Microsoft: What Should Be The Focus Of Investors

Nov. 10, 2022 7:01 AM ETMicrosoft Corporation (MSFT)10 Comments
Bert Hochfeld profile picture
Bert Hochfeld
20.97K Followers

Summary

  • Microsoft's fiscal Q1 earnings were not well received.
  • Investors were concerned about the slowdown in percentage growth of the company's Cloud service, Azure.
  • They were concerned as well about projections of slower growth in other areas of the company's business as macro headwinds bite.
  • Beneath the concerns, Microsoft's strategies in terms of products and technology are winning market share battles.
  • The shares, down about 1/3rd this year, have become attractively valued.
French headquarters of Microsoft, Issy-les-Moulineaux, France

HJBC

A safe haven doesn’t mean that rain can’t fall

October was a strong month for most stocks. Even software stocks bounced with the IGV (IGV), the software ETF rising about 7%, while the WisdomTree Cloud Computing ETF (WCLD) rose about 3.5%. But while October was strong for the market as a whole, it was basically highly disappointing for large cap tech equities. And as the calendar flipped to November many software stocks fell as leaves from trees do in autumn. And that includes shares of Microsoft (NASDAQ:MSFT). Last month, Microsoft shares basically were unchanged. Microsoft shares have fallen about 34% so far this year, and are down just a little bit more than that from their high. And the shares have started off November on a sour note as well, although not nearly as sour as the decline in valuations of high growth IT shares.

Overall, MSFT shares reacted quite poorly initially to the release of quarterly earnings and guidance. Was the reaction reasonable? Or does the reaction yield a substantial buying opportunity as investors misinterpret the performance of yet another company in the midst of macro headwinds? I obviously think the latter is the case or I wouldn’t be writing this article.

In investing, as in much else, one size does not fit all. Not everyone will be interested in the asymmetric opportunities presented by Microsoft. In some ways, writing on this post election evening, it might be described as a centrist investment. Microsoft shares lack the upside of a Snowflake (SNOW) or a SentinelOne (S) but they are also without the dramatic drawdown potentials of faster growing, more highly valued IT names. If you are looking for the best potential recovery play, that isn’t Microsoft. But if you are looking for exposure to the beaten down IT space, with a vendor whose market share gains are palpable and significant, then consider Microsoft. There is plenty of upside here, and lot less excitement. Sometimes just what investors want is a bit of ballast in an otherwise high beta portfolio, and Microsoft, with its elevated free cash flow yield is likely to be far more stable, both on the upside and the downside.

It has now been about two weeks since Microsoft released its earnings. Lots of dust has settled, and I think it appropriate to look dispassionately about the positives and the negatives in the earnings release. Microsoft is followed by more than 40 analysts and innumerable authors have written screeds about the prospects for the shares on SA over the months and even since earnings. Hopefully, I will manage to provide some insights for readers that may not have been covered by all of those innumerable articles.

With earnings season more than half over, and with additional news coming in, it should be evident, if it wasn’t before, that the IT space is feeling headwinds of varying intensities from the global economy. It has been a rare company-surprisingly, perhaps, one such has been IBM-that hasn’t chosen to reduce its expectations or to forecast cautiously. Microsoft may have seemed an outlier with its own guidance a couple of weeks ago; at this point its forecast looks far better on a relative basis than was the case immediately after its earnings were released. By now, the success of Microsoft in terms of share gains in many areas against its many rivals should be more apparent. In particular, the linked study shows Azure with a share of 21% of the cloud market in Q2-2022, vs. Amazon at 34%. That gap has narrowed by about 25% in just two years, and it narrowed further in Q3, although a formal market share analysis covering the latest period has yet to be released.

One thing that won’t be covered in this article is the pending acquisition of Activision. Obviously the merger would have significant impacts on growth and margin expectations if it happens. But it has many regulatory hurdles to cross, and there is more than a bit of uncertainty as to whether and under what terms the deal gets done. Even if all goes well, the deal is not likely to close before the middle of 2023. Much will happen between then and now, and I simply lack the insights necessary to provide an informed evaluation of the probability of the deal closing, let alone under what conditions.

I also haven't tried to explicitly evaluate the recent acquisition of Nuance. Nuance has brought lots of capabilities and some operating losses for Microsoft. Over time, the acquisition plays into Microsoft's platform strategy, but given the relative size of Nuance, it hasn't and won't contribute visibly to financial results although it is probably a modest headwind in terms of operating margins for the balance of the company's fiscal year.

Microsoft shares, at least to me, are an investment for many seasons. On the one hand, the company, despite what has been happening to its Windows OEM cash cow where revenues are falling precipitously, generates lots of cash. Its free cash flow margin was actually 45% last quarter (Microsoft’s fiscal Q1 sees the highest percentage cash flow margin of the year due to the seasonal decline in accounts receivable), although free cash flow dollars were marginally below year-earlier levels because of a one-time tax payment. I am forecasting the company will still be able to achieve a free cash flow margin of 35% for the fiscal year, not a bad level in a trough. Microsoft’s free cash flow yield is actually close to 5%.

On the other hand, the company continues to take share in key markets such as that for its cloud solutions, for its enterprise applications, and for its plethora of solutions that are components of Office 365.

I think that a company that can grow at low double digit rates during a recession when adjusted for FX headwinds, with growth further constrained by the cyclical decline in its Windows OEM business is an investment for most seasons. The huge percentage decline in the Windows OEM business will abate sometime in the next 3 quarters as comparisons lap the unsustainable levels from the pandemic. The negative performance of gaming is also likely to abate, at least in percentage terms.

The strong competitive position of Microsoft will enable it to resume mid-teens growth when the economy emerges from a recession. I will not make a call with regards to FX, but at some point that headwind will also abate. With the decline in the share price, and the continued growth of the company, the shares now have an EV/S ratio of 7. Is that low enough? Given the strong free cash flow margin and a free cash flow yield of nearly 5%, I think it is.

But how well might it do in a recovery scenario? Just how strong can growth reach? Simply assuming an absence of negative currency impacts suggests that revenue growth would return to the mid-teens percent. And expecting that the significant decline in year over year revenues from Windows OEM laps, would allow revenue growth to reach the high teens. And in a better economic environment…My guess is that many investors underestimate the effect of the company's market share gains on its revenue growth potential.

Further, this current fiscal year, with impacts from FX and a down PC cycle is expected to see operating margins decline by about 100bps. In particular, as more and more of Microsoft’s revenue comes from Azure and the cloud, there tends to be a headwind to margins. But absent the baleful influence of the PC cycle, and in a neutral FX regime, operating margins should reverse that decline.

Stocks continue to react to concerns about interest rates, Fed pivots and a deteriorating macro environment. Even companies reporting strong quarters and providing strong forward guidance see their valuation easily upended by trends in market sentiment brought on by fears of the Fed. Last week in addition to Fed fears, investors fled shares in the IT space on concerns about flagging growth brought on by disappointing guidance from a number of companies including Twilio (TWLO), ZoomInfo (ZI) and Atlassian (TEAM). At the slightest indication that the job market is too strong, and that the strength in the jobs market will delay the Fed pivot, IT shares have continued their decline. At one point, it was the megacap shares that were leading the decline, particularly after the results reported by Meta (META) and Amazon (AMZN); Microsoft, is of course, part of that group.

This week, risk concerns have centered on the plight of a leading crypto currency fund which has suggested the possibility of insolvency.

Many stocks, especially those of IT companies were in almost free fall on the afternoon of Wednesday, November 2, 2022 as traders scrambled to react to the less than straightforward remarks by the Fed chairman. One well known hedge fund leader, Jay Gundlach, a well-known hedge fund manager. commented that the Fed Chairman ”straddled the problem rather than threaded the needle.” I might simply observe that Mr. Powell’s comments about incoming data not suggesting some early signs of an abating inflationary spike are simply inaccurate, and have left financial markets awash in uncertainty, something statements from Fed chairmen are never supposed to do. And of course Friday marked a panic that imploded valuation for most “SaaS” stocks, more or less indiscriminately.

But this is not an article about the Fed, its statement, its pivot per se. I will simply observe that the Fed has wrought an economic contraction of some magnitude, perhaps unnecessarily, and this contraction has sapped business confidence and has led, inexorably, to a pullback in investments in IT solutions. And Microsoft, along with most other IT vendors exists in that context. Eventually, of course, the environment changes. Perhaps it is worth noting that the infamous Fed dot plot with regards to expected interest rates has proven to be wildly inaccurate in its forecast. The knee jerk reaction of traders to comments about terminal interest rates, and to the duration of a restrictive policy has to be measured against that record. But in evaluating a potential investment in Microsoft shares, I contend that context is everything, and based on context the company is performing at a high level, gaining share, and setting up for stronger growth than anticipated when macro conditions “normalize.”

Contextual analysis is one of the ways that cyber-security software can detect potential hacks. It is pretty common at this point and just about all observability companies have modules which utilize the technology as part of their offering. But while it is widely accepted in observability, it doesn’t seem nearly as accepted when it comes to investing. When analyzing Microsoft earnings, context is everything. The reality is that the quarter was another signpost of a working strategy, producing outsize market share gains, and setting the stage for several years of double digit growth. That in some regards, the outlook particularly, didn’t live up to expectations is not terribly surprising given the context.

It seems obvious that at this point in time, relatively few investors are interested in context, or in relative performance, or analysis that looks for secular as opposed to cyclical trends. There are some analysts who almost crow about their prescience with regard to cyclical impacts on demand for IT solutions. About the only business area in IT that seems to have a chance of escaping the current macro environment with demand signals intact is cyber security. And not even all companies in that space seem immune to cyclical problems as the latest results from both Rapid7 (RPD) and from Fortinet (FTNT) might indicate.

There are very few areas of the economy that are immune to cyclical headwinds. And while IT demand is not overly cyclically sensitive in the way that housing is cyclically sensitive, it does not exist outside of the macro economy. If customers are constraining budgets, IT budgets are going to be more significantly scrutinized. Most IT projects are sold on the basis of ROI. But higher interest rates mean that ROI has to be greater to account for the rising cost of capital, and to a certain degree, for perceived risk that the benefits of a project might not be realized in a slowing macro environment. It doesn’t mean, however, that the overall growth in IT spend will experience a secular decline.

A recession has been on the horizon for some time now. Macro headwinds are impacting an increasing number of segments of the economy, and that is increasingly seen in the results of IT companies. Does that mean that readers should sell IT shares? There are some commentators and analysts who have adopted that stance. The Macquarie brokerage initiated coverage on 13 software companies on November 2-10 of them with hold ratings. Morgan Stanley has also had a consistently negative view on the space, particularly its valuation, although it has been less negative in that regard lately.

There are certainly elements of cyclicality in demand for Microsoft services. The decline in PC sales is one significant element in that. But even Azure, the company’s cloud service has a cyclical growth component. Azure “only” grew by 42% in constant currency and has been pointed out ad infinitum, was below prior guidance for 43% growth. And the company is forecasting a contraction in percentage growth for Azure in this current quarter.

Microsoft reports lots of numbers. Too many perhaps, in terms of making analysis straightforward. The key numbers on which most analysts focus are revenue growth in the 3 principal reporting segments, Productivity and Business Process, Intelligent Cloud, and More Personal computing. The company also reports revenues for its some of its different cloud offerings, including Azure, LinkedIn, Dynamics 365 and Office Commercial 365. And, it usually addresses the growth of its Windows OEM business. Some observers also look at revenue items such as Xbox and advertising/paid search. Most observers, but certainly not all, tend to focus on constant currency changes. So, there easily can be some confusion as to how well Microsoft performed in a given quarter, and just how much its guidance implies when compared to prior expectations.

At a high level, the company reported revenues of $50.1 billion, or $52.4 billion in constant currency. That later metric represents constant currency growth of 16%, significantly greater than prior company guidance or any published expectation. The company provided revenue guidance for the current quarter of about $52.85 billion at the mid-point of its range, and the analyst consensus has gone to $52.97 billion, almost in line with the prior expectations. That revenue forecast, if it actually happens, would be growth of just 2.5% year on year, although in double digits when adjusted for FX fluctuations.

The company has reduced its EPS estimate by 11% for the current quarter, compared to the prior consensus, and by 8% for the year. A significant component of the change in EPS guidance relates to FX. Overall, FX fluctuations are expected to reduce revenue by about 5% and expenses by 3%. That is the preponderance of the decrease in the company’s expectation for operating margins.

The company did call out other factors including higher electricity costs needed to operate its data centers and a mix shift from high margin Windows sales to lower margined revenues from Azure-even though margins from Azure are rising slightly. In addition, Nuance, which was recently acquired is also a drag on operating margins at this point.

Azure and Microsoft’s Intelligent Cloud-A growth engine that keeps on growing

Probably the most important business segment for Microsoft is intelligent cloud which is currently about 41% of revenues and which is forecasted to achieve constant currency growth in the range of 22%-24% this quarter. Many things have been written about Microsoft’s growth but obviously, the overall growth in the cloud business is such that the company’s prospects for many years of double digit growth remain as they have been. Many, many commentators have vexed themselves about the fact that the constant currency growth of Azure was 42% rather than the 43% forecast. And concerns have been expressed as well that constant currency Azure growth is forecast to be 37% for the quarter. One thing to note was the strong performance of the company’s backlog metric which is reported for the company’s entire cloud segment. Microsoft cloud bookings were quite strong with a growth in constant currency of 31%. Overall, commercial backlog grew by 34% in constant currency. Some of the strong bookings growth has been a function of long-dated contracts which don’t immediately translate into revenue.

There has been much concern expressed about Azure consumption, and the company’s forecast for declining growth rates-although 37% growth given the current size of Azure, is hardly a cause for significant alarm. Part of the reason for declining growth rates is a function of the optimizations that Microsoft provides its Azure users. Basically, the company analyzes use cases and workflows and helps users to develop a more efficient pattern of consumption. This has been standard practice in the cloud space for years now and is embraced by most vendors. In the first quarter or two subsequent to the implementation of particular optimizations, revenues tend to fall, but the long term impact of optimization almost inevitably leads to greater consumption because of very strong price elasticity. This is not the first time Microsoft has provided users optimization tools; while, of course, this is a different environment than in the past, the result almost always is to see additional use cases switch to Azure as the economics of doing so have gotten progressively better.

Azure: Why it continues to see market share growth

One of the artifacts about the current environment is that it tends to delay and obscure some secular trends. At the end of the day, workloads are moving to the cloud at a substantial cadence and that will continue to be the case for the foreseeable future. I have linked here to Gartner’s growth projection. It forecasts growth in the total cloud market of 20%-22%, although overall, some segments are growing quite a bit faster than others. One reason for Microsoft’s share gains is simply that it has a disproportionate number of services that sit within the fastest growing components of the cloud business such as applications, a business component in which its rivals, Amazon and Google, have limited entries, and Cloud Infrastructure Services, which accounts for about 35% of total cloud growth.

But there are other reasons for Azure’s success. I don’t want to suggest that there is some single reason for the success of Azure. I have provided a link here to a rather detailed study of who has which features in the space but frankly, the analysis, which is the most comprehensive of several such studies I looked at doesn’t really get to the point of why Azure is gaining share.

The answer, at least for me, is not that Azure is cheaper, or “better” or that it has more services, or that it has better customer support. All the cloud vendors say that their offerings of AI services produce superior results. There is simply no way I could ever validate such a contention. Overall, while there are doubtless some use cases in which Azure overall has superior characteristics based on user preferences when compared to AWS or to GCP, the reverse is also the case.

In my opinion, however, real reason for Azure's market share gains, is, and has been that Azure is part of a very comprehensive set of offerings that span many areas of IT requirements. Azure benefits substantially because it is part of a unified set of interrelated offerings. For example, Microsoft offers developers GitHub. Is GitHub “better” than what is offered by its principal competitor GitLab? (GTLB) On a standalone basis, I doubt it. The reverse may be true, in fact. But the fact is that with GitHub, Microsoft is able to leverage its development tool into demand for Azure-when developers use GitHub they are very likely to optimize the applications they develop to run on Azure, although applications developed on GitHub can, of course, run on any cloud and on any platform.

Some other major Microsoft growth engines

Microsoft has a large and impressive set of cloud based applications, Dynamics 365. Dynamics 365 continues to grow at surprisingly elevated rates, and is apparently gaining share in a crowded space. Overall, Dynamics revenues rose 22% in constant currency, and its Cloud offering, Dynamics 365 grew by 32% in constant currency. These growth rates are significantly greater than those achieved by the company’s principal competitors. And the company’s forecast for Dynamics for this current quarter is consistent with its performance last quarter.

The success of Microsoft is not necessarily a function of overall capabilities in the space that are greater than competitors. Just for the sake of completeness I have linked to an analysis of Dynamics vs. Salesforce. I could present similar links comparing Dynamics 365 to Oracle (ORCL) Fusion, to SAP (SAP) and to Workday (WDAY). The elevated growth of Dynamics is almost certainly a function of the benefits users see in acquiring application software from their cloud vendor. They believe that they will enjoy some performance benefits, they will have fewer vendors with which to deal, and will ultimately get improved service by consolidating their purchases. I believe many investors underestimate the power and the value proposition that Microsoft can present because of its unique positioning in terms of offering both a public cloud solution and highly competitive enterprise applications.

I would also point to what I might consider surprising strength coming from LinkedIn. Everyone knows the digital advertising space is in disarray, and LinkedIn is a digital advertising platform. And tech hiring has slowed; indeed layoff notices in tech abound. And yet despite that, LinkedIn revenues continue to show considerable strength. Last quarter, LinkedIn revenues rose by 21% in constant currencies, and this quarter despite what some might describe as hurricane force headwinds, the company has forecast Linked In revenues to grow in the low-mid teens percent in constant currencies. A slowdown of course, but not the kind of catastrophic slowdown in growth that Snap (SNAP) and Meta have recently reported.

Trying to determine why LinkedIn is doing so much better than so many other tech advertising platforms is not totally apparent. Of course the word most commonly used is that of engagement. It is not something that is easy to quantify or to account for. Obviously LinkedIn is one of the principal billboards of the tech space and that has been the case for some time now. But again, I think that the relative resilience of LinkedIn demand has more to do with its integrations with, and support of various other Microsoft services.

The same theme is true when considering the success of Office 365/commercial with growth of 17% in constant currency and a forecast of comparable growth in the current quarter. The elevated growth of Office 365 is basically a function both of its brand, but more importantly the many, and increasing functional elements that are offered on the platform. Most lately, the company has achieved success with its Teams offering as well as functions such as digital editing and creating.

Microsoft’s Issues

Of course Microsoft has issues, and some of them are issues beyond the current state of the economy. Most of the company’s issues are in its segment of “More Personal Computing” whose revenues declined marginally last quarter. More Personal Computing is currently about 26% of total Microsoft revenues. The company has forecast that revenues in that segment will decline by about 17% this quarter year on year, basically because of a mid-30% decline in Windows OEM revenues. In addition, the company does sell PC’s and is forecasting its devices revenue to fall by 30%. And gaming revenues are also expected to fall-the projection is for a revenue decline in the range of low to mid-teens percent.

While gaming revenues are notoriously volatile, and depend on product cycles and cyclical factors, it is disappointing that the company hasn’t been able to enjoy an extended period of strong growth in gaming. Obviously there are segments of More Personal Computing that are growing, such as search and advertising and particularly, as mentioned earlier, the company is still achieving growth of its Microsoft 365 offering which now includes both an advanced Teams product as well as advanced security functionality.

It would be far too optimistic to expect that Microsoft is going to regain the approximately $3 billion of quarterly revenue decline in More Personal Computing it is forecasting for this quarter any time soon. The decline in quarterly revenue from More Personal Computing will probably peak in Q4 of the current fiscal year; More Personal Computing revenues reached $20 bil.+ in the June 2022 quarter which was the highest recorded in the fiscal year and was actually up by more than 30% over a 2 year span.

The growth prospects for PC’s are not great. And there really is not much that Microsoft can do to impact the revenues from Windows OEM, and market share gains and losses in the PC segment are not going to be large enough to really move the needle for a company whose annual revenues are greater than $200 billion.

My contention, however, is that the huge decline from Windows OEM that is weighing on revenue and profit projections for this year, will not continue. I don’t expect a recovery-simply stabilization at a very reduced level. Overall, the decline in More Personal Computing revenues will probably wind up reducing MSFT FY 2023 growth by 300 bps+. Just removing the boat anchor will have a major impact on the company’s forward growth rate in the coming years, and yet it seems by far to be the most likely scenario.

Microsoft’s valuation/Summary/Recommendation

Almost all software companies are on sale these days with historic markdowns. And almost all software companies have experienced significant levels of demand destruction, although I do not think any of it is long term in nature other than because of company specific issues. I think the layoffs announced by Salesforce (CRM) and the guidance provided by the Trade Desk (TTD) is simply an affirmation of the cyclically induced waning growth outlook. It is almost like a Black Friday sale, although I believe the merchandise on offer in IT growth equities is far more durable with loads of value. Microsoft shares are part of the dramatic valuation reset and its growth outlook has been impacted, although by far less than many other companies. Microsoft looks far more interesting in this environment than might have been the case a year ago when investors had a less negative view of the future.

Currently Microsoft shares have an EV/S of about 7X based on conservative estimates for the next 12 months of revenue. That’s above average for a company with an estimated 3 year CAGR in the low to mid teens percent, but it is offset by the company's elevated free cash flow margin. Overall, looking at the combination of free cash flow margin+ revenue growth leaves the shares valued a bit below average. But that itself can be misleading. The short term Microsoft forecast probably has far less risk and uncertainty than some other forecasts. Some investors will want to pay for that.

Microsoft shares are simply not going to offer the greater percentage return to investors when a recovery comes. They aren’t beaten down by as much, and while I think growth prospects are better than ever, given the overall sources of the company’s revenues it is hard to imagine growth of greater than the high-teens percent, even during a strong recovery. And Microsoft margins, while certainly still having room to expand and reach new record levels, are already greater than levels achieved by most companies.

I view investing in Microsoft shares as equivalent to laying in ballast for an IT portfolio. The space has been incredibly volatile over the years both on the upside and the downside with investors going from a love affair to a divorce in a matter of months. I have maintained a holding of Microsoft shares for years; at times it limited the percentage upside of my portfolio; in years like this it has been somewhat contra-cyclical in terms of its performance.

When I considered the company’s results what I have been most struck by is the resilience of demand other than gaming and Windows OEM. Macro headwinds have been observed, but not at gale force levels. And I continue to be struck by the company’s market share gains as its overall strategy of being a platform company for the internet resonates with IT buyers. This seems to me to be an optimal entry point into the shares in the midst of what has been a toxic environment, and I expect to see the shares generate positive alpha over the next year.

This article was written by

Bert Hochfeld profile picture
20.97K Followers
Bert Hochfeld graduated with a degree in economics from the University of Pennsylvania and received an MBA from Harvard. Mr. Hochfeld has enjoyed a long career in the tech world, working for IBM, Memorex/Telex, Raytheon Data Systems, and BMC Software. Starting in the 1990s, Mr. Hochfeld worked as a sell-side analyst and won awards from the Wall Street Journal for his coverage of the software space. In 2001, Mr. Hochfeld formed his own independent research company, Hochfeld Independent Research Group, which provided research services to major institutions including Fidelity, Columbia Asset, SAC Capital, and many other prominent institutions and hedge funds. He also operated the Hepplewhite Fund, a hedge fund that specialized in technology investments. Hedge Fund Research, an independent 3rd party firm that specializes in ranking managers, rated the Hepplewhite Fund as the best performing small-cap fund for the 5 years ending in 2011. In 2012, Mr. Hochfeld was convicted of misappropriating funds from a hedge fund he operated. Mr. Hochfeld has published more than 500 articles on Seeking Alpha, all dealing with companies in the information technology space. Highly esteemed for his investment wisdom accumulated over decades, Mr. Hochfeld ranks in the top 0.1% of Tip Ranks analysts for his selection of information technology stocks and their subsequent successes.

Disclosure: I/we have a beneficial long position in the shares of MSFT either through stock ownership, options, or other derivatives. 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.

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