Investing In Microsoft: Can The OG Tech King Hold Onto Its Crown?

12 mins

Investing In Microsoft: Can The OG Tech King Hold Onto Its Crown?

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Welcome To Microsoft

Learning: Why knowing about Microsoft is essential.

Microsoft – the second-biggest US public company behind Apple – is worth almost $2 trillion. Its sheer size therefore makes it a major component of most large stock market indexes: it represents 6% of America’s S&P 500, for example, and 3% of the MSCI World Index. If you’re invested in an exchange-traded fund (ETF) tracking one of these, among many other broad-based or indeed tech-focused indexes, then you’ll already have some skin in Microsoft’s game without even knowing it. In fact, anyone with a pension probably owns a piece of the tech giant these days.

So if you’re an indirect shareholder – and especially so if you’re a direct one – it’s worth knowing what makes Microsoft tick, when you can tell if it’s doing well, and how to value the company’s stock. This Pack will give you all that information, allowing you to decide for yourself whether and when to buy in or cash out. And all in under fifteen minutes...

The Productivity Puzzle

Learning: How Microsoft’s Productivity business works.

Microsoft’s Productivity business raked in $46 billion of revenue in 2020: 13% up on the year before. And with a juicy 40% profit margin, that translated into a not-so-micro $19 billion of pre-tax profit. Perhaps even more impressive, however, is the fact that most of this cash came from subscription services.

A big and growing trend in the tech world is the shift away from selling software outright and towards renting it out instead. This business model, called “software-as-a-service” (or SaaS), involves hosting a computer program on cloud infrastructure – like Microsoft’s data servers – and charging users a monthly fee to access it.

Tech companies unsurprisingly prefer the predictable revenue of SaaS to the messy business of selling software individually. The latter can be a victim of its own success: the more people who buy, the fewer potential new customers, eventually leading to a decline in sales until the next generation is rolled out. The beauty of SaaS is that it delivers a company consistent subscription cash without relying on new customers – money it can then use to develop new SaaS software.

It could be argued that no company pulled off the transition between the two business models better than Microsoft with Office 365. It has over 200 million active users, and is reportedly adding a staggering three million new ones on average every month. With the cheapest personal plan costing $80 a year, and business subscriptions considerably more, that’s at least $16 billion of recurring annual revenue from Office 365 alone.

The point about differently priced plans is an important one. As well as growing revenue by adding more Office 365 users, Microsoft can also convince existing customers to upgrade to more expensive offerings. Back in 2019, for example, growth in Office 365 revenue was actually faster than growth in user numbers – implying Microsoft instead made more money per user.

That might’ve been partly down to the bit of Office 365 that’s gotten investors particularly revved up recently: online collaboration platform Teams, which is Microsoft’s answer to Slack. While Slack had first-mover advantage, Microsoft’s benefited from a massive pre-existing client base hooked on Office 365. It took Slack six years to get 12 million daily active users, but Teams hit 20 million in half that time – and has since left Slack in the dust.

Microsoft Teams now has 75 million users to Slack’s 12 million (Source: Business of Apps)
Microsoft Teams now has 75 million users to Slack’s 12 million (Source: Business of Apps)

Since Teams is only available on more expensive Office 365 plans, its uptake should accelerate the number of Office 365 users upgrading their packages. That means more revenue per user, boosting Microsoft’s profit margin and therefore its earnings.

And it’s not only growth prospects among digital-native employees getting investors excited. They’re also hoping that Teams can penetrate the as-yet untapped market of “firstline workers” – those in factories and stores, for example, who don’t spend their days at a desk and traditionally haven’t been Microsoft customers. The firm reckons that there are more than two billion such workers worldwide – all of whom might benefit from a mobile, chat-based productivity app.

The takeaway: Microsoft’s Productivity business is largely based on recurring revenue from Office 365 subscriptions, with Teams providing a tailwind. The key figures to keep your eyes on are Microsoft’s user growth and revenue per user, as that’ll indicate whether the company’s successfully adding new subscriptions and getting existing customers to spend more.

Head In The Clouds

Learning: Where Microsoft’s cloud computing segment fits in.

Microsoft’s cloud computing business principally comprises Azure, which launched in 2010 offering both outsourced cloud services for companies and software like Windows Server for those simply wanting to run their in-house infrastructure better.

Today, Azure is the second-largest player in the cloud computing market after Amazon Web Services, with the two widening their lead over distant third Google, IBM, and Oracle. Analysts expect smaller competitors to fall away given the costs involved in maintaining cloud infrastructure and security, but those who survive will have plenty of room to grow – and that’s what gets investors really excited.

Mainstream adoption remains in relative infancy, and with new applications emerging all the time – like Azure’s AI-driven data analytics allowing clients to identify improvements in their own businesses – revenue per user is also likely to increase. Given all this, it’s little wonder that Azure’s near-term growth rate is arguably the most-watched metric for Microsoft investors.

And sales at Microsoft’s cloud business have indeed been growing apace: in 2020, it took in $48 billion in sales, up 24% on the year before. With a healthy 38% profit margin, that meant a tidy $18 billion of operating profit. The segment also includes revenue from on-site offerings like Windows Server and Enterprise Services; but while Azure’s precise solo sales figures aren’t public, its standalone annual growth rate was 72% in 2019 and 50% in 2020.

Investors are hoping this will continue – but they’re also keen on the continued expansion of the cloud unit’s gross profit margin. It’s been rising in recent quarters, driven by premium products and Azure services scaling up.

The takeaway: Microsoft's on the precipice of a large opportunity in cloud computing – and is expected to keep gaining market share as take-up expands. The key figure investors pay attention to is therefore Azure’s growth rate.

A Window Into Personal Computing

Learning: The outlook for Windows and where gaming goes next.

Microsoft’s Personal Computing unit houses the sort of products you’re probably most familiar with, such as Windows and Xbox. It brought in $48 billion of sales in 2020 – but because it’s a lower-margin business, it actually contributed the least to Microsoft’s operating profit.

Almost half of Personal Computing revenue comes from the Windows operating system. While huge, this only grows at a single-digit percentage each year, relying on upgrades to a potentially shrinking installed base of PCs.

The juicy bit of Personal Computing is gaming: a $10 billion-plus business with annual growth in the double digits. The 2001 release of Microsoft’s Xbox console was swiftly followed by Xbox Live – a subscription-based online service. With 90 million monthly active users today, it continues to be a strong source of both growth and reliably recurring revenue.

That’s helpful because sales of physical consoles are lumpy, dependent on new releases and holiday seasons and with low profit margins to boot. But an installed base of potential customers for Microsoft’s higher-margin subscriptions makes all this worthwhile. For example, Microsoft’s gaming revenue increased in 2019 thanks to Xbox software and services growth of 19% more than offsetting a 13% decline in console sales ahead of the launch of the new Series X and S in 2020.

But the way we play is changing, and the rise of cloud gaming services – where users stream games via web browsers rather than consoles – is a risk to Microsoft. The company launched its xCloud offering in late 2020, but competition is fierce and the future could belong to any one of a number of companies.

For now, the more hardware-focused nature of Microsoft’s Personal Computing business gives it the lowest profit margin: around 30%. Still, the growing shift towards higher-margin gaming subscriptions may soon change that.

The takeaway: Windows is a cash cow, but future growth in the Personal Computing division looks set to come from gaming subscriptions – and potentially from cloud gaming in particular.

What’s Microsoft Worth?

Learning: What to consider before buying Microsoft’s shares.

Microsoft is a well-loved stock: every single one of the 24 Wall Street analysts covering the company recommend buying its shares. On average, they think Microsoft’s stock is worth $281 – which implies about a 16% upside on its share price at the time of writing.

Investors’ love affair with Microsoft is perhaps unsurprising. Despite rising competition from younger tech giants, the company has managed to not only keep growing sales but has significantly expanded profit along the way. Microsoft’s revenue increased 57% between 2016 and 2020 (at a 12% compound annual growth rate, or CAGR) and its profit more than doubled in that period as margins widened (up 116%, at a 21% CAGR). To cap things off, the company is sitting on a massive net cash pile of over $70 billion.

Still, there’s no such thing as a free lunch – and Microsoft’s valuation reflects that. As of the time of writing, shares cost 32x next year’s projected profit – 30% higher than their five-year average, and almost 40% more than the average S&P 500 stock. This “price-to-earnings ratio”, while the same as Apple’s, is higher than tech peers Facebook (24x) and Alphabet (30x), albeit lower than Amazon’s punchy 71x.

One thing Microsoft’s stock does that none of those others do (bar Apple) is pay a regular dividend. Microsoft has grown this by an average 10% per year over the past five, and its shares offer a 0.9% “dividend yield” at the time of writing. Again, sustained dividend growth is unsurprising: Microsoft's dominance in operating systems and productivity products gives it a strong profit base from which to pay investors. And as the company shifts more towards subscription services such as Office 365 and Xbox Live, profit – and dividend – growth should only become more predictable.

We can therefore try to figure out Microsoft’s value ourselves using a dividend discount model or DDM – a technique that aims to calculate how much a stock is worth today based on how much its regular dividends will pay out over time. The particular variant we’ll use here is known as the H-Model.

The H-Model is a two-stage DDM that assumes a faster dividend growth rate for an initial period while the company is still in high-growth mode. The model then assumes a slower constant dividend growth rate for the company’s remaining lifetime (i.e. forever). But the H-Model’s beauty is that it doesn’t assume that the first fast growth rate suddenly drops down to the slower long-term rate – instead, the change is gradual. Here’s the formula:

Dividend discount model diagram

Where:

H = length in years of the high-growth phaseD = current dividend per shareg_high = high growth rate during the initial H phaseg_LT = long-term growth rater = “discount rate” (shareholders’ required minimum rate of return, given the company’s relative riskiness)

When it comes to Microsoft, feel free to make your own assumptions – but we’re going to set the high initial growth rate in our H-model at 10%, the average rate at which Microsoft’s grown its dividend over the last five years. And we’re setting the long-term growth rate at 3%, on the assumption that Microsoft will be able to increase its profit and dividend at the same pace as the overall (post-coronavirus) economy.

We’ll set an H value of 20 years – which means we think the current 10% dividend growth rate will decline gradually every year for the next 20 before settling at 3% forever. We’ll use an 8% discount rate, given Microsoft’s more predictable nature relative to other tech companies (read our Pack entitled The Tricks And Techniques You Need To Value Stocks for more on discount rates).

D – Microsoft’s annual dividend per share at the time of writing – is $2.24, but this should really be adjusted. The company actually makes twice as much “free cash flow” (the amount of cash generated after all necessary reinvestments) as it pays out in dividends, returning this extra cash to shareholders through stock buybacks. In order to capture this in the H-Model, we can double D to $4.48.

Plugging all those numbers in gives us a $155 per share value for Microsoft – some 35% below its stock price as of the time of writing, implying the company looks expensive. Of course, at the time of writing, interest rates are at record lows. If we better reflect the current valuation environment by lowering the discount rate to 6%, we’d get a price of $260 a share for Microsoft – implying a 7% upside.

You should, however, play around with the H-Model using your own assumptions, or use a different valuation model entirely if you prefer. Developing your own considered view on Microsoft is important if you’re mulling it as an investment.

And so is weighing the pros and cons of the company’s fundamentals: the debates around any company shift over time and are worth regularly revisiting. At the moment, you’ll likely find Microsoft bulls are charmed by the company’s stability in the face of technological change, its increasing predictability as its revenues become more subscription-based, and the resulting attractiveness of its regular and growing dividend.

A Microsoft bear, meanwhile, might argue the company’s slapdash use of cash is worrisome: its high-profile acquisitions of Skype and LinkedIn have been relative disappointments. Future deals may similarly risk destroying – rather than creating – shareholder value.

Only once you understand Microsoft and have had a go at valuing the company should you consider investing in it. Happily, this Pack should have helped put you in a good position to make that decision. Whatever you choose, good luck!

In this Pack, you’ve learned:

🔹 Microsoft has been one of the top names in tech for decades, with one of the company’s greatest strengths its diversified and recurring revenue stream.

🔹 Reliable revenue from Office 365 subscriptions makes up the bulk of Microsoft’s Productivity business, with Teams providing additional growth.

🔹 Microsoft’s cloud business is growing fast as the market expands and the company gains share at smaller players’ expense.

🔹 Windows is a cash cow – but future growth in Microsoft’s Personal Computing division will come from gaming, especially subscriptions and potentially from cloud gaming services.

🔹 Microsoft’s steadily growing dividend makes it a good candidate for valuation using a two-stage dividend discount model.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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