What Investors Need to Know About Microsoft's Interest in Communication Platform Discord

In this episode of Industry Focus: Tech, host Dylan Lewis is joined by Motley Fool contributor Brian Feroldi to break down how Discord would fit into Microsoft's (MSFT -1.27%) gaming ambitions, what the service could look like under the Microsoft umbrella, and what separates Discord from Teams competitor Slack.

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This video was recorded on March 26, 2021.

Dylan Lewis: It's Friday, March 26th, and we're talking acquisition rumors and Microsoft's gaming ambitions. I'm your host, Dylan Lewis, and I'm joined by Fool.com's antiquated accessor of analyzing anti-awesome asset acquisitions, Brian Feroldi. Brian, how are you doing?

Brian Feroldi: I'm doing a great, Dylan. Excited to be talking about some news. We haven't covered news in many weeks.

Lewis: It's been a while. We like to mix it up. I like to think of us as a pitcher that has a couple of different pitches in our repertoire. Sometimes, we go at the deep dives. Sometimes, we like to go radar stocks, throw three or four different companies that are in the same space at our listeners. But every now and then, it's nice to talk about something everybody knows. In this case, we're going to be talking about Microsoft and some really splashy news related to big tech companies.

Feroldi: I think it should say really splashy potential news here.

Lewis: [laughs] That's true.

Feroldi: What we're talking about is Microsoft potentially spending a cool $10 billion to buy Discord. But I think that this is more than a rumor. The odds of this actually happening, I think, are pretty high. But I guess we should point out this is just a rumor at this point.

Lewis: It is. Rumors are very fun and there is no shortage of headlines related to what the various big tech companies could go out and buy. It's a [laughs] very tantalizing idea. In this case, from what I've read at least in the reports, Discord approached Microsoft just trying to see what their interest was. I think you're right. I think there's some pretty serious talks happening here. Of course, $10 billion is not a bank breaking amount of money for a company like Microsoft to throw out there.

Feroldi: There's really only a few companies out there that Discord could approach to go after and Microsoft is certainly on the shortlist. To your point, yeah, if Microsoft wishes to drop $10 billion on this company, while that is a lot of money, it's still less than 1% [laughs] of Microsoft's market cap.

Lewis: Yeah. I think that could cover it. I think pretty comfortably that could cover it. I'm sure a lot of our listeners are familiar with Microsoft. Probably, a lot less of our listeners are familiar with Discord. If you are in the gaming space or you're someone who is just generally on the cutting-edge of tech, software applications, and the way that people are communicating, you know this name. There are a lot of people that don't though.

Feroldi: Dylan, were you familiar with Discord before the story came up?

Lewis: Yes, but I will say I was not a user. I have looked under the hood a little bit, I have a lot of friends who are big fans of it, however, I am not a diehard user the way that I know some of my friends are and some fellow Fools are.

Feroldi: Yeah. I was asked to sign up to play, to connect with my cousin so I'm familiar with it through that. I guess I am technically one of the 140 million users. But for those that are unfamiliar with this, Discord is a chatting app that is used primarily to allow gamers to communicate with each other while they're playing. It was founded with two co-founders, Jason Citron and Stan Vishnevskiy. Wow, did I mispronounce that. But two co-founders that are still involved. They were just lifelong gamers, and they were really struggling because they wanted to play games with other people, and have a friendly chat with them. There weren't any good tools that time so they built one, founding story we've seen and we love.

Lewis: Yeah. That's generally a pretty good recipe, Brian. People who are super in a community really understand the wants and needs of the core power users there, coming out with something that addresses those. Not surprisingly, millions of people have adopted it because it's a great homegrown service.

Feroldi: The numbers that I saw thrown out was that Discord currently has 140 million active users and they have four billion conversation minutes logged daily, so this is a sizable platform.

Lewis: Yeah. Crucially, you can really communicate in a variety of different ways using Discord. It would be easy to quickly think of it as a Slack-type thing, but it's very rich in the different communication methods that you can use when you're on the platform.

Feroldi: Totally. The company makes its money by selling premium subscription services where you can customize your profile and upload high resolution images and videos. Cost is anywhere for about $9.99 a month, so about $10 a month, or you can do an annual subscription fee for about $100. The numbers that we've seen show that this company is doing about $130 million in annual revenue over the past 12 months.

Lewis: What's interesting about this business in particular and I think what opens it up to the really broad base of users that it has, is it's platform agnostic. It is something that allows you to communicate with people regardless of what you are using in terms of your core console on the games you're playing. We've seen a lot of businesses be successful with that model, Brian.

Feroldi: I think that's almost a requirement here. If you are a gamer and you want to connect with the other gamers, it can't necessarily be tied to only one type of gaming platform. Something like that would not have universal appeal. I know back in my Fortnite days, I used to play that and we would play with some people that would be on iPads, other people would be on Xboxes, other people would be on PlayStation 4, so the universal accessibility of this is crucial.

Lewis: It is. I think what is really interesting to see is, we talked about how this was something that was born out of problems the founders are running into. It has not stayed in the gaming space. I think a lot of people have realized the benefits of it as a communication platform, being able to use text, being able to use images, being able to use video, all these different things. It is going where a lot of, I think, more early adopter tech communities tend to go in terms of topics, communities. I know that there are Investing Discords, there are Crypto Discords, there are all different types of Discord groups that are propped up. I've seen book clubs [laughs] that get set up on these things just because it offers such unique and rich communication capabilities.

Feroldi: That is probably one major reason why Microsoft or any other business is interested in acquiring this. Yes, it got its start in gaming and that is still where the core conversation goes, but like we saw with Instagram which started out as one specific niche use, can go mainstream in some cases. If Discord is on that trajectory, it could be worth serious money down the road.

Lewis: It could. We threw out that $10 billion sticker figure that we have seen reported, that would be an increase on what we've seen from the recent valuation rounds. I think their last valuation round was somewhere around $7 billion. This is a price that a lot of early investors in Discord would probably be pretty happy with. But I think it's interesting talking about Microsoft going out and possibly buying a communication platform because there has been no shortage of interest in other players in that space, homegrown apps and [laughs] software in that space, and really just interest in Microsoft in general, buying other companies that are in the social communication platform industries.

Feroldi: Yeah. In the recent past, we've seen Microsoft makes some interesting deals. They bought out LinkedIn several years ago, I believe that was their largest acquisition ever and they really paid up to do that. More recently, last year when there was kind of a bidding war for the U.S. version of TikTok Business, Microsoft was an interested party there, but it ultimately lost out to Oracle. Maybe Microsoft just has money burning a hole in its pocket and wants to find something. [laughs]

Lewis: Yeah, it is tempting. When you start seeing a lot of money pile up in your brokerage account or in your checking account, Brian, it's a one-off put to use. I can only imagine what that's like when the number is denominated in billions, and it's cash sitting on your balance sheet, hurting some of your internal efficiency metrics. I think we also can't forget, Microsoft was interested in buying Slack at one point. You go back to 2016 and there were some really serious conversations internally happening about whether or not it made sense for them to go out there and buy. Bill Gates in more of a tech advisor role with Microsoft at the time. Satya Nadella ultimately decided it was not a decision that they wanted to make. Instead of going out and buying this, a business that had a brand associated with it was a hybrid of enterprise software, but also had its own consumer brand, they decided to go and say, "You know, we can build a messaging platform internally. We'll call it teams, and I think we're going to be able to do just fine." That's pretty much what's played out. We fast forward to 2021, Brian. There are more people using teams than using Slack.

Feroldi: Yeah, Microsoft uses their marketing reach to really promote teams, and that was a bit of a risky strategy because we've seen several times that companies say, we're not going to buy this thing, we're going to try to build our own better version of it. More often than not, those efforts are not successful. It was interesting that they did not move forward with the Slack acquisition and they were able to make Teams a success. It's still worked out pretty well for Slack, getting bought out by Salesforce for a cool $27 billion, but it is interesting to see the strategy that they went with.

Lewis: I'm sure they're going to be some people that are wondering why discord, why not Slack? I think we'll touch on it a little bit as we work through some of the gaming stuff, but I think at core, one of the things to keep in mind with these different services is that Slack was ultimately something where enterprise is going to be the buyer. Like you have to sell to a business, to have paying users for Slack, for the most part. Discord is much more of a direct-to-consumer model. For the most part, brand value is going to matter a lot more in direct-to-consumer. If Microsoft was to absorb a company like Slack and then roll it into what they are offering to businesses, they basically need to say, OK, this is going to be part of this bundle, and we will realize some element of value in what we bundle it with all of our office software or we're just going to include it and use it as a retention tool, which makes it hard to pony up for that brand name.

Feroldi: Microsoft has some recent history with trying to build a gaming product from scratch and ultimately failing. It wasn't all that long ago that Microsoft was trying to build mixer, which was a product that was designed to compete with Twitch, which is owned by Amazon. Microsoft really put a lot of resources behind that, and notoriously paid Ninja, which was one of the most popular streamers in the world, to Twitch to become exclusive on mixer. I think they paid him around $30 million to make that switch. After they did that, they ended up abandoning that strategy and shutting down the platform because they just weren't making inroads against the likes of Twitch, Facebook, gaming, and YouTube as they were expecting to. Yeah. Once a brand name with consumers gets established, it can be really hard to build a competitive product.

Lewis: You mentioned Twitch. There's no shortage of big tech investment in the gaming industry in general. Facebook made that huge Oculus acquisition a while ago. It feels like now if you're talking in tech years. There's only a couple of years ago, but it feels like it's like a decade-and-a-half ago, at this point. Apple is making more and more steps in the gaming direction as they are trying to emphasize their services offering. We're seeing Google [Alphabet] emphasize Stadia. There's a lot of investment here, and it makes sense to me that Microsoft wants to put more money here when you look at their overall business.

Feroldi: Yeah, Microsoft has been in the gaming industry for going on two decades now with its Xbox division. Xbox is actually becoming a relatively important part of the company's business. Last quarter, in fact, Xbox was one of its fastest-growing segments overall. Revenue from the Xbox division grew 40%. That was in part due to the launch of the new series of Xbox. The Xbox series X&S, the most recent console. Revenue from that category grew 86%. Microsoft knows that gaming is a huge, huge business and they are really spending to be a part of it.

Lewis: Yeah, it's something that we've talked about, some of the kinds of it. There's a mega trend here. The online gaming space is only becoming bigger. There are a lot of players in it. It's not going to be a winner take all market, but there's a lot of money going into it. We know how appealing digital services are as a business. With people staying at home, I think the benefits of these types of businesses have really been highlighted recently. If you are looking at Microsoft overall, top down as the business, they need something to be pretty big for it to be even remotely interesting for them. Just to show you what the pilots like for them in 2020. They have server products and Cloud services, that was $40 billion. Office products and Cloud services, $35 billion. Windows was $22 billion, gaming, $11 billion. What does even make the top four for them is LinkedIn, which I think was about seven or eight billion in revenue contribution, and that was a massive stand-alone business. When you start putting numbers like that together, you see, for the most part the story is going to be office and Azure. Unless they're able to prop up another really big pillar of the business. What we see with some of the growth rates in gaming, just the general interest in gaming. There's potential there, and they already have Sony properties in this space. We've seen their proclivity to bundle things, Brian. It seems like there's something pretty tempting here.

Feroldi: It really does. I really think that this would be a nice acquisition fit for them, and they have proven in the recent past that they are willing to pay up to really bolster their gaming division. Several years ago they bought Mojang, which is the maker of the ridiculously popular game, Minecraft. Last year, we actually saw them spend $7.5 billion for them to acquire something called Zenimax Media, which was the parent company of several gaming studios that brought games like Doom and fall into the category. Microsoft has clearly identified gaming as a major growth avenue for the business long-term and they are willing to spend up to really bolster it.

Lewis: Yes. You see them positioning themselves in the much more lucrative parts of the market, Brian. Like at core, you go back a couple of years, they were exposed to gaming, but it was much more because of their Xbox division and hardware. That was really the association that I think a lot of people had with gaming and with Microsoft. It's a very different story when you start getting into video game publishing, when you start getting into the platform that gamers communicate on. I think that's probably where the money is and that segment is going to check a lot more the box that I know you like to personally invest in businesses.

Feroldi: That's exactly right. The part of gaming that interests me is for current revenue, Shocker, I know but when you have Microsoft, I clearly made a bunch of investments in that category. I know that we have an Xbox in my house and every month my credit card is hit with my son's Xbox solid gold subscription. That subscription is worthwhile because it gives them access to games, but more importantly, it allows him to play and communicate with his friends online. That is just a much better business model than the old video games business.

Lewis: It is. It's much more compelling, and when you have so many different things within the video gaming ecosystem as Microsoft does, and may have, you know, if they went up going through this acquisition, it becomes pretty easy for them to say, you can charge someone x amount of month or x amount of year and you just get everything. You don't have to think too much about it. You have access to all of the different elements that you need. You don't have to go through all the hoopla that we currently have with a lot of streaming steps, looking for different services you're trying to figure out, what shows on what's. In the case of video game providers. If you're more vertically integrated, it gives you a lot of interesting pricing power. It gives you a lot of different options that you can offer to consumers. As we talked about data, you are starting to get into the high-margin part of this industry which is going to be super compelling for that.

Feroldi: This would, I think, round out their ecosystem and to your point, their recurring services even more compelling. If there is some merit to this rumor, I think that it makes a lot of sense for Microsoft to go through with this.

Lewis: Yeah, I do too. I mean, I look at the way that they have their revenue broken down right now. With Azure and with Office being such a large part of where the money is coming from. They're not quite in Apple territory with an iPhone problem, but they're pretty concentrated. They have a couple of business lines that are really going to be driving them for the foreseeable future, unless they can find some interesting growing markets that will go from being single digit or low double digit billion on an annual basis to $20 billion, $30 billion, $40 billion in longer term and the run rates that it can ultimately hit. This feels like one of those industries, particularly as they can roll more things into it. I am curious though, Brian, if [laughs] at a certain point, regulators start to look at the space the way that they have so many other acquisitions from the big tech [laughs] space in the last decade.

Feroldi: That will definitely be something to watch. Although from my eyes and again, I'm not a legal expert, I don't think that regulators will have a problem. This would be a relatively small acquisition for them in the grand scheme of things and will be used to bolster their gaming division. This wouldn't be under the same eyes of say, Facebook buying an Instagram nowadays, or even a Microsoft buying a TikTok nowadays. But that kind of thing is always unpredictable, so we'll just have to see how that story plays out.

Lewis: It is always unpredictable and I think it's so easy. What's hard about the antitrust stuff, Brian, is it's so easy when the deals are happening to say, well, look how many users Instagram has. What is Facebook even going to do? You fast forward a couple of years and they are probably the greatest acquisition ever made in terms [laughs] of pure ROI and really strategic fit for business. It's hard to anticipate that when those deals are made originally.

Feroldi: It really is. I agree with you there. I think that Facebook-Instagram deal will go down as the best acquisition ever, or at least in the top five, at the very least acquisitions ever. To your point, if you would just look at where Discord is today, I think Microsoft can make a pretty compelling argument that hey, this is just for the gaming community, it's pretty niche. Longer term if Discord branches out and goes from say, 140 million monthly users to a billion monthly users because it has success in getting into different conversations, that could be something. You could argue, if Microsoft is going to do this deal, better do it quickly.

Lewis: Yeah. I'm sure some people hearing them be interested in something like this Discord knowing that they have a product like Teams are wondering, Brian, is this something that Microsoft probably allows to continue to operate as it currently is under its own name, or does it wind up getting integrated into all of the communication stuff that Microsoft currently has? My hunch is that Discord under Microsoft is still called Discord and still runs as its own business. But I'm curious what you think about that.

Feroldi: Yeah, I think that makes sense. One of the big benefits of Discord is that it's not tied to any specific platform. If they took this and said we're going to make it so that only Xbox customers can only talk with other Xbox customers, that would really kill a huge amount of the appeal of Discord right now. I think from that perspective, if it wants to keep the gaming community happy, it's going to have to say yes, we're going to keep this as a separate business, allow it to run the same way that it's done with LinkedIn. Yeah, I agree with you there. I think that that's the most likely case scenario.

Lewis: Yeah. My guess would be that the folks over on the Teams team talk a lot with the folks on the Discord team and they wind up possibly taking some of the things that they have learned over in that space and bring it over to what they are offering all of these customers that are paying for Office, paying for Outlook, all these types of things. But I think they keep the brand separate, and really just use it as a space to delight a very, very loyal customer base. [laughs] because gamers love their products, and they're very vocal [laughs] when things get messed up with their products. Then it ultimately becomes something that forms an add-on service for them within their core money making software.

Feroldi: Yeah, totally. Microsoft knows that. It has made a couple of big bets in the gaming arena. The last thing that it wants to do is [laughs] make that community mad at it. If it does go through with this, it's certainly going to have to keep that in mind.

Lewis: It will. You know what? We say it all the time, it's a fun story to watch, it's a delightful one to watch. It's really interesting because we have slept on Microsoft a little bit, I think over the last five years in doing the show. I know you're a shareholder, right, Brian?

Feroldi: My children are, I was not strong enough [laughs] to buy and sell myself.

Lewis: Did your kids pitch you Microsoft?

Feroldi: Every year when they go to go buy stocks, I ask them what they want to buy, and when my son discovered Xbox is owned by Microsoft, he picked it. It's amazing how sometimes being that simple with your investment decisions, I like Xbox, [laughs] therefore, I like Microsoft, sometimes that works out.

Lewis: Yeah. He saw the thesis before we did. [laughs] But I think we have slept on this company a little bit and unfairly because it's been a wonderful compounder, as I'm sure your son's portfolio can attest. Their core businesses aren't really slowing down. This is a nice thing for them where they can invest in growing spaces. They have cash cow businesses that in some ways are mature, but really are continuing to grow at pretty rapid rates, and the share price appreciation has been wonderful. I think if you're a Microsoft shareholder, this is mostly upside. I don't look at what they're talking about here and say this doesn't look good. There's a probability that this doesn't work out, it doesn't look good for you.

Feroldi: It's really incredible to me that if you look at Microsoft's results over the last couple of years, this company is still growing its top line in the Teams grade. Off of the size of this company and the billions that it is pulling in, they have done an unbelievably impressive job in turning this from a stodgy, low growth dividend paying company into a high growth business. Your hats have got to be off to Satya Nadella and the team.

Lewis: Yeah. They just continue to identify interesting industries to pour money into. We've seen with Azure in the cloud, we're seeing it now with the gaming industry. I think they see the potential here, and they know that they're going to have to find more revenue streams. They want to diversify if they want to become a multi-trillion dollar business, which I'm sure that's the ambition for them, knowing where they are now. They've done a great job identifying and executing so far. I think leadership has been absolutely fantastic. This is a great logical next step for them.

Feroldi: I completely agree. What's really amazing is that while Microsoft has done phenomenally well as a stock in the recent past, given its growth rates, I don't think it's all that expensive today. This is a company that's trading for around 30 times earnings, it buys back stock, it's still growing at a double digit rate. If you're looking for a low risk stock idea, boy, could you do a whole lot worse than Microsoft?

Lewis: Yeah. I feel like Microsoft is probably the tech dividend stock that I would throw out to people. People who are chasing yield generally are like, "Come on." [laughs] But the reality is it's a best of both worlds company where you're getting consistent dividend payments that you know they're not going to have any trouble servicing. That dividend is not going anywhere, and yet it's a wonderful growth company; it's been an incredible appreciator and a wonderful compounder, and there are still so many reasons to be excited about the business.

Feroldi: Moreover, it's just one of the ways that they're returning capital to shareholders. This company also regularly buys back gobs of stock and is actually reducing the share count. If you're going to be looking at this, yes, don't just look at the dividend yield, you have to consider the total shareholder return.

Lewis: All that to say in future episodes, I won't be having, Brian Feroldi on, I'll be having his son on instead. [laughs]

Feroldi: He has a higher accuracy rate with picking winning stocks than I do. That's probably a smart move, Dylan.

Lewis: You taught him well, Brian. You taught him well, right? [laughs]

Feroldi: That's right.

Lewis: Brian, thanks so much for joining me on today's show.

Feroldi: Thank you, Dylan.

Lewis: Listeners, that's going to do it for this episode of Industry Focus. If you have any questions or you want to reach out and say, "Hey," shoot us an email at [email protected] or tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes, Spotify, or wherever you get your podcasts. As always, people in the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for all his work behind the glass today and thank you for listening. Until next time, Fool on!