The share price of Microsoft (MSFT) has appreciated by 35% over the past 12 months, compared to an 18% return for S&P 500 Index. Despite the significant run-up, I still view the stock to be a solid buy given the reasons discussed below.
Stabilizing PC market
Recent developments have proved that the secular PC market decline has somewhat stabilized. In Q2 2014, Microsoft's PC business declined just 3% year-on-year. Both Lenovo (OTCPK:LNVGY) and Hewlett Packard (HPQ) recently reported better-than-expected PC sales primarily owing to the end of Microsoft's support for Windows XP in April 2014. Intel (INTC) also echoed the trend by beating market expectation for its PC business and citing a strength in consumer desktops. Looking forward, these companies all share a consensus view that the PC sales decline is likely to be moderate in 2014 due to stable consumer demand and some corporate upgrade activities. It is believed that the stabilization trend will materially benefit approximately 40% (in terms of revenue) of Microsoft's businesses that are still tied to consumer and corporate PC markets.
Transition of Business Mix
Management recently changed the company's reporting segment. The revision shows that approximately 60% of the company's revenue and 75% of gross profits are now generated from enterprise-focused businesses which are not affected by the declining PC sales. On the enterprise front, Microsoft has been aggressively pursuing development opportunities in public cloud services market, which Gartner expects will generate $200B revenue by 2016. The company is currently in its early stage of Windows Azure and Office 365 product roll-out. Windows Azure is currently sold as both infrastructure-as-a-service ("IaaS") and platform-as-a-service ("PaaS"), with industry revenue CAGRs from 2011 to 2016 of 42% and 27%, respectively, projected by Gartner. The Office 365 product is being sold as software-as-a-service ("SaaS") with expected industry revenue CAGR of 19%. It is noted that Microsoft's Windows Azure has emerged as a primary competitor to Amazon Web Services ("AWS"), which is currently the leader in cloud infrastructure and platform services market. Given Microsoft's success to date and that the year-on-year growth of its total commercial cloud revenue (including both Windows Azure and Office 365) has accelerated from 103% in Q1 2014 to 107% in Q2 2014, it is my view that the company will eventually capture a significant share in this lucrative market and become much less vulnerable to the declining PC business.
New CEO as A Catalyst
Bloomberg recently reported that the company is preparing to name Satya Nadella as the next CEO. Mr. Nadella is currently the chief of the enterprise cloud business. I view this news as a positive for the company given Mr. Nadella's impressive effort in leading Microsoft's expansion in the cloud services businesses, which is critically important for the company's turnaround. In a recent research note, Deutsche Bank suggested that the new CEO is expected to take on cost-cutting initiative to enhance shareholder value.
Continued Dividend Growth and Share Buyback
Since 2010, management has been raising the dividend per share annually by an average rate at above 20%. The company has also repurchased approximately $6B value of shares in the past 12 months, which represents 2% of the current market capitalization. Given the company's strong cash flow generation (i.e. levered free cash flow margin has been trending consistently above 20% over the past 5 years), I believe the current pace of the dividend growth and share buyback will be sustainable going forward.
Inexpensive Relative Valuations
The price appreciation has narrowed the forward P/E multiple gap between Microsoft and S&P 500 Index from 37% in 12 months ago to 10% at present (see chart below).
Nevertheless, I view the 10% market discount remains exaggerated given that 1) Microsoft's consensus long-term earnings growth estimate of 8.5% is in line with the average (8.7%) for S&P 500 companies; 2) the company has an above-average profitability and cash flow performance; and 3) the stock's 3.0% dividend yield is notably above the S&P 500 average at just 1.9% and the share price is supported by a sizable buyback program. After factoring in the earnings growth potential, Microsoft's 1.6x PEG is at 8% discount to the 1.8x PEG for S&P 500 Index.
In summary, given the stock's discounted relative valuation to market and a few identifiable upside drivers just mentioned, I encourage investors to buy into the current price strength.
All charts are created by the author except for the consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the article and the charts is sourced from S&P Capital IQ unless otherwise specified.