Alphabet Inc’s (NASDAQ:GOOG, NASDAQ:GOOGL) Google aims to grow from the convergence of the internet, cloud computing and smartphones. Microsoft Corporation (NASDAQ:MSFT) also has what it calls three bold ambitions.
Microsoft’s first global goal is to create more personal computing. This makes sense as it builds off of the company’s multi-decade dominance in personal computing software, including its Windows operating systems and Office suite. MSFT’s Windows software, combined with Intel Corporation’s (NASDAQ:INTC) PC chip dominance, has been known as the “Wintel” franchise. Office 365 in the cloud is helping fulfill this goal.
Microsoft’s second strategic goal is to reinvent productivity and business processes. This can be served by its third ambition, which is to help build intelligent cloud platforms. Its Azure initiative competes with Google’s related platforms, as well as those being pursued by Amazon.com, Inc. (NASDAQ:AMZN), Accenture, and International Business Machines Corp. (NYSE:IBM).
Oh, and MSFT wants people to play games, too. Its Xbox gaming system is a huge hit among gamers. This isn’t a bad consolation prize for essentially being left out on the software that drives smartphones. Alphabet’s Android is the undisputed winner in this space right now, followed by Apple’s iOS, which powers its iPhones.
MSFT Stock by the Numbers
Microsoft’s recently-announced third-quarter results gave investors insight into how it is succeeding on its three primary ambitions. Reported third-quarter sales looked solid, jumping 8% to $22.1 billion. Growth wasn’t as nearly as robust when excluding the purchase of LinkedIn, which accounted for $975 million of the $1.6 billion boost in the top line. But still, the sales progress was commendable, given just how large Microsoft has grown. And, management sees only about a 1% hit to full-year earnings as a result of the LinkedIn purchase.
Of the three main reporting segments, the Intelligent Cloud (IC) unit posted the strongest growth of 11% to account for nearly 31% of total sales. Azure cloud computing sales jumped a very impressive 95% and should lead the way in terms of overall growth for some time to come. This is the main reason investors remain (perhaps overly) enthused about Microsoft stock.
More Personal Computing (MPC) was the weakest segment — sales fell 7% to 40% of the total sales pie. Surface sales were particularly weak and fell 26%. Tablet sales, including even Apple’s iPad, have been suffering amidst the strength of smart phone sales. This is a concern, but not a big deal in the overall context of the diversified sales and product base.
Total company operating income growth of 6% (to $5.6 billion — a very impressive operating margin of 25.3%) was respectable, but hit by merger-related costs and expenses related to LinkedIn. MPC profit growth was actually quite strong, jumping 20% to $2.1 billion.
Bottom Line for Microsoft Stock
The question for investors in Microsoft stock is if its growth potential is properly reflected in its valuation. Based off earnings expectations, I would say that there is at least a slight mismatch. The forward P/E of 24x prices in a number of years of above-market growth.
Of course, Microsoft is a financial powerhouse. Its operating margin speaks to the scalability of software, and before Alphabet and Facebook Inc (NASDAQ:FB) came along, MSFT had one of the largest installed client bases on the entire planet. It also boasts $126 billion in cash on the balance sheet, though this is netted out by $76.2 billion in debt, which nearly doubled due to the cost of placing LinkedIn into the corporate fold.
Considering the current valuation of MSFT stock, I am more inclined to invest in Alphabet at 29x forward earnings expectations. Or even Facebook at 31x. They have much higher growth potential.
On the other side of the fence, IBM competes in many of the same markets and trades only 11x forward earnings estimates. Yes, it is even more growth constrained than Microsoft, but the fact it trades at less than half of Microsoft’s earnings multiple leaves plenty of downside protection. Plus, IBM also boasts a dividend yield of 3.74%.
So, while Microsoft is humming along and not expected to experience a major sales or earnings drop, the valuation is such that any negative surprise could head shares of MSFT stock significantly downward. And, given the lofty earnings valuation, I think there are better opportunities to gain exposure to higher-growth big tech names.
As of this writing, Ryan Fuhrmann owned shares of Alphabet.
