Microsoft's Horizontal Diversification Strategy Primes Them For Long-Term Growth

Summary

• MSFT appears to be contesting in many highly competitive markets, which might diminish long-term returns.
• However, these high-growth industries allow them to stave off intense competition, giving them the opportunity to nurture assets into new pivots for growth, using resources from existing segments.
• Their broader focus on horizontal diversification versus concentric diversification gives them a potential first-mover advantage in leveraging on new growth trends.
• This style of diversification also exposes them to less political risk, which can lead to revenue stability.
• Finally, a DCF analysis reveals that it is also undervalued at current prices, making it a very attractive investment after considering its qualitative factors.

Photo by da-kuk/E+ via Getty Images

A Household Name

Microsoft (NASDAQ:MSFT) is a household name in tech, not only because it dominates our internal operating systems and the very productivity devices that we work and play on, but because it has consistently been one of the top performers in the stock market. We know this in part because of the acronym FAAMG – a term coined by Goldman Sachs (GS) as a variant of FANG to describe the primary drivers of growth in the stock market. While being in a high-growth industry is characteristic of any big tech firm nowadays – e-commerce, social networking, internet services, or smart devices, it's less true for MSFT.

Today, the majority of computers in the world run already run some version of the operating system, to the point where there is barely any more room for growth. Indeed, the “More Personal Computing” segment in their 10-K filings where Windows-derived product revenues accrue has only grown at an average of 5% in the past 4 years, suggesting a sunset era for the segment that was so revolutionary just two decades ago. In spite of its challenges, CEO Satya Nadella has managed to deliver years over years of performance. Using an impressive horizontal diversification strategy, MSFT has managed to bring new sources of revenue growth through various high-quality acquisitions and innovations that have grown under their umbrella. With their acumen in identifying key technological assets and pivoting growth towards these areas, it is my belief that they will continue to stay the course in a post-Windows world, and even after current high-growth trends start to wane.

Highly Contested Markets?

Perhaps one key point to be critical of is in its strategy to acquire companies in many different markets that are only loosely related to the broad vision of MSFT as a software-focused technology company. Taking a look at many of its operating segments, many exist in industries that have significant competition at the moment, with more to be expected in the future given the great contestability of these markets.

MSFT’s business segments can be categorized into three broad groups, namely:

• Productivity and Business solutions: This segment primarily consists of products and services that are geared towards enhancing the productivity of consumers, as well as creating solutions for businesses and business processes. For instance, Microsoft Office 365 is used extensively for productivity worldwide; LinkedIn is used as a Talent Management platform; and Microsoft Dynamics serves as a cloud-based enterprise system for businesses.
• Intelligent Cloud: This segment consists of server products and cloud services such as Azure, SQL Servers, Visual Studio and GitHub.
• More Personal Computing: This segment consists of products and services that focus on personal computing, through software (Windows), Devices (Surface and other PC accessories), Gaming (Xbox), and Search Engines (Microsoft Edge).

At the expense of having its fingers dipped in many markets and submarkets, MSFT exposes itself to significant competition with many niche and non-niche players in that field.

(Some of the key competitors of MSFT in different segments. Source: Author)

As a consequence of being heavily invested in technology, many of its products are prone to significant disruption from new entry, as well as competition from existing developers. This is true because many of the high growth areas incentivizing entry also have comparatively low barriers to entry as a result of their low capital requirements. There is also a greater ease of capturing market share because of the low switching costs of certain software use cases. For instance, consumers can easily make the switch from using Skype or Microsoft Teams to Zoom (ZM); Developers can switch from Visual Studio to another IDE like Eclipse without much hassle; Collaborators can switch from Microsoft 365 office to the open-source Google Drive (GOOG) (GOOGL) network. Even in enterprise-level use cases such as in CRM software, Cloud Computing or Database management, modern migration techniques make it entirely possible, suggesting that brand loyalty matters less than once thought.

Some high-growth industries such as the Cloud Computing market are also prone to disruption, especially from Chinese tech companies like Alibaba (BABA) and Tencent (OTCPK:TCEHY), that have both the financial capabilities and technological know-how to make effective substitutes to MSFT’s Azure.

Spreading its expertise so thinly can also pose a significant problem to MSFT, and it can possibly mean that their product offerings are inferior to niche competitors that have devoted much of their life towards honing the product. In the long run, this could at best imply mediocre performance. If the coming death of Internet Explorer is any precedent for the future, there may exist a future where MSFT’s other products become so legacy that they have been completely phased out.

At the heart of MSFT lies a horizontal diversification strategy, but if this exposes it to so much competition in the face of an ever-changing tech landscape, can MSFT continue to guarantee its historical double-digit growth rates in the future?

Horizontal Diversification and Pivots to Growth

Room to Grow

Even in spite of significant competition within the industries that it contests, MSFT is able to hedge against the competition by taking advantage of the significant growth rates of the base industry itself. While there are other niche competitors in the field that may have more market share than MSFT at the moment, the naturally growing size of the pie allows the firm to still grow its baseline earnings more than sufficiently to survive amidst the competition, which makes it an apt decision to horizontally diversify into growth areas.

For MSFT, their entry and pivot into the cloud computing market allude to his very point. In the 2000s, many firms have already identified the promise of cloud computing, in lieu of our exponentially growing data needs and the spawning of data-driven decision making. When MSFT launched Azure in 2010, cloud services revenues were already forecasted to grow at upwards of 16%, but it was by no means the first mover in this field – NetSuite and Salesforce (CRM) were already here before the 2000s; Sun Microsystems in 2000; VMWare (VMW) in 2001; AWS in 2006; and Google App Engine was released in 2008. Yet, despite a comparatively late entry into a field with already so many competitors, the nascent nature of the cloud computing industry and its submarkets (IaaS, PaaS, and SaaS) also meant that that there was still significant technological uncertainty in cloud computing products. With no set industry precedent on product policy, marketing techniques, and pricing models, there was still a great deal of room for the industry to be disrupted since there was always the opportunity for even an unremarkable new entrant to slowly nurture their product into a compelling one.

Even in spite of AWS’s dominion over IaaS cloud computing market for the larger half of the decade, MSFT has managed to gain significant ground, with some estimates putting it at 16.9% in 2019 up from 14.2% in 2018 and AWS losing share from 36% to 32.3% in the same period. In the PaaS market, the same parallels can be drawn.

Past primary cloud offerings in IaaS and PaaS, MSFT has also managed to successfully contest the market for enterprise services and servers, to wrestle market share from early competitors like IBM and CRM, and become a leader in the SaaS field.

(MSFT's Dominance in Enterprise SaaS. Source: Bessemer)

Nurturing Growth under the MSFT Umbrella

A typical horizontal diversification strategy has to be carefully considered because it might stretch resources too thinly. Even if the new industries that the firm expands to past its original home base can promise significant growth, the reallocation of scarce resources can lead to diseconomies of scale from disorganized management, lack of focus, and lack of innovation. In this aspect, the case for MSFT potentially losing against incumbents and niche players can certainly be made, but its competitive edge against other firms that try for such a strategy lies in the fact that it is a trillion-dollar firm with the capacity to fund and nurture businesses under its umbrella.

We can see the idea of growth nurturing in action through a growth-share analysis of the operating segments of MSFT. In the diagram below, the three main operating segments were plotted according to their relative market share to the next biggest competitor, their market growth rates, and their revenue. On this chart, high relative market share segments are positioned on the left, high market growth segments are positioned vertically higher, and the circle size is proportionate to revenue. Note that only the current business segments have been plotted (i.e. the darker-colored bubbles), and the rest are positioned there for illustration purposes only.

(Illustration of Nurturing Growth Assets. Source: Author)

The diagram paints a story of the transformation into the cloud and enterprise-focused software firm that MSFT is right now. Initially, the high growth and high market share of Windows OEM licensing in Personal Computing generated high returns on investment, but as the industry matured, there was less incentive to invest further in this segment. This means that much of the cash generated here can be funneled to other more promising areas such as its productivity and business segment and cloud computing. The rapidly growing industry but lack of a defined playbook suggested that these areas were still ripe for disruption, and a higher return on investment. After years of funneling cash into these new growth areas that MSFT has diversified into, these growth areas were pushed towards higher market dominance, where revenues expand. This is exactly what we have seen as MSFT gains market share in the enterprise SaaS vendor industry, and the IaaS+PaaS industry from the 2010s to today.

One key insight from this is that MSFT can make use of a similar strategy to propel growth in the long run as well, past the cloud era. As cloud and productivity markets mature, they will become the next cash-generating segments for MSFT. Through funneling cash generated into systematically chosen new growth assets, they are primed to continue the cycle of growth by pivoting their focus to these new areas.

Finding New Growth Assets

It is no big surprise that the majority of large tech firms like MSFT and FAANG rely significantly on internal research and development, as well as the acquisition of new firms in order to push towards new areas of growth. But the way by which they pursue new growth and pad their bottom lines are drastically different. Over here, MSFT’s style of seeking growth through horizontal diversification primes them to preferentially select winners in the future over their peers.

In general, big-tech firms prefer a style of innovation that is closer to concentric diversification, which relies on building high-level synergies between each business segment. In other words, acquisitions and innovation for diversification double down on their existing product lines. One salient example is Facebook’s (FB) high-profile acquisitions of WhatsApp and Instagram, that serve as highly synergistic extensions of their Facebook platform for social networking. As another example, Apple (AAPL) had invested in developing their internal navigation technology, music, and video streaming capabilities, as well as artificial intelligence and healthcare technologies to act as complementary software for their primary Apple product ecosystems.

This method of innovation prioritizes synergistic relations between products because it helps to solidify brand loyalty through making a compelling product. Since the primary consumer market that these firms reside in is still in a high-growth phase, pursuing diversification in this manner helps to secure their market share and prevent disruption from other new entrants so they are able to maintain comparatively high growth along with the industry.

MSFT, however, is met with the unique challenge of a maturing industry in a post-Windows era, which implies a lower return on investment. This means that the diversification style has to be broader, pursuing segments that are less synergistic and less aligned with its original core business.

Observe that while many of its operating segments are concentrated somewhat in tech, high-level business synergies that attempt to drive at a Microsoft-branded ecosystem are less obvious. The focus is rather on capturing submarkets within broader consumer markets (such as targeting software development professionals with GitHub, and networking professionals with LinkedIn, within a broader market of professionals that all use Microsoft Office for productivity)

• Cloud-based offerings, including enterprise cloud (Azure, Dynamics)
• Productivity (Microsoft Office, Outlook)
• Social Networks (Teams, Skype, LinkedIn)
• Operating Systems (Windows)
• Human Capital (LinkedIn)
• Microsoft Gaming (Xbox, Microsoft Store)
• Software Development (GitHub, Visual Studio)
• Hardware (Surface Tablets)

Different circumstances will dictate different diversification, acquisition, and growth styles, but the lack of priority on synergistic factors means that MSFT will likely be the first movers to find value in certain growth areas when it still does not make sense for some firms to acquire or internally develop products or services in these fields.

(Promotional Image of HoloLens. Source: MSFT)

HoloLens is an example of this. While other non-consumer electronics firms have demonstrated an interest in pursuing Augmented Reality, the current focus for them is not about building a completely functional device for productivity, but rather on how the AR tech can benefit their existing segments. For instance, Amazon (AMZN) had rolled out AR apps in the past, but they are largely for improving the consumer e-commerce experience. In this case, MSFT’s initial foray into such technology allowed them to secure a contract with the US Army for AR headsets, before any real substitute to it is commercially available. Other examples echo a similar sentiment:

• Human Capital Management (LinkedIn) – this is a prime area for disruption, but professional networks are not the key focus for consumer-oriented ecosystems in AAPL, GOOGL, or FB.
• Audio-based social network offerings (Potential acquisition of Discord, and a rumored Clubhouse competitor). These might make sense for social networking firms, but are less important for firms that are less invested in this field.

While some tech firms might find value in these new technologies depending on what segments they already operate in, the key idea is that MSFT’s diversification style allows for a much broader reach and are more likely to be the first ones to leverage on certain growth areas than other firms that prioritize synergy.

Part of MSFT’s growth strategy is relying on acquisitions for growth by outright purchasing the expertise in a particular area that they are interested in contesting. But many have argued against such a strategy because taking in a smaller company under the larger hood of a conglomerate can sometimes obscure the focus of the acquired firm. Certainly, MSFT’s historical write-downs of aQuantive and Nokia Devices/Services can testify for poor outcomes after activist management, but the approach has changed to be more passive under CEO Nadella, according to the acquired firm independence. In fact, it was this hands-off approach that sold CEO Jeff Weiner on the acquisition of LinkedIn.

If this style of managing acquired companies in the future continues, then there will be a high likelihood that acquired firms will be able to nurture further into compelling products in a win-win situation for MSFT. On the one hand, MSFT is able to provide the capital and technical resources which allows the acquired firm to take even greater risk and pursue disruptive innovation without fear because of a lifeline support. On the other hand, MSFT is able to leverage on the firm achieving its fullest potential with a greater risk-taking attitude, and contest new growth areas that are ripe to be contested. In the case of LinkedIn, this means pursuing more innovations in the human capital realm, a field which has largely been stagnant in the past few years.

For many firms, medium-term growth is driven by demand for cloud computing and its associated services, but what happens after is still a big question. MSFT strikes out as different for me because it has already been through one iteration of reinvention, managing to pivot away of the MSFT of old into the MSFT of new, meaning that they are better prepared for the eventualities of industry maturity. Through the strategy of acquiring or developing growth assets and funneling cash from maturing segments to nurture these areas into new pivots of growth, MSFT is primed for long-term growth and continued outperformance.

Dodging Political Risk

As a consequence of their investment and growth style, MSFT is also less susceptible to political and regulatory risk. Large big-tech firms have largely been plagued by lawsuits of antitrust violations over the past few years, stemming from the perceived notion that they are too dominant in the fields that they primarily compete in.

Lawmakers have accused the largest tech firms – AAPL, AMZN, GOOGL, and FB – for anticompetitive practices because of their respective dominance within their own fields or sub-fields. AAPL has been investigated for a potential monopoly over their app store; AMZN over their e-commerce dominance; GOOGL in online search and marketing; and FB in social media. The fact that they primarily invest and grow their bottom lines by investing in complementary products or services that augment the already large reach of their ecosystems is not helping their case either. But with a more horizontal style of growth, MSFT partially trades off some market power for a lack of scrutiny from regulators. Most notably, the big-tech antitrust report released late last year has excluded MSFT from the list of offenders.

The impact of this should not be underestimated. While other firms may struggle to get past the regulatory scrutiny of lawmakers when deciding to acquire other firms to improve product offerings, MSFT has the leeway to continuously seek new areas of growth. In other words, MSFT’s progress towards long-term outperformance is less likely to be stalled by lesser-known political stances, which is good news for investors that like to see predictability and stability in revenues. Perhaps it was a good thing to be a veteran in tech – MSFT has brought along with it lessons from what was at that time a landmark antitrust case, scaring them into treading lightly in front of regulators.

Possible Caveats to the Thesis

MSFT’s diversification and growth strategy might position them for long-run growth, but there is still the other side of the coin. While it remains speculative to say mention less quantifiable risks, it is prudent to acknowledge these blind spots before making an informed decision.

Possibility of being outcompeted due to a lack of synergy

Earlier on, I argued that MSFT’s lack of emphasis on synergy compared to other peers allows them to be a first mover in recognizing value in new growth assets, which lets them leverage on new growth trends first. However, even after an initially successful entry into the new market, they may be outcompeted in the long run if they are not able to develop a compelling product in comparison to other players in the market.

Growth industries are generally prone to disruption because there is no set precedent on how to conduct business, and consumers are still less experienced in selecting the best product offerings. This is good for MSFT if they are a late entrant into the market, but the same argument applies even if they are an early entrant into the market. Other large tech firms may be slightly late to the market, but if they are able to effectively synergize product offerings with their ecosystem, the use case for the product will inevitably be more compelling than a standalone offering from MSFT.

For instance, while HoloLens seems like a top competitor in the AR glasses space because of their contract with the military, competing products like Apple AR glasses in the future might be a more compelling buy for everyday use because it synergizes well with its other wearable devices in the Apple Ecosystem.

In fact, we do not even have to look that far in the future to see the above point in action. MSFT’s Xbox lineup (and its broader gaming segment) has largely been underperforming relative to peers in the console gaming industry such as Sony (SONY) in terms of unit sales. As I have argued in a separate article, SNE’s synergy with its other business units gives them many opportunities to create first-party exclusive games, to rope in consumers from a different market.

Evaluating Risks

Nonetheless, it is also not entirely accurate to say that the lack of ecosystems will inevitably lead to underperformance vis-à-vis peers in the long run. Over here, MSFT might not have the same walled garden that AAPL has, but there are still smaller synergies that can be capitalized on, even though their broader growth strategy might reflect otherwise. For instance, their foray into quantum computing synergizes well with IaaS + PaaS offerings, since it enables them to offer more computing power for cloud-based services. LinkedIn was also said to be integrated within the Office 365 product suite, serving to broaden the quality of productivity services to include networking social media. These can serve as medium to long-term catalysts to boost their top-line growth in these booming industries.

In cases where synergy is not available, MSFT has taken steps to reduce the gap between their peers. To address the lack of first-party exclusives that appear to bring in many consumers, MSFT has acquired Bethesda to create more exclusive releases so that they are able to compete better with SNE.

Realistically, how these smaller synergies will play out versus larger ecosystems and inter-business synergies in other firms is still a big speculative factor. But I still think that from what we can tell about MSFT right now, it is not too far-fetched to say that they can innovate sufficiently compelling products to not lose out to the pack, given their ability to attract talent and devote financial resources to nurture new assets as a trillion-dollar company.

MSFT is undervalued

If you subscribe to the school of thought that MSFT’s intrinsic value can be estimated using quantifiable cash-flow projections stemming from its future potential, then you will also be relieved to find out that middle-of-the-line forecasts of MSFT earnings will lead to a conclusion that it is undervalued.

As usual, the valuation of MSFT comes from a three-stage DCF method, with reference to a relative valuation built from industry-average ratios. The first stage of growth is projected for 5 years, while stage 2 projects 10 additional years beyond the first 5, followed by a final terminal growth stage. Below are some of the key assumptions used in building the model:

DCF Model Assumptions

The model is more sensitive to revenue and cost inputs, so I will discuss them in more detail. All figures discussed with respect to historical values were derived from MSFT's SEC filings:

• Revenues were projected separately for its three business segments – Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.
• Productivity and Business Processes were assumed to grow at 12% for the next 5 years. This is a conservative number because the 4-year historical average for this growth in this segment is 15.8%, and also because 12% is below the forecasted CAGR for the productivity software industry at 13.4%
• Intelligent Cloud was varied from 18% growth to 22% growth, which is in the expected range of values for growth in this segment for the past 3 years. This is also around the expected growth of the IaaS/PaaS markets (that take up a large portion of Cloud Computing) at 22.9% and 20.3% respectively
• More Personal Computing was projected to grow at 5% CAGR, which is the historical 4-year average for this segment. While Gaming can serve as a large boost to growth in this segment, I will peg growth to a stable number in the spirit of conservative valuation.
• Cost and expenses were taken at a 5-year historical average percentage of revenues since they typically scale with revenues at approximately the same rate every year. There is still potential for economies of scale in the cloud market as it expands its infrastructure around the world, but I will not include that in either. Share-based compensation expense is projected separately, but also as a percentage of revenues.

Other assumptions used to balance the model are as such:

(DCF Assumptions. Source: Author)

For the second stage growth and terminal growth, I have used the following assumptions:

(DCF Assumptions. Source: Author)

Comparable Firms

These are the comparable firms used to build the valuation. They are generally large tech companies that compete with MSFT one way or another in various different fields. While the actual set of competitors can be way larger than these few, I have chosen the more reputable big-tech firms and larger players in the enterprise SaaS vendor space for comparison since they are closer to where MSFT stands.

(Comparable Firms and Ratios. Source: Tikr.com)

Overall Results

Sensitivity analysis was performed by varying inputs such as Intelligent Cloud revenue growth, end-state WACC, terminal growth rate, and operating margins. Over the range of values obtained from 140,679 total cases, the 25^th percentile and 75^th percentile estimates of intrinsic value lie at $267.22 and $315.02, respectively. By treating the median estimate of $289.39 as the price target, there is an implied upside of approximately 13.5%. This is a reasonable estimate because it also falls in line with the street targets as shown below, confirmed by the range of values implied from a relative valuation.

(Football field Valuation. Source: Author)

Conclusion

Much of the focus on MSFT is on how they are primed for outperformance in the long run because of tailwinds from the cloud computing industry or because of their well-performing productivity and business segments. But beyond the cloud, MSFT is also well-positioned for true long-term performance as a result of their diversification strategy. Finally, the potential for upside at present prices further sweetens the deal, making MSFT a clear investment in today’s markets.

Analyst’s Disclosure: I am/we are long MSFT, AAPL, BABA, FB, AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.