When Bill Gates and Paul Allen co-founded Redmond, Washington-based Microsoft (NASDAQ:MSFT) on April 4, 1975, they aimed to write a BASIC interpreter for the Altair 8800 to make it easier for personal computing hobbyists of the day to make better use of the breakthrough machine.
Today, Microsoft ranks third on Forbes' list of most powerful brands and employs more than 144,000 people around the globe. Its products include PC operating systems (Windows), video games (Xbox), software development tools (Visual Studio), laptops and tablets (Surface), search (Bing), productivity suites (Office), social media (LinkedIn), and a robust public cloud platform (Azure). Combined, they helped Microsoft generate $39.2 billion in net profit and $38.3 billion in free cash flow on $125.84 billion in fiscal 2019 revenue.
Microsoft has come a long way in the four decades since its founding.
Not only is the company the world's largest by market cap, teetering at or just over $1 trillion in total value depending on the day's action, but at a 35.12% share, Windows is also the world's second-largest provider of personal computing operating systems. (Android leads at 39.91%, StatCounter reports.) Similarly, 56% of global organizations use Office 365 versus just 25% for Alphabet's (NASDAQ:GOOGL)(NASDAQ:GOOG) G Suite, according to Bitglass, a provider of cloud-hosted security software that tracks the usage of the apps its products protect.
Even the relatively nascent business Azure is making gains against industry leader Amazon (NASDAQ:AMZN) and its Amazon Web Services suite, holding 16.5% of the market for public cloud services at the end of 2018, according to Canalys. CEO Satya Nadella's letter to employees on his first day of work on Feb. 4, 2014 shows Microsoft has been gunning for this day for a while.
And yet Nadella -- handpicked to be CEO by Gates and Nadella's predecessor, Steve Ballmer, at the occasion of Ballmer's retirement -- has always wanted to win well. He's wanted to see Microsoft become a world leader in environmental, social, and governance (ESG) -- an investing strategy employed by investors seeking to align their portfolio with their values -- since day one. From the letter:
Many companies aspire to change the world. But very few have all the elements required: talent, resources, and perseverance. Microsoft has proven that it has all three in abundance. And as the new CEO, I can't ask for a better foundation. Let's build on this foundation together.
So far, so good. JUST Capital ranks Microsoft No. 1 for its ESG efforts. The Drucker Institute puts the company third on its 2018 list of top performers, due in no small part to Microsoft's work in social responsibility and employee engagement and development. Microsoft also appears on several other ESG-related lists, including Ethisphere's World's Most Ethical Companies, CR Magazine's 100 Best Corporate Citizens, Fortune's World's Most Admired Companies, Barron's 100 Most Sustainable U.S. Companies, Glassdoor's Best Places to Work, and Forbes' America's Best Large Employers. Microsoft is also on the Dow Jones Sustainability Index and the FTSE4Good Index.
There's good reason for these accolades and high rankings. For years, Microsoft has put out a detailed sustainability report that uses the Global Reporting Initiative (GRI) Sustainability Reporting Standards, as well as the United Nations' approved disclosures for reporting on human rights and progress as defined under the UN Global Compact. Does that commitment to transparency make Microsoft a responsible investment? Let's turn to our 10-question ESG framework for the answer.
1. Does the company treat its employees well?
Yes. Three of the nine factors listed in its sustainability report that Microsoft says affects its business relate to how well the company treats employees: accessibility, ethical business practices, and human capital. Humane and respectful treatment of employees is a core value of the company.
Microsoft ranked 34th on Glassdoor's 2019 Best Places to Work while subsidiary LinkedIn ranked sixth. There's even better news when you dig deeper: 81% of the employees surveyed at Microsoft have a positive outlook for the company, 86% would recommend working there, and 96% approve of Nadella. For comparison's sake, only 80% of Google employees have a positive outlook, 87% would recommend working there, and 92% approve of CEO Sundar Pichai. Nevertheless, Google ranks 8th on Glassdoor's list.
Overall, Microsoft is an elite employer that treats its employees very well. This finding is supported by the tenure ratio, calculated as the total years the top three officers have spent at the company divided by its total years in business. Microsoft has been in business for 44 years. At 1.58 out of a maximum of 3, Microsoft's top officers -- Nadella, President Brad Smith, and Chief Financial Officer Amy Hood -- have spent an average of more than 22 years at the company. Microsoft has a history of retaining people and promoting them into leadership. Nadella is just one example.
Areas for improvement: As the diversity section below shows, Microsoft would likely rank higher on ESG lists were it not for well-known and ongoing issues with gender discrimination. Nadella's team has much work to do in this area.
2. Is the company a good steward of the environment?
Yes. Environmental leadership is at the center of three -- and perhaps more interestingly, two of the top three -- of Microsoft's nine nonfinancial material factors affecting its business:
- Applying technology for environmental and social good
- Climate change and energy
- Responsible sourcing and device lifecycle impacts
Data centers are potentially one of the world's great polluters because of their relentless need for electric power to push and pull data from around the globe at a blistering pace. This same process creates heat inside the servers doing the processing, which creates demand for power from cooling mechanisms. This unvirtuous circle can lead to extraordinary levels of power consumption.
In a recent blog post, colocation provider vXchnge cited some troubling statistics that Microsoft is tackling head-on with advanced technology:
In 2017, US based data centers alone used up more than 90 billion kilowatt-hours of electricity. To give some perspective on how much energy that amounts to, it would take 34 massive coal-powered plants generating 500 megawatts each to equal the power demands of those data centers. On a global scale, data centers power consumption amounted to about 416 terawatts, or roughly three percent of all electricity generated on the planet. For context, data center energy consumption around the world amounted to 40 percent more than all the energy consumed by the United Kingdom, an industrialized country with over 65 million people.
How is Microsoft fighting back? Since 2014, the company's operations have been 100% powered by renewables, landing it on the Carbon Disclosure Project's A list. The Environmental Protection Agency ranks Microsoft as the second-largest green power purchaser in the U.S.
Just the sheer scale of Microsoft's data center ambitions shows how important its efforts to go green have been and continue to be. There are already 54 global regions in 140 countries where Microsoft has at least one data center serving the local population.
Expanded infrastructure is helping the Azure business unit grow quickly, with fiscal Q4 revenue from Azure up 64% over the past year. And yet Microsoft is committing to growing responsibly. One year ago, the company kicked off a long-term research effort called Project Natick, aimed at testing the viability of 100% sustainable data centers submerged off the coasts of major population centers.
So far, the results have been excellent. The initial test, submerged off the Orkney Islands in the North Sea, is powered by a combination of on-shore wind and solar and offshore hydroelectric power. All sources are 100% renewable. The Natick data center is also easier to keep cool (which reduces the need for power), needs no oxygen source (which reduces corrosion), and is built to be welcoming to sea creatures. Seals frequently visit.
And while it's not a massive data center, the "North Isles" data center -- the first pod deployed as part of Project Natick -- uses customizable chips called field programmable gate arrays (FPGA) to deliver plenty of horsepower to the 18 Microsoft business units that log into its servers regularly. According to Microsoft:
12 racks containing 864 standard Microsoft datacenter servers with FPGA acceleration and 27.6 petabytes of disk. This Natick datacenter is as powerful as several thousand high end consumer PCs and has enough storage for about 5 million movies.
The best part of all this? If the initial experiment continues to go well, lasting largely intact for the full five years while providing a friendly environment for the sea creatures in its midst, Microsoft estimates that it can get new pods from "factory ship to operation" in 90 days. It's entirely feasible that 20 years from now, a plurality or even a majority of the data center equipment powering the Azure cloud will be sunken under the sea, operating on 100% renewable power.
3. Does the company promote diversity and inclusion?
No. At first blush, Microsoft looks like a model corporate citizen that gets accolades for diversity, inclusion, belonging, and sustainability (DIBS) and representing areas of focus for companies aiming to operate humanely and responsibly.
The Human Rights Campaign scored Microsoft a perfect 100 in both 2018 and 2019 on its Corporate Equality Index. Thomson Reuters ranks Microsoft 16th on its Diversity and Inclusion Index. And, of course, there are the Glassdoor rankings.
Microsoft is working for these rankings. In July 2018, the company hired IBM's (NYSE:IBM) former Chief Diversity Officer, Lindsay-Rae McIntyre, to the same role. Microsoft issued a press release announcing her appointment in February 2018, noting she'll report directly to Chief People Officer Kathleen Hogan.
In a Forbes article McIntyre explains the company's DIBS practice, including how, as of 2016, Microsoft now ties executive compensation to diversity and inclusion goals.
In 2016, we tied executive compensation to internal diversity and inclusion goals to hold leaders accountable for improving representation at all levels, which includes retention strategies...we are encouraging our employees to be intentional, engaged, and accountable owners of the culture by incorporating an inclusion goal into our performance review process at all levels.
Programmatic efforts include unconscious bias training, expanded parental leave (a benefit highly valued by The Motley Fool), and a program called Dialogues Across Differences for teaching employees how to have conversations about cultural perspectives. The board's Compensation Committee values these efforts enough that in both 2017 and 2018 it awarded Nadella 145% of his eligible cash incentives tied to "culture & organizational leadership," which includes D&I.
And yet, Microsoft isn't without scars in the social component. In 2015, researcher Katie Moussouris filed a gender discrimination suit that remains ongoing. Two other former female Microsoft employees joined the case and together with their attorneys, they filed for class action status in February 2018. That petition has since been denied and is awaiting appeal. A page set up to provide information on the suit and the complaints that led to the suit -- more than 200 in all, filed between 2010 and 2016, meaning some complaints were made during Nadella's tenure as CEO -- warns potential litigants that the case may fail to achieve class action status.
More troubling is an April story in Quartz that describes an internal email chain that went viral and ultimately produced at least 90 pages of stories of demeaning, dismissive, harassing behavior directed at women and the men who claimed they were powerless to stop it. As one woman wrote in the thread, referencing the history of unaddressed complaints: "This is a Microsoft thing, a common one." Mix in the attempted class action suit aimed at closing the gender pay gap and it's impossible to score Microsoft highly when it comes to D&I.
Bloomberg appears to agree: Microsoft isn't on the company's Gender-Equality Index. Microsoft is also 86th on Forbes' Best Employers for Women, which demonstrates how far it has to improve to be a leader.
The good news? We can give credit for the efforts Microsoft is making. Hogan, the CPO who hired McIntyre to lead Diversity at Microsoft, responded to the email thread highlighted by Quartz, offering an ear to anyone who wanted to share their story.
I discussed this thread with the [senior leadership team] today. We are appalled and sad to hear about these experiences. It is very painful to hear these stories and to know that anyone is facing such behavior at Microsoft. We must do better. I would like to offer to anyone who has had such demeaning experiences including those who felt were dismissed by management or HR to email me directly. I will personally look into the situation with my team.
Clearly, it's not enough for Hogan and Microsoft to just offer space for women to share their stories. But it is a start, as is tying compensation to diversity metrics. In fact, I'd say putting executive pay on the line for the sake of improving the way everyone at Microsoft is compensated is an important step -- one of many still to be taken.
Areas for improvement: Tools that make it easier for employees to report diversity and inclusion violations would not only make it easier for victims to report but for HR to respond systematically and track progress. Reporting on progress in this area (or a lack thereof) in the annual sustainability report is a must.
4. Does the company have ethical corporate governance principles?
Yes. Microsoft checks all the important boxes for a shareholder-friendly board that practices ethical principles. From the company's most recent proxy statement.
More broadly, Microsoft has a tenured board where 12 of the 14 members (86%) are independent, including an independent chair: John Thompson, who joined in February 2012. He's an experienced senior leader with deep technology knowledge and is African American. Overall, 29% of Microsoft's directors are women and 21% are ethnically diverse.
Gates remains on the board as an advisor and Nadella has a seat as well. It's reasonable to believe Microsoft's board is independent enough to make decisions that would favor shareholders and hold management accountable as needed.
Finally, it's worth noting that Microsoft pays for performance that rewards all stakeholders. Executive pay includes cash incentives that are 50% tied to pre-determined financial metrics such as revenue growth and gross margin, and 50% to qualitative factors that include D&I, corporate citizenship, and customer satisfaction scores, among other factors. Performance stock awards are tied to the measurable financial performance of Microsoft's different product lines.
5. Do the company's business model and its investments promote ESG principles?
Yes. Microsoft sells desktop and mobile software, usually via subscription and delivered via the cloud, to billions of people around the globe. Its financial reporting is organized into three segments:
- Productivity and Business Processes for selling tools such as Excel and Word under the Office brand name, for selling the Dynamics business intelligence software suite, and for selling LinkedIn's services for connecting professionals with opportunities.
- Intelligent Cloud for selling access to the Azure public cloud and the tools developers use to create and support modern, cloud-hosted software.
- More Personal Computing for selling Windows licenses to PC makers, for selling the Surface line of products, for selling the Xbox and associated gaming products, and for all business related to the Bing search engine.
To support all these products Microsoft invested $13.9 billion in capital expenditures in fiscal 2019, up from $11.6 billion last year and $8.1 billion in fiscal 2017. The majority of the increase is flowing to Intelligent Cloud. From the most recent 10-K:
We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources.
ESG-minded investors should like this trend. Microsoft's efforts in data center innovation through Project Natick could have the twin effects of increasing global access to the public cloud while also making computing as a whole more green than it is today. The servers and systems behind the Azure public cloud are already 50% powered by renewable energy sources. New capital expenditures will go at least partially toward pushing that ratio to 60% by the end of 2019 and 70% by 2023. Long term, Microsoft is aggressively pushing to be fully reliant on renewables. Project Natick shows that it's possible.
And yet Natick is just one of many areas where Microsoft is investing dollars in an ESG-friendly manner. The Airband Initiative aims to close the rural broadband gap in the U.S. and around the globe, bringing high-speed internet access to millions who lack it today. (The latest figures say more than half the world's population will finally have internet access by the end of 2019 — two years later than its original prediction.)
Airband is part of Microsoft's dedicated Technology and Corporate Responsibility Group, led by 14-year veteran Shelley McKinley, who reports to Smith. Apparently, she's been given license to think big.
"It's been clear to us for some time that the digital divide in this country is an urgent national crisis that must be solved," McKinley wrote in a recent blog post. "Since 2017, we've been working with internet service providers to do just that, through our Airband Initiative, and we're on track to cover 3 million Americans in unserved rural areas by 2022."
Longer term, McKinley's team is aiming to close broadband gaps around the world through technology and funding partnerships. Early endeavors include partnerships in Latin America (Colombia, Argentina), Africa (Ghana, Nigeria, Uganda, Kenya, Rwanda, Tanzania, the Democratic Republic of the Congo, Zambia, Botswana, and South Africa), and Asia (Indonesia, Bangladesh, Nepal and India).
Finally, Microsoft has a generous corporate philanthropy program that encourages employees to volunteer. From the page describing the company's program:
Microsoft matches each employee's donations of money, products, and time to nonprofits, up to $15,000 a year. The match of volunteer time is $25 per hour that an employee volunteers. Donations and time can be easily logged in an online system; donations can be withdrawn automatically from paychecks; and if employees aren't sure where to begin, Microsoft has a database of more than 55,000 nonprofits and schools to choose from. If employees don't see the one they love, they can nominate it to be added.
Read the whole page when you get a moment to get a better sense for how much Microsoft values employee efforts to make the world a better place, powerfully reflecting Nadella's sentiments in his Day One letter to employees as well as co-founder Bill Gates' large-scale humanitarian work through the Bill and Melinda Gates Foundation.
6. Does the company have a healthy balance sheet?
Yes. Microsoft has net cash of $47.4 billion and its net cash makes up 16.5% of total assets. Microsoft is one of only two U.S.-based companies with a AAA credit rating. This is likely a function of its large net cash position, recurring revenue, tremendous FCF generation, and product relevance. The company has increased its dividend per share payout by 10.4% annually over the past five years, and its dividend yield stands at 1.32% today.
Critics will rightly point out that Microsoft carries more than $86 billion in debt so it's not like the company is free of obligations. And yet it's worth looking at where that capital has gone. Much of it was used to make greener corporate buildings and construct modern, energy-efficient data centers. (Microsoft counts $79.2 billion in gross property, plant, and equipment as of fiscal 2019, more than double the $38.2 billion on the books in fiscal 2016. Total outstanding debt is up 58.5% over the same period.)
Importantly, these investments appear to be paying off. Microsoft's return on assets (ROA) temporarily dipped from 9.2% in fiscal 2016 to a low of 8.3% the next year but now sits above 9.8%. Gross margin has also improved -- from 64% three years ago to 65.9% currently. Continued gains seem likely, given management's history of success using balance sheet resources for the good of the company and its stakeholders.
This isn't just conjecture. Microsoft's stewardship of its abundant resources explains why it's one of just two American companies with a AAA credit rating, higher than the U.S. government. (Johnson & Johnson (NYSE:JNJ) is the other.)
7. Can the company generate organic revenue growth supported by long-term tailwinds?
Yes. Microsoft either leads or is a serious contender in most of the markets in which it competes. Even Bing, the search engine that badly trails Google, is still a common option for online advertising. In May, Bloomberg cited figures from research firm eMarketer estimating Microsoft's 2019 direct revenue from online ads -- including LinkedIn -- at $4.9 billion versus $3.4 billion for Verizon (NYSE:VZ) and $1.5 billion for Twitter (NYSE:TWTR). The figures support a claim Microsoft had been making for years. "Bing is bigger than you think!" the company said in an August 2017 tweet.
While it's nice to see Bing delivering consistently, it's not a growth driver for Microsoft's business. Three products are the wind in the company's sails: Azure, Office365, and LinkedIn. All three have grown revenue over 20% year over year in each of the last six quarters. Azure grew 64% in fiscal Q4 alone, and that's down from 89% in last year's fiscal fourth quarter. It's a good bet Azure will continue growing at a breakneck pace over the next three to five years, and perhaps much longer.
Investors should like this for a couple of reasons. First, despite heavy investments in infrastructure, the Intelligent Cloud business that Azure anchors runs at a 35.7% operating margin, within spitting distance of the heady 39.4% generated by the Office-led Productivity business unit. Second, Gartner estimates total spending on public cloud services will grow 16% annualized -- from $182.4 billion to $331.2 billion -- over the four years spanning 2018 to 2022.
Expect Microsoft to take a big chunk of that spend as the company continues a long-term trend of expanding market share as a public cloud provider. (From 9% in 2016 to 16% through the first quarter of 2019, according to Synergy Research.) Just last month, the company announced a major deal to supply public cloud services to AT&T (NYSE:T). TechCrunch cited sources valuing the deal at $2 billion.
While good engineering and marketing are no doubt responsible for Microsoft's wins in the cloud and its other businesses, Nadella also deserves credit for making smart acquisitions. Revenue and operating income in the Productivity and Business Processes division jumped from $26.43 billion and $11.76 billion to $41.16 billion and $16.22 billion, respectively, in the three years since acquiring LinkedIn for $26.2 billion.
Today's Microsoft is nearly as well positioned for the ongoing cloud revolution as Gates' Microsoft was positioned for the PC revolution. It's reasonable to expect the company to keep growing revenue at or above the 7.7% rate it's achieved over the past five years. Tuck-in acquisitions to bolster the reach and capabilities of Azure could push Microsoft's growth over the next five years well into the double digits.
8. Can the business generate growing FCF and sustain high ROIC?
Yes. Microsoft has grown free cash flow by 53% between fiscal 2016 and the most recent fiscal year. Impressive as that is, it pales compared to what Microsoft has brought in as a whole: $128.6 billion in four years, and $38.26 billion in free cash flow in fiscal 2019 alone. Few companies in the world generate as much cash as consistently as Microsoft does, at margins that run between 29% and 32% annually.
This, in a nutshell, is why debt isn't much of a concern for Microsoft, even though as the balance sheet shows, the company carries a hefty amount. The other reason? High return on invested capital (ROIC). Microsoft generated 24.13% in ROIC in fiscal 2019, Morningstar reports, and scored a 24.03% return on cash flow invested over the same period. In choosing to take cheap debt and put it to work at high rates of return, paying down balances slowly with its generous cash flow, Microsoft is creating value for shareholders at an accelerated pace while also making the world a better place.
9. Is the management team focused on driving long-term profitable growth?
Yes. Nadella is playing a long game, and with Azure, he and his team are playing to win at a scale not seen since Windows 95 revolutionized how we came to see and use PCs. And you know what? He's been thinking this way since his first day on the job. From his letter to employees:
I believe over the next decade computing will become even more ubiquitous and intelligence will become ambient. The coevolution of software and new hardware form factors will intermediate and digitize — many of the things we do and experience in business, life and our world. This will be made possible by an ever-growing network of connected devices, incredible computing capacity from the cloud, insights from big data, and intelligence from machine learning. This is a software-powered world.
Indeed it is, and Microsoft is profiting handsomely as a result.
10. Does the company have a medium- or lower-risk profile?
Yes. Microsoft checks just one box on the list of risk factors that inhibit potential ESG Compounders, and that's largely due to its size and global reach. Burdensome regulation is a potential problem for all multinational corporations. And yet the problem is greater for Microsoft thanks to General Data Protection Regulation (GDPR), which requires companies operating in the European Union to give people control of their data and ensure it not be transferred or sold to other parties outside the EU. The legislation has since given rise to a global discussion in which countries are debating how and whether to implement their own data privacy protections.
There's also the long shadow of U.S. vs. Microsoft, the 1998-2001 antitrust trial that still follows the company in press coverage. The stories appear to have had one practical effect on the business: Nadella's Microsoft is more humble, more collaborative, and increasingly proving to be a powerful force for good.
Consider the company's contributions to open source, software that's professionally built by skilled developers and then let loose into the world for anyone to use — free of charge. At the time of its $7.5 billion deal for GitHub, Microsoft was the single largest contributor to the site, backing more than 2 million open source projects. Helping developers do more with technology is a wonderful and industry-specific way to do good in the world, and it may help to explain why -- just nine months into the acquisition -- GitHub's installed base of developers using the platform had ballooned by 28.6%. Microsoft is winning over the audiences it most needs.
A 9 of 10 makes Microsoft an ESG top performer
While Microsoft isn't perfect, a nine out of 10 on The Motley Fool's ESG Compounder Checklist is a sterling result. Should efforts to improve the company's diversity and inclusion practices continue to improve, it may not be long before we see Microsoft stick the landing alongside Accenture (NYSE:ACN), which scores a perfect 10. Keep this company on your ESG shortlist if you don't already own shares.