Apple vs. Microsoft: Comparable Market Caps, but Vastly Different Fundamentals

It's been over eight years since Apple (AAPL -1.22%) and Microsoft (MSFT -1.27%) have had comparable market valuations, but the two tech giants are now both worth approximately $850 billion. Microsoft has been steadily marching higher while Apple has pulled back on fears around iPhone demand and President Trump's ongoing trade war with China. While the two boast similar market caps, each company has very different narratives regarding fundamentals.

In this segment from Industry Focus: Tech, host Dylan Lewis and Fool.com contributor Evan Niu compare the the two titans of tech.

A full transcript follows the video.

This video was recorded on Nov. 30, 2018.

Dylan Lewis: 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.

Evan 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 megacap 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.