Investment Thesis

As some of you may know, I have been publicly bullish on Microsoft (MSFT) since February and privately bullish for much longer. My investment thesis has centered on the future strength in Microsoft’s Business Services and Intelligent Cloud segments. The latest set of financials brought the resilience of Microsoft’s business to the fore and reaffirmed my aforementioned bullish thesis.

Here’s a bulleted summary of my views on Microsoft:

  • Microsoft’s influence in the cloud market is on the rise. This is evidenced by the robust ~17% growth in its Intelligent Cloud revenues.
  • Despite a slowdown in the Productivity and Business Processes segment during the last quarter, the growth rates should normalize post-pandemic.
  • Windows is an unlikely source of revenue growth, and in my opinion, the accelerated growth in the Personal Computing segment will prove to be ephemeral.
  • The stock remains undervalued and offers potential returns of ~15% per year over the next decade.

In today’s article, I share my analysis of Microsoft’s latest earnings and discuss their long-term implications. Further, I reiterate my projection of Microsoft’s intrinsic value using the L.A. Stevens Valuation Model. Using my proprietary model astride my qualitative analysis of Microsoft’s business segments, I conclude that Microsoft is indeed still a buy at today’s price of ~$203.

Let’s get into it!

Strong Quarter Despite Covid-19

In our present challenging business environment, Microsoft managed to grow its quarterly revenue by 13% y/y (and free cash flow by 16% y/y). In my opinion, these numbers are excellent, and management’s performance remains as commendable as ever (as ever is defined as the last 7-10 years).

Source: Microsoft Earnings Slides

The continued strength in Microsoft’s cloud business was expected, as, if anything, the virus pulled forward 2-3 years of digital transformation basically overnight this year.

The highlight from the Intelligent Cloud segment came from Azure, again, as expected, with its revenue growing at 47% y/y. Azure’s rapid growth enabled the Server Products and Cloud Services revenue to grow at ~19% y/y. On a slightly disappointing note, Enterprise services revenue was relatively unchanged (0% growth). In the long-term, I expect Azure to continue driving Microsoft’s Intelligent Cloud revenues (and, by extension, free cash flow) higher.

Source: Microsoft Earnings Slides

However, as the title of this article related, the results were mixed. Microsoft’s Productivity and Business Processes revenue growth rate slowed down drastically from ~15% to just 6%. This slowdown was linked directly to Office and LinkedIn revenues.

READ ALSO  Kremlin Says US Elections Have Become "Competition In Russophobia"

Source: Microsoft Earnings Slides

The extraordinary slowdown in LinkedIn revenues likely stemmed from LinkedIn being one of the first ad channels to be removed from reduced ad budgets. While this is disappointing, it should not be seen as a permanent dynamic for the LinkedIn business segment. Across my coverage universe, I am witnessing valuation re-ratings in companies with ad channels due to the present economic environment.

Thus, I expect to see a recovery in the Productivity and Business Processes segment as businesses recover from the pandemic-induced recession. In the long term, I expect this segment to grow steadily at a, conservatively speaking, normalized rate of ~10% per year over the next decade. Therefore, the current short-term pain in this segment should bear no long term implications on Microsoft’s business in the future.

Surprisingly, the Personal Computing segment registered a strong revenue growth of ~14% on the back of “stay-at-home” trends. The highlights of this segment were the 65% growth in Xbox revenues, 28% growth in Surface revenues, and, last but not least, a resounding 34% growth in Windows OEM non-Pro (a segment which has been waning).

As the threat of the virus slowly vanishes, and it will, the demand for personal computing products will return to historical levels, which will slow down this segment’s growth rate. In the long term, I see Personal Computing as a stable to slightly declining revenue and free cash flow stream for Microsoft over the next decade. Ultimately, its value to Microsoft will be to funnel cash into the company’s buyback program, about which I am not complaining.

Source: Microsoft Earnings Slides

Microsoft’s quarterly free cash flow rose to $13.9 billion (up 16% y/y). This free cash flow growth enabled the company to increase its shareholder capital return program by 16%. Even during these challenging times, Microsoft paid dividends of $3.9 billion and repurchased shares worth $5.1 billion. I applaud management for not giving into the hysteria around buybacks during March.

Further, Microsoft’s balance sheet remains an absolute fortress. Should you want to learn more about said fortress balance sheet, feel free to peruse my most recent article on the company.

Since announcing its results on the 22nd of July, Microsoft’s stock has dipped ~4%. On nearly every post-earnings dip, the stocks I cover become strong buys. In fact, I view the pessimism as nothing but an opportunity!

But do I feel that way in the case of Microsoft? Let’s find out.

READ ALSO  Armenia Launches Ballistic Missiles On Azerbaijan Amid Retreat In Nagorno-Karabakh Region

Re-evaluating Microsoft’s Intrinsic Value

To determine Microsoft’s intrinsic value, I will be utilizing the L.A. Stevens Valuation Model. Here’s what it entails:

  1. Traditional discounted cash flow Model using free cash flow to equity discounted by our (as shareholders) cost of capital
  2. Discounted cash flow model including the effects of buybacks
  3. Normalizing valuation for future growth prospects at the end of the ten years. (3a.) Then, using today’s share price and the projected share price at the end of 10 years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.

In addition to the assumptions stated in the picture below, I use a free cash flow margin of 35%; i.e., I assume true free cash flow generation potential of the company is 35% of its TTM revenues, which, in light of its ~68% gross margins, is likely conservative. So let’s check out the results!

Source: L.A. Stevens Valuation Model

As can be seen above, I estimate Microsoft to grow its free cash flow per share organically, i.e., via its cash from operations less capex, at about 10% annualized over the next 10 years.

Inorganically, I estimate it will grow its free cash flow per share at above 13% via a massive accelerated share repurchase that is inevitable at this point, as illustrated by its $140B cash hoard, and its absolutely massive free cash flow generation each year that adds to said hoard.

Alright, lastly, let’s check out what we can expect in the way of returns when accounting for dividends. Thankfully, this is extremely easy to estimate due to the process being coded into my valuation model!

Projection Of Total Expected Returns

To determine total expected returns, I simply grow our starting free cash flow per share at the assumed rate above (share repurchases accelerate said growth and said accelerated growth is automatically factored into the calculation below). At the end of ten years worth of growth, I multiply the resulting free cash flow per share by a conservative Price to FCF ratio of 25x (Microsoft trades at Price to FCF of 34.4x right now and Proctor and Gamble (PG) trades at 25x with nearly zero percent growth. The market pays for quality.). By doing this, we arrive at the following result:

Source: L.A. Stevens Valuation Model

The total expected price CAGR of 11.66% is slightly above our hurdle rate of 9.8%. Thus, I rate Microsoft a buy strictly on the basis of capital appreciation alone.

READ ALSO  Oil Production Cuts Could Be Extended: Putin

Alright, lastly, let’s check out what we can expect in the way of returns when accounting for dividends. Thankfully, this is extremely easy to estimate due to the process being coded into my valuation model!

Source: L.A. Stevens Valuation Model

After accounting for dividends, Microsoft’s total expected CAGR reaches about 13%, which further reinforces the idea that Microsoft offers compelling value relative to the security of its business and the low risk thereof.

Concluding Thoughts

From my perspective, Microsoft is the latest incarnation of “value” in the traditional sense. While “value investors” spin their wheels buying oil and tobacco (read: value traps), a subset of the investing population understands that life is an evolution, and we must evolve our understandings of business dynamics so as to succeed astride an ever evolving world. While 34x free cash flow isn’t exactly cheap, when we adjust for growth capex, growth R&D, and cash on the balance sheet, we find that 34x is likely much lower, and as a result, the stock is much cheaper.

Since my initial buy recommendation in February, Microsoft’s stock has moved up ~18%. However, the stock still trades below its intrinsic value. Relative value and potential growth (price + dividend) make Microsoft one of my top recommendations among “MAFANG” or “FAAMG” or whichever is in vogue these days.

Key Takeaway: I rate Microsoft a buy at $200.

Please provide your feedback in the comments below.

Thanks for reading; remember to follow to get more stock ideas; and happy investing!

Beating the Market: The Time Is Now

There has never been a more important time in stock market history to buy individual stocks at the heart of secular growth trends. Mature market performers/underperformers and index funds simply will not cut it, as we face a decade during which there is absolutely no guarantee the overall markets will rise. 

This is why the time is now to discover high-quality businesses with aggressive, visionary management, operating at the heart of secular growth trends. 

And these are the stocks that my team and I hunt, discuss, and share with our subscribers!

Disclosure: I am/we are long MSFT. 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.