Earnings season kicked off last week when a slew of big banks reported their quarterly numbers. This week, the earnings frenzy continues as Netflix, Inc. (NASDAQ:NFLX) kicked off the week with stellar numbers, Goldman Sachs Group Inc (NYSE:GS) gave back 2.5% on disappointing bond figures, and Microsoft Corporation (NASDAQ:MSFT) and eBay Inc (NASDAQ:EBAY) gear up to report Thursday, among many others.
Of those names, one that is particularly interesting is Microsoft. Although it is often left out in the discussion of hyper-growth tech stocks (maybe there isn’t a place for the letter “M” in the acronym “FANG”), MSFT stock has been a big winner as of late. Over the past year, MSFT stock is up 36%.
That puts it in the ballpark of Facebook Inc (NASDAQ:FB), Amazon.com, Inc. (NASDAQ:AMZN), and Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG). All three of those hyper-growth tech stocks are up somewhere between 33% and 37% over the past year.
Can that run higher continue on Thursday after the company reports fourth-quarter results? I think so, but investors should also be cautious about MSFT’s expanding valuation.
Here’s why.
MSFT Stock Could Rise After Earnings
There is a buzz word in tech thats been around for a while, but it still hasn’t lost its appeal. That word is cloud. At Microsoft, the growth story is all about the cloud. All aspects of Microsoft Cloud are booming, and Office 365 has been a particularly bright spot.
Whereas at one point in time, investors were concerned about cloud-based platforms like Google Docs eating into Microsoft’s work-space market share, those concerns have been almost entirely erased. Microsoft has successfully transitioned its old-fashioned, CD-based Office suite of products into a comprehensive cloud solution.
As a result, growth has just taken off. Last quarter, Office 365 commercial revenues grew 45% year-over-year while the number of Office 365 consumer subscribers jumped to 26.2 million. That is up from 12.4 million just two years ago, implying Office 365 is adding about 575,000 new subs every month.
The Office 365 growth story is simply a microcosm of the entire Microsoft growth story. Everywhere, the company has successfully transitioned its old-fashioned business model into a cloud-based business model positioned for multiple years of future growth. Dynamics 365, Microsoft’s cloud-based ERP and CRM enterprise system, saw revenues rise 82% last quarter. Azure, the company’s cloud-computing service, experienced revenue growth in excess of 90%.
These increases are more than offsetting declines in the company’s other more traditional segments. Revenues were up 7% last quarter, and are expected to increase 4.5% this year and 7.8% next year. Meanwhile, gross margins are expanding due to a higher-margin product mix (the cloud stuff carries higher margins).
All in all, the growth story at MSFT has been and will remain quite favorable. As the cloud transition continues, Microsoft will continue to impress with its quarterly numbers. The Q4 report on Thursday will provide additional evidence of this, and that should send MSFT stock materially higher.
But Microsoft’s Valuation Is Full
But investors need to exercise caution at these levels.
MSFT stock was compelling a year ago because it was trading around 25.5 times trailing earnings. But since then, the price-earnings multiple has expanded more than 25% to above 32-times. Considering earnings growth is pegged at just 9% per year over the next five years, a 32-times P/E multiple feels quite rich.
Moreover, MSFT stock trades right around 16.6 times trailing Ebitda (according to YCharts). That is as richly valued as MSFT has been in the past 10 years. Although the cloud growth narrative does warrant a new look at valuation, a 10-year high Ebitda multiple feels a little too full.
I’ve loved MSFT stock for some time, but the valuation is getting a little too full for my taste. That said, MSFT stock looks like it could pop after earnings, so it might be worth sticking with this name into the end of the week.
As of this writing, Luke Lango was long MSFT.
