Buy Microsoft For Its Cloud Business – Seeking Alpha
Microsoft’s (MSFT) performance in the cloud space has been nothing short of impressive. Specifically, I’d like to touch on Azure and explain why I think that this business will be a significant growth driver in the future – far more significant than the company is currently getting credit for. Unfortunately, Wall Street is still too focused on increasing operating margins, which are a short-term problem and the result of scaling efforts. The takeaway would appear to be that this provides a good opportunity for those who are in it for the long haul.
Azure’s revenue grew 97% on a year-over-year basis (98% in constant currency). This impressive growth would appear to be the result of a competitive advantage the company currently has. According to management, companies prefer the hybrid aspect of Azure. Azure is now available in more than 40 regions globally, which, according to management, is more than any other global cloud provider. The quote below further underscores my point:
We closed the highest number of multi-million-dollar Azure deals to date, and improved our annuity mix to 86%, up 3 points year-over-year. As a result, commercial bookings grew 30%, and commercial unearned revenue was $27.8 billion, significantly higher than we expected. Our contracted not billed balance increased to more than $31.5 billion.”
Such high growth levels would appear to be unsustainable. In order to assess whether this is indeed unsustainable or not, we can take a look at the TAM (Total Addressable Market). Of course, the fact that this growth was achieved on a baseline of billions of dollars in revenue would suggest that this growth rate should be sustainable. Nevertheless, we can still look at the TAM.
According to 451 Research, the number of enterprise workloads running IaaS will grow significantly as only 6% of enterprise workloads ran on IaaS. It estimates that this number should be 12% by 2018. Another thing to consider is that only 60% of enterprise workloads are run on a cloud model. This is not to say that the other 40% will run on IaaS, but it does provide investors with an idea of the growth potential. Certainly, it should alleviate any concerns about slowing growth in the near term.
This isn’t all hype, akin to the dot.com period. Most of those companies weren’t even making a profit. Microsoft’s fiscal year 2017 cash flow of $31.4 billion was its biggest in years. This represents a year-over-year growth rate of 26%. Even though 26% sounds impressive, this does not reflect the company’s true cash flow potential as margins were higher due to scaling efforts. To be sure, investors should definitely expect elevated margins for the time being.
As the company completes its scaling efforts, free cash flow will increase without the need for higher prices or a bigger customer base.
Now that we’re on the topic of margins, I’d like to address a perceived concern. Specifically, “the street” seems to be disappointed with the company’s margin guidance. To be sure, the company has already started improving margins. Commercial cloud gross margins were 52%, up 10% on a year-over-year basis. On a consolidated basis, this is not nearly as impressive as the company’s gross margin increased by a mere 1%. Of course, a big contributor to this is the segment mix as legacy revenues still represent the biggest portion of overall revenues.
Things don’t look a lot better on the operating side. Total operating expenses were up 9%. More than all of this was the result of LinkedIn and the company’s efforts to digest the acquisition. LinkedIn contributed 12% to the increase in operating expenses, of which $154 million was a result of amortization of intangibles.
It is true that amortization is a non-cash charge but it would be unwise to ignore this charge. Amortization of acquired intangibles can be dubbed as management admitting it overpaid. In the worst-case scenario, it is sometimes seen as admitting incompetence. Of course, given the small charge relative to the acquisition price – A sloppy $26 billion – this can’t be seen as a confession of incompetence. Still, we must be wary of additional and constant charges.
In any case, yes, Wall Street does have somewhat of a point when stating its disappointment regarding both gross and operating margins. Nevertheless, it is critical to place this around relevant context. The relevant context here is that of scaling in a highly competitive environment. While Microsoft lays claim to an economic moat, it would be naïve to discount competition – and its related problems – to 0.
Why I am looking to buy
All in all, I find it unreasonable to forfeit exuberance in the cloud performance in favor of pessimism regarding margin development. The cloud segment will be over 50% of revenues within two years if the company manages to keep up its performance. Any Cloud pure play would be trading at significant multiples to reflect such an outperformance. The fact that Microsoft is not a pure play definitely warrants a discount. Although, I feel that the current forward P/E of 20 is merely reasonable. Keep in mind that this multiple is based on analyst projections of $3.60 a share. Given the recent blowout quarter, this EPS consensus estimate might well be below reality.
Microsoft is looking better than it has in at least the last five years. On top of that, the company provides a decent 2% yield. I do not normally buy stocks for their yield; in fact, I rarely buy blue-chip stocks. I am a value investor who focuses predominantly on stocks below a $2-billion valuation. This is not to say that bigger stocks do not provide alpha or are not interesting. I simply confess to having less of an edge when over three dozen analysts publicly comment on the same company. However, I am more than happy to buy Microsoft in lieu of holding cash since bargains are hard to find in today’s market. I will be looking to write puts so as to acquire a slightly lower cost basis.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MSFT over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.