How high can Microsoft’s and Alphabet’s margins go?

Investors may still be underestimating how profitable both companies can get

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On Tuesday 27 April, large-cap tech giants Microsoft Corporation (NASDAQ: MSFT) and Alphabet Inc (NASDAQ: GOOG) (NASDAQ: GOOGL) each reported first-quarter earnings. While Alphabet stock surged and Microsoft shares fell slightly after the release, both companies posted impressive growth metrics.

As companies become larger, it often becomes harder for them to grow as fast as they did in the past. Yet Alphabet and Microsoft, helped along by their cloud computing divisions, managed to post eye-opening 34% and 19% revenue growth rates, respectively.

Despite both companies being well-known entities among investors, it’s quite possible they are actually still being underrated. That’s due to another factor besides mere revenue growth — and that factor is margin expansion.

Revenue growth is nice, but operating leverage is a magical combination

What investors may not fully appreciate is each company’s ability to expand its operating margin into the future. Last quarter, Alphabet posted an impressive 29.7% operating margin, while Microsoft posted an even more incredible 40.9%.  

These are larger than typical, owing to the strong competitive advantages, or “moats,” each company has. Yet with such already-large operating margins, investors may still be underestimating how much further each company’s margin can grow in the future.

Microsoft is on a steady upward trajectory

Microsoft should be able to expand its operating margin because, well, its margin has been ticking up consistently over the past five years. In 2016, the company-level operating margin was 28.6%, but it consistently increased to 37% in 2020 before reaching nearly 41% last quarter.

How has Microsoft been able to grow its margin so much? Chalk it up the massive scale of its various software platforms, including Office and Dynamics 365 cloud software offerings, as well as its growing Azure infrastructure-as-a-service (IaaS) platform. These core software offerings, along with the asset-light Windows operating system and LinkedIn social media platform (purchased in 2016), are basic enterprise tools used all over the world. Since they’re being delivered via the cloud, each incremental sales dollar requires very little incremental cost since the development that goes into each service is largely fixed.

Enterprise software is also a really attractive business because it’s pretty sticky. If a company adopts your software, it’s a pain to switch and retrain all of their workers on a new platform. So, enterprise software companies usually don’t drop prices, they can usually increase prices a bit every year or so.

One other factor is that the 2016 operating margin was likely held back by the company’s large investments in Azure. Microsoft doesn’t break out Azure revenue or margin specifically, only growth rate (Azure grew 50% last quarter). Five years ago, Azure was likely a drag as Microsoft invested in data centers and personnel to get it up and running to compete with leader Amazon.com Inc (NASDAQ: AMZN) Web Services. Now that Azure is achieving greater scale as the No. 2 IaaS platform in the world, its margin is likely expanding toward AWS’ 30% margin and boosting the company’s overall bottom line.

Alphabet’s core and cloud businesses are getting more profitable, too

Unlike Microsoft, Alphabet recently began breaking out its revenues and margins across various segments, including the breakout of cloud profitability. As the up-and-coming third-place cloud platform, Google Cloud Platform (GCP) is still losing money. In fact, GCP reported increasing losses each of the last three years, chalking up a $5.6 billion operating loss in 2020.

At the same time, Alphabet’s core Google services (search, ad networks, YouTube, Android) segment has made a fairly steady operating margin of 32% to 33% each of the past three years. However, last year was affected by the pandemic, depressing the margin at the beginning of the year. Google services’ operating margin had jumped to 36% by the fourth quarter as the company recovered, showing core Google is actually getting more profitable.

Yet last quarter, both Google services and cloud got a big margin boost. Google services’ operating margin jumped to 38.2%. Meanwhile, GCP still produced losses, but the operating loss margin fell from -62.3% to -24.1%.

Both companies did receive some benefit from lower travel expenses during the pandemic, as well as lower depreciation costs as it was determined both companies’ cloud servers should have a longer useful life than previously thought. Still, those server savings, while different from the past, should be a permanent cost reduction going forward. And it’s likely business travel won’t quite return to normal once the pandemic is over as companies have discovered some meetings can easily take place over videoconferencing.

How big could margins get? Three examples provide optimism

Last quarter proved there is still strong double-digit growth to be had for Microsoft’s software platforms as well as Google search and YouTube, even though these dominant services have been around for quite a while. As long as both companies can grow these wide-moat products and services by double-digits, I don’t see why operating margins can’t continue to expand with scale.

How big could margins get? There are a few examples of other global technology networks that have higher margins than Microsoft or Google. For instance, Visa Inc (NYSE: V) and Mastercard Inc (NYSE: MA), which operate global credit and debit card networks worldwide and benefit from increasing swipe fees over a fixed network, have operating margins of 67.2% and 53.4%, respectively, even in the pandemic-affected 2020. Another tech monopoly, VeriSign Inc (NASDAQ: VRSN), the domain registry for the .com and .net domain names, has an operating margin of 64.9%.

Meanwhile, Microsoft’s dominant software platform and Google’s search and YouTube platforms have similar characteristics to Visa, Mastercard, and VeriSign. That is, a dominant fixed-technology platform, which achieves global scale without much in the way of incremental costs.

While Amazon Web Services’ operating margin is around 30%, Google’s and likely Microsoft’s cloud margins are lower and a current drag on overall company margins. Yet as the cloud market matures, both should grow their cloud margins toward AWS. And who’s to say AWS and the other cloud IaaS players can’t eventually make margins even higher than that, as cloud computing grows over the next decade?

While both companies’ operating margins may not reach quite the heights of a Visa or VeriSign any time soon, it’s not out of the question that they could consistently move toward that 60% region over time. That’s why I still think both stocks could continue to surprise to the upside and benefit shareholders over the next decade.

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Billy Duberstein owns shares of Alphabet (C shares), Amazon, and Microsoft and has the following options: short June 2021 $1320.0 puts on Alphabet (C shares). His clients may own shares of the companies mentioned. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Mastercard, Microsoft, and Visa and recommends the following options: long January 2022 $1920 calls on Amazon and short January 2022 $1940 calls on Amazon. The Motley Fool Australia has recommended Alphabet (A shares), Alphabet (C shares), Amazon, and Mastercard. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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