Costco’s success as a business and as a stock investment has been driven by numerous factors. The warehouse giant has gained market share over decades, primarily due to its popular price leadership selling approach. However, the real driver of its positive financial returns is Costco’s remarkably stable profit growth. Unlike most retailers that rely on product markups, Costco’s earnings are propelled by steadily increasing membership fees, resulting in less volatility in annual earnings, despite shifts in sales trends.
But is there a better investment option offering this kind of predictable income in more profitable industries? Enter Microsoft, a tech company with a similar subscription-based approach to its software services, which has the potential to provide a more stable and profitable investment opportunity for shareholders.
Recurring Revenue Model
Microsoft’s diverse product portfolio, spanning video games, productivity software, computing devices, and cloud enterprise services, is increasingly transitioning towards recurring revenue from annual subscriptions or contracts. For instance, the company boasts nearly 80 million subscribers to its 365 consumer platform, with most of its profits stemming from cloud services contracts with large enterprises committed to its platforms, such as Azure.
Notably, Microsoft’s steady sales figures reflect the positive impact of this recurring revenue, with overall revenue climbing 11% and accelerating to 16% in the most recent quarter, despite declines in certain sectors.
Enhanced Profitability
Comparatively, Microsoft stands out as one of the most profitable businesses in its industry, with an operating profit of 44% of sales, surpassing competitors like Amazon and Apple, whose margins pale in comparison. The company’s robust financial position is further evidenced by surging cash flow, which enables management to allocate resources to strategic investments, such as artificial intelligence (AI), with a whopping $81 billion in cash reserves as of early 2024.
Valuation and Risks
While Microsoft’s stock is currently valued at a premium of 14 times sales, compared to Apple’s price-to-sales ratio of 8, it presents the risk of overpaying for this high-performing business. The potential disappointment of shareholders could stem from the failure of the anticipated AI boom, a slowdown in tech IT spending trends, or a suboptimal acquisition strategy by Microsoft in its aggressive pursuit of leadership in the AI shift.
However, with the understanding of these risks, Microsoft has the potential to deliver substantial value in an investor’s portfolio over the next several years.