Microsoft Corporation (NASDAQ:MSFT) has hit almost all the right notes lately. Even a so-so earnings report last week did little to slow down the momentum. Despite an initial sell-off, MSFT stock righted itself and subsequently advanced to new all-time highs. Having finally topped the dot-com high stock price in 2016, Microsoft has at last reached uncharted territory.
However, bears argue that the company’s soft quarter is reflective of mounting headwinds to the business. Profit margins are a real concern. Bulls contend, on the other hand, that advances in the cloud business outweigh the other issues. Let’s take a look at the details.
MSFT Stock Cons
Lackluster Earnings Report: MSFT stock is trading higher now. But, investors initially gave Microsoft’s earnings release a mixed reception. Microsoft surprised investors by missing the consensus revenue estimates for the first time since 2014.
Surface sales disappointed in particular, plunging 25%. While this unit has faced more competition as of late, the rate of decline still surprised analysts. The company also guided revenue for this quarter at slightly below the Street’s estimates. The earnings report had plenty of good news as well, but the overall tone wasn’t as strong as you’d expect for a stock trading at all-time highs.
Falling Margins: Microsoft has grown new business divisions successfully. However, we shouldn’t lose track of the fact that Microsoft’s profitability is on an inexorable decline. Selling pre-installed or boxed software provided huge margins. The sorts of businesses Microsoft can grow now simply won’t be similar cash cows.
Consider the cloud business. Microsoft has done a great job building it out. But, it is subject to intense competition. Microsoft faces numerous well-funded competitors. For its core legacy businesses such as Windows and Office, Microsoft simply dominated the market.
Microsoft’s operating margin peaked at 39% around the turn of the decade. It dipped below 30% a couple years ago, and most recently has fallen to 24%. Given that net revenue hasn’t been rising that quickly, net income has actually fallen slightly since 2008. In that year, Microsoft earned 17.7 billion dollars, while by comparison, it earned 16.8 billion in 2016.
Rather Expensive Stock: MSFT stock is now trading at 30x trailing earnings. That is really pricey. Assuming analysts are correct about the future, the company will be at 22x earnings next year. That’s better. But, it is still a high price for a company whose core profit stream is a stable low-to-no growth legacy business.
Yes, Microsoft has rapidly escalating new revenue channels. However, as explained above, to a degree, it is replacing high-profit margin sales with low profit-margin sales. This lack of earnings growth makes the stock increasingly more expensive over the years.
While the company keeps raising its dividend, as of yet it hasn’t added the profits necessary to back it up. Investors have good reason to be optimistic for Microsoft’s more revolutionary ventures. But, so far, they simply haven’t converted into much profitability. Until they do, MSFT stock will look expensive, priced on future expectations rather than current successes.
MSFT Stock Pros
Big Cloud Growth: It’s easy to think of Microsoft as a Windows and Office play. They certainly make plenty of money on those products. However, Microsoft has shown surprising ability to get ahead of trends in recent years.
The cloud is the latest big win for the company. The commercial cloud business has now reached a $15 billion annualized run rate, according to the recent earnings report. That figure is up 50% compared to last year. Profit margins are also on the incline for this unit. Given the generous amount of value investors have assigned Amazon.com, Inc. (NASDAQ:AMZN) and its web services division, it’s easy to see how Microsoft’s exploding cloud revenue can power MSFT stock even higher.
Tax Code Changes: Microsoft has a huge cash balance. However, like many American tech giants, its cash sits largely in foreign bank accounts and would be exposed to massive taxes if Microsoft brought that money back the United States. Apple Inc. (NASDAQ:AAPL) is the leading example of companies with stranded cash. However, don’t underestimate Microsoft’s exposure to tax code changes. The company currently holds $123 billion in cash and marketable securities.
The latest rumors suggest that President Trump would permit this money to come back to the U.S. while facing only nominal repatriation tax. Analysts have suggested that the rate would likely be set around 10%. More broadly, the corporate tax cuts Trump has proposed would also pad Microsoft’s profit margins.
Decent Dividend: Most people don’t think of tech companies as dividend stalwarts. However, as the giant American tech companies mature, they are providing bigger paychecks to shareholders.
MSFT stock currently offers a 2.2% dividend yield. That isn’t huge, though it is larger than the S&P 500 as a whole. The current yield misses the bigger picture, though. Microsoft delivers huge dividend increases.
It has grown the dividend at an 18% compounded rate over the past five years, and 15.5% over the past 10 years. Given the huge cash pile offshore just waiting to be unlocked, Microsoft has plenty of ammunition for further dividend hikes going forward.
Verdict for MSFT Stock
Microsoft is a fine choice for a dividend-focused investor who needs another tech stock. The company hasn’t delivered much in the way of earnings growth, that is true. However, with so much offshore capital that Microsoft will soon repatriate, the coffers are plenty loaded to pay a fat yield for years to come.
As a longer-term investment, however, monitor Microsoft’s profit margins closely. The company really needs to figure out how to convert more of these new revenue streams into fatter earnings. Otherwise, MSFT stock could be in for a downturn.
As of this writing, Ian Bezek held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.
