Microsoft: Buying At Rock BottomNov 01, 2022
Price Target: $345 (45% upside)
Current Price: $252
Target Date: Q2 2023
Stock: Microsoft (MSFT)
Well, we've made it through a wild earnings season and it was a bloodbath for big tech.
And it's honestly been a wild month in the economy and markets in general.
Meta has crumbled under Mark Zuckerberg's VR ambitions, Alphabet's been tripped up by ads budgets drying up, Amazon cannot escape the pain of ongoing supply chain issues, and Microsoft is suffering under similar headwinds.
But Microsoft is not on a mild downturn in a vacuum.
All of Big Tech has given up an average of 8% of its value -- with Amazon down a full 10% and Meta down a staggering 25%. For a long time now, we have been leaving the growth-hungry market of the 2010s and entering into an economy that needs to see more profits than anything else.
Therefore, the ludicrously expensive P/E ratios we loved pre-pandemic are simply unsustainable now. With rising costs, rising interest rates, and a dollar that is strengthening out of control -- this economy is a put-up or shut-up moment for all of the "tech darlings".
And of all big tech, Microsoft is the best positioned to power through these headwinds. And you may be surprised to hear that.
The market is fleeing tech stocks in droves (so much that the NASDAQ is straight-up diverging from the DOW Industrial Index) so much so that we actually see this as a strong opportunity to add to our Microsoft position.
Why? Well, the main reason is we see a lot of the headwinds Microsoft is facing right now being short-lived.
Furthermore, Microsoft is down after earnings despite some strong growth. There are a lot of reasons why Microsoft's woes aren't going to last long because we see a strong, diversified business that's about to have a solid number of revenue lines expand despite their shiniest toy getting mildly downgraded.
So today we're going to cover the markets, the economy, the headwinds, and where Microsoft plays into all of this.
But to be clear: Our thesis on Microsoft is genuinely unchanged.
While Azure revenue slowing down is a genuine concern--we see it as a product of a few short-term headwinds more than anything else. Meanwhile, Office 365 is growing fast enough to be an exciting new pillar for MSFT moving forward as they fight to be the singular digital infrastructure for all big-business moving forward. Compared to the rest of big tech (excluding Apple) Microsoft is going to appear to be the strongest software play for the long haul.
There are a lot of details to cover beyond that, so let's start untangling our reasoning for Microsoft 👇
While we're still confident that Microsoft is in a strong position moving forward--they have some minor headwinds that really spooked the market this week:
Rising costs lead to slower Azure growth. Microsoft's cloud juggernaut--Azure--grew by 1% less than expected this quarter. But Microsoft also announced that they estimate a steeper slowdown in the year as we move through more earnings reports. A lot of Microsoft's valuation is tied to accelerating Azure revenue and margins. Heck, so many of the runaway valuations we saw from 2011 to 2021 were tied to how insanely profitable big tech firms were from scalable products like Azure. Even a hint of a slowdown has caused investors to flee big tech in droves. Microsoft's selloff is the most tepid of all big tech--but dropping 10% since earnings is pretty significant.
The US's response to inflation has made the dollar a wrecking ball. The EU and other countries are finally getting their acts together and raising rates enough to keep pace with our Federal Reserve--but for a minute there the Fed was the most aggressive actor on inflation. This strengthened the US Dollar against every other currency and made paying bills in USD really expensive on the international stage. Multinational corporations like Microsoft are watching their revenue gets pummeled by exchange rates alone. Of all the headwinds, this is the shortest-lived, but it's brutal for margins.
Oh yea, there's still a semiconductor shortage and supply chain issues. PC and device revenue growth got cut in half as it's still very expensive to build computers and demand for them has absolutely cratered. We never expected PC and Xbox to be central to our growth thesis for Microsoft--but lower demand AND lower margins really eat into the MSFT bottom line.
All of these headwinds add up to the shellacking we saw in Microsoft stock last week. What's wild is that this appears to be industry-wide. Amazon also crashed 25% on worries that their cloud play, AWS, was also going to have lower revenue and lower profits.
What's even wilder is that all these issues compound into each other. Rising energy costs and a supercharged dollar make the semiconductor issue worse and make it harder for businesses to buy services to be more productive. It's a massive issue that the market clearly does not have a lot of confidence about being solved in the short term, hence the sell-off.
We're not worried though, because one trend we kept mentioning in previous updates is genuinely starting to take shape.
Office 365 Is Starting to Take Off:
In our original thesis on MSFT (read that here) we talked about Microsoft's bundling and enterprise strategy--and how they would use that to add multiple paths to their growth strategy.
And in a quarter where Azure began to slow--Office 365 started to accelerate. 365 is becoming a solid standard of digital infrastructure for a LOT of enterprises, pushing its revenue growth to 14% YoY. This is nothing compared to the revenue being brought in by Azure--but it is a solid enough trend to give us confidence that Microsoft's digital infrastructure business can buoy total revenue if this slowdown in cloud spending is industry-wide or lasts a long time. 365 can easily be a gateway product for the rest of Microsoft's product suite.
That’s why we love Microsoft long-term. After Apple completely overtook them in the personal computing space and created the luxury operating system for individual customer households, Microsoft decided to take a similar approach to the B2B model.
Microsoft is rapidly regaining ground as the table-stakes software ecosystem for mature businesses and enterprises.
Office 365 is just continuing to accelerate. And that's why both of these should lead Microsoft towards double-digit revenue and operating income growth over the next 2 years, especially once all this inflation pressure has finally let up.
It’s genuinely an interesting time to be in certain sectors of big tech. Alphabet and Meta are going to be in a difficult position in the medium term as advertising budgets tighten.
That downward momentum is going to place unfair pressure on Amazon and Microsoft, leading to them potentially being a little oversold.
Meanwhile, Microsoft is firmly establishing its business as the medium-growth, long-term powerhouse for business and niche consumers.
They’re winning the right battles at the right time, and are only being mildly tripped up by the specific macro headwinds hurting some of the other big players in their cohort.
Risk/Reward: Medium / High
Market Cap: $1.89T
Dividend Yield: .98%