If someone had told you three-years ago that Microsoft (MSFT) would be on track to reach a $1 Trillion valuation many of you would have laughed or heckled the person. I’m sure I would have, but then again, premium valuations derive from the quality of a business franchise, and very few business franchises have stood the test of time like Microsoft.
With Microsoft’s market value at $900 Billion currently, it’s only a matter of time before the firm surpasses the coveted $1 Trillion mark and stays above the valuation. It’s one of only two businesses with a AAA credit rating from Standard & Poor’s, and it has a lot to do with the lack of financial leverage on the balance sheet, and durability of its business model/revenue runway compared to all other technology peers.
Microsoft exhibits way less drawdown on broad based market pullbacks when compared to technology peers, and it’s sustaining much more price momentum to new all-time highs when compared to other technology peers, which is precisely why the firm tends to attract long-term growth investors, because it’s inherently less volatile, and it can also derive a fair valuation that can be rationalized by investors without the inherent worry of an overly inflated forward multiple.
Microsoft’s revenue in FY’19 is expected to grow 12.4% y/y according to consensus estimates, which outpaces Apple consensus estimates of -3.9% y/y growth, and with profit margins that are even more generous than what Apple or Intel can provide shareholders.
Keep in mind, Apple is less profitable than Microsoft, so even when Microsoft’s revenue base is lower than Apple it doesn’t mean that Microsoft will need to produce the same consolidated sales figures to produce the same results financially. Microsoft’s net profit margin tends to hover in a narrow 27%-30% range historically, whereas Apple’s net profit margins tends to hover in a narrow range of 21% to 24% historically. There’s only one other major tech giant that’s more profitable than Microsoft and that would be Facebook at a 40% net profit margin.
So, when comparing Microsoft’s expected revenue of $125B versus Apple’s expected revenue of $255B for FY’19, it implies that Microsoft can produce $37.5B in net profits at the high-end of its margin range, whereas Apple would produce $56.1B in net profits at the mid-point of the range (remember less iPhone units sold means less profit margin this year). So, when taking this into consideration, the two competing giants tend to produce similar eye-popping figures.
What makes Microsoft a little more differentiated is the high-margin business categories that also produce insane growth rates. Pair this with the fact, that software and cloud price/earnings and price/sales multiples are substantially higher than hardware/semiconductors firms, and it’s more likely that Microsoft can hold onto a $1T valuation upon crossing that threshold when compared to some of the other tech peers that pushed past $1T to regress back below, i.e. Amazon and Apple.
What’s really driving the business growth narrative is the cloud computing segment, which tends to appeal to enterprise, as opposed to mobile applications (AWS really shines in the mobile app/video streaming segment), and with the ability to operate in both a private/public environment (hybrid cloud) via Microsoft Server and Microsoft Azure the firm tends to appeal to enterprise IT customers that demand better control/security from a private cloud environment paired with the advantageous cost of public cloud.
Hence, the Intelligent Cloud segment, approximately a $40B business this fiscal year (inclusive of server products, cloud services, and enterprise services) grew by 20% y/y in the prior quarter, but what was more eye-popping was the fact that Azure (it’s public cloud service) was able to grow revenue by 76% y/y.
This transition to public cloud is being driven by specific datacenter applications that require heightened security like banks, brokerages, i.e. financial firms that manage the monetary system via a private ledger. Really, really important to keep the data-entry accurate, and incorruptible from various cybersecurity threats because it ties directly to the value of money in the financial system.
What particularly stands out is the adoption of hybrid cloud among financial institutions, which are looking to pair down costs by improving the overall efficiency of datacenters by migrating to a public/private cloud and away from on premise datacenters (which are now considered legacy systems). This transition is expected to take 3-years, according to UBS, which diminishes the number of workload instances to 10% on premise, 30% Public Cloud, and 60% Private Cloud. These hybrid-type configurations are mostly tied to Microsoft’s ecosystem, which is why Azure’s growth rate has been so stellar when compared to all of its other business units.
UBS Senior Analysts, Jennifer Swanson Lowe and Eric Sheridan surveyed 203 Senior IT Executives at leading banks and came to this conclusion:
Of those using public cloud currently, nearly half indicated that they were using Azure, but Google, AWS, IBM, and even Oracle saw reasonable levels of uptake as well. We expect Microsoft to be a leader in large traditional organizations given the company’s long history as a trusted provider of enterprise solutions and ecosystem of strategic implementation providers. Google at #2 is perhaps more surprising, and we suspect linked to the company’s strong capabilities in AI.
The keyword was that half the banks surveyed use Azure. In cases where critical data is stored (like the amount of money in the financial system) the preferred choice was Microsoft in comparison to all the other competing providers (Amazon Web Services, Google Cloud, Oracle, IBM and Cisco).
It’s why Azure’s revenue growth of 76% this prior quarter makes more sense, because behind the raw numbers, it’s differentiated enough to win meaningful share from large IT customers. There’s substantial demand to migrate onto Azure over the next 3-years from various banks, and with the various other opportunities to win other large enterprise clients (outside of banking), it wouldn’t be surprising to anticipate a meaningful growth runway that’s substantially additive to Microsoft’s valuation going forward.
While Microsoft has a broad business portfolio, the Intelligent Cloud Segment, which by itself is a $40B/year business can grow at a sustained 20% CAGR over the next 5-years based on various adoption and deployment scenarios, which implies that it could grow into a $100B/year business by FY’24. This business unit has a much better growth runway than the rest of Microsoft, and it’s also why investors should anticipate Microsoft to reach $1T+ market cap and hold onto that valuation when compared to other tech firms.
Disclosure: Alex Cho does not own a position in Microsoft.