Investment Overview - $Microsoft(MSFT)$ (MSFT)

MSFT is the market leader in productivity software market. With a market share of 85% in productivity software, MSFT enjoys certain key competitive advantages over its peers. This is due to its industry-leading product range, widespread market presence, extensive and deep C-level relationships, and solution selling capabilities.

According to ResearchAndMarkets.com, the global productivity software market is predicted to expand at a 14% CAGR over 2022-2026 to US$98bn while during the same period, cloud-based office productivity software market is expected to grow at a 25% CAGR to US$51bn by 2026. Consensus forecast revenue CAGR of 11% over FY23-26 (June fiscal year) for MSFT's productivity and business process segment which includes (Office, LinkedIn, Dynamics).

MSFT's Azure has become the key growth driver. Consensus expects Azure to deliver CAGR of 16% over FY23F-26F, reaching US$136bn revenue in FY26F, rising from 38% of group revenue in FY22 to 45% in FY26F. MSFT holds 21% market share (AMZN 32%) in the cloud services market.

Operating margin for cloud business stood at 43% in FY22 vs 35% margin in the personal computing segment (30% of group revenue). So, MSFT is likely to see an uplift in its margins when customers switch from its on-premises install bases (e.g. Windows and Gaming) to its cloud platform.

However, in 1Q23 Azure revenue grew 35% y-o-y, but a drop from 40% y-o-y growth in 4Q22. Growth in Azure consumption continued to moderate, and higher energy costs are impacting the gross margin of Azure. Furthermore, management indicated a sequential drop of about 5% growth in 2Q23 for Azure.

Declining global PC shipments is a near-term worry for windows. Revenue from personal computing segment which includes Windows, Xbox, Surface and advertising from the Bing search engine continues to drop. Revenue from sales of Windows licenses to device makers dropped 15% y-o-y in 1Q23. According to IDC, shipments of PCs and tablets are forecast to decline 12.8%/2.6% during 2022/2023 as consumer demand is slowing down, education demand being largely fulfilled and enterprise demand is being dented due to the worsening macroeconomic conditions, while the growth will slightly recover afterwards generating a CAGR of 0.8% over FY22-26F, but still not at pre-pandemic levels.

Furthermore, on the gaming, potential acquisition of Activision Blizzard for ~US$69bn, MSFT's Game Pass would get access to 361m active monthly players. MSFT's massive investment in the gaming business is evident that it sees potential development in the coming years.

Hence, MSFT would seem bullish, based on 12m-forward P/E of 26x at a 40% premium to Apple's (AAPL) 18.5x and 25% premium to peers' 20.5x. The TP for MSFT is based on 26x 12- month blended net profit of US$77bn at 34% margin. MSFT enjoys a large mix of recurring revenue than AAPL's higher mix of transactional revenue which justifies the premium. Furthermore, MSFT has materially lower exposure to cyclical revenue streams such as advertising, devices, etc., compared to its peers. Overall MSFT offers FY23F-26F revenue and earnings CAGR of 13.3% and 15.9% respectively

Risks

Enterprise application spending is cyclical, given the more discretionary nature of applications projects. During an economic slowdown, when firms are faced with shrinking IT budgets, projects involving application upgrades, migrations or new installations are often deferred. This could present a higher degree of risk for Microsoft, in the event of an economic slowdown. Slower-than-expected commercial cloud growth, slowing cloud spend, foreign currency risk, negative economic conditions, inability to hire, increasing competition, and PC or Server market decelerate faster than expected are also some downside risks for MSFT.