A Financial Analysis of Microsoft in 2021
It’s no secret that Microsoft can be a great company to invest in. First, let’s look at the business profile and then dig into financial metrics.
Microsoft’s Business
Revenue Drivers, Market Penetration and Customer Base: They dominate in so many of the areas that they offer products and services. To name the obvious candidates, Windows is a fundamental part of the way many businesses runs today. Few productivity tools have managed to maintain a loyal customer base the way that Microsoft Office has. Its cloud offering of Office 365 has only made that market dominance more pronounced. The collaboration tools they’ve invested in like Sharepoint and OneDrive had some growing pains but given that it’s easier for enterprises to integrate these tools into their Microsoft Active Directory identity system, there’s a compelling reason for businesses to use these over competitors. The company is also a strong force in cloud computing — Azure may not be as technically advanced as AWS or Google Cloud, but with the kind of investment Microsoft seems to be making and the desire for enterprises to be untethered to one cloud offering, it seems inevitable that Azure will maintain sizeable market share. Putting aside the bets that the company is making on artificial intelligence or gaming, these product lines are proven revenue generators in businesses that have high switching costs.
Management Credibility: Many of these business lines weren’t clear winners from the start and some bets didn’t pan out. The ideas have been floating around since the late 90s but have only now become much more mainstream. The implementations are more user friendly. Until recently, many businesses were reluctant to have their data in the cloud and wanted to manage things locally. Microsoft’s ability to assuage those doubts required a combination of things — offering clear privacy and cybersecurity controls, enabling a mix of local and cloud data storage and managing the R&D well to create better products. With the benefit of hindsight, this shows good engineering and management decisions were made which creates confidence for me as an investor. From an enterprise software perspective, they focused clearly on a specific target market and pushed hard to create an ecosystem of tools that work reasonably well together given their scale.
Geographic Factors: Microsoft has created a unique foothold in most geographies across the world. There’s high brand awareness and the tools are desired by most enterprises wherever you go. When it comes to fundamental products like Windows, they also win the battle on price. In countries like India where the median income is lower, it’s much more likely that individuals and businesses will choose Windows machines over Macs. Developers in these countries build software that only works on Windows, creating a circular loop where using a Mac feels like tying one hand behind your back. In my personal experience, I’ve seen many banking and government websites in India only work when accessed via Internet Explorer (now Edge). The company has also fared reasonably well in China when compared to many other American technology companies. While threats to the business remain in that region, there is a similar ubiquity of Windows, and the ecosystem of tools that come with it. In any developing country where the move to digital tools for day-to-day business is still ongoing, Microsoft is well positioned because they typically represent a lower cost option than the competition, while still being a platform that has millions of applications you can access easily.
Microsoft’s Financials
If you believe that the market position of Microsoft is likely to remain, the question then becomes — at what point is the stock price too high?
I spent some time digging into their yearly SEC filings. The latest 10-K looks at fiscal year ended June 2020, so the full effects of the pandemic aren’t visible in my analysis, but it’s safe to say that the move to a work-from-home mindset has only helped the business overall. What I tried to do is take a risk-averse view of the financials.
Revenue: The personal computing business which includes Windows, Surface devices and Xbox, raked in $48.2 billion and grew 6% from FY 2019. This side of the business seems in steady growth mode, not much surprise here. The heavy hitters from a valuation perspective are what they call Productivity and Business Processes and Intelligent Cloud. This includes Office, Office 365, Dynamics (the CRM solution), LinkedIn and Azure. These businesses brought in a staggering $94.7 billion in revenue. Azure revenue grew 56%, with cloud services revenue increasing by $8.8 billion. This is evidence that Microsoft has traction in this space. Productivity tools weren’t far behind, with a revenue increase of $5.2 billion or 13%. Overall, Microsoft’s top line grew 14%, which for a company that went public over 30 years ago is not bad at all. My view is that the cloud computing business has the capacity to keep that momentum going for at least a few more years. Even taking a conservative approach, I wouldn’t be surprised if their revenue crosses $200 billion by 2023.
Profitability: If we look at gross margins, it suggests that Microsoft is generating more and more revenue from higher margin businesses. Gross margin increased 13% for the productivity tools business, 26% for cloud computing and 12% for personal computing. Across the board, for every dollar in revenue that the company is earning, they are generating higher profits, which bodes well for shareholders. The company didn’t just stop there. They grew their cash stockpile which sits at $136 billion as of June 2020. They’ve continued to make important investments in research and development, increasing spending on Azure, LinkedIn and cloud engineering. They also increased spending on sales and marketing by 8% since 2019. It’s interesting to see how their operating income margins have increased as well, steadily rising from 32% in 2018 to 37% in 2020. My outlook is that the company has done a good job balancing steady revenue growth while increasing profitability.
Whether I value the company based on revenue multiples or by looking at a discounted cash flow, a range of $230 to $270 per share seems within reason even in a risk-averse scenario.
Disclaimer: This isn’t as thorough as you would get from an asset management or equity research professional. I’ve made assumptions based on my personal views of the business. Use it at your own risk.
