Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector
of the stock market every day. It's Friday, November 30th. We're talking about a battle
for the world's largest market cap. I'm your host, Dylan Lewis, and I'm joined on Skype
by senior tech specialist, Evan Niu. Evan, what's going on?
Evan Niu: Not much. Ready for the weekend! Lewis: Ready for the weekend! Did you have
a nice Thanksgiving holiday? Niu: Yeah. We took it easy here in Denver,
didn't travel a lot. Which is good since there were those storms in the Midwest that canceled
hundreds of flights last weekend when people were trying to get home for the work week.
But, yeah, nice to stay at home, hang out with friends.
Lewis: It's always easier to spend the holidays when you're not moving too far. If people
come to you, even better. That was not my experience. I went home to New Jersey,
got to see some family, which was great, spent my birthday on a bus back to D.C. hanging
out last weekend. It was nice to see family, but I'm ready to be back in D.C. until I have
to go back to New Jersey again for Christmas. But, I'm looking forward the weekend, as well.
I'm excited for that! Before we can get to the weekend, though,
Evan, we have to talk some tech stock news. Really, the story that's been dominating
a lot of headlines recently is, Apple was the largest company, the first one to hit $1 trillion.
Now, Microsoft and Apple are jockeying for that title. Two very different paths to getting to that point.
Niu: Right. They're both right around $850 billion
in market cap. They're comparable. Whoever's in the lead just depends on when
you're checking the quotes. They're neck and neck. To put some context to it, the last
time Microsoft and Apple had similar market caps was when Apple first overtook Microsoft's
market cap back in mid-2010. At that time, Steve Jobs was still alive. The iPad had just
been released. The current iPhone was a 3GS. There was no such thing as a retinal display,
and Microsoft was still selling the Zune. That seems like ancient history.
Lewis: It was a different time, a simpler time, one might say. But them being neck and
neck now is a nice entree into us talking about Apple and Microsoft, where these two
companies might be going. Really, we haven't spent a lot of time talking about Microsoft
as a business. They've been flying under the radar and putting up some pretty good results.
We're going to hit that today. We're also going to hit some new news from Spotify and
their international expansion. To kick things off here, Microsoft is up 30%
over the past 12 months, while the market has been pretty much flat. Evan, this stock has been
crushing the market. Apple has had the opposite happen. They've been getting crushed.
What's been going on with these companies? Niu: Apple peaked in early October, and then
all the China trade war stuff combined with earnings and these reports that they're cutting
production on the iPhone XR. A lot of these negative storylines are controlling to Apple
pulling back quite a bit. Meanwhile, Microsoft, even further out, the past two or three years,
it's been marching steadily higher. Very consistent, up and to the right. I think a lot of that
is attributable to CEO Satya Nadella continuing to execute well on his cloud and cross-platform strategies.
Now, with Apple pulling back, Microsoft continuing to go up. Here we are
now, they're neck and neck again. Lewis: The story for Microsoft is,
they made this switch in how they were delivering the Office Suite, and making it an as-a-service business.
This helped remedy a lot of the issues that they were experiencing. In the past,
you could run on old Office software that you'd bought for quite some time,
and run it until your machine hit the ground and it was useless. Now, you're paying a monthly
subscription or something like that. It's much more appealing, gives them much more
steady cash flows. We talk about this a ton, but as-a-service businesses are just better
if you're trying to deliver software content. They made that switch. It was a little painful
for them to do that, but they're clearly enjoying the results of that now.
Niu: Right. They started this a long time ago. You're absolutely right. Generally speaking,
investors love subscription businesses, because it’s recurring, it's usually high-margin,
and it gives you a lot of visibility into where the business is going. Microsoft recognized this
many years ago, well before Nadella was named CEO. They launched Office 365 back in 2011.
Office has always been one of their most profitable cash cows. Getting that business
to a subscription model was always uncertain, but they've done an incredible job with that.
They now have over 170 million users for Office 365, including both commercial and consumer.
I think they've done a really good job over the past seven years getting that business
into a subscription model, and really justifying why that model makes more sense for most customers,
including both enterprise and home users. Lewis: The software side is really what separates
these two businesses. Apple is a hardware company that is trying to build its Services segment.
Microsoft is a software company that just seems to have its hands in everything.
You look at the gross margins for these two companies, Microsoft over 60%, less than 40%
for Apple. That's a big part of why we see two very big companies trading at totally
different valuations. Niu: Right. Microsoft is trading at about
45X earnings compared to Apple's 15X. That's a pretty stark contrast in terms of the underlying
earnings valuations of these two companies, even though their market caps are now similar.
In contrast, Apple's only been focusing heavily on this Services business for a couple of years.
Of course, they've always been trying to grow it, but really highlighting it, in
terms of telling investors, "Hey, look how well we're doing," they only really started
talking about it back in early 2017 when they publicly put out that goal to double the business
over the next four years. But, as you mentioned, a lot of this business is still very much
dominated by hardware, which is fundamentally less profitable than software.
Lewis: Yeah, and these models are a little bit different, too. Even though Apple is saying,
"Hey, we're focusing on software," well, all of that software is predicated on their own
hardware sales. They aren't really getting much in the way of revenue if someone is buying
an Android device. That's not the case for Microsoft. They don't have to worry as much
about hitting with hardware products because the software that they make
is industry-standard. It's ubiquitous. Niu: Right. Those are all reasons that are
contributing to why Microsoft has this premium compared to Apple. Apple's total revenue base
is also about 2.5X as large as Microsoft. The market is recognizing that Microsoft probably
has a little bit more upside in a lot of its core markets. If you compare it to the smartphone market,
which globally is relatively saturated, in terms of unit volumes, which we've seen
play out with Apple's own unit volumes that they've been reporting. Whereas Microsoft,
the enterprise productivity market is huge and still growing. They also have a lot of
exposure to the really booming cloud infrastructure market,
cloud hosting services for third party companies.
They're only second to Amazon Web Services. That market has massive upside,
many years going forward. For example, last quarter, the third quarter, the overall market
grew almost 50%. That's the kind of growth that they have exposure to that Apple doesn't.
Lewis: Something that's really compelling about that is, you think about the major players there.
If Amazon's No. 1, and you're, say, a retailer, or you're in the e-commerce space,
would you rather give your business to Microsoft or Amazon? You know? By not operating there,
they are able to offer a lot of people who would probably rather be separate from Amazon
a pretty viable No. 2. I think that's probably going to be something that gives them a lot
of success in the cloud market. Niu: They're doing better than Alphabet, too.
They're ahead of Alphabet. Their market share is about twice as big as Alphabet right now.
Amazon is No. 1, Microsoft’s No. 2, Alphabet's No. 3. I think Microsoft has a
much stronger case because it's always been such a strong enterprise software and services player.
They have so much else they can offer to companies that need these services in addition
to just cloud infrastructure. They have productivity software and all these things. So, yeah,
I think they have a really strong value proposition overall.
Lewis: I think the natural question is, OK, the market has been choppy. I'm sure that
there are a lot of people that are looking for some safety when it comes to the stocks
that they own. These mega-cap companies offer that. They offer dividends. They aren't going anywhere.
They pass the snap test -- if these companies disappeared overnight, people would notice.
If you have to pick between Apple and Microsoft, which one are you going with?
Niu: I would say Apple's safer, just by virtue of that earnings multiple being so low. Fundamentally,
any company that has a higher earnings multiple is a little bit more subject to volatility
if people start getting concerned about the market and volatility is going up. That being said,
I still think Microsoft is doing incredibly well and executing very well.
But, if you look from a valuation standpoint, I would say that Apple's a little bit safer.
Lewis: What about on the business model side? I'm thinking about this outside of the core financials.
I look at what Microsoft's doing, I look at what Apple's doing. I mentioned before,
Apple's success is predicated on hardware sales. Not that the iPhone is going away anytime soon,
but that is that looming existential threat to that entire ecosystem, that a better
mousetrap is developed in the smartphone space, or some other device comes along. If you're saying,
I'm going to set this and forget this for five years, are you sticking with Apple?
Niu: I'd probably say so. I don't think Microsoft's a bad play by any means.
Lewis: Yeah, I think you could do a lot worse. For my money, if I'm going to throw one out there,
I'll take the other side of this one. I'll take Microsoft over the next five years.
The recurring revenue is appealing to me. I say this as an Apple shareholder, of course.
The recurring revenue is impressive to me. I think that the floor on their business,
despite the higher valuation, is going to be a little bit higher. It's going to be easier
for them to find success. I look at all these different spaces that they're in. I talked
with Nick Sciple, who hosts the Thursday show, before we came down and taped, because he's
a Microsoft bull. Loves this company. He made the point, beyond just cloud,
they are one of the leaders in gaming, they are one of the leaders in the AR and VR space with HoloLens.
They have their fingers in so many different pies right now. It's pretty incredible.
I'm impressed with what they've done, especially with their core product.
Niu: I think you have a good point there, in terms of downside to the actual fundamentals
in things like revenue. There's a lot of talk about a recession on the horizon, maybe in
the next one or two years. If a recession hits, you're absolutely right that consumer
hardware is going to get hit pretty hard. People don't have to buy an iPhone.
If they already have one, they might delay those purchases.
But enterprises still have to do business.
They're still probably going to be spending a lot of money on Microsoft. I think you have
a good point there, too. Lewis: Those Fortune 500 companies are going
to continue to pay for the Office Suite. It's nice to disagree every now and then, Evan.
We spend so much time agreeing with each other. It's nice to take opposite sides of something.
Evan, for the back half of today's show, we are going to be catching up on some news from
Spotify. It's a company you follow quite a bit.
Niu: We're getting reports now that they're about to launch in India. They've been eyeing
that market for a long time, and really talking up the potential there. Now, it seems like
they might actually be able to launch in the next six months. India is the second most
populous country in the world, with 1.3 billion. There's a lot of people there to potentially address.
Their prospectus for the IPO earlier this year confirmed that they had at least
some office space and hired some employees. They were already laying down some groundwork.
It sounds like they're getting close to moving in.
Lewis: The international expansion strategy we've seen them roll to more and more countries
in the past year. They've enjoyed some good amount of success with that because
they are not forcing people to pay for a product right off the bat. They have this model that lets
people come in, use something on the free side, see all the benefits, then work their
way up to a paid subscription model. Niu: Right. That's been a real key to their
growth in emerging markets, is the fact that they have this free ad-supported tier that
they can get people on board for at no cost, then try to convert them to paid subscriptions
later on. Of course, that's the opposite of what Apple does. Apple Music has no free tier,
there's only a paid version, which does limit its uptake in emerging markets. Just as another
interesting point here, Spotify previously said that with this model, once they successfully
convert a free user to a paid user, it takes 12 or 13 months for them to break even compared
to all the money they were missing out on when they were offering the free service.
Lewis: There was some speculation that they might buy into this market and acquire someone
rather than expand their own platform there and start from scratch. Are you surprised
that they wound up going this route? Niu: It sounds like they just couldn't get
a deal done, so they're going to go ahead and expand on their own organically.
They do have a very strong brand globally. It might be a little bit trickier to build that brand
from scratch in India, since there are a lot of other players there. We'll have to wait
and see how that plays out. Lewis: It's worth noting here, there are,
I think, two big streaming players that are domestic market players, on top of the competition
that they're going to be getting already from people using YouTube and things like that
to consume content. It's not like Spotify's just going to go in there and immediately
add a ton of subscribers. There's a pretty competitive market there. The local services,
Gaana and Saavn, both have tens of millions of subscribers. So, a little bit of an uphill
battle there for Spotify, Niu: Right. And YouTube is by far the dominant
source of music for India, specifically because it's free and there's so much music content
on YouTube. The big thing here is that one of the biggest hurdles, as is often the case
in the music streaming industry, is obtaining the licensing rights to be able to operate
in those markets. A lot of these rights holders weren't very happy with Spotify.
Over the past six months, Spotify has been inking these direct licensing deals with independent artists,
which cuts record labels out of the loop. And they're not happy about that.
But, of course, Spotify has always said, "Hey, we're not trying to replace labels. We're just trying
to offer different models for how to do business with these smaller artists that maybe don't
need that type of representation." That creates some tension and some issues. But reportedly,
those have all now been resolved, and Spotify does have enough of the rights that it needs
to feel comfortable with this launch. Lewis: I think big-term, this is something
that a lot of Spotify investors are probably pretty thrilled with. You mentioned before,
it's the second-largest market, and it's not like China is going to become accessible.
They are very walled off to a lot of foreign players. This is the remaining big fish for
them to go out and really establish themselves in.
Putting this into context, understanding how this news, how this move, will start impacting
the numbers that investors are looking at quarter to quarter, what I think we'll see
as they get up and running is a surge in free users. What's important to note, and you and I
were going back and forth before the show about this, is that this won't hit their ARPU number,
even though these are free users coming on board.
Niu: Right. The ARPU number that they report is specifically related to their Premium segment.
That being said, the ad-supported segment, they don't make a lot of money there.
The margins are terrible, as you would expect. I think that's going to be the real big challenge here,
is monetization and Premium conversion over time. India is not a rich country, most
people don't have a lot of discretionary income to pay for a service like Spotify.
That's going to be a challenge. If you look super long-term, though,
like decades out, India's rising middle class could help. As more and more people come into the
middle class, that could change their ability and willingness to pay for a music streaming service.
But that could take quite a long time. In the meantime, if Spotify can just
get in there, establish a stronger presence of brand and position than Apple --
Apple has always done very poorly in the Indian market in pretty much every way -- I think
it could still end up paying off. Lewis: This is something that is more or
less an extension of what we've seen from them as a strategy. It's not like this is
going to be any different in terms of operating process or anything like that. And it's not
like this is going to be the move that really changes the financials for this company.
If anything, it might make things a little bit worse before they get better.
Niu: Right. In the near-term, I'd agree with that. But I do think it's still worth going after.
There's just many people. And there's a big opening. Apple doesn't really address
these emerging markets, so Spotify can really fill that void. But, again, the challenge
will be building sustainable and profitable business on it.
Lewis: Yeah, always struggle. Evan, thanks for hopping on and talking about it with me!
I hope you enjoy your weekend! Niu: You too! Thanks for having me!
Lewis: Listeners, that does it for this episode of Industry Focus. We have a quick housekeeping
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for all his work behind the glass today! For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!