It’s been awhile since investors were this excited about Microsoft Corporation (NASDAQ:MSFT). MSFT stock is up about 130% over the past four years, and it hit another all-time high Monday.
Yet nearly all of the substantial appreciation — which has added a quarter of a trillion dollars to MIcrosoft’s market capitalization — has come from expanding cash flow and earnings multiples.
Adjusting out one-time factors, Microsoft’s per-share earnings have been remarkably consistent (or stubbornly stagnant, depending on your point of view). Earnings per share over the past five years have been $2.73, $2.65, $2.63, $2.46 and $2.79 (in FY16).
Clearly, investors are pricing in a re-acceleration of earnings growth going forward. And there are reasons for optimism on that front. The most notable is Microsoft’s Azure cloud platform, a major cause of the current optimism toward MSFT stock. But Microsoft also has growth opportunities in gaming, search and other categories.
Still, it looks from here like the optimism toward MSFT stock might be a case of “too far, too fast.”
The acquisition of LinkedIn, which closed earlier this month, should provide an earnings boost — although 2016 estimates of $1 billion in EBITDA imply only roughly 10 cents in incremental EPS to Microsoft. Beyond that deal, the categories it’s targeting for growth through its “mobile-first, cloud-first” strategy all have large, successful incumbents — who in most cases have a head start on Microsoft.
So while Microsoft does have opportunities, it will have plenty of competitors fighting it tooth and nail. To support the current price of MSFT stock — let alone any upside — Microsoft will have to start winning more battles in verticals like cloud and gaming.
The problem is that MSFT already seems to be playing from behind.
Microsoft Has Many Challengers
It’s not as if the legacy products that have driven Microsoft revenue are collapsing, but expecting much in the way of growth seems optimistic. Even Microsoft stock bulls would admit that.
Windows 10 now is installed in over 400 million devices, according to the Q1 conference call, and Office 365 adoption continues to impress: constant-currency revenue increased 8% for Office consumer products in the first quarter. Gross margins in 365, however, are lower than under the traditional version, and Windows OEM revenue was flat in Q1 and -1% in fiscal 2016.
Microsoft needs to drive growth elsewhere, and it does have avenues to do so … but it will have to defeat some solid rivals to get there.
The Greatest Opportunity for MSFT Stock
The largest opportunity for Microsoft is its Azure cloud platform. The company still doesn’t break out figures for Azure revenue or profits, but Q1 growth was 116% year-over-year after a 113% increase in fiscal 2016.
Microsoft’s biggest opportunity, however, sits where it faces its largest and toughest competitor: Amazon.com, Inc. (NASDAQ:AMZN). And in the early going, Amazon has a huge lead.
Estimates from MKM Partners suggest that Azure sales are just over $2 billion annually. In contrast, Amazon Web Services is on track to drive nearly $12 billion in revenue this year. AWS sales have increased 59% year-over-year through the first nine months of 2016. That’s a lower growth rate than Azure, but its larger base is such that AWS’ dollar growth in 2016 should be nearly double Azure’s total revenue.
Amazon and Microsoft aren’t alone: Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL) has a billion-dollar business of its own. Legacy providers like Oracle Corporation (NYSE:ORCL) and International Business Machines Corp. (NYSE:IBM) are transitioning to cloud as well. To be sure, there may well be enough growth to go around as cloud takes revenue away from hardware manufacturers. But Microsoft needs to capture a good deal of that growth to support current expectations. If a rising tide lifts all boats, then cheaper shares, such as ORCL and IBM, seem more likely to outperform.
Microsoft infamously bought the hardware division of Nokia Corp (ADR) (NYSE:NOK) in a deal that closed in early 2014 and almost instantly turned into a failure. In fact, Microsoft’s $7.2 billion investment turned into just $350 million barely two years later.
It does appear that Microsoft is taking one more shot at the mobile hardware market, with a Surface Phone reported to be released in 2017. Considering the success of Surface tablets (and the recent unveiling of the admittedly impressive Surface Studio), there may be some optimism toward Microsoft’s second go-around in mobile.
But as well-reviewed as Surface has been, total device revenue in FY16 was just over $4 billion — or about 5% of Microsoft’s total sales. At least in the U.S., Google and Apple Inc. (NASDAQ:AAPL) have solidified their dual hold of the mobile phone market. Internationally, low-cost manufacturers threaten to commoditize the space. (That commoditization is one key reason why AAPL stock is valued so cheaply on an earnings basis.)
Microsoft’s ability to become a significant third player in the mobile phone market thus seems limited — and late.
MSFT is benefiting from mobile through initiatives like 365 apps on Android and iOS. But entering mobile hardware seems like it will be difficult. As analyst Richard Windsor put it, Microsoft’s strength has been in “Digital Work” — but mobile phone usage is based on “Digital Life.” And with access to Microsoft’s successful enterprise products already available through Android and iOS, the clear need for a Surface phone isn’t so transparent.
Bottom Line on MSFT Stock
In the rest of the business beyond Windows 10 and Office, Microsoft similarly looks to be playing from behind. In gaming, the Xbox has sold somewhere around half the units as Sony Corp’s (NYSE:SNE) PlayStation 4. In artificial intelligence, Cortana seems a step behind Siri and Google Assistant, and Amazon is making a major push with its Alexa service. Search engine Bing has made modest progress — turning profitable in FY16 — but it’s a clear, and distant, No. 2 to Google in that category.
The reason MSFT stock was so cheap for so many years was that investors feared it didn’t have much to offset likely declines in Windows 10 and Office from decreasing PC sales. With the stock now getting a growth stock multiple of 21 times FY17 EPS estimates plus cash, those fears seem to have been forgotten.
But that risk still seems present. There is a path for Microsoft to grow again, with cloud in particular a major potential catalyst. But there are powerful and successful companies in Microsoft’s way. And in most areas, they have a head start.
Investors anticipating a new wave of growth from Microsoft are expecting the company to win at least a few of those battles. But they might be well-served to remember that Microsoft is playing from behind.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.