Microsoft Corporation (MSFT), one of the largest companies in the world, thoroughly understands how to build a competitive advantage. Some call this advantage similar to a protective moat that prevents other firms from taking Microsoft's market share.

Economies of scale, the network effect, brand strength, intellectual property, and regulation can all contribute to competitive moats. Without these factors in place, competition from comparable products and services eventually erodes operating margins. This sustainability of advantage is hugely important for investors that follow the philosophies of Charlie Munger or Warren Buffett.

These competitive advantages illustrate how Microsoft operates globally with popular product suites such as Windows, Office, and Azure. The network effect, economies of scale, and strong branding all work in Microsoft's favor, but it operates in highly competitive markets that are changing at accelerating rates.

Morningstar assigns Microsoft a wide economic moat based on the competitive success of Office and cloud products. In order to maintain this competitive advantage, Microsoft will need to continue to grow its margins and profits, particularly in the area of intelligent cloud services.

Key Takeaways

  • Microsoft has what Warren Buffett calls a strong moat: competitive advantages that protect it from rivals and enable its large profits.
  • Microsoft's intellectual property—specifically, its patents and proprietary software code—contribute to the depth of its moat.
  • As a household name, Microsoft's brand name is a significant part of its moat.

Economic Moats

Warren Buffett helped develop and popularize the concept of an economic moat, defined as a sustainable competitive advantage that allows a company to generate an economic profit for the foreseeable future. Without a moat, margins will eventually erode until they become equal to return on invested capital (ROIC).

Moats can be established by economies of scale, network effects, intellectual property, brand identity, or legal exclusivity. Buffett's strategy revolves around identifying companies with sustainable moats that generate cash flow, estimating the present value of future cash flows, and purchasing stock when the price dips below the present value of those cash flows.

Microsoft's Business

Microsoft's business consists of three segments: productivity and business processes, intelligent cloud, and more personal computing. The productivity and business processes segment includes licensing and subscription revenue for Office and Office 365 for commercial and consumer customers, LinkedIn solutions, and Dynamics business solutions. In 2020, this segment generated about 32% of all revenues.

The intelligent cloud segment includes the public, private, and hybrid server offering and related services. It contributes another 34% of gross revenue. The more personal computing segment includes Windows OS licensing, devices, gaming, and search advertising, and this accounts for roughly 34% of gross revenue.

In 2020, Microsoft's research and development expenses grew by 15% or $2.2 billion as the company invested heavily in cloud and artificial intelligence, engineering, gaming, LinkedIn, and GitHub.

Microsoft's Moats by Segment

The Office suite was a dominant force in the productivity application space for a long time, but the rise of cloud computing, replication by open-source alternatives, and changing expectations for document collaboration and sharing helped Alphabet Inc. (GOOG) seize the lead in the space with Google Apps.

Microsoft's Office 365 has made headway as it boosted its market share, driven by more flexible pricing, better support, and familiarity with legacy products. Office has a strong brand and benefits from the network effect, especially as collaboration and file sharing become more commonplace in business operations. However, the fluctuations in market share indicate that the segment-specific moat relative to other major competitors like Google is somewhat narrow. Office solidified supply-side economies of scale by combining cloud services and Windows at the company-wide level.

Microsoft's cloud services segment is one of several key players in the global market, but storage and related services are largely commoditized. Amazon.com Inc. (AMZN) dominates the industry with a 32% share, followed by Microsoft at a 20% share, and Google Cloud at 9%. Alibaba Cloud (BABA) ranks next at 6%, followed by International Business Machines Corporation (IBM) at 5%, and Salesforce.com Inc. (CRM) at 3%. Cloud services can contribute to overall economies of scale, but it is difficult to establish a segment-specific moat in this highly competitive space.

Combining all versions of Windows, Microsoft has nearly 75% share in the desktop operating system (OS) market. It has a strong brand identity, and users are very familiar with the OS. It comes with most new personal computers, illustrating and entrenching its wide moat in this category. However, Windows holds less than 1% market share for mobile devices and tablets, and consumers are shifting quickly to form factors in which Microsoft is less dominant. There are concerns about the durability of its moat, at least at its current width.

Microsoft's Moat

Quantitative tests for competitive moat are margin stability and return on invested capital (ROIC) relative to weighted average cost of capital (WACC). Microsoft's latest 12-month ROIC as of June 1, 2021, was 26.4%, while its WACC was approximately 6.8%.

Microsoft's ROIC measures its ability to generate a return on invested capital, while its WACC represents the minimum return required by the company's equity and debt capital providers. Because Microsoft's ROIC is greater than its WACC, the company is creating value for its shareholders, which will be reflected in the stock's share price. These metrics are also indicative of the strength of the company's competitive moat. In fact, Microsoft's ROIC ranks in the 96.5% percentile for companies operating in the Information Technology sector in the United States.