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Since hitting an all-time high of $349 in November, the share price of Microsoft Corporation (NASDAQ:MSFT ) has fallen 25%. A variety of macroeconomic issues are casting doubts on the company’s prospects. And late last week, the stock took a hit when management cut the company’s revenue and earnings outlook for the fourth-quarter.
However, investors should also consider that for 12 consecutive quarters, MSFT has beaten analysts’ revenue and earnings forecasts, and over the past 12 months, Microsoft has churned out $63.6 billion in free cash flow,
Yes, there are a number of headwinds facing this giant tech company, but there are also areas of robust growth to be considered.
One reason for the drop in Microsoft’s stock is that big tech companies, the darlings of Wall Street for many a year, have fallen out of favor. The Nasdaq Composite is down roughly 24% this calendar year. Call it guilt by association.
However, one lingering concern for prospective investors in MSFT is the supply chain issue resulting from China’s sweeping COVID related lockdowns.
It has been one step forward, two steps back for MSFT as the company made headway after the first round of restrictions. The supply chain problems could strike Microsoft on two fronts: sales of Microsoft’s Xbox and Surface devices could be affected, and PC manufacturers that use Microsoft Windows are facing a shortage of chips to produce their own products.
Next, we have taken into account the current impact of shutdowns in China in our outlook. However, extended production shutdowns that reach into May would further negatively impact our outlook across Windows OEM, Surface, and Xbox hardware.
The current macroeconomic climate, as well as the sense of uncertainty that prevails, is leading some investors to fear that Microsoft’s customers could cut back on technology spending. If a recession strikes, the firm’s Bing search engine and LinkedIn professional networking website would suffer, as advertising revenues are closely tied to consumer spending.
Another series of negative headlines that might weigh on sentiment is the revelation that MSFT lost a significant percentage of the employees the company has dedicated to the development of HoloLens. In the nascent battle to become the dominant metaverse company, over 100 of Microsoft’s HoloLens team members deserted, with 40 going to work for rival Meta (FB).
Although Microsoft’s latest earnings beat estimates, even that was a sample of how good news can be bad news. Q3 resulted in the smallest revenue beat since 2018, besting estimates by a hair. Throw in the fact that sales and marketing expenditures increased at the fastest pace in over three years, rising 10% higher than the year-ago quarter, and you have reason for some to pause.
All of these are legitimate concerns that are being weighed by investors; however, late last week, the stock took an additional hit when Microsoft’s management provided updated guidance for the closing quarter of FY22.
Last May, management guided for a negative impact due to foreign currency headwinds. It was estimated that exchange rates would cut total revenue by 2%. The firm’s intelligent cloud and personal computing segments were expected to take a similar 2% cut while the productivity and business process segment would suffer a 3% blow to revenue.
Flash forward to last week. Due to the strong dollar, Microsoft lowered its Q4 EPS forecast from a range of $2.28 to $2.35 per share to $2.24 to $2.32 per share. Likewise, the estimate for Q4 revenue is now in a range of $51.94 billion to $52.74 billion versus the previous $52.4 billion to $53.2 billion.
The Productivity and Business Processes segment is expected to take a $170 million hit to revenue, Intelligent Cloud $180 million, and More Personal Computing $110 million. Along with other factors, management expects a negative impact on net income of roughly $250 million, and a cut in EPS of $0.03.
The news resulted in the shares dropping more than 2% pre-market on Thursday, and the stock was down nearly 1.7% for the week when the market closed on Friday.
While the news wasn’t welcome, investors need to keep in mind that the update means MSFT is still expected to record 13% year-over-year sales growth.
Way back in 2014, my first article on Microsoft was published. The company was out of favor, and the stock traded for a bit over $37 a share That was well below its all time high, set at the turn of the century, of around $52. I rated the stock as a buy, and Microsoft's total return since that article debuted is approaching 750%.
2014 was also the year Satya Narayana Nadella became the CEO of MSFT. Nadella focused on Microsoft’s fledgling cloud business, transforming it into the company’s primary source of growth. To understand the full impact the cloud has had on the company, consider this: from FY14 through FY21, Microsoft's revenues increased at a compound annual growth rate (CAGR) of 10%, while EPS recorded a CAGR of 17%. However, commercial cloud only generated 5% of the company’s revenue in 2014. By 2021, 41% of MSFT’s revenue flowed from the cloud business.
Furthermore, while the cloud market is growing at a rapid pace, MSFT is slowly but surely increasing its market share.
It is as sure a bet as one can find that the global cloud computing market will grow markedly for the foreseeable future and that Microsoft will be a major player in that market’s expansion. Research from Fortune Business Insights forecasts a CAGR for the cloud market from 2021 through 2028 of 17.9%.
The clarity associated with the growth path the cloud provides is one reason why investors are willing to accumulate shares of Microsoft even as it sports a P/E ratio well above the market’s norm.
A second, under the radar source of growth lies in the size of Microsoft’s security business. Last January, for the first time Microsoft revealed both the size of that division as well as its growth. Satya Nadella told analysts annual revenues from security had hit $10 billion and that the business had notched a 40% growth rate.
This took a number of observers by surprise. Andrew Rubin, the CEO of Illumio, a business data center and cloud computing security company, remarked that, “Nobody had any idea it was a $10 billion business.”
That perspective was echoed by Mizuho Securities analyst Gregg Moskowit. He believed Microsoft’s security business was worth somewhere between $5 billion to $10 billion.
Gartner estimates Microsoft controls around 8.5% of the global security software market. That would make it the largest company in that field. With a single digit market share, it is reasonable to believe that Microsoft has room for growth in that arena.
Another area where MSFT may see outsized growth lies in the gaming industry. I provided an in-depth assessment for the company’s gaming prospects in my recent article covering the Activision Blizzard (ATVI) acquisition.
As I outlined in that piece, Microsoft’s proposed Activision deal, which reinforces the firm’s acquisition of Xandr, is the largest in the company’s history. Microsoft is pivoting hard to expand deeper into gaming, and the strategy is to shift gaming onto the cloud.
Should this initiative pick up momentum, no other company can come close to matching their advantage, as they are a dominant cloud provider. Count me as one who believes the company’s strategy will succeed, and that it offers a real opportunity to drive growth. The fact that as of the last earning report, Azure gaming was up 66% this fiscal year, lends support to my perspective.
If a picture is worth a thousand words, at times the utterances of a CEO might be worth a thousand dollars. Please entertain the unorthodox method I will use to highlight both the manner in which Microsoft is growing and the company’s potential to expand into a variety of markets. The following excerpts are taken from the most recent earnings call. In each case, I am quoting CEO Satya Nadella.
The number of $100 million-plus Azure deals more than doubled year-over-year. And we’re seeing consumption growth across every industry, customer segment, and geography.
The number of companies using skills filters on LinkedIn to fill open roles has doubled year-over-year. In this dynamic labor market, hires on LinkedIn has increased 88%.
The number of use cases is increasing as is the amount of time spent on PCs. More than 100 million PCs have shipped in each of the last eight quarters, and Windows continues to take share.
…the number of Windows, Android, and iOS devices protected by Intune grew over 60% year-over-year. And we’re expanding to new market segments…driving our overall growth. All up, the number of customers who trust our security solutions grew nearly 50% year-over-year to 785,000…
In AI, we continue to see strong usage of Azure Machine Learning. The number of monthly inference requests increased 86% year-over-year, with companies like PepsiCo using the service to predict which products are most likely to sell.
Microsoft is one of only two publicly traded companies with a AAA credit rating from Standard & Poor's.
MSFT currently trades for $268.75 a share. The average 12-month price target of the 30 analysts rating the stock is $355.61. The 14 analysts that rated MSFT following the last earnings report have an average price target of $346.07.
MSFT has a P/E ratio of 28.73x, very near the company’s 5-year average P/E of 28.84x. The company’s 5-year PEG ratio is 1.81x, this is significantly below the average PEG ratio for the last five years of 2.22x.
The current yield is 0.92%, the annual payout ratio is 26.48%, and the dividend’s 5-year growth rate is 9.60%.
Over the last year, I’ve authored five articles that focused on Microsoft. On each occasion, I rated the stock as a hold. I should add that if there is anything the current market should reinforce in the investment community, it is that even the best stocks eventually sell off, and patience can be a well rewarded virtue.
However, Microsoft is such a high caliber company, that it can present a quandary for even veteran investors.
In my estimation, all of the headwinds I enumerated in this article are transitory in nature. In fact, unlike the overwhelming majority of investments, there is really no strong negative to consider. Meanwhile, all of the positives, the fact that MSFT is one of only two publicly traded firms with a AAA debt rating, that the cloud is a robust avenue for growth that will continue to drive revenues for the foreseeable future, the understanding that the company has a number of other divisions that are likely to contribute growth, these all mean the only real concern is the stock’s current valuation.
In other words, there is a problem we face with the tiny handful of companies of Microsoft’s caliber. It will be a rare day indeed when our fellow investors allow the highest quality stocks to trade at bargain level prices. Consequently, I maintain that the only real concern is Microsoft’s current valuation.
In terms of its current P/E ratio, MSFT is not a bargain. However, when considering the 5-year PEG, the stock is trading at a valuation metric that is significantly below the norm for the company. When I take that into account, as well as the continued growth prospects for MSFT, I rate the stock a BUY.
I will add that I don’t view this a “back-up-the -truck” valuation level. Rather, I think it is a good time to initiate a small position or to add incrementally to a current position. However, an additional 10% drop in the share price would convince me to increase my investment in MSFT significantly.
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This article was written by
As of 07/01/2022 I am rated among the top 1.4 % of authors in terms of overall results. This is according to TipRanks, which provides a 60% success rate and an average 17.5% annual return for my articles. (I update this score on at least a quarterly basis for readers.)
My primary focus is dividend bearing stocks; however, I also invest in some high growth names to boost my total return.
I am a value / buy and hold investor. Since I require a discount in the share valuations of my investments, my ratings are generally very conservative. My valuation requirements, combined with the high quality companies that I often highlight, mean many stocks I rate as a hold perform well over the long term. Readers should consider this when weighing my buy/hold/sell recommendations. I seek a degree of safety in my investments by focusing on companies with competitive advantages and reasonable to strong balance sheets.
I am a retail investor, with no formal training in investing.
I am a graduate of the U.S Army Ranger school and a former member of the 1st Ranger Battalion and The Old Guard (U.S Army Honor Guard.) I am a retired law enforcement officer. I have approximately 20 years experience as a retail investor.
Best of luck in your investments, Chuck
Disclosure: I/we have a beneficial long position in the shares of MSFT, FB 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 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. Although I endeavor to provide accurate data, there is a possibility that I inadvertently relay inaccurate or outdated information. Readers should consider their own unique investment profile and consider seeking advice from an investment professional before making an investment decision.