Company Overview
Microsoft (Ticker Symbol — MSFT) develops and licenses consumer and enterprise software. It is known for its Windows operating systems and Office productivity suite.
The company is organized into three overarching segments:
Productivity and business processes:
- legacy Microsoft Office
- cloud-based Office 365, Exchange
- SharePoint, Skype, LinkedIn, Dynamics
Intelligence cloud
- Azure
- Windows Server OS
- SQL Server
Personal computing
- Windows Client
- Xbox
- Bing search
- Display advertising
- Surface laptops, tablets, and desktops
Through acquisitions, Microsoft owns Xamarin, LinkedIn, and GitHub.
My Investment Thesis
Key Performance Indicators:
- Cash Flow Growth — DCF method
- Consistent Dividend Growth
- Growing market Share — Revenues Growth
- EPS Growth
- Low Debt to Equity Ratio — Respective of the industry
- ROE, ROA, ROIC growth
- Owner’s Earnings Growth
Competitive Advantages
Microsoft has a well-established ecosystem which creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. They establish significant scale in the marketplace, which is necessary to achieve and maintain attractive margins.
Microsoft has a dominant position in the desktop PC market, with its operating systems being used in the majority of PCs worldwide. This is particularly true of the enterprise where the company generates much of its revenue and profits. Across all platforms, the Windows OS has a market share of 35.83%(77% in Desktop integration) — May 2020.
Microsoft’s advantages in this respect are two-fold. First, the company has a very large installed base of Office users. Most legacy data are based on Office, so enterprises are usually reluctant to use other productivity solutions. Second, the Bring Your Own Device (BYOD) model is dependent on security and cloud integration, both of which are Microsoft’s strengths. As a result, Microsoft has been largely successful at retaining enterprise customers, which holds promise.
To further emphasize Microsoft’s strength in cloud computing, Azure revenues surged 61% at constant currency on a year-over-year basis in third-quarter fiscal 2020, driven by robust growth in consumption-based business.
Moreover, ongoing expansion in Microsoft Teams subscriber base is aiding the company in strengthening position in the enterprise communication market against Slack and Zoom. Out of Fortune 100 companies, 93 have implemented Microsoft Teams. Notably, Microsoft Teams boasts of more than 75 million daily active users, up from 20 million daily active users in the prior quarter. The uptick can be attributed to coronavirus-led work-from-home, stay-at-home, telehealth and online learning wave.
Management execution has been good in recent times. This has helped Microsoft build cash and short-term investments balance of $137.63 billion as of Mar 31, 2020, up from $134.25 billion from the previous quarter. As of Mar 31, 2020, total debt (long-term plus current portion) came in at $73.86 billion compared with $76.8 billion at the end of the prior quarter. This translates to a net cash position of $63.77 billion as of Mar 31, 2020, compared with $57.45 billion at the end of the prior quarter. The strong cash balance provides the flexibility required to pursue any growth strategy, whether by way of acquisitions or otherwise.
I believe efforts to reward shareholders through share buybacks and dividend payments deserve a special mention. In the fiscal third quarter, the company returned $9.87 billion to shareholders in the form of share repurchases and dividends. Also, the company reported operating cash flow of $17.5 billion in the third quarter of fiscal 2020, compared with $10.7 billion reported in the previous quarter. Free cash flow came in at $13.7 billion, compared with $7.1 billion reported in the prior quarter. The increasing cash flow trend reflects that the company is making investments in the right direction and is expected to help it sustain current dividend payout (0.36) level at least in the near term.
Cons
My immediate concern about Microsoft is regarding the softness in the core computing market. The company is dependent on this market for the largest chunk of its revenue. Microsoft continues to be impacted by the tablet and mobile cannibalization of computers. This is a secular negative for the company and the future growth of Windows is greatly dependent on its ability to build position in mobile devices, particularly tablets. Moreover, stiff competition from Android and Chrome at multiple price points with Apple making things difficult at the high end, remain a headwind.
Microsoft is the dominant provider of operating systems into the PC market. So, any new player, or any technology advancement in the space, unless by Microsoft itself, results in market share erosion. While Google Chromebooks/ Android tablets and Apple Macintosh/iPad are splitting the market, Microsoft’s opportunity lies in its ability to transition rapidly to a cloud and mobile focus. To date, the sales of many Microsoft products are tied to the attach rates of its Windows OS, but as more of its products are made available under an as-a-service model (like Office 365) on even competing platforms, there can be new revenue streams compensating for the loss of Windows licensing fees. The transition period is not likely to be easy and execution will be key.
Microsoft is seeing increased competition from all quarters. Particularly, Google seems to be present in all its markets. Although Google’s focus has in the past been on search and online advertising, while Microsoft’s has been on selling its software, the two companies are increasingly pitted against each other because of the conditions in the market. Google is seeing tremendous success, with its Android OS emerging as the leading platform for smartphones and increasingly, tablets. Its Chromebooks are also seeing a good deal of success. Moreover, Apple’s Macintosh has a loyal customer base, which is an additional pressure in the high-end computing market, while its iPads are tough competition in the tablet segment. Although Microsoft’s Azure has been steadily gaining market traction for quite some time now, but Amazon’s cloud computing arm, Amazon Web Services, leads the cloud computing space, which is a major headwind. Also, the gaming console market is also extremely competitive since Sony and Nintendo are equally strong. Moreover, there is severe price competition in this market and successful gaming titles are a must in order to push sales.
I note that the Microsoft currently has a trailing 12-month Price/Earnings (P/E) ratio of 35.44X. This level compares unfavorably to some extent with what the industry saw over the last year. Additionally, the ratio is higher than the average level of 29.69X and is near the high end of the valuation range in this period. Consequently, valuation looks slightly stretched from a P/B perspective.
Intrinsic Value Assessment
To determine the Intrinsic Value of MSFT I used the Discounted Cash Flow (DCF) method. DCF uses MSFT’s Free cash flows, which represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets and estimates the value of the investment to project it’s future cash flows and justifies the price I pay now for this expected return.
MSFT’s average Free Cash Flow(FCF) over the past ten years is $27738. I conservatively expect MSFT to grow their FCF at a rate of 5% and grow at a rate of 3% into perpetuity.
With these numbers in mind, MSFT’s intrinsic value per share is $220.00 at a 5.00% annual discount rate. Based on the cash flows I have forecasted and a market price of $196.33, MSFT may yield a 5.23% annual return — Not taking dividends into account.
Dividend Growth
This is important as it shows discipline within management and compensates the stockholder for trusting the company with their money. An excessive offload of profits to investors via dividends can signal a loss of vision within management and their inability to seek growth. No dividends can also be destructive as holding onto profits might lead to excessive executive compensation, sloppy management, and unproductive use of assets. For the average investor, the money they have in the stock can be seen as more trustworthy when it makes its way into the shareholders pocket.
This is the historical payout ratio of Microsoft Corp. If payout ratio is close to or higher than 100%, dividends might not be sustainable.
This is the historical trailing annual dividend yield of Microsoft Corp. Buying stocks at higher yield relative its historical values is usually more profitable.
Revenues Growth
Personal Computing segment, which primarily comprises Windows, Gaming, Devices and Search businesses, contributed 31.4% to total revenues. Revenues were up 3% (up 4% at cc) year over year to almost $11 billion.
Windows revenues increased 5.6% to $5.22 billion backed by growth in Windows Commercial. Windows commercial products and cloud services revenues increased 17% year over year.
Windows OEM pro revenues improved 5% on a year-over-year basis. Increase in demand from remote work and online learning wave also contributed to the upside. However, supply chain constraints in China limited growth.
Surface revenues improved 1% from the year-ago quarter to $1.34 billion, driven by remote work and online learning-led demand increase.
Gaming revenue decreased 1% to $2.35 billion. Xbox hardware revenue declined 20%, owing to a decrease in price of consoles sold. Xbox content and services revenue increased 2% year over year. The increase was driven by increased engagement led by stay-at-home wave.
Intelligent Cloud segment, which includes server, and enterprise products and services, contributed 35.1% to total revenues. The segment reported revenues of $12.28 billion, up 27% year over year.
Server product and cloud services revenues rallied 30% year over year to $10.49 billion. The high point was Azure’s revenues, which surged 59% year over year, driven by robust growth in consumption-based business.
On-premise server products revenues increased 11%, driven by customer demand for hybrid solutions, and premium server versions. Further, robust demand from end of support for Windows server 2008 was a positive.
Further, enterprise mobility installed base revenues improved 34% to more than 134 million seats, driven by continued benefit from Microsoft 365.
Moreover, enterprise service revenues increased 6% in the reported quarter, on account of growth in Premier Support Services. However, delays in consulting limited growth.
Productivity & Business Processes segment, which includes the Office and Dynamics CRM businesses, contributed 33.5% to total revenues. Revenues increased 15% on a year-over-year basis to $11.74 billion.
Office Commercial business (products + Microsoft 365 & related cloud services) revenues were up 13% from the year-ago level. Office 365 commercial revenues climbed 25%, driven by strong installed base growth and average revenues per user (ARPU) expansion. Office 365 Commercial seats improved 20% to nearly 258 million, driven by improving mix from Microsoft 365.
Office Consumer products and cloud services revenues increased 15% driven by growth in Office 365 subscription revenue and Office 2019. Office 365 Consumer subscribers came in at 39.6 million, up from 37.2 million reported in the prior quarter, benefiting from the coronavirus crisis-led increased demand courtesy of work-from-home wave.
Dynamics business improved 17%. Dynamics 365 revenues surged 47%. Dynamics adoption is improving with companies like C3.ai, Patagonia and American Express, selecting the application to securely digitize critical business processes.
LinkedIn revenues advanced 21% from the year-ago quarter to $2.05 billion. LinkedIn sessions were up reflecting acceleration in engagement. However, slowdown in advertising limited growth.
Microsoft is gaining from expanding user base of different applications like Microsoft 365 and Teams. Both solutions continue to witness record adoption. Notably, Microsoft Teams boasts of more than 75 million daily active users, up from 20 million daily active users reported in the prior quarter. The uptick can be attributed to coronavirus-led work-from-home, stay-at-home, telehealth and online learning wave.
Windows 10 has more than 1 billion monthly active devices, up 30% on a year-over-year basis, with significant demand for Windows 10 PCs.
Low Debt to Equity Ratio — Respective of the industry
Debt-to-Equity of MSFT is ranked lower than 75.31% of 1750 companies in the Software industry. Industry Max: 432.2, Med: 0.2, Min: -146.67 and MSFT is 0.65.
Microsoft’s Short-Term Debt & Capital Lease Obligation for the quarter that ended in Mar. 2020 was $3,748 Mil. Microsoft’s Long-Term Debt & Capital Lease Obligation for the quarter that ended in Mar. 2020 was $70,110 Mil. Microsoft’s Total Stockholders Equity for the quarter that ended in Mar. 2020 was $114,501 Mil. Microsoft’s debt to equity for the quarter that ended in Mar. 2020 was 0.65.
A high debt to equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.
During the past 13 years, the highest Debt-to-Equity Ratio of Microsoft was 1.24. The lowest was 0.00. And the median was 0.20.
Because a company can increase its ROE % by having more financial leverage, it is important to watch the leverage ratio when investing in high ROE % companies.
ROE Growth
ROE % is calculated as Net Income attributable to Common Stockholders (Net Income minus the preferred dividends paid) divided by its average Total Stockholders Equity over a certain period of time. Microsoft’s annualized net income attributable to common stockholders for the quarter that ended in Mar. 2020 was $43,008 Mil. Microsoft’s average Total Stockholders Equity over the quarter that ended in Mar. 2020 was $112,305 Mil. Therefore, Microsoft’s annualized ROE % for the quarter that ended in Mar. 2020 was 38.30%.
During the past 13 years, Microsoft’s highest ROE % was 44.84%. The lowest was 14.36%. And the median was 28.80%.
MSFT’s ROE % is ranked higher than 96% of the 1970 Companies in the Software industry.
ROE % measures the rate of return on the ownership interest (shareholder’s equity) of the common stock owners. It measures a firm’s efficiency at generating profits from every unit of shareholders’ equity (also known as net assets or assets minus liabilities). ROE % shows how well a company uses investment funds to generate earnings growth. ROE %s between 15% and 20% are considered desirable.
ROA Growth
ROA % is calculated as Net Income divided by its average Total Assets over a certain period of time. Microsoft’s annualized Net Income for the quarter that ended in Mar. 2020 was $43,008 Mil. Microsoft’s average Total Assets over the quarter that ended in Mar. 2020 was $284,122 Mil. Therefore, Microsoft’s annualized ROA % for the quarter that ended in Mar. 2020 was 15.14%.
During the past 13 years, Microsoft’s highest ROA % was 23.77%. The lowest was 6.51%. And the median was 14.21%.
MSFT’s ROA % is ranked higher than 93% of the 2142 Companies in the Software industry.
ROA % measures the rate of return on the total assets (shareholder equity plus liabilities). It measures a firm’s efficiency at generating profits from shareholders’ equity plus its liabilities. ROA % shows how well a company uses what it has to generate earnings. ROA %s can vary drastically across industries. Therefore, ROA % should not be used to compare companies in different industries. For retailers, a ROA % of higher than 5% is expected. For example, Wal-Mart (WMT) has a ROA % of about 8% as of 2012. For banks, ROA % is close to their interest spread. A banks ROA % is typically well under 2%.
Fluctuations in the company’s earnings or business cycles can affect the ratio drastically. It is important to look at the ratio from a long term perspective. ROA % can be affected by events such as stock buyback or issuance, and by goodwill, a company’s tax rate and its interest payment. ROA % may not reflect the true earning power of the assets.
Many analysts argue the higher return the better. Buffett states that really high ROA % may indicate vulnerability in the durability of the competitive advantage.
ROIC Growth
ROIC % measures how well a company generates cash flow relative to the capital it has invested in its business. It is also called ROC %. Microsoft’s annualized return on invested capital (ROIC %) for the quarter that ended in Mar. 2020 was 26.74%.
As of today (2020–07–02), Microsoft’s WACC %(weighted average cost of capital — is the rate that a company is expected to pay on average to all its security holders to finance its assets) is 5.56%. Microsoft’s ROIC % is 28.88% (calculated using TTM income statement data). Microsoft generates higher returns on investment than it costs the company to raise the capital needed for that investment. It is earning excess returns. A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases.
Owner’s Earnings
In 1986 Berkshire Hathaway Shareholder Letter, Warren Buffett defined owner earnings as follows:
“These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in c))…Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since c) must be a guess — and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes — both for investors in buying stocks and for managers in buying entire businesses…All of this points up the absurdity of the ‘cash flow’ numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) — but do not subtract c).”
To make it simple, then you will have:
Owner Earnings per Share (TTM) = (Net Income + Depreciation, Depletion and Amortization + Change In Deferred Tax — 5Y Average of Maintenance Capital Expenditure + Change In Working Capital) / Shares Outstanding (Diluted Average)
Microsoft’s Owner Earnings per Share (TTM) ended in Mar. 2020 was $5.79. It’s Price-to-Owner-Earnings ratio for today is 35.35.
During the past 13 years, the highest Price-to-Owner-Earnings ratio of Microsoft was 80.12. The lowest was 3.14. And the median was 6.16.
MSFT’s Price-to-Owner-Earnings is ranked lower than 62% of the 962 companies in the Software industry.
IN SUMMARY
Microsoft is benefiting from momentum in Azure, outstanding Teams user growth led by way of coronavirus-induced work-from-home wave, uptick in Surface gadgets and substantial demand for Windows 10 PCs. Moreover, the agency is gaining from growing user base of its exclusive applications like Office 365 commercial, and Dynamics. Azure’s expanding client base remains a key catalyst. Furthermore, it is properly poised to increase the total addressable market thru acquisitions of GitHub and PlayFab. Notably, shares have outperformed the industry in the year-to-date period. However, broader macroeconomic weak point and decrease spend on advertising and marketing owing to the coronavirus outbreak are probable to weigh on LinkedIn and Search revenues. Further, delays in consulting enterprise contract renewals and grant chain constraints in China are predicted to limit growth.
