014) within the Enterprise Mobility Suite. Yes, that means all those iOS and Android as well as Windows devices. This is another point of competitive advantage for MSFT, in that the device business (with relatively low gross margins) is intrinsically less attractive than the type of mission critical software with switching costs that MSFT is using to manage the devices and enable them to be productive in a secure way.

The ability of services run on Azure to accommodate various cross platform devices at incredible scale was exampled in the largest content streaming event in history, the Sochi Winter Olympics. Content was streamed via over 6 million app installations cross platform on mobile devices, and over 500 million web pages were viewed with more than 25 billion requests to Windows Azure virtual machines.

MSFT dominance in historical productivity services and apps means hybrid cloud represents an extension of MSFT’s durable competitive advantage into the future. Here MSFT is leveraging its franchise in office to extend its competitive advantage to the cloud, in a way that competitors cannot. By enabling customers to keep managing their data flexibly and continuing to use established management software, MSFT is keeping the high margin productivity software business as customers gradually transition to the cloud with software as a service (Saas) such as Office 365. Meanwhile, MSFT is competing with AWS and Google Cloud by lowering prices in infrastructure as a service (Iaas). AWS and Google have fewer high margin businesses to move to the cloud.

5. For the past 2 years, because businesses demand services from providers other than Microsoft in the public cloud, Windows Azure has increasingly accommodated services on 3rd party platforms running on Linux or from other providers such as Salesforce, SAP, Oracle and many, many others. These disparate services and platforms can be accessed on Azure via a single sign on credential using Active Directory, allowing businesses to efficiently and securely manage access to services by staff worldwide. In fact, 3rd party platforms or services are easily managed within a graphical user interface. As Azure accommodates the platforms and services that are demanded in global business, this has produced a hockey stick upshift in Azure revenue growth.

6. Emerging classes of applications on the cloud include business intelligence (BI) and machine learning. (ML). In BI, cloud applications can process large amounts of data from MSFT and non-MSFT platforms running in Azure and present it in useful ways to the customers. This was demonstrated using Salesforce in the recent WPC 2014. In machine learning, amounts of data that are too large or physically separated to process on the business’s own datacenter are analyzed in the cloud to make predictions. For instance, a retailer might upload data from customer purchase behavior to be analyzed in Azure ML, to guide targeted email marketing to target offers based on predicted next purchases. Machine Learning is the basis for the newly announced Delve, which provides up front display of the most relevant information for the user within Office 365, thereby keeping track of relevant events and new information from the entire enterprise for the user. BI and ML are being introduced to the widely used applications within Office to integrate the power of cloud computing to enable more complex questions to be answered simply, in everyday business.

Recent revenue growth in Azure and related software is a result of the ability of Azure to enable innovative agility, scale and distribution to Microsoft software applications that have switching costs with captive customers. Even though Microsoft has not been the first to the public cloud, it is succeeding because of previously existing competitive advantages. Moreover, openness to 3rd party platforms and applications enables access to novel markets.

Over 57% of Fortune 500 companies are now deployed on Azure. Synergy Research Group reported that in the second quarter of 2014, Azure revenue grew three times faster than the other hyper scale cloud providers: MSFT at 164% yoy, AWS 49%, Google 47%. In the 2014 Q4 Earnings Release \ it was announced that Commercial Cloud revenue (Azure) had grown 147% since the year previous Quarter, at a run rate of over $4.4B. The attractions of the cloud (low cost, scale, agility, global reach) are helping MSFT applications. Over 25% of global businesses have now licensed Office 365.

Summary:
The emerging generation of cloud driven apps brings the power of hyper scale computing to everyday business applications. But the path to that new era runs from on premises datacenters through the hybrid cloud. MSFT is using its dominant market position in productivity apps to forge a strong share in IaaS hosting 3rd party platforms and becoming a one stop shop for enterprise software. Over a period of likely more than a decade, MSFT can bring businesses to MSFT platforms in the cloud as a PaaS provider, to cement its control of business “plumbing”, the standards for business processes. Then, it will control its economic future in the public cloud. An investment in MSFT represents a part ownership in this massive future market. In 20 years when we say, “business today runs on the cloud”, to what extent will this imply, “runs on MSFT software”? Notwithstanding, surely there will always be partners as well as competitors at all levels.

Finally, where does this leave us regarding a purchase decision? I will not add an exhaustive valuation analysis of MSFT here. In fact, for years the investing community has had low enthusiasm for Microsoft and therefore valuation of MSFT is relatively safe.

MSFT had Free Cash Flow (FCF) of over $26B in 2014, with FCF/sales of over 30%. The lowest such ratio in the past 10 years was 27%, in the teeth of the recession in 2009. PE is 17, midway between the high PE of 25 and low of 9 in the past 10 years. One of my favorite valuation measures is also extremely simple: Cash Return. This is the cash a company generates, as a percentage of its capital, both equity and debt. Cash Return equals FCF plus interest expense divided by enterprise value. Enterprise value (EV) is market cap, plus debt, minus cash. EV is in fact the price an investor would need to pay to purchase the entire company. According to Morningstar, MSFT Cash Return is 8.5%. Excellent, considering this is a company with clear competitive advantages that should continue to generate an above average return on its investments well into the foreseeable future as it has in the past, without important changes to its capital investment requirement.