I’ve been skeptical of the big run in Microsoft Corporation (NASDAQ:MSFT) shares for one key reason: MSFT stock is now being priced like a growth stock, which seems to make some sense. Fiscal 2017 adjusted earnings per share rose 19% year-over-year. But that wasn’t always the case for Microsoft stock and won’t necessarily be in the future.
It was just a couple of years ago that Microsoft stock was considered “dead money”. And with good reason: Between fiscal 2012 and fiscal 2016, non-GAAP earnings per share grew by 3 cents, total. Adjusted net income actually declined by 5% over that period.
The strength shown in fiscal 2017 stands in marked contrast to that performance. The problem is that I’m far from convinced that FY17 really was that great a year for Microsoft. There are a number of one-time effects in those numbers that suggest that investors expecting consistent double-digit growth are setting themselves up for disappointment.
But on the other hand, there are signs of real growth opportunities, most notably in Azure, that can drive Microsoft earnings, and the shares, higher. While I’m starting to come around to the value of those opportunities, I still see them as mostly, if not fully, already priced into MSFT stock.
Was FY17 A Good Year For Microsoft?
On its face, it seems like a silly question. Microsoft stock gained 28% in the past year, and some 16% so far in 2017. Non-GAAP revenue rose 5% last year (that figure adds back deferred revenue), and adjusted EPS, as noted, increased 19%.
It sounds like an excellent year and — at least consideringf MSFT stock — it was, even if it paled in comparison to other mega-cap tech names like Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG) and Facebook Inc (NASDAQ:FB), at least in 2017. But from a fundamental perspective, there’s an argument that the performance wasn’t quite what the numbers suggest.
Most notably, Microsoft’s fourth-quarter earnings benefited from a one-time tax impact that skews full-year numbers as well. Backing out that 23 cents-a-share benefit, EPS rose a still-solid, but not quite as impressive, 10.3%. And for the full year, margins were flat, with adjusted gross and operating income both growing 5% year-over-year, right in line with non-GAAP revenue figures.
In those numbers, there’s another one-time effect: the benefit of Windows Phone. Microsoft hasn’t published its 10-K yet. But figures from the 10-Q released after the third quarter suggest that the Windows Phone, which Microsoft bought from Nokia Oyj (ADR) (NYSE:NOK), lost money last year. Simply getting those losses off the books almost certainly created some of this year’s profit growth.
All told, FY17 was a good year for Microsoft — but I’m not convinced it was a great year.
Can Growth Drive MSFT Stock Higher?
To be fair, with Microsoft stock selling at about 21x FY18 EPS estimates, it’s not as if investors are pricing in torrid growth. There are some opportunities here, notably in the cloud platform. Azure seems to be set to become a clear number two to Amazon.com, Inc. (NASDAQ:AMZN), and near-100% growth in Q3 and Q4 bodes well for FY18. The Surface tablet line is a legitimate competitor to Apple Inc. (NASDAQ:AAPL).
But SEC filings, and analyst estimates about Azure revenue (which still hasn’t been broken out), suggest those two growth drivers combined are about 10% of total revenue. Microsoft remains highly reliant on Windows and Office, with much of its cloud services growth simply coming from users transitioning from disk-based to cloud-based versions of those products.
Looking forward, then, the growth concerns become a bit more apparent. It’s tough for ~10% of revenue to drive overall growth — even with the impressive rates in Azure. Margins are expected to contract in FY18, per the Microsoft Q4 conference call. That compression is coming from amortization of the LinkedIn acquisition, which isn’t a cash cost. Still, margins still should be flat, and revenue growth in the single digits in FY18.
And that seems like the long-term trend for Microsoft as well, assuming PC sales stay reasonably stable.
Microsoft Stock Looks About Right — At Best
At 15x earnings, that kind of growth profile looks attractive. At 21x, it’s not quite as much so.
Microsoft did have a good year, and CEO Satya Nadella has done a phenomenal job. This undoubtedly is a better company than it was when he took over.
However, MSFT stock’s risen 164% since the beginning of 2013. And it sure looks like those gains have priced in most — if not all — of the improvements made in the past few years. The idea that FY17 represents some sort of inflection point in growth seems too aggressive. MSFT has deserved most of its gains so far — but I do think those gains will slow going forward.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.