Microsoft is a Blue Chip Stock Cash Cow: When to Buy It

RichVintage

Microsoft based in Redmond, Washington (NASDAQ: MSFT) is the second largest company by market capitalization in America, just behind Apple (AAPL). Microsoft has shown a unique ability to reinvent itself nearly three decades after its ubiquitous Windows software was first used started building the business billion dollars in annual profits. If you’re a longtime Microsoft holder, you’ve made a lot of money.

Chart
MSFT data by YCharts

Today, Microsoft is still a big company.

  • Millions of people use Microsoft Office daily.
  • azure cloud business continues to grow massively.
  • And if MSFT’s acquisition of Activision Blizzard (ATVI) goes through, the combined company will be the third-largest video game company in the world. Interesting way, Warren Buffett bets billions dollars this year that the deal closes.

On these points, investing would be super easy if all you had to do was choose the most profitable companies and invest in them. This is not completely wrong in itself, because historically the infamous “disposition effect” keeps the shares of big companies cheaper than they should be rationally. However, since I started writing for Seeking Alpha in 2018, stock market valuations have all but risen, forcing investors to pay more and more for every dollar of future earnings. When I first started writing here, I could often write articles with titles like “Back the Truck Up” and “25% Down + 100% Up.” Now all the fruit at hand has been picked and the metaphorical nights are getting colder, with winter on the way.

A quick look at the top 10 S&P 500 holdings as of July 31 (SPY) shows this.

Valuations of major SPY holdings

SPY Top 10 Holdings (Etrade)

Apple is trading for 28 times its earnings in 2021, and analysts expect single-digit growth going forward. 2021 revenues were themselves inflated by thousands of dollars in stimulus checks per household, calling into question the company’s ability to even sustain what it achieved in 2021. Amazon (AMZN) and Tesla ( TSLA) both trade more than 100 times their revenue, which is historically perilous to predict for companies of their size. UnitedHealth (UNH) and Johnson & Johnson (JNJ) are also trading for fairly high multiples and are prime targets for any future health care reform, threatening at the very least their ability to increase profits. And Nvidia (NVDA) is down sharply this year, but still trading for almost 60 times its earnings. NVDA was rightly compared to Cisco (CSCO) in 2000.

That leaves Microsoft, Google (GOOG) (GOOGL) and Berkshire Hathaway (BRK.A) (BRK.B) MSFT has a 29x multiple on 2021 earnings but much better growth prospects than Apple, analysts say. Similarly, Google’s multiple is quite reasonable given its long-term growth prospects, and a substantial portion of Berkshire’s value is in Apple shares, but BRK.B is trading at a nice discount to Apple. These are the stocks you should be looking to recover in the event of a downturn. I’m comparing these stocks with 2021 earnings because I pulled them in bulk, for MSFT I’ll compare with 2023 earnings below. I would be cautious about extrapolating 2021 earnings with certain stocks, but MSFT’s earnings are more stable than most tech or consumer discretionary companies.

Meanwhile, back at the farm

Here’s how Microsoft’s business worked.

Cloud

Amazon has similar cloud exposure through AWS, but Microsoft outshines them and gain market share. In one of the fastest growing technology markets, Microsoft is again showing an impressive ability to break through against an established market leader with massive resources. Going forward, I expect this trend to continue as Amazon is forced to face the reality of running a global logistics business with 1.6 million employees and trying to defend AWS market share – a war on two fronts. It’s not necessarily zero-sum since the cloud market is growing rapidly, but the rest of Microsoft’s business is so much more attractive than Amazon’s to me and MSFT also has less downside risk and valuation risk . Despite a stronger dollar, Microsoft has grown its cloud revenue by about 20% over the past year. This was discussed on MSFT’s last quarterly earnings conference call.

Cloud revenues and profits (billions)

MSFT cloud revenue

Microsoft cloud revenue (Investor Presentation 2022)

Office/Productivity

Microsoft Office followed the tech industry’s grand plan to move from selling primarily products to selling primarily subscriptions. It was a good plan – moving from a one-time sales model to a subscription model has dramatically improved Microsoft’s revenue from Office. MSFT also saw good growth in this segment (note that they also include their acquisition of LinkedIn in this category). As with cloud computing, industry watchers have called for huge growth in this market over the next 10 years as the workforce continues to decentralize after the initial shock of the pandemic. One area that is expected to experience strong growth is what is called “enterprise content management“, which is the management of documents, spreadsheets, contracts and scanned images. Box (BOX) is one of the big players in this space now – I wouldn’t be surprised to see Microsoft make them an offer of redemption or clone them as they did, taking Zoom (ZM) with Microsoft Teams.

MSFT Productivity and Business Process Revenues

MSFT Productivity Revenues

Microsoft Productivity Earnings (Investor Presentation 2022)

Games

Microsoft is burying its gaming revenue with the legacy business of Windows and other catch-alls, but they’re now making a huge push into gaming. This line of business has been more or less stagnant, but the push aims to launch the ball rolling, by tying Microsoft even more deeply to the global video game market, which is should grow approximately 12% per year over the next five years. Specifically, Microsoft is acquiring Activision Blizzard, the controversial but profitable video game company best known for playing Call of Duty. Of course, MSFT already owns Xbox, so this is vertical integration at its best. If you own the console, operating system, and video game company all in one, you don’t have to split the profits with anyone.

Revenue from MSFT Games

Microsoft Other income (Investor Presentation 2022)

The offer is $95 per share, but ATVI is trading for just under $79 as I write this. Warren Buffett, one of the world’s biggest merger arbitrageurs, has bought billions of ATVI shares – he will pocket $95 per share if the deal is successful. The deal should be done by June 2023, but requires antitrust approval in several countries. Merger arbitration is not new – it was described as a strategy by Benjamin Graham in his books. I think the strategy is underused by investors. Buffett has used fusion arbs extensively over the past six decades, including strongly in the 1980s.

If there’s one tradeoff I’d make here, it would probably be to follow Buffett’s judgment on ATVI. The stock price hasn’t changed much since the announcement, so you’re getting more or less the same deal as Buffett here.

MSFT Valuation and Target Price

The overall market valuation is too high. First, earnings aren’t sustainable without a massive stimulus to the economy, and second, price-to-earnings multiples are too high compared to what you can get in cash as the Fed raises rates to fight the inflation. I covered this in detail this week in my first and second Jackson Hole articles and encourage readers to revisit my thoughts on macro imaging.

Market-wide, stock prices have risen faster than corporate earnings over the past few years, and Microsoft is unfortunately no exception to this trend. However, Microsoft’s valuation is better than that of its larger S&P 500 peers, and of course Microsoft’s business is also better managed. This doesn’t necessarily mean you should pay 30 times earnings, as that will lower your future annual returns, but at worst Microsoft is at the high end of a range where you might consider the stock fairly valued. .

I think the broader stock market is overvalued by just under 20% at current prices as the post-pandemic economic hangover slowly resolves. Microsoft has great underlying activity, but I expect the Fed and the economy to drive the stock over the next 6-12 months. Using FY2023 earnings estimates for MSFT of around $10.25 per share, and applying a multiple of 20 to 21x, you get a target price to buy MSFT of around 205 $ to $215. This is about 20% less than the current price. That’s where I would buy it. But if you’re okay with a multiple of 25x, then MSFT is a buy at around $255, only about 3% off the current price. If you buy now, you could get 9% annual returns, but if you can mark the stock for $210, you’re looking at 15% a year instead.

In any case, compared to some other popular stocks trading at 50-100 times earnings that might drop 50% and not even go cheap, MSFT has a much better risk/reward ratio. This is fairly typical for blue chip stocks, which are often good companies trading for higher valuations, so you need to hunt them down to have a good chance of buying. Historically, growth stocks trade at a steep valuation premium in bull markets but trade closer to the market median in bear markets, which justifies this approach. Since such a large amount of MSFT is held by ETF investors, the macro environment will dictate the short-term valuation.

Conclusion

Microsoft is a big company, but the stock is connected to the broader market struggling with the Fed’s efforts to drain excess liquidity from the system. If you buy MSFT now, I think you’re getting decent long-term rewards, but you’ll probably face some short-term downsides. For this reason, I would rate MSFT as a hold and look to buy MSFT shares around 20% below the current price. For a Buffett-approved trade you can make right now, consider buying ATVI and wait for the deal to close.

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