Not long ago, big-tech titan Microsoft Corporation (NASDAQ:MSFT) was an unloved company and MSFT stock was equally unloved. Although former CEO Steve Ballmer was effective, the tech community in Silicon Valley did not openly embrace him. More importantly, consumers were flocking to Apple Inc.’s (NASDAQ:AAPL) sexier iPhone mobile devices, iPad tablets and Mac computers.
It appeared that MSFT was being left in the dust, forever tied to stagnating personal computers and a disastrous acquisition of Nokia Corp (ADR) (NYSE:NOK) to try and break into the smart phone space.
But rather quietly, Microsoft developed the Surface tablet, which has been a surprising success that helped bridge the PC and table worlds. Its Xbox franchise is as strong as ever, and although most users complain they don’t have a choice at work, its operating and software systems still dominate the overall computer space.
It also announced it is buying LinkedIn Corp (NYSE:LNKD), which is growing gangbusters.
CEO Satya Nadella is also more likeable than Steve Ballmer and he has played a big role in shaping MSFT’s more welcome image in the tech space. His strategic moves are also clearly communicated and firmly in the right direction.
They specifically consist of growing in cloud computing (the Internet of Things), continuing to help consumers embrace personal computing and assisting businesses in operating more efficiently (the big data secular trends).
The funny thing is, despite the improved image, Microsoft isn’t growing its overall business much these days. So, while the firm’s message and strategic thinking have vastly improved, and MSFT stock has performed well for over five years now, the outlook for shareholders is far from certain. Here’s why.
MSFT: The Full-Year Results
Microsoft’s total reported 2016 sales fell nearly 9% to $85.3 billion. That’s a pretty big drop. Service revenue jumped an impressive 35% year-over-year to almost $24 billion, but core product sales (the flagship Windows and Office franchises) dropped a rather severe 19% to $61.5 billion.
Like other tech juggernauts including International Business Machines Corp. (NYSE:IBM) and Oracle Corporation (NYSE:ORCL), MSFT is shifting gears to operate in the cloud. Microsoft’s stated goal is to build an “intelligent cloud platform” and it targets $20 billion in commercial cloud revenue. Its Azure cloud platform is growing rapidly, but just not enough to move the total overall sales needle forward.
The profit picture was much more promising, but not completely sustainable. Operating income improved 11.1% to $20.2 billion for an awe-inspiring profit margin of almost 24%. Reported profit growth was also impressive at 38% to $16.8 billion, but income tax expense fell more than $3 billion to juice the bottom-line growth. Year-over-year earnings per share improved to $2.10 per diluted share, but the trend in recent years has been flat, at best.
Despite the impressive profitability and success with smaller business units (Surface, Xbox, Azure), MSFT stock’s overall growth and profitability trends are more suspect.
The firm’s ambitions to grow in the cloud are worthy, but its success should be met with some suspicion. A recent article in investment publication Barron’s suggested that Amazon.com, Inc. (NASDAQ:AMZN) clearly breaks out its cloud-based business in its financial statements. Amazon is said to be the firm leader in the cloud, with Microsoft, Alphabet Inc’s (NASDAQ:GOOG, NASDAQ:GOOGL) Google and IBM being the smaller players that don’t provide enough specifics on how they define cloud-based revenue.
So far, Microsoft’s growth in the cloud and other successes have yet to push overall growth forward. The current year’s sales fell below 2014 levels and reported earnings have been erratic and just matched levels seen in 2010. Free cash flow peaked in 2012 at $29.3 billion.
Although it is extremely impressive for the absolute level, free cash flow this year came in a smidgen under $25 billion.
The Bottom Line on MSFT Stock
There is little denying the strong showing in the MSFT stock price in recent years. It has more than doubled from its levels in 2011, where it was below $27 per share. However, most of that has stemmed from multiple expansion. MSFT stock’s trailing price-to-earnings ratio is 27.9 and it has risen steadily, well above the five-year average of about 16.
The forward P/E (based off expectations this year for $3.05 in earnings) is more reasonable at 18.2, but is still high for a company whose overall growth outlook is murky. IBM has even bigger questions surrounding its ability to grow (sales have fallen for more than a decade now), but trades at a forward P/E of only 12 and has a relatively high dividend yield of 3.4%. Microsoft’s yield is only 2.5%
Oracle is also evolving into the cloud, but trades at a forward multiple of less than 15, but its dividend yield is only 1.5%. Apple is at 12 and sports a modest yield of 2%. Add it all up, and there are arguably other big-tech names outside of MSFT that are equally ambitious in the cloud space and trade at much more reasonable earnings multiples.
As of this writing, Ryan Fuhrmann was long MSFT.
