Microsoft: The Devil Is In The Details

Investment Conclusion

To be candid, we have never been overly enamored by Microsoft Corporation (NASDAQ:MSFT). We viewed it as a one trick pony, riding on the success of its Office suite. And we are not wrong. Office came bundled with Windows and Internet Explorer, or really folks had to purchase Windows and Internet Explorer to get their hands on Office. In addition, the company has great talent at frittering away the first mover advantage it secures with its businesses. Internet Explorer launched in 1995 had 95% market share until 2005, before being upended by Safari, Chrome, and Firefox. MSN Search launched in 1998 as a top search engine, and remained an also-ran for years before being rebranded as Bing in 2009. Windows appears trending towards a similar fate, with revenues declining with each year.

Moreover, based on business conditions, growth metrics associated with MSFT’s current businesses appear less rosy than the grapevine suggests. Alphabet’s (GOOG) Workspace has wrested leadership position from Office, and continues to capture 1% to 2% market share every year. LinkedIn, although undoubtedly the top recruitment platform, with 950 million users, it is likely to evidence dwindling growth due to saturation of the subscriber base. We have already alluded to Windows despondent fate above.

With respect to Xbox, the platform underpins an opportunity for significant growth if cloud gaming catches on. However, MSFT gave a lot of the house away to get the Activision Blizzard deal through regulators. That leaves Azure integrated with AI, and AI embedded in every segment of the MSFT business. The firm is well positioned to benefit from the AI revolution through Azure integrated with AI, and through AI embedded in every MSFT business. However, based on competitive dynamics, the company with the most data, which is GOOG, and the company with the largest market share in cloud computing, which is Amazon (AMZN), are likely to dominate cloud computing and AI, in our opinion.

Nevertheless, MSFT’s cloud computing and AI businesses are likely to experience strong growth. However adjusting for declining growth in most of the corporation’s other business, the overall long-term financial picture appears less optimistic. Based on inputs to a 10-year Discounted Cash Flow ("DCF") model used to derive our 1-year Price Target, MSFT appears overvalued. We are initiating on the company with a 1-year Price Target of $286/share and a Sell Rating.

Investment Thesis

MSFT was founded in 1975 by Bill Gates and Paul Allen in Albuquerque, New Mexico. The corporation’s current headquarters are located in Redmond, Washington. MSFT has offices, research and development facilities, and data centers located across the world, in the U.S., Canada, China, France, Germany, India, Ireland, Japan, the U.K., and the Netherlands.

The company operates in three segments, productivity and business processes, intelligent cloud, and more personal computing. MSFT’s revenues are derived from server products and cloud services, Office products and cloud services, Windows, gaming, LinkedIn, search and news advertising, enterprise services, devices, and Dynamics. Over FY23, server products and cloud services accounted for 37.7% of total revenues, Office products and cloud services for 23%, Windows for 10.1%, gaming for 7.3%, LinkedIn for 7.1%, search and news advertising for 5.8%, enterprise services for 3.6%, and devices and Dynamics each for 2.6%.

The predominant issue surrounding MSFT is whether management optimism on the firm’s prospects is accurate? The secondary element drawing investor interest is what is MSFT’s long-term financial outlook? We provide answers below.

Secular Growth Projections Appear Overdone

MSFT’s business outperformance between 2020 and 2022 was driven by the anomalous demand created by the pandemic and its after effects. The company’s FY2023 financial outcomes were significantly below that experienced during the prior few years. Based on the condition of MSFT’s business, we have a more conservative view of the firm’s growth prospects.

In regard to Windows, the operating system’s market share has declined from 90% in the 1990’s to 31% in September 2023. Considering desktop computers, where Windows most resides, growth in the category expanded 7% between September 2022 and September 2023. However, Windows desktop market share plummeted to 68% in September 2023 from 75% in September 2022. In contrast OS X and ChromeOS captured 5% and 1.5% market share during the period. Clearly, the tide has turned against Windows, with the increase in form factors, including tablets and smart phones, and the proliferation of relatively more user friendly operating systems, such as iOS, OS X, ChromeOS, and Android.

Although PC sales that are the hegemony of Windows rebounded during the pandemic but then declined over the next couple of years, they are expected to revert to growth in 2024, according to Gartner, we expect the slump in Windows sales to continue into the foreseeable future, based on the dynamics expressed above.

With respect to MSFT’s productivity suite, Office, most of the rapid growth has been captured. Now, it is GOOG’s productivity software, Workspace’s, time to shine. Workspace provides similar functionality as Office - email, the ability to generate documents, spreadsheets, and slides, as well as video conferencing. The platform comes free with a Google account, although the enterprise and premium versions require a paid subscription. Conversely, Office requires a paid subscription, even for the basic consumer version, and for the enterprise version. In addition, since Workspace was developed for the World Wide Web, the platform is relatively more user friendly than Office. Further, although both Workspace and Office are in the cloud, given Office’s enterprise focus, there are additional steps to collaborate and to gain access to the platform.

Not surprisingly, Workspace has captured significant market share from Office, and currently dominates the segment with 50% market share, with Office accounting for 47% of the total revenues associated with the segment. Overall, our opinion is that Office is superior in regard to the creation of advanced spreadsheet models and slide decks. Therefore, although we expect large companies to continue to select Office as their productivity software, consumers, start-ups, and academics are likely to gravitate towards Workspace. Considering these factors, we anticipate that sales growth associated with Office will moderate over time, in-line with Gartner’s data that demonstrates a 1% to 2% shift in market share from Office to Workspace, every year.

In the context of LinkedIn, its talent solutions segment has a lock on matching job seekers with hiring companies, specifically in regard to Middle America. In addition, we expect revenues associated with the category to continue to expand, driven by the strong growth in number of subscribers hailing from India. Further, we expect revenue acceleration in LinkedIn’s business to business advertising, as the 75 million companies that have LinkedIn accounts seek to leverage the platform to promote their products and/or services.

However, we are less optimistic about LinkedIn’s premium subscription’s category, as folks have moved away from vanity penchants such as identifying "people who viewed your profile." Moreover, as LinkedIn has developed into a cesspool of reportedly fake accounts reaching out to members from across the globe, with nefarious intentions, connection requests are seldom entertained by serious professionals. Overall, the premium subscription segment provides limited value to subscribers.

Cumulatively, considering our argument that with 950 million subscribers, expansion in LinkedIn’s subscriber base is likely to moderate looking ahead, we believe most of LinkedIn’s major sales growth has been had. Accordingly, we expect revenue growth to decline moving forward.

Now to MSFT’s gaming platform, Xbox. The company’s acquisition of ATVI is complete. MSFT is now the owner of Call of Duty and World of Warcraft, considered to be among the world’s largest gaming franchises. The company had to give up quite a bit of the house to get the deal through regulators, including providing 10-year rights to Call Of Duty to Sony (OTCPK:SNEJF) and potentially Nintendo, and 15-year exclusive cloud gaming rights to the entire ATVI gaming portfolio to Ubisoft. Nevertheless, the takeout represents a highly favorable development for MSFT, catapulting the company into direct competition with Sony’s gaming franchise.

Along with the additional revenues associated with the buyout, MSFT secures additional popular games such as Diablo, Overwatch, and Candy Crush, which can potentially be kept exclusive to its consoles, GamePass, and cloud gaming platform. In addition, there are a large number under promoted ATVI games, which MSFT could potentially monetize. Further, the firm can now deploy ATVI’s expertise in mobile gaming to its library of games, potentially unlocking a significant opportunity for revenue growth. Moreover, sales growth is expected from advertising and in-application purchases which are additional capabilities ATVI brings to the table. Additional revenue drivers include significant growth in GamePass subscriptions due to the inclusion of ATVI games, and cloud gaming, a global market of seven billion gamers, being courted by AMZN and GOOG, as well. Net-net, Xbox could likely develop into a strong secular growth driver for MSFT.

In regard to Azure, the cloud computing industry has grown rapidly over the previous decade. Additional strong growth driven by global uptake of the service is projected by Gartner and IDC. Nevertheless, growth associated with the industry was estimated to decline to ~17% by 2030, compared to the typical ~30% and above growth, experienced on overage over the prior several years. However, with the AI wave, the cloud computing segment has received a second jolt of energy, as AI is largely dependent on cloud computing. Given that the advent of AI is projected to expand technology spending to 10% of GDP from the current 5%, it is clear that the AI driven opportunity for cloud computing is dramatic.

Therefore, as one of the largest providers of cloud computing infrastructure and services, MSFT is well positioned to benefit. Cumulatively, we believe, Azure represents a core strong long-term growth driver for MSFT.

In the context of AI, with Bing having conceded market share between September 2022 and September 2023, it appears that the first mover advantage associated with the integration of ChatGPT 3/4 into Bing has evaporated. Supposedly, based on MSFT commentary, the impact of its AI platform on revenues is reflected through Azure. However, both Azure and AWS suffered 1% declines in market share during the second quarter, with Google Cloud benefiting from their shortfall, achieving an 11% market share versus 10%, it evidenced a year ago.

Nevertheless, given our conviction that use cases surrounding primary AI functions are likely to explode, MSFT, considering its position as a major AI and cloud computing company, appears well placed to experience significant growth associated with AI. MSFT has plans to embed AI across every business through co-pilots, which are AI systems that support users in performing functions associated with the respective platforms. The firm debuted the Windows co-pilot in September and expects to launch an Office copilot in November. Additional co-pilots for coding, sales and marketing, and Dynamics etc., are anticipated shortly.

However, MSFT’s AI capabilities represent rudimentary AI functions (text/slide generation, summarizing, translation, transcription, coding, data analysis, and security), which are being marketed or under development at GOOG and AMZN. In regard to productivity software, GOOG has matched the Office co-pilot with its Duet AI. In response to the integration of ChatGPT into Bing, GOOG introduced Bard. For coding, if MSFT has the Github co-pilot, AMZN has Code Whisperer and Bard has the ability to generate code. Both AMZN and GOOG provide large language models to their cloud computing customers through Bedrock and Vertex AI. AMZN does not provide productivity software such as Office and Workspace. However, it makes up for the shortcoming with its retail focused AI features, which developed for in-house use are promoted to AWS customers, once they achieve commercial grade.

Therefore, it does not appear that MSFT is likely to capture a majority of AI-driven business. In our opinion, since data is key to AI, the company with the most data, is likely to benefit over the competition. That company is GOOG. In addition, as AI wars are likely to be fought in the cloud, the firm with the largest market share will be at an advantage. That firm is AMZN, with AWS. Overall, we do not expect any major shifts in market share associated with cloud computing, due to AI integration. AWS is likely to retain its leadership position, followed by Azure, and then Google Cloud, which is likely to benefit most from the AI revolution.

Long-Term Financial Outlook Appears Tempered

MSFT’s FY23 financial performance was disappointing. The company’s net income and operating cash flows declined compared to the prior year’s figures. Although gross profits increased, spending related to investments in Azure and AI, employee downsizing, and real estate consolidation, that reflected in higher expenses associated with research and development, selling and marketing, and general and administration, impacted the bottom line. In our judgment, as the increased spending did not constitute one time expenditure, but was simply the cost of doing business, MSFT should have had the ability to absorb the higher expenses, and expanded net income and operating cash flows over the previous year. Considering its cost structure, it appears that MSFT’s current revenue growth is insufficient to generate profit growth.

To be specific, during FY23, revenues were ~$212 billion, reflecting a growth of 6.8% compared to FY22; net income was ~$72.4 billion, representing a decline of 1%, and earnings per share was $9.68 versus $9.65, a year ago. Over the period, year-over-year growth associated with server products and cloud services was 18.7%, that linked to Office products and cloud services was 8.6%, Windows was negative 15%, gaming was negative 4.7%, LinkedIn was 9.6%, search and news advertising was 5.3%, enterprise services was 4.4%, devices was negative 24. 4%, and Dynamics was 11.7%.

In addition, as a percent of sales, cost of revenues declined by 800 bps to 31.1%, research and development spending expanded by 100 bps to 13%, selling and marketing costs remained flat at 11%, and general and administrative expenses advanced by 100 bps to 4%. Further, gross margins increased by 800 bps to 68.9%, operating margins escalated by 600 bps to 41.8%, and profit margins declined by 100 bps to 34.1%. Moreover, operating income associated with productivity and businesses processes increased by 15%, that related to intelligent cloud was up by 14%, and that linked to more personal computing declined by 20%. At the end of FY23, MSFT had a cash and cash equivalents balance of ~$111.3 billion and long-term debt of ~$42 billion on its balance sheet.

With respect to the long-term, we believe the growth focus has shifted. Key growth over the next decade will be derived from Azure and AI; Office and LinkedIn will generate moderate growth; while Windows will continue to experience negative growth. With regard to the gaming platform, our opinion is mixed. Xbox will achieve some growth owing to the ATVI acquisition and GamePass. However, potential significant growth in Xbox will be dependent on the uptake of cloud gaming.

In addition, on a secular basis, we anticipate margin expansion as capital expenditure associated with developing infrastructure related to the cloud computing and AI segments declines, the effect of lower spending on labor and real estate, and additional efforts to rein in spending to account for potentially softer revenue growth, reflect in operating leverage.

Considering our revenue growth and margin expectations, we anticipate that net income and operating cash flows are likely to expand, over the long-term. However, consistent with the tempered growth of the business, bottom-line growth is likely to be moderate, in our opinion.

Incorporating inputs from the analysis described above into our 10-year Discounted Cash Flow model, we arrive at a 1-year Price Target of $286/share for MSFT. Our valuation assumes a normalized 10-year revenue growth rate of 12% (vs. the FY23 revenue growth rate of 6.8%). In addition, we derive our net income for 10-years using a net profit margin of 35% (vs. net profit margin of 34.1% during FY23). Based on our analysis of MSFT’s historic financial reports, we model normalized 10-year operating cash flows as 42% of revenues/year and straight line 10-year capital expenditure as 14% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 9% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 7,472 million to arrive at our 1-year Price Target.

Risks

MSFT Secures Complete Control Of Open.AI. MSFT is rumored to have a 49% interest in Open.AI, secured through a cumulative injection of $10 billion in the company. Based on documents describing the sale of employee shares, Open.AI is currently valued at $90 billion. The investment provides MSFT rights to commercialize Open.AI’s inventions.

We view a potential takeout of Open.AI by MSFT as unfavorable for the latter. Our conviction is based on an opinion that MSFT would stifle innovation associated with Open.AI by imposing its profit maximization culture on the organization, through excessive control of Open.AI projects. Specifically, we are concerned that MSFT would implement onerous timelines favoring rapid product delivery over creativity. Considering data which demonstrates that most buyouts are unsuccessful, we believe that it is in the best interests of Open.AI to remain independent, over the medium term, at the least.

Bottom Line

Based on our coverage of large technology companies, we envision Tesla (TSLA) as a cheeky erudite teenager, Apple (AAPL) as a diligent square-jawed young man, AMZN as a straight-shooting professional, and MSFT as a corner store owner who will nickel and dime you until thy kingdom come. MSFT has turned profiteering into its mission, (as TSLA’s is to electrify the earth and AMZN’s is to help customers lead better lives), forcing customers to purchase unwanted applications and services. No wonder consumers are walking away, reflected in dwindling growth across most of its business.

Overall, saddled with several growth drivers that are aging poorly, and an alienated base of current and potential customers, Microsoft Corporation is hardly a "one for the generations" stock. No decades-long growth story here.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.