I rate Microsoft Corporation (NASDAQ: MSFT) a buy due to their robust FCF generation, rapid organic growth with minimal CAPEX, and the firm’s strong position within the rapidly expanding cloud computing market. Under the strong leadership Satya Nadella, the company has flourished. If they can continue to execute on their cloud endeavors (smart cloud), MSFT will become increasingly more profitable due to the segment’s wide margins. This profitability will drive significant free cash flow, giving MSFT the necessary cash to innovate for years to come.
Financials (High P / E Ratio is warranted / WIDE MARGINS, ROBUST FCF, low debt, organic growth)
MSFT’s high P / E ratio is warranted, given their wide margins, robust FCF, minimal debt, and continued organic growth. Microsoft is one of the most profitable tech companies within the industry, continuing to widen their margins year in and year out. In 2021, the company had 42% EBIT margins and 52% EBITDA margins. Because of these margins, the company has continued to grow organically.
MSFT’s increased profitability YoY can mainly be attributed to the growth of their cloud computing segment, the smart cloud. As of 1Q22, this segment boasts 45% EBIT margins (see below) Comparatively, Amazon’s cloud segment (AWS) has EBIT margins of 35.3%. Additionally, Amazon is struggling in other segments of their company after a week earnings report, giving Microsoft a leg-up in acquiring market share.
These healthy margins have continued to fuel Microsoft’s growth initiatives, such as the acquisition of Activision for $ 68.7 Billion to expand growth in the personal computing segment. MSFT’s core profitability will continue to generate robust free cash flow to fund further capital projects and reward shareholders.
Microsoft has continued to experience organic growth with minimal need for external financing. MSFT has CF / CAPEX ratio of 3.71, meaning that MSFT does not need external financing to support its CAPEX requirements. Additionally, MSFT has more cash on its balance sheet than total debt, giving MSFT flexibility to grow without taking on debt or issuing more equity.
Valuation of MSFT’s Assets by Segment
Currently, I believe that MSFT investors are receiving free revenue from their personal computing segment. To illustrate the free revenue being generated, I built a valuation model for Amazon’s assets (see below) by taking the TTM revenue of each asset and multiplying it by the EV / Revenue multiple of a company that has similar operating assets. After multiplying each asset by the corresponding EV / Revenue multiple, we arrive at each segment’s valuation (see below).
After calculation, my model indicates that MSFT’s cloud segment is worth $ 998 billion, while the productivity and business processes segment’s assets are worth $ 839 billion (see above). After adding these two valuations together, I arrived at a combined total of $ 1.83 trillion. When subtracted from the enterprise value of $ 3 trillion, we arrive at $ 201 Billion in free revenue. This implies that investors are not paying for MSFT’s personal computing segment and, therefore, it is revenue for free.
Cloud Computing Market Share
For Microsoft, the cloud computing segment is and continues to be a generational opportunity. The global market size for cloud services is currently $ 369.9 Billion and forecasted to grow at a CAGR of 14.17% from 2022-2030. One market research firm is predicting the cloud market to grow to $ 2 Trillion in the next 10 to 20 years (see below), demonstrating the significant upside for MSFT’s cloud computing segment.
As of 4Q22, MSFT is currently 2nd in the cloud services competition with 21% market share, while Amazon is the dominant player with 33% market share (see below). Amazon launched AWS in 2006, which gave the company a four-year early bird benefit over MSFT. As of FY21, more than 95% of Fortune 500 companies use Azure. In the last 4 years, MSFTs have been witnessing higher growth rates in cloud computing than AWS. A key driver behind this growth is that AWS is 5 times more expensive than Azure on Window’s servers. Window’s servers currently hold a 75% market share in operating systems, which will benefit Azure due to cost-savings.
Inflation’s Minimal Impact on Cloud Spending
MSFT’s Intelligent Cloud segment provides businesses with solutions that increase efficiency. Despite inflation, companies will continue to invest in cloud computing to modernize their infrastructure. Companies see cloud computing as a mandatory investment because of the significant benefits that enhance efficiency. 1Q22 earnings demonstrated cloud spending’s immunity to inflation.
Both AMZN’s AWS and MSFT’s Intelligent Cloud have continued to grow at a robust rate. In 1Q22, AMZN reported 37% Y / Y growth in AWS, while MSFT reported 26% growth. Cloud Spending has continued to be one of the few bright spots in this economy. Despite uncertainty, cloud spending will remain robust into the foreseeable future because of the efficiencies that Azure and AWS provide.
Discounted Cash Flow Model
For my discounted cash flow model, I used analyst consensus estimates for Adj. EBITDA in FY22 and FY23. I made assumptions of a 15% CAGR in revenue for FY24 and FY25 (see above). After inputting these assumptions into my DCF analysis, I arrived at an intrinsic value of $ 356.34 per share (26.81% upside from current price of $ 281.00). Regarding costs and expenses, I used the 3-year historical averages as a% of sales.
Over the past three years, MSFT’s average cost of revenue was 32.46% of sales. Their 3-year average of operating expenses was 29.84% of sales. Non-operating expenses were 1.78% of sales. Capital expenditures were 11.38% of sales. And finally, changes in net working capital were 3.12% of sales. Regarding terminal value, I used the 10 Yr Treasury Note as the perpetuity growth rate. After placing these assumptions into my DCF model, I arrived at the following cash flows for FY22 through FY25:
For my discount rate, I calculated MSFT’s WAAC to be 6.63% using their current market capitalization and current market value of debt (see below). To calculate MSFT’s Cost of Equity, I arrived at market risk premium of 4.23% for their cost of equity by taking the difference between an expected market return of 7% and risk-free rate of 2.77% (US Treasury 10Y). To calculate the market value of debt, I used the interest expense from 2021, total debt (book value) from YE21, and a period of 4 years.
After applying a WACC of 6.63% to my forecasted future cash flows for MSFT, I arrived at an intrinsic value of $ 356.34 per share (pictured below). This represents 26.81% upside of from the current share price of $ 281.00. My price-target falls just below the median of Wall Street’s 12-month price targets, which range from $ 298.00 to $ 410.00 per share.
There are several risks to consider before investing in MSFT. Despite the healthy state of the consumer balance sheet, the risk of recession is steadily increasing and may come sooner rather than later. Bloomberg sees the current probability of recession at 25%, while Goldman Sachs is even more pessimistic as high as 35%. This is very much a possibility soon given the geopolitical turmoil, inflationary environment, high oil prices, and potential corporate tax hikes. Given the healthy state of the consumer balance sheet, the next recession will hopefully be not as bad as the dot com bubble or sub-prime mortgage crisis.
Because of Microsoft’s wide array of product offerings, the company is exposed to a broader competitive pressure. Apart from Xbox, Microsoft has struggled to find traction in the personal computing market. The company’s stronghold continues to be threatened with heavy competition within the cloud computing, open source, operating systems, and server project markets. While I believe that Microsoft is winning most of these battles, they face fierce competition from other tech firms that possess valuable operating assets.
Another risk is sooner than expected deceleration in demand for Azure demand. Growth in Microsoft’s Azure has been high double digits for the past two fiscal years. However, Amazon’s (AMZN) AWS remains the top-player within the cloud computing market, which could further slow share shifting. Noticeable deceleration in growth of Azure could cause investors to react negatively, especially since MSFT is reliant on their cloud computing segment’s EBITDA growth. Additionally, deceleration in cloud computing will cause the company to miss out on the segment’s wide EBIT / EBITDA margins.
Microsoft is faced with a generational opportunity in the highly profitable cloud computing market. Cloud computing is expected to expand to $ 1 trillion in the next 8-10 years. Over the past 4 years, MSFT has experienced higher growth rates in the cloud than AMZN. MSFT’s successes within this space will aid in continued organic growth due to the incredibly wide EBIT margins segments, driving significant cash flow to reward shareholders for the next 10 years. Long MSFT.