Friday, April 17, 2020

f A Downturn Comes, Microsoft Will Eat Zoom's Lunch



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| About: Microsoft Corporation (MSFT), Includes: WORK, ZM


 

Long only, internet, software, tech
Summary


Microsoft's inexpensive offerings will be sought after if companies need to start saving money.

Firms like Slack or Zoom that charge a hefty price (in comparison to Microsoft 365) should be worried about a downturn.

Microsoft 365 is cheap, leaving Microsoft with pricing power in the future. This is beneficial as >4% of the world's workers are already users.


In a previous article I published on Seeking Alpha, I described Microsoft (MSFT) as the "cornerstone of a portfolio." I still stand by that. The company is incredibly diverse, massive, and operates in areas that were, before COVID-19 took its grasp, growing at incredible rates.

In today's piece, I would like to focus on one arm of Microsoft, in particular, Productivity. Getting more specific, the newly rebranded Microsoft 365, and why it is terrible news for the likes of Slack (WORK) and Zoom (ZM), and how much the Productivity sector means to the business as a whole.

I want to discuss Microsoft 365 because no matter how bad things get (even though we're seemingly out of the woods with COVID-19), Microsoft has the best productivity software in the business. As the components of Microsoft's Productivity segment continue to grow in quality and scope, Microsoft will become a one-stop-shop for enterprise software needs. That kind of thinking should put smaller firms with a narrow focus, like Slack or Zoom, on notice.
Introducing An All-New Microsoft 365



Image: Microsoft 365 Pricing Table

Microsoft 365 has been a product at Microsoft for a while. The company has been making quite a few packaging and pricing updates of late, so, in short, the Microsoft 365 branding is about to become a lot more prevalent.

As part of the new Microsoft 365 subscription, users get access to Office 365, a Windows 10 license, advanced security, and device management. This bundle, available starting at $20 per month per user, makes it easy for businesses to get everything they need at one low price.

While that subscription is excellent and will become the norm among large enterprises that use the full suite of Microsoft products, the product most worth discussing is the entry-level "Office 365 Business Essentials." This service is available for just $60 per user per year and includes almost everything a team needs to communicate, share, and get work done.

The offering, which includes Teams, online versions of Office apps, email, calendars, and 1TB of file sharing, in addition to many other features, is ~16% cheaper than Alphabet's (GOOGL)(GOOG) G-Suite offering of a similar package ($5/mo vs. $6) and offers the user more in return.
Slack & Zoom Are Disadvantaged

G-Suite, in the long-run, is fine, but I do worry about companies with more narrow-focused software offerings. Without an acquirer, something I've written about Slack needing in the past, Slack and Zoom will see their market share slowly eroded over time.



Image: Slack's Pricing Page

I am not going to dispute that Slack and Zoom are on a good run, and that good run may continue for some time. Still, Microsoft's (and Google's) suite of tools offers comparable functionality at significantly reduced prices. At $5/mo, Microsoft 365 is cheaper than Slack's cheapest (usable in a business sense) offering. It's considerably less expensive than Zoom's $14.99/mo offering, too, and offers twice the number of participants.

I will be the first to say that having used Teams, Slack, and Zoom, the latter two are better. They're not so much better, however, that I'd find myself paying $21.66/mo for the cheapest offerings when Microsoft 365 can be had for $5/mo.

If we're heading into tougher times post COVID-19, say, a recession, companies will be looking to cut costs across the board. A firm with 100 employees that are using Slack and Zoom in their cheapest form will be paying $25,992 per year. One call to a struggling firm from a Microsoft sales rep showing how employees can still communicate, and keep the video calls rolling, all while getting Office apps in the browser for $6,000/yr might be all it takes for many companies to make the switch.
How Big Will Microsoft 365 Become?

Admittedly, Microsoft 365 is already massive, but there is still some room to grow. With the newly announced prices for Microsoft 365, the firm also has future pricing power, so things won't become stagnant from a revenue front.

Image: Productivity slide from Microsoft's Q2 call

During Microsoft's Q2 report, the company announced that Office 365 commercial seats had grown 21% year-over-year. The consumer, not to be forgotten, had increased by 11.7% YoY.

Unfortunately, Microsoft rarely provides a specific number of commercial seats sold. Looking back through previous transcripts, the CEO Satya Nadella mentioned that there were 180M users in their Q319 report. If we take that, add on 20% for annual growth, then we're looking at ~216M users during the Q320 report.

At such levels, we're likely getting close to market saturation. There are ~5 billion working-age people around the world (7.8B population, 65% 15-64), which means that Microsoft already has 4% of the world's workforce signed up for a commercial seat. Not to state the obvious, but the lion's share of that workforce age population does not need productivity software.

Having 4-5% of the world's working population paying, at a minimum, $60 per year for your product is a fantastic business. However, such saturation means we're going to see growth slow in terms of raw user numbers. That statement should not be alarming, however. Microsoft still has Azure as their heavy growth sector, and don't get me wrong, the company will likely still see double-digit growth from Microsoft 365 thanks to pricing over the coming years.

If we were to take a 216M user assumption at the close of the next quarter, and go for Microsoft 365's middle tier as the average revenue per user (ARPU), the firm would bring in some $32.4B in revenue from Office commercial alone per year. As with most SaaS products, incremental revenue comes with higher margins, so Microsoft only stands to gain more in terms of profitability with a higher user count.

The productivity segment runs at a 39% operating margin today. With just 15% growth across the segment (which includes Office commercial, consumer, LinkedIn, and Dynamics), this segment should bring in $47B in revenue this fiscal year, which is roughly $18.5B in operating income. Data by YCharts

In my previous Microsoft article, I stood by a price of $175/share on my top end. Since then, the company has been beaten up and seen a resurgence back towards the $170s, and I have been buying the whole time. I think that $175/share is an exceptionally fair price for this company, especially given the security its assets offer. With a 15% margin of safety, I'll continue to add to my position if pullbacks bring us under $150/share.
Strategic Risks

If things go bad, like the IMF recently predicted they would, Microsoft wants to be there to provide an entire productivity suite for a low price. It is hard to see such a strategy failing, but this article would not be a valid assessment of Microsoft if we didn't address at least some risks.

The most apparent longer-term risk is competition. That competition can come in many forms, but the most evident would be from those offering a better user experience (Slack or Zoom), or from those with a similar inexpensive packaged offering like Google's G-Suite.

The reasoning behind Google is obvious, I feel. They offer many competing products across all of Microsoft's operating segments, and a couple of correctly placed steps on their part could have commercial entities switching providers.

Slack and Zoom are a little more "out there." When I previously wrote about Slack, I wrote that they were "a viable acquisition target for companies looking to challenge Microsoft," and I think that is becoming the case, even more so, as time goes on. If Slack, Zoom, or even both, found themselves as part of a more extensive portfolio of productivity products, Microsoft's Productivity segment would find itself with longer-term growth issues.

There's also the possibility that commercial buyers alter their previously known long-term behaviors. Meaning instead of buying the Allen key of productivity tools (Office 365), they instead opt to buy the best tools on an individual basis. Given the significant cost increase, this type of behavior change would be a real game-changer, but we've seen plenty of those these past few months.
In Closing

In this article, we discussed productivity, but Microsoft has much more than that. While productivity growth will slow over the coming years, I expect we will see Cloud continue massive gains on the back of Azure.

When the markets have stopped bidding Zoom up to unsustainable levels, Microsoft will still be around, offering video calls for 200 participants at a fraction of the cost with Teams. Is it the best tool? No. Is it the cheapest? No. Teams, however, is a part of one of the best-packaged software subscriptions available, and that package offers significant pricing power over the likes of Zoom and Slack.

Disclosure: I am/we are long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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