Widening the Moat

I’ve seen a few interviews lately with value investors like Tom Russo and Pat Dorsey that made me realize I was overlooking a critical piece of company analysis; I’ve put together some historic data for Coca-Cola (KO) and Microsoft (MSFT) to show this. Here’s what Microsoft’s capital expenditures and M&A spend looked like over the past five years:



And here’s what cash flow from operations looked like over the same time period:



Now let’s compare this with Coca-Cola over the same period:



And here’s what cash flow from operations looked like over the same time period:



Now let’s compare these figures:



There’s one big issue with this comparison – GAAP accounting requires research & development to be expensed (except for software that has reached technical feasibility); while this isn’t a big expense for Coca-Cola, it is a huge cost for Microsoft:



Now let’s relook at those numbers, with Microsoft’s R&D added into the investment account:



When we add in the R&D spend, Microsoft and Coca-Cola don’t look at that different. Looking at Microsoft’s results over this period, we see that Server & Tools and the Microsoft Business Division are responsible for the majority (60%+) of the change from 2008 to 2012:



On the other hand, the Online Services Division has been a perpetual drag on operating results; from 2008 to 2012, the segment has lost more than $1 billion (and usually more than $2 billion) each and every year. This is concerning for a couple of reasons, the most important one being that there is no clear indication how this business in any way relates to strengthening the company’s moat; at best, it appears like a foray into a business with huge barriers to entry, which may one day be a profitable addition to the company’s collection of businesses.

The goodwill balance attributed to OSB shows how Microsoft has continued to throw money at this business (it has decreased back to a couple hundred million after the recent impairment charge):



Again, as I noted above, it’s unclear how Microsoft’s diversification into businesses such as search tie back to the moat which surrounds the key business segments. Compare this to Coca-Cola, where the company is spending billions in key emerging markets over the coming years in an attempt to rebuild the dominant position the company holds in most of the developed world (looking at the market share data, it appears they’ve done a fantastic job so far). This, in my opinion, is Microsoft’s biggest problem: Windows and Office throw off billions year after year – yet only need a fraction of that amount to make the incremental investment required to maintain the businesses moat. The question is, would you rather own a business that generates fantastic returns on invested capital with limited opportunities to redeploy that cash, or a more capital intensive business, but one that still generates highly attractive rates of return and offers the compounding that comes from reinvesting capital back into a good business?

With Microsoft (although this can’t be quantified with 100% accuracy since we don’t have visibility into CapEx like we do with M&A), I would be willing to bet that a disproportionate amount of investment is going into OSB and Entertainment & Devices, two businesses that don’t appear to be particularly attractive (E&D’s big 2011 was followed up with a 71% drop in operating income); my contention is that even though return on incremental invested capital looks strong, the result is skewed higher by the businesses like Server & Tools and MBD – which only can sustain so much reinvestment.

Again, I can’t confirm all of this from looking at the annual reports; my beliefs may be incorrect, and this particular example could be flawed. The point still remains: for the benefits of compounding to work their magic over time, a company must have a way to reinvest free cash flow in a competitively advantaged business (usually, it will simply be an extension of their current example, like KO is doing in new geographies and product categories); without a way to reinvest excess capital back in the business, the benefits of a moat are greatly diminished – and value creation can quickly turn to destruction when management chooses to focus on empire building, rather than on widening the moat and distributing excess cash back to the owners of the business.