Tech Giant Microsoft Is A Worthy Investment Choice

From time-to-time, companies pop up on the Green Screens that are, obviously and without a lot of research, great companies.

Today's subject, Microsoft (MSFT), is clearly one of those. It recently screened up in the "Tortoise" portion of the Green Screens.

Microsoft has unquestionably been one of the best companies in the world since going public in the mid-1980's. The company pioneered the software licensing model, allowing it to fully profit from the proliferation of PCs in the 80's, 90's, and 2000's. Its Windows and Office products achieved such market dominance that the company came under anti-monopoly investigations in the 1990's. The firm stagnated a bit in the late 2000's and early 2010's, trying and failing to enter a number of large consumer markets, while its Windows/Office hegemony failed to deliver the growth investors were looking for.

In 2014, CEO Steve Ballmer was replaced with long-time Microsoft cloud boss Satya Nadella. Since then, the firm has "found its mojo", again catapulting itself to be one of the top tech names in the entire world. Today, the firm's $2.4 trillion market valuation makes it the second largest publicly traded company in the world, behind only long-time rival Apple (AAPL).

Despite that, I think Microsoft's incredibly strong competitive position and absolutely enormous addressable markets give it plenty of runway to continue delivering outstanding returns to shareholders. Let's take a closer look at this behemoth.

What Microsoft Does

A firm as large as this has a lot of parts. Microsoft organizes its business into 3 units:

Productivity and Business Processes

These are a collection of Microsoft's enterprise software products and services. The bulk of it (70%) consists of sales of Office products, the ubiquitous suite containing such well-known programs as Powerpoint (for making presentations), Excel (spreadsheet), Word (word processor), Outlook (email and calendar), and others. Its software development tools (Visual Studio, SQL Server, etc.) are another notable contributor here.

This segment also includes Dynamics, Microsoft's customer relationship management (CRM) offering. It also includes revenue from LinkedIn, the professional social network acquired in 2016.

For the most part, this segment consists of subscription sales, nowadays. Office and Dynamics have moved away from version licensing into "365" products that are recurring subscriptions (and regularly updated).

Productivity and Business Processes makes up 33% of total company revenue. At a very healthy 49.4% profit margin, it is the company's most profitable business unit, and comprises 39% of total company profits.

Intelligent Cloud

Intelligent Cloud is really Microsoft's biggest success story under Nadella's leadership. At 22% market share, its Azure cloud computing platform has rapidly grown into the 2nd biggest worldwide, behind only Amazon's (AMZN) AWS (at 32% share).

For those unfamiliar, Azure is a cloud computing "platform-as-a-service" (PaaS). Businesses as large as Coca-Cola and Delta Airlines run their entire online presence on the platform (websites, mobile apps, online services, etc.), instead of maintaining their own IT infrastructure. For this, they pay large recurring subscription and usage fees to Microsoft.

Intelligent Cloud is 41% of company revenue and by far the fastest growing segment. Margins, at 43.1%, and strong and increasing. The segment is Microsoft's largest from a profit perspective, making up 43% of total company income.

More Personal Computing

I think of this segment as "traditional Microsoft". These businesses are what most consumers think of when they hear the name. It includes sales of the Windows operating system to PC makers, search advertising sales on the Bing search engine, company-designed devices such as the Surface line of premium PCs, and the Xbox line of gaming devices, services, and content.

More Personal Computing makes up 26% of the company's sales at a 30% profit margin. 19% of company profits come from here.

Is Revenue Growing and Recurring?

At $212 billion in trailing twelve month revenue, it takes a LOT of growth to move the needle for Microsoft. Its 3 year compound annual growth rate is strong at 14%, but eased to just 7% for fiscal (June) 2023. We are generally looking for 10% revenue growth at a minimum, so can Microsoft make the cut?

I think it can. Analyst outlook is for low double-digit sales growth over the next several years. The Cloud segment still grew over 17% in 2023, and the Business unit was up 9%. The Consumer unit was the laggard, down 9% off of a weak PC market which drove down Windows sales 12% and Surface sales 20%. Consumer is by far the least attractive of the company's 3 business units, and will probably be somewhat cyclical. A bit better performance here and the company would have been over 10%.

Looking long-term, I still see a lot of growth potential. Just look at some of these addressable markets:

The platform-as-a-service market was worth $75 billion in 2022, and expected to grow at a 19% rate to reach $206 billion by 2028.

Business software-as-a-service is a huge space, worth $237 billion in 2022, growing at 19% to exceed a staggering $900 billion by 2030.

Gaming is a $73 billion industry in 2021, expected to grow at 14% annually to reach $218 billion by 2030.

Those are some pretty attractive growth rates for Microsoft's most profitable businesses. The company makes the cut on "growth potential".

And, of course, one of the most admirable things about the firm is its portfolio of recurring revenues. Office 365, Dynamics 365, Azure, and the service portion of Xbox are all recurring subscription sales. LinkedIn and Bing are ad platforms that are essentially "toll booth" businesses. Windows fits into this "toll booth" model as well, a nearly required expense for every new PC sold. So, yeah, we've got a very solid recurring revenue base here.

How's the Moat?

No company gets to a $2.4 trillion valuation without having a wide economic moat, and Microsoft is no exception.

I see two clear moat factors in play. The first, which has gotten Microsoft where it is today, are NETWORK EFFECTS, particularly in Windows and Office. They were "first mover" tools as PCs became ubiquitous in the workplace, and quickly became the IT standard. Office workers need to share and exchange work files, and Office's formats became the standard for that as well. Much of this remains the case today, 30+ years going.

Microsoft's network effects also manifest in other ways. By long ago standardizing on Windows and Office, many enterprises consider Microsoft a "first vendor" for other solutions, including software development tools (IDEs, compilers, databases, etc.), chat and collaboration software, security software, and more. It gives the company a low friction way to enter pretty much any new enterprise software market it wants. This is a huge competitive advantage.

The second moat factor are HIGH SWITCHING COSTS. Could your company take away Excel, or Outlook, or Windows tomorrow and not suffer major productivity disruption? I think not, and this applies to most Microsoft offerings. Firms that run their entire online businesses on Azure would face daunting challenges in migrating to a competing PaaS.

The moat remains quite wide and powerful for Microsoft. No concerns here.

Management and Financials

After a decade of stagnation and failed initiatives under former CEO Steve Ballmer, Satya Nadella, the company's cloud boss, was elevated to CEO in 2014. Under his leadership, Microsoft has executed an incredibly strong comeback, largely due to its transition to focus on cloud and "software as a subscription" business models. During his tenure, which included some lean early years, Microsoft has grown revenue 11% annually and operating profits 13%.

At 56 years of age, Nadella should have a good 5+ years remaining in charge. Along with CFO Amy Hood, who started about the same time, Microsoft's top leadership is proven successful and trustworthy, with a strong finger on the pulse of where the enterprise technology market is headed. I have no concerns about leadership at all.

As for financial health, well... Microsoft has ALWAYS been one of the most financially impressive publicly traded companies there is. That's still the case today. The firm has maintained free cash flow margins in the mid-30% range for a very long time. While there have been some bad acquisitions in the past, overall we still see a very strong cash return on invested capital figure of 33%, meaning management has generally been good about allocating capital. Microsoft is also a reliable share repurchaser (about 1% of shares retired annually), and it also pays a dividend that has been increased in 13 consecutive years.

Risks

Certainly, in the context of the other stocks reviewed here, Microsoft is a lower-risk pick from the perspective of losing a substantial amount of capital. The firm's economic moats are just too wide for it to fall apart quickly, barring some unforeseen circumstances.

That's not to say there isn't risk. Microsoft faces very strong, capable players in nearly all of its business segments. There are free alternatives to many of its offerings, including Office and its suite of software development tools. Dynamics competes directly with Salesforce, HubSpot, and others. Azure is challenged by two equally huge platforms in Amazon's AWS and Google's GCP. Windows remains the leading PC operating system, but has seen its market share dwindle from 92% in 2009 down to 57% in 2023, ceding most of that to Apple's MacOS.

Fiscal 2023 results also shined a light on the firm's achilles heel: its Consumer business. It declined 9% on the year and there's no guarantee it will rebound. PCs are no longer a growth market, which makes both Windows and the devices unit more or less stagnant lines of business. Bing has always been a second-rate search engine. And Xbox, while a strong property, is not growing particularly rapidly and faces strong competition from Sony and Nintendo, among others.

Any of these factors contributing to less-than-10% revenue growth will make our fair value estimate look too optimistic.

Finally, we always need to keep in mind regulatory risk when considering any of these giant tech names. It has certainly happened before to Microsoft, and certain geographies (notably the EU) have been more and more aggressive in regulating the power these firms yield.

Conclusion

There was little question when I began investigating the firm that Microsoft would make the cut as a "green dot" stock, and not much changed my mind during research. It checks the boxes rather clearly on recurring revenue, economic moat, leadership, and financial strength. The growth outlook can be argued, but it operates in such massive, rapidly growing industries that I think sustained 10% growth is plenty achievable.

So what is the stock worth? Using typically conservative targets of 9% annual sales growth, 1% annual net share buybacks, a 34.25% free cash flow margin (below the 5-year average of 35.5%), and a 9.5% discount rate, I get a fair value of $409 per share. That makes the stock about 19-20% undervalued at present. I'd like to see just a bit more margin of safety before jumping in, but this is one to watch closely for a "Buy" call in the near future.