Microsoft: Firing on All Cylinders

Price Target: $240

Between 1998 and 2012 Microsoft’s stock price was flat. Eight years ago, investors were convinced Microsoft was a company in decline. It had missed the smart phone revolution, and its latest iterations of Windows were so poorly received that companies were sticking with Windows XP and Office 2003 instead of eagerly upgrading to the newest versions. In addition, stories of fiefdoms within the company were common knowledge and investors had lost confidence in Steve Ballmer’s ability to grow revenue and margins.

The last seven years are an entirely different story. Microsoft’s stock price is up almost 10x with revenues growing in the mid-teens and margins in the mid 30% range. Satya Nadella, who took over from Ballmer in 2014 as CEO, can do no wrong in the eyes of the Market and expectations for Microsoft are high.

Given this background, it seems like an interesting time to take a deeper look at Microsoft to determine whether the stock is still a good investment at today’s levels.

Microsoft’s Business Segments

The company breaks down its businesses into three main segments – Productivity and Business Processes (PBP), Intelligent Cloud (IC) and More Personal Computing (MPC).

PBP is composed primarily of Office (commercial and consumer), Exchange, SharePoint, Teams, Skype, LinkedIn, and Dynamics.

IC is made up of public, private and hybrid cloud products, including Azure, SQL Server, Windows Server, Visual Studio, and GitHub. It also includes Enterprise Services such as consulting and support.

MPC includes Windows (in its various forms), devices such as Surface and PC accessories, and gaming (Xbox along with all content and services).

Revenue Growth and Margins

Each of these segments made up about one-third of revenue in 2019. However, I expect growth rates will vary significantly for each segment over the next ten years. I expect IC to grow the fastest, with enterprises continuing to migrate to the cloud. PBP may see some COVID related weakness in 2021, but I expect growth rates to return to double digits in 2022 before slowly declining. MPC has grown at 7% on average over the last three years, but I expect COVID will impact growth in 2021 before picking up to 6% in 2022 and slowly declining from then on. My assumptions for revenue growth in each segment are on the “Segments” tab of the model.

Based on these growth rates, Microsoft’s revenue would essentially double from $143B in 2020 to $297B in 2030. According to Gartner, total IT spending globally in 2019 was $3.7T. Assuming spending grows in line with inflation over the next 10 years (which I’m guessing will be about 3%), it’s not unreasonable to assume that Microsoft grows at roughly double that rate (~7%) given they’re a leading player in the space. If anything, these growth assumptions for Microsoft are likely conservative.

I assume margins for each of these segments going forward are static and equal to average margins for each segment over the last four years. Given margins have improved in the last four years, this is likely conservative, but I expect competition will continue to be strong and there is a chance of significant regulatory overhead (though this is more of a concern for Amazon, Google and Facebook).

Valuation

Based on these revenue growth and margin assumptions, and a terminal value multiplier of 20x, I arrive at a per share value of $240 for Microsoft’s stock. While this is about 10% higher than the current price, I’ll be waiting until the stock dips below $200 to add to my current position.

As always, my model is available here if you’d like to make your own assumptions for the company going forward.