Microsoft Is Now A Value Stock

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Shares of Microsoft (NASDAQ:MSFT) went through another drop in June which creates a buying opportunity for this undervalued software and cloud company. Microsoft submitted a modified outlook for the fourth-quarter last week that took some investors by surprise. Although Microsoft lowered its guidance for its top line as well as its EPS due to a stronger dollar, Microsoft’s shares represent excellent free cash flow value for investors!

Microsoft is doing better than other tech stocks

Microsoft went through a 20% drop in pricing in 2022 but did better than other high growth companies in the one-trillion-dollar club. Tesla currently has the largest year to date decline of 33%. Amazon is down 27% year to date and Alphabet’s stock price has fallen 21%.

Data by YCharts

New guidance has been submitted for Q4’22

Microsoft lowered its expectations for Q4’22 revenues and EPS last week. The software and cloud company said that it expects $51.94-52.74B in revenues in the next quarter compared to a prior guidance of $52.40-53.20B while EPS guidance has been lowered from $2.28-2.35 per-share to $2.24-2.32 per-share. Shares of Microsoft skidded after the new outlook was presented, but I believe the market is overreacting to the updated guidance since the net effect is minimal: Microsoft lowered its revenue guidance by less than one percent while EPS guidance was lowered by less than two percent. While not an ideal outcome, the revenue and EPS effects are very small and hardly justify a fundamental reevaluation of Microsoft’s earnings and free cash flow potential.

Microsoft

The perfect example of a distraction

Instead of worrying how forex effects could lower Microsoft’s revenues and earnings by 1-2% in Q4’22, investors should focus on the real story for Microsoft: Cloud strength and free cash flow value. Microsoft’s cloud business is soaring, and the recent price drop has made shares of Microsoft more attractively priced.

Microsoft’s Intelligent Cloud generated 29% year over year growth to $19.1B in Q3’22, in constant currencies. Cloud is the largest revenue contributing segment for Microsoft with a revenue share of 39%, the fastest growing business for the software company and hugely profitable: it consistently generated gross margins of around 70% in the last year.

Microsoft

Within cloud, Azure is driving Microsoft’s revenue growth. Azure is Microsoft’s cloud computing platform that allows users to build, run and manage applications across different clouds which helps companies scale their digital transformations. Azure and other cloud services saw 49% revenue growth in Q3’22 (in constant currencies) which is the fastest revenue growth of any segment for Microsoft. Due to strong market demand for cloud-based solutions, growth remained strong throughout the last year with year over year top line growth rates never dropping below 45%.

Microsoft

Turning to Microsoft’s free cash flow.

Microsoft is an insanely profitable software and cloud company. In Q3’22, Microsoft generated $20.0B in free cash flow in a single quarter on revenues of $49.4B which calculates to an incredible FCF margin of 40.6%. Total LTM free cash flow was $63.6B and Microsoft’s free cash flow margin was 33.1%. Microsoft is one of the strongest companies I have ever seen, regarding free cash flow, and the FCF gives the company considerable resources to repurchase shares.

$billions

Q3’22

Q2’22

Q1’22

Q4’21

Q3’21

Y/Y Growth

Revenues

$49,360

$51,728

$45,317

$46,152

$41,706

18%

Cash Flow From Operating Activities

$25,386

$14,480

$24,540

$22,710

$22,179

14%

Capital Expenditures

($5,340)

($5,865)

($5,810)

($6,452)

($5,089)

5%

Free Cash Flow

$20,046

$8,615

$18,730

$16,258

$17,090

17%

Free Cash Flow Margin

40.6%

16.7%

41.3%

35.2%

41.0%

(Source: Author)

Microsoft is expected to grow its top line to $332.8B in FY 2026, implying 13.7% annual growth over the next four years. Assuming that the firm will be able to generate free cash flow margins of 33-35% by then, the firm is looking at annual free cash flow of $110-116B.

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Due to Microsoft’s growth in the cloud segment, especially Azure, I estimate that the software company could generate between $70-75B in free cash flow next year. With a current market cap of $2.0T, Microsoft trades at a (forward) P-FCF ratio of 27-28 X and a P-E ratio of 25 X. Microsoft is also expected to grow its EPS at a higher rate (17.24%) this year than other large tech companies.

Data by YCharts

Considering the enormous amount of free cash flow Microsoft earns from software sales and cloud services as well as its high gross and free cash flow margins, I believe that Microsoft should be seen as a value stock.

Microsoft is set to buy back more shares

In Q3’22, the software company returned $12.4B to shareholders, $4.6B came as dividends and $7.8B came as stock buybacks. Microsoft is repurchasing shares consistently in the market and the decline in the firm’s valuation this year makes stock buybacks even more attractive from a shareholder point of view. Microsoft has reduced the amount of shares outstanding by more than 10% in the last decade and the firm will likely repurchase more shares in 2023.

Data by YCharts

Risks with Microsoft

While the stronger dollar is going to have a (minimal) impact on Microsoft’s revenues and earnings, the software company’s core business are performing well. Microsoft is getting stronger in cloud which is the growth market of the future. However, risks to top line growth and a continual appreciation of the U.S. dollar is a problem for companies that generate a large amount of overseas sales.

Final thoughts

Due to Microsoft’s enormous free cash flow, Microsoft should be seen as a value stock. The company did well in the first quarter, revealing significant revenue momentum in its business, especially cloud, which has taken over as a growth driver in recent years. Microsoft’s risks related to the stronger U.S. dollar are greatly exaggerated and the stock is a buy!