Stockwatch: have Microsoft shares finally peaked?

The tech star's quarterly results divide opinion. Here's what our companies analyst thinks of the shares.

Reactions to latest quarterly and full-year results to 30 June for Microsoft (NASDAQ:MSFT), showing 13% revenue growth, are mixed. This is partly because consensus opinion has appeared to vary, making it tricky to assert whether the numbers are strictly a beat or a fail.

But they certainly are not a strong beat like I have noticed before, and is why, after a strong rally to an all-time high of $214 in early July, the stock has met with profit-taking.

Last night, the share price closed down over 4% at around $203, versus a 2.6% drop in the Nasdaq 100 as higher jobless claims triggered fears that soaring Covid-19 infections will slow economic recovery. 

Technical situation has become strained

The current dilemma is the stock having rallied nearly 60% over three months, from a March low of $135, as one of the key leaders of Nasdaq’s charge.

Yes, cloud computing has been a powerful theme serving the new “stay-at-home" economy for those workers lucky enough. But this has priced the shares for perfection: around 20x sales, on 35x earnings and a sub 1% yield, which allows nothing adverse to creep into the numbers or narrative.

Meanwhile, and ahead of these results, analyst coverage was universally bullish: 30 of them rated the shares a ‘buy’ versus three on ‘hold’ and notably no sellers. The average price target is $221.

Anyone who understands the contrarian mindset can recognise that the odds of attracting enough fresh buyers in such a situation, to offset those investors mindful to protect gains, have become slim. So the stock’s advance has halted, at least for the time being.  

$5 trillion value for Apple, Amazon and Microsoft 

It is also worth noting in a macro context, how the big three tech companies now constitute over a third of the Nasdaq 100 index and over 16% of the S&P 500 index – a collective market value near $5 trillion being larger than the entire economy of Germany and around the size of the Japanese economy.

Moreover, at the micro-economic (i.e. company) level, the big three are on a similar aggregate price-to-free cash flow ratio around 45x (albeit with Amazon (NASDAQ:AMZN) weighting this) which applied at the top of the 1999-2000 tech stock bubble.

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 Bulls will say that tech nowadays has greater traction and reach – also the shift towards cloud will become pervasive. Yet these benchmarks suggest very full if not over valuation, and even if “reversion to the mean” is not as dramatic as Cisco Systems’ 80% plunge after the 2000 bubble burst, it would be reckless to assume a 35x price/earnings (PE) ratio enduring.

For a $1.5 trillion company such as Microsoft, to grow into this valuation is a big challenge, and 20 years later Cisco (NASDAQ:CSCO) has steadily recovered to a more realistic PE in the high teens, than the time when it was a tall tulip. 

Yet the stock seems unlikely to interest short sellers

Holders for the long term say Microsoft can indeed do this, given it continues to gain share from Amazon and others, in a total addressable market for cloud estimated at $600 billion by 2022. So there will be buyers when the stock dips.

I can empathise with this in the sense that overvaluation per se is not sufficient criteria to embark on short selling. That would need the business to be seen meeting reduced demand, suffering competition and/or management weakness – none of which seem truly likely for the medium term.

According to classic reasons for a 'sell' stance, you would want to see the reasons for buying change. I originally drew attention to Microsoft as a contrarian investment at $20.75 when the PE was sub 9x and the company appeared a sound way to play global recovery, anticipating cyclical upturn in IT spending. So, on a very basic level, there is massive PE divergence, although Microsoft is nowadays a much stronger beast. 

I then liked Satya Nadella’s becoming CEO in July 2014, declaring a break with the past to prioritise cloud and mobile. As a strategy I suggested only last October, this “could apply for years yet” with the stock around $140, hence a 'hold' stance. Although I was already concerned, the exceptional growth rate for Azure was slowing, hence a habit of earnings releases beating expectations was likely to ebb. A prospective yield of around 2% was no prop I suggested, if perception ever shifted to Microsoft being a so-called “ex-growth” stock. And here we are now looking at a sub-1% yield after a 45% rally overall since last autumn.

So, yes, aspects of valuation have changed. In the short term at least, I suspect Microsoft shares will be a tussle between those investors sitting on big gains that they will seek to protect, and money managers looking for liquid stock to buy on a drop. But unless a return to Covid-19 lockdowns or a US/China war triggers major risk aversion, it is hard to see triggers to attract short-sellers.

Latest results can be interpreted as quite mixed

It is certainly a credit how such a big company has achieved double-digit growth in revenue and operating income growth over 23% for the full fiscal year. Demand for commercial cloud offerings have helped this lately, Covid-19 driving the stay-home economy (for those workers able to do so). There is also a very strong 94% “annuity” element to such earnings as clients commit to cloud infrastructure, implying high quality earnings even if recent growth slows.

Over the last four quarters, profits from cloud have risen from 36% to near 40% of group total. In this latest quarter, Azure has grown 47% like-for-like, albeit slowing from 59% in the previous quarter and 64% achieved in the same quarter of 2019. The table shows revenue from Microsoft’s overall cloud segment including Azure, up 17% to $13.37 billion from a year earlier. Listening to discussions for instance on CBNC, it appears commentators are quite fixated with Azure, but I think investors need to mind progress elsewhere, specifically the productivity & business process side, which includes Microsoft’s classic “Office” software suite and the LinkedIn website, which has seen revenue up 6% but profit is down 9% which hints at competition.

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Perhaps I am among others who paid quite handsomely for an Office Professional disc some years ago, which does the job more than amply, and I resist upgrading to an annual subscription for latest bells and whistles I have no need for. It seems tricky for this division to come up with “something genuinely new”.  

The personal computing side is more successful in this regard, hence a 15% rise in like-for-like quarterly revenue with profit up likewise. “Surface” laptops and PC’s are now established as a premium benchmark rivalling Apple’s, although the chief driver has been Xbox gaming sales up 65%, and where the release of a new console later this year may help keep growth rates high.

Forward guidance is modestly softer 

Also to its credit, Microsoft is one of very few businesses currently providing guidance, and it is possibly harsh to quibble with the suggested revenue range of $35.15 billion to $36.05 billion for the current quarter, where the median is slightly down on consensus for $35.87 billion. One also should not make a fetish about quarterly performance. Yet, with the stock on 35x earnings and an overwhelming 'buy' consensus, there is absolutely no room for disappointment.

Consequently, I think taking at least some profit is prudent. Markets could also destabilise again in reaction to Covid-19 woes and/or a Democratic victory in November heralding corporation tax rises. It is entirely possible, money managers recognise another chance to buy, as a means of exposure to cloud. However, I still suspect mean reversion is due long-term, from the 35x PE rating. Avoid. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.