It’s interesting how the narrative about Microsoft Corporation (NASDAQ:MSFT) has changed over the past few years. Microsoft stock not that long ago was “dead money” — in fact, MSFT stock basically didn’t move between 2007 and 2013, and low-teen earnings multiples showed investors’ lack of faith in the company’s growth. Meanwhile, a company that once was called the “Evil Empire” looks far less threatening amid the rise of fellow behemoths Alphabet Inc (NASDAQ:GOOGL) and Amazon.com, Inc. (NASDAQ:AMZN).
Investors clearly view MSFT very differently: MSFT stock has risen over 150% in a little over five years despite minimal earnings growth over that period. And while Microsoft clearly is different, I remain skeptical that either the company, or the stock, is necessarily better.
After all, the reason Microsoft seems less threatening is because it’s not nearly as dominant. Microsoft’s landmark antitrust case, for example, was based on allegations that it unfairly bundled its Internet Explorer browser with its Windows operating system. Microsoft now has barely a 5% share in the browser market. The Xbox is second to the PlayStation from Sony Corp (ADR) (NYSE:SNE). In cloud, MSFT’s Azure trails Amazon Web Services, with offerings from Oracle Corporation (NYSE:ORCL) and many others also fighting for share.
Yet it’s in cloud computing where sentiment toward Microsoft stock has changed the most. And I continue to view that change as overly optimistic. Azure is a tiny fraction of Microsoft sales; much of the rest of Microsoft’s cloud business simply is shifting revenue away from legacy products. On a net basis, I’m still skeptical that cloud offers enough to drive MSFT stock higher.
Cloud Growth And PC Declines
Most of the bullish commentary toward MSFT stock touches on growth in cloud revenue in one form or another. But it’s important to remember that Microsoft’s cloud growth isn’t organic. Unlike Amazon — where AWS revenue is purely additive — much of Microsoft’s cloud revenue simply is coming from a shift away from its legacy applications. In what the company calls its “Intelligent Cloud” segment, its dominant SQL product is more expensive to use than the Azure cloud platform. Office 365 — grouped into the “Productivity and Business Processes” segment — has led the legacy Office product sales decline.
Microsoft management has insisted that overall, cloud revenues do boost overall growth. And the numbers appear to back up that assertion, with Intelligent Cloud sales rising 11% and 12% in Q1 and Q2 of fiscal 2017, respectively. But there is some offset to cloud growth from a sales standpoint.
Meanwhile, profit margins actually have come down, at least so far. Intelligent Cloud operating profit declined year-over-year in the second quarter. Over time, that may change, as Microsoft is making upfront investments to drive Azure growth. But expansion isn’t guaranteed. Microsoft already has cut pricing on Azure, and cutthroat competition is going to limit pricing power going forward.
All told, there is an opportunity here — but it might not be what many Microsoft stock bulls predict. Moving Office to the cloud helps a bit, but it’s not a pure growth driver. The company still hasn’t broken out Azure revenue, though current estimates are in the $3 billion range. That’s less than 4% of total MSFT revenue. Microsoft stock is worth $500 billion. $3 billion in sales — even at impressive growth rates — shouldn’t be enough to really move the needle.
Second Place
But if not cloud, then what? The PC segment still drove nearly half of FY16 sales, and revenue and profits in that business will decline long-term. The Surface has been a success, but still is well behind Apple Inc.’s (NASDAQ:AAPL) iPad. According to the Microsoft 10-K, Surface revenues in FY16 were just over $4 billion — less than 5% of total sales, and at lower margins.
There is reason for some of the sentiment change toward Microsoft and MSFT stock over the past few years. But I don’t see enough to move the earnings multiple from 12-14x to 20x+. Microsoft hasn’t grown earnings over the past few years, and the $26 billion acquisition of LinkedIn aside, isn’t driving all that much going forward. Competition will be intense, the PC business is in secular decline, and Microsoft isn’t nearly as dominant as it used to be.
Obviously, that doesn’t imply that Microsoft is going to collapse, or that MSFT is going to zero. But the current valuation of Microsoft stock seems to focus only on the growth opportunities – and not on the revenue streams that will be impacted by that growth. Microsoft may have better growth potential than it did 3-4 years ago. But it doesn’t have enough to keep Microsoft stock at current levels.
The author has no positions in any securities mentioned.
