One lovely drizzly day, clad in Gore-Tex, I was enjoying a walk through my leafy Seattle neighborhood when I happened upon a neighbor putting the finishing touches on a thirty foot high fence around his house.
"Hello, Neighbor!" I said, "Why did you build that tall fence?"
"To keep out the dinosaurs." He replied.
"Dinosaurs! There are no dinosaurs here."
"See!" he said, "It works!"
My neighbor took his paranoia to the silly extreme, but a good business should employ a healthy degree of paranoia to ensure dominance over competitors. Most value investors agree on the importance of economic moats, a term coined by Warren Buffett, but they often disagree on whether individual companies have established a moat. A company can establish its moat in numerous ways such as through a superior brand, advantageous cost structure, intellectual property and economies of scale. In this article I propose an objective way to assess whether or not a company has a moat and argue that Microsoft has managed to build, defend and widen its moat over the past three decades.
How to spot a moat
Investors can make sound qualitative arguments about whether a certain company has a moat. For example, Apple (AAPL) fans may argue that consumers love their iPhones and are very loyal to the company's products, which has resulted in Apple's moat. Google (GOOG) fans may argue that when the company's name turns into a verb and used worldwide then you know you have a moat. Amazon (AMZN) fans may argue that the company is the dominant web retailer as judged by its market share; it is the go-to site for consumers and, therefore, has created a moat.
These are all fine arguments but an investor needs to find objective measures to verify the existence of a moat. A company cannot claim it has a moat unless it has:
1) High profitability and
2) Consistency over time.
A well-funded competitor with a hundred billion dollars in cash should be unable to destroy the company's business. I look at a company's return on equity (ROE) as a proxy of "high profitability". A single year of high ROE or even a string of 7 years is not sufficient. A company that has not achieved high ROE for many years (at least ten) cannot claim to have a moat yet. A company that has recorded a high ROE for only a few years will put itself in the cross hairs of competitors and entrepreneurs. A short string of high ROE is merely the first step in establishing a moat.
As Friedrich Nietzsche said, "That which does not kill us makes us stronger." Part of the process of establishing a moat is beating the army of competitors. Once you have achieved high rates of profitability then you will come under attack. After beating and humbling the competition, the company will widen its moat further. Mounting a serious challenge is expensive for competitors, and when a company defends its turf after challenges, it will discourage future attacks. For example, Google is dominant in search. Its main competitors, Microsoft's Bing and Yahoo (YHOO), have no shortage of cash to challenge Google. So far, judging by Google's 67% market share, the well-funded competitors have not made huge inroads. Meanwhile Microsoft's Online Services Division, whose offerings include Bing, posted a $1.2 billion loss in 2013, according to Microsoft's 2013 10K . If Google continues to successfully defend its search business then it will get stronger and widen its moat. So far, the results look encouraging for Google but I believe the company is still in the early stages of claiming a decided moat.
Now let's turn our attention to Microsoft's moat. Microsoft's three main divisions are Windows, Server and Tools, and Business, which includes "Office". The three divisions supply the bulk of the company's 2013 revenues and profits as reflected below.
Server and Tools
Source: 2013 10K
Unlike Google and Apple, Microsoft has been a very profitable company for over three decades. It has been assaulted by competitors throughout its history. To be sure, even today Apple is continuously trying to breach Microsoft's relations with businesses. Now let's take a look at Microsoft's ROE for the past ten years as compared to Apple and Google.
Source: Value Line
As you can see above, Microsoft's worst year was in 2004 when it still achieved over a 15% ROE. Apple's ROE was only 1.8% in 2003. As recently as 2001, Apple had negative earnings. A company with a moat rarely loses money. Of course, Apple could be on its way to establishing a formidable moat, but it is too early to tell whether it will succeed. Analyzing whether Apple and Google will achieve moats is beyond the scope of this article. Microsoft's over 25% ROE since 2005 is impressive, especially in light of its huge cash position. Because of this large cash position the numbers above actually underestimate Microsoft's true profitability. For example, in 2013 Microsoft's net income and shareholder equity were $21.8 billion and $78.9 billion (ROE = 21.8/78.9 = 27.7%, slightly different than the Value Line number above) respectively. Microsoft had net cash of approximately $61.4 billion ($77.0 of cash minus $15.6 of debt). This cash is unnecessary for the day to day operations of the company and potentially could be returned to shareholders. Had they "unburdened" themselves of the cash, their ROE would have been 124% (ROE = 21.8/ (78.9-61.4) = 124%). Few companies can boast these numbers. Of course none of this is news to Microsoft's competitors but they still have not managed to put a dent in the company's profit margins from its three main divisions.
Microsoft's CEO, Steve Ballmer, announced his retirement on August 23, 2013. On that day the stock shot up by over 7%. I was not surprised by the reaction of investors, who often judge the success of a company by its historical stock price movement. A company's stock price can be uncorrelated to its performance over long periods of time. Often investors mistakenly judge management's performance, for better or worse, by looking at the company's stock price. Microsoft's performance has been exceptional over Ballmer's tenure. However, since he took over as CEO in January of 2000, the stock has dropped from over $55 a share to its current price. The stock price drop after the dot com bubble burst, and its subsequent stagnation, is no fault of management. During the same period the company has returned billions of dollars to shareholders in the form of share buybacks and dividends. As I argued in my previous article, Microsoft is well managed and shareholder friendly. Moreover, investors can rest easy since the company has unusually conservative accounting principles. Since January of 2000, revenue per share has increased from $2.25 to $9.34 and EPS has more than tripled. The CEO's job is to take care of the business and not the stock price. Ballmer, and before him company founder, Bill Gates, have defended and widened Microsoft's moat. Contrary to investor sentiment, as judged by the price action on the day of Ballmer's announcement, his retirement may be a blow to the company. However, investors can be comforted that he and Gates will continue to play integral roles in the company through their board involvement. The two have a passion for the business beyond their financial interests in the company.
"A Great Company at a Fair Price"
Buffett touts buying great companies at a fair price. As a small investor who has a much smaller investment portfolio than him, I strive to find great companies at not just fair prices but at great prices. Microsoft's current valuation suggests not a bargain but a fair price. It is becoming increasingly difficult to invest in large market cap companies at fair prices due to the recent run up in stock prices. In today's market there are many great companies, but unfortunately very few are priced fairly. Microsoft was a terrific company in 2000, but due to its stock price was a lousy investment at that time. In 2014 Microsoft is a far better business with a wider moat and will prove to be a great investment over the next decade. It still offers an opportunity for those who are looking to invest in large market cap companies at reasonable prices. Microsoft's earnings yield of 7% and dividend yield of 3.1% are both better than the 10 year Treasury yield currently. The company's consistency, superior management, and conservative accounting will continue to reward investors for many years to come.
One of the costs of building and defending your moat may be spending money that may not seem smart in the short run. Microsoft's multi-billion dollar acquisitions of Skype and Nokia's (NOK) devices and services business may result in future write downs, but most likely those companies were acquired for strategic reasons as a way to further enhance Microsoft's core businesses and to keep competitors at bay. Investors cannot judge those acquisitions the same way they would judge a conglomerate's acquisition. For example, Google's recent $3.2 Billion acquisition of Nest Labs or Facebook's (FB) $3 Billion attempt to acquire Snapchat were meant to defend the acquirer's turf and to insert themselves further into consumers' lives. A future write-down does not necessarily mean the acquisition was a failure. However, if Berkshire Hathaway (BRK.A) took a write-down due to its 2009 acquisition of Burlington Northern Santa Fe, then it would mean that Buffett made a poor decision when he acquired the company. So far the Burlington acquisition has been very positive for Berkshire shareholders.
Qualitative arguments can be made about whether a company has a moat, but it can only truly claim to have a moat if it has high rates of profitability and consistency in producing those numbers over a long period of time. Microsoft has managed to build and defend its main lines of business. At the current market price, the company offers a good opportunity for investors interested in a large market cap company at a fair price.