Microsoft (NASDAQ: MSFT) is nearly fifty years old and has been a giant firm for decades. It has defied gravity and the tendency of successful firms to revert toward the mean and eventually get swept aside by capitalism’s gale forces of destruction. Yet, when people talk about the great tech stocks, Microsoft often gets ignored. People will talk about the FAANG stocks, Tesla, Zoom, and many other tech stocks before they settle on Microsoft. This is a mistake.
Microsoft belongs in every tech investor’s portfolio because it gives an investor exposure to cloud and cloud has become secular and noncylical, as the success of cloud companies in 2020 proved.
Microsoft is an important part of the cloud landscape and apart from its PC/Surface and gaming segment, revenues are driven by cloud, and even gaming is shifting to cloud. Microsoft has transformed itself into as close as you can get to a pure play cloud company, as chief executive officer, Satya Nadella has been able to take them. Considering that we are talking about a company valued at over $1.5 trillion, it is incredible to imagine that Microsoft could be on the cusp of meaningful growth.
What makes Microsoft so special is that, whereas cloud software companies operate in fiercely competitive markets where profitability has proven hard to attain, all these cloud software companies rely on cloud infrastructure, cloud infrastructure which Microsoft provides.
Strong Financial Results
Microsoft has steadily grown economic profits over the last few years. Economic profits per share have grown from $1.58 in 2016 to $5.79 for the trailing twelve month (TTM) period. Microsoft has also proven to be a fantastic allocator of capital, increasing returns on invested capital (ROIC) from 28.7% in 2016 to 42.2% for the TTM period.
Microsoft’s free cash flow (FCF) is $39,366 million for the TTM period and its current Enterprise Value is $1,828,610 million. Consequently, FCF Yield is 2.2%. Microsoft’s current Price-to-Economic Book Value (EBV) per share is 2.1. Microsoft’s stock price is $247.86 and its EBV per share for the trailing twelve months is $119.95. The market-implied duration of profit growth (GAP) measures the number of years the company must maintain an edge over its competitors by earning ROIC greater than the weighted-average cost of capital on new investments.
Microsoft’s stock price embeds an unattractive level of market expectations because there is a large difference between the expected financial performance implied by its market price and the company’s historical performance. At Microsoft’s current stock price of $247.86, the market is expecting revenue to grow at 6.7% for the next 20 years. Over this period,MSFT is also expected to generate an average Economic Profit Margin of 40.6%.
Despite strong financial results, the pricing is not yet right for an investor to buy into the company as they would the best dental implants.
The Path to Hybrid Cloud Was Accelerated by Covid-19
In an earning call last year, Nadella argued that Covid-19 had accelerated digital transformation such that Microsoft had experienced as much digital transformation in two months as they had expected to experience in two years. Nadella pointed to the explosion in demand due to the changes that companies were forced to undergo in response to Covid-19.
Current customers deepened their usage of cloud solutions, while also pushing slow-adapters (businesses and industries) to dramatically accelerate their shift to cloud. The slow-adapters, because they were so far back in development, tend towards hybrid cloud solutions, an area in which Microsoft is peerless.
This is why Microsoft has been able to successful rival AWS: it is just superior when it comes to hybrid cloud. This is because of Microsoft’s inherent advantages. When people talk about tech, they often assume that startups and young companies are inherently superior to older tech businesses. This ignores the advantages that come with age. Microsoft emerged in an era in which being available on site was crucial. Consequently, it understands businesses that are slow-adapters and more conservative with respect to digital transformation. These companies are not prepared to migrate overnight, especially those with meaningful intellectual property or security concerns that cannot be addressed by overnight migration. A 2018 survey showed that among the most important reasons for using hybrid cloud solutions were controlling where key data is stored (71%) and the need to use cloud to backup data and for disaster recovery (69%).
Hybrid cloud appeals to businesses who need to keep sensitive data on their own servers, while saving workloads on private or public cloud where they gain from more efficient data mining, greater accuracy and heightened productivity.
This is the heart of Azure’s competitive advantage over AWS and other rivals. It’s a competitive advantage born of Microsoft’s pedigree, not the youthfulness of startups. This is why Azure is used by 95% of Fortune 500 companies.
A Goldman Sachs survey taken before the global health crisis showed that most executives preferred Azure to AWS. Microsoft has been trending up since the bi-annual survey began in 2017. However, Amazon earns 200% more revenue than Microsoft from its cloud infrastructure than AWS.
AWS shines outside the Fortune 500, where it has many loyal users among startups and small-to-medium businesses, as well as with highly scalable, agile firms like Facebook and Netflix.
Microsoft: A Great Company That Every Investor Should Keep an Eye On
