Microsoft ( $MSFT)- Shaping the Future, One Innovation at a Time

Table of Contents

1. Summary

2. Why is now the time to buy $MSFT?

3. MICROSOFT Q3CY24 Highlights:

4. Revenue Growth

5. Intelligent Cloud: Azure & Cloud Computing

6. Business Software: The Ultimate Bundle

7. Personal Computing: Bing, Windows, & Gaming

8. Profitability

9. Earnings Per Share

10. Cash Is King

11. Balance Sheet Assessment

12. Final Thoughts

Summary

Short for microcomputer software, Microsoft (NASDAQ:MSFT) is the largest software vendor in the world with its Windows operating system, Office suite, and cloud computing services.

• Microsoft is one of the great brands not just in tech but all of business. It produces mission-critical software and bundles it together, resulting in cream-of-the-crop gross margins.

• The company's elite unit economics lead to robust profit margins that improve over time. This speaks to the scale advantages and operating efficiency across its diverse portfolio, which spans everything from Office and Azure to Minecraft.

• Microsoft has a virtuous cycle of returns. Its dominant market position enables it to generate strong free cash flow, and it reinvests these funds into promising ventures that further strengthen its competitive moat.

Why is now the time to buy $MSFT?

Microsoft is trading at $447.27 per share, or a 33.1x forward price-to-earnings ratio. Valuation is lower than most companies in the software space, and we believe Microsoft is attractively-priced for its quality.

Our analysis and backtests consistently tell us that buying high-quality companies and holding them for many years leads to market outperformance. Entry price matters less, but if you can get a good one, all the better.

MICROSOFT Q3CY24 Highlights:

• Revenue: $65.59 billion vs analyst estimates of $64.56 billion (1.6% beat)

• Operating Profit (GAAP): $30.55 billion vs analyst estimates of $29.2 billion (4.6% beat)

• EPS (GAAP): $3.30 vs analyst estimates of $3.11 (6.2% beat)

• Intelligent Cloud Revenue: $24.09 billion vs analyst estimates of $24.03 billion (small beat)

• Business Software Revenue: $28.32 billion vs analyst estimates of $27.94 billion (1.3% beat)

• Personal Computing Revenue: $13.18 billion vs analyst estimates of $12.68 billion (3.9% beat)

• Gross Margin: 69.4%, down from 71.2% in the same quarter last year

• Operating Margin: 46.6%, down from 47.6% in the same quarter last year

• Free Cash Flow Margin: 29.4%, down from 36.6% in the same quarter last year

• Market Capitalization: $3.11 trillion

Revenue Growth

Microsoft proves that huge, scaled companies can still grow quickly. The company’s revenue base of $129.8 billion five years ago has nearly doubled to $254.2 billion in the last year, translating into an exceptional 14.4% annualized growth rate.

Over the same period, Microsoft’s big tech peers Amazon, Alphabet, and Apple put up revenue growth rates of 18.5%, 17%, and 8.5%, respectively. Comparing the four is relevant because investors often pit them against each other to derive their valuations. With these benchmarks in mind, we think Microsoft’s price is attractive.

We emphasize long-term growth, but for big tech companies, a half-decade historical view may miss the impact of emerging trends like AI. Microsoft’s annualized revenue growth of 11.9% over the last two years is below its five-year trend, but we still think the results were good and suggest demand was strong.

This quarter, Microsoft reported year-on-year revenue growth of 16%, and its $65.59 billion of revenue exceeded Wall Street’s estimates by 1.6%. Looking ahead, sell-side analysts expect revenue to grow by 13.1% over the next 12 months, an improvement versus the last two years. This projection is admirable for a company of its scale and illustrates the market is baking in success for its AI-enabling products.

Intelligent Cloud: Azure & Cloud Computing

The most pressing question about Microsoft’s business is how much AI can boost its revenues. The company's cloud computing division, Intelligent Cloud, is one we watch carefully because its Azure platform and server/database offerings could be the biggest beneficiaries of the AI megatrend.

Intelligent Cloud is 36% of Microsoft’s total sales and grew at a 17.3% annualized rate over the last five years, faster than its consolidated revenues. The previous two years saw deceleration as it grew by 10.5% annually.

Intelligent Cloud’s 20.4% year-on-year revenue growth met expectations in Q3. Microsoft Azure, a business line the market watches with bated breath due to its AI exposure, grew by 33.4% and accelerated from last quarter. This was faster than AWS’s 19.1% increase but slower than Google Cloud’s 35%.

In terms of market share, Azure is a close second as its run-rate revenue (current quarter’s sales times four) is around $80 billion versus roughly $100 billion and $45 billion for AWS and Google Cloud. If Azure can continue outgrowing AWS in the coming years, it certainly has a chance to overtake it as the top cloud provider.

Comparisons and peers aside, Azure’s 30%+ growth this quarter is strong evidence that the AI impact is indeed moving the needle.

Business Software: The Ultimate Bundle

Microsoft is injecting AI capabilities into its Office Suite and Dynamics platforms, which include Excel, PowerPoint, and Power BI. Our question is if Microsoft can successfully upsell its AI software like Copilot+ and how long it would take to contribute meaningfully to revenues.

Business Software is the biggest chunk of Microsoft’s revenue at 43.2% of total sales and grew at a robust pace over the last five years, clocking in at 20.9% annualized. On a two-year basis, growth was above its five-year trend at 25%, impressive given its highly penetrated market and large customer base. This shows it’s successfully upselling its newer products

This quarter, segment revenue grew by 12.3%, beating expectations by 1.3%. The quarterly print was lower than its two-year result, so there’s no clear evidence yet that its AI products and services are supercharging sales like they are for Intelligent Cloud.

Personal Computing: Bing, Windows, & Gaming

OPersonal Computing includes the renowned Windows operating system along with Gaming (Activision, Minecraft, Xbox) and Bing, its search engine. This segment is the least levered to AI, though the technology is shaking things up in its search business, which is attempting to chip away at Google’s 80%+ market share.

Microsoft’s Personal Computing performance was uninspiring over the last five years as its top line grew at a 2.7% annual rate. Its momentum has deteriorated even further, as its sales dropped by 4.4% annually over the last two years.

In Q3, Personal Computing revenue rose 16.8%, topping expectations by 3.9%. Search advertising revenue, primarily driven by Bing, grew by 19%.

Bing managed to gain market share from Google Search this quarter, which recorded a slower 12.2% growth rate. A caveat is that its growth came from a significantly smaller revenue base. To pose a genuine threat against the incumbent, Bing would need to sustain extraordinarily high growth rates over an extended period, an unlikely outcome given its weaker brand. However, advancements in AI could create the ever-slightest opening.

Profitability

Microsoft is a special business because its focus on software, bundling, and upselling leads to robust unit economics and vendor lock-in. The company’s elite business model and pricing power can be seen in its high gross margin, which averaged 68.9% over the last five years.

However, this dynamic is not new. A good way to have a more differentiated view on Microsoft’s profitability is through its operating margin, a metric that represents how much revenue is left after accounting for all operating expenses – everything from hiring engineers and IT infrastructure to selling, product development, and administrative overhead.

Analyzing the trend in its profitability, Microsoft’s annual operating margin rose by 6.3 percentage points over the last five years, as its sales growth gave it operating leverage. If its customer base embraces its AI offerings, this figure could rise again as incremental software sold to existing buyers flows nicely into the bottom line.

Earnings Per Share

We track the long-term change in earnings per share (EPS) alongside revenue and margins because it shows whether a company’s growth is profitable and what else affects shareholder returns.

Microsoft’s EPS grew at an astounding 17.9% compounded annual growth rate over the last five years, higher than its 14.4% annualized revenue growth. This tells us the company became more profitable on a per-share basis as it expanded.

We can take a deeper look into Microsoft’s earnings quality to better understand the drivers of its performance. As we mentioned earlier, Microsoft’s operating margin declined this quarter but expanded by 6.3 percentage points over the last five years. Its share count also shrank by 3.1%, and these factors together are positive signs for shareholders because improving profitability and share buybacks turbocharge EPS growth relative to revenue growth

Cash Is King

Although earnings are undoubtedly valuable for assessing company performance, we believe cash is king because you can’t use accounting profits to pay the bills or invest for the future.

Microsoft has shown terrific cash profitability, driven by its lucrative business model that enables it to reinvest, return capital to investors, and stay ahead of the competition while maintaining an ample cushion. The company’s free cash flow margin was among the best in the software sector, averaging an eye-popping 30.9% over the last five years.

Taking a step back, we can see that Microsoft’s margin dropped by 4.9 percentage points during that time. Microsoft’s five-year free cash flow profile was compelling, but shareholders are surely hoping for its trend to reverse. Continued declines could signal it is in the middle of an investment cycle as it competes for the best AI chips to power its products.

Microsoft’s free cash flow clocked in at $19.26 billion in Q3, equivalent to a 29.4% margin. The company’s cash profitability regressed as it was 7.2 percentage points lower than in the same quarter last year, which isn’t ideal considering its longer-term trend.

Over the next year, analysts predict Microsoft’s cash conversion will fall. Their consensus estimates imply its free cash flow margin of 28.6% for the last 12 months will decrease to 24.6%

Balance Sheet Assessment

Businesses that maintain a cash surplus face reduced bankruptcy risk.

Big corporations like Microsoft are attractive to many investors in times of instability thanks to their fortress balance sheets that buffer pockets of soft demand.

Microsoft is a profitable, well-capitalized company with $78.43 billion of cash and $61.48 billion of debt on its balance sheet. This $16.95 billion net cash position gives it the freedom to borrow money, return capital to shareholders, or invest in growth initiatives. Leverage is not an issue here.

Final Thoughts

The latest quarterly earnings matters, sure, but we actually think longer-term fundamentals and valuation matter more. Investors should consider all these pieces before deciding whether or not to invest in Microsoft.

There are multiple reasons why we think Microsoft is an amazing business. First of all, the company’s superb long-term revenue growth driven by the Intelligent Cloud segment suggests Azure is catching up to AWS. And while its falling returns show it may be getting harder to find good investments, its outstanding free cash flow generation enables it to make bold bets, like a $10+ billion investment into ChatGPT’s Open AI. Additionally, Microsoft’s one-of-a-kind installed base leads to low customer acquisition costs and a strong operating margin.

Microsoft’s price-to-earnings ratio based on the next 12 months is 33.1x. Scanning the software space today, Microsoft’s fundamentals really stand out, and we like it at this price.