As you know, I’ve been spending the last week or so researching technology titans such as Intel and Microsoft. Microsoft appears especially undervalued. But the fears that investors have about their future (which is reflected in the low stock price) as Windows and Office could become less relevant in an increasingly mobile world are not without just cause. Now every bargain stock has flies on its story that a value investor must get comfortable with. As in every other case, the question with Microsoft is how big is the risk that, in this case, Windows and Office become less relevant in the future. Let me explain where I come out on this question.
They say the Internet has flattened the world, and I agree. The implications for businesses is immense. Only 20 years ago, when you started a business, your customer base included your friends, family, and local residents. Basically, anyone that could reach you by foot or car and could physically see your presence. As people began to buy your product or service, hopefully word-of-mouth would spread to your neighbors and other new customers who would make a point to drive to your store. If demand exceeded what your local store could fulfill, then maybe you branch out and open a second store in a nearby town. From there, if you are a smart business person you could grow into a national and maybe international business over time as giants like Wal-mart and Toyota have done). As we know, this process takes time with brick and mortar businesses. In comparison, today, the instant you launch your website, your audience is every single person who can connect to the Internet. That audience numbers in the billions of people! If you can get this massive audience to choose you as their go-to source for whatever it is that you sell you will grow … and FAST! It is this dynamic that explains the meteoric rise of such businesses as Google, Apple, Groupon, and Amazon among others.
Word of mouth is still of utmost importance in this Internet age but word travels at the speed of light (literally) with social media avenues like Twitter and Facebook. As a result, competition is more fierce than ever. Anyone in the world can come up with a new idea, better than yours, put it up on the web, and start competing with you. If customers like the new idea better, within weeks or months, they have shifted away to the competitor. As a result, the rise and fall of online businesses happen with the blink of an eye (both on the way up and especially on the way down) as we have seen with Groupon (who’s IPO price continues to fall, I wouldn’t be surprised if it never happens at all).
This dynamic is at the heart of evaluating Microsoft as a potential investment. They are the established player in PC and server operating systems (Windows) and productivity software (Office). Unseating them has proven extremely difficult over the last two decades as an entire ecosystem of devices, software, and developers has sprouted up around them. But now, with rise of Apple and Google in the mobile devices space, they have the infrastructure, resources, and now ecosystem to finally challenge Microsoft in their core (cash cow) market. The ferocity and speed of competition could literally dethrown the king in a matter of a couple years. As mobile devices become powerful enough for most daily computing tasks and software and services migrate to cloud computing, Microsoft could lose it’s dominance in PC’s and servers as early as with the next generation of devices (which means a year or two). If Microsoft loses the battle, this would result in a business value only a fraction of what it is today. When doing a valuation on Microsoft, the worst case scenario has to include what may appear to be extreme outcomes like a 90% reduction in revenues, but in my opinion this is very realistic.
Now Microsoft isn’t sitting still. They feel the heat of the competition, and Steve Balmer and his troups will fight to the death. And don’t think that bringing down Goliath will be easy, it will be a brutal fight that will leave the incumbents bruised at the very least. Keeping this in mind, let’s see what Microsoft’s valuation looks like in the next post.
Comments
One thing definitely worth considering is their Xbox and Skype assets; interest in gaming is not waning, particularly with the growth in mobile and social, and communications is undergoing lots of exciting change (IM, VOIP, twitter, etc).
Skype fits Clayton Christensen’s definition of a disruptive innovation to the letter. VOIP entered the market as largely a free toy used by consumers, and so largely escaped the gaze of competitors while Skype improved and scaled their service. The true value of Skype will be unlocked as MSFT likely integrates it into services such as Xbox, Lync, Messenger, etc, and as VOIP benefits from the inexorable improvements of the underlying technology. The potential to steal market share from traditional PSTN systems within the enterprise is just one opportunity that will result.
SSD, thanks for your comments. I’ve tried envisioning how Xbox and Skype can serve to protect Microsoft’s “moat” in a world of ubiquitous computing but it’s beyond my abilities. Another important fact is their partnership with Facebook. Office users can now collaborate on documents somehow using FB. Pretty cool.
This does come back to one of the essential challenges as an investor. There are too many unknowns to try and understand all of the details. We have to remember the 80/20 rule when doing investment research. In the case of Microsoft, I think simply knowing the dynamic of how Microsoft’s business could play out (i.e. colossal loss is a real, and not small probability) is very important to know in the valuation process but trying to guess which technologies are going to win and why is nothing more than a guess (at least to me).