SI360 Investing – MSFT – 2018-12-14

Microsoft Corporation – Growth Opportunities, but high Valuation

Microsoft Corporation (MSFT) as one of the largest Market Cap in the world. It recently surpassed AAPL (at least for a few days) and it also challenges AMZN for the top spot in Market Cap. It is fair to say that investors who bought in during the 1980’s have benefited tremendously from the growth of this company.

Even if the stock price remained quite flat between 2003 to 2012, the company has managed to regain its momentum since 2013.

Let’s now discuss if MSFT is a good investing opportunity for long-term investors.

Financials

MSFT managed to produced solid revenue growth between 2013 and 2018:

Revenues

   -Increased from $77.9B in 2013 to $110.4B in 2018

   -Growth rate of 7.2% between 2013 and 2018

Net Income

   -Decreased from $21.8B in 2013 to $16.5B in 2018

   -Growth rate of -5.5% between 2013 and 2018

Net Margins

   -Decreased from 27% in 2013 to 15% in 2018

   -On track for Net Margins of 16% in 2019

While Revenue grew at a compound rate of 7.2% between 2013 and 2018, net income shrank. Net Margins have dropped by close to 10% during the period. At first, these numbers do not look good. However, MSFT is spending more on its R&D programs. And just like other american giants, they are putting in large amounts for Income Tax Provision. For 2018 alone, they had a Provision for Income Tax of close to $20B. It looks like the company is moving funds back to the USA.

Income before tax were $36.4B in 2018 compared to $23.1B in 2017. This is a solid 57% increase y-o-y. This means that if we look past Tax Provisions, the company has managed to increase its operating income dramatically during the last few years. We will discuss this topic in the next section.

The company’s Balance Sheet is solid. With a current ratio of 2.9, the company has its debt covered quite easily.

The Cash Flow Statements also look good. The company generated more than $43B of positive cash flow in 2018 from its operating activities.

Discussion and Outlook

In the previous section, we have noted that MSFT has managed to grow its Operating income (before tax) by a substantial margin. One of the key driver behind this is that MSFT has migrated during the last few years from selling its products on CDs to selling subscription plans. They now sell their products via downloads and monthly and /or annual subscription fees.

In a previous blog, I have pointed out that this new business model has provided solid results for Adobe inc. (ADBE). Itseems like MSFT is also managing high margins from this strategy.

Let’s now look at MSFT growth opportunities during the next 5 years.

Cloud Solutions

Analysts are putting a lot of fate into MSFT Cloud Services. The list of products and services offered on Microsoft Azure is impressive. From analytic tools, to SQL database and storage, clients can purchase MSFT solutions for their needs.

And since most of its products are now offered via download, we can expect that MSFT will be able to generate higher margins than when they were selling their products through retail stores. It will be interesting to see how much MSFT can grow this segment in the next 3-5 years. This business segment will certainly be the main driver in terms of sales in years to come.

Artificial Intelligence

It may take years before AI becomes a profitable industry. But when it will, MSFT will be part of it. It is most likely impossible to evaluate what will be the worth of the AI industry in 10 years, and how profitable it will be. But odds are that MSFT will benefit from it.

Automotive– Self-Driving Cars

There are a bunch of large cap companies who are currently working on driverless cars. MSFT is involved with various car makers in the development of a self-driving car that could be on the market during the next decade.

Its looks like MSFT is working on partnerships, and its current involvement is to develop the operating systems for car makers. Again, this is a market that will develop itself in years to come. There are plenty of growth opportunities (and R&D costs) for those who wish to succeed.

Emerging Countries

MSFT provides some of the most widely use software for PCs. From MS Office to Windows, it is fair to believe that as Emerging countries are catching up to the West with the latest technologies, more and more citizens from these countries will have access to a PC. More PCs should equal to more licenses sold by MSFT.

Valuation

Now that we have discussed the Financials and Growth Opportunities for MSFT, we must discuss the company’s valuation. As we have stated in the introduction, MSFT has one of the largest Market Cap on the market.

Its stock is currently selling at a market price of $108.23 / share. Here are some valuation ratios:

   -Price-Earning Ratio (PE): 44.7

   -Expected Growth Rate (next 5 years): 13.7%

   -PEG Ratio: 3.26

It is true that MSFT is an amazing company, and it has various  opportunities in years to come to grow its business. However, its current valuation is a bit high. We like to see PEG ratio below 2, and PE ratio around 20, not more than 30.

It is true that if we compare MSFT with some of its peers, MSFT has a better PEG ratio than the likes of IBM or Oracle. However, some other stocks, like ADBE, offers a better Price-to-growth ratio than MSFT.

The risk with MSFT valuation is that since we are in a quite volatile market, it would not take much to see its Price-Earnings ratio reduced. One earnings miss, or reduced forecasts from upper management, could have a negative impact on the company’s valuation.

Conclusion

Microsoft Corporation is an amazing company. Its shift to Cloud services have improved the company’s operating margins, and have provided momentum for the growth of its business. The company also have growth opportunities in the AI industry, Self-Driving Cars, and in the PC markets of emergent countries.

MSFT stock price has survived the latest market sell-off, most notably of tech stocks. However, given the volatility of the markets, and the above market valuation of MSFT stock, long-term investors should:

   -Wait and see how the market will react during the first half of 2019

   -Wait for an opportunity to purchase MSFT stock at a lower Price-Earning

   -Find alternative investing opportunities

At this time, there are alternative investing opportunities in this industry with more attractive valuation and growth potential.

Disclaimer:The author and SI360 portfolio do not own shares of MSFT, and do not intend to initiate a position in the following month.