The company has a near-bulletproof recurring revenue stream.
Microsoft’s strong growth is also nearly guaranteed.
The real question is, how much should we pay for Microsoft shares?
In one of my first articles, penned early in 2014, I touted Microsoft (MSFT) as a stock worthy of an investment. Here are excerpts from that article.
With a PE ratio of 13.5, I believe Microsoft is a classic example of a company that is temporarily out of favor with the market.
The company's entry into cloud services will prove highly profitable.
I believe in Microsoft and I've "put my money where my mouth is." I'll go on record as stating I executed an entry level position at 36.63 per share on 01/29/14. I hope to at least double my position in the coming weeks.
In my article of last December, I related how Microsoft had taught me, an inveterate value investor, that some companies are a bargain when trading at fair value.
The company possesses the business equivalent of a split personality. On one hand, you have the juggernaut known as Azure Cloud. With revenue that grew 59% year over year in Q3, it is the fastest growing among the cloud leaders.
On the other hand, you have Office and Dynamics products providing a generous stream of recurring, bulletproof revenuers.
So, where does Microsoft stand today? While conducting research for this article, I noted a great deal of commentary regarding the company’s prospects of reaching a $2 trillion plus market cap in the not so distant future. That implies a 33% increase in valuation.
When assessing a company as an investment, one oftentimes must work hard to determine whether the business can fend off competitors, experience reasonable growth, and, at the same time, evaluate the firm’s financial foundation.
None of these are concerns with Microsoft. There are but two questions to be answered. How strong and long is the growth curve, and does that dynamic support the present valuation?
The Gift That Keeps On Giving: Office 365
The recurring revenue from Microsoft’s subscription services is a powerful positive when assessing Microsoft as an investment.
Paid subscriptions to Office 365 commercial are approaching 258 million, a 20% YoY increase. Microsoft Office 365, including the perpetual license version of the software, provides roughly 26% of the company’s revenue. High switching costs and the ubiquitous nature of Microsoft Office practically guarantee a revenue stream benefiting investors well into the future.
The pandemic created a shift to remote work and communications via video meetings. This new paradigm promises to cement Microsoft’s position, as more than one billion devices use Windows 10, an increase of 30% YoY as of Q3.
We’ve seen two years’ worth of digital transformation in two months.
Microsoft CEO Satya Nadella.
Released in November of 2016, Microsoft Teams is a significant driver of growth for 365. By September of 2018, Teams was recognized as the fastest growing application in Microsoft’s history.
In June of 2019, Microsoft counted 13 million daily active users (DAUs) for Teams, surpassing Slack (WORK). In November of 2019, the DAUs leapfrogged to 20 million, and in March of this year, DAUs totaled 44 million.
When the last earnings call hit, DAUs totaled 75 million.
Microsoft investors should follow Teams’ progress. Slack could put a significant portion of the company's recurring revenue at risk.
Blue Skies Smiling At Me
Those blue skies contain Microsoft’s cloud, and the cloud is the growth side of the company’s future. The chart below summarizes projected cloud growth.
Source: Metrics by Gartner/ Chart by Author
Studies indicate 34% of companies are in the initial stages of implementing cloud, while 28% are in the planning and evaluation stage.
Although Azure is second to Amazon’s (AMZN) AWS, Microsoft had YoY revenue growth of 62% last quarter versus 32.8% growth by AWS.
A Goldman Sachs report revealed Azure leads AWS among Global 2000 companies. The 100 IT executives surveyed indicated 56% use Azure as their cloud provider. Furthermore, those respondents see Azure as the number one provider of cloud services over the next three years.
Many brick and mortar retailers perceive a partnership with AWS as a form of assisted suicide. At the same time, Microsoft can use Windows and Office as a natural segue for the adoption of Azure.
Enter The Digital Twin Market
A digital twin is a digital version of a physically existing object. A digital twin provides engineers and designers the ability to simulate devices and to introduce variables needed to monitor, troubleshoot, or gain data for design purposes.
Testing can be conducted without the cost of operating the actual device, an advantage when the item monitored is costly. The process lowers failure rates for manufacturing systems, thereby avoiding costly maintenance shutdowns.
Late last year, ANSYS (ANSS), an engineering simulation company, partnered with Microsoft's Azure IoT cloud system to provide digital twinning to industrial clients.
The number one company in its field and twice the size of its nearest rival, ANSYS specializes in 3D design software and simulation engineering.
Consider this example of savings through digital twinning: CNH Industrial (NYSE:CNHI) designs and manufactures agricultural, commercial and industrial vehicles and power trains. One minute of downtime caused by maintenance issues costs the company more than $160,000. CNH paired with a company to use digital twinning to successfully address maintenance issues.
The digital twins market is projected to grow at CAGR of 37.8% through 2025, an increase from $3.8 billion today to $35.8 billion.
This market dovetails with the Augmented Reality market and Microsoft’s HoloLens 2. My previous article, Microsoft: A Deep Due Diligence Dive Or How A Value Investor Embraced Microsoft, covers that subject in detail.
The Cloud And Healthcare
Last month, Microsoft introduced its Microsoft Cloud for Healthcare initiative. Data is a critical component of healthcare services, and the cloud provides a means to rectify the healthcare industry's paucity of resources.
In an era when healthcare costs are the subject of intense scrutiny, Microsoft may prove to be a compelling value for hospital administrators. I’ll add the healthcare industry counts 34 million users on Teams.
Microsoft As An IoT leader
According to Statista, the Internet of Things (IoT) connected devices will grow from 22 billion in 2018, to 38.6 billion in 2025, and 50 billion in 2030.
Microsoft may have the inside path for growth related to connected devices. The company currently lists Starbucks (SBUX), Volkswagen (OTCPK:VWAGY), Chevron (CVX) and Walmart (WMT) as current IoT clients.
Microsoft recently acquired Cyberex, an IoT security company, to bolster the company’s IoT security offerings.
A bit over a year ago, the company also acquired Express Logic, a leader in real-time operating systems for IoT and edge devices powered by microcontroller units. Prior to the acquisition, Express Logic could boast that its ThreadX real-time operating system (RTOS) was embedded in 6.2 billion devices worldwide. Like Cyberex, ThreadX technology serves to enhance the safety and security of devices.
Due to the number of devices with ThreadX technology, it is believed that the acquisition would lure customers to Azure that might have opted for a rival's offerings.
Microsoft And The Nation Of Poland
In May, Microsoft announced a deal worth $1 billion “to accelerate innovation and digital transformation” in Poland. The initiative will span seven years and includes the construction of a new Microsoft data center region to facilitate Poland’s efforts to provide “broad access to cloud solutions across all industries and enterprises in Poland.”
“I deeply believe that Microsoft’s investment in Poland will be important for enterprises, public institutions and the education system and will enable them to digitally transform and implement new work standards. Our primary goal is to accelerate Poland’s transformation into a technological hub for the region of Central and Eastern Europe,” said Mateusz Morawiecki, prime minister of Poland.
Microsoft Nixes Mixer, And More
After struggling to gain traction, Microsoft announced earlier this month the shutdown of Mixer, the company’s gaming platform. Launched in 2017, Mixer was the company’s answer to Amazon’s Twitch. The move came as a surprise as Microsoft invested heavily in the platform; the company integrated Mixer into Xbox One, and recently spent a reported $30 million to $50 million to entice Tyler "Ninja" Blevins, an esports star, to stream exclusively on its site.
Microsoft will merge Mixer’s community with Facebook (NASDAQ:FB) Gaming.
Microsoft also acquired ADRM software, a “leader in large-scale, industry-specific data models.”
ADRM collaborated with Microsoft for more than a decade on joint customer projects. The company aids large firms in their efforts to manage data.
Microsoft recently teamed with FedEx (FDX). The move is designed to utilize data and analytics to improve the movement of goods. The two companies already have a service dubbed FedEx Surround. The following quote provides insight into how Surround will aid FedEx and its clients.
So if you’ve got five pieces of inventory in Ohio and it’s not selling, you will know that inventory is selling in the Bay Area or (Los Angeles) and can move the merchandise there and have a much more efficient and high-turn sales and fulfillment process.
FedEx Chairman and CEO Fred Smith
Debt, Dividend, and Valuation
Microsoft is one of only two publicly traded stocks with a AAA credit rating from S&P.
The company has cash and investments of approximately $137 billion, and debt of $69.6 billion of Q3. The yield hovers around 1%, the payout ratio is a bit below 36%, and the 5-year dividend growth rate is 10.45%.
As I type these words, MSFT trades for $196.33 per share. The average 12-month price target of 36 analysts is $196.68. The average target of the 7 analysts rating the stock over the last month is $221.08.
Microsoft has a current PE of 34.63, a forward PE of 31.56, and a PEG of 2.28.
There is much to recommend for an investment in Microsoft. The company has strong recurring revenues. As I outlined in this article, the company has a robust and nearly guaranteed growth trajectory, as well as a fortress financial foundation. The stock checks the primary boxes needed to push the buy button.
Analysts project Microsoft's revenue will rise 13% in fiscal 2020, while earnings will increase 20%.
Analysts also predict Azure’s revenue growth will slow considerably over the next few years. Azure’s revenue grew 59% in Q3. The projection is the growth rate will slow to 42% in fiscal 2021 and fall to the mid-30% range in 2022.
I note, however, that the growth is a smaller percentage of a larger sum.
Predictions are that earnings growth will average a bit over 15% a year for the next five years.
While it's one thing to have growth catalysts on the horizon, that doesn't mean much if the potential growth is already priced into the stock.
Although I have an overall positive view of Microsoft as an investment, I find the stock to be trading significantly above fair value. I note other tech darlings, such as Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Apple (AAPL), trade at significantly lower PE and Forward PE multiples.
While I recognize some names warrant elevated valuations, and I count Microsoft as one of those stocks, I conclude the current share price is too dear for my taste.
Consequently, I rate MSFT as a HOLD.
I will add that my current view of the market leads me to believe that there may be an opportunity to add to my Microsoft investment in the not too distant future. I hasten to add, however, that the stock is at the top of my watch list, and I am eager to add to my investment in Microsoft whenever I view the shares as in the fair value range.
One Last Word
I hope to continue providing articles without cost to SA readers. If you found this article of value, I would greatly appreciate your following me (above near the title) and/or pressing “Like this article” just below. This will aid me greatly in continuing to write for SA. Best of luck in your investing endeavors.
Disclosure: I am/we are long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have no formal training in investing. All articles are my personal perspective on a given prospective investment and should not be considered as investment advice. Due diligence should be exercised, and readers should engage in additional research and analysis before making their own investment decision. All relevant risks are not covered in this article. Readers should consider their own unique investment profile and consider seeking advice from an investment professional before making an investment decision.