To The Moon

Summary

• Q3 2022 results marked the 12th consecutive beat of consensus revenue and earnings forecasts.
• Microsoft’s move to strengthen its gaming offerings is gaining momentum.
• The cloud is an assured growth engine.
• The company faces multiple macroeconomic headwinds.
• Microsoft recently reduced its fiscal fourth-quarter revenue guidance.Microsoft Corporation’s Q3 earnings marked the twelfth consecutive quarter the company beat on the top and bottom line. Management’s moves in gaming are gaining steam, and the cloud is providing a long growth runway.

However, Microsoft’s business stretches across theglobe. In fact, almost half of the firm’s revenue comes from outside the US. That worldwide reach serves to exacerbate current supply chain issues. At the same time, foreign currency exchange rates weigh on company results. $Microsoft(MSFT)$

Furthermore, Microsoft’s lack of a meaningful presence in mobile devices limits the company’s access to the largest gaming platform.

A Scan Of MSFT's Q3 Results

In late April, Microsoft reported results for fiscal 3Q22. The company delivered beats on the top and bottom line, with revenue topping consensus estimates by $336 million and EPS beating consensus by $0.03. Revenue was up 18% year-over-year to $49.4 billion.

By segments, Intelligent Cloud revenue increased 26%, as server and cloud services revenue grew 29%. Azure and other cloud services grew by 49%.

A strong showing by Office 365 and Office Consumer resulted in 17% growth in Productivity and Business Processes. Strength in the PC market pushed OEM revenue up 11%, and the More Personal Computing segment revenue rose 11%.

Operating income rose 19.5% to $20.4 billion, and operating margins increased by 40 basis points to 41%.

What Is Microsoft's Bullish View?

The cloud-based version of Microsoft Office is Microsoft 365 (formerly Office 365). Together those two products account for a bit over a quarter of the company’s revenue. The metamorphosis from perpetual license sales of Office to the cloud-based subscription services provided by 365 initially resulted in a financial drag.

However, the transition has now reached the point where sales of 365 are accelerating. With 165 million subscribers, 365 now constitutes more than half of Office revenue. With a virtual monopoly in its space, one can make a reasonable argument that no company has a more bulletproof source of revenue than that provided by Microsoft Office and Office 365. Although Office products are generating a large fraction of Microsoft’s revenue, they are growing at a low single-digit rate.

In contrast, LinkedIn provides a single digit percentage of the company’s revenue, but it is growing at a rapid rate. LinkedIn is a professional networking tool that is in some ways similar to Facebook. The service provides a database of professionals for recruiters, as well an advertising platform. With over 600 million registered users, LinkedIn revenue grew 38% over the first three quarters of 2022 to $10.1 billion.

LinkedIn’s growth has now reached a level where a virtuous cycle is in place: the large number of users attracts more recruiters which in turn results in more professionals using the service.

This scale results in the potential for greater advertising revenues. LinkedIn helped to push the company’s digital search and news advertising revenues up 29% to $8.7 billion over the first three quarters of the fiscal year.

Another potential source of growth lies in the company’s gaming division. Gaming notched 10% revenue growth through the first nine months of 2022; however, keep in mind that this follows a COVID inspired 42% boost in gaming revenue during the first nine months of 2021.

The company's gaming business generated $15 billion in revenue in fiscal 2021, and with the additional $9 billion Activision generates, MSFT will control 14% of the gaming industry. Along with that jump in revenue, Activision Blizzard also brings 400 million monthly active players across 190 countries.

Furthermore, Microsoft’s xCloud will provide gaming to any device with an internet connection. This means gamers will no longer require consoles or PCs. The company’s extensive network of data centers also allows local servicing of game requests and reduced latency while enhancing game quality, an advantage others cannot match at this juncture.

Microsoft’s goal is for gaming to evolve into a recurring, stable subscription fee. I contend that the cloud is the future of gaming, and if that proves true, MSFT holds a distinct advantage over rivals due to the firm’s position as a leader in the cloud.

Through the cloud, we’re extending the Xbox ecosystem and community to millions of new people, including in global markets where traditional PC and console gaming has long been a challenge. And when we look ahead and consider new possibilities, like offering Overwatch or Diablo, via streaming to anyone with a phone as part of Game Pass, you start to understand how exciting this acquisition will be.

Satya Nadella,CEO

There is evidence that Microsoft’s gaming initiatives are gaining steam. Sony's PlayStation Plusgamesubscription service lost 600,000 users from the end of 2021 through March of this year. In contrast, as of January, Microsoft's Xbox Game Pass notched a 39% year-over-year increase in subs.

With our Xbox Series S and X consoles, we have taken share globally for two quarters in a row, and we are the market leader this quarter among the next-gen consoles in the United States, Canada, U.K., and Western Europe. And with Xbox Cloud Gaming, we are redefining how games are distributed, played, and viewed.

Satya Nadella,CEO

Last, but far from least, there is Microsoft’s cloud business. One cannot fully weigh an investment in MSFT without understanding that Azure is not only a rapidly growing division, but that it also generates very high profit margins.

Azure is the primary reason Microsoft’s operating margin has climbed from 34% in FY 2019 to 37% in FY 2020, and to 42% in FY 2021. Furthermore, over the last two years, revenue from Azure sales increased 55% while operating profits rose 82%.

That robust growth assuredly lies in the fact that the cloud service market is projected to experience robust growth for the foreseeable future: Gartnerestimatesglobal spending on public cloud services will grow 20.4% in 2022, to $494.7 billion. The forecast for 2023 is for the public cloud market to reach nearly $600 billion in sales.

Furthermore, MSFT has a history of increasing its share of the overall market. In 2017, the company held roughly 12% of the cloud provider market, but by the fourth quarter of 2021, Microsoft's market share had grown to 21%.



What Is Microsoft's Bearish View?

There is a flip side to Microsoft Office and Microsoft 365. Yes, it is a sure source of revenue for as far as the eye can see. The problem, so to speak, is that it constitutes 26% of the firm’s revenues while only growing at a low double-digit pace.

If MSFT was a run-of-the-mill company, Office and 365 would rightfully be touted as a nearly ideal business. However, Microsoft is not an average company. Investors are willing to invest in the stock when it trades for a high P/E because there is a history and an expectation of outsized growth in revenues. So in a sense, Microsoft Office and Microsoft 365 are holding the company back.

Another problem besetting the company is one common to this era: supply chain woes. During the most recent earnings report, CFO Amy Hood discussed the effect of supply chain issues.

…our guidance reflects the current constraints from the shutdowns in China, which have negatively impacted Q4 supply for OEM, Surface and Xbox consoles.

Although the chip shortage will have a relatively small impact on Microsoft’s product lines, it could cause a slowdown in PC sales. In turn, this could bleed over into the Microsoft Office and Office 365 side of the business.

Hood also warned that gaming revenue is likely to slow in coming quarters.

And in Gaming, we expect revenue to decline in the mid-to-high single digits driven by lower engagement hour’s year-over-year as well as constrained console supply. We expect Xbox content and services revenue to decline mid-single digits though engagement hours are expected to remain higher than pre-pandemic levels.

Hood’s guidance appears likely to prove true, as NPD Group recentlyreportedvideo game sales hit a 27 month low, falling 19% in May. The drop in video game sales was accompanied by a fall of 11% in hardware sales while accessory sales tumbled 7%.

Moreover, with the possibility of a recession on the horizon, technology spending could slow markedly. Furthermore, Microsoft’s Bing search engine and LinkedIn professional networking website could suffer a slowdown in advertising spending, should the economy falter.

As previously noted, MSFT is a company with a global footprint, and the company’s wide geographic reach presents additional headwinds.

Early this month, MSFT lowered itsguidancedue to foreign exchange issues. Management now forecasts Q4 EPS of $2.24 to $2.32, down from the previous range of $2.28 to $2.35. Revenue is now expected to land in a range of $51.94 billion to $52.74 billion, versus a previous forecast of between $52.4 billion and $53.2 billion.

MSFT Stock Basics

Microsoft is one of only two publicly traded companies with a AAA credit rating from Standard & Poor’s.

MSFT has a yield of 0.94%, a payout ratio of 26.48%, and a 5-year dividend growth rate of 9.60%.

The stock currently trades for $256.48 a share. The 12-month average price target of the 30 analysts covering the stock is $353.36. The price target of the 15 analysts that rated MSFT following the last earnings report is $342.80.

Microsoft's forward P/E of 27.34X is about 3.5 points lower than the stock's average P/E over the last five years. The 5-year PEG ratio of 1.79X is well below the company’s average PEG ratio over the last five years of 2.21X.

Is MSFT Stock A Buy, Sell, or Hold?

While momentum is slowing in the ongoing shift to subscriptions, particularly in Office, Microsoft is recording sustained double-digit growth for most of its businesses. Testimony to Microsoft’s growth trajectory lies in the fact that the company’s $168 billion in revenue in FY 2021 was nearly seven times that of 2001.

Some of that growth can be attributed to the company evolving to subscription based services, while another enduring source of growth lies in the cloud.

I see Microsoft’s headwinds as largely transitory, while the company’s growth engines are accelerating.

I will readily admit that I often struggle to determine whether a stock is a buy or hold, as many valuations fall in a gray area. However, Microsoft’s P/E ratio is now the lowest we have seen since March of 2020. Furthermore, the PEG ratio is well below that of the stock’s average PEG over the last five years. Consequently, I think it is a clear cut and simple task to evaluate MSFT.

I rate MSFT as a BUY. 

My only caveat is that I believe a recession is on the horizon.

Should we experience an economic downturn, I think it is likely that the markets will head lower for longer. If that proves true, investors will almost certainly be able to invest in MSFT at a more attractive share price.

Source: Chuck Walston