Microsoft (NASDAQ:MSFT) is a significant force in the world of technology. Its Office and Azure Cloud, Xbox and Teams, Windows, and Dynamics franchises hold commanding market share majorities in most markets. Through most market cycles, the company’s recurring revenue models, such as enterprise license/maintenance agreements, provide stability and growth to both the top and bottom lines. The stock’s valuation has become its biggest detractor, rising from the customary 5–15x EV/EBITDA multiples in the 2002–2014 period to a high of close to 44x late last year. Microsoft stock currently trades at 17.8x forward estimates.
The company has the advantage of legally binding 3-year license and maintenance contracts for businesses and annual subscriptions for most of its cloud offerings, making Microsoft a powerhouse of earnings. We don’t think that competition will materially harm the business within our limited (1-3 month) time horizons; franchises built over decades don’t break down in a few weeks, despite a case being made that its dominance is being gradually undermined by rival offerings that continue to improve in the market. As a result, we advise buying Microsoft stock with a price target of $300 (22% potential upside) and a stop-loss on a consistent basis below $235.
Microsoft Is Dominating the Market
We think Microsoft stock will benefit from a period of relative calm leading up to the election and the generally strong Q4 because the company is on such a solid competitive footing with rivals. As an illustration, data from Microsoft’s Investor Relations site reveals that Azure holds 21% of the market for cloud computing, while AWS holds 34% and Google holds 10%. Although not particularly impressive on its own, Azure has been able to grow by almost 50% for the majority of the past ten years. Microsoft doesn’t need to develop a brand-new barnburner product for the stock to reach our target because of its dominant share in areas such as office productivity (48% versus Google Docs 46%, but Office outearns competitors by a vast margin and maintains a clear technology lead), operating systems (45% versus MacOS at 29%), servers (11.2%, which is 5x more than its closest rival), and gaming (50% share of the US market per Statistica). While markets await the election results, it simply needs to overcome short-term fears of a recession and inflation. Strength does not merely come from sharing. Operating leverage is significant, as seen by its gross margins, which dominate the industry and have been maintained for many years. Seasonal strength also benefits its growth categories, like Xbox and anything cloud-related. The Activision deal’s advantages will soon be realized, which should boost the stock price slightly.
Growth in Segments Indicates Operating Strength
Microsoft business shows strong growth and profitability of Microsoft’s businesses. Its market share, which has remained consistent for many years, is solid and defendable in all areas except search. Microsoft has proven to be a worthy opponent throughout the years. Even though we do not support monopolies or oligopolies, the corporation has maintained its position in each market for decades despite intense efforts by competitors to unseat them. This is likely to continue. President Brad Smith has demonstrated his skill as a negotiator and strategist by guiding numerous potentially problematic situations, such as the Linux, Windows, and EC antitrust affairs, to good resolutions for shareholders. CEO Nadella has also led the business to more successful outcomes than anticipated by increasing growth in the cloud, servers, and Dynamics throughout his career. We think the future of the company is in capable hands.
The majority of Microsoft’s risks are macro. Rates would need to rise significantly soon if the Fed truly begins to combat inflation rather than merely talking about it, which would cause all high multiple equities to decline simply on a duration adjustment. It would probably take more time to filter through quarterly financial reports if there were any impact on the top and bottom lines. The scenario with the most significant impact on valuation multiples and future growth expectations is one where rates continue to climb and the economy experiences a severe downturn just before the election. We believe that a recession that most likely began in April is accelerating. Still, with elections just around the corner, it is difficult to imagine how political survivors like the Fed would act against their institutional interests by slowing inflationary pressures before the political waters are clear. This window of time allows us to observe how any positive news will positively affect Microsoft’s value formula.
A Refreshing Pause During the Elections?
Since mid-November, when inflation started to materialize as a danger to growth stocks, the stock has been in a protracted drop phase. In March, when concerns about inflation eased somewhat, the stock increased. The summer rally also helped Microsoft stock, again on the assumption that a slowing economy would reduce price pressure. Around $240, Microsoft stock may be forming a double bottom, with a potential upside to $300+ in the coming weeks. On the retest of the lows in mid-September, the RSI displays a positive divergence, indicating higher prices are likely to occur soon.
Microsoft is a market leader in many fast-growing industries. Its management is first-rate, and industry insiders continue to admire its technology. Going into the typically robust Q4, the operating leverage is significant. The company’s revenue models offer stability when competitors experience instability due to shifting economic conditions.
However, we believe the odds are in favor of the bulls, at least through the election and possibly until the end of the year, even though Microsoft stock is not immune to downside risk.
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