As Microsoft approaches its Q2 earnings report, several key factors will be closely examined:
- Azure Performance: Azure’s growth exceeded expectations, achieving a 31% year-over-year increase compared to the 28% guidance. Artificial intelligence contributed significantly to this growth. Microsoft plans to invest heavily in expanding AI capacity, with estimated capital expenditures of $15 billion to $20 billion next year, potentially reaching up to $50 billion for the year. CFO Amy Hood has indicated that investment will continue into the next fiscal year.
- Activision Blizzard Integration: Watch for updates on how Microsoft is progressing with integrating Activision Blizzard. There are also rumors that Microsoft may increase prices for Game Pass.
- Commercial Bookings and Performance Obligations: Key metrics to observe include growth in commercial bookings and remaining performance obligations.
- General Demand Trends: Microsoft’s early reporting in the earnings cycle can set the tone for broader software industry trends. Last quarter showed strong performance with notable large deals and solid bookings.
Fair Value Estimate for Microsoft
Based on our valuation, Microsoft’s stock is fairly valued with a 3-star rating. Our long-term fair value estimate is $435 per share, reflecting a fiscal 2024 enterprise value/sales multiple of 12 and an adjusted price/earnings multiple of 37. We project a 13% compound annual growth rate for revenue over the next five years, factoring in the Activision acquisition. Despite potential macroeconomic and currency pressures, Azure, Office 365, Dynamics 365, LinkedIn, and AI adoption are expected to drive revenue growth. Azure remains a critical revenue driver, and consolidation in IT vendors should boost growth for Microsoft’s key segments.
Morningstar Metrics for Microsoft
- Fair Value Estimate: $435.00
- Morningstar Rating: ★★★
- Economic Moat Rating: Wide
- Uncertainty Rating: Medium
Economic Moat Rating
Microsoft is rated with a wide economic moat due to high switching costs, network effects, and cost advantages. This moat is expected to support returns above the cost of capital over the next two decades. The productivity and business processes segment, which includes Office 365, Dynamics 365, and LinkedIn, benefits from switching costs and network effects. The intelligent cloud segment, featuring Azure and other key technologies, is also rated with a wide moat for similar reasons.
Financial Strength
Microsoft’s financial strength is robust, supported by a strong balance sheet and expanding margins. As of June 2023, the company held $111 billion in cash and equivalents, against $47 billion in debt, resulting in a net cash position of $64 billion. With a gross leverage ratio of 0.5 times fiscal 2023 EBITDA, Microsoft is expected to maintain strong revenue growth driven by cloud adoption, AI, and digital transformation initiatives. Free cash flow margins have averaged 31% over the past three years, with expectations for further improvement.
Risks and Uncertainties
Microsoft faces several risks, including potential revenue declines in on-premises products as cloud adoption accelerates. The company must sustain faster growth in cloud-based offerings to offset these declines. High-profile acquisitions have had mixed outcomes, with notable successes like LinkedIn and GitHub, and challenges including the recent Activision deal. The integration of high-profile acquisitions and ongoing strategic investments will be crucial to Microsoft’s long-term success.
MSFT Bulls Say
- Azure is a leading public cloud service, crucial for future enterprise computing.
- Microsoft 365 benefits from upselling into higher-priced plans.
- Dominance in OS and Office segments provides strong revenue support for Azure growth.
MSFT Bears Say
- Slowing momentum in subscription services, particularly Office.
- Lack of significant presence in the mobile market.
- Microsoft trails competitors in key growth areas like Azure and Dynamics.
