Continued Operational Progress
In 2011, many observers expected the decline in PC sales and a lengthening of the hardware replacement cycle to be a death sentence for Microsoft. When we began investing in the business that year, it was trading at about 7x earnings after backing out its huge net cash position. Not only did the management team have a clearly articulated strategy for giving up margin in Windows to secure its Office and Server franchises, it also began executing this strategy before Steve Ballmer left. As it turns out, Ballmer was ineffective as a messenger, but the silos that had caused internal conflict were already being broken down and integrated under his watch. Additionally, Microsoft suffered because in the minds of many analysts and observers, all that mattered was the consumer channel. At the time, the market was narrowly focused on the success Apple and Google were having with consumer products and services. Microsoft’s inability to build or buy traction in its mobile phone business blinded many to its earnings power with Office and Server among business customers. Accordingly, analyst ratings and market valuations did not reflect the potential we saw at the time. At around an average price of $26 per share, we were able to buy Microsoft for less than its run-off mode value while also acquiring a free option on any success Microsoft would have growing its business. We love this type of low-risk, high-reward situation.
With Satya Nadella as CEO, Microsoft operations have outperformed even our more optimistic expectations. Microsoft keeps growing its cloud and subscription businesses at high rates. Microsoft is not simply providing computing infrastructure through the Microsoft Cloud, but rather the company is layering powerful productivity software on top. We believe that infrastructure as a service (IaaS) businesses like Amazon Web Services will ultimately yield very low or zero margins. Microsoft can provide this service as a loss leader when paired with a profitable software as a service (SaaS) layer on top. While Microsoft’s recurring revenue franchises carry lower margins than the legacy one-time/up-front operating system license payments, these businesses create sticky annuities that tend to generate higher cumulative revenue volume and owner-earnings over time. Unfortunately, the market is attuned to this performance improvement, and the stock has appreciated sharply and is no longer priced at a deep discount to intrinsic value. Microsoft grew to around 20% of the Fund assets in late 2014, and we sold about half of the position around $46 per share. We roughly halved the position again in late 2015 at $54 per share. The stock price has crept up into the $63-66 per share range in early 2017, and we are watching the valuation level closely.