Portfolio Highlights: Two Essential Investments
To get a full picture of my investment approach it is helpful to understand the way I think about individual companies, which is why I like to regularly share detailed descriptions and analysis of some of our core holdings.
Below I have included two investment highlights, focusing on Microsoft and Salesforce.com, stocks I continue to believe hold great potential. Both are software companies, at least in part. (Microsoft is a software company and cloud computing behemoth, while Salesforce is a pureplay software as a service company.) I happen to love software companies for a few key reasons: they scale in an incredible way and are high margin businesses that can have exceptionally high barriers to entry and enormous recurring revenue streams. I’ve included these company analyses here because Microsoft and Salesforce both operate in a similar space and, despite their differing sizes in market capitalization and overall business models, both exemplify the types of companies to which I am drawn.
Microsoft
After a very long period of stagnation, Microsoft has again emerged as one of the market’s most exciting technology companies. CEO Satya Nadella has done a phenomenal job of turning the entire business around in the last four years, returning all of its divisions to growth by focusing on corporate culture and the company’s transition to the commercial cloud (CC) business.
Right now, the cloud is driving growth across Microsoft’s product lines, and becoming an enormous source of revenue growth. Microsoft’s commercial cloud business – which now makes up approximately a quarter of Microsoft’s overall sales and is growing at 50%+ – has an addressable market that's 180x its current size and rapidly expanding. Today, pretty much every enterprise is moving forward quickly with the transition to the commercial cloud. JNJ plans to have 85% of its applications in the CC by the end of the year, GE an even higher percentage by 2020, and the list of large global enterprises goes on and on and on. The CC market is not unlike the IT outsourcing market in the early ‘90s. One by one the list of concerns that prevented firms from outsourcing were alleviated and most enterprises moved forward, fully embracing it—just as we’re seeing happen now with the commercial cloud. The CC business dwarfs the size of the outsourcing business, has much higher margins, and scales in a much, much bigger way. And instead of hundreds of companies competing in the space, there are literally only two. Microsoft and Amazon sit in astoundingly powerful positions. The capital requirements necessary to win in the business lock out every other player in the world, with the possible exception of Google. At this point Google has next to no experience with enterprise customers and is years behind Microsoft and Amazon. However, should they make a big play in the space and succeed, the massive market will still thrive as an oligopoly. (And remember, we own all three).
Microsoft has several distinct advantages in the commercial cloud race. For starters, their cost of customer acquisition is negligible, as they’ve already captured pretty much all the potential customers. They also have the advantage of being able to offer hybrid computing. Microsoft can run the exact same systems on premise and in the cloud, and that’s very attractive and reassuring to big enterprises. Finally, they have a worldwide presence and can meet both global and local needs, satisfying all regulatory and data sovereignty issues, which is crucially important. In addition, they are the only global player in China. It’s incredibly difficult to establish a foothold in China and it has taken years and years of partnering and trial and error to accomplish.
90% of all Fortune 500 companies have deployed Microsoft cloud, and over 60% have at least three cloud offerings. This sets Microsoft up for massive scale as companies build out and expand their offerings enterprise wide. Whether a company starts with software as a service (SaaS), infrastructure, or net new applications around things like data or artificial intelligence, eventually it will need all three.
There is one crucially important thing about Microsoft that is not at all well understood by the investment community: the company uses the same cloud footprint for all of its offerings, which means that as they scale and enhance efficiency gross margins improve for the entire cloud offering. Gross margins are rapidly expanding, and there's material upside moving forward to the tune of 1,500 basis points (15%!). And this is Microsoft we’re talking about, not some start-up; that’s immense leverage for a company of its size and we know they have the capability of actually delivering on that potential.
Azure (Microsoft’s public cloud computing platform) has grown at approximately 100%+ for years and is still growing in the high eighties. When a software offering is moved from on premise to the cloud with Azure it generates 3-4 times the revenues for Microsoft. But applications don't simply get moved from on premise to the cloud. Hyper-scale computing allows for the creation of entirely new workloads that are completely incremental and the growth here is exploding. Azure has been effectively 100% net new revenue growth to Microsoft.
Microsoft’s remarkable transition from Office to Office 365 (O365), or licensed software to software as a service (SaaS), is another highly successful cloud offering. O365’s 35%+ commercial revenue growth is impressive, and with 135M current commercial monthly average users and over 1B individual and commercial users left to convert, there’s still a long way to go. 60% of O365 users are opting for premium versions with significantly higher pricing. With double the average revenue per user, increased retention rates, and a transition to annualized recurring revenues, this SaaS product line offers a lot to like.
IDC and Gartner put the commercial cloud total addressable market at over $2.5 trillion. Microsoft now believes it is $4.5T – that’s right, with a capital T. Microsoft was spending $2.3B in capital expenses a year in 2012 and that stepped up to over $11.6B in the fiscal year just ended. Approximately $9.3B, if not more, is attributable to the commercial cloud offering. The beauty here is that Microsoft got to a point where operating margins and return on invested capital had peaked and revenue growth became anemic. Now they have a place to deploy their massive free cash flow and invest in rapid revenue growth in an enormous total addressable market.
Microsoft should continue to blow away its commercial cloud annualized recurring revenue (ARR) goals, as it did in FY18, by multiple billions. Amy Hood, the CFO, explained that a lot of the increase is simply driven by usage growth: "The meters are up and running and it’s building on itself, and we’re going to continue to see this going forward." That's the analogy to remember, and, as far as I’m concerned, one of the most thrilling things about Microsoft.
Microsoft should throw off over $50B in free cash flow in fiscal year 2020 (which starts less than a year from now in June of 2019). The company is sitting in the catbird seat with the ability to acquire any SaaS company if they find they’re unable to develop that particular type of offering on their own and compete successfully. Microsoft can make any attractive target out there (even Adobe, Salesforce, Workday, etc.) highly accretive; they may very well not need to buy any of these companies, but they certainly can if they want to.
Microsoft is at an inflection point, with revenue and earnings poised to accelerate. The total addressable market is bigger than any market I’ve ever seen. Scott Guthrie, Microsoft’s EVP Cloud and Enterprise, described it as “limitless,” adding, “…obviously there's some limit, but I think a lot of it is going to be bounded less by market size and more just our own creativity.” I would agree with that. No matter what you think about Microsoft’s story already being known, the reality is it hasn’t yet been fully digested by the investment community. Not even close. This is the first inning, a $25B run rate in a $4.5 trillion market. And with its model transition, moving forward Microsoft should begin to be valued on an enterprise to free cash flow multiple. Give it a reasonable 20x multiple and, despite the recent move up in the stock, it should still increase in value by another 30%+. Long term, despite its size, Microsoft could well be a multi-bagger from here.
Salesforce
The software industry is in the midst of a generational transformation from being installed “on-premise” to being run in the cloud. With this shift to Software as a Service (SaaS), the model changes from a perpetual license paid up front to an annualized recurring subscription. Salesforce.com is the largest pure-play SaaS company in the world – more than five times the size of the next biggest player – and the highest-profile business disrupting the enterprise software space.
Over half of the SaaS market is controlled by the three largest vendors: Microsoft, Salesforce, and Adobe. While it took over a decade for the market to reach $40B in sales last year, it’s projected to more than double in size to exceed $130B by 2020. These three companies are well positioned to capture the lion’s share of that overall growth, which would more than double their SaaS sales as well. This is why we’re very happy to own all three.
Salesforce is the leading provider of business applications delivered on the web through SaaS and a cloud computing technology infrastructure. Its customer relationship management (CRM) apps are used by sales reps, customer support agents, and marketers. The company’s SaaS platform business also enables customers and other software vendors to build custom applications for CRM and non-CRM uses. Salesforce has such a massive, vibrant application partner ecosystem that it has become essential to its customers’ overall existence. Most users at this point couldn’t possibly switch to another software vendor, a fact not fully appreciated by the investment community.
Salesforce sits in a powerful position, as CRM will soon become the largest market in all of software. It will overtake the Operating System and ERP markets this year and the Database market in 2020. Considering that Microsoft, SAP, and Oracle are the respective giants in each of those three markets, Salesforce will be in pretty rarified company. The beauty of Salesforce is that not only is it the undisputed leader in what will be the largest software market, but its App Platform is also allowing it to successfully expand into new areas of spending outside of CRM. Salesforce’s total addressable market will exceed $100B in 2020, over 10x the company’s current size, which leaves it plenty of runway ahead.
In 2016 Salesforce tried to acquire LinkedIn (which was ultimately bought by Microsoft) and then late that year flirted with the idea of buying Twitter. Either purchase would have been extremely large for Salesforce, and investors also questioned the underlying logic, particularly in Twitter’s case. Yet despite the fact that Salesforce definitively decided against buying Twitter, its stock price got hit, creating a great additional buying opportunity for us. The prevailing concern at the time was that Salesforce was still going to do some other very large acquisition. I believe this is highly unlikely. All the potential deals investors are worried about when vigorously analyzed make little to no sense.
Salesforce has built an incredibly innovative, growth-oriented culture with one of the best execution teams in the entire tech industry. Its extensive front-office software suite, app platform strategy, enormous partner ecosystem, and massive organizational scale should allow it to continually expand its total addressable market and move into adjacent markets. When I can find high-margin recurring revenue streams in rapidly expanding markets with strong barriers to entry, I’m willing to size up positions and remain patient. This is one of those cases.
Salesforce, in contrast to many of its peers, is now throwing off a ton of free cash flow. In 2020 Salesforce should achieve 30%+ free cash flow margins on $20B+ in revenues. Give it a reasonable 25x multiple and it will be a $150B+ market capitalization company, which should take its stock price up another 50% from here. In the long run, Salesforce.com could grow to be multiple times its current size.
Adam M. Aron