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.