I believe that software/Internet stocks, with at least two profitable and long-standing businesses, will outperform the businesses deriving the majority of their profits from a single line of business over the next business cycle (2010-2013).
Hence, Microsoft (NASDAQ:MSFT), with two successful business lines in productivity and system software, will outperform a company like Google (NASDAQ:GOOG), which derives most of its profits (I want to stress profits and not just revenues) from the search business.
Below is a table which displays the market value, cash as a percentage of market value and Price/FCFE of US large-cap (market cap > $3 billion) software/internet firms for 2005-2009. While Google's increase in market value has outpaced Microsoft over the 2005-09 period, my argument is that it may not do so in 2010-2013 or beyond. Oracle (NYSE:ORCL) has outpaced SAP (NYSE:SAP) in the same period, and in this case my hypothesis is that Oracle will continue to do so.
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Microsoft vs. Google
Yes, Google has increased profits and free cash tremendously in the last five years. Cash and short-term investments are $24 billion, accounting for a whopping 300% increase from 2005. The cash reserves of Google are currently equivalent to 14% of its market cap, while they constituted ~7% of Google's market value in 2005. Whereas the cash generated is getting factored into the market value, Google's increase in market value has not really kept pace with the increase in its cash pile.
As the table above shows, Google's market value has increased by ~$65 billion while its cash pile has increased by ~$16 billion. So ex-cash, Google's market value has increased by ~$40 billion in the 2005-2009 period.
Microsoft on the other hand has seen a marginal decline in its cash from $37.5 billion (in 2005) to $36 billion (in 2009), while its market value has increased from $243 billion (in 2005) to $255 billion (in 2009). Google is still approximately one-third of Microsoft in terms of revenues and net profits (as of December 2009). But what we must remember is that Google was one-tenth of Microsoft in terms of net profits in 2005.
So despite the phenomenal growth in profits over the last four years, Google's market value is ~$75 billion less than Microsoft's, and Google might find it difficult to bridge the gap contrary to expectations 2-3 years ago. On the contrary, any disruptive competition in the online business will bleed Google more than Microsoft, as investors have already discounted Microsoft's losing online business in its valuations.
In the software/Internet industry, discounting future free cash flows beyond 4-5 years is a risky business in itself. Google, for example, has its own share of head-aches in terms of its China business and monetizing its other businesses/projects (Youtube, Google Maps, Buzz, etc).
Google derives 97% of its revenues from search advertising. So Google's free cash flows are tied to the singular success (and continued success) of its search business. I wouldn't bet on Google taking any further market share in search as it already has a dominant share (globally), and so the increase in market value can only come from higher search yields ( that is more paid clicks and more revenue per paid click). Search advertising, like any other business, has its 'explosive' growth phase behind it and the future growth expectations can at best be moderate.
Microsoft,on the other hand, has two mature and profitable businesses: System software and productivity applications. Despite intermittent threats from other entrenched competitors, and new entrants (Google itself), Microsoft has held its own in these businesses. While its online business is still leaking money, its entertainment and devices business has turned moderate profits. The Xbox installed base can be another source of steady cash flows for Microsoft in the future, in addition to its two other highly profitable businesses.
So Microsoft will probably grow its profits at a slower pace than Google, but it looks like it has divesified its risk much more than Google as of now. In my view, that is more important from a long-term perspective, as even 2-3 years of difficult times for one particular business can be cushioned by the two other businesses. Google, on the other hand, doesn't have this luxury.
Google naturally attracts a Price/FCFE premium thanks to its faster growth rates. But as of April 1, 2010, Google traded at a Price/FCFE of ~21.5, while Microsoft traded at 14.1. Interestingly, Microsoft's Price/FCFE multiple is the same as the end of 2005, while Google trades a far lower mutiple (it was ~75 in 2005 end).
Oracle vs. SAP
Going back to 2004, Oracle Applications were no match to SAP's mySAP in terms of market presence and share. Oracle had a successful database business but Microsoft was increasingly eating into its market share and profits. Since then Oracle has stiched together a strong suite of applications to take on SAP, and it has succeded.
In terms of market value, Oracle started off 2005 with a ~$65 billion value, accounting for a ~$11 billion lead over SAP's market cap of ~$55 billion. However, as of date, Oracle has a market cap of ~$128 billion versus SAP's $57.8 billion.
So what went wrong for SAP? The answer could be that it did nothing for a long time, and by then it was too late. SAP has spent a large chunk of money to acquire Business Objects, and also to establish its SAAS presence through its BusinessByDesign offering. While SAP did offer encouraging comments on the prospects of volume business for its SAAS offering, it is unlikely that the impact is going to be felt in 2010 itself.
From a growth perspective, Oracle is better positioned than SAP, and has a much larger cash reserve to fall back on for inorganic growth. Oracle has a cash balance of ~$20 billion against SAP's `$3.2 billion cash balance as of Dec 2009. Oracle seems better valued than SAP on a Price/FCFE basis as well. With a more diverisifed revenue and profit base, Oracle can continue to outperform SAP, as Oracle has three business lines to fall back on: Database and Middleware, Application suite and its recently added Sun-branded software and hardware.
While I have focused on the big names, many such names across the software/Internet spectrum can be compared in such a manner. Adobe (NASDAQ:ADBE) is another name which can take advantage of its diversified business model despite its limited market reach as of now thanks to its focus on enterprise customers only.
For a long term investor, I would argue that it's safe to go for a stock with a diversified software model. When it comes to large-caps, the industry lends itself to disruptive innovations and discounting cash flows from a single line of business. Looking beyond a 4-5 year timeframe is risky (margins too can fall dramatically). This is especially true when valuations seem a bit expensive since earnings growth could be muted.
Disclosure: No positions