Microsoft: Buy The Dip?

Summary

• With valuation off its peak, bargain hunters will likely appreciate MSFT's 6% pullback in the past month.
• In my view, Microsoft continues to do a great job at transitioning its business model from legacy to high-growth initiatives.
• Yet, I continue to find the stock too pricey to qualify as an enticing buy-on-weakness play.

I have been a long-time skeptic of Microsoft (NASDAQ:MSFT). That's not to say that I don't appreciate the company's prospects in intelligent cloud or the momentum in cloud-based CRM and ERP solutions. But I haven't been quite able to digest the stock's valuation well. Ever since I published my first article on MSFT, in 3Q16, forward P/E has climbed from 18.5x to nearly 24x about 6 weeks ago.

Credit: Tech Central

Bargain hunters, however, will likely appreciate the stock's 6% pullback in the past 30 days. Forward P/E has retreated to 20.6x (see graph below) to trade at the same earnings multiple of January 2016. The question in my mind: Is now a good time to jump in and scoop up a few shares of MSFT on the dip?

MSFT PE Ratio (Forward) data by YCharts

In my view, Microsoft continues to do a great job at transitioning its business model from legacy (i.e., personal computing, software licenses) to high-growth initiatives (i.e., cloud platform and infrastructure, cloud-based applications). The slowdown in the growth pace of Azure has been playing out as I had previously expected (see chart below), as the platform becomes a more meaningful revenue generator and pricing pressure from giant Amazon (AMZN) is unlikely to subside.

Yet, Azure continues to charge ahead at a near-triple digit pace. With revenues representing what I estimate to be only about 3% of the company's total, I believe cloud still has quite a bit of room to run. Even if Azure continues to be a small piece of Microsoft's portfolio, I estimate that the YOY increase in sales will represent nearly half of the company's total top-line growth in the next few quarters.

Source: DM Martins Research, using data from company's reports

The momentum in productivity and business processes, with Dynamics, Office and LinkedIn all showing strength as of late, should be enough to help Microsoft soften the blow of an unwinding personal computing business (40% of total company revenues last quarter, down -7% YOY). Weakness in Surface (down a whopping -25% last quarter) will likely persist, but I find the sharp decline in tablet sales largely irrelevant to the investment thesis.

Yet, I continue to find the stock too pricey

With the company's fundamentals healthy and a decent dividend yield of 2.3% supported by strong free cash generation, I might find myself tempted to buy MSFT on the dip. But upon closer inspection (see chart below), the stock might still be too pricey to qualify as an enticing buy-on-weakness play.

Source: DM Martins Research, using data from SEC, Yahoo Finance and SA and priced as of mid-trading on Monday

Compared to six months ago, MSFT's current-year P/E of 22.6x is still richer than it was in January of this year. PEG is 8% higher as expectations for five-year EPS growth has decreased slightly, and net cash-adjusted PEG is 15% richer. Within the mega-cap tech peer group, MSFT continues to trade at a richer PEG than all other names except AMZN.

At the end of the day, I see the recent pullback in MSFT's price as not much more than a slight adjustment that reflects the broader move away from tech stocks in June. Shares continue to look like a hold to me, as valuations continue to be relatively rich. MSFT may very well pick up the pace and head past $70 per share once again. But I continue to stay away from what I consider to be a fairly-priced name at best.

Note from the author: if you have enjoyed this article and would like to receive real-time alerts on future ones, please follow DM Martins Research. To do so, scroll up to the top of this screen and click on the orange "Follow" button next to the header, making sure that the "Get E-mail Alerts" box remains checked. Thanks for reading.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.