Microsoft's Competitive Advantage: An Inside Look

Microsoft Corporation (NASDAQ: MSFT), one of the largest technology firms in the world, thoroughly understands how to build competitive advantage. Some call this advantage similar to a protective moat that keeps other firms from taking its 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 erode operating margins. This sustainability of advantage is hugely important for investors adhering to the philosophies of Charlie Munger or Warren Buffett.

These competitive skills illustrate how Microsoft operates globally with popular product suites such as Windows, Office and Azure. Network effect, economies of scale and strong brand 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 recent competitive success of Office and cloud products, but tumbling margins and profits approaching the opportunity cost of capital are troublesome signs that the moat may be unsustainable.

Microsoft's productivity and business process segment includes licensing and subscription revenue for Office and Office 365 for commercial and consumer customers, as well as the Microsoft Dynamics suite. Productivity and business generated 28% of gross revenue over the first nine months of fiscal 2016. The intelligent cloud segment includes the public, private and hybrid server offering and related services. It contributes 26% of gross revenue. The more personal computing segment includes Windows OS licensing, devices, gaming and search advertising, and this accounts for 46% of gross revenue.

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. (NASDAQ: GOOGL) seize the lead in the space with Google Apps. Microsoft's Office 365 recaptured the lead as it tripled its market share in 2015 to 25.2%, driven by more flexible pricing, better support and familiarity with legacy products. Office has a strong brand and benefits from network effect, especially as collaboration and file sharing become more commonplace in business operations. However, the wild fluctuations in market share indicate that the segment-specific moat relative to other major competitors like Google is somewhat narrow. Office can solidify supply-side economies of scale if it is combined with 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. (NASDAQ: AMZN) dominates the industry with 31% share, followed by Microsoft at 9% share, International Business Machines Corporation (NYSE: IBM), Google and Salesforce.com Inc. (NYSE: CRM). 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 90% share in the desktop operating system (OS) market. It has 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.

Quantitative tests for competitive moat are margin stability and return on invested capital (ROIC) relative to weighted average cost of capital (WACC). Microsoft's ROIC was 8.62% over the 12 months ended March 2016, while its WACC was approximately 6.14%, assuming a market risk premium of 6.16% and a blended effective interest rate of 2.71%. This spread is positive, but narrow, and it has grown more narrow over time as gross margin and operating margin have shrunk. With profit margins settling at decade-long lows, Microsoft's moat may lack long-term sustainability.