Schroder Investment Management Group, a multinational asset management company, published its Q4 Investor Letter – a copy of which can be downloaded here. A return of 7.40% was recorded by the fund for the year, below its MSCI World TR Net benchmark that delivered a 13.5% return. You can view the fund’s top 5 holdings to have a peek at their top bets for 2021.
Schroder Investment Management, in their Q4 2020 Investor Letter, said that they added their position in Microsoft Corporation (NASDAQ: MSFT) because of the company’s commendable growth. Microsoft Corporation is a company that develops, manufactures, and sells computer software and related services. It has a $1.8 trillion market cap. For the past 3 months, MSFT delivered an 8.26% return and settled at $242.20 per share at the closing of February 5th.
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Here is what Schroder Investment Management has to say about Microsoft Corporation in their investor letter:
“The fund added to its holding in Microsoft Corporation (“MSFT”) during Q4. We view MSFT as a ‘growth staple’ capable of generating low and mid double-digit revenue and earnings growth respectively for a number of years, and find its valuation – PEs of 27x and 23x 2022 and 2023 earnings – attractive in the context of stock markets, given the durability of its growth, its high percentage of recurring revenues and its strong balance sheet.
Satya Nadella, MSFT’s superb CEO, has reinvigorated the company, by investing heavily in its cloud service, Azure, and in the subscription version of Office, O365, which, in both cases, has involved the necessary cannibalisation of very high margin (90%+) license sales, for less, but still profitable, recurring revenues. The company is now highly aligned with current trends in IT and scores strongly on metrics such as its technology vision and trends in future wallet share.
MSFT’s last two sets of results have been less stellar than before. Growth in commercial cloud has remained strong, but declines in the Office Commercial licensing business have accelerated, growth in Office 365 has slowed and revenues in Server & Tools and Windows OEM revenue turned negative, all likely reflecting higher SMB churn, free introductory O365 offers and very tough comps in Server & Tools due to the end of life of Windows Server 2008 and SQL 2008 in FY 2020. The company faces ‘tough comps‘ in the upcoming quarter but, beyond that, we see revenue and EBIT growth accelerating.
More importantly, we see plenty of evidence that secular trends such as cloud adoption and digital transformation are accelerating while MSFT’s positioning for these trends is improving. We expect the IT spending environment to remain sluggish and enterprises to consolidate to fewer vendors. The company’s value proposition is very appealing in this environment.
The pandemic has made cloud adoption a more urgent and broader scale priority for enterprises of all sizes. It has become clearer that the cloud is in fact a better location for critical workloads than on-prem, whether for reasons of resilience, security or cost. Enterprises need to make their services available to end-customers digitally, because of the trend to remote working, which results in strong growth in Azure usage. All this is accelerating plans to move Tier 1/legacy workloads (as opposed to new apps/programmes) to the cloud. The cloud has proved to be an effective place to run critical infrastructure as well as allowing customers to save money/benefit from scale economies/flexibility etc.
Azure is now a $25-30bn revenue business, which has grown at c.50% over the last two quarters. It addresses a vast TAM, while cloud migration raises MSFT’s share of wallet, and we expect its revenues to grow by 29% per annum over the next five years. MSFT flagged material growth in the number of $10+ million Azure contracts, strong bookings growth driven by an increase in large long-term Azure deals, and higher GMs during its last earnings call, and the company’s strong growth in RPO/backlog support our view that any deceleration in growth will only be modest. Azure’s gross margin is already well over 50% (on our estimates), and we think that it can grow as capacity utilisation rises and premium services grow strongly. We believe that our Azure revenue growth estimates are conservative, and hope for upside, while margins of the Commercial Cloud business, in which Azure revenues are booked, could also be higher than our estimates of +50bp per annum. Group profits are highly leveraged to Azure revenue growth and if it is only a few percentage points higher (i.e. low 30’s rather than 29%) than our assumptions, our 2025 EPS estimates would be 5-8% higher.
Office 365 is central to enterprises’ digital transformation plans. MSFT continues to add features and products across its packages and is successfully upgrading customers to higher priced SKUs. Its integrated suite is particularly good value relative to the cost of assembling best of breed single point solutions to yield the same functionality: E3, MSFT’s basic enterprise Office offering, sells for $20/seat/month (list) versus the cost of a like-for-like set of apps of $50-60 per month, while the same comparison for E5 (the highest price SKU for enterprises) would be $35 versus close to $100.
Office 365 ARPU growth should accelerate because increased interest in Teams and security is growing the uptake of E5, and this mix shift should be a powerful driver of revenue and profit. We estimate that ARPU per Office seat is currently below $10 and forecast $12 by 2025 and believe that strong adoption of E5 would drive these numbers higher. We estimate MSFT has c.270mn commercial Office subscribers so its earnings are very highly leveraged to ARPU – we estimate that every additional $1 would raise EPS by 3.5%.
Teams is MSFT’s unified communication platform, which integrates messaging, video conferencing, meetings and collaboration into a single user interface. The product has had a tremendous uptick in usage with DAUs increasing from 32m in March to 115m in Sept. Teams is essentially ‘free’, but some of its voice and telephony features are only available on the higher priced Office SKUs and so are driving upgrades.
The E5 version of Teams includes advanced features such as audio conferencing tools and a phone system. The audio conferencing facility can accommodate up to 250 people from a mobile device and is useful for users who have no access to the Teams app. The phone system is a Private Branch Exchange (PBX) which can replace an onpremise system with features delivered from O365 that can be integrated within the business’ cloud without complicated and expensive on-prem equipment.
Security is naturally a priority of institutions and is another key driver of MSFT’s IT wallet share gains. As with Teams, MSFT has integrated a suite of best-in-class products at a lower price than the cost of assembling such functionalities via standalone apps.
Security products are usually taken as an add-on products to core services. As these core services (e.g. Office productivity tools and infrastructure software) move to the cloud, legacy tools are no longer fit for purpose, so MSFT has the opportunity to gain share and disrupt the industry by offering security products which work with the cloud. The company’s identity access management (IAM) tools have been a key driver of customers’ adoption of MSFT365 (a much broader and higher priced package than Office 365). Similar to IAM, MSFT has introduced a new Endpoint protection tool which is tightly integrated to Windows 10 at the operating system level. Advanced Threat Protection product is available in the E5 SKU or as a standalone SKU to add to lower tiers. Other additional products included in E5 are O365 Cloud App Security, O365 Advanced Compliance and Communication Data Loss Prevention.
We think that MSFT’s position as a dominant enterprise software provider is better and more durable than before its transformation and that it has a long runway of growth ahead of it.”
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Last November 2020, we published an article telling that Microsoft Corporation (NASDAQ: MSFT) was in 234 hedge fund portfolios. Its all time high statistics is 235. MSFT delivered a 31.71% return in the past 12 months.
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Video: Top 5 Stocks Among Hedge Funds
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