This article first appeared in The Edge Malaysia Weekly on December 17, 2018 - December 23, 2018
AMID the huge selloff on Wall Street over the past two weeks, software behemoth Microsoft became the largest company in the world by market capitalisation once again, overtaking smartphone giant Apple and e-commerce supremo Amazon.com. The shuffle at the top of the technology sector may seem like a sign of times but the new world order of listed global corporates has more to do with just how much the market has punished Apple (whose stock is down 23% from its peak) and Amazon.com (down 17% from its peak) in recent weeks than anything Microsoft itself has done in terms of revenues or even profits.
Ironically, Microsoft was being written off as a has-been that could not do anything right just a few years ago. Its best days seemed over, and its shares were languishing, having gone nowhere for more than a decade when it was the world’s most valuable company. At its trough during the 2008 global financial crisis, Microsoft stock was down over 70% from its tech bubble peak. In late 2014, however, the Seattle-based company finally ousted founder Bill Gates’ Harvard dorm-mate Steve Ballmer as CEO and appointed self-effacing, low-key software engineer Satya Nadella as the head honcho. He swiftly began remaking Microsoft into a customer-focused firm betting on themes such as cloud computing and with a strong recurring subscription income stream. The stock has more than tripled since.
Unlike the late Steve Jobs of Apple, Amazon’s Jeff Bezos or Tesla’s Elon Musk, Nadella is no rock star CEO. He is as bland as they come. Yet, boring is the new sexy. Indeed, Microsoft has long been the embodiment of boring. For nearly a decade, rival Apple actually ran a series of TV ads featuring a buttoned-down PC guy and a cool Mac guy. But just as Apple’s market value touched a record US$1.1 trillion (RM4.6 trillion) nearly three months ago, Microsoft was emerging as a steady come-from-behind runner in the race.
To be sure, the narrative around the high-flying global tech stocks known as FAANG (social media giant Facebook, Amazon, Apple, streaming pioneer Netflix and search giant Google’s owner Alphabet) and BAT stocks made up of Chinese tech leaders Baidu, Alibaba Group Holding and Tencent Holdings has dramatically changed in recent months. Earlier this year, Alphabet had a clear lead over Microsoft, and Facebook seemed poised to overtake the software giant as well. Indeed, even Tencent and Alibaba were nipping at its heels. Yet Microsoft, down just 7% from its own recent peak, persevered, emerging as a safe harbour in the storm that has engulfed Big Tech this year.
Predictable earnings, recurring revenue
It is not that Microsoft’s earnings are suddenly accelerating or that its stock is cheaper than its peers’. Indeed, it is quite the contrary. In the current uncertain and volatile climate, investors seem to like the predictability of its earnings and its increasingly attractive recurring-revenue model. Microsoft stock sells at just over 24 times next year’s forecast earnings compared with Apple, which is trading at just 12 times its drastically reduced 2019 estimated earnings, while Alphabet stock is trading at 18 times next year’s earnings and Facebook at 16.5 times 2019’s forecast earnings.
Of the Big Tech stocks, only Amazon trades at higher multiples — over 65 times next year’s earnings — though that has a lot to do with its recent rapid earnings growth. And while the market may be valuing Microsoft at US$830 billion and Apple at just over US$810 billion, Microsoft had a net profit of US$17 billion on revenues of US$110 billion in its year ended June, while Apple had a net profit of over US$60 billion — or nearly 3½ times — on revenues of US$266 billion in its fiscal year ended September.
Analysts expect Microsoft to grow its earnings by 14% in its current fiscal year and have cut Apple’s earnings growth to just over 6% for its current fiscal year on lower iPhone sales. Microsoft, a predominantly software firm, has gross margins of around 60% whereas Apple, which makes most of its money from hardware such as the iPhone, iPad and the Apple Watch, has a 38% gross margin.
Founded by Gates and Paul Allen, who wrote the first operating software for PCs, Microsoft ran away with the big prize by licensing its software to International Business Machines, which made PCs. Today, it is the world’s largest maker of software. It is best known for its Windows operating systems and productivity Office suite applications, which include Word, Excel and PowerPoint. Its XBox console is a leader in gaming alongside Sony, whose pioneering Playstation was once the dominant force. At the height of the tech bubble in late 1999, Microsoft’s share price touched US$119.94, giving it a market capitalisation of US$618 billion, or about US$911 billion in today’s dollars. After the bubble burst, its stock price tanked over 70%.
Microsoft’s missteps have been well chronicled. It missed three big tech revolutions over the past two decades — internet, mobile and social media — big time. In 1995, Gates emerged as one of the early evangelists of the internet era with his book The Road Ahead, which was about the then under-construction “information highway”. Realising the huge potential of the internet, Microsoft used strong-arm tactics to elbow out Netscape, which was then the Internet browser leader, by bundling its Internet Explorer with its Windows operating system, which eventually helped trigger anti-trust scrutiny by the Department of Justice.
Although Microsoft was not broken up like some other monopolies — Standard Oil was forced to split into 34 smaller oil firms a century ago, and telco giant AT&T was split into eight different entities including seven “Baby Bells” 36 years ago — it struggled to maintain growth for years under Ballmer, who famously dismissed emerging new tech segments like mobile, search, e-commerce and social media. Even when he finally did make acquisitions, he only bought what now look like duds. Microsoft paid US$$9 billion for Skype. Though Skype has been integrated into the Microsoft Office Suite, few actually use it, preferring Facebook’s WhatsApp video or Apple’s FaceTime.
After dissing Apple’s iPhone as a “vanity” product, Ballmer eventually tried to break into the smartphone market with its own Windows Phone. When those efforts failed, he spent US$7.2 billion buying the mobile phone business of stumbling Finnish giant Nokia. Microsoft has since written off its entire investment in Nokia and most of its Skype investment. And, it abandoned Internet Explorer three years ago. The two big browsers these days are Google’s Chrome and Apple’s Safari. Microsoft was also bleeding money in other consumer businesses such as its search engine Bing and Xbox gaming console. According to some estimates, Bing had accumulated losses of up to US$20 billion.
Microsoft’s transformation
Under Nadella’s leadership, Microsoft has transformed into a key player in the cloud services arena. Though its Azure still lags behind Amazon Web Service, Microsoft’s cloud sales grew 76% in the September quarter compared with Amazon Web Services’ 46%. Third-placed Google has faltered this past year. Late last month, it announced that its cloud chief Diane Greene would step down to make way for a new leader who will try to help it close the yawning gap with Microsoft and Amazon. Cloud now makes up a third of Microsoft’s revenues; Microsoft Office suite and business processes another third, and all the other businesses including the Windows operating system, Xbox and other products account for the rest.
The market seems to love Microsoft’s diversified and recurring-revenue business model as well as its strong ties with companies around the world through its Office suite. Every year, these companies pay up to hundreds of dollars per worker and renew their subscription of Office 365. The emerging “subscription economy” allows companies to build a closer bond with their customers, aside from a stable recurring revenue stream. Microsoft has shrewdly moved away from selling customers occasional shrink-wrapped or downloadable software products to providing cloud-based Software-as-a-Service. Software subscribers also benefit from frequent updates as well as online storage. Four years ago, subscriptions accounted for just 10% of total Office suite sales, with traditional licence sales of the software making up the rest. Now, they make up more than half of it.
Even as he tries to grow Microsoft’s footprint in cloud services, Nadella has also built it in other areas. In recent years, the software giant has ventured into hardware products including touchscreen products such as Surface. Two years ago, it bought business-focused social network LinkedIn for US$26 billion. Last month, it acquired GitHub, a leading software development platform, for US$7.5 billion. Microsoft is now focused on high-growth areas such as artificial intelligence and cloud, as well as software products or services for multiple platforms. Its recent resurrection comes at a time when the software business is in a sweet spot. Advances in computing technologies, faster and cheaper memory and storage, as well as availability of ever bigger internet bandwidth, are helping software become the driver of new technologies and innovation including AI, machine learning, deep learning, Big Data and cloud computing.
Though it may have slowly clawed its way back to the top of the market-value table alongside Apple and Amazon, Microsoft faces formidable challenges in the years ahead. For starters, it must deal with a much-weakened position in consumer products. Without a smartphone ecosystem like Apple, and being in a lagging position in the living room where Amazon’s Echo and Google Home rule, Microsoft is seen to be at a long-term competitive disadvantage.
Moreover, the shift to mobile and cloud means operating software is increasingly becoming integrated or free like Apple’s iOS and Google’s Android, and cloud-based applications like Google Apps, Evernote and Box are chipping away at personal productivity software. It also faces competition from cloud services firms such as Salesforce.com and Slack. Moreover, Amazon Web Service with its large market share in Infrastructure-as-a-Service is trying to elbow it out by passing on the economies of scale to customers.
Crawling back up to take its old position as the world’s most valuable firm has been no mean feat for Microsoft. The challenge for the software giant now is whether it can keep flying at the same altitude as Apple, Amazon and Alphabet in the years to come.
Assif Shameen is a technology writer based in North America
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