Microsoft: Expectations Still Have To Settle
Contributor since 2011 / 24286 Followers
Summary:
- Microsoft has seen a solid fourth quarter, driven by a diverse set of growth engines.
- The company is a key player in AI but sees investments ahead of revenue contributions on this front.
- While the long-term potential is certainly there, 33 times current multiple is simply a bit too rich for me here, making me a patient buyer.
jewhyte
When Microsoft (NASDAQ:MSFT) posted its third quarter results, I believed that the company was firing on most of its cylinders, posting strong growth in an uncertain macro environment.
This came after ChatGPT and AI bolstered the imagination of investors, triggering a huge recovery from the 2022 lows. Investors believed that these trends might broaden and accelerate growth, with the impact of these trends being far more powerful than uncertainty related to the Activision deal.
Nonetheless, it felt as if investors had gotten a bit too excited about the prospects, making me a bit cautious as the run in the shares continued.
A Look At The Quarter
Microsoft posted a resilient 8% increase in fourth quarter sales to $56.2 billion, although this number is a bit misleading as product sales were actually down and its key services were growing at double that pace (in aggregate).
As the shift towards higher-margin services is evident and tight expense control was demonstrated upon, operating earnings rose in a more pronounced way with operating profits expanding from $20.5 billion to $24.3 billion. Net earnings of $20.1 billion worked down to a $2.69 per share number for the quarter. This meant that Microsoft ended the year with nearly $212 billion in sales on which flattish net earnings of $72 billion were reported, with earnings coming in just shy of ten dollars per share.
Net cash was reported at $64 billion as the company was increasing the net cash position ahead of the Activision deal, with these numbers even excluding equity investments apparent on the balance sheet to the tune of nearly $10 billion as well.
These trends are set to last, and while the headline sales numbers for the quarter do not look that strong, it is the shift to subscription and cloud services, away from traditional upfront and equipment sales, which drive margins. This drives impressive earnings growth here, placing Microsoft firmly on track for earnings of $10 per share, or even a bit higher in the coming year.
Retesting The Highs
Shares peaked around the $350 mark late in 2021 and, like the rest of the technology sector, shares sold off significantly to a low around $220 in the fall of 2022. Shares recovered and hit the $300 mark in May before rallying further to highs around $360 in recent weeks, as they retested the 2021 highs. This was followed by a modest sell-off to current levels of $338 in the wake of the quarterly results.
The reality is that with nearly 7.5 billion shares outstanding, the resulting $2.5 trillion market capitalization is huge, as net cash is very modest in relation to these numbers. Note that this net debt load would be entirely depleted following the Activision Blizzard deal, if and once that closes.
With earnings power now trending at $10 per share, it is needless to say that a 33 times earnings multiple, or 3% earnings yield, is very modest in this environment, but clearly the market is not expecting interest rates to be stuck around 5% for a long period of time. Furthermore, Microsoft offers, unlike a bond, growing coupons as it might even be more safe than a bond-like investment from a credit point of view. After all, its services are so desperately needed by people and professionals across the globe.
What Now?
The reality is that years ago, or even decades ago, Microsoft’s earnings yield surpassed risk-free rates by a comfortable margin, but now it trails by about two points marking a massive re-rating. This raised expectations a great deal, yet Microsoft has been regarded as a much better play now, showing decent growth and having multiple and diverse growth engines to propel the business further and shares higher.
On top of the known and existing growth engines, investors believe that Bing, ChatGPT and AI solutions have the potential to pull the shares, but for these developments to start to make a real revenue contribution is still a long way off on a standalone basis. That said, improvements by these developments in the services of existing offerings like Bing and Office have the potential to further strengthen the ecosystem and drive monetization potential.
On the one hand, the company is doing well with the Activision deal likely proceeding (as depleting the net cash position would not be a major issue given the huge profitability of the firm), Microsoft being regarded as an AI leader and reported Azure cloud growth of percentages in the mid-twenties being superior compared to its peers.
That is about the good news as the strength and diversification makes Microsoft a long term hold in any portfolio, but at 33 times earnings with topline sales growth in line with inflation here, I still cannot make myself to commit more capital here, amidst many moving parts.
Reiterating A Cautious But Upbeat Stance
Given the discussion above, in which I have great respect for Microsoft and see a long-term rosy outlook for the business, I still have the issue that the valuation simply is too rich for me.
With AI set to drive an investment cycle and not likely resulting in strong earnings growth in the near term, I am cautiously waiting for a better entry levels as the “magnificent 7” or the wider technology group has seen quite some outperformance lately. This makes me a patient buyer in case of an unexpected sell-off, or stagnation in the shares.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.
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