Microsoft Corporation (NASDAQ:MSFT) stock is on a spry run more befitting a younger, growthier tech company. After spending the years after the financial crisis in the investor wilderness, MSFT stock has nearly tripled since the beginning of 2013.
In fact, Microsoft stock set an all-time high in late July, and currently trades not far from those levels.
The change in Microsoft stock reflects a change in Microsoft’s business.
The company’s long reliance on personal computers led earnings to stall out as PC and notebook sales did the same. Microsoft’s adjusted net income actually declined 5% between fiscal 2012 and fiscal 2016. And it seemed reasonably likely that Microsoft had been passed by newer, more nimble upstarts like Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL) and Amazon.com, Inc. (NASDAQ:AMZN), among others.
The move away from Windows and PCs to efforts like the Azure cloud platform and the acquisition of LinkedIn have changed the narrative surrounding Microsoft, and consequently, MSFT stock. And a recent announcement of a new initiative led Credit Suisse analyst Michael Nemeroff to declare that this is “not your father’s Microsoft anymore.”
But it’s there that I disagree with MSFT stock bulls — and the Microsoft stock price. The Redmond, Washington, company might not be what it once was, but it’s still a lot more reliant on the PC business than many investors seem to think.
And that seems to create an ongoing risk to Microsoft stock.
A ‘New’ Microsoft, Right?
To be sure, Microsoft has managed to diversify away from being almost wholly reliant on Windows and Office. Azure revenue grew 99% year-over-year in FY17, according to the company’s 10-K filing. LinkedIn added nearly three points to FY17 revenue growth. Surface tablets and PCs have been a success. Windows and Office have moved into the cloud, turning one-time license fees into recurring subscription revenue.
And of course, Xbox gives the company exposure to gaming.
But the argument from Credit Suisse might be a bit early, at the least. Per figures from the 10-K, nearly 30% of revenue comes from Office. Nearly 10% comes from Windows PC — the figure is closer to 16% when adjusting for deferred revenue changes. Combined, that’s roughly half of non-GAAP revenue coming from precisely the areas that kept Microsoft stock cheap for most of the decade.
That’s not really that much of a change from the past. A decade ago, in fiscal 2007, roughly 60% of revenue came from what the company then called the “Client” and “Microsoft Business” segments — which included Windows, Office, and Dynamics. Microsoft might be less dependent on Windows and Office — but it’s still more dependent than some bulls seem to think.
The Second-Place Problem For Microsoft Stock
At 45% of non-GAAP revenue, that simply isn’t going to grow all that much going forward, even with the shift to cloud. And in the rest of the portfolio, I’m not sure the news is that much better. Outside of its PC dominance, Microsoft largely remains a second-place company.
The Xbox sells less than the Sony Corp (ADR) (NYSE:SNE) PlayStation, and its revenue contribution declined in FY17. Surface is well behind Apple Inc. (NASDAQ:AAPL) products, not to mention legacy hardware manufacturers like HP Inc (NYSE:HPQ) and Dell Inc. (NASDAQ:DELL). Bing is a distant second to Google. Dynamics trails salesforce.com, inc. (NYSE:CRM).
Even Azure, as impressive as its growth is, is far smaller than Amazon Web Services, and based on estimates, likely drives maybe 5% of total Microsoft revenue, at most.
So while Microsoft has diversified, it hasn’t done as much as some investors and analysts argue. And, Azure aside, I’m not sure it has diversified as well as it appears either: Surface sales, for instance, fell in FY17 and Consumer Reports pulled its recommendation of the products in early August.
MSFT Stock Looks Stretched
Considering all of those issues, Microsoft stock still looks overvalued, even at a seemingly reasonable valuation of about 21x forward EPS.
As well, 45% of the business likely isn’t going to grow and over the long-term will decline as PC usage fades. The other 55% of the business has some opportunity for growth, notably in cloud. But that growth potential is somewhat capped by the fact that Microsoft lacks leadership in the new areas, whether hardware, artificial intelligence, or gaming.
This may not be “your father’s Microsoft,” as Credit Suisse argues. But I still think it’s a lot closer than the bulls realize. And that’s a big concern for MSFT stock going forward.
As of this writing, Vince Martin has no positions in any of the aforementioned securities.
