Chit Chat Stocks - Microsoft (Ticker: MSFT) Not So Deep Dive

Episode Date: January 10, 2023

Microsoft operates in three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The company was founded in 1975 and is headquartered in Redmond, Washington. At the end of the month, we will publish an Arch Capital episode that will cover the company: Alphabet. Listen closely as Brett and Ryan go through the history, financials, and future prospects of Microsoft. Enjoy the show! ****************************** This episode is sponsored by Stratosphere.io, a web-based terminal for financial data, KPIs, and more. Try it out for FREE or use code “CCM” for 15% off any paid plan. Sign up here: https://www.stratosphere.io/ ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (3:01) Industry | (18:26) Management & Ownership | (23:43) Earnings | (27:19) Balance Sheet | (34:42) Valuation | (36:53) Our Analysis | (38:54) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Welcome to Chit Chat Money. My name is Brett Schaefer, and I'm joined by my co-host, Ryan Henderson. As always, today is our Tuesday not-so-deep-dive episode where we analyze

one stock by covering its business model, ownership, financials, and future growth opportunities. After listening to this episode, we hope you can get a better perspective on the company we cover, and we cover a company each week. So this week, today, we are covering Microsoft, one of the technology giants and the second largest company in the world by market cap, at least as of this recording. But before we get to the episode, we have a few housekeeping items. One, if you are a regular listener to the Not So Deep Dive episodes, subscribe to our free newsletter and get our show notes and charts for each episode. The link is in the show notes, or you can search Chit Chat Money on Substack or Chit Chat Money newsletter, maybe on Google

Search. It's fairly easy to find. Second, if you like watching these episodes, which I'm not sure you may or may not, it's just us on the Zoom call. So I know some people do though. You can either do so on YouTube by searching Chit Chat Money or on the Spotify app or on your TV as well. Third, if you enjoy the show, give us a review on either Spotify or Apple Podcasts. That is the best way to help the show. We're going to get into the episode, but let's talk about our sponsor first. Today's episode is presented by Stratosphere.io, the best web-based research terminal for company-specific metrics like KPIs and segment revenues. Stratosphere has clean data for KPIs, segment data that is triple-checked for accuracy, and beautiful data visualizations

helping save you time and frustration digging through SEC filings. As we all know, SEC filings are not meant to be readable. They're built by lawyers to make it hard to get information out of. We use Stratosphere as our investing home screen, and you can too for free by going to stratosphere.io. That is stratosphere.io. The link for that is also in the show notes. Tell them that we sent you or you can add them and us on Twitter and tell them that you're using the product. They will greatly appreciate it. All right, Ryan, that's enough for the intro. Let's get into Microsoft. I can guarantee you on this one, every single person has heard of this company but they do a ton so i think you have a big project here how do you in a couple of minutes

describe what they do yeah they do they do a lot and did uh i'm really to be honest like semi not looking forward to this month because it's big tech and every single one of these companies has like a bunch of different elements under their umbrella microsoft maybe more so than any other company, I guess Amazon maybe. But I guess I'll just try to steal a line from our friend Matt Cochran here to try to encompass it in sort of a one-liner. He says, there might not be any company more ingrained in enterprises and businesses worldwide than Microsoft. I think that's a really good description in a single sentence of their influence in the world. and they have three basic reporting segments but i think they're probably going to end up

restructuring their reporting segments probably a couple of times if you own this for a long time so it's keep in mind this might change basically the big products i'll talk about but this is how i'm going to break it down for the episode so there's three reporting segments productivity and business processes intelligent cloud and then more personal computing so let's start with uh productivity and business processes. And each one is... Intelligent Cloud is the largest. It's also growing the quickest. So it'll be the biggest percentage of the business, but each one is a significant driver. So productivity and business processes accounts for 32% of revenue. This consists of basically three things. Microsoft 365. And I know some of these names and the rebranding that

they've constantly done is kind of annoying, but Microsoft 365 is basically Office 365 rebranded with some extra goodies on top. And then they have LinkedIn in here and Dynamics 365. So Microsoft 365, this is exactly what you think about. It's the one-stop shop for all productivity and security needs for both consumers and businesses. So it encompasses Word, Excel, PowerPoint, Teams is in there as well. And Teams, for anyone that doesn't know, that's like the Slack messaging, both video functionality. There's some phone functionality as well. It's sort of the messaging and communication competitor to Slack, as well as Zoom. And then they have Outlook, OneDrive, SharePoint.

There's even some Skype minutes. I don't know if people are using that as much anymore. But basically, it's everything you can need in terms of creativity and productivity tools for a business or even an individual. And the pricing for that, and they also, this is the part I don't understand quite as well, But they have advanced security options as well for their larger business customers. That's kind of why they lumped it into this Microsoft 365. But for kind of context on pricing, because I think a lot of people just end up getting

Office 365 and they don't even really know how, whether it's part of like through some institution or through an organization. I know we had it for college for a good amount of time. Context on pricing, a personal plan costs $70 a year. and this is all delivered via the cloud now. So it's, it's downloadable web browser based. And there's, there's a number of different plans. They've got business and then consumer plans, but you could also do two to six people for a hundred dollars a year on a personal plan. So it's really, really cheap relative to the value they're providing.

Second element here, and I know I'm probably going to go long, so I'll try to speed through LinkedIn. Most people know this there, but just in terms of like size, maybe people don't know the numbers. So it's the world's largest professional networking site. They have more than 875 million professionals on the platform. That number kind of blew my mind. I didn't know it was that large. And then they generate revenue because this part isn't always super intuitive either through a number of stuff. So Talent Solutions is their biggest driver. This is businesses basically paying LinkedIn to help them find potential employees. So they'll give them recommendations based on a number of criteria or data that LinkedIn has. There's also your typical

marketing solutions. And then you can also pay for premium subscriptions. People might know that if you have a premium subscription, you can see who views your account. And then there's paying for leads as well if you're a salesperson. Over the last six years, and this stat blew my mind as well, LinkedIn's revenue, because they were acquired from Microsoft in 2016. So since the acquisition, LinkedIn's revenue has gone from $3 billion to roughly $13 billion. So they have done just a remarkable job scaling that business. And then the last one here, this is important as well as Dynamics 365. This encompasses all of Microsoft's business applications. So this is their enterprise resource planning solutions, their customer resource management. So their CRM,

ERP stuff, they've got a financial platform on there. They've got an HR platform on there, supply chain management platform. Basically, there's a whole bunch of applications for different business use cases. And pricing varies depending on the number of solutions that you buy. I'll stop there if you want to butt in. Do you want to add anything there? The one thing I would add for Microsoft 365, or excuse me, Office 365, it's also confusing, is that a lot of people listening might think that they don't really succeed that well with consumers and that it's all in enterprises, but their consumer subscribers have gone from, I'm trying to look at this chart here from Stratosphere, about 10 million, maybe 20 million

in the 2016, 2017 range to 60 million over the trailing 12 months, which I guess is just the last update. So they have 60 million subscribers paying $70 a year. And I wonder how much pricing power they have in that as well. Again, though, the majority of that Microsoft Office 365 stuff is going to be from enterprises. All right. Second element of the business here, the second segment is intelligent cloud. So this is probably the part that maybe frustrates investors the most because it encompasses Azure, but it doesn't break out Azure specifically. Very frustrating. Very, very frustrating. Which makes it very tough to make comparisons between the big three cloud providers.

But the way I understand it, this is bulk of its Azure, but there's also some other cloud and developer services on top of it as well. So I think I'm not a cloud expert. I think that's probably pretty obvious for our regular listeners. But I stole this quote from Microsoft's chief marketing officer to kind of explain how important Azure is to the business. And it maybe provides some context around why they don't break it out explicitly, because I think it powers a lot of other parts of their business as well. So the chief marketing officer said, you should just think of it as the oxygen that the company runs on. If you just look at infrastructure, you just look at lift and shift and the move to the cloud, you just look at tier one workloads, then you add data on top, you add gaming on top, you add business on top. It is the backbone of the entire Microsoft.

That sounds exactly what a chief marketing officer would say at a big tech company. They are very, that's compelling right there. Like, wow, that's amazing. Still, I think the bulk in kind of trying to read through the tea leaves, the bulk of this revenue from the segment is just companies using Azure for compute and storage power or storage needs.

It's similar to the other cloud providers. As for like competitive differentiators, I really don't know. The only take I'll regurgitate from someone else we talked to is it's better for AI applications. But that's literally just me stealing words from someone else. So you kind of have to take that at face value. I think unless you're a developer, it's hard to understand the true differentiators between the big three providers. But that's the bulk of the business.

The other ones, other cloud services, I have no experience here. This is basically all developer tools. You could probably just call this entire segment developer stuff. This includes, I'm going to steal a line from their 10K, SQL Server, Windows Server, Visual Studio, System Center, Related Client Access Licenses, and Nuance and GitHub. I know Satya Nadella, the CEO, has expressed a lot of optimism around GitHub. So I'll kind of explain that one. It's fairly easy to understand. And it's basically just one of the world's most popular, probably the most popular platform for

developers to share code and work on projects together. And it monetizes by selling subscriptions to teams and organizations. So it's basically just this giant open source developer platform. And then they also have consulting and support for their own cloud services, primarily for the enterprise customers. So that's included there as well. But I imagine that's quite low margin. Right. That's kind of just the add-on stuff for their sales team, product managers, stuff like that. And then the last segment, this is 30% of revenue. It's called more personal computing, which I don't know why they had to call it more personal, but anyway, they did. This one's a

little easier to understand since I think most people are probably familiar with the products. So Windows is included here. This is their operating system that comes pre-installed on a variety of devices. People might think, well, Windows is free for me. how do they monetize from that so they're paid by the actual uh manufacturers or the oems so you think like hp uh or dell or what are some of the other ones that'd be based essentially all computing devices that aren't apple right maybe maybe i don't know exactly if google integrates vertically integrates their own for the chromebooks or whatever they do for that but i believe they still run windows i'm not exactly sure but anything that's not apple

essentially will be running with windows and this is their the original business model and it's still an amazing business because yeah there's you can't i guess we a lot of people know this already but a manufacturer of laptops is not going to be looking for multiple operating systems they're going to be looking for one and it's going to go on all their computers so windows with their ability to get onto all these makes them the standard and no one's going to be able to switch. And that gives them amazing walk-in

and a ton of durability. Yeah, and just in terms of revenue source, they pay Microsoft in bulk for these licenses or the ability to license COS. And I assume, judging as they want to make money, those OEMs probably just pass through the cost to the customers without the customers really thinking that they're paying for the operating system.

The second element here is devices. So Microsoft, it's probably a small total percentage of the revenue, but they make and sell a number of their own physical devices. So the one people are probably familiar with is the Surface tablet, but they also have Surface laptops. And I believe their HoloLens is also included here. Of note, the Xbox hardware is not included. That's its own segment, which is next, which is gaming.

This is basically their entire Xbox ecosystem. So this includes Xbox physical hardware sales, game sales, game pass subscriptions, app store fees from third parties. Um, if, if you're interested and there's probably, I think there's a couple of other revenue streams as well, but, um, if you're interested, we did a whole episode on just the Xbox ecosystem a couple of months ago. Um, it's, it can, a whole show can be done on it, but it's still a tiny fraction of Microsoft's overall business. Um, and then the last segment here is just search and news advertising. So this is comprised of search ads for their own browsers, like Bing and Microsoft edge,

as well as third-party browsers. So they power the search monetization for Yahoo. The other part they acquired is Xander, which is, I know this is kind of a vague term, but an advertising platform. So that gets included here as well. And I believe people have probably heard about the Netflix deal that's incoming.

That I believe would be lumped in here also. So search and news ads, gaming, Windows, those are, I guess, the big three segments, just to summarize again, cloud, office products, and personal computing stuff. That's my more general terms. I know that's a lot to kind of swallow in one bite, but I'll talk about the history briefly. No need to go too long here. I think people know the story. Bill Gates and Paul Allen founded Microsoft in 1975. Allen had graduated from Washington State University, Brett and I's alma mater. So there we go. Yeah. Shout out there. And he was working as a programmer at Boston. Gates was still a student at Harvard. He dropped out. The genesis for the business was just to build software for the Altair 8800, which was basically the early personal computer at the time.

And then in 19, I think they did okay with that. They had sort of a million dollars in sales, which is a fairly sizable business. But I think things really took off in 1980 when they struck a deal with IBM to build the operating system for IBM's personal computer. By 1985, they were obviously a much larger business. They introduced the Windows operating system. A year later, They went public. I believe at that point, Gates became the youngest billionaire ever. And then they were the largest software company in the PC space for some time and without a whole lot of competition for a while there or anyone of note. And that came to the forefront in the late 90s, early 2000s when they were charged with antitrust, violating antitrust laws.

and they ended up reaching a settlement in 2001. But I think this kind of took its toll on Bill Gates, who stepped down at the time. He was replaced as CEO by Steve Ballmer. Steve Ballmer took over in 2000, retired in 2014. During that time, and part of this just kind of sucks for him because it was just unfortunate timing, the stock was underwater the entire time. So 14 years. The business did, the fundamentals improved of the business. They grew their earnings and whatnot, but the ridiculous valuation during the dot-com bubble kind of gives Steve Ballmer a rough track record. He was then replaced by Satya Nadella, who I think has done just a remarkable job running the business. And we'll talk about that in a little bit, but that's history.

Yep. And for anyone wondering, the Microsoft Excel came out in 1985 as well. So right in the late 80s is when they hit their stride and became the dominant player in the software space. All right. I'll hit industry and competition. Pretty hard as well, right? Because there's so many different things to cover. So I'll try to hit them all fairly quickly. And when we look at the industry and competition for all these big tech companies, which if anyone listening doesn't know, that's our theme for the month of January. I forget what we're doing. Amazon, Microsoft, Meta Salesforce and Google

Salesforce and Google We didn't want to do Apple Because we covered them Previously So we included Salesforce In there as well And they'll be very fun to cover Since they're going through layoffs

But that's besides the point It's For all these companies That we're covering this month They compete with each other And it's very difficult To parse out direct competitors Because they compete with really

Every software And internet service out there I'm referring to Microsoft here Looking at the industry size though I wanted to hit On the cloud market specifically Because that is going to be the biggest growth driver for them going forward. The cloud market is estimated to be around $500

billion today and is expected to hit about $1.5 trillion worldwide by 2030. So that's a trillion dollars in new spend coming online. Those estimates could be overhyped. I think it's possible it's overhyped, but who knows for sure. And that is really a long time for now. But again, there's still a gigantic opportunity. And even if that's wrong by a lot, and it's only half that opportunity, there's still hundreds of billions of dollars in revenue to go after for a company like Microsoft Azure. Within competition, I'm going to divide it up into separate sections. So within Office, the competitors would be Apple, Google, Okta, Slack, Zoom. Apple and Google are mainly the software suite competitors. And then the individual ones would be like Okta,

Slack versus Teams, Zoom versus Teams and Skype and stuff like that. Within LinkedIn, they are competing with other online recruiting networks. So think something like ZipRecruiter. And then they also compete with other social networks. Although I think anyone listening

would hope they become more of a recruiting network and less of the social network because that is the worst. Wouldn't you agree, Ryan? The worst of all the social networks, just everyone. The LinkedIn influencers? Yeah. That's right. The influencers on LinkedIn are the absolute worst. All right.

Third, Azure main competitors are Amazon Web Services, which we'll reference as AWS and then Google Cloud. We're probably going to reference them throughout the episode as well. And we're going to cover them as well on Amazon and Google episodes. The market share for the cloud right now is about 30% for AWS, 20% for Azure, and then 10% for Google Cloud. I think it's a little bit different on the exact numbers, but for anyone, just to keep in the back of their mind it goes amazon one microsoft two google third and amazon's uh yeah

it's kind of that three two one there then within xbox gaming everyone knows this nintendo and sony are the competitors within windows apple and google are the competitors for the operating systems for various things a big thing that happened uh is that apple and google won the mobile operating system war and windows had to cancel that so they really lost than mobile which kind of disappointed people. And that's really, I think, a big reason. And again, we're younger, so we weren't around during this time. I think we were in high school, in kind of the 2010-2012 range, where people were very nervous about Microsoft because they totally lost the smartphone wars. And they thought that was going to crush them, but it didn't end up

happening. Within hardware and devices, they compete with HP and Lenovo and other computer manufacturer is not really relevant. And then in search and advertising, everyone knows they compete with Google, meta platforms, which is just Facebook, Instagram, and then the other big ones. I don't think you should forget that Bing exists because they, I believe, have less than 10% market share within search engines, but still sizable. And then one thing I'd ask here is that you should notice the trend among these competitors. The competitors are almost always the other big tech companies. But Ryan, anything else? I would just say there's still some buzz around Bing and Microsoft search efforts. Even though Google is dominant, people are starting to, and this might just be short term, but I think that there are some AI synergies between some of the AI stuff that Microsoft is doing, like the, what do you call it?

the advanced language learning models and somehow having synergies with the search. Nadella has said that they have actually gained share in search in the last couple of years. It's still probably, it's obviously small relative to Google, but they do generate some ad revenue from that. Yep. And they, we don't need to get into the details here because the show is going to run too long but the new uh browser uh because what really hurt them i guess in the 20 say 10 years ago is

when google chrome started dominating as the browser and they really what's it even called microsoft edge i don't even use it edge yeah yeah edge that that's a lot better than the old one which is probably a big reason why uh bing is growing as well but that was also a big time thing they botched is when they lost to google chrome but let's hit management and ownership a pretty simple one here. CEO Satya Nadella, they have 12 members of the board, which also includes Nadella. All of the board members are independent. Just as a note, Bill Gates and Ballmer are not on the board anymore. And then each board member gets paid around $350,000 a year. It is pretty funny, I think, or maybe disheartening to see Microsoft board members get paid less than board

members at a company that we cover, that's about 1% the size of it. I also remember talking about Tesla and how Kimball Musk, the board member, get paid millions of dollars a year. And I said that it would be fine if that happened at a company like Microsoft. And that was my specific example. But even at Microsoft, I think it's pretty rational. They only pay their board members $300,000 a year, which is great. Now we move towards executive compensation. Microsoft just renewed Nadella's long-term equity plan. I have a note here for this. If you read the newsletter, you can kind of read all the stuff here.

And they were just very, very adamant that they needed to keep him as the CEO. But you can read that if you want. After revising their equity compensation structure, 100% of Nadella's stock awards are now performance-based targets, which I like to see. It's better than just giving someone RSUs and then they sell them. The executives, and I want to say shockingly here with quotes, get a base pay, annual cash incentives, and then performance stock awards. The annual cash incentives are based off of revenue and operating income, plus some ESG stuff. ESG stuff, whatever, it's fine. It's like 20% of it. Hopefully it doesn't turn into all of it over time. And then the long-term incentive awards

are interesting. They're based on some very interesting metrics. They are based off of Microsoft Cloud Revenue, Microsoft Cloud Subscribers, Microsoft Teams Monthly Active Usage Growth, Xbox Game Pass Subscriber Growth, Windows OEM Revenue Growth, and LinkedIn Sessions. So I think this is very indicative of what they're focused on, what their key KPIs are for their growth over the next decade and what they think is important. If we look at executive compensation, 135 million dollars total in fiscal year 2022 which ended in was it june or september i think it was september right or they just wrapped up their q1 so yeah that would have been june i think okay yep so their executive compensation while high if this was a maybe a company that did a

few billion dollars in revenue a year it was still a negligible part of their 2022 gross profit so great to see they're they're not paying their executives like another company i may have just mentioned a billion dollars a year just because their company is that large. Last note here, even with the large stock awards, executives and directors still own less than 1% of shares outstanding. The Gates family now owns really an inconsequential stake in the business relative to the size of it because they've sold it down over time. Although I would mention that if Gates kept and never sold his entire stake since the IPO, he would be a trillionaire today. And then Ballmer, I believe, also sold down a lot of his stake. I couldn't find him

in all the aggregators on Stratosphere. I really didn't see them. And it was very, very boring. Look at it. It's really just index funds, pension funds, and large investment funds. We got Vanguard, BlackRock, State Street, Fidelity, really not important. And it highlights within these big companies, unless Buffett takes a stake, he's the only one sizable now, or Berkshire Hathaway, unless Berkshire Hathaway takes a stake, it's just going to be these general index funds and they really drive the market. But let's move on to earnings, Ryan. Why don't some of them some things here and uh yeah yeah i don't think uh there's much of an activist concern here for executives um would buffett be the only one buffett would huh yeah but microsoft

at this point is probably too large for even him given their cash bet right yeah all right doesn't matter earnings um so last 12 months they've done just over 200 billion dollars in revenue. That was growing 15% for the 12 months prior. Of that $200 billion in revenue, they generate $88 billion in operating cashflow. That's 43% operating cashflow margin. They do spend a lot on CapEx and that's been rising actually. This is probably a good time to share a chart to show the CapEx. Yeah. I had it pulled up as well. Are you looking at the same thing I'm looking at? Do you want to pull it up here for anyone that's actually watching? Yeah, I'll pull it up and describe it.

Let me share the screen. Zoom's got to fix that. Whenever you want to expand the thing, it's right where their shared screen thing goes. Okay, okay. And this is from Stratosphere. Let me find it. It's the one that goes, yep, there you go. Yeah, so do you want to describe this one, Ryan?

Basically just goes nothing, and then boom, they start investing in the cloud. Yeah, really nothing. Well, I don't want to say nothing. because it probably felt like a lot then, but it was really about maybe $5 billion in CapEx around 2010. I'm just doing it off the y-axis here. I think it went from about $2.5 billion in CapEx in 2000 to $5 billion in 2010, so a slight increase. It basically doubled to CapEx over that decade. And then from 2010 to the last 12 months,

it's gone from 5 billion to 25 billion in CapEx. So really sort of the onset of Azure Forum has been, I imagine, the largest driver of that CapEx. Oh, definitely, definitely, definitely. So hopefully that, I know sometimes we don't do the best job describing the charts for podcast listeners, but hopefully that provides some context.

um anyway so that that basically and people look at this kind of differently but the way i see it is if capex takes a big jump i essentially look at it as their they have growing demand for azure do you kind of look at it the same way i agree i agree yes there is a slight risk that they overbuild right but given the long-term tailwind that seems like less of a risk versus say someone building out a bunch of oil stuff right in the energy space seems a little bit risky less risky in that more reliable i guess something we should have done is kind of looked at and this is kind of getting to like the nitty-gritty but looked at like the depreciation schedules of their server

space or the databases or not at their data centers, because I don't know how much they have to recycle servers in their data centers. Or how much is maintenance capex. Yes. That's why when I looked at valuation, I wanted to look at both operating income and free cash flow, because free cash flow is going to be a bit lower now, but hopefully as Azure matures, they will both converge over time. Yeah. Either way, you're looking at 30% plus free cashflow margins. For the last 12 months, they did more than $60 billion in free cashflow. They returned about 77% of that free cashflow to shareholders, mostly on buybacks, but they also pay a decent dividend. So shares outstanding over the last year declined by just under 1%, and then they pay over just

1% dividend yield. So a little bit of shareholder returns there as well. As for the most recent quarter, they're seeing a lot of currency headwinds. Revenue overall was $50 billion. It grew 16% in constant currency, but just 11% in reported currency. Strength was really still driven by cloud. Intelligent cloud overall was growing 26% constant currency. LinkedIn, surprisingly, is still growing quite quickly, which I would have thought they'd see more of an ad pullback. I think they are maybe starting to see it now based on a little fireside chat transcript that I saw. A little quiz for you here. Since fiscal year 2017, can you guess what the compound annual growth rate was? And if you looked at our shared chart thing here,

you'll be able to spoil it and you'll get it right. But for LinkedIn plus the search slash ad revenue business, if you combine them, what do you think the compound annual growth rate was that from 2017 to 2022? 35%. I don't know. Ooh, a little aggressive. 24.5%. Still very impressive.

It went from $8 billion to $25 billion. Okay. Other elements here, the only real lag or the drag on revenue growth here was probably devices. um most devices revenue was actually flat to down year over year it was up slightly in constant currency depending on what device you chose um office revenue and then dynamics so like the business productivity and applications continue to just grow really steadily i think honestly

they can choose their growth rate with especially with office like if they want to raise pricing mix at a certain rate they can now. And being that they deliver it via the cloud now, it makes, I think, raising prices so much easier and just makes their business that much more predictable. But capital return to shareholders actually declined by 11%. This is maybe the only big, big takeaway I had for the quarter was that they significantly decreased their buyback program

or the money they allocated to buybacks. I don't know if we should read into that too much. Maybe they're saving up a little more cash for the Activision acquisition if it goes through, but- They already have plenty, right? Over a hundred billion. So it's a little disappointing to see that, that they were buying back more when the stock was at 40 times earnings versus today when it's at 20. Yeah, it just feels like it could be more accretive now, obviously. But we also just saw a company go bankrupt because they spent – that won't happen at Microsoft, but because they spent too much on buybacks to try and appease shareholders. Other notes, $17 billion in free cash flow for the quarter. It's down slightly year over year, but really on a normalized basis, I would say that it grew slightly. The only things that were hurting them was CapEx grew, which like we've said, we think it's basically indicative of demand. For reference, operating income was up.

And then last year, they had some big tax benefits, so they basically didn't pay any taxes in Q1 of last year versus $4 billion, I think, in taxes this year. So that hurt cashflow relative to their comp. As for the balance sheet, I'll just go through this quickly. They have more than a hundred billion dollars in cash and short-term investments. Most of that cash is just held in US bonds and they generate 60 billion plus in free cashflow every year. Liabilities, they have basically half of their cash worth of liability. So 49 billion in total debt. Most of it's long-term. 60% of it is actually due after 2027. Just to summarize their balance sheet, we'll have a little graphic here if you read the newsletter that shows all the bonds they actually have issued. Their balance sheet's a thing of beauty. It's exactly what

you'd want as a shareholder. They consistently issued new low-cost debt up until 2021. And in fact, let me take the bond issuance from 2020 was a $10 billion issuance. 2021 was an $8.2 billion issuance. Both those are due in 2060 and 2062, and they have an effective interest rate less than 3%. So they borrowed money up until 2021 to constantly refinance and pay down older, more expensive debt. And then they stopped in 2021. And now they're earning more in interest from their cash pile or their short-term investments than they're paying out in interest expense every quarter. So last quarter, they had $500 million in interest expense and received $641 million in interest income.

So perfectly managed that interest rate cycle. As a shareholder, I think it's hard to be anything but impressed. Yeah. Only complaint would be that they didn't take on more debt. Yeah. Yeah, you could say that. Now, they're going to have probably half that cash balance after the Activision acquisition if it goes through. Yeah. But they're going to generate 64 billion. So I guess usually the free cash, 70% of it gets returned to shareholders. But yeah. All right. Let's move on. We got to get

going on these episodes because they're going to run too long. Look at the valuation quick. After today, wow, stocks are up big today. All right. Because the valuation was 1.6 trillion yesterday. It's 1.7 trillion today. So market cap, 1.7 trillion. Enterprise value, 1.6 trillion. EV to operating income of 19.1 and EV to free cash flow of 25.5. So like I said, there's the discrepancy right now because there's the big CapEx stuff, the big build out for Azure,

free cash flow is going to be a little bit lower. But the enterprise value to operating income, which is just enterprise value divided by operating income, 19.1. That's probably the key one I'm tracking. And I'm just using the trailing 12-month numbers there. One thing I want to look at, and this is another good time to share the screen

and look at our stratosphere.io stuff. Again, you can go use, check them out for free. That's our home screen for investing stratosphere.io, the link in the show notes. They had a great chart here. And what's beautiful about them

is they go back as long as the company is in existence, really. They're not going, well, if the company is 100 years old, they're not going back 100 years. But for someone like Microsoft, you can go back very, very far.

And I thought it was very interesting to look at a nice visualization here of their price to free cash flow going back to, say, the early 90s. So in the early 90s, as they're growing quickly and as the dot-com bubble hit, their price to free cash flow

hit about, what, 45? Am I seeing here, Ryan? Kind of a high 35 to 50 maybe range. And then all the way during Steve Ballmer's reign, which is just unfortunate for him because he did a lot of things right, setting up the business

for the cloud growth. And yeah, Nadella might have been part of that as the president of the cloud segment. But it went from 45 down to the low point would have been in June 2012 at 8.5. So it went from 50 down to 8.5. And then the last decade, the multiple expansion has been quite impressive at the peak in June 2021.

We're at about 38.3, so pretty close to the dot-com bubble. And then today, like I mentioned, back closer to 25. All right, let's move on to anecdotal evidence. This is a tough one here. I don't think anecdotal evidence is going to be really that fun for these episodes. but what do you got for us, Ryan? Yeah, I think it probably just honestly doesn't matter. I actually kind of find it interesting.

I have minimal exposure to Microsoft's products in my daily life. And maybe we can talk about this in a second, but I use G Suite, not Office 365. I use Apple, not Windows, although that might change from my computer. Ooh, new computer coming? Yeah, if I get a new computer,

I'm probably going to go with Windows. But for the time being, I still use Apple. I don't use Bing. I use Google Search. And I pretty much use Twitter as a substitute for LinkedIn, I would say. I do a lot more of my, I mean, we get a lot of our interviews via Twitter. I just, I have a LinkedIn account, but barely use it. I wouldn't read into a whole lot of it though, because I think if I worked at a bigger business,

everything I just said would, other than Bing, would probably be switched. I would probably use Office 365, I'd use Windows, and I'd probably be on LinkedIn a lot more often. Yeah. And we write for The Motley Fool, or we do contract work for The Motley Fool. They use, I believe they use Office 365, but the one key thing we use all the time is, what's it called? 365 email? I forget. Outlook. Outlook 365, or whatever it's called. So yeah, the entrenchment within these large businesses where they're providing this tons of value. And the key really, I think, is Microsoft Excel.

that one has, just anecdotally, the most entrenchment. Because you can switch your Word documents potentially, but Excel stuff gets all messed up and you don't want to ruin your entire business just because your Excel files get ruined. But my anecdotal evidence, again, it's going to be different for all these tech giants. But I think I want to highlight something

that older listeners might not be aware of. And that is Google Drive dominates usage on college campuses or for younger people in general. On the one hand, I used to think like, wow, this is a threat to Microsoft's business. And it may still be over time. But on the other hand, Google is really just giving away the software for free. We use the free version of Google Workspace. We get Google Docs, Google Sheets, and I guess we don't use Slides. But we have those two and all the other stuff for free. And Microsoft is still doing fine.

So I think that is a testament to the switching cost because Google is saying, here, take this stuff for free. Or if you hit this storage level, you have to pay a little bit of money. And Microsoft is still doing great. I think that's a moat test that they passed with flying colors. But let's move to future growth opportunities. Ryan, you stole mine, although I took the one that I think needs to be talked about just because it's going to be the core driver, but you have advertising. Yeah. So I guess this is kind of like a news break to a lot of investors. I think it was first mentioned in the second quarter of 2022, but Microsoft has an advertising arm that generates more than $10 billion in annual revenue.

I would say that they do sneak it in at the end of the annual report, which is like, if anyone's interested throughout the whole annual report, you can be very frustrated how they only have those three broad segments, but at the end of the annual report, they do revenue, not earnings uh for some of these segments yeah but i mean they they i think they break down search and news and then they have linkedin which linkedin has a mix of revenue composition it's not all advertising so it's like oh that's right so it's combining some of these yeah okay yeah basically i think they're kind of with the new zander acquisition i think they're consolidating a lot of their advertising efforts but nadella breaks it down into three elements so he says

we've got linkedin we've got owned and operated which includes bing microsoft edge microsoft store so like product placement stuff for like games um uh and then third party so they power yahoo's ads and then like you think about like the new netflix deal stuff like that and i think that third party could be a big growth avenue from them uh it felt like more and just for reference like half of the advertising revenue i believe is all linkedin um but from what i can tell prior to the zander acquisition it was kind of a hodgepodge of like independent advertise advertising assets and now they're kind of consolidating that into one single comprehensive platform um and so maybe i'll uh they're they do these fireside chats where basically they just talk to like the head of ir

talks to the head of different segments and they talk to the advertising one and he he had a quote that I thought was pretty interesting. He said, I tend to think about it like this. The more people we have using Windows, the more people we'll have using Edge, which is our browser, and the more people that use Edge tend to keep Bing as their default search engine

and Microsoft Start as their personalized content feed. The more people we have in the Microsoft ecosystem, that just gives us more opportunities for us to monetize engagement. Next, we have the international expansion of our products and services. We're significantly expanding our coverage this year by over 100 markets in this year alone

for a total of 131 markets. um so i i think the ambitions are big here and i think it's also kind of you're getting probably one of the best data-driven independent advertisers so not a walled garden and that ctv element i think is big they talked about that in that uh in that conversation as well as there's bigger ambitions beyond netflix for ctv um and they've had a lot demand from a lot of other companies in the the connected tv space as well yeah i agree it'll be interesting to see them see how big this gets because you're going against google you're going against who's the other one why am i forgetting meta you're going against some of the traditional

advertising avenues it'll be quite interesting but that industry again is very large so it's not surprising that this is one they're going after as well along with gaming you don't think that when you hear Microsoft, you don't think its advertising business is bigger than Snapchat and Pinterest combined. Yeah.

I mean, it's really, I don't know. I think that was kind of impressive that they have these little things they don't even talk about that are just like behemoths on their own. I agree.

I agree. There are a lot of smaller parts of the business that are doing well and we'll move to my future growth opportunities. I wrote down here there are a lot of choices

you could do here. If you're interested in gaming, I would recommend listening to our Xbox-dedicated episode from September. But I think my choice has to be Azure and cloud because while there are these smaller parts of Microsoft's company, like advertising, that are growing quickly and doing quite well, the key growth driver is going to be Azure over the long term. So if we look at Microsoft's total cloud revenue, not just Azure, it's $96 billion today compared to just $9.5 billion in 2016. Again, if you go to Stratosphere, they have some great KPIs on that. You can check those out.

This division has driven the majority of revenue and earnings growth over the last five years and will do so over the next five as well. I think if you're betting on the stock today, you have to be betting. I forgot to write it here, but I remember what I was going to write.

You are betting on Azure revenue growth staying, I don't want to call it, maybe double digits, 15% plus, whatever it would be. All right. Highlights and lowlights, Ryan. And there's a lot to like about these businesses. I think to caveat it for the big tech companies,

there's obviously going to be a lot of things to like because if they weren't good businesses, they wouldn't have gotten to a trillion dollars in market cap. But with that caveat, go ahead, Ryan. Yeah, I'll try to kind of speed through this because I know we're going kind of long. But highlights for me, I mean, just the switching costs

and then the advantages of scale. I think thanks to their size and the comprehensive product suite that they already have, they're able to offer competing products at a fraction of the cost of competitors and kind of just steal share. So while also increasing dependency

from their customers on Microsoft. So the one example that I have here is Teams. Teams grew like a weed during COVID. They were able to basically just integrate that into Office 365. And it's obviously a fraction of the cost of paying for Slack on its own, if you're an enterprise.

So, yeah, I mean, that's just one of the big advantages they have in being so large. The other one, I'm going to skip past some of them. The big one for me, they have done a remarkable job, at least from my vantage point, they've done a remarkable job turning almost all their revenue streams into recurring revenue cloud-based subscriptions. So office, people used to have to come and pay $500 for a license or downloadable or- No, literally a box. Maybe not $500. I think it was more like 50, but still. Yeah. Was it only 50? I mean, because they'd have these for some time, right?

Yeah, you would have to- Four or five years. You'd have to buy it individually. Maybe it wasn't 50, but again, there's been a little bit of inflation, I think. Either way, it's a way worse business model. Right. And then not only... It's way worse because you have to convince people to come in and buy the new version. And you have to say, well, it's also going to be a little higher price. So if people have something that's working, they're not very incentivized. Now you can easily just launch new features and raise prices.

It just makes the business so much, like growth just comes so much easier. Other elements that have become subscriptions, Dynamics 365, security cloud subscriptions, even gaming to some extent, they're turning into, or they're trying to turn into a subscription. It just makes the business so much easier to run

and growth so much more less costly, I guess. Low lights for me though, and I think you touched on this. I think, and I don't know what comes to this, maybe it doesn't matter, but I think Google has done a better job capturing younger audiences when it comes to like the productivity

and creativity tools. And then the other one, I mean, there's not a lot of low lights because it's a really damn good business, but regulatory pressure, Basically, any acquisition they make at this point, people are going to find a way to call it anti-competitive. I think you're seeing that with the Activision deal. I think the FTC just sued them for breach of something.

So they've made some big acquisitions in their past that made a huge difference for the business. It might just be harder to do that moving forward. Yeah, and I think one of the lowlights could also be the focus on acquisition versus build. because I don't know if that might show up as a little bit of bloat maybe five, 10 years from now where you acquire, say, Activision Blizzard is going to be $70 billion. Would there be better ROIs over time

taking $10 billion of internal cash over the next, say, five years? And maybe they're already going to do this and trying to build out the cloud gaming stuff and become the platform instead. I know that they could do both at the same time, but there is that concern they are very acquisitive

honestly that Activision Blizzard acquisition on it's own for me is a bit of a low light I don't love it I want to know what their strategy is because it's unclear yet how they're going to try to

make the economics work I think the business of Activision Blizzard business on it's own is good they paid up for it but we'll see how they can integrate it. Yeah. I mean, like if you,

the idea to like how it would benefit your ecosystem is you make it exclusive and then people have to come to Xbox, but that's just going to off all your customers for all the Activision customers. So I don't think they're going to do that. So I don't see like what the synergies are other than like good, good, like development teams.

That's right. Like it is. Yeah. We don't need to go into this forever, but there is a good business on its own. That is. Would you have rather spent, maybe even go with a, whatchamacallit, a meta platform strategy and say, we're going to spend $50 billion over the next decade building out cloud gaming

and stuff like that, because that's a huge technological challenge instead of buying this company. But either way, let's move on. We don't need to keep going. My highlights, switching costs of Office software are huge, and I think it makes them extremely competitively advantaged. As I mentioned above, they compete with companies who are giving away the product for free, and people still won't switch, and that's very indicative.

Second, the growth potential of the cloud is staggering. And Azure has proven it can actually gain market share. Over the last five years, they've gone from around, these are third-party estimates, 15% share to 20% share of the infrastructure market. It would not be surprising to me if Microsoft Cloud Division is doing $200 billion in revenue five years from now with solid margins. could be... Well, I'm trying to divide it here. $50 billion in annual earnings, something like that. And I also like management. Maybe I just like Satya Nadella because the stock's done so

well. And he seems like he has the Midas touch. And it seems like you're required to like Satya Nadella. But I think the track record speaks for itself. Let's see. Only low light. Let's see if you hit these. Yeah, I talked about... You hit on as well the GE risk of too much diversification that could hurt the business if they get the wrong executive team because the Nadella and the team the executive team right now they're really working all the synergy to

the stuff together but right you know Azure as the backbone you're adding on stuff like GitHub communications you're building gaming on top of Azure all that good stuff but if the wrong executive team takes this over I worry a bit that yeah the Office 365 business is

hard to kill that's really or it's hard to mismanage, right? Because you just kind of keep it as it is. But some of the other stuff could get mismanaged. And then I also worry about employee growth over the last few years. It has been staggering.

And I worry that if you grow employees too quickly, it can get mucked up and get bloated, stuff like that. I don't think Microsoft is the biggest concern here. I think Amazon, Google, and Meta would be a bigger concern

from my standpoint. But it is also something I wonder how it'll affect margins, especially if we hit a recessionary period. All right, let's wrap things up. Bull case. Ryan, what do you think?

Well, I think you're going to lay it out here in a second pretty well, but I think basically the three drivers, I think it's pretty simple. So if Office or Microsoft 365 and Dynamics 365 grow earnings at 10%, and then Azure grows earnings or revenue, which I think will probably grow in line, earnings might outpace it a little bit, grows at 15%. at least over the next five years, maybe you get some upside from the other businesses. But I think if those two things occur, investors will get market performance or better from here. And the thing is Azure, I think it can grow probably close to 20% over the next five years and at least 10% plus over the next 10. If Azure does well, I think the business does well because the other ones are so easy to run. Yep. And 2023, there's been some news articles out there about how 2023 might be a slow year

for the cloud. And that's fine. But I think we're trying to extend the time horizon and all these businesses will switch over time. Because if there is a recession, maybe less people are going to spend on the cloud. Who knows? There's so many variables there. But yeah. All right. I'll hit my bull case. And I think the bull case here is hopefully going to give anyone perspective if they're thinking of buying the stock, because the big concern here is the valuation. So on the week we're recording this episode, Microsoft is trading at an enterprise value of approximately $1.6 trillion. I think if you were going to buy the stock today, you need to be asking yourself, when will the business hit $160 billion annual earnings

slash cashflow? Today we are at, what is the cashflow? 63 billion. So I use 160 billion because that is a 10% yield on current prices and around double where it trades today. If the cloud division, or it's even more than double, if the cloud division continues its impressive growth and you have some additional things that we all talked about during this episode, and then the legacy business stays stable, I think it's doable to hit that 10% free cash flow yield on current prices within five to seven years. But you have to ask how long is it going to take? I think that's the big question. Is it going to be within three years? Probably not. Is it going to be within five years? Maybe within this decade? Definitely.

But there is still that catch-up period if you're expecting 9% returns from this equity going forward. All right. Bare case, Ryan, what do you think? Yeah. I struggle to see any sort of significant downside other than if there's a general economic slowdown, maybe there's some top line pressure both at Azure and then maybe people are less inclined to pay higher prices for office, although I think they can raise prices at will. So maybe there's some margin compression. Ultimately, if there's meager earnings growth, I think you're probably going to get something that maybe trades sideways for a while or is just a market underperformer. But I don't know. I have a hard time seeing the downside. There could still be some multiple

compression, but I don't see it being a whole lot. Yeah, I agree. My realistic bear case is really slowing growth. Competitive threats kind of show for Office where they're not able to raise prices as much as they can, and maybe they lose a couple of customers and they're not growing customers as much as they would. And then you have the multiple compression because of that. In this scenario, I don't know if you lose money over five years just because you're still going to get that growth from Azure, but at the current earnings multiple of, what is it around? Just below 20. And then the free cashflow multiple of 25. If the multiple compresses back down to 10, which could happen. I'm not, I doubt it would, but it also could,

it could happen. I think it's a different business. Yeah. But you never know. Like I'm saying, if growth slows, you never know. Apple, as we all know, is a great business and their earnings multiple went well, well, not well below 10, but slightly below 10 because people were worried about slowing growth. I think that well, is it likely? No, but I think that's the bare case I'll be thinking about if I own Microsoft today.

And I don't know if I owned the company and I've owned it for five or 10 years. I don't think that's a reason I would sell today, but maybe if I'm a prospective buyer, it's a reason I wouldn't buy today. If you get what I mean. Yeah, I agree.

All right. More or less interested. Well, I think I got to say, yeah, it is a great business. And as long as Nadell is there at the right price, this is a very easy buy, I think, to get low risk returns. It depends on what price, though. This is one where buying it at, given their buybacks, given their dividends, all that stuff, buying it at, say, 14 times earnings versus 20 is a big, big difference. So I think I'm more interested, but probably not at this price.

I think some of the other big tech companies are more attractive at lower multiples yeah I'm more interested as well I think it goes without saying this is

maybe in my opinion after looking at it I would I could say this is probably top two top three businesses in the world

like Google Google number two in that list too I don't know I mean I think Microsoft might be up there after kind of

looking at this whole thing yeah I think the only thing like stopping me is how boring it is. Oh yeah. Yeah. I think it just feels like, I know there's no points for originality and investing, but like,

I don't know. Like it just, I don't know. I don't know. It just feels sometimes like whenever I see a big business like this, my knee jerk reaction is that, and I don't see a lot of like pessimism around the business. I always think like this is efficiently priced.

Yeah, I agree. I think that's definitely a risk here. One thing I'm looking at, and we'll wrap up quickly here, is that people get worried about the short-term stuff. So people are worried about Azure growth in 2023. If that happens, maybe the multiple compresses enough where it's more attractive. But with Microsoft, what's always kept me away is when the market was at its bubble valuations, they were trading at 40 times earnings. And now as we've come down, and I'm talking about cashflow, they're trading at 25 times cashflow. It's more of an opportunity cost thing,

where if I owned it, I wouldn't be selling. But if I'm looking at prospective things to buy, if I see an attractive business at less than 15 times earnings, Microsoft's not going to grow that quickly on a consolidated basis. That's where I'm weighing things, really. All right.

What stock do we have next week? Yep. Stock for next week is going to be Amazon, something everyone else knows. And we are going to... We've actually been looking at it. it's been on our watch list for a while. So it'll be fun to look at that one in more detail. All right. That's going to do it for this episode. Thank you all for listening. Remember,

we are not financial advisors. Anything we said or discussed on this show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you to stratosphere.io for sponsoring the episode. Check them out. The link is in the show notes. We'll see you all next week. Bye.