Microsoft (MSFT) is one of the world’s most powerful software companies. Its Windows operating software and Office platform are virtually inescapable.
But there’s a lot more to the company than that. Among other ventures, Microsoft has its Xbox gaming ecosystem, cell phones, servers, cloud subscription services and so on. While PC sales, and thus Windows revenue, appear to be in unrelenting decline, the company has many other fires in the iron. Can MSFT stock continue to keep up its recent strong performance or is the recent earnings miss a sign that Microsoft’s best days are behind it?
MSFT Stock: Pros
Fastest Growing Cloud Player: While Amazon (AMZN) is still the dominant player in the space in terms of overall revenues, MSFT is now the fastest growing out of the top five. Alphabet (GOOG, GOOGL) is the only top five player other than Microsoft that has a more than 100% growth rate. Microsoft’s cloud business is much larger than Alphabet’s though, so Microsoft is in the catbird seat to take advantage of any potential Amazon missteps.
Microsoft’s Azure has some advantages to Amazon Web Services. Azure has more native compatibility because of many things like MS SQL Server that provide a crucial competitive edge with certain clients. Since most systems are still hosted on Windows, and MSFT has much better experience selling products at volume while making a profit than Amazon, there’s real potential for Azure to knock Amazon off the top spot heading into the future.
Surprising Success In Tablets: When I think of Microsoft, I generally don’t think of great consumer products. Anyone remember the Zune? Or its various smartphone efforts? However, Microsoft’s Surface line of tablets is making real headway.
Apple (AAPL) originally dominated the space, with the iPad earning above 50% market share for several quarters. However that gave way to Android tablets. Android now controls two-thirds of the market. However, Microsoft’s Surface is up to 10% share, slowly creeping up on Apple for second place. By 2019, Strategy Analytics estimates Surface will be up to 18% market share, with its tablet shipments up to 49 million. That’d make for a 120% increase from present levels.
Good Conservative Choice: MSFT stock offers investors a nice combination of stability and growth. Microsoft offers a 2.8% dividend yield. That’s not exactly high, but it is well ahead of the market’s average. The company’s valuation, after the recent selloff, is pricey but not outrageous.
In return for that safety you get a business with some upside. The core Windows business is in slow decline; we’ll get to that in a minute. However it will continue to throw off mountains of cash for many years to come. And slowly taking its place will be the cloud business along with various other potential opportunities such as tablets.
MSFT Stock: Cons
PC Sales Coming In Light: PC sales were down big in 2015. They dropped 8% to 289 million units. However, it was hoped that 2016 would reverse the negative momentum. In the long run, PC sales are expected to keep dropping, as more computing goes mobile, and people have fewer and fewer reasons to upgrade old but still functional machines. Windows XP, 15 years after launch, and two years after Microsoft entirely stopped supporting it whatsoever, still remains the third most popular computer OS in use.
As people have fewer reasons to upgrade their machines, PCs face a slow sales cliff. However, for Microsoft, there’s still plenty of cash to wring out of the PC cow. Managing the decline will be important. 8% yearly sales drops will diminish the franchise quickly. If the declines could be limited to 1-2% a year, MSFT has a far stronger position. In January, Gartner estimated a 2016 sales drop of just 1%, while competing analytics firm IDC forecast a small gain.
Instead of those upbeat forecasts, new Q1 data shows an estimated decline of between 9% and 11% for the quarter. Even factoring in a slight expected pickup later in the year, sales are way under forecast. Quarterly unit sales are now hitting levels not seen this low since 2007. This is a big long-term obstacle for MSFT stock.
Stock Is Expensive: MSFT stock is quoted at about a 36 P/E on many financial sites. This is not a fully-accurate figure. The company had a one-time item last year in the quarter that ended in June. Excluding that, 2015 earnings would have been about $2.50/share.
Even recalculating the P/E ratio to adjust for normalized earnings, MSFT stock is still trading at 20x earnings. That’s really up there for a company whose main product is seeing its market slowly shrink. 2011 earnings were $2.73/share. With the stock in the high 20s then, MSFT recently was a 10x P/E stock. It’s hard to think the positives for Microsoft are so great that the stock’s P/E ratio should have more than doubled.
Earnings Miss Shows Weakness: Microsoft missed on earnings last week. MSFT stock dropped about 10% shortly thereafter, taking the stock down from its 52-week high. The earnings shortfall was triggered by several issues. PC, discussed above, is a big headwind.
Beyond that, foreign exchange problems are another issue, though one that isn’t unique to Microsoft. Regardless, the strong dollar will be an ongoing concern. Furthermore, Microsoft faces a severe long-term problem: falling profit margins. The cloud business is exciting, but for now, and presumably well into the future, it will generate far lower returns than software. The company is pivoting from a near-monopoly to a brutally competitive arena. Microsoft has the resources and talent to compete successfully in cloud, but the company’s profit margins, and thus valuation, are likely to be lower going forward.
Microsoft Stock: Verdict
MSFT stock was really expensive heading into earnings. At $56/share, it was really hard to justify optimism. At the new post-earnings miss level around $51, it’s easier to buy the stock if you are so inclined. It has a long and profitable stream of cash coming to it from legacy businesses that will allow it to make forceful entries into emerging new markets such as cloud. However, know that there won’t be a lot of immediate upside for MSFT stock until the decline in the PC segment shows some signs of letting up.
At the time of this writing, Ian Bezek had no positions in any stocks mentioned. You can reach him on Twitter at @irbezek.
