Going Into Earnings, Is Microsoft a Buy, a Sell, or Fairly Valued?

Microsoft MSFT is set to release its fiscal third-quarter earnings report on April 25. Here’s Morningstar’s take on what to look for in Microsoft’s earnings and the outlook for its stock.

Key Morningstar Metrics for Microsoft

• Fair Value Estimate: $420.00
• Morningstar Rating: 3 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium

Earnings Release Date

• Thursday, April 25, after the close of trading

What to Watch for In Microsoft’s Q3 Earnings

• Azure: Guidance is for flat growth sequentially. Even one point of acceleration would likely have a noticeable positive impact on the shares.
• Artificial intelligence: We’ll seek commentary on new products or monetization opportunities. We would love to hear a dollar amount or growth rate impact from AI.
• Office 365: This has been an important growth driver over the last few years, so it remains important even if it’s overshadowed by AI for now.
• Other areas to watch: Keep an eye out for commentary on Activision, general commercial demand, and continued recovery in LinkedIn and Bing advertising.

Fair Value Estimate for Microsoft

With its 3-star rating, we believe Microsoft’s stock is fairly valued compared with our long-term fair value estimate of $420 per share, which implies a fiscal 2024 enterprise value/sales multiple of 12 times, adjusted P/E multiple of 36 times, and a 1% free cash flow yield.

We model a five-year revenue compound annual growth rate of approximately 13% inclusive of the Activision acquisition. However, we believe macro and currency factors will pressure revenue in the near term. We believe revenue growth will be driven by Azure, Office 365, Dynamics 365, LinkedIn, and emerging AI adoption. Azure in particular is the single most critical revenue driver over the next 10 years, in our view, as hybrid environments (where Microsoft excels) drive mass cloud adoption. We believe the combination of Azure, DBMS, Dynamics 365, and Office 365 will drive above-market growth as CIOs continue to consolidate vendors. We believe More Personal Computing will grow modestly above GDP over the next 10 years.

Read more about Microsoft’s fair value estimate.

Economic Moat Rating

We assign Microsoft overall a wide moat arising from switching costs, network effects, and cost advantages. We believe it is a leader across a variety of key technology areas, which should result in economic returns well over its cost of capital for years to come. We believe Microsoft’s different segments and products benefit from different moat sources.

Microsoft’s Productivity and Business Processes segment includes Office, Dynamics, and LinkedIn. We assign the segment a wide moat based on high switching costs and network effects.

We believe Microsoft Office (including both 365 and the perpetual license version) is protected by a wide moat, driven by high switching costs and network effects. Office 365 is the cloud-based version of the traditional perpetual license Microsoft Office productivity suite. Office 365 is available for a monthly subscription. Together, the two products account for approximately 26% of revenue and are growing in the low double-digit area. Office 365 represents more than half of Office revenue. We expect perpetual license sales of Office to continue to decline in terms of both absolute dollars and as a percent of revenue, with growth in Office 365 more than offsetting the declines.

Read more about Microsoft’s moat rating.

Financial Strength

We believe Microsoft enjoys excellent financial strength, arising from its strong balance sheet, growing revenue, and high and expanding margins. As of June 2023, Microsoft had $111 billion in cash and equivalents, offset by $47 billion in debt, resulting in a net cash position of $64 billion. Gross leverage is at 0.5 times fiscal 2023 EBITDA.

Our base case assumes that revenue grows at a healthy pace, driven by Azure public cloud adoption, Office 365 upselling efforts, AI adoption, and broader digital transformation initiatives. We see strong margins improving further over the next several years. Free cash flow margin has averaged 31% over the last three years, which we expect to generally improve over time.

Read more about Microsoft’s financial strength.

Risk and Uncertainty

Microsoft’s risks vary among its products and segments. High market share in the client-server architecture over the last 30 years means significant high-margin revenue is at risk, particularly in OS, Office, and Server. Microsoft has thus far been successful in growing revenues in a constantly evolving technology landscape, and it is enjoying success in both moving existing workloads to the cloud for current customers and attracting new clients directly to Azure. However, it must continue to drive revenue growth of cloud-based products faster than revenue declines in on-premises products.

The public cloud buildout remains in its early phases. AWS has taken the market by storm, with Azure trailing, but the two are seen as clear leaders. This is a rapidly evolving market and Microsoft must continually adjust its offerings, add solutions to the stack, and compete with a company that has built a business around aggressive pricing.

Read more about Microsoft’s risk and uncertainty.

MSFT Bulls Say

• The public cloud is widely considered the future of enterprise computing. Azure is a leading service that benefits the evolution first to hybrid environments and ultimately to public cloud environments.
• Microsoft 365 continues to benefit from upselling into higher-priced stock-keeping units as customers are willing to pay up for better security and Teams Phone, which should continue over the next several years.
• Microsoft has monopoly-like positions in various areas (OS, Office) that serve as cash cows to help drive Azure growth.

MSFT Bears Say

• Momentum is slowing in the ongoing shift to subscriptions, particularly in Office, which is generally considered a mature product.
• Microsoft lacks a meaningful mobile presence.
• Microsoft is not the top player in its key sources of growth, notably Azure and Dynamics.

This article was compiled by Sokhoeun Noeut.