Microsoft Corporation’s (MSFT) Valuation Is in the Clouds

In today’s technology industry, nearly any company associated with cloud computing, or the ability to store and retrieve data via the Internet, can get investors fired up.

microsoft stock-msft

The resulting enthusiasm can help push a stock price firmly forward, and much of it is for good reason. Online retailing giant, Inc. (NASDAQ:AMZN) also happens to be the industry’s largest cloud-computing operator, and the business unit accounts for a large portion of the company’s total profit.

Tech titan Microsoft Corporation (NASDAQ:MSFT) is estimated to be the No. 2 player in the cloud arena. Its Azure platform is growing rapidly and helps serve both companies and individuals as they increasingly use the cloud to store files, data, photos, videos and related information.

The cloud emphasis and new CEO Satya Nadella, who replaced an effective, but largely unpopular, former leader, Steve Ballmer, have helped improve Microsoft’s former reputation as a slow-growing has-been among large capitalization technology companies.

Still, Azure is a small part of Microsoft’s corporate empire. Management claims impressive growth in cloud computing, but analysts and investors aren’t exactly sure how much revenue MSFT actually garners from Azure. It probably isn’t profitable, yet, either, though it could be fantastically so within a few years.

2015 revenue related to Azure is estimated at roughly $2 billion, or a tiny percent of Microsoft’s total sales of $85.4 billion. Yet, overall revenue for MSFT has stagnated at roughly $90 billion for several years now.

Legacy Businesses Still Dominate

Microsoft’s legacy businesses, which include Microsoft Office, server products and tools, and its Windows PC operating systems, are the main drivers of MSFT’s overall fortune. Collectively, these accounted for 60% of sales last year. The Azure segment is part of the “other” category, which has been flat at roughly $6 billion in annual sales.

The problem with the legacy businesses is they aren’t growing much. Only the server unit, which is benefiting from a shift to cloud storage and retrieval, is posting positive sales growth.

There are, of course, many positive operating aspects. The Xbox gaming platform and Surface tablet were developed internally and are growing briskly (sales last year were $9.4 billion and $4.1 billion, respectively). MSFT also generated $6.1 billion in advertising, making it one of the largest players in Internet and related ad-selling. It rivals both Facebook Inc (NASDAQ:FB) and Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL) in this space.

The end result is billions of dollars in profit and cash flow for investors. Last year, Microsoft generated close to $25 billion in free cash flow, well ahead of reported net income of $16.8 billion, or $2.10 per share. This year, analysts expect a nice jump in earnings to $3 per share, and another boost to $3.28 in fiscal 2018 (Microsoft’s fiscal year end is June 30).

The Bottom Line

Overall, investing in MSFT stock gives investors instant and diversified access to some of the best growing markets in the technology space. Cloud computing, gaming, Internet advertising, a resurgence in server-computing, and (thanks to the legacy businesses) some of the highest cash flow any company has ever reported. MSFT also recently bought LinkedIn Corp (NYSE:LNKD), which is growing rapidly.

Yet, total growth remains a concern. Microsoft’s legacy businesses are likely to lose out as consumers move away from traditional personal computing. Businesses will still embrace this type of computer usage, but the move to the cloud opens up new competition. It is hard to fathom consistent profit growth until total sales growth perks up.

The current valuation for MSFT stock is the biggest investing negative, in my opinion. The Donald Trump-fueled rally has pushed Microsoft stock to current highs of nearly $64 per share. That represents a forward valuation above 21 times earnings projections.

Given Microsoft’s dubious overall growth prospects and subsequent lofty valuation, I think there are better big names in tech. Intel Corporation (NASDAQ:INTC) and International Business Machines Corp. (NYSE:IBM) are the bona fide value plays. Intel, obviously, has similar growth challenges for the same reasons that Microsoft does, but it trades at less than 14 times forward estimates. IBM hasn’t grown its top line for the better part of a decade, but trades at only 12.3 times forward earnings.

Facebook and Google represent more compelling growth plays. Additionally, they sport earnings valuations that aren’t at significant premiums to Microsoft, which is comparatively much more growth-challenged. Facebook is at 30 times earnings, but should realistically grow sales more than 50% this year. Google is at 23 times, but is consistently growing sales in the high-teens annually.

When you add it all up, Microsoft’s transformation is enviable, but still in the early stages, and too much of it is already priced into the stock. MSFT stock investors have a higher chance of success in either of the value plays in tech, or they should gun for more growth.

As of this writing, Ryan Fuhrmann is long shares of Facebook.

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