Jean-Luc Ichard
While the current downsizing has been painful for many large-cap tech companies, I think Microsoft Corporation (NASDAQ:NASDAQ: MSFT) is the best of the bunch and is set to outperform its peers. Microsoft has the most influence for mission critical business functions (office productivity software, cloud computing) that is relatively more immune to financial hurdles. Additionally, Microsoft’s valuation has already normalized to pre-COVID levels, offering an attractive entry point.
Large-Cap Tech Stocks Have Sold, Now What?
As many investors know, 2022 was marked by almost indiscriminate selling off of high-growth technology stocks, with some former high-flyers like Meta Platforms, Inc. (META) down almost 60% YTD (Figure 1). Even the world’s largest tech company, Apple Inc. (AAPL), has begun to falter in recent days over concerns about slowing demand for its new phones, which I wrote about in a recent article.
Figure 1 – Total return on MAGMA shares (Looking for alpha)
Is this a repeat of the tech crash of the early 2000s, and should investors run for the hills and avoid all tech investments for years? While there are signs of speculative excess in recent years (the meme stock phenomenon and SPAC, for example), I don’t think we’ll see a lost decade like the early 2000s, particularly for solidly profitable companies like Microsoft.
cleaner dirty shirt
Each of the large tech mega-caps faces unique challenges and problems. For example, Alphabet Inc. (GOOG, GOOGL) and Meta face threats to their core advertising businesses from Apple and Amazon.com, Inc (AMZN), as well as headwinds from a worsening economy. Apple is seeing a slowdown in demand for its phones, which generates the majority of corporate profits. Amazon’s retail business is also threatened by a slowdown in consumption due to the worsening economic outlook. The only company out of the five tech mega-caps (“MAGMA”) that seems best positioned to outperform is Microsoft.
Extremely sticky SaaS subscriptions
Looking at Microsoft’s operations across its major business segments, we can draw several observations. First, the Productivity and Business Processes segment, which encompasses the Office productivity franchise, continues to see strong revenue growth. In the LTM as of June 30, Productivity and Business Processes registered a growth of 17.6% YoY. Operating profit grew even faster at 21.7% YoY, to an operating margin of 46.8% (Figure 2).
Figure 2: Microsoft Segmented Revenue and Operating Revenue (MSFT Report Q4/F22)
Essentially, Microsoft has a stranglehold on office productivity software. In previous years, companies could choose to delay upgrading to the latest version of Office. As long as users didn’t mind what was new, basic business functionality such as spreadsheets and word processing were not affected by using an earlier version of the software. In fact, I’ve personally only used four versions of Office over two decades (2000, 2007, 2013, and Office 365), as the IT departments of the companies I worked for didn’t believe that the other versions offered significant benefits compared to Its cost. .
However, as customers have migrated to SaaS-based Office 365 (and equivalent consumer offerings), the delayed upgrade cycle is no longer possible. If companies don’t pay the subscription fee, they lose access to all their mission-critical software and data.
Additionally, the SaaS subscription model gives Microsoft the ability to raise prices annually, with companies essentially locked in.
Cloud benefiting from a growing pie
Increasingly, businesses are finding it cheaper and more convenient to get computing power from the “cloud” rather than building their own server farms. Amazon’s AWS, Microsoft’s Azure, and Google’s Cloud Platform (“GCP”) together account for more than 60% of the cloud computing market (Figure 3).
Figure 3: Cloud Computing Market Share (Synergy Research Group via theregister.com)
While some analysts have highlighted increased competitive pressures in the cloud computing market, it has so far not led to pressure on margins. AWS reported operating margins of 29% in the latest quarter, and Microsoft’s cloud segment appears to be even more profitable, with operating margins of 43.4% in LTM as of June 30 (from Figure 2 above).
While economic weakness could dampen some of the cyclical growth in the cloud business, I believe the secular tailwind of rising cloud adoption should still provide plenty of growth and earnings opportunities for Microsoft Azure in the years to come ( Figure 4).
Figure 4 – Secular tailwind of cloud computing (iot-analytics.com)
The weakest link in personal computing
The weakest business segment in Microsoft’s portfolio is the “More Personal Computing” segment, which encompasses Windows OEM installation, Bing search revenue and Xbox revenue. These are more cyclical businesses that could face headwinds in a difficult economic environment. So far, in Figure 1 above, we can see that revenue growth has slowed to just 2.1% year over year in the last quarter, and operating profit actually dipped to an operating margin of 31.9% compared to 34.7%.
However, investors should put these figures in context. A business that generates $14 billion in quarterly revenue with a 32% operating margin is still fantastic!
Valuation at a justified premium…
Microsoft is currently trading at a P/E FWD of 23.3x, above the industry median of 16.7x. Compared to the rest of MAGMA, MSFT doesn’t filter cheap either, having the second highest P/E FWD multiple.
Figure 5 – Assessment of MSFT vs. peers (Looking for alpha)
However, valuation multiples should be viewed in the context of return and risk. Of the MAGMA peers, Microsoft has the highest net margin at 36.7% (Figure 6).
Figure 6 – MSFT performance against peers (Looking for alpha)
Furthermore, when we think about the core business of each of the MAGMA pairs, we find that they are all at significant risk from a weakening economy. AAPL’s business is consumer-oriented, and the consumer is suffering right now from high inflation. AMZN derives the vast majority of its revenue from its online retail operations, which are also consumer-facing. Both GOOGL and META generate most of their revenue from advertising, which could face headwinds as companies cut ad spending.
Microsoft, by contrast, has 70% of revenue tied to mission-critical functions (Office 365, cloud computing) that companies are unlikely to cut unless absolutely necessary.
…and normalized to pre-COVID-19 levels
Additionally, when viewed through a historical lens, Microsoft’s current valuation appears to have normalized, with FWD P/E and EV/EBITDA returning to pre-COVID levels.
Figure 7 – MSFT valuation normalized to historical levels (tikr.com)
Although Microsoft’s valuation may still fall further, at least Microsoft isn’t trading at a significantly higher valuation than it was pre-COVID like AAPL, for example, currently trading at 23x FWD P/E vs. 15x FWD P/E before Covid.
Technicians set to outperform
From a technical perspective, we can see that Microsoft has been in a multi-year sideways consolidation pattern, relative to the technology sector, represented by the Technology Select Sector SPDR Fund (XLK). I believe this chart pattern will trend to the upside as Microsoft’s sticky productivity and cloud business will allow it to outperform its tech peers in the coming quarters as the global economy weakens (Figure 8).
Figure 8: MSFT Relative to XLK in a Bullish Consolidation Pattern (Author created with price chart from stockcharts.com)
conclusion
In short, while the current downsizing has been painful for many tech companies, I think Microsoft is the best of the bunch and poised to outperform its peers. Microsoft has the biggest advantage for mission-critical business functions (office productivity software, cloud computing) that it is relatively immune to economic headwinds. Additionally, Microsoft’s valuation has already normalized to pre-COVID-19 levels, offering an attractive entry point.