Will Microsoft's Big Problem Cause Losses For Shareholders?

Summary

• Microsoft's stock price has soared since the Great Recession, but so has its valuation.
• Today, shares trade for a price-to-earnings ratio 80% above its average valuation over the past 10 years.
• Microsoft is a tremendous business, but because of its high valuation, the stock is not a buy today.

By Bob Ciura

It is almost impossible to find anything wrong with Microsoft Corporation (NASDAQ:MSFT). The company is growing at a high rate, thanks to its successful transition to cloud software and services. It also has an excellent balance sheet, and is a strong dividend growth stock.

Microsoft is a Dividend Achiever, a group of stocks with 10+ consecutive dividend increases. You can see the entire list of all 265 Dividend Achievers here.

At the same time, Microsoft stock has had an unstoppable rally since 2009. Shares have appreciated by more than five-fold off the Great Recession low.

MSFT data by YCharts

The huge rally has been due in part to Microsoft's earnings growth. But it has also been due to a rising price-to-earnings multiple. Microsoft's valuation has expanded significantly, and is now dangerously above its average over the past 10 years. In addition, Microsoft's dividend yield has sunk to a multi-year low.

While there is no shortage of accolades an investor can heap on Microsoft as a business, the stock does not appear to be an attractive investment today.

Business Overview

Microsoft is a technology giant. It manufactures a wide range of software, including its flagship Office and Windows. Its other main products include the Xbox video game business, Surface tablets, and it also owns LinkedIn.

Microsoft has had a lot of momentum recently, thanks to its transition away from the personal computer. Sluggish PC sales around the world compelled the company to move into the cloud. Its cloud offerings, such as Azure and Office 365, are performing well.

In fiscal 2017, Microsoft’s adjusted revenue increased 5%. Cost controls and share repurchases fueled 19% earnings per share growth. The company ended the fiscal year on a strong note. In the fourth quarter, revenue grew 10%, while adjusted earnings per share soared more than 40%.

Source: 2017 Earnings Presentation, page 9

The company is off to a bang to start fiscal 2018. Microsoft beat analyst expectations across the board for the fiscal first quarter. Earnings per share of $0.84 beat by $0.12 per share while revenue exceeded estimates by nearly $1 billion. Revenue rose 12% year-over-year while earnings per share increased 17%.

Growth Prospects

Microsoft’s growth in the past two years has certainly impressed. However, looking further back, Microsoft has increased diluted earnings per share by just 5% per year, in the past five years and 10 years.

To be sure, Microsoft has largely worked past the growth slowdown of 2014 and 2015, thanks to the cloud businesses. And Microsoft is likely to continue its growth moving forward, as the shift to the cloud is ongoing. Microsoft’s Office commercial revenue increased 10% last quarter, due to 42% growth for Office 365 Commercial. Separately, Dynamics revenue increased 12%, driven by the shift to Dynamics 365.

Total commercial cloud revenue increased 55% last quarter. Gross margin for the commercial cloud businesses rose by 8 percentage points, which is a remarkable combination of revenue growth and margin expansion.

Source: Q1 Earnings Presentation, page 5

There are very few criticisms to be made regarding Microsoft’s business overview or growth prospects. However, one area of concern is Microsoft’s balance sheet, which has taken on a great deal of debt to finance its strategic investments.

Microsoft ended fiscal 2017 with long-term debt of $104 billion. Five years earlier, it had $24.5 billion of long-term debt. Microsoft has raised huge amounts of debt for its cloud investments and M&A, such as the $26 billion acquisition of LinkedIn. These investments are a big reason for Microsoft’s growth in the past year. But as leverage increases, there is less room to take on additional debt to finance growth.

Another negative aspect of Microsoft stock is its lofty valuation, which makes the stock fairly unattractive as an investment.

Valuation & Expected Returns

Microsoft had diluted earnings per share of $2.71 in fiscal 2017, according to the company annual report. Based on this, the stock has a price-to-earnings ratio of 31. Using adjusted earnings per share of $3.31, which excludes non-recurring charges, results in a price-to-earnings ratio of 25.4. This is better, but in either case, Microsoft is trading well above its historical average.

According to ValueLine data, Microsoft has held an average price-to-earnings ratio of 14.1 over the past 10 years.

Source: Value Line

Microsoft’s share price gains since 2011 have been fueled in large part by its rising valuation multiple. In the past 10 years, the company grew earnings per share by 5% per year, according to ValueLine. Today, Microsoft’s price-to-earnings ratio is roughly 80% above its 10-year average. If Microsoft were to experience contraction of the price-to-earnings multiple, it would have a significant impact on the share price.

The other downside of buying a stock at a far higher valuation is that the investor must accept a low dividend yield. As you can see in the following chart, Microsoft’s dividend yield has steadily fallen over the past several years.

MSFT Dividend Yield (TTM) data by YCharts

Microsoft currently yields 2%, which is on par with the S&P 500 Index average. The company does raise its dividend each year, but its dividend growth rate has slowed. The most recent dividend increase of 7.6% was well below Microsoft’s five-year compound annual dividend growth rate of 13%.

Final Thoughts

Microsoft is a great company. As a stock, it is not as great. Shares have handsomely rewarded investors over the past five years. But whether the next five years will be as rewarding is a different question. Microsoft will likely continue to grow revenue and earnings, but the stock could still experience a contracting valuation multiple.

In order for Microsoft’s tremendous rally to continue moving forward, the company needs to keep surpassing expectations, which keep climbing along with the price-to-earnings ratio. With a high valuation and a low dividend yield, the risk-reward does not seem to be in investors’ favor right now.

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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.