Wide-Moat Microsoft Looks Attractive

Dan Romanoff: We see wide-moat Microsoft as an attractive investment opportunity throughout 2019, as there are very few companies the size of Microsoft that can offer 12% revenue growth and 15% earnings growth in each of the next several years. With shares hovering around $111, we see more than 15% upside to our $130 fair value estimate.

We expect revenues to be driven by the explosive growth of Azure, and the continued growth of both Office and Dynamics as those businesses shift to a subscription model. Microsoft has passed a trough in top-line momentum due to the shift from a perpetual license model to a subscription model to the point where growth has accelerated and margins are improving. Office 365 subscriber adds have been robust and will remain so in the near term our view. Dynamics 365 is already a $2.5 billion business, with growth accelerating nicely in fiscal 2018 to 13%, and accelerating further in the December quarter to 20% year over year. The inclusion of LinkedIn's Recruiter and Sales Navigator solutions into Dynamics further rounds out the suite and is clearly having a positive impact on sales momentum. By midyear we also expect the chip shortage for low-end PCs to ease, allowing the cash cow Windows operating system business to perform a little better as well.

We estimate Azure is approximately a $7 billion business and it still grew by a staggering 76% year over year in the December quarter. The battle for cloud supremacy has become a two-horse race between Azure and AWS, and Azure is well-positioned given its installed base at enterprise customers with Server, Database, Dynamics, and Office. Enterprise clients are increasingly adopting a hybrid cloud environment, which plays into Microsoft's strong position, as the company can offer customers their existing environment in either public cloud or on premise flavors.

The model transition has also passed the pain point for margins, which cratered from 39% in fiscal 2011 to 19% in fiscal 2015, and have already rebounded to 32% last year. While Azure is still below corporate average gross margin, it is scaling rapidly, with commercial cloud gross margin up 500 basis points year over year in the December quarter. We believe there is a long runway for margin improvement as all of the company's cloud businesses continue to scale throughout 2019.