Why microsoft is a buy

Today I want to delve into the digitisation thematic and explore why I believe Microsoft (MSFT:NAS) is so well-positioned to benefit from this mega trend.

In the past 15 years, the share of US jobs that require high levels of technical and digital capability has increased more than fourfold. Salaries of these workers are more than twice on average than those with low levels of technical competency.

Automation is increasing its penetration in lower skilled jobs, albeit adoption is varied across sectors. These statistics are representative of the broader digitisation thematic. Digitisation is the adoption of digital technologies and information to transform business operations, according to Gartner. We believe we are in the early stages of this theme, as innovation accelerates and thus it remains a core research focus for the Aitken Investment Management (AIM) team.

Some high-level facts to illustrate how digitisation is underpinned by many of the daily activities we undertake, which can compound quickly:

• There are 250 million computers sold annually.
• Microsoft Office is used by ~1.2 billion people globally.
• The Cashless Society is growing double digits to US$15 trillion per year.
• 98% of Americans have access to high speed wireless internet.

These few examples have not only required faster computing power, storage and data transmission, but have also led to innovative technologies and opportunities that would not have been possible without digitisation.

We are fortunate to meet companies from around the world and travel to all corners to identify opportunities for our investors. Our channel checks indicate that digitisation will accelerate in the coming years and consequently one of our core holdings has been Microsoft.

It is hard to overestimate the consumer, product and geographical breadth of Microsoft. Through its more than 130,000 staff and extensive distribution network (OEM, direct & resellers), the mission to “empower every person and every organisation on the planet to achieve more” is on track. Microsoft makes it easier for customers to be more productive and efficient. The world and business needs Microsoft not only to operate, but to evolve and innovate.

The prize is large and competitive pressure is a risk, however customer retention rates are high, and no individual customer has accounted for more than 10% of revenue over the past three years. Despite being the largest company in the world, with a market capitalisation of US$1 trillion, we believe there is substantial upside in the medium term for earnings and share price, as Microsoft sits at the epicentre of the digitisation thematic.

Microsoft: five-year chart

Source: nabtrade

The Microsoft business has broadened since Satya Nadella was appointed as CEO in 2014. Underpinned by curiosity and innovation, Nadella has led a business that in his words is “hungry to learn and connect with new ideas”. This has been reflected in the shift Microsoft has taken, with a focus on the Cloud, Artificial Intelligence, subscription services and gaming. These segments are growing substantially and enable customers to achieve more. It is not only Microsoft’s customers who are beneficiaries of the new products, but the company continues to invest and innovate. For example, Microsoft has more than 50,000 patents and another 30,000 pending and this will grow, in no small part thanks to investment. R&D as a share of sales continues to increase on an absolute basis, at $15 billion per year. The R&D budget alone is the equivalent to the total market capitalisation of an ASX top 20 company.

As management has innovated, new growth areas have performed strongly. Commercial Cloud has grown at an 85% compound annual growth rate (CAGR) since 2013, yet penetration levels are fairly modest, with approximately 30% of the US economy digitised, on our analysis. This is as simple as companies storing past or future information on the Microsoft Cloud – a trend we believe will grow more quickly and compound beyond market expectations.

Beyond new products, the traditional software products that many of us use daily, through the Windows Office Program, remain strong performers and cash generators. Growth rates are more modest, but subscription revenues are substantial. This is clearly illustrated in the most recent quarterly results, with the company gaining share and spend of the IT wallet.

In the past quarter, Microsoft generated US$13.5 billion of free cash flow from operations, growing 11% year-on-year. As a key leader in digitisation, a secular growth trend, we expect the top line and EPS to grow at double digits for the medium term. Management has confidence in this strategy and we even think there is upside risk to this optimistic scenario as the network effect takes place. The stock is valued at a price to growth ratio of 1.6 and has US$60 billion in cash. The company pays a dividend and will likely buy back US$20 billion of stock this year.

MSFT is a classic example of a dominant business that is increasing its dominance. The so-called “moat” around its business is expanding and leading to expanding margins, profit growth and returns to shareholders accelerating in the form of dividends and buybacks and underpinned by the digitisation thematic.

What are the risks?

While the opportunities for Microsoft appear significant, there are risks investors should be mindful of. In particular, intense competition in cloud computing from rivals such as Amazon Web Services means that Microsoft needs to keep investing in cloud infrastructure and innovation, potentially impacting the company’s revenue and operating margins. The company’s increasing focus on services presents execution and competitive risks.

Microsoft has had a patchy history with major acquisitions. In 2012, the company took a US$6.2 billion write-down, largely tied to aQuantive, which the company admitted at the time was not working out as expected. In 2015, Microsoft cut nearly 8,000 jobs and took a US$7.6 billion write-down related to its acquisition of Nokia’s smartphone business. In 2016, Microsoft bought LinkedIn for US$26.2 billion and so far the verdict is still out on whether this deal has been a success. Regardless, investors should be cautious of the risks associated with mergers and acquisitions.