At AIM we position our portfolio to capture the future. We identify sectors with structural growth themes and invest in the market leader in that sector. We are working hard to own the best businesses in the strongest sectors globally. Today we look at the structural growth theme of digitisation and how it drives our high conviction investment in Microsoft (MSFT.US).
In the past 15 years, the share of US jobs that require high levels of technical and digital capability has increased more than 4x, to 25%. Salaries of these workers are 2.4x higher on average than those with low levels of technical competency. Automation is increasing its penetration in lower skilled jobs, albeit adoption is varied across sector. These statistics are representative of the broader digitisation thematic. Digitisation is the adoption of digital technologies and information to transform business operations and drive efficiencies, according to Gartner. Whilst tremendous change and growth has occurred, we believe this thematic has much further to play out, as innovation accelerates. This is a core research focus for the AIM team and reflected in our portfolio through a number of businesses.
Some high level facts to illustrate how digitisation is underpinned by many of the daily activities we undertake, which can compound quickly:
- There are 250 million computers sold annually.
- Microsoft Office is used by 1.3 billion people
- The Cashless Society is growing double digits to $15 trillion per year (a core theme for AIM. See our thoughts HERE – Link)
- 98% of Americans have access to high speed wireless internet
These few examples not only require faster computing power, storage and data transmission, but have also led to innovative technologies and opportunities that would not have been possible without digitisation. Adoption rates of new technologies and products are accelerating, which may make forecast estimates conservative. For example, it is worth remembering that the first iPhone was released only 12 years ago. Amazon AWS (Cloud) had 1 service in 2006, today it has 150 services. Approximately 30% of workloads are run or supported by the Cloud and it took 5 years to reach this level. Microsoft as a leader in Cloud technologies has been a beneficiary thus far. However, we think adoption rates are likely to accelerate and estimate growth rates of 20-30% y-y, for the next three years.
At AIM, we are fortunate to meet companies from around the world and travel to all corners to identify opportunities for our investors. Our channel checks indicate that digitisation will accelerate in the coming years and consequently one of our core holdings for some time has been Microsoft.
Source: Kleiner Perkins & The Economist
It is hard to overestimate the consumer, product and geographical breadth of Microsoft. Through its more than 130,000 staff and extensive distribution network (OEM, direct & resellers), the mission to “empower every person and every organisation on the planet to achieve more” is on track. Microsoft makes it easier for customers to be more productive and efficient. The world and business needs Microsoft not only to operate, but to evolve and innovate. The prize is large and competitive pressure is a risk, however customer retention rates are high, with no individual customer accounting for >10% of revenue over the past three years. Despite being the largest company in the world, with a market capitalisation of $1 Trillion, we believe there is substantial upside in the medium term for earnings and share price, as Microsoft sits at the epicentre of the digitisation thematic.
The Microsoft business has broadened since Satya Nadella was appointed as CEO in 2014. Underpinned by curiosity and innovation, Nadella has led a business that in his words is “hungry to learn and connect with new ideas”. This curiosity has been reflected in the shift Microsoft has taken, with a focus on the Cloud, Artificial Intelligence, subscription services and gaming. These segments are growing substantially and enable customers to achieve more, as the more data that is gathered, the more analysis can occur, which leads to improved products and offering, attracting and retaining more customers. Despite this compounding effect for all, Cloud computing costs are falling, despite strong margins for Microsoft and better products for customers. It is not only Microsoft’s customers who are beneficiaries of the new products, but the company continues to invest and innovate. For example, Microsoft has more than 50,000 patents and another 30,000 pending and this will grow, in no small part thanks to investment. R&D as a share of sales continues to increase on an absolute basis, at $15bln per year. The R&D budget alone is the equivalent to the total market capitalisation of an ASX Top 20 company.
As management has innovated, new growth areas have performed strongly. Commercial Cloud has grown at 85% CAGR since 2013, yet penetration levels are modest, with approximately 30% of the US economy digitised, on our analysis. This is as simple as companies storing past or future information on the Microsoft Cloud – a trend we believe will grow more quickly and compound beyond market expectations. Beyond new products, the traditional software products that many of us use daily, through the Windows Office Program, remain strong performers and cash generators. Growth rates are more modest, but subscription revenues are substantial. This is clearly illustrated in the most recent quarterly results, where the company gained share and spend of the IT wallet. Through its range of products, Microsoft will enable and facilitate the global champions of tomorrow. This is significant given up to 40% of the S&P 500 may be replaced over the next 15 years.
The company’s financial performance continues to be strong. In the past quarter, Microsoft generated $13.5 billion of free cash flow from operations, growing 11% y-y. As a key leader in digitisation, a secular growth trend, the top line and EPS we expect to grow at double digits for the medium term. Management have confidence in this strategy and we even think there is upside risk to this optimistic scenario as the network effect takes place. The stock is valued at a price to growth ratio of 1.6x and has $60bln in cash. The company pays a dividend and will likely buy back $20bln of stock this year.
MSFT is a classic example of a dominant business that is actually increasing its dominance. The so-called “moat” around its business is expanding and leading to expanding margins, profit growth and returns to shareholders accelerating in the form of dividends and buybacks and underpinned by the digitisation thematic. It remains a core holding for the AIM Global High Conviction Fund.