Microsoft Corporation (NASDAQ:MSFT) stock continues to trade just off all-time highs, with its market capitalization now at $500 billion. I continue to be surprised at the strength shown by Microsoft stock. MSFT stock has risen roughly 150% in just four years — despite little movement in profits. Adjusted earnings per share were $2.78 in fiscal 2012 and only a penny more, at $2.79, in fiscal 2016.
Admittedly, there are some reasons for the increase in the Microsoft stock price. Both investors and customers are high on the Azure cloud platform. The Surface product line shows significant promise. And CEO Satya Nadella has received top marks from analysts and shareholders.
There’s a real case that the “new” Microsoft is different from the “old” Microsoft, which has been to the benefit of MSFT stock. Earnings growth should return: Wall Street consensus estimates forecast a 7% increase in FY17 per-share earnings and 9% the following fiscal year.
But even that doesn’t seem enough to keep Microsoft stock above $60. MSFT is valued at almost 22 times FY17 earnings, a multiple that implies consistent growth. Meanwhile, Windows and legacy Office products are declining and most of the new initiatives cannibalize existing sales, in at least some manner.
Microsoft obviously isn’t going to collapse, and long-awaited earnings growth may just be at hand. But more modest growth expectations seem to support a share price closer to $50 than to $60.
Growth Drivers Simply Aren’t That Big
All the bullish talk surrounding Microsoft stock seems to focus on the Azure cloud offering and the Surface line. But those two categories aren’t major drivers here: combined, they drive less than 10% of total sales (Azure is estimated to bring in around $2.5 billion.)
To be sure, cloud as a whole is a bigger part of MSFT revenue. The company is looking for a $20 billion run rate in commercial cloud in FY18, which would imply more than 20% of total sales coming from the cloud. Surface is a great product and a Surface Phone could — finally — get Microsoft a consistent presence in the smartphone space.
All told, I can see the reason for some optimism regarding the two growth drivers. But not too much, considering that growth in both categories has some drawbacks.
Taking Revenue From Elsewhere
The other issue with counting on Azure and Surface, beyond their relatively small contribution, is that growth in both categories is coming from the existing revenue base. The $20 billion commercial cloud figure sounds great — but that growth is coming largely from Office 365 and Azure. Revenue from those products isn’t new to Microsoft; much of it is coming from legacy, disk-based Office customers and/or existing SQL buyers.
Even Surface isn’t necessarily a pure growth driver. Taking a sale from a rival like HP Inc (NYSE:HPQ) is a win, but an HP sale still drives Windows 10-related revenue for MSFT. That software revenue drops to the bottom line at much higher margin than sales of a Surface product.
Basically, growth isn’t 100% organic for Microsoft. It doesn’t portend some sort of top-line acceleration for the company as a whole, nor does it make MSFT stock a growth play.
A Winner In Declining Businesses
Adding to those concerns is that Microsoft isn’t quite as well-positioned in the newer areas. Azure is second to Amazon.com, Inc.’s (NASDAQ:AMZN) Amazon Web Services (AWS). Microsoft wants to grow in China, but so does Alibaba Group Holding Ltd (NYSE:BABA), which is rolling out its own AWS-type solution.
For Office 365, Tableau Software Inc (NYSE:DATA) is challenging Excel – and 27% revenue growth in 2016 suggests DATA is taking share from MSFT. Behemoths like Oracle Corporation (NYSE:ORCL) and many others are in the cloud space. Microsoft’s Dynamics CRM product is a distant second to salesforce.com, inc. (NYSE:CRM).
There are still a lot of obstacles and a number of tough competitors in the way of Microsoft’s growth. In fact, in most of the key areas, Microsoft is second place, at best.
Bottom Line for Microsoft Stock
Overall, the idea that Microsoft stock is pricing in accelerated growth strikes me as far too optimistic. There are drivers — but I’m skeptical that all will come through — and in the meantime, Windows and disk-based Office revenues will continue to decline.
The 150%-plus gain in MSFT stock has come in large part from the idea that Microsoft is in a different position than it was in 2012 or 2013. Then, investors were concerned about declining PC sales, and the lack of any real ability for MSFT to grow otherwise.
Microsoft is in a better position now, but it’s hardly perfect. PC concerns still remain; phones, cloud and notebooks are tough spaces and overall growth continue to be rather muted. There’s enough here to expect some sort of EPS growth, which likely implies a high double-digit multiple. But that, in turn, implies a share price in the $50-$55 price range.
That values Microsoft somewhere around $100 billion less than where it trades at the moment. If that sounds like a lot of money, bear in mind that Microsoft stock has added $300 billion in value over the past four years and essentially zero in net income.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.
