Massive tech giant Microsoft (MSFT) is a well-known diversified technology company. Most consumers are familiar with their windows operating system, which has a 75% desktop OS market share as of 2020, their Microsoft Surface Laptop, which they’ve advertised aggressively, and their Office 365 productivity suite, which is commonly used in schools and businesses alike.
Their operations can be broken up into 3 broad categories: Productivity and Business Processes (32.44% of revenue), Intelligent Cloud (33.82% of revenue), and Personal Computing (33.74% of revenue). Let’s break these segments down!
Productivity and Business Processes
This segment includes Microsoft’s Office product line, LinkedIn, and Dynamics.
Office saw stellar growth during the pandemic. In Microsoft’s 10-K filed in June of 2020, we can see that Office revenue grew by 4.5B or 15%. Office accounts for 64.63% of this segment’s revenue. I don’t see all that much future growth potential here. Google’s productivity suite will cut into margins and makes the moat here very small. While Office Commercial could be alright, Office Consumer will probably get blown out of the water by Google’s free product offering.
LinkedIn is another pandemic out-performer. This product grew revenue 1.3B or 20% in 2020 and currently accounts for 14% of this segment’s revenue. There’s a lot of unrealized potential here and I want to go a little in-depth here because I think this is overlooked by a lot of people.
Think about the amount of data LinkedIn has for a second. You willingly enter in: your current place of residence, your age, your current place of work, your past working experience, your prior education, your interests, what skills you have, etc. This is a data GOLDMINE. All the information Google spends billions on developing algos to infer about you is offered up to Microsoft by over 740 million members. If Microsoft identifies this as an opportunity they’d be willing to pursue, it could be huge.
Finally, there’s Microsoft Dynamics. I feel so-so about this product. It has fierce competitors who dominate the entire CRM industry (namely Salesforce with 19%+ market share), and I just don’t think they have a superior offering here.
This is what many people end up talking about the most when it comes to Microsoft. As someone with a pretty decent amount of cloud knowledge, I can say with confidence it’ll be a two-horse game in the future with AWS and Azure dominating. The problem with AWS is actually the fact that they’re a subsidiary of Amazon!
If you’re a retailer and you’re looking to pick a cloud provider, you can’t use AWS because you’ll be supporting a direct competitor of yours. As a result, many of these companies will end up taking their money to Microsoft. It’s also worth noting that the government has shown a preference to use Azure in the past when it comes to military contracts.
This segment includes Windows OS, the Surface Laptop, Xbox, and their Search engines.
I don’t expect that much growth here, however, I expect Windows will continue to grow by 2-4%, their search engine will probably stagnate and Xbox will continue to lose ground to Playstation, and Surface’s growth will slow.
Bullish case for MSFT stock
In my bull case, I’m assuming Microsoft successfully monetizes LinkedIn, and Azure growth is faster than expected. I’m assuming a 17% 5-year revenue CAGR, an 8% discount rate, a 4% perpetual growth rate, and a 47% EBITDA Margin. Using these parameters, I got an FV of $270.80 (14.8% upside).
I think the FV is probably between the current price and this bull case.
Bearish case for MSFT stock
In this scenario, I’m assuming Azure loses market share, and Office growth stagnates. I think fair parameters in this scenario would be a 7% revenue CAGR, an 8% discount rate, a 4% perpetual growth rate, and a 45% EBITDA Margin. In this scenario, I got an FV of $168.89 (-28.4% upside).
I find this bear case highly unlikely. In my opinion, the idea that Azure growth will slow is misguided
While Microsoft is a great company with large amounts of growth ahead of it, the current valuation is frothy and there isn’t enough of a margin of safety to justify an investment.