Interactive Investor

Stockwatch: can Microsoft shares continue to rally?

29th October 2021 10:36

Edmond Jackson from interactive investor

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There’s no doubting the power and success of the tech giant, but the shares are at an all-time high. Find out if our companies analyst joins the Microsoft bulls.

Credit: Microsoft CEO Satya Nadella

Shares in Microsoft Corp (NASDAQ:MSFT) have risen 45% this year, reaching 40x trailing earnings. The price added 4% to an all-time high of $323, which is being sustained, after first-quarter fiscal (third-quarter calendar 2021) results beat expectations and technology analysts cheered the progress – with a firm “buy” consensus targeting around $375.   

Is this warranted or more reflective of exuberance, such that the risk/reward profile on Microsoft and other big US tech stocks has become unattractive, given capital protection should be a first priority? If Benjamin Graham still has relevance, where is the margin of safety?   

Astounding financial dynamics, at least for now 

Supposedly, “elephants don’t gallop”, yet a $2.5 trillion (£1.8 trillion) company has achieved quarterly operating profit up 27% to $20.2 billion on revenue up 22% to $45.3 billion. Moreover, the like-for-like operating margin has advanced nearly 5% to 44.7%. 

Net income is up 48% or 24% according to a Generally Accepted Accounting Principles (GAAP) view, or respectively non-GAAP, likewise for advances in earnings per share.  

Despite a sub-1% yield meaning no prop should the growth story slow, it is worth also respecting how net cash from operations rose 27% to $24.5 billion, and free cash flow after investment and financing by 11% to $19.2 billion. 

All operating divisions beat revenue expectations, not only the fashionable cloud side - led by Microsoft Azure and other cloud services revenues up 50% - but also legacy aspects of the group such as Office 365 in a 40% growth range. Likewise, the near 20-year-old LinkedIn website.   

Azure is proclaimed as the world’s computer

It has become a hook for bullish sentiment, cloud being the way of the future, led convincingly by a portfolio of services that constitute Azure. Operationally at least, it is very hard for bears to dispute this, although it is unclear quite how, after three years leading the global cloud rankings, Microsoft can likely consolidate this in years ahead. Amazon (NASDAQ:AMZN) is in second place with Google closing in, and Oracle is also making paces. 

Azure helps organisations build and manage applications anywhere, its global data centres partnering with key telecoms carriers in the US, Europe and Asia Pacific. 78% of the Fortune 500 use Microsoft cloud technologies, and “leading companies in every industry…” 

Microsoft’s overall commercial cloud revenues are up 36% to $20.7 billion - constituting 46% of total revenue – with Azure growing around 50% even with quarterly revenue over $10 billion. Dynamics 365, in enterprise resource planning, is also just shy of 50%.  

In the earnings call, the CFO evidenced widespread momentum, declaring: “We are off to a strong start in the 2022 financial year, with tremendous opportunity to drive sustained long-term revenue growth.” 

What hedge fund would presently dare open a short unless stocks in general are slumping?  

I think this is partly why momentum buyers prevail, despite such growth rates being unlikely in a few years' time. Yes, an extent of mean reversion in the stock rating is due longer-term, but the short side, typically a means to let air out of stocks overvalued on fundamentals, feels compromised. 

Take your view on inflation or deflation ultimately prevailing 

Microsoft is relevant also to a key tactical question in stock-picking. Its CEO contends: “Businesses small and large, are improving productivity and affordability by building tech intensity.” Implicitly, the likes of Microsoft provide a check on current price rises – the key question being, will such deflation (that has prevailed a decade if not longer) eventually win out, or inflation? 

Two high-profile US fund managers epitomise contrasting views: Bill Ackman, who contends inflation is the biggest risk currently, and Cathie Wood who argues price rises are just a hiatus in long-term deflationary context – driven by technology.  

That is why Microsoft and Apple (NASDAQ:AAPL) are among biggest holdings for her Ark Investment firm. 

Whether to hold Microsoft as a genuine investment – i.e. a minimum two years’ forward view – quite hinges on which scenario you subscribe to. 

Microsoft bulls will argue it is strong enough to pass higher prices on to customers. But I think that if inflation sticks, fewer people will upgrade and instead make do with technology they have, likewise firms.  

Yes, subscriptions to cloud services and 365 will persist, but in two years the bulk of shift to cloud will have happened, hence growth rates are liable to ease. 

And if Ackman is more likely correct, then interest rates may rise by more than markets currently anticipate, which will take froth out of growth stocks.    

My wary view is not simply “on the fence”, it is a genuinely difficult call because we do not know what may come out of China; what happens to that economy; the extent imported goods go up in price.  

I do not have either fund manager’s conviction, but you need Wood’s, to own Microsoft on a multi-year view. 

Microsoft Corporation
Segment revenue and operating income

$ million Three months ended
    30-Sep
Revenue 2020 2021
Productivity and    
Business Processes 12,219 15,039
Intelligent Cloud 12,986 16,964
Personal Computing 11,849 13,314
Total 37,154 45,317
Operating income    
Productivity and    
Business Processes 5,706 7,581
Intelligent Cloud 5,422 7,562
Personal Computing 4,748 5,095
Total 15,876 20,238

Source: Microsoft Q1 2022 results

Acquisitions may also influence investor perception 

With over $130 billion of cash, Microsoft has a war chest for acquisitions both to augment any gaps in current operations as markets evolve, or diversify intelligently. 

Its track record inspires confidence. The June 2016 acquisition of LinkedIn for $26.2 billion has proven long-term successful, when some doubted it. Last April, the $20 billion purchase of Nuance, a cloud and speech recognition software company, helped increase exposure to healthcare. 

There appears a good balance of organic and acquisitive development, where Apple became quite a victim of its own success – criticised and under pressure by activists such as Carl Icahn, to buy back stock and raise dividends. Yet that can come across negatively, as if managers lack ideas for investment. If Microsoft sustains its active and good track record for acquiring, this can support sentiment. 

In principle, I am not a fan of buybacks at current price levels, which could prove little more than a near-term prop. Nor of a materially higher dividend payout, which could be interpreted as Microsoft maturing than generating vigorous investment projects. 

In practice, I recognise Apple did both a few years ago, which was followed by stock out-performance – but I say was due to product innovation coinciding then with strong demand for technology from March 2020. 

Premature to sell, perhaps, albeit a wary hold

My essential view is of Microsoft constituting too high risk on valuation grounds, given its financial momentum is liable to moderate on a two-year view. Interest rates may indeed need to rise, affecting all growth stock valuations. I cannot therefore join Microsoft bulls.  

I was a fan of the stock as a contrarian investment below $21, back in 2012 on a sub 9x price/earnings multiple, then a new CEO in 2014 declaring a break with the past to prioritise cloud and mobile.  

My contrarian instincts are similarly raised, lest this behemoth’s underlying momentum eases in a financial environment less than conducive for growth stocks. Microsoft appears off-limits, but for alert traders: Hold

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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