Microsoft Stock: 3 Things That Smart Investors Should Know (NASDAQ:MSFT)

Elevator Pitch

I continue to assign a Buy rating to Microsoft Corporation’s (NASDAQ:MSFT) stock.

In my previous article for Microsoft published on November 3, 2022, I analyzed the effects of the company’s layoffs. The focus of my latest update for MSFT is the key items that investors should be aware of prior to considering a potential investment in Microsoft’s shares.

My analysis finds that Microsoft has an excellent track record of delivering top line growth, and the company has been able to record relatively stable profit margins notwithstanding the difficult economic environment. In addition, the growth runway for MSFT is long, considering its ability to exploit growth opportunities in the AI space. I reiterate my Buy rating for MSFT with this current write-up.

Microsoft Stock Basics

Microsoft is the world’s leading software company whose name is synonymous with office productivity software and computer operating systems. MSFT’s Azure and Xbox businesses are also among the leaders in the worldwide cloud computing and console games markets, respectively. These are the basics for Microsoft.

What Investors Should Know About Microsoft Stock

The 80/20 rule or Pareto Principle comes into play when assessing any stock as an investment candidate. A few factors have a disproportionate impact on a company’s business outlook, which are what investors really need to focus on.

In my opinion, there are three key things that investors should know about MSFT’s shares, namely profit margins, revenue predictability, and artificial intelligence.

I will elaborate on the above-mentioned items in the subsequent sections of the article.

Profit Margins

MSFT achieved a marginal +0.3% earnings beat for the Q2 FY 2023 (YE June) financial period, despite a slight -0.8% revenue miss in the most recent quarter. Microsoft’s above-expectations Q2 FY 2023 bottom line was mainly attributable to better-than-expected profit margins.

Microsoft’s Q2 FY 2023 non-GAAP adjusted operating profit margin was 40.9%, which turned out to be +120 basis points higher than Wall Street analysts’ consensus operating margin estimate of 39.7% as per S&P Capital IQ data. MSFT indicated at its Q2 FY 2023 earnings briefing on January 24, 2023 that its actual non-GAAP adjusted operating costs for the recent quarter came in approximately $0.5 billion below what the company had earlier guided for.

Moving forward, Microsoft expects the company’s adjusted operating profit margin, excluding the effects of accounting estimate changes and restructuring charges, to decline by around 200 basis points for full-year FY 2023. In other words, MSFT’s management guidance implies that its headline operating income margin (including restructuring charges and accounting estimate changes) is only expected to contract by roughly 1% in fiscal 2023 which is pretty impressive.

At the company’s most recent quarterly investor call, MSFT specifically mentioned about “aligning our own cost structure with our revenue growth.” MSFT’s reasonably favorable FY 2023 operating profit margin guidance shows that the company is able to maintain strong profit margins even as its revenue comes under pressure from macroeconomic headwinds.

Revenue Predictability

Microsoft has increased its revenue in 18 of the past 20 years as per S&P Capital IQ data. Looking ahead, the sell-side analysts predict that MSFT will continue to expand its top line in every year for the next decade.

A key metric known as Commercial Remaining Performance Obligation or commercial RPO provides support for the view that Microsoft’s future revenue growth is visible and predictable. In its 10-K filing, MSFT describes commercial RPO as the “commercial portion of revenue allocated to remaining performance obligations” comprising of “unearned revenue and amounts” which will be “recognized as revenue in future periods.”

MSFT’s commercial RPO expanded by +29% to $189 billion as of December 31, 2022, which is roughly equivalent to a year of the company’s total sales. As indicated at the company’s Q3 FY 2023 earnings call, Microsoft expects to have close to half or 45% of its commercial RPO accounted for as revenue in the subsequent one year. More importantly, the component of MSFT’s commercial RPO which is expected to be converted into revenue after one year grew by a substantial +32% YoY. This gives investors the confidence that Microsoft is well-positioned to continue generating positive top line expansion in the medium term.

Artificial Intelligence

MSFT stressed at its recent Q3 financial results call that it boasts “the most powerful AI supercomputing infrastructure in the cloud”, and noted that it has “partners like OpenAI” which is best known for its AI chatbot ChatGPT. Seeking Alpha News reports in the past one month imply that Microsoft has plans in place to exploit synergies between ChatGPT and its existing products such as Azure and Bing.

A recent February 3, 2023 research report (not publicly available) titled “A Guide To The New Age Of AI” published by Barclays (BCS) forecasted that global “AI-based application software revenue” will double from $400 billion in the prior year to $800 billion by 2026.

Microsoft’s portfolio mix puts it in a good position to capitalize on growth opportunities in AI. Being the outright market leader in the productivity software and computer operating system segments with its Office and Windows product offerings, MSFT has the luxury of allocating substantial excess cash flow into new growth areas like AI.

What Is The Long-Term Outlook?

The financial outlook for Microsoft in the long run is excellent.

Based on the consensus financial projections obtained from S&P Capital IQ, MSFT’s top line is estimated to expand at a +13.0% CAGR from $209.0 billion in FY 2023 to $301.7 billion for FY 2026. Analysts also forecast that Microsoft’s normalized EPS will grow from $9.32 for FY 2023 to $15.87 in FY 2026, which translates into a +19.4% bottom line CAGR.

The strong long-term outlook for Microsoft is underpinned by the company’s revenue predictability, resilient profit margins, and the growth potential relating to AI as outlined in the prior sections of this article.

The Bottom Line

I maintain my Buy rating for Microsoft’s shares. There are quite a number of things that make MSFT an attractive investment proposition, such as top line stability, good expense control, and AI-related growth opportunities.