Microsoft’s Moat

Yesterday we saw Jeff Raikes’ analysis of Microsoft’s moat. And many of his observations still hold true today, even though Microsoft has broadened its product line greatly since then—moving to the Web, to video games, mp3 players, and television.

Even today, Microsoft’s most profitable products—far and away—are its Windows operating system and its Office suite. What makes these products so profitable? As Raikes observed, the products are cheap to reproduce, easy to transfer and store, and they largely sell themselves. PC users are most familiar with these programs and reticent to try alternatives. As a result, and most importantly, they offer “pricing discretion.” On Microsoft’s financial statements, these qualities translate into a low cost of goods sold and high margins. High margins and high profitability give a company the resources to widen, deepen, and bolster its moat.

As Buffett observes, it is as if Microsoft has a royalty on an increasingly important communications stream for our society. In a sense, Microsoft is the tollbooth that stands at the gateway to most modern communications and collects its hefty fee. Whereas in the recent past most communication could travel without such fees via typewriters or a pen and paper, Microsoft has positioned itself to command an upfront fee for access to communication, largely because our habits have shifted. Today almost every form of published or printed communication requires paying Microsoft the requisite access fee.

So, should the savvy wide moat investor throw all her capital into Microsoft, so long as the price was right? Perhaps not. For the worry, as Raikes also observes, is that a paradigm shift in communications may break our current habits. For example, if written communications shifted instead to cell phones, Microsoft may not be sufficiently prepared to provide the software and garner the fee. For a wide moat investor like Buffett, an important element of a company’s margin of safety is the durability of its customers’ preferences. For companies like See’s Candies or Coca Cola, Buffett expects that their customers’ preferences will be more enduring than Microsoft’s. If that is true, then Microsoft’s moat may be narrower than it initially seems. And the wide moat investor should wait for a fatter pitch.

Disclosure: No position in the aforementioned companies at the time of this post.

Warren Buffett on Moats

So long as we talk about businesses’ moats on this blog, you should expect to often see Warren Buffett’s wisdom amble by. Today I offer up a couple of extended quotes from an email exchange between Warren Buffett and Jeff Raikes on the topic of Microsoft’s moat. This 1997 email was revealed among the evidence in the trial Gordon v. Microsoft, which Microsoft eventually settled in 2004 for 182 million dollars. Though the Oracle has some interesting comments, I actually find Raikes’ comments on Microsoft more useful for the investor [comments edited for clarity]:

RAIKES: “In some respects, I see the business characteristics of Coca Cola or See’s Candy as being very similar to Microsoft. I think you would love the simplicity of the operating system business. For example, in 1996, there were 50 million PCs sold in the world, and about 80% of them were licensed for a Microsoft operating system. Although I would never write down the analogy of a “toll bridge,” people outside the company might describe the business in that way. Those 40 million licenses average about $45 per, for a total of about $1.8 billion in revenue…

In 2000, there will be about 100 million PCs sold. We think we can reduce piracy to 10% and license 90% or 90 million of the PCs. But we also have “pricing discretion” – I think I heard this term used in conjunction with your pricing decision on See’s Candy. We will be transitioning the world to a new version of our operating system, Windows NT… We can achieve average license revenue of $80. So 90 million licenses at $80 per license totals about $7.2 billion, up from just under $2 billion in 3 to 4 years. And since there are effectively no cost of goods sold and a worldwide sales force of only 100-150 people, this is a 90% plus margin business. There is an R&D charge to the business, but I’m sure the profits are probably as good as the syrup business…

So I really don’t see our business as being significantly more difficult to understand than the other great businesses you’ve invested in. But there is one potential difference that worries me, and it is key part of the reason I spent the time to share these thoughts with you. The difference I worry about is the “width of the moat.” With Coca-Cola, you can feel pretty confident that there won’t be a fast shift in user preferences away from drinking sodas, and in particular, Coke. In technology, we may more frequently see “paradigm shifts” where old leaders are displaced by new. Graphical user interface replaces character user interface, the Internet explodes, etc…

In technology, the moats may be narrower… I am very confident about our business for the next 5 to 10 years. But I will admit it is easier to be confident about Coke’s business for the next 10 years… My theory is that you don’t invest in technology or Microsoft because you see the moats are narrower; too much risk and the potential for a fast paradigm shift that would too quickly undermine your equity position…”

BUFFETT: “Your analysis of Microsoft, why I should invest in it, and why I don’t, could not be more on the money. In effect the company has a royalty on a communication stream that can do nothing but grow. It’s as if you were getting paid for every gallon of water starting in a small stream but with added amounts received as tributaries turned the stream into an Amazon. The toughest question is how hard to push prices…

Bill has an even better royalty [than Coke]—one which I would never bet against, but I don’t feel I am capable of assessing probabilities about, except to the extent that with a gun to my head and forced to make a guess, I would go with it rather than against… If I had to make such decisions, I would do my best but I prefer to structure investing as a no-called-strikes game and just wait for the fat one.”

Disclosure: No position in the aforementioned companies at the time of this post.