The market has been treating Microsoft (NASDAQ:MSFT) in an unusual manner considering its resilience against the current COVID-19 situation. After a sharp decline that saw the stock go from over $185 in the second half of February 2020 to under $135 within a month. The general sentiment around the company has been positive since then but, despite Microsoft reporting that "COVID-19 had minimal net impact on our revenue" and several firms raising their targets after earnings for Q3-2020, the periodic dips show that investor confidence has not yet been fully restored. The stock continues to trade under $175 as I write this piece and I think it's time for investors to understand the underlying upsides, not only from a post-coronavirus perspective but also through a better understanding of the company's long-term vision. MSFT is a clear buy at this price and I hope this article will justify that view.
Source: Seeking Alpha
The Whale in the Shallows
For a long time, Microsoft had been sitting on its laurels as the largest desktop OS and office productivity suite provider in the world. But when Windows 7 sales started to decline around 2011, it was a rude awakening for the Redmond, WA, company. PC shipments initially started to decline at a slow rate, gradually picking up momentum. It was time for the company to diversify, and the only way, or so it seemed at the time, was the jump into the mobile phone market with both feet.
In a rush to catch up with Apple (AAPL) and Asian manufacturers, Microsoft bought Nokia. In 2010, Microsoft had also launched Windows Phone, and the Nokia acquisition should have given the company a leg up in the mobile market. However, by 2011, Apple and Samsung were already nearing the top of the smartphone market, threatening Nokia's market share position. The worst was yet to come, but even two years before Microsoft bought Nokia (2013) it was clear that the Finnish-born brand wasn't equipped to retain its leadership position. It neither had an innovative product like the iPhone nor the capability to walk in Apple's path like so many others, including Samsung and several Chinese smartphone makers, did.
Source: Gartner via GSMArena
A quick look at 2011 vs. 2010 overall mobile phone sales shows that Nokia had lost 5% market share, primarily to Apple (up 2.1%), ZTE (up 1.3%), HTC (0.9%), and Huawei (0.8%). There were other market share losers as well that year, but Nokia was the most significant one because it was the market leader. What's significant here is that Microsoft's relationship with Nokia began the previous year when Nokia hired Microsoft's Stephen Elop as CEO in a bid to establish a broad partnership between the two companies; the acquisition itself happened in 2013, which means there was ample time for Microsoft to consider the initial partnership and eventual acquisition as a bad deal. That didn't happen. Instead, Microsoft made a bet on Nokia, which eventually ended up being a massive write-off. And the Windows Phone attempt pretty much came to a similar end.
Source: Microsoft 2013 Annual Report
The Great Microsoft Turnaround
Meanwhile, Windows and MS Office licensing revenues were still declining; by FY2013, licensing revenue had dropped to under $19 billion. By the time the annual report came out, the new CEO, Satya Nadella, had already announced his mobile-first, cloud-first strategy, and Microsoft had started taking its core Office applications to the cloud. There was still speculation about a mobile future because of the way the vision was worded but Mr. Nadella's emphasis was on mobility rather than mobile devices. That distinction was lost on most people at the time, even though he spelled it out during a press briefing less than two months after he took over:
I talked about this in my first mail to all Microsoft employees as a mobile-first, cloud-first world. And like any place that's got predominantly computer scientists, I get back this mail saying, hey, look, how can two things be first? I mean, do you have a problem with ordinal numbers or something? (Laughter.)
And the reality is it's one and the same. It definitely is that cloud that is not connected to devices is just latent potential because how does the cloud interact with the real world? It is through by being able to get to devices. It could be a sensor, it could be a mobile device, it could be a tablet, it could be a big screen in a conference room or a living room. And likewise, a device which is not connected to the cloud just cannot complete the scenarios.
So to us it is one and the same, and it's the magical coming together of the cloud and the mobile.
What he meant was that cloud and mobility were inextricably intertwined: a cloud computing platform without a device on which a user can interact with it is as meaningless as a device that can't hook up to the cloud. That was his vision, and he walked the walk. Four years later, when Microsoft announced its Q1-2019 earnings, it was clear that he had delivered on the cloud part of that promise. On a trailing twelve months basis, Microsoft had overtaken Amazon's (AMZN) cloud revenues $26.7 billion to $23.4$ billion.
But that vision needed a little tweak because it was time to solidify the 'mobile' part of that vision with a related area of focus: edge computing. So, earlier that year, the new Microsoft mantra under Mr. Nadella became: "Intelligent Cloud, Intelligent Edge." This extended the company's vision into three distinct areas: cloud and edge, artificial intelligence, and mixed reality.
By this time, Windows 10 was a mature product and it was time to shift the focus to Microsoft 365, essentially an integration of Windows, Office, other applications, and the cloud experience delivered across the device spectrum. It was a transition that Mr. Nadella explained as follows:
Computing experiences are evolving to include multiple senses and are no longer bound to one device at a time but increasingly spanning many as we move from home to work and on the go. These modern needs, habits and expectations of our customers are motivating us to bring Windows, Office, and third-party applications and devices into a more cohesive Microsoft 365 experience.
This, in turn, led to a reshuffling of roles and portfolios at senior levels and resulted in three major units: the Microsoft 365 devices experience, led by Rajesh Jha; Cloud and AI, led by Scott Guthrie; and AI and Research, headed by Harry Shum.
This structure clearly shines the spotlight on cloud delivery, the edge experience, AI innovation, and Mixed Reality experiences, all of which are aligned with the "Intelligent Cloud, Intelligent Edge" philosophy.
Focus on Open Source
Mr. Nadella also understood the need for Microsoft to be more inclusive, which led to several interesting developments on the M&A side. Following the acquisition of LinkedIn in 2016, two more key acquisitions show how Microsoft is intricately linking itself with the top cloud and development talent around the world. The first is the 2018 acquisition of GitHub and the second is the upcoming acquisition of npm (Node Packet Manager) under GitHub, which was announced in March 2020.
The reason I segue into this part of Microsoft's long-term strategy is that all of these initiatives and structuring around the cloud, the edge, AI, and MR require a collective push from the development community as much as OEMs. That being the case, the open-source community was obviously something Microsoft could no longer ignore. Ironically, the concept of open-source code development was once held in disdain by the company that relied on licensing proprietary software for the bulk of its income. Not that much has changed in terms of the revenue model, but the company eventually realized that the open-source community was not an enemy but a friend they hadn't yet made.
These acquisitions were - and remain - pivotal for Microsoft because they yielded the world's largest social platform for professionals, the largest source code hosting repository, and the largest software registry. The reason these acquisitions are so significant is that many enterprise companies depend on these platforms for their own revenue growth, proprietary internal systems, and custom software development needs.
By owning these platforms, Microsoft is potentially a control point of sorts for the entire enterprise segment, whether they operate with an on-prem, multicloud, or hybrid model. Does that mean Microsoft will start restricting open-source projects to use it to its advantage? Most probably not, one reason being that there are several alternative platforms that developers can resort to when push comes to shove. That actually happened - to a certain degree - when Microsoft bought GitHub. In fact, even Alphabet (GOOG) was prompted into taking part in a $100 million round - in addition to the earlier $20 million from a 2017 round - in GitLab, the rival code platform that lost the bid to buy GitHub and gained thousands of developers in the process.
To use a very loose analogy, think of how Alphabet's Google owns the Android platform but Android is still open-source and freely available for OEMs to use. However, its ownership gives Google an advantage over other OEMs. This is why their own hardware - Google Pixel smartphones - gets the first Android updates out of the gate and Google's apps are stock on most Android devices. But that's where the similarity is likely to end. Google was accused of using Android as a vehicle to push its own apps to the forefront, which is why it got into trouble with the EU in the first place.
If it has learned anything from Google's example, Microsoft is likely to tread very carefully with GitHub and npm. It's been suggested that the move "could allow Microsoft to dictate the policies around these open source projects in future," but I'm not a fan of that theory because it would be counterintuitive to what Microsoft is trying to achieve, which is to 'infiltrate' (for lack of a better word) the ranks of Fortune 500 companies through the open-source developers that supply a lot of the code and packages they use for their own custom software and systems. Putting a choke chain on open-source would alienate them from the very human resources they're hoping will get companies to be more reliant on their proprietary products. Let's be clear about the fact that it's still all about revenue. It's just a more inclusive way to get there.
Microsoft's Next Chapter
What's more in line with Microsoft's current philosophy is that it will enhance the capabilities of GitHub as a code collaboration tool as well as a distribution tool to make it a compelling product for pro and premium users, primarily in the enterprise segment. In essence, this will allow the company to gain an inside position by embedding itself into the core growth engines that drive these companies forward - LinkedIn for sales growth and professional networking; the Azure portfolio for infrastructure, platform, applications, and hybridization of on-prem; and the resources and tools of Xamarin, GitHub, and npm for their internally developed software and systems. And that's the 'insider plan' that the title of this article refers to.
There are three reasons why I think this is a plausible outcome:
First of all, Microsoft has already become a formidable force in cloud infrastructure; and, in many ways, it is better suited to a large subset of Fortune 500 companies running Windows Server and SQL Server. It makes sense because there's deeper integration across products when you're dealing with a single vendor. Of course, the multicloud and hybrid models are equally compelling because they help companies avoid being locked in, but Microsoft has that covered as well, with Azure Stack products like Azure Stack Edge, Azure Stack Hyperconverged Infrastructure (Azure Stack HCI), and Azure Stack Hub, among others.
Second, Microsoft is a major player in the database game with SQL Server and Microsoft Access. It further extended its coverage by offering Azure SQL Database, which is essentially a managed cloud database service, or DBaaS (Database as a Service) that the company says offers the "broadest SQL Server engine compatibility and up to a 212% return on investment." That's a significant advantage in a cost-conscious environment where potential cloud migrants are still on the fence. Despite what's being propagated about rapid cloud migration, the fact remains that less than 25% of enterprise workloads are on the cloud. It's something I talked about in my recent article on IBM (IBM) as well. The truth is, on-prem is still a huge gold mine for companies like Microsoft and IBM that have strong portfolios of hybrid cloud products and services.
The third leg of that stool is open-source resources. By supporting open-source over the past several years, Microsoft has been building a bridge that wasn't there to begin with. Windows and Office represented the exact opposite of freely available code. However, Microsoft began its open-source journey by sidling up to the Linux Foundation and eventually joining it as a Platinum Partner in 2016. It prefaced the move by open-sourcing projects like .NET and Visual Studio Code, but its membership with the foundation cemented its commitment to open-source - that, and the Xamarin acquisition that was announced earlier that year.
These three strategic moves have now led to the fourth piece of the puzzle: the GitHub and npm acquisitions. With these four pillars in place, Microsoft now represents a relatively simple choice for enterprise users who still have massive workloads running in on-prem data centers. Several points are to be noted here:
The width and depth of Microsoft's offerings now make it easy for companies to build and run applications and store data in the cloud or deploy a cloud environment in their own data centers for those purposes.
From a database perspective, Microsoft offers a comprehensive suite of solutions for migration and in the form of managed services.
With the acquisition of GitHub and npm, Microsoft can improve the security, cross-functionality, infrastructure, and performance of these platforms. The planned investments around npm and ongoing changes at GitHub will offer enterprise companies a secure private environment to host their code and distribute their software packages.
All of these elements represent a tremendous amount of revenue potential down the road, and I don't think that has been factored into the stock price at the current level. As of this writing, MSFT is trading at under $175, which is still a good entry point despite the fact that you may have missed the series of dips that began in late February this year. The COVID-19 situation will not only give Microsoft a growth spurt in the quarters to come, but it will change the way businesses operate in the long run. Cloud adoption and workload migrations, in my opinion, will get more aggressive as companies realign their workforces to a WFH-heavy (work from home) model, and Microsoft is well-positioned to take advantage of this shift.
Putting it all together, it's amply clear that Microsoft is targeting a larger and larger share of the enterprise pie with the strategy it has been pursuing over the past several years, and there's every reason to believe that it will continue to execute toward that goal.
Are there any risks involved if you invest in Microsoft right now? Absolutely. If there's one sure bet, it's the fact that nothing is a sure bet. However, the risks appear to be minimal because the long-term upsides that this article discusses have most certainly not been priced in. The moves that the company has been making and continues to make are well-aligned with its long-term goals. Moreover, I believe the post-coronavirus landscape will be a catalytic booster for Microsoft's growth story.
More to the point, though, Mr. Nadella's leadership has already proven its efficacy and he's got a clear roadmap that's unfolding as you read this. So, I guess the real question is: are you prepared to invest in him and his vision despite the current unpredictability of the market? I sincerely hope this article has helped you answer that question, one way or another.