Big-Tech Investment Series - Microsoft Corp.

No temptation has overtaken you except such as is common to man; but God is faithful, who will not allow you to be tempted beyond what you are able, but with the temptation will also make the way of escape, that you may be able to bear it.

1 Corinthians 10-13

This is a tough and amazing Bible verse. On the one hand, my sinful nature is my only admittance when I fall victim to temptation and sin. On the other hand, when I obey and follow God, my path is free from those same evil temptations. “The way of escape” is a standout phrase for me. Over the course of my many investment years, I’ve felt the bonds of no escape multiple times while trying to navigate Wallstreet’s tentacle-gripped markets. God’s words ring true for my life to live in His glory, and this same truth can be very applicable to resisting and escaping emotional desires and drivers leading to premature investment decisions.

The next company in the Big-Tech investment series is Microsoft Corp. (MSFT).

Key Takeaways for Retail Investors

• MSFT’s overvaluation level is not to the same degree as Big-Tech peers including AAPL and NFLX.

• The company will likely continue to pursue a growth-by-acquisition strategy focusing on services/other segments.

• MSFT’s core strength is its ability to continue to integrate businesses while sustaining and improving cash flow margins.

• Dividend investors should avoid MSFT as like AAPL, the company is focused on Wallstreet’s mechanisms and tactics to keep MSFT’s perception as a growth stock at the forefront; this is the core overvaluation driver and risk for investors.

  
  

The first two blogs on Apple, Inc. (AAPL) and Netflix, Inc. (NFLX) have focused on overvaluation. MSFT similarly is overvalued, but the degree is not as extreme. MSFT is unique in that its growth-by-acquisition strategy has been highly successful. Success has been defined by an expansion in operating cash flow margin and sustained double-digit revenue growth rate. Wallstreet recognized this potential and execution during the last Trump Administration as valuation multiple expansion proceeded to increase all four subsequent years.

The COVID-19 pandemic inflated many companies and Big-Tech has continued to benefit from the pandemic multiple expansion. So the question is, is MSFT worth eight times enterprise value to sales and 20 times operating cash flow per share, or 12 and 26 times respectively.

MSFT’s operating cash flow has not witnessed a straight-line increase in margin performance, but through acquisitions and over time, the company has been able to increasingly improve it. More recent declines in free cash flow beginning in 2016 and intensifying in 2021 to current can be attributed to MSFT’s increasing investments into its cloud business competing with Amazon, Inc. (AMZN) and Alphabet, Inc. (GOOG).

For those denying MSFT’s growth-by-acquisition business model, one need only look to the company’s rapidly growing goodwill and other intangible assets. MSFT has made many deals including companies like LinkedIn Corp., GitHub, and most recently Activision Blizzard.

MSFT has been able to pay down debt and grow its capex, but it has also witnessed a greater than 30 percent drop in its cash and investments. Still the company for the most part has continued to maintain a greater than two times amount of cash and investments versus total debt.

When thinking about relative valuation, some could argue or try to justify AAPL having a premium closer to MSFT, however, when we segregate MSFT’s service and other revenue, we can see an amazing rate of growth and key driver for the business which is a testament to the premium valuation.

While MSFT and AAPL are not direct competitors for their services, MSFT’s cloud business segment has clearly been the dominant driver against AAPL’s services (which AAPL does not break out at all). AAPL has outperformed MSFT’s productivity and business processes segment. While AAPL also does not break out its services operating income, while of MSFT’s 44 percent margin (which is near operating cash flow margin of 48 percent), 83 percent was derived from its services/other segments. Clearly MSFT’s expansion from product to services businesses has been a major boon.

MSFT’s products and services/other segments are further broken down by external customers offerings providing more granularity versus AAPL’s services and wearables, home, and accessories segments. While offerings like gaming, LinkedIn, and search and news advertising continue to grow, MSFT’s server products and cloud services and Microsoft 365 commercial products and cloud services are clearly the leading drivers for the company.

The most telling graphic of MSFT’s overvaluation is the company’s dividend yield. This is an area that is directly consistent with AAPL as both yields are around the 0.50 percent level. For companies like MSFT and AAPL that have been afforded such premiums based on their businesses, it is a major disservice in my opinion to investors to receive such a paltry dividend return. This is an important point as companies with dividend yields to this degree are considered growth businesses and Big-Tech is not a rapid growing group anymore. Something will give at some point.

Over the years two things stand out for MSFT’s discretionary free cash flow decisions; priorities have revolved around stock buybacks and acquisitions. Paid dividends have increased over time, $191.5 billion from fiscal year 2008 through 2024, but this pales in comparison to the other two, $423 billion, or 2.2 times that amount. This clearly aligns with Wallstreet’s tactics and influence as MSFT looks to focus on earnings per share targets and growth-by-acquisition.

Final Thoughts

Based on my financial model, assuming continued growth-by-acquisition, I expect that MSFT can sustain an 11 percent annualized revenue growth rate over the next five years. This is expected to continue to be led by server/other products and cloud services, followed by gaming. I do expect MSFT’s operating cash flow margin to moderately drop towards 45 percent throughout this time. Even with a 10 percent annualized rate of growth for operating cash flow per share and assuming 25 times cash flow per share, MSFT is poised to only generate around eight percent of annualized returns over the mid-term.

MSFT’s stock price has been choppy for the past year, and I expect more of the same for the company in the short term. MSFT currently trades at a discount to both AAPL and NFLX, making the company a much better investment option today. The stock price could come down a little more but investors should be expecting a little less than a 10 percent annualized return over the next five years at today’s stock price.

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