Microsoft's diversification helps it stand out from other mega-tech stocks

Published Mon, Sep 14 202012:46 PM EDTUpdated Tue, Sep 15 20203:38 PM EDT

Key Points

Microsoft now derives over one-third of revenue from cloud products.
The company hasn't completely abandoned consumer markets, meaning that it's not overly dependent on cloud for income.
Free cash flow is higher than ever as Microsoft's stock keeps hitting new records.

Many people look at Microsoft and see a dusty company that has benefited from the shift to cloud computing. That's not wrong. It just overlooks the reality that Microsoft still gets most of its revenue from other markets. The 45-year-old company sells ads, game consoles, operating systems, PCs and other products. Investors like that Microsoft is diversified. That attribute distinguishes it from other highly valued technology companies, including cloud rivals Amazon and Google . The pandemic did not weigh on second-quarter results as much as it did for Google, which experienced its first revenue decline . And older assets continue to enable Microsoft to invest in newer ones. "Windows provided the financial capacity for Microsoft to undergo a significant investment in capital and building a business" in cloud infrastructure, said Nicholas Puncer, a portfolio manager at Bahl & Gaynor Investment Counsel, based in Cincinnati. The firm first bought Microsoft shares in the early 2000s. At the end of the second quarter Microsoft was its biggest holding, according to a filing . Puncer said that Microsoft is a better cash producer than it's ever been and that newer products such as Teams set up the company for greater monetization. Since replacing Steve Ballmer as Microsoft's CEO in 2014, Satya Nadella has pushed the company away from some consumer categories, such as e-books, health wearables and phone hardware, but he hasn't switched Microsoft into a pure enterprise company, either. The company has boosted its investment in gaming, for example. As a result, it's hedged against softness in any one market, and profit flows from many parts of the business. Nadella has occasionally drawn on the company's balance sheet to further diversify the business and avoided missteps his predecessor made, including rushing to integrate. And Nadella has orchestrated a business-model change in the Office productivity-software franchise and made the company work harder to ensure that customers like what they pay for every year, so they renew their subscriptions. Microsoft shares have appreciated almost 500% since the CEO change and it ended 2018 as the world's most valuable public company, although it has since been overtaken by Apple . "I would say the market has recognized that Microsoft is where it has needed to be and has maybe caught up from missing the consumer-device revolution," Puncer said. Cloud concentration In the past decade the cloud is probably the area where Microsoft has proven itself the most. More than 36% of Microsoft's revenue now comes from its Commercial Cloud group, which includes Azure, business subscriptions to Office 365, Dynamics 365 enterprise software and commercial LinkedIn products, compared with 10% four years ago. "If you look at how much of their business is actually pure cloud, it's a bigger percentage than some of their competitors," Jason Ader, an analyst at William Blair with the equivalent of a buy rating on Microsoft stock, told CNBC in an interview last week. "That makes me feel really confident about their positioning strategically for the future." Ader values Microsoft's Commercial Cloud business at $990 billion and the rest of the company at $725 billion. He adds $73 billion in cash and debt and arrives at about $1.79 trillion. Given the current 7.57 billion outstanding share count, Ader's valuation would make Microsoft worth about $235 per share. The stock was trading around $207 on Monday. Looking ahead, Ader expects Commercial Cloud revenue to grow about 28% in the current 2021 fiscal year, coming in at $66 billion. The figure includes $29.1 billion from Azure, implying 43% growth, and $28.8 billion from Office 365 business customers. Ader is far from the only analyst who recommends Microsoft stock. As of Sept. 11, all but two of the 25 analysts tracked by FactSet had buy ratings on Microsoft stock. The other two analysts rated Microsoft at hold. That makes Microsoft more highly rated than Alphabet, Apple, Amazon and Facebook. Deal credibility The Commercial Cloud concept dates to 2013, a few months before Satya Nadella replaced Steve Ballmer as CEO. Under Nadella the definition of the term has broadened. Today it includes part of LinkedIn, which Microsoft bought for $27 billion. Investors remain focused on Commercial Cloud despite that acquisitions have made it harder to compare with past performance. Microsoft made deals under Ballmer, too, but some of them, such as aQuantive and Nokia , didn't work out. Some investors appreciate the lack of write-offs from deals Nadella instigated. "Looking at the historical track record under Satya, I would say he's sort of earned his credibility in terms of the types of targets they've gone after and the way they've managed the company once they acquired them," said Peter Choi, a senior research analyst at New York's Vontobel Asset Management. The firm had $953 million worth of Microsoft shares as its largest holding other than Alibaba at the end of the second quarter, according to a filing . Nadella's biggest deal was going to be acquiring part of social media app TikTok from Chinese company ByteDance, but on Sunday the company said ByteDance had rejected its offer. CNBC had reported that a deal might have been worth $20 billion to $30 billion , which would have made TikTok Microsoft's biggest deal to date. Some investors weren't sure that a deal would have been successful. "Candidly, I'm skeptical about the investment thesis there, because they are an enterprise company, and it's not obvious to me, at least now, why TikTok would benefit that," Puncer said. He said Microsoft has proven to be innovative and he might have given management some benefit of the doubt on a TikTok deal. Ader said buying TikTok could have helped further diversify Microsoft, although he had not modeled the impact of a deal. Growing free cash flow Microsoft's finances can stay healthy even without TikTok because it's already diversified. The company's free cash flow reached a new high in the second quarter at $13.9 billion , partly thanks to 19% operating income growth in the Intelligent Cloud business segment that contains Azure. Puncer said he watches free cash flow closely because it impacts dividend, which Bahl & Gaynor cares about. Microsoft began paying shareholders dividends in 2003 following the resolution of antitrust lawsuits and has regularly increased quarterly dividends. Amazon, Facebook and Google don't pay dividends. "The cool thing about where they are now is that they've done a really good job of transitioning the installed base to more of a subscription orientation," Puncer said. Going forward, he said Microsoft can increase free cash flow further by deriving higher average revenue per customer, particularly in Office. While Commercial Cloud is growing faster than the rest of Microsoft, Puncer said that contributions in operating profit from those two parts of the business are more balanced. Microsoft was able to consider a TikTok transaction because it had nearly $137 billion in cash, cash equivalents and short-term investments at the end of the second quarter, more than almost any other company in the S & P 500 in the most recent quarter, according to FactSet. Only Berkshire Hathaway had more. In the Nadella years Microsoft has failed to deliver gross margins above 70%, unlike Ballmer. The highest gross margin yet under Nadella, at 69%, came in the second quarter of 2019. Not everyone thinks that's a bad thing, though. "We would still want them to invest efficiently to make sure they have that runway for top-line growth, because the opportunity is certainly there," Choi said. Microsoft stock is more pricey than it's been in the past. On Friday it traded at a price-to-earnings multiple for the next 12 months of about 32, more than twice the five-year average of 15, according to FactSet. The multiple moved higher as investors flocked to the stock because of an improvement in Microsoft's finances, Puncer said. Here's a rundown on the major parts of Microsoft and the company's upside potential: Devices Microsoft has sold hardware since 1980, with the release of the Z-80 SoftCard for the Apple II. It's only since 2012 that the company has made its own Surface PCs. At about 5% of total revenue, the device business, with Surface and Microsoft-branded accessories such as keyboards and mice, does diversify Microsoft. It's just not growing especially fast, at 6% growth in the 2020 fiscal year. Puncer called it "a pretty good business" for Microsoft. Coming out with new Surface models each year means Microsoft can set the standard for other Windows PC makers, such as Dell and HP , he said. Microsoft has done a good job of coming up with new device designs over the years, including with the original convertible Surface, Ader said. And the company is still widening the Surface lineup. Microsoft will release its $1,400 Surface Duo dual-screened smartphone running Android in time for the holiday season. Dynamics Customer relationship management, a type of software for keeping track of current and future clients, isn't glamorous. It's dominated by Salesforce. Microsoft's Dynamics lineup offers an important alternative to Salesforce, though, because not every organization will want to comply with Salesforce's cloud-only business model, Choi said. Microsoft introduced Dynamics 15 years ago this month. Choi called it a hidden gem and a relative success. Dynamics revenue grew 13% in the second quarter, and within that, the Dynamics 365 cloud suite grew 38%, although it's smaller than other parts of Microsoft. With Dynamics, Microsoft has optionality, Ader said. Microsoft could become a bigger player in the market but hasn't necessarily prioritized or invested heavily in it, he said. "It's just not a best-of-breed product," Ader said. "It works and is appropriate for some segment of the world, primarily smaller customers. But there's just better products out there." Enterprise services Microsoft counts on tens of thousands of partners to work with customers. At times it does provide customers with consulting services and support to help them use its products, and it offers training and certification. For example, the company picks up revenue when people take exams that can show their knowledge of Microsoft services. This part of the business represents almost 5% of revenue, and it grew about 5% in the past year. "I don't really see it as a growth engine for the company, but it coat-tails strength in other areas of the business," Ader said. Gaming Microsoft has sold Xbox consoles, challenging Nintendo and Sony, since 2001, and this holiday season it will release the Xbox Series X. The company has refined its gaming strategy during the Nadella years and now offers video games from its studios on other companies' hardware. Its Game Pass subscription service gives people access to over 100 games for as little as $5 per month, and later this month people who pay for the Ultimate tier of Game Pass will be able to play games that are streamed from Azure on mobile devices, removing the need for long downloads and powerful hardware. "They've assembled a couple interesting pieces, and that certainly can become more relevant going forward," Choi said of the Microsoft gaming unit. "Gaming is an $11 billion business for them, bigger than Bing or Surface." Ader said he doesn't think playing games from the cloud can match the performance of playing on a console but he does expect the company to reach that point in a few years. LinkedIn The economic recession brought on by the pandemic has hurt LinkedIn, the professional social network Microsoft acquired in 2016. In the second quarter revenue grew 10%, the slowest rate since 2016, and Microsoft expects "low- to mid-single-digit revenue growth" in the third quarter, Amy Hood, the company's chief financial officer, said in July. LinkedIn holds the title of Microsoft's biggest acquisition ever. Still, this summer Microsoft has announced job cuts at LinkedIn and the sale of LinkedIn's SlideShare service to Scribd. LinkedIn has grown during its time under Microsoft ownership, even though some people were skeptical of the deal when it was announced, Choi said. He points to LinkedIn's $8.08 billion in revenue in the 2020 fiscal year and the acquisition price. "At three times the revenue, if you look at any SaaS multiple today, it's certainly a lot higher," he said. "It's hard to argue they didn't create a lot of value with that." Looking ahead, LinkedIn, at 706 million members, can grow further, Ader said, adding that its prospects are neither very weak nor very strong. Office During Nadella's tenure Microsoft has changed the business model of its productivity software suite, which dates to 1990. Microsoft has gone from primarily selling Office licenses as one-time purchases to primarily selling customers subscriptions to Office 365 . License revenue will be easily outweighed by the lifetime value of a contract with recurring revenue, Puncer said. At the same time, Microsoft has sought to expand the Office product lineup, which can help customers feel like it's worth sticking around. Perhaps the biggest addition in the past decade is Teams, the team communication app that rivals Slack . Microsoft has been quickly adding Teams features, such as an option to view video-call participants in a classroom with their actual backgrounds removed, so everyone appears to be together. "There's maybe a script to be written for Teams to be driving levels of monetization and engagement and growth that may end up resulting in their PBP [Productivity and Business Processes] segment having a growth engine that is Teams but is similar to Azure within IC," said Puncer, referring to the Intelligent Cloud segment containing Azure and server products. Microsoft can still pump up Office revenue by persuading customers to upgrade to richer versions of the bundle, Ader said. For example, companies that want to deploy phone system and audio conferencing features in Teams must opt for the E5 bundle of Microsoft 365, formerly known as Office 365, or security features only available through E5. Microsoft could sell more Office subscriptions, but there's a finite number of possible subscribers around the world, Ader said. Microsoft continues to dominate in the office productivity market , while Google has a small share. Search advertising Microsoft has been in the web search business since the late 1990s, and it's fielded Bing since 2009. Bing turned profitable in 2015. It hasn't managed to topple Google, though. In August Google held 70% desktop search-engine market share, while Bing was in second place with 13%, according to NetApplications. On mobile devices Bing was in fourth place, with less than 1% share, while Google controlled nearly 94%. At 5% of Microsoft's total revenue, search advertising isn't insignificant, but then again, it's not one of Microsoft's strongest areas, Ader said. Additionally, it's exposed to the economy. In the second quarter search advertising revenue fell 18% year over year, the first decline in more than three years. Hood called for a steeper drop in the third quarter. "I'm not sure what the opportunity set looks like there or how incrementally meaningful it would be," Puncer said. Server and cloud The largest part of Microsoft's business, at about 29% of total revenue, is called server products and cloud services. It's a generic name that hides some notable brands, including Azure, GitHub, SQL Server, Windows Server and Visual Studio. The biggest star among them is Azure. Microsoft's public cloud encompasses over 60 regions of data centers that can remotely perform a wide variety of tasks, including computing, data storage, networking and analytics. Microsoft has been getting large customers such as retailer Albertsons to adopt Azure, and younger companies such as Change Healthcare and Snowflake use it, too. Microsoft has also chosen to move LinkedIn and Minecraft to Azure. In 2019 Microsoft had about 18% share of the public cloud market, making it only smaller than Amazon, with 45% share, according to Gartner . The public cloud market grew 37% from 2018 overall, though, and Microsoft grew an estimated 58%. Plus, the market looks poised to grow further. A 2020 IDG study of 551 technology buyers found that 32% of IT budgets would be allocated to cloud in the next year, up from 30% in 2018. "Our thesis has been Azure is worth 70% of the business at this point, and growing," said Andrew Chan, co-chief investment officer at First Foundation Advisors, based in Irvine, California. A filing shows that Microsoft was the bank advisory group's top holding at the end of the second quarter. "At the end of the day Microsoft has done a great job of evolving from a mature technology company to really kind of redefining themselves." Ader said Microsoft's on-premises server products could be cannibalized as Azure keeps growing, although that hasn't really happened yet. That points to the success Microsoft has had with its strategy of supporting hybrid architectures that include public clouds and existing data center infrastructure, he said. Still, he thinks server licensing has much weaker growth prospects than Azure. GitHub provides online storage for developers' source code, allowing many people to collaborate on each project. Buying it for $7.5 billion in 2018 meant Microsoft could demonstrate its ability to operate a tool that tens of millions of software developers — the company's original audience — depend on, and Microsoft can offer those developers cloud services to use when the time comes to deploy their code, Ader said. "This should be one of the highest-growth assets that they have," he said. Now that GitHub is a Microsoft property, developers might start to look at Azure and consider it good enough for their applications, rather than go with the market-leading cloud, Amazon Web Services, Puncer said. Windows Arguably Windows remains Microsoft's flagship product, even as the company has enabled its applications to work on other operating systems. Windows 10 is running on over a billion devices, including PCs in offices and homes. The company has done a good job of protecting Windows' market share, even with the rise of machines running Google's Chrome OS, Ader said. From a profit standpoint, Windows is as critical as ever. Ballmer said in 2018 that Windows delivered $13 billion or $14 billion in operating profit, which would have represented about 39% of the total for Microsoft 2018 fiscal year. Microsoft does not specify exact operating income from Windows or any other individual product. Still, Windows is mature, and revenue growth is generally slow. Windows revenue from device makers has benefited from the end of support of Windows 7 in the past few quarters but can't grow as much as other products, Ader said. WATCH: Teams will be the real driver for Microsoft