3 Reasons Why Microsoft Stock Is A Strong Buy

Summary

• Despite lacking the hype and drama of FANG stocks, Microsoft is putting up surprisingly good revenue and EPS growth numbers.
• Cloud and gaming dominance and recent relative strength mean Microsoft shares are worth a look.
• Consider picking up shares in Microsoft ahead of the New Year.

Microsoft (NASDAQ:MSFT) never gets the attention that FANG stocks get but has been putting up shockingly good EPS numbers lately. With MSFT briefly eclipsing Apple (AAPL) as the world's most valuable company, Microsoft's success isn't likely to be ignored going forward. Both companies are good buys, but since Microsoft doesn't get as much attention as Apple, I'd like to highlight three reasons why MSFT is also an attractive buy.

1. Cloud and gaming dominance

One of the reasons that Microsoft languished during the 2000s was the inability of the company to grow as fast as the market had priced during the tech bubble. Microsoft earned billions and billions of dollars from 2000 to 2009 and the multiple fell and fell. MSFT dramatically underperformed the market during this time.

In 2010, Microsoft got into the cloud computing business with the launch of Microsoft Azure (then called Windows Azure).

Even after the cloud business launched, Microsoft continued to struggle with the perception that they couldn't innovate. As the business grew and grew, the numbers became too big to ignore. By 2016, Microsoft caught up with the broader index and has gone pretty much straight up since.

Microsoft is growing faster than Amazon is in the cloud space, and rightfully so. CEO Satya Nadella on their value proposition during the last quarterly CC:

No customer wants to be dependent on a provider that sells them technology on one end and competes with them on the other. Getting this equation right is key to their success going forward. Microsoft is uniquely positioned to help.

This is a tough point to argue against for advocates of Amazon AWS. As long as Amazon competes against its customers worldwide in a variety of industries, Microsoft will have an edge in the enterprise cloud business. Don't buy into the Amazon competition thesis? Here are some recent examples of Amazon competing against their cloud customers.

Gaming revenue also grew a staggering 44 percent year over year. I'm not a big gamer, but the data shows that gaming is the future of entertainment, at least from a revenue perspective. Again, Microsoft's growth is hard to ignore.

I always recommend that shareholders read through the conference calls or, if you have the time, to listen to them. You can learn a surprising amount from the tone of voice and back-and-forth with friendly and critical analysts in general on quarterly conference calls.

2. Strong relative momentum

Over the last six months, the Nasdaq (QQQ) has zigged, but Microsoft has zagged. Microsoft has shown continually strong price momentum over the last couple of years. I expect this to continue.

Microsoft and Apple are heavily tied to index holdings in the Nasdaq. Both companies represent over a 10 percent weight in the QQQ, so selling pressure in the QQQ is likely to depress the share price of both of them over the short term. However, even with all the selling pressure on the broader market, Microsoft stock refuses to go down.

My experience with this kind of situation in the past with other stocks is that when the selling pressure on the index subsides, the stock surges. I would expect a similar pop in Microsoft. As Microsoft is one of the strongest performers in the market as of late, should the Fed relent on their plans to hike rates, tech is where capital is going to flow, and Microsoft is one of the most attractive names in large-cap tech at the moment.

3. The Microsoft carry trade

Like Apple, Microsoft's management is extraordinarily shareholder friendly. Microsoft is blessed with the kind of business that has high margins and doesn't require a lot of leverage to operate.

This has allowed Microsoft to use their pristine balance sheet to issue bonds at extremely low interest rates to buy back stock, invest in R&D, and acquire competitors. For example, Microsoft sold $17 billion in 10-year bonds in 2017 for a 3.3 percent interest rate. They used the money to pay for their financing on the LinkedIn acquisition and buy back stock. Conservatively assuming that Microsoft can earn a 9 percent return investing the money by buying back their stock, Microsoft shareholders realize a billion dollars per year in positive carry from Microsoft monetizing their pristine credit rating.

While I don't think Microsoft should try to become a hedge fund, Microsoft's stable and growing earnings, ability to borrow at rock-bottom rates with their AAA credit rating and buy back their stock create a formula for management to generate almost effortless EPS growth.

Microsoft also pays a respectable dividend, which they just hiked to 46 cents per share.

Price Target

Microsoft trades for roughly 25 times earnings, which is a decent premium to the market and to its large-cap technology cousin, Apple. However, 25 times earnings is a fair price for Microsoft given that they just happen to have two amazing businesses (Azure, gaming) and one steady, strong one (Office) to produce growth. This is on top of how easy it is for Microsoft's management to create EPS growth through nothing more than a simple carry trade by issuing AAA rated debt at 3 percent to buy back their stock at a 9-10 percent return.

Current analyst estimates are for next year's EPS to come in at 5.03 per share. However, Microsoft always sandbags sell-side analysts, so I would expect EPS to come in a little less than 5 percent higher at $5.25. This, combined with the current multiple of 25 times earnings gets us a 12-month price target of $130.

Companies like Microsoft and Apple are always going to be susceptible to the macro environment due to the heavy ties of their P/E multiples to index-fund trading, so this will depend on how the broader market does. However, the base case for Microsoft does see the stock trading to $130 by this time next year.

Good luck to all!

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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.