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In this commentary, we examine the increasing importance of software companies relative to hardware companies and why the former will be better investments going forward. In doing so, we have isolated three companies, which are fundamentally suited for long term investing and well positioned for this concept.

The Premise

In the near future, there will be a point during the technology cycle where hardware will reach a "good enough" level in terms of performance for most users. Said another way, the point of diminishing returns between hardware generations for most users has begun. Other than a marginal bump in performance, battery life, or form factor, most users will not see the value of upgrading their previous generation hardware.

When this dynamic begins to unfold, it will mean that such users will demand less from hardware and will shift their focus over to software. Within the next few years, we will prominently see a greater focus on software as the driver of innovation because users will demand their experience with existing hardware improves.

In this dynamic, software will be king and the key differentiator between platforms; it will be the innovation engine of the future. We already have seen proof of how valuable software can be to consumers in such examples as Apple's (AAPL) iOS. In this instance, users have already defined they like products that "just work" in the mobile market; Apple was privy to this industry dynamic much sooner than the competition, which rewarded their shareholders greatly.

Software Platforms

Below are 3 companies with dominant software platforms in their corresponding market segment well positioned for this shift in dynamic:

Oracle (ORCL):

Primarily focused within the enterprise market, over 70% of Oracles total revenue stems from software licensing of some form. As evidenced by their most recent earnings report, Oracle realized revenue growth in both software divisions (New Licenses and Renewals) and a decline in its hardware segment; this could perhaps indicate that our premise is beginning to take hold in the enterprise market. Looking fundamentally, Oracle is a cash generating machine, with Free Cash Flow reported for fiscal Q3 2012 increasing 36% from the year prior. Based on this metric, it is unlikely Oracle will have any difficulties ensuring their ability to invest in future software innovation.

Microsoft (MSFT):

According to recent estimations, Microsoft dominates approximately a 90% market share in the PC market. On the mobile front, a sad picture is painted for Microsoft, commanding less than 2% of the market. However, Microsoft is betting that will change dramatically with the introduction of the highly anticipated version of Windows 8 to be released October 2012. This version of Windows will support Arm Holdings (ARMH) chip architecture, enabling mobile devices running Windows 8 to utilize the same applications found on the PC. Also noteworthy is Microsoft's Xbox 360 platform, which has made considerable progress in the TV segment as a cable box alternative, with a recent big win from Comcast. Fundamentally speaking, Microsoft grows Free Cash Flow 13.8% per year, annualized on a 5 year basis; it is also well known that Microsoft has boatloads of cash, ready to be deployed. Although Microsoft's shares haven't done much of anything for the past 10 years, the next decade may be much brighter for shareholders.

Google (GOOG):

Google primarily is thought of as an internet advertising giant, with a track record of exceeding analyst expectations. We like to think of Google as a software developer with platforms on multiple mediums, whether it be web, mobile, or some combination of both. Innovation is one of Google's strong suits, especially in the realm of software. Founder of Android OS, Google has grown US smartphone market share to over 50% in less than 4 years; in many ways, Android is to phones as Microsoft was to PCs. Fundamentally, Google is also a cash generating machine, with Free Cash Flow growth of 26% on a 5 year annualized basis; they report next Thursday, with a consensus EPS of $9.64.

Final Thought

In a future where software is the driver of innovation for end users, these three companies are competing for the kingdom in their respective landscapes. Fundamentally, each are capable and well positioned to deliver the innovation end users will begin to demand more and more in the coming years.

In many respects, Microsoft and Google are viewed as direct competitors, but not all. Android as a tablet OS has yet to be mastered by any OEM and Microsoft likely views this as an opportunity to be the unified front competing directly against Apple's iPad. Without question, this will be an uphill battle for Microsoft and many investors have seemingly doubted their ability to drive future innovation. Luckily in the future, software will be king; there is no doubt that Microsoft is well positioned for this next phase of innovation.

Source: Tomorrow Software Will Be King, Hardware Irrelevant