Sean Gallup
Elevator Pitch
I rate Microsoft Corporation’s (NASDAQ:MSFT) stock as a Buy.
In my earlier update for Microsoft written on April 8, 2022, I assessed MSFT as a potential metaverse play. This current article discusses Microsoft’s intermediate term outlook and determines whether this has been fully priced into MSFT’s share price and valuations.
Microsoft should be able to still maintain a reasonably fast pace of top line expansion and expand its operating profit margins in the next five years based on my analysis. But MSFT’s current PEG (Price/Earnings-to-Growth) ratio is below the historical average, and this points to a mismatch between the stock’s current valuations and the company’s future growth prospects. As such, I upgrade my rating for MSFT from a Hold to a Buy.
Microsoft Stock Key Metrics
MSFT announced the company’s Q4 FY 2022 (YE June 30) financial results with an earnings press release issued on July 26, 2022. Although Microsoft’s most recent quarterly headline earnings per share or EPS of $2.23 fell short of Wall Street’s consensus bottom line estimate of $2.29 by -3%, this was mainly driven by certain non-recurring items. MSFT noted at its Q4 FY 2022 earnings briefing on July 26, 2022 that the increase in operating costs in the recent quarter “included roughly 2 points from the decision to scale down operations in Russia, employee severance and the impact from the Xandr acquisition (June 2022 completion).”
Looking beyond the headline EPS miss, Microsoft’s performance in the most recent quarter was reasonably good judging by certain key metrics.
Firstly, MSFT achieved a +46% YoY revenue growth for Azure and other cloud services in Q4 FY 2022 on a constant currency basis. This is faster than the +45% YoY currency-adjusted top line increase that Microsoft delivered for Q4 FY 2021. More critically, Microsoft mentioned at its recent quarterly investor call that it observed “larger and longer-term commitments” for Azure, which bodes well for this business line’s long-term growth outlook.
Secondly, the company’s Office 365 Commercial product line witnessed a strong +19% YoY revenue growth adjusted for foreign exchange effects in the final quarter of fiscal 2022. The key driver was Office 365 E5, which MSFT describes as “a cloud-based suite of productivity apps combined with advanced voice, analytics, security, and compliance services.” At the company’s fourth-quarter investor briefing, Microsoft mentioned that “demand for security, compliance and voice value in Microsoft 365 drove strong E5 momentum.” Specifically, the number of Office 365 E5 seats increased in excess of +60% YoY in the recent quarter to account for 12% of the installed base for Office 365.
Thirdly, Microsoft disclosed at its Q4 FY 2022 results call that the company has taken market share from competitors in key areas of its business for the recent quarter. The business lines in which MSFT has enjoyed market share gains include Teams, Windows for PCs, Security, Data and AI among others. This serves as the best form of validation for MSFT’s execution capabilities and its products’ value proposition.
Is Microsoft Expected To Grow?
Microsoft is still expected to grow in the near term, notwithstanding macroeconomic headwinds.
MSFT offered management guidance suggesting that it can generate “double-digit revenue and operating income growth in both constant currency and U.S. dollars” for full-year FY 2023, as per management comments at the recent Q4 FY 2022 earnings call. Microsoft also mentioned at the recent quarterly investor briefing that negative foreign exchange effects should be approximately a -400 basis points headwind for the company’s fiscal 2023 revenue growth.
In other words, this implies that MSFT is expecting the company to achieve at least a +14% (double-digit top line growth guidance and 4% foreign exchange impact) revenue growth in constant currency terms. A possible slowdown in Microsoft’s YoY constant currency top line expansion from +19% in FY 2022 to +14% in FY 2023 explains why the company’s shares have underperformed the broader market in this calendar year thus far.
Microsoft’s stock has corrected by -23.5% in 2022 year-to-date, while the S&P 500 has decreased by a relatively milder -18.2% during this period. In summary, MSFT should still deliver decent positive growth this year, but investors have nevertheless penalized the stock as a result of slower growth expectations in the short term.
What Are Microsoft Catalysts To Watch For?
As discussed in the previous section, MSFT’s shares have done worse than the S&P 500 year-to-date. Microsoft’s current consensus forward next twelve months’ normalized P/E multiple of 25.1 times as per S&P Capital IQ is below its three-year and five-year average forward P/E ratios of 30.8 times and 28.5 times, respectively. This raises the question of whether there are any re-rating catalysts to watch for.
In my opinion, there are three catalysts for Microsoft that investors should pay attention to.
The first catalyst is the sustained growth momentum for Azure.
Azure is the fastest growing business line for MSFT by a wide margin. As indicated earlier, constant currency revenue growth for Azure and other cloud services was an impressive +46% YoY in Q4 FY 2022. The next fastest growing product or service line for Microsoft is Dynamics365 which saw its segment revenue increase by +36% YoY on a constant currency basis in the recent quarter.
Even though market conditions are tough, Microsoft has still guided for a very strong +43% YoY constant currency revenue growth in relation to Azure and other cloud services in Q1 FY 2023. Given that transitioning to the cloud is a key part of many companies’ plans to optimize their costs, Azure’s near-term growth might turn out to be more resilient than what the market expects.
The second catalyst is better-than-expected profitability.
Microsoft’s fiscal 2023 management guidance points to the company’s operating profit margin being maintained at the same level as FY 2022 adjusting for foreign exchange effects.
There is a good chance that MSFT can meet or even beat its operating profitability guidance for full-year FY 2023 by slowing its pace of hiring. A prior July 20, 2022 Seeking Alpha News article highlighted that MSFT was “cutting a number of open job listings.” Separately, Microsoft noted at its recent quarterly earnings call that the rate of increase in its operating costs “will moderate materially over the course of the year as we slow the rate of hiring.”
The third catalyst is the completion of the Activision Blizzard transaction.
In my early-April 2022 article, I stressed that “MSFT’s proposed acquisition of Activision Blizzard (ATVI) is another key milestone in the company’s plans to capitalize on growth opportunities linked to the consumer metaverse.” As such, the conclusion of this deal will be a boost to Microsoft’s long-term growth ambitions in the metaverse.
Notably, Activision’s CEO published a letter he wrote for his staff on September 1, 2022. In the letter, the CEO of Activision reiterated the earlier guidance that the Microsoft-Activision transaction will be completed before the end of FY 2023 on the basis that progress on the regulatory front is within expectations.
In the next section, I focus on Microsoft stock’s 5-year outlook.
Where Will Microsoft Stock Be In 5 Years?
In five years’ time, my view is that Microsoft will become a more profitable company in terms of operating profit margins, while sustaining a reasonably fast pace of top line growth.
In specific quantitative terms, I forecast that MSFT will achieve a low-to-mid-teens percentage revenue CAGR for the forward 5-year period. Based on my estimates, both Microsoft’s EBITDA and EBIT margins should expand by at least +200 basis points (on a cumulative basis) over the next five years. This should translate into a five-year EPS CAGR in excess of +15% for Microsoft going forward.
The robust top line growth projection for Microsoft in the coming years is realistic. MSFT is expected to be a key beneficiary of the digital transformation secular trend, and its broad suite of products and services put in a good position to win an increasingly larger share of customers’ information technology spend.
With respect to operating profitability improvement, Microsoft’s profit margins are expected to expand as a result of positive operating leverage. In particular, MSFT’s cloud/Azure business line should see much more significant economies of scale over time. Microsoft’s Intelligent Cloud segment recorded $75.3 billion of revenue in fiscal 2022, and the business segment should easily cross the $100 billion mark within the next five years which could be an inflection point for the profit margins of the Intelligent Cloud segment and the company as a whole.
Is MSFT Stock A Buy, Sell, or Hold?
I rate MSFT stock as a Buy. Microsoft’s shares are undervalued based on a historical comparison of the PEG valuation metric. MSFT is currently trading at a PEG ratio of 1.67 times (P/E multiple of 25.1 times and my expectations of a long-term annualized EPS growth of +15%). In the past five years, MSFT has traded at a higher mean PEG multiple of approximately 1.9 times as per S&P Capital IQ data. In conclusion, I think that Microsoft warrants a Buy rating, as its valuations are not reflective of the company’s medium-to-long term bottom line growth potential as indicated by the PEG ratio.
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