I’ve been mostly bearish toward Microsoft Corporation (NASDAQ:MSFT) stock so far this year and I missed out on a nice run in MSFT stock as a result. Microsoft stock is up 25% year-to-date, not including the MSFT dividend. It now trades just off an all-time high ahead of the company earnings report due out next week.
As I wrote last month, I have started to come around to the bull case, even if I’m not 100% on board.
One major concern is that MSFT earnings really haven’t moved all that much. Adjusted net income actually declined 5% between fiscal year 2012 and FY2016, before about a 9% increase in FY2017 (excluding a one-time tax item in the fourth quarter).
Over that period, however, Microsoft stock has just about tripled, including the MSFT dividend. Most of those gains have come from the increased earnings multiple applied to MSFT stock, not from MSFT earnings.
Admittedly, that makes some sense. Microsoft unquestionably is in a better position than it was just a few years ago. Investors should value stocks on future growth, not past results. Still, I question whether a ~22 earnings-per-share multiple, even backing out cash, is a reasonable price for single-digit earnings growth. Heading into the MSFT earnings announcement, with the stock up another 6% since late September, I still think MSFT is overvalued. But, I’ll admit, I’ve been wrong so far.
MSFT Dividend & Earnings Growth
The biggest concern I have about MSFT stock is whether the company really can grow earnings consistently– and significantly. It certainly seems like Microsoft stock has been pulled along by optimism toward fellow large-cap tech stocks like Alphabet Inc (NASDAQ:GOOGL,NASDAQ:GOOG), Amazon.com, Inc. (NASDAQ:AMZN) and Facebook Inc (NASDAQ:FB).
But Microsoft simply isn’t growing to the extent that those companies are — and I’m still skeptical it ever will. Microsoft still has a large reliance on the PC, despite MSFT stock bulls claiming that “this isn’t your father’s Microsoft.” It’s not really a material difference, at least for a company with a market cap nearing $600 billion, that revenue is shifting from on-premise Office licenses to cloud-based Office 365. That’s still a low-growth category. The same is true of Windows 10 and, including deferred revenue, those two products alone account for 40%+ of non-GAAP revenue.
In contrast, the hyped growth drivers like Azure and Surface are in the 10% range — combined. There are future opportunities in areas like artificial intelligence and virtual reality. And Microsoft at the least has proven that it’s not the next International Business Machines Corp. (NYSE:IBM) — a dinosaur that can’t adapt. But IBM trades at ~12 times earnings, MSFT ~22x plus cash and much faster-growing FB ~23x plus cash. It certainly seems like MSFT stock could move closer toward IBM than FB, given MSFT earnings growth lags badly behind similarly valued stocks like FB and GOOGL.
The ‘Second-Place Problem’ for Microsoft Stock
The other concern I have with Microsoft is that it hasn’t been able to win in new categories. Office is dominant. Windows is dominant. Elsewhere, Microsoft isn’t no. 1 or even a close no. 2. Azure is well behind Amazon Web Services. The XBox lags the Sony Corp (ADR) (NYSE:SNE) PlayStation. Bing is light years behind Google.
Just in the last two weeks, Microsoft has left the Windows Phone for dead and exited the streaming music space. At the same time, Apple Inc (NASDAQ:AAPL) remains obviously dominant in phones and sees its services business growing to $50 billion.
This isn’t necessarily to say that Microsoft is a poor company or that its stock is a good short candidate, but the optimism towards Microsoft — and the valuation of MSFT stock — seems to imply that the company is competitive with other tech giants. And I’m just not sure that is the case. Microsoft is losing more often than it’s winning. And even where it’s winning, like Azure and Surface, it’s not exactly winning big from a market share standpoint.
Caution Ahead of MSFT Earnings
Again, I’ve made some version of this case for some time — and there are reasons for optimism toward Microsoft stock. MSFT earnings aren’t going to collapse, and the MSFT dividend pays almost the same as a 10-year Treasury bond.
But with the stock now moving toward $80, I still think the run in Microsoft stock has to moderate, if not outright end. Investors continue to price in ever-increasing amounts of earnings growth and I remain highly skeptical that’s what Microsoft actually is going to deliver.
As of this writing, Vince Martin has no positions in any securities mentioned.