Microsoft Corporation (NASDAQ:MSFT) has had an impressive run for most of the last year. MSFT stock has gained some 35% in the last 12 months despite a recent pullback.
There is some logic to the gains, which have added roughly $140 billion to MSFT’s market cap. Most notably, Microsoft’s cloud business is growing nicely. That growth has turned the biggest risk to Microsoft stock — that the shift to cloud would erode high-margin Windows and Office revenues — into a tailwind for MSFT stock.
But I’ve argued that the gains in Microsoft stock have gone a bit too far and I still believe that’s the case. Microsoft’s strength in cloud has taken away some downside risk. But a stock still valued at about 21x 2018 EPS estimates now is pricing in substantial growth. Between the company’s persistent “second-place” problem and stretched valuations in the tech sector overall, that makes Microsoft stock look expensive. And with recent developments only confirming some of the company’s problems, I don’t think the case for MSFT stock is much stronger, even with about a 6% pullback over the past few weeks.
Expanding Beyond Windows And Office
Microsoft’s half-trillion-dollar valuation has been built on its long-term dominance in Windows and Office. Obviously, those aren’t Microsoft’s only two products. And MSFT has had success in other areas, notably Microsoft Server.
But in so many non-core products, Microsoft comes in second place — at best. In many key areas, Microsoft has outright failed.
Microsoft never gained any traction in phones, even with a $7 billion acquisition of the handset business of Nokia Oyj (ADR) (NYSE:NOK). It’s basically ceded that valuable business to Apple Inc. (NASDAQ:AAPL) and Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG). It’s tried for years to grab Internet browser share. Yet there too, it lags Google, and even nonprofit Mozilla has nearly comparable share with its Firefox product.
It hasn’t been all bad for Microsoft beyond its legacy desktop-based products. And success in cloud and other areas has driven Microsoft stock from below $30 in 2013 to above $70 just last month. But even that success has had some problems – problems that continue.
The Second-Place Problem For Microsoft Stock
Even where Microsoft is having success — success that, again, is boosting MSFT stock — it’s generally not in first place. Most notably, the company’s Azure cloud platform has fueled optimism about earnings growth.
But Azure revenues literally are a fraction of those of Amazon.com, Inc. (NASDAQ:AMZN). An analyst report in June that posited that Microsoft cloud revenues would surpass those of Amazon was true but not entirely the point. Microsoft’s Commercial Cloud business is likely large than Amazon Web Services but Azure appears to be a small portion of Commercial Cloud revenue. (The figure is likely 20% at most, based on analyst estimates of a $2.5-$3 billion run rate for Azure.)
Most of that revenue is coming from Office 365, a product first released 27 years ago. And that’s a product under threat from Tableau Software Inc (NYSE:DATA) and others focused on data visualization and other processes.
The fact is that AWS revenue likely is at least five times that of Microsoft despite the fact that Amazon is essentially new to the corporate IT game.
That’s not the only area Microsoft lags. The Xbox lags the Sony Corp (ADR) (NYSE:SNE) PlayStation in market share. Meanwhile, the new Xbox One X is priced higher, and with weaker games, than the PlayStation 4 Pro.
Microsoft Edge market share hasn’t budged from a sub-6% level. Sales of Surface tablets and PCs are growing but Microsoft is nowhere close to a market leader there, either.
Just a few years ago, the knock on Microsoft was that it was unable to extend its dominance beyond its 1990s-era operating system and office software verticals. That’s still the case even if its performance elsewhere has improved. But that improvement doesn’t seem like enough to justify the growth expectations now baked into MSFT stock.
Is The Growth Priced Into MSFT Stock Really Coming?
The question for Microsoft stock at the moment is simple: Are Windows, Office 365, and Azure enough? And it’s there that I remain skeptical. Windows sales are doing better than expected Sbecause PC sales appear to have stabilized. But there may be another leg down in those sales, given longer lifespans and better experiences on mobile devices.
Office 365, meanwhile, cannibalizes existing revenue. Indeed, much of the enthusiasm toward Microsoft’s cloud business ignores the fact that a good chunk of the business is coming from existing desktop-based customers in Office, Server, and other areas. And Azure, while growing at a nearly 100% rate, is a ~$3 billion business against a market cap for MSFT stock well over $500 billion.
There’s a case where that’s enough for modest, consistent earnings growth. The problem is that Microsoft stock near $70 isn’t pricing in that kind of growth.
Rather, investors are expecting years of double-digit earnings growth, at least based on a 21x forward multiple. And it’s there where I disagree with the Microsoft stock bulls. I don’t think there’s enough to support those expectations. And that makes Microsoft stock look too expensive, still.
As of this writing, Vince Martin has no positions in any of the aforementioned securities.