Microsoft Corporation revenues will continue to grow at a healthy pace, driven by higher adoption of public cloud.
The recent across the board sell-off in the tech stocks have created pockets of buying opportunities. One stock which investors looking for exposure to technology sector can consider is Microsoft (NASDAQ:MSFT). As we had discussed in our previous post, Microsoft is a dividend growth company with strong cash flows and has successfully transitioned to cloud. The company will continue to benefit from the global move towards the public cloud.
To be sure, there are concerns about Microsoft's valuation. MSFT stock is currently trading at an adjusted PE of 27.6x, which is towards the higher end of its five-year average. However, valuation multiples must not be seen in isolation. What one must keep in mind is that Microsoft was in the middle of restructuring process for the better part of the last five years. There was no long-term revenue visibility. MSFT stock was carrying a much higher risk. Over the last year or so, the Redmond, Washington-based company has successfully transitioned to a cloud-based solution provider under the leadership of Sathya Nadella.
The company now has lower risks and better growth prospect. The company's cloud transition is going well. Commercial cloud revenue, which primarily comprises of Microsoft Office 365 commercial, Azure, Microsoft Dynamics 365, and other cloud properties, increased 56% to $5.3 billion. And it is not just revenue growth. Commercial cloud gross margins increased by 7%, primarily across Azure and Office 365. Microsoft's future lies in the cloud. The role of Windows OS shrinking.
Public cloud growth will continue.
Going forward, we expect Microsoft's cloud revenue growth to remain strong driven by higher adoption of public cloud. According to Gartner estimate, Public Cloud Services revenue will grow from $260.2 billion in 2017 to $411.4 billion in 2020. We expect Microsft to grow at a faster rate than the market as has been happening in the past.
A suite of cloud-based products is providing Microsoft advantage over its rival. Microsoft’s cloud offering spans from core infrastructure services to platform-as-a-service capabilities and up the stack to the application layer. The combination of these services makes Microsoft's offering compelling for customers. Apart from cloud-based applications like Office 365, Microsoft also provides business analytics tools, Power BI, which is becoming increasingly popular with customers. Microsoft will also benefit from the move of enterprise solutions from on-premise to cloud. Currently, 90% of enterprise workloads remain on-premise. The shift towards cloud has been the main driver behind Office 365 commercial's revenue growth of 41%.
Add to this Microsoft is planning a to launch cloud-based subscription service for gaming in a big way. Microsoft already offers two gaming subscription services a) Gold Pass subscription which offers over 100 titles at $9.99 a month and b) a premium Xbox One Live online service which already has 59 million subscribers. The company is now planning to build upon these services.
The company has created a new Microsoft gaming cloud division to leverage Azure in a big way. The new division is designed to entice developers and game publishers to use processing power and hosting capability of Microsoft’s cloud services. Since Azure hardware will do the processing and hosting, the games could be streamed to virtually any connected device, expanding Microsft's potential market to 2 billion estimated gamers. If Microsoft succeeds in its efforts to create a cloud-based subscription service, it's gaming segment to get a big boost.
Given the growth in the public cloud market and Microsoft's attempt to create a new subscription-based gaming model, we believe the company will deliver higher growth than what it was able to achieve in the past five years. Microsoft saw its adjusted EPS grow at a CAGR (compounded annual growth rate) of 5.62% in the last five years. For the next five years, adjusted EPS is expected to grow at a CAGR of 11.07%, almost double the past rate (according to Yahoo Finance).
Strong balance sheet and dividend growth will provide a cushion.
The transition to the subscription model from selling product increase revenue predictability, reducing risk. Moreover, Microsoft has a strong balance sheet with a net cash position of around $70 billion. Add to it, the company generates tons of cash from operations. The fact that Microsoft, along with Johnson & Johnson, remains the only companies to hold the coveted AAA credit rating speaks about the strength of companies balance sheet. And if you are an income investor, Microsoft brings a healthy dividend yield with a healthy eight-year track record of annual dividend increases. All in all Microsoft stock looks a good buy at current levels.
Looking for fundamentally better tech stocks? Check out Amigobulls' top stock picks from the tech sector, which have beaten the NASDAQ by over 107%. Interested in automotive stock? Then, we also have our top picks from the auto sector, which have beaten the S&P 500 by a massive 280%.