On March 5th, 2020, the value of Microsoft (NASDAQ:MSFT) shares stood at $166 each. Now, two years later, Microsoft has delivered an impressive total return of 109%, outperforming the broader market’s 48%. Despite this remarkable performance, my perspective remains unchanged: Microsoft stock continues to be the bedrock of a robust growth portfolio. While achieving 100% growth in two years may seem ambitious, it is certainly within the realm of possibility. With exciting advancements in AI on the horizon and Microsoft’s strong presence across the technology landscape, I firmly believe that anything is possible. Let’s delve deeper into the reasons behind this viewpoint.
Unparalleled Stability
When selecting a cornerstone for an investment portfolio, stability is a crucial attribute. In this regard, Microsoft surpasses expectations. While an exhaustive review of the company’s offerings is not necessary, it’s worth highlighting a few key components:
Windows: With a commanding 68% share of the Desktop OS market, Windows is a dominant force.
Office 365: Holding a virtual monopoly in Office productivity software, Office 365 stands as the primary alternative to Google’s Suite.
Azure: Currently in second place to AWS in the cloud infrastructure arena, Azure is steadily gaining ground.
Xbox & Game Pass: Microsoft’s presence in the gaming industry through Xbox and Game Pass further diversifies its portfolio.
Each of these facets, if considered independently, would qualify as S&P 500 contenders. The true strength of Microsoft lies in its successful integration of these components, consistently expanding them at a pace that surpasses market trends.
Impressive Revenue Growth
Microsoft’s revenue over the past twelve months totals a staggering $208 billion. Over the last decade, the company has more than doubled its top line, displaying no clear indications of hitting a growth ceiling anytime soon. Microsoft has strategically positioned itself as a market leader in several emerging sectors, which we will explore shortly.
Positioned for AI Success
In addition to its stability, Microsoft is well-positioned to capitalize on the growth of artificial intelligence (AI). While we acknowledge Microsoft’s investment in OpenAI, let’s momentarily focus on Azure, which is set to play a pivotal role in the learning and inference stages of future AI systems.
The cloud AI market is projected to reach a staggering value of $650 billion by 2030, with a promising compound annual growth rate (CAGR) of over 40%. As the second-largest cloud services provider and a company closely collaborating with OpenAI, Microsoft is poised to capture a significant market share in this space.
If the estimated $650 billion market value holds true and Microsoft can sustain its 23% slice of the cloud market, Azure’s AI offerings alone could generate an astonishing $150 billion in annual revenue. To put this into perspective, Microsoft’s “Intelligent Cloud” segment reported $84 billion in revenues over the past twelve months.
Furthermore, there are projections suggesting that AI could provide a $100 billion boost to Microsoft’s top line by 2027. Multiple voices hint at a similar conclusion: a significantly more prosperous Microsoft.
Beyond Azure, Microsoft’s potential gains from AI extend to other areas. The integration of various forms of AI into its Office 365 toolset enhances user adoption and stickiness. GitHub, a Microsoft-owned platform, features Copilot, a tool that boosts software developers’ performance by 30-50%. Even Windows will soon incorporate an LLM-based co-pilot.
Positive Outlook and Growth Potential
As Microsoft approaches the conclusion of its 2024 fiscal year, the outlook has never been more promising. Let’s analyze the company’s performance across its reporting segments.
Microsoft’s three reporting segments grew over the years. With the exception of the “More Personal Computing” category in the past twelve months, every other sector has displayed substantial and consistent growth.
While the “More Personal Computing” segment, comprising Windows OEM, Devices, Xbox, and Search, experienced a decline in year-over-year revenues for Windows OEM and Devices, this should not raise significant concern. Hardware is not Microsoft’s primary source of revenue, and the decrease in OEM sales can be attributed to the company’s strategic shift in selling Windows.
The areas that investors should closely monitor are Productivity and Business Processes and the Intelligent Cloud. Both these sectors stand to benefit significantly from AI innovations. However, even without the AI-powered boost, their growth trajectories remain promising.
According to the previous quarter’s earnings report, Office 365 Commercial witnessed a 14% year-over-year increase, while LinkedIn revenues grew by 8%. Azure experienced a remarkable 27% growth, and server products registered a 17% gain. Even the search segment witnessed a 10% revenue spike. The potential revenue jump could be substantial if Bing manages to secure a larger market share through AI integrations.
Capital Expenditure Growth and Shareholder Returns
Microsoft allocates over $200 billion annually for updating and maintaining data centers, with a significant portion assigned to traditional components like CPUs and memory. With AI’s demand for “accelerated computing” chipsets, Microsoft is likely to augment its substantial spending in the upcoming years.
As Microsoft aims to maintain its edge in the AI landscape, an increase in capital expenditure (CAPEX) can be expected in the years ahead. We anticipate the company’s capex to reach approximately $30.4 billion by the end of the current fiscal year, marking a modest increase from the previous year’s $29.2 billion. Investments required to maintain its AI leadership could push this value up by 10-15%.
Investors should be aware that while significant top-line growth is expected, it may be accompanied by some margin contraction as Microsoft expands its essential infrastructure. This short-term surge is reminiscent of Amazon’s trajectory, promising long-term returns.
In terms of shareholder returns, Microsoft demonstrates remarkable consistency in its buyback approach. The company repurchases $4.6 billion in equity per quarter and has retired over 1 billion shares over the last decade. In the previous quarter alone, Microsoft returned $9.7 billion to shareholders through share repurchases and dividends. With $26.9 billion authorized for further share buybacks, this trend is likely to continue.
Microsoft Stock Valuation
It is evident that Microsoft currently trades at a significant premium compared to the broader market. This article is not targeted at value investors. The premium valuation of Microsoft is justified by its exceptional stability and future potential.
The decision to buy Microsoft shares now or await a potential wider market pullback depends on the investor’s horizon. As a long-term investor, I practice dollar-cost averaging and have been incrementally increasing my decade-long Microsoft holding in recent months.
Let’s now focus on the two sectors most impacted by AI: Productivity and Intelligent Cloud.
In the Productivity segment, Microsoft can anticipate continued double-digit growth driven by user expansion and rising costs. The integration of AI to enhance productivity will inevitably result in cost increases. By maintaining approximately 10% growth in this sector, Microsoft could achieve $90 billion in revenue by fiscal year 2026 ($93 billion if the company maintains exactly 10% annual growth). With an operating margin of around 46% in this segment, this equates to $41.4 billion in operating income.
The Intelligent Cloud segment, which currently houses Azure, is poised for significant gains. With consistent growth in the range of 25%, this momentum is likely to continue. Assuming 23% growth this year, followed by 25% in 2024 and 2025, and 20% growth in 2026, Microsoft’s Intelligent Cloud could generate $173 billion in annual revenue. This aligns with the potential addition of $100 billion to the top line from AI alone.
After a period of reduced capex, Microsoft’s operating margins in this segment are projected to rise from 43.4% in 2022 to 46% by 2026. This would result in $80 billion in operating income for the company.
Assuming the “More Personal Computing” sector remains steady, Microsoft could reach $141.4 billion in operating income by FY26. With consistent net margins, this would translate to approximately $120 billion in net income. Applying a 25x price-to-earnings (PE) ratio, the valuation would reach $3 trillion.
Considering the dominance of Microsoft as described, a $3 trillion valuation could be achieved with a share price of around $405. However, one could reasonably argue that such a dominant Microsoft would command an even higher premium. Should the company trade at a 30x PE ratio, the share price would be approximately $490.
To be conservative, and in my view, this is a conservative estimate, Microsoft’s fair value today would be $405. This suggests a potential 17% gain over the current share price.
Risks
While AI is expected to be a prevailing force in the coming years, there is a possibility that infrastructure spending may not materialize to the extent anticipated, affecting Microsoft’s benefits as a key beneficiary. Additionally, market sentiment can fluctuate, leading to multiple compression for Microsoft. Although the stock currently trades at a premium, the market’s perspective may diverge in the future.
Final Thoughts
Undeniably, Microsoft is poised to become a formidable player in the AI sphere, offering investors significant potential for growth. While challenges may arise along the way, creating more favorable entry points, I believe that Microsoft stock is currently undervalued by approximately 17%, considering the predicted surge in AI spending, ongoing share buybacks, and growth in other segments. Given these factors, it would not be surprising if Microsoft were to double its present valuation in the years to come.
Featured Image: Pixabay
