Microsoft: Resiliency Amidst Turmoil Will Be Rewarded

Summary:

• Microsoft sees a tough road ahead – the market yawns.
• The company continues to gush cash and reward shareholders with dividends and share repurchases.
• The company maintains a net cash balance sheet and arguably can eventually take on net leverage.
• The stock is trading at reasonable valuations and multiples may expand on account of the strong performance during difficult times.

Microsoft (NASDAQ:MSFT) is often considered a bellwether for the tech sector and that is evident in its resilient stock price amidst the tech crash. Despite its latest quarter showing decelerating growth and guiding for more of the same, investors have remained loyal – why? It appears that investors are willing to overlook modest growth expectations in the near term on account of the diversified product portfolio, robust cash flows, and generous return of cash to shareholders. MSFT stock may not look obviously cheap, but I expect the ongoing share repurchases and growing dividends to lead to multiple expansion over the long term as the company works through a tough macro environment.

MSFT Stock Price

MSFT stock has fallen slightly from its peak but remains a strong performer over the past few years and decade.

The stock is still not obviously cheap here as solid profits appear to be keeping the stock price afloat. I last covered MSFT in November where I rated the stock a buy due to the resilient fundamentals and the stock has returned 27% since then. MSFT remains a quality play as its best comparables may be stocks outside of the tech sector.

MSFT Stock Key Metrics

The most recent quarter showed that even the giant Microsoft is not immune to macro troubles. Revenue growth came in at just 2% (7% constant currency). It was only a couple of quarters prior that management guided for double-digit revenue growth for the full year.

Operating income declined by 8% and net income declined by 12% in spite of the revenue growth. Yet investors might be looking at those numbers optimistically, as many other tech companies have seen greater margin compression as slowing top-line growth followed over-aggressive headcount growth. Amidst recessionary risks, the takeaway is that earnings did not drop by so much at this company – the company continues to gush cash.

On the conference call, management noted that expense growth mainly came from “investments in cloud engineering, the Nuance acquisition and LinkedIn.” Headcount was 19% higher than a year ago, but grew by less than 1% sequentially. MSFT announced a layoff of 10,000 employees in mid-January.

The biggest detractor from company performance was unsurprisingly from the “more personal computing” segment as the company had benefited from a pull-forward in demand during the pandemic. Windows OEM revenue declined 39% YOY with search revenue being the lone bright star at 10% growth. Management noted that while the number of PCs shipped declined to pre-pandemic levels in the quarter, the usage intensity remains nearly 10% higher than pre-pandemic levels.

Meanwhile, MSFT generated solid 7% growth in “productivity and business processes” which houses its most famous products like Microsoft Office. It is impressive that MSFT continues to sustain double-digit growth (constant currency) in this segment in spite of the large revenue base. This just goes to show the secular tailwinds behind digital transformation of enterprises.

The Intelligent Cloud segment led the way with 18% revenue growth (24% constant currency), driven by 31% growth at Azure. I estimate that Azure is generating around $11 billion in quarterly revenue.

During the quarter, the company returned $9.7 billion to shareholders through share repurchases and dividends in the quarter. That was 11% less than the amount returned a year prior, as the 8.9% growth in the dividend was more than offset by a 27% reduction in share repurchases. While free cash flow was indeed lower in the quarter, in my view the shortfall may have just been timing issues and I’d expect the company to increase its shareholder returns over the coming year, recession or not. MSFT ended the quarter with $99.5 billion in cash, $7.1 billion in equity investments, and $48 billion in debt. Over time, I can see the company not only monetizing that net cash but also utilizing net leverage.

Looking ahead, management expects currency fluctuation headwinds to negatively impact revenues by around 3%. LinkedIn is expected to grow at a mid-single-digit pace as it faces headwinds from a slowdown in advertising and hiring. LinkedIn has significant exposure to the tech sector which has undergone a vicious round of layoffs across the board.

Investors are likely most focused on the outlook for Azure. On the call, management stated that they “exited Q2 with Azure growth in the mid-30s in constant currency” and “Q3 growth to decelerate roughly 4 to 5 points in constant currency.” That implies growth of around 30% on a constant currency basis. Judging by how the stock price has reacted since then, investors seemed to have mostly shrugged off that steep projected deceleration. Altogether, management stated that they might miss their previous guidance for revenue growth (as stated above that they had previously been guiding for mid-teens growth) but expect operating margins to remain very steady. It is clear that management wants Wall Street to focus on the resilient earnings power of the company in spite of the macro backdrop, and it appears that they have succeeded in that task.

Is MSFT Stock A Buy, Sell, or Hold?

At around 30x forward earnings, MSFT might not seem that cheap. However, one must also remember that the S&P 500 is trading at around 21x earnings and MSFT is expected to grow at an above-market pace over the coming years.

Amidst the carnage in the tech sector, it bears reminding ourselves that tech companies possess attractive unit economics as each incremental customer comes with minimal costs. That means that in theory, net income should eventually grow much faster than revenue once operating leverage takes hold.

In the absence of any changes in the valuation multiple, I could see MSFT delivering double-digit returns from here based on projected earnings growth and the roughly 3.3% earnings yield. Yet I could also see some potential for multiple expansion upon a recovery in economic conditions and the tech sector, as the company’s strong financial results during this difficult time may help investors see the company as being closer to a consumer staple in terms of financial stability. For reference, the stocks of Pepsi (PEP) or Coca-Cola (KO) trade at price to earnings growth ratios (‘PEG ratio’) around 5x, a steep premium to the roughly 1.5x PEG ratio that MSFT trades at. One must also consider the company’s recent push to boost their Bing search engine with artificial intelligence. MSFT might earn $2 billion in incremental revenue for every percentage gain in search market share. It is unclear how long it may take for market share gains to take place, if at all, but I wouldn’t be surprised if the mere potential for it proves to be a catalyst for multiple expansion.

What are the key risks? MSFT is trading at some premium to tech peers – Alphabet (GOOGL) for instance is trading at only 20x forward earnings. Yes, one could make the argument that enterprise tech revenues should prove more resilient than online advertising revenues, but in exchange for greater volatility I still expect GOOGL to sustain stronger growth rates over the long term. The uncertain macro environment may cause the company to underperform projected growth, which may call into question the valuation premium as that seems to be assigned based on perceived safety. While the company remains highly profitable and has a net cash balance sheet, it is unclear how the stock will react in the near term following such disappointing news. A potentially underappreciated risk is that of disruption. MSFT seems to be often thought of as a disruptor in enterprise tech, similar with Amazon (AMZN) in e-commerce. The idea is that MSFT is a mega-cap tech company with deep pockets and can overtake any leader in any tech industry that it enters. As someone who closely follows the tech sector, I have a differing opinion than this consensus view – one need only to try comparing the experience of Microsoft Teams versus Zoom Video (ZM) to get anecdotal evidence for why. It is possible that MSFT’s slowing growth rates are not only due to macro pressures but also due to losing market share to more nimble competitors – though at present I find this unlikely as the digital transformation growth story has more legs to it. As discussed with subscribers, I view a carefully chosen portfolio of undervalued tech stocks as being the best way to position for a recovery in the tech sector. MSFT can fit right in with such a portfolio as a higher quality allocation on account of the resilient profitability and GARP valuation.

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Disclosure: I/we have a beneficial long position in the shares of GOOGL, AMZN either through stock ownership, options, or other derivatives. 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 am long all positions in the Best of Breed Growth Stocks Portfolio.

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