Is Microsoft a good stock to buy? Let’s take a look at the legendary rise, fall and rise of this legendary company. And what’s in for investors looking to jump in now.
“If you are born poor it’s not your mistake, but if you die poor it’s your mistake.”
– Bill Gates
I read this quote many years ago, a time when I was still a student. And it stuck with me since then. Not so much of the chase for money back then. But more of the importance of hardwork and the level of control one can have in our own lives.
Bill Gates may not be so much of an inspiration to many of my generations, since he stepped down as Microsoft’s CEO in 2000. Back then I was still in primary school, barely using computers. And I guess it applies to a lot of my peers as well.
The Rise of Microsoft
But his founding of Microsoft is nothing short of amazing. The company was founded in 1975 with his childhood friend, Paul Allen, following Gates’ dropout from Harvard. Many successful products were created from the beginning till the time when Gates stepped down in 2000.
You are probably familiar with Microsoft’s operating system in many of our computers which still remain very relevant today. Same with their Office suite of products (Word, Powerpoint and Excel) that we are so dependent on, whether in school back then or at work now. And also not forgetting Internet Explorer that took off with the boom of the internet era in the late 90s.
The Fall of Microsoft
But Microsoft’s story hasn’t always been a tale of easy days and triumphant victory. Following Gate’s departure, Steve Ballmer, the company’s 30th employee took over the reign as CEO.
Unlike Gates who was a technical guy, Steve originated from a business background. He restructured the company centered around the business people instead of the engineers and tech people. This fundamentally shifted the identity of the company and its direction.
During Steve’s tenure as the CEO from 2000 to 2014, many consider this period as the downfall of Microsoft. It seemed that the company’s new product launches were always late in the game. For instance, Amazon, originating as a e-commerce e-retailer, actually led the cloud computing industry instead of tech and software companies like Microsoft.
But the major flop was its Windows phone, which was also probably Steve’s biggest failure as CEO of the company. The key reason is that Microsoft is too late in the mobile operating system game.
To quote Gates, “In the software world, particularly for platforms, these are winner-take-all markets.”
So, unlike Microsoft’s dominance in the PC operating system, it failed to catch the wave of mobile devices. Instead, Android became the standard for non-Apple phones. In which Gates commented that it was supposed to be “a natural thing for Microsoft to win” instead.
To add on to the misstep of being too late in the mobile game, Steve pushed for the purchase of Nokia’s phone business in 2013 for more than US$9 billion. And this was ultimately written down after current CEO Satya Nadella took over.
You can now see why people saw Steve Ballmer’s era as the downfall of Microsoft. In fact, once Steve announced his resignation, Microsoft’s stock price jumped 7%.
The rise of Microsoft, Again – Is Microsoft a good stock to buy?
However, that’s not to discredit some of the other great works that he has done. For instance, Xbox’s growth was phenomenal during Steve’s tenure. Some of the acquisitions such as Skype and Yammer added tremendous value for the company as well.
And more importantly, Steve created the enterprise division back in 2008. This constituted to the birth of Azure, the now rising star in its cloud computing business. It didn’t have the chance to flourish until Satya Nadella took over the reign as CEO in 2014. Since then, its cloud computing business has blossomed and grown exponentially.
Other than investing for the future such as cloud computing, Artificial Intelligence (AI) and Virtual Reality (VR), Nadella charted a new philosophy for Microsoft. He embraces collaboration and open source development that Steve was against during his tenure as CEO.
With that, Nadella brought Microsoft Office to iOS and the Android operating system. This resulted in the extension of its dominance in productivity tools from desktop computers to mobile devices.
Another great investment under Nadella was its acquisition of LinkedIn in 2016. LinkedIn is now one of the key growth drivers for the company. Given the social network’s focus on professionals, it has created much synergy with Microsoft’s other enterprise solutions.
Microsoft’s booming business in the recent years has led to a steady climb in its share price.
Indeed, a rollercoaster ride not just for the company, but also for its shareholders as well.
So now, what does it entail for Microsoft and investors thinking of jumping in?
Is Microsoft a good stock to buy? Performance Review
Source: Microsoft Annual Report FY2020 / Segment Results of Operations
First, understand that Microsoft segregates its business into 3 operating segments for reporting purposes. Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.
Within each of the segments, they house a myriad number of businesses.
Productivity and Business Processes
Source: Microsoft Office
Under the Productivity and Business Processes segment, its core product lies in the Office suite of products and tools that many of us are familiar with. Other than the Word document, Excel spreadsheet and Powerpoint presentation slides, it is also integrated with Outlook for emailing purposes, as well as Skype and Teams for communications for organizations or personal use.
This segment also contains LinkedIn which the company acquired in 2016. The social media network monetizes through a few channels. For instance, they have this thing called Learning Solutions. Companies pay LinkedIn for the courses they provide as part of the training for their employees. Other forms of business include Marketing and Sales Solutions. This is where LinkedIn helps businesses build relationships with other organizations and professionals, and in the process acquire new opportunities.
Source: Microsoft Dynamics 365
And finally we have Microsoft Dynamics 365 that hosts a portfolio of business applications. From customer relationship management (CRM) to financial and supply chain management, it caters business solutions to companies and organizations of varying sizes.
Source: Microsoft Azure / The future of computing: intelligent cloud and intelligent edge
Next, take a look at its Intelligent Cloud segment. This segment is mainly associated with its Azure brand. Azure provides a comprehensive set of cloud services for a wide range of customers from developers to enterprises. It gives them the tools to build, deploy, and manage applications on any platform or device, all in one place.
It also provides Premier Support Services and Microsoft Consulting Services to enterprises to assist them in developing and deploying Microsoft server and desktop solutions.
More Personal Computing
As for the last segment More Personal Computing, it is probably something we are familiar with as well. From the Windows operating system in our computers, to devices like its Surface tablets and laptops, Microsoft serves the consumer market mainly through this segment.
Not only that, its gaming business associated with its popular Xbox hardware and Xbox content video games is also parked under this segment.
Also, not forgetting its Search business – Bing. It serves the consumers in this segment, albeit a small share of 2.5% it has in the Search Engine Market.
Is Microsoft a good stock to buy? FY2020 Performance
Now, hopefully you have a better understanding of Microsoft’s business so far. Let’s take a look at the performance metrics for FY2020 first, which ended on 30 June 2020. This will help us have a clearer idea of the full year’s performance.
Source: Microsoft Annual Report FY2020 / Segment Results of Operations
Observe that all business segments continue to grow their revenues. This is even though the first half of 2020 was hit by the coronavirus outbreak. Most notable will be its cloud computing business, which continues to grow very quickly. Its revenue and operating income grew at 24% and 32% year-on-year respectively.
Source: Microsoft Annual Report FY2020 / Income Statements
Whether it’s the revenue, operating or net income, you can observe that Microsoft continues to show strengths in its businesses. Overall, FY2020 saw the company’s revenue increased by 14% from the previous year.
Is Microsoft a good stock to buy? Q2 FY21 Performance
Source: Microsoft Quarterly Earnings FY21 Q2 / Segment Revenue and Operating Income
Now, let’s turn to the latest quarterly performance for Q2 FY21 that ended on 31 Dec 2020.
Here we continue to see strong growth numbers compared to the same quarter in the previous year. All the operating segments are still registering double digits growth in revenue. Productivity and Business Processes at 13%. Intelligent Cloud at 23%. And More Personal Computing at 14%.
Source: Microsoft Earnings Call Slides FY21 Q2 / Financial Summary
Overall, operating income and net income grew substantially at 29% and 33% respectively, compared to the same quarter in FY2020.
Source: Microsoft Quarterly Earnings FY21 Q2 / Assets
Source: Microsoft Quarterly Earnings FY21 Q2 / Liabilities
In terms of financial health, Microsoft has always maintained a very strong balance sheet. Based on the latest quarterly report for Q2 FY21, the company’s total cash, cash equivalents, and short-term investments amount to about US$132 billion. This far outweighs its debt level of around US$60 billion as of the end of Dec 2020.
Well, indeed Microsoft deserves to trade at a premium, given its strong financial health and solid moat around its businesses.
The question is, how much can the company continue to grow.
Is Microsoft a good stock to buy: Growth Elements
Productivity and Business Processes Growth
Office Commercial and Office Consumer
According to Gartner’s 2018 research, Microsoft continues to dominate the email and office suite market with more than 80% of the total productivity suite market share.
However, note that the increasingly popular productivity suites are now adopted on a subscription basis via cloud distribution. In fact, it was Google which pioneered the concept first back in 2006. Back then Microsoft was still focusing on distributing its productivity softwares via conventional means. It was mainly by installation on desktop and laptop computers.
Source: Statista / Market share of major office suites technologies in the United States as of October 2020
Therefore, if we just look at the website market, i.e. customers who are subscribing to online office productivity suites, Google’s G Suite has a more substantial market share in the United States.
So, definitely there’s still more work for Microsoft to capture the website market through its Microsoft 365 office productivity suites subscription model.
Source: Statista / Productivity Office Software Growth Projection 2021 – 2025
Nonetheless, given Microsoft’s entrenched office productivity tools business, this portion of the business should grow at least with the industry. The industry is projected to grow at a compounded annual growth rate (CAGR) of 5.16% between 2021 to 2025.
Let’s take 5% as the growth rate for its Office products in the next few years.
Source: Statista / Annual revenue of LinkedIn from 2017 to 2020
LinkedIn’s revenue accounted for US$8.05 billion for FY2020. And its revenue has been growing very strongly over the past few years, as observed from the chart above.
LinkedIn encompasses a few monetization channels, from Talent Solutions to Marketing and Sales Solutions. We will not delve too much to derive its potential growth rate here.
LinkedIn has been experiencing more than 20% growth in revenue for the recent years. Hence, it will be conservative to peg its growth rate to the growth of digital ad spending. As such, let’s assume a 10% growth for its LinkedIn business in the next few years.
Source: CNBC / Microsoft Dynamics Growth
Let’s look at the final part of its Productivity and Business Processes Segment. Its Dynamics business has grown at a very healthy rate of 15%–20% every quarter compared to the prior years. And Dynamics contributed more than US$3 billion in revenue for FY2020.
Source: Grand View Research / U.S business software and services market size, by software, 2014 – 2025 (USD Billion)
Hence, it is reasonable to assume that Microsoft can continue to capture the growing market of business software solutions. This is market is projected to grow at a CAGR of 10.7% from 2019 to 2025.
Let’s take 10% as the growth rate for its Dynamics business for the next few years.
Productivity and Business Processes Overall Growth Estimate – Is Microsoft a good stock to buy?
Therefore, we can derive a weighted average growth rate for its overall Productivity and Business Processes operating segment, base on a rough estimate of the respective revenue weightage as follow:
Weighted Average Growth Rate
= (63% x 5%) +(10% x 5%) + (17% x 10%) + (7% x 10%)
Intelligent Cloud Growth
Source: Statista / Worldwide market share of leading cloud infrastructure service providers in Q4 2020
Next, let’s look at Microsoft’s cloud business Azure, classified under the Intelligent Cloud segment. It is one of the leading cloud service providers with 20% market share, just behind Amazon’s AWS.
Source: GlobeNewswire / Cloud Computing Industry to Grow from $371.4 Billion in 2020 to $832.1 Billion by 2025, at a CAGR of 17.5%
Being one of the market leaders in the forefront of the fast growing cloud computing business, we can expect its Intelligent Cloud operating segment to grow at least at the same rate as the industry at a CAGR of 17.5%.
This should be a conservative estimate, given Microsoft’s Azure business growing at more than 20% annually in the recent years.
More Personal Computing Growth
Windows and Devices
Source: Statcounter / Desktop Operating System Market Share Worldwide
For the More Personal Computing Segment, its Windows business continues to dominate the desktop operating system. It has more than 75% market share.
The good thing is that this business has a very strong economic moat. I don’t see any competitors dethroning Microsoft’s leading position in this market that it has been in since the birth of the company. However, the downside is that there’s limited growth in this category as well.
Nevertheless, given Microsoft’s entrenched position in the market, we can expect Windows business to continue to grow with the market for desktops and Notebooks. These markets are expected to grow a CAGR of 4.3% and 4.0% respectively between 2021 and 2025. Let’s take Windows growth as 4%.
We will use the same growth rate for its business in selling devices as well.
Source: Mordor Intelligence / Gaming Market – Forecasts (2021 – 2026)
With Xbox being one of the leading gaming platforms, we can expect Microsoft’s gaming business to grow with the industry at a projected CAGR of 10.5% for the next few years.
Source: Backlinko / Bing Market Share
And finally for its Search business. Google is a clear leader in the industry as the Search Engine of choice, with more than 90% market share. With Microsoft’s Bing recording dwindling share of the market, I don’t see any competitive advantage for Bing here. Hence, we will assign zero growth to this subcategory.
More Personal Computing Overall Growth Estimate – Is Microsoft a good stock to buy?
Therefore, we can derive a weighted average growth rate for its overall More Personal Computing operating segment, base on a rough estimate of the respective revenue weightage as follow:
Weighted Average Growth Rate
= (44% x 4%) + (12% x 4%) + (20% x 10.5%) + (24% x 0%)
Microsoft Overall Growth Estimate
Now that we have the growth rates for each of Microsoft’s operating segments, we will derive a weighted average growth rate for its overall business, base on a rough estimate of the respective revenue weightage as follow:
Weighted Average Growth Rate
= (32% x 6.4%) + (34% x 17.5%) + (34% x 4.3%)
To sum it up, is Microsoft a good stock to buy? Well, definitely it is a great company with strong economic moats around many of its businesses. Especially in its entrenched market leader position in its office productivity suites of tools, as well as its Windows operating system.
These businesses will continue to be the cash cow for the company to redeploy to more research and development efforts, investing in growth and acquiring businesses of new opportunities. Or just return to its shareholders through dividends and share repurchase.
In addition, we are seeing some strong growth in cloud business and in the gaming sector. And also not forgetting some great investments and acquisitions it has made, like LinkedIn, which continue to grow at double digits level.
Source: Yahoo Finance / Microsoft Corporation Share Price 2-Year Chart
It is no wonder why its share price has been on an upward trend. After the market correction in March 2020 due to the coronavirus-induced market sell-off, the stock has climbed even higher.
However, given the overall growth rate of about 9%, at the current share price of US$250, I think it’s valuation is on a higher side.
Source: YCharts / Microsoft PE Ratio 5 Year Chart
Moreover, looking at its Price-to-Earnings (P/E) ratio of around 38 currently, it seems to be on a higher side compared to the historical levels. So, there may be risk of multiple compression.
Say if we take its earnings per share (EPS) of US$5.76 for FY2020, and grow at 9% annually for the next five years. We will derive a projected EPS of US$8.86. Assume the P/E calibrates to a more reasonable level at 30. The projected share price will be US$266, which represents limited upside from the current price.
So, I’m definitely adding it to my watchlist and monitor first, and perhaps get in when better opportunity strikes.
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Keep learning and happy investing. 🙂