Does Microsoft Have A Healthy Balance Sheet? Is The Stock A Good Buy?
Contributor since 2012 / 10496 Followers
Summary:
- Microsoft has a healthy balance sheet considering its significant cash position, and its good solvency and liquidity financial ratios.
- The company has gained meaningful traction in AI judging by specific metrics relating to its Q3 FY 2023 results and Q4 FY 2023 guidance.
- MSFT is a good buy, as the company’s strong financial position provides it with the capacity to invest in new growth areas such as AI.
Jean-Luc Ichard
Elevator Pitch
I have a Buy investment rating for Microsoft Corporation’s (NASDAQ:MSFT) stock.
My earlier February 6, 2023 update for MSFT focused on Microsoft’s income statement, or more specifically the company’s “revenue predictability” and “strong profit margins.”
I turn my attention to MSFT’s balance sheet in this current write-up. Microsoft’s financial position is sufficiently strong to provide support for the company’s AI investment plans, and this bodes well for MSFT’s long-term growth potential. Therefore, I choose to reiterate my Buy rating for Microsoft.
MSFT Stock Key Metrics
There are three key metrics disclosed as part of Microsoft’s recently announced Q3 FY 2023 (YE June 30) financial results that are worth your attention.
MSFT’s first key metric is interest income. Microsoft’s interest income grew strongly by +44% YoY from $519 million in the third quarter of fiscal 2022 to $748 million for the most recent quarter, thanks to its strong financial position ($104 billion of cash and short term investments as of March 31, 2023). The larger than expected increase in interest income was a key factor driving MSFT’s +10% earnings beat for Q3 FY 2023. Looking forward, Microsoft guided at its Q3 FY 2023 earnings briefing in late April that “interest income is expected to more than offset interest expense” for Q4 FY 2023, leading to other income of $300 million in the coming quarter.
The second key metric for Microsoft relates to the company’s progress in capitalizing on growth opportunities in Artificial Intelligence or AI. At the company’s recent third quarter earnings call, MSFT revealed that the number of Azure OpenAI Service customers jumped by 10 times on a QoQ basis to over 2,500 in Q3 FY 2023. Moving ahead, the company is guiding for a +26%-27% YoY increase in revenue (on a constant-currency basis) contributed by Azure and other cloud services for the final quarter of fiscal 2023. Notably, MSFT expects AI-related services to account for 1% of Azure’s Q4 FY 2023 top line growth.
Microsoft’s third key metric is associated with the company’s allocation of capital to investments. Capital expenditures for MSFT increased by +15% QoQ to $7.8 billion in Q3 FY 2023, and are expected to continue rising in the near term. Microsoft sees “a material sequential increase” in capital expenditures for Q4 FY 2023 “driven by investments in Azure AI infrastructure” as per the company’s management comments at the Q3 FY 2023 results call.
In summary, Microsoft’ capital expenditures are growing due to AI-related investments, and it is assuring to know that MSFT has a substantial cash pile. In the subsequent sections of this article, I delve deeper into Microsoft’s financial health, balance sheet, and financial position.
What Is The Financial Health Of Microsoft?
Microsoft’s financial health is good, judging by short term liquidity and long term solvency ratios taken from S&P Capital IQ.
The company’s current ratio and quick ratio were reasonably good at 1.91 times and 1.66 times, respectively as of March 31, 2023. This suggests that MSFT has no short term liquidity issues, as its short term assets exceed its short term liabilities by a wide margin.
MSFT’s negative cash conversion cycle was -8 days for Q3 FY 2023, which is calculated by summing up receivable days and inventory days and deducting payable days. A negative cash conversion cycle implies that Microsoft is receiving cash from customers faster than it takes to pay its suppliers or vendors, which boosts the company’s free cash flow generation.
Long term solvency isn’t a significant risk factor for Microsoft considering its leverage and coverage metrics. MSFT’s gross debt-to-equity and gross debt-to-capital ratios were reasonably comfortable at 40.7% and 29.0%, respectively as of end-Q3 FY 2023. Also, Microsoft’s trailing twelve months’ interest coverage ratio (EBIT divided by interest expense) was as high as 39 times.
Does Microsoft Have A Good Balance Sheet?
I deem a company to have a good balance sheet if it is sufficiently cash-rich that provides the financial flexibility to invest in tough times, and Microsoft fits the bill.
As mentioned earlier, Microsoft has cash and short term investments amounting to $104 billion as of end-Q3 FY 2023. This is equivalent to more than half of its annual revenue (using FY 2022 as a reference) or close to 5% of its current market capitalization.
Even if adjusted for debt, MSFT’s net cash balance as of March 31, 2023 is still substantial at approximately $25 billion.
Is Microsoft In A Strong Financial Position Now?
MSFT is in a strong financial position, taking into account downside risks and upside optionality as detailed in the preceding two sections.
Downside risks related to liquidity and solvency are limited for Microsoft. MSFT’s current ratio is well above 1.0, and the company boasts a negative cash conversion cycle indicating a low degree of short-term financing risks. Microsoft’s financial leverage ratios are pretty low, and it should have little trouble serving its interest payments.
With regards to upside optionality, financial strength supported by a meaningful cash position allows a company to engage in counter-cyclical investing which is typically very rewarding. In the current environment where the economy is weak and financing is tough due to high interest rates, cash-rich companies such as Microsoft have the opportunity to make value-accretive investments unlike their peers and competitors which are constrained by high financial leverage and weak balance sheets.
In a nutshell, Microsoft’s financial position is strong, and this is positive for the company’s prospects in the long run as discussed in the next section.
What Is The Long-Term Outlook?
Microsoft’s healthy balance sheet has a favorable impact on its long-term outlook.
In my prior article for MSFT, I cited research from Barclays (BCS) estimating that the “global AI-based application software revenue will double from $400 billion in the prior year to $800 billion by 2026.” Microsoft’s management comments at the most recent quarterly earnings call are aligned with the sell-side’s forecast of the growth potential for AI. At its Q3 FY 2023 results briefing, MSFT stressed that it is “investing to lead in the new AI wave” and “expanding our TAM (Total Addressable Market). Microsoft also emphasized that it has “a good lead” in the AI segments it is operating in, as a result of “our differentiation (e.g. OpenAI partnership) at the very start of a cycle.” In an earlier section of this article, I highlighted Azure OpenAI Service client growth and AI services’ contribution to Azure’s overall top line expansion as signs indicative of MSFT’s AI leadership.
According to a December 16, 2022 article titled “Planning For 2023” published by McKinsey, a study of more than a thousand US- and Europe-listed companies found that the degree of financial optionality was the key factor that separated outperformers and underperformers during the Global Financial Crisis. Specifically, McKinsey’s study suggested that companies boasting higher retained earnings, a stronger working capital position and lower financial leverage as compared to their peers delivered superior total shareholder returns for the 2007-2011 period. It is reasonable to expect that Microsoft will emerge stronger from this current economic downturn vis-a-vis other companies, thanks to MSFT’s financial strength which enables it to invest aggressively in the new big long-term growth opportunity, AI.
Is MSFT Stock A Buy, Sell, Or Hold?
MSFT stock continues to warrant a Buy rating based on my analysis. Microsoft’s balance sheet health is supportive of the company’s ability to invest for the future, which explains why I continue to rate MSFT as a Buy.
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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