Jean-Luc Ichard
The Microsoft stock (NASDAQ:MSFT) has lost about a quarter of its value this year as the stock continues to move in tandem with benchmark indexes (Nasdaq 100: -29% YTD; S&P 500: -20% YTD) amidst one of the worst market rout in decades. Yet, it is still one of the best performing contenders in SaaS. The stock sold off the least in SaaS thanks to Microsoft’s robust operating cash flows and diverse revenue portfolio, which have worked to “keep the company’s moat intact”.
While Microsoft remains one of the few rather safe investment picks under the currently volatile market climate, it is important to acknowledge that its underlying business is not fully recession proof. Some of the company’s core performance driving segments, like its More Personal Computing (“MPC”) business, bear significant exposure to increasing recession risks. Specifically, demand for Microsoft’s best-selling productivity software, alongside other retail products and services like its Xbox, Game Pass and Surface offerings will likely be impacted from slowing consumer spending in the near-term. Meanwhile, resilient commercial demand for critical workplace software like Office 365, Microsoft Dynamics, Power Platform applications, and Azure cloud solutions is expected to compensate for the consumer slump ahead.
Nonetheless, the stock is largely expected to trend lower in the near-term as it continues to move in tandem with the markets in response to heightened macro challenges ahead. Uncertainties over how the Federal Reserve’s quantitative tightening measures, rising inflationary pressures, and looming recession risks will play out remain the largest barrier against the Microsoft stock’s near-term performance, as investors mull on how tech valuations will prevail as a result. And this is expected to create better entry opportunities over coming months to gain exposure to Microsoft’s promising long-term upsides. Despite near-term market challenges, Microsoft will re-emerge from current macro headwinds stronger than others in its peer group considering its strength in maintaining robust cash flow growth, buoyed by the “mission-critical” nature of its offerings that continue to garner demand under the faltering economic outlook.
Breaking Down the Near-Term Headwinds
While Microsoft’s long-term growth drivers – market leadership in key software segments, robust fundamental performance, diverse revenue portfolio, and sustained margin expansion – discussed in our previous coverage remain largely intact, the rapidly evolving macro challenges this year are poised to create some near-term turbulence. The most prevalent near-term impacts to Microsoft’s business would count 1) slowing consumer sentiment, and 2) FX risks.
1. Slowing Consumer Sentiment
Consumers are forced to cut back on discretionary spending as persistent inflationary pressures risk continued erosion of household savings. And Microsoft’s MPC segment, which generates revenue from the sale of Windows licenses, Surface computing devices, gaming hardware and services, as well as search ads, is expected to be the most impacted business ahead of tightening consumer budgets. The segment on average accounted for more than 30% of the company’s revenues over the past three fiscal quarters.
- Softening PC market: The softening PC market is expected to levy a direct impact on Microsoft’s near-term Surface and Windows licensing sales, which accounted for 16% of consolidated revenues on average over the past three fiscal quarters. Consumer PC demand has already demonstrated signs of normalization, with shipment levels now on polar opposites from trends observed during peak pandemic-era when individuals across all demographics were scrambling for a computing device to accommodate remote working and learning needs. Global PC shipments have shown accelerating declines in the first half of the year – first quarter volumes dropped by 6.8% compared to the prior year to 78 million units, while second quarter volumes dropped by more than 15% to 71 million units. And enterprise PC demand, which many have been more optimistic about during the first quarter, has also started to wane as corporate belt-tightening measures driven by heightened macro uncertainties cause businesses to push back on their inventory upgrade cycles. Global PC shipments are on track towards a 9.5% decline this year, led by an estimated 13.1% drop in consumer PCs and 7.2% drop in enterprise PCs.
- Weakening ad spending: Forecasts for total global advertising spending this year have also been on a rolling decline due to waning consumer sentiment, which is expected to adversely impact Microsoft’s near-term search advertising sales. Leading media intelligence MAGNA Global has trimmed its prediction on global ad spending growth this year from 12% to 9% amid growing risks of a structural economic downturn later this year. This compares to global ad spending growth of +23% year-on-year in 2021 (U.S. +26% y/y), buoyed by a brief stint of post-pandemic economic recovery.
- Waning demand for games: Seasonality-driven declines in gaming demand ahead of the summer months are expected to be further exacerbated by the decrease in consumer discretionary spending this year given heightened recession risks. This is further corroborated by the sixth consecutive month of y/y declines in gaming content and hardware sales. The sector only generated $3.68 billion in May, down by almost a fifth from $4.5 billion last year. While much of the gaming sector’s sales declines in earlier months were driven by console shortages due to supply chain constraints – as in the case of Microsoft – the recent slowdown is suggesting added pressure from weakening demand. Specifically, gaming content sales declines accelerated in May to 19%, while gaming hardware sales declines decelerated to 11%. This is expected to slow Microsoft’s higher-margin Game Pass cloud-based gaming subscription sales in the near-term, while the supply-demand balance for Xbox consoles continue to normalize.
Microsoft’s Productivity and Business Processes (“PBP”) business, which generates on average 32% of consolidated revenues in the past three fiscal quarters from the sale of commercial and consumer software subscriptions and LinkedIn services is also expected to slow in the near-term. Consumers will likely rely on access to Microsoft’s productivity software (e.g. Office 365) via subscriptions from work or school to save on duplicate spending.
And while the labour market has remained resilient so far despite rising recession risks, with unemployment rates steadying at a low of 3.6% alongside a stronger-than-expected pace of hiring, the increasing trend of layoffs observed across corporate America could also impact subscription volumes for Microsoft’s commercial software offerings (e.g. Office 365, Dynamics, Power Platform applications, etc.) in the near-term. The cooling labour market could also result in weaker demand for LinkedIn advertising and service sales in the near-term, as engagement on the professional social networking platform slows.
2. FX Risks
About half of Microsoft’s consolidated revenues are generated from operations outside of the U.S., which increases the company’s exposure to risks related to currency fluctuations, geopolitical tensions, and broader macroeconomic challenges. This is further corroborated by management’s recent decision to revise guidance as a result of stronger-than-expected FX headwinds amidst a surging U.S. dollar.
Pronounced FX headwinds are expected to continue through the remainder of the year. With the June inflation print coming hot off the press at a whopping 9.1%, the Fed is inclined on implementing a more aggressive rate hike trajectory. And this will continue to push Treasury yield towards higher and more attractive levels, and inadvertently “increase demand for dollar-denominated securities, boosting the dollar’s value”.
Considering the Compensatory Factors
Yet, there are still reasons that make Microsoft a stock to own ahead of a potential recession:
1. Critical Software Provider
Microsoft has created a moat for its business by being the provider of critical productivity software that are relatively price inelastic and resilient in a slowing economy. While the increasingly prominent trend of job cuts and slowed hiring in corporate America might increase churn in seat-based license sales at Microsoft in the near-term, critical subscription-based workplace software like Office 365, Dynamics and Power Platform will be “difficult to unplug” altogether, given the universal nature of these applications across the corporate sector.
Microsoft’s close-knitted ecosystem of critical software offerings also supports stickier demand, which further bolsters its resilience under the looming economic downturn. For instance, the rise in demand for secure and integrated cloud-based collaborative and productivity tools from the commercial sector continues to drive success for Microsoft 365. The integration of Microsoft Teams with Microsoft’s suite of productivity tools like Dynamics 365, Power Platform, and Microsoft Office also makes Microsoft 365 the only turnkey cloud solution that can ensure an organization’s success in the shift towards a virtual workspace.
Since the start of the pandemic, the use of collaboration and productivity platforms has increased by 44% to accommodate new working arrangements. Today, more than 250 million monthly active users rely on Microsoft Teams to interact and collaborate with one another. Commercial Office 365 also now boasts an installed base of close to 350 million seats. And despite pre-emptive cost-savings measures implemented across the commercial sector in preparation for economic uncertainties ahead, Microsoft’s commercial subscriptions are not expected to decline materially. Instead, take rates are expected to keep growing – despite potential deceleration in the near-term – as organizations adapt to an increasingly digital work environment.
2. Robust Cloud Demand
The bullish commercial demand environment for cloud-computing solutions has continued to provide partial insulation for Microsoft from any consumer slowdown, assuaging investors’ angst that the increasingly complex macroeconomic environment might result in a pullback in corporate IT budgets and backfire on the business’ growth outlook. In a world where data-driven decision-making plays a critical role in day-to-day operations, and only 4% of organizations say they have sufficient capacity to make sense of vast data troves on hand, Azure continues to benefit from significant headroom for additional growth. More than half of corporate organizations are expecting cloud adoption to account for the largest portion of their investments in the foreseeable future, which will accordingly drive the global cloud-computing market towards a value of more than $800 billion by 2025.
Microsoft’s continued investment in building out its global network of server infrastructure to support ongoing expansion of Azure availability overseas will also be critical to growing its market share in the long run. While profit margins on Microsoft’s Office offerings are likely approaching a “steady-state” given its current size and maturity, continue growth in Azure will support sustained expansion of the company’s consolidated bottom-line, even in an economic downturn.
3. Sustained Margin Expansion and Strong Balance Sheet
Investors’ concerns over risks of stalling growth due to tightening financial conditions are now exacerbated by persistent inflationary pressures that threaten to erode profit margins. Profitability is expected to take the center stage at the upcoming earnings season, with investors embracing a “cash flow or bust” mindset that might overshadow prior preferences for “growth at all costs”. And this is expected to be a boon for Microsoft, which boasts gross margins that are steadily pacing towards 70%, and operating margins that are also gradually edging above 40%, supporting continued growth of the company’s already-strong balance sheet.
And Microsoft’s robust cash flows allows it to leave its checkbook open for continued investments into growth. This includes potential consolidation through M&A activities, especially considering how this year’s selloff has created attractive valuations for some opportunities that could help bolster Microsoft’s offerings and growth trajectory. This could ultimately strengthen Microsoft’s share gains and reinforce our view that the company will re-emerge stronger than most from current macro headwinds.
Is Microsoft Stock a Buy, Sell, or Hold?
With headline inflation running hot at a fresh 40-year record high of 9.1% in June, central bank tightening will likely remain aggressive, dialling up the risk of a recession soon. And in response, markets will remain volatile in the near-term, with equity valuations trending lower until inflationary pressures show structural signs of easing.
While we remain optimistic on our $340 price target for the Microsoft stock considering the underlying business’ long-term bullish thesis has not materially changed as a result of recent macro headwinds, we believe the dire near-term market climate will create better entry opportunities in coming months.
There is still significant uncertainty on how looming recession risks will play out, considering mixed data that involves a strong labour market but weakening consumption, alongside tightening financial conditions where prices remain elevated and interest rates rise. The Fed is largely expected to deal another “jumbo-sized” rate hike (75+ bps) later this month and potentially at the next FOMC meeting in September – this suggests market volatility will likely last through the summer at least until there is structural evidence that inflation has peaked. Market valuations are not expected to show a structural rebound until there is greater clarity on mounting macroeconomic uncertainties ahead, implying that the bottom has yet to make an appearance and better entry opportunities for Microsoft await.
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