Downside at Microsoft

🌈 Abstract

The article discusses the challenges faced by Microsoft, a highly successful tech company, in keeping up with the rapid changes in the technology landscape. It examines Microsoft's missed opportunities in mobile, search, and social media, as well as its transformation into a more capital-intensive business with the shift to cloud computing. The article also raises concerns about the quality of Microsoft's earnings, the impact of AI and cloud solutions becoming commoditized, and the company's current valuation.

🙋 Q&A

[01] Downside at Microsoft

1. What are the key points about Microsoft's missed opportunities in mobile, search, and social media?

• Microsoft was a dominant player even before the launch of the iPhone, Google search engine, and Facebook, but still lost out in these areas.
• Microsoft launched products like MSN Messenger and Hotmail, which were widely used, but have since been largely abandoned.
• Microsoft tried to compete with Google and others in these areas but was ultimately unsuccessful, despite its efforts.

2. How has Microsoft's business transformed in the past decade?

• Microsoft's sales, EBIT margins, and EPS have all seen significant growth in the past 10 years, with the stock price increasing 12x.
• Much of this growth has been driven by the company's shift to cloud computing, with the "Microsoft Cloud" revenues growing by around $20 billion per year.
• However, Microsoft has become a more capital-intensive business, with the ratio of sales to net PPE (property, plant, and equipment) declining from $8.7 in 2014 to $2.4 in 2023.

[02] Quality of Earnings, Peter Lynch and Warren Buffet

1. What does the article say about the quality of Microsoft's earnings?

• Microsoft's free cash flow (FCF) conversion has declined from 97 cents per $1 of EBIT in 2014 to 67 cents in 2023, due to increased capital expenditure.
• The company has also changed its depreciation accounting for server and network equipment, increasing the estimated useful lives from 4 to 6 years, which added $3.7 billion of operating income in 2023.
• The article suggests that these accounting changes may be used to make the company's books look better, and that impairment charges could be used if things don't work out.

2. How does the article apply the Peter Lynch and Warren Buffett principles to Microsoft's valuation?

• According to the Peter Lynch formula, Microsoft's shares are overvalued by 3.65x, as the company's P/E ratio of 34x is much higher than its growth rate of around 10%.
• The article also cites Warren Buffett's "second-order thoughts" on the risks of companies investing heavily to keep up with industry trends, which can ultimately neutralize each other and lead to reduced returns.
• The article questions whether Microsoft can achieve sufficient return on its significant capital expenditure, especially in the face of potential commoditization of AI and cloud solutions.

[03] Standing on their Tiptoes & Second-Order Problems

1. What are the concerns raised about Microsoft's AI strategy and its impact on clients?

• Microsoft's Copilot, which uses AI from OpenAI, is aimed at boosting productivity and creativity, but the article suggests that the benefits may be illusory.
• As more companies invest in AI solutions to avoid being left behind, the article argues that the promised benefits may become the new baseline, neutralizing the competitive advantage.
• The article suggests that once the initial "honeymoon phase" of broad AI adoption is over, companies may start looking for cost-efficiency and bargains, and may cut services that don't deliver.

2. How does the article apply Warren Buffett's "second-order thoughts" to Microsoft's situation?

• The article draws a parallel between Microsoft's capital-intensive cloud and AI investments and Buffett's observations on the textile industry, where individual companies' rational investment decisions ultimately neutralized each other and led to reduced returns.
• The article suggests that Microsoft and its competitors may be in a similar situation, where the fierce competition in the cloud and AI space could lead to commoditization and reduced profitability, despite the initial investments.

[04] Rounding it all up

1. What are the key questions the article raises about Microsoft's future performance and valuation?

• How much return on capital can Microsoft achieve on its significant capital expenditure?
• Will AI and cloud solutions become commoditized over time, and how will this impact margins for hyperscalers like Microsoft?
• How much are hyperscalers growing profitably versus cannibalizing each other?
• Considering these uncertainties, is there sufficient margin of safety in Microsoft's current valuation?