Microsoft: Buy, Sell Or Hold?
- Microsoft is one of the best-known technology companies, which is developing and licensing software, services, devices, and solutions for individuals and businesses around the world.
- Not only Microsoft has a strong balance sheet, but also one of the strongest moats a business can have.
- While we are dealing with a great and durable business, MSFT stock might not be the best investment right now.
- And Microsoft is also a great example of what can happen when investing at the wrong time in history.
In the past few years, I have tried to identify companies with a wide economic moat around the business. While there are thousands of companies I did not cover so far, some that might be a surprise are missing. One of those companies that were still missing is Microsoft Corporation (NASDAQ:MSFT). In the ranking of the biggest companies in the world by market capitalization, Microsoft is the second-largest with a market cap of $1.9 trillion and without any doubt, we are dealing with a great business. In the following article, I will try to answer the question, if Microsoft also has a wide economic moat around its business.
I don’t know if Microsoft needs much introduction, but I will write a few words about the business model anyway. Microsoft was founded in 1975, in 1986 the company went public and today it is one of the most famous technology companies in the world. And almost everybody around the world knows Bill Gates, who is the fourth-richest person right now (for several years, Bill Gates was the richest person in the world).
Microsoft is developing and licensing software, services, devices, and solutions for individuals and businesses around the world. Its products include many well-known applications like Microsoft Office, Exchange, SharePoint, Skype for Business, or Microsoft Teams as well as the Windows operating system. Microsoft also offers cloud services and in 2016, Microsoft acquired the social network LinkedIn. Additionally, Microsoft is one of the major players in the gaming industry.
Last week, Microsoft reported third quarter results and continued growth with a strong pace. In the three months ended March 31, 2021, Microsoft generated $41,706 million in revenue, which is an increase of 19.1% compared to the same quarter last year. Diluted earnings per share for the quarter were $2.03, which reflects an increase of 45% YoY. And on a non-GAAP basis, free cash flow was $17,090 – 24% higher than in Q3/20.
(Source: Microsoft Q3/21 Presentation)
Microsoft is reporting in three business segments:
- Productivity and Business Processes: This includes Office Commercial including Office 365 subscriptions, also including Microsoft Teams, Skype for Business, Exchange, and SharePoint. It also includes LinkedIn, which was acquired by Microsoft. In fiscal 2020, this segment generated $46.4 billion in revenue – an increase of 12.7%; operating income from this segment was $18,724 million resulting in an operating margin of 40.4%.
- Intelligent Cloud: This segment consists of the public, private and hybrid server products and cloud services. Revenue from this segment was $48.4 billion – a 24.1% YoY increase; operating income in fiscal 2020 was $18,324 million resulting in an operating margin of 37.9%.
- More Personal Computing: This segment consists of products and services that put customers at the center of the experience with Microsoft technology. This includes search, devices (including Surface and PC accessories), gaming (including Xbox, video games, video games royalties), and Windows including licensing of the Windows operating system. In fiscal 2020, revenue from this segment was $48.3 billion, an increase of 5.6% YoY, and operating income in fiscal 2020 was $15,911 million resulting in an operating margin of 33.0%.
Wide Economic Moat
One of the major questions we are trying to answer here is if Microsoft has a wide economic moat around its business. And the answer is not only a clear “Yes” but Microsoft most likely has one of the strongest moats a business can have as the competitive advantage is based on several sources.
First of all, Microsoft is profiting from intangible assets: two very valuable brand names. Not only is LinkedIn on the list of the most valuable brands in the world (currently on the 90th spot), but Microsoft is also on the 3rd spot (according to Interbrand). A brand name is leading to trust and reputation and will enable a company to charge either higher prices or reduce search costs. And Microsoft is one of the most reliable technology brands in the world. The brand name could for example be helpful for the cloud business, where it is more difficult to create a wide economic moat (as we are dealing more or less with a commodity). But Microsoft’s brand name plays a strong role and as many people trust Microsoft more than other companies, I might rather choose Microsoft instead of a competitor. Of course, we also have to point out that the two major competitors – Amazon (AMZN) and Google (GOOG) – are also in a great position and have powerful brand names.
Additionally, the social network LinkedIn is profiting from network effects. And as I have described the power of this economic moat several times – for example in articles about Facebook (FB) or Tencent (OTCPK:TCEHY) – I will not repeat the arguments here again.
While the brand names and network effects are certainly helpful, the true source of the wide economic moat is switching costs. Today, most users are very familiar with Microsoft’s operating system (often pre-installed) as well as the applications Word, Excel, or PowerPoint. Microsoft has about 80% market share in the desktop operating system market and Microsoft’s products are deeply embedded in the business world – almost everybody is using Word, Excel, or Windows. Large corporations won’t switch when thousands of employees are trained using the software. It would take time and a lot of money to retrain the staff and no company is willing to invest the time and money for a product that might be a little bit cheaper. And even for individuals, it is difficult when using other software: when everybody is using Word, you are almost forced to use the same program if you want to exchange documents. And while Word or Excel (at least the way most people use them) is not extremely complicated, there is a learning curve nevertheless and as long as most other people are using the same software, most people won’t be willing to switch. However, there is also a problem. Windows has almost no market share for mobile devices and tablets and this could undermine the dominance of Microsoft and one could actually question how durable the moat is in this category.
In line with the question of how durable the moat actually is, we can also look at some metrics, which are also not perfect. One of the most important aspects I demand from high-quality, wide moat companies is stability and consistency. When looking at revenue growth, we actually see high levels of stability (revenue only stagnated a bit in 2016 and 2017 and during the Great Financial Crisis). However, earnings per share fluctuated much more during the last decade, and only in the last few years Microsoft could report impressive EPS growth rates.
(Source: Author’s work based on numbers from Morningstar)
Aside from revenue and EPS growth, we especially have to look at the company’s margins and once again we are looking for consistency. In the case of Microsoft, we see declining margins until 2016 – not a picture we like to see in the case of wide economic moat companies. But since then, the margins could improve again. Aside from margins, we especially focus on return on invested capital, which was 21.15% on average during the last decade. These are very impressive numbers indicating a wide economic moat.
(Source: Author’s work based on numbers from Morningstar)
We can also look at the stock performance compared to the S&P 500. Since 1986 (IPO of Microsoft), the S&P 500 increased 1,580% and Microsoft has increased 22,3400% in the same timeframe. This is such an impressive outperformance over 35 years that the question if Microsoft actually has a wide economic moat, seems rather a mood. The stock increased about 25% on average annually (not including dividends), which is beating Warren Buffett’s Berkshire Hathaway (BRK.A) and probably almost every other company on earth.
Aside from the wide economic moat, Microsoft can also profit from a strong balance sheet. Similar to Facebook (FB) or Apple (AAPL), Microsoft is sitting on a lot of cash. On March 31, 2021, the company had $13,702 million in cash and cash equivalents and $111,705 million in short-term investments. In total, Microsoft has $125.4 billion in extremely liquid assets that could be used for dividends, share buybacks, or acquisitions.
Microsoft has not only a lot of cash and short-term investments, but also has debt on its balance sheet. $50,007 million in long-term debt and $8,051 million in short-term debt. When comparing the total debt to the shareholder’s equity of $134,505 million, we get an acceptable D/E ratio of 0.43. We can also compare the total outstanding debt to the operating income the business can generate. When using fiscal 2020 numbers, it would take about 1.1 times the operating income to repay the outstanding debt – and we really should not be worried about Microsoft’s ability to repay the outstanding debt. However, the balance sheet is not perfect. Another negative aspect is $49,698 million in goodwill (about 16.1% of total assets). Nevertheless, the balance sheet is rather a strength for Microsoft.
Dividend And Share Buybacks
Microsoft is also paying a quarterly dividend since 2004. And since then, Microsoft has increased its dividend almost every single year. Only during the Great Financial Crisis in 2009 and 2010, the company kept the dividend stable for 8 quarters in a row. Since 2004, Microsoft increased the dividend with a CAGR of a little over 12%, and right now, it is paying a quarterly dividend of $0.56. This is resulting in an annual dividend of $2.24 and a dividend yield of 0.89%. In fiscal 2020, Microsoft paid $1.99 in dividends, and with earnings per share of $5.76 we get a payout ratio of 34.5%. This is making the dividend very safe and further dividend increases in the years to come very likely.
(Source: Author’s work based on numbers from Morningstar)
Aside from the dividend, Microsoft is also distributing cash to its shareholders via share buybacks. In 2001, the company started to reduce the number of outstanding shares from 11.15 billion to 7.63 billion right now. During the last decade, the pace of share buybacks slowed down. But Microsoft still decreased the number of outstanding shares by about 11.2% during the last ten years.
Intrinsic Value Calculation
I think we have established so far that Microsoft is a great business. In order to determine if Microsoft is also a great investment, we have to calculate an intrinsic value for the stock and we will once again use a discount cash flow calculation.
As a basis for our calculation, we take the free cash flow of the last four quarters ($53,789 million). The more difficult task is to estimate what growth rates might be realistic in the years to come. In order to be fairly valued (assuming 10% discount rate), Microsoft has to grow 11% annually for the next decade and then 6% till perpetuity. For perpetuity, I always use 6% growth and due to Microsoft’s wide economic moat, there is no doubt that these growth rates are justified.
The more important question is if 11% growth for the next decade is justified. In the last five years, earnings per share increased with a CAGR of 23.45% and when considering these growth rates, the question if 11% growth is realistic seems almost laughable. However, the last five years might not necessarily be representative for Microsoft’s long-term growth potential. When looking at the EPS growth during the last ten years, the CAGR is only 10.56%. Between 2011 and 2016, the trailing twelve months' earnings per share could not really grow. Bulls would probably argue that we can’t include these years as Microsoft’s business is different now and we should just look at the last few years.
And while we can’t dismiss this argument, I would nevertheless be cautious. First of all, Microsoft is one of the businesses profiting from the pandemic – and the pandemic will pass. Second, phases of such high growth rates for mature businesses are rather seldom and should not be taken for granted (despite a wide economic moat).
What I can state with certainty: Microsoft is not a bargain at this point, and I would not invest. If Microsoft is fairly valued at this point or rather overvalued is quite difficult for me to answer. However, I also don’t think Microsoft is extremely overvalued at this point – at least not compared to many other stocks.
Lessons From History
In the past few months, I included these sections in several articles and I will do it once again. Paying attention to history is always a good lesson, but in my opinion, it is particularly important to look at examples from the Dotcom bubble right now – as history is at least rhyming (if not repeating). In the past, I talked about Allianz (OTCPK:ALIZF) being a terrible investment, I wrote about Garmin (GRMN), which reached former highs after more than 13 years again, and in a few days, I will publish an article about Cisco (CSCO), which is probably THE example of a terrible investment in 2000. And I might also publish an article about Deutsche Telekom (OTCQX:DTEGF) in the next few weeks, which is one of the most terrible investments Germans could make during the Dotcom bubble (or: “Neuer Markt” as it was called in Germany).
And Microsoft is also a good example of what can happen when investing at the completely wrong time. For those that bought at the Dotcom bubble peak, it took 16 years to break even. And I don’t care how mentally strong you are, this is a very long time to suffer through. What is even worse, from the high in 2000 it actually took almost one decade for the stock to bottom – during the Great Financial Crisis, the stock hit its low point (75% below the former all-time high).
And if you think, there is a fundamental reason for this performance during these 16 years you are not completely wrong, but also not really close to the truth. During these 16 years, free cash flow increased about 100%, diluted earnings per share increased about 200% and revenue increased even 300%. So, the fundamental business improved during these 16 years and there should be every reason for the stock to improve as well. But investors in 2000 bought at such a wrong time in history they had to suffer 16 years before an investment in that great company became a profitable investment.
And while Microsoft today is not belonging in the category of extremely hyped stocks – these are other assets one should avoid – one should also be cautious if an investment in Microsoft right now is the best idea. We are without doubt dealing with a great business that performed admirably especially in the last few years. Nevertheless, Microsoft is no bargain.
This article was written by
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.
I might buy Tencent in the next few days or weeks.
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