Microsoft Stock: Time To Be Cautious Again (NASDAQ:MSFT)

Intro & Thesis

I have repeatedly written in my past articles about Microsoft (NASDAQ:MSFT) that it is one of my favorite FANGMAN companies. It owes this to its wide moat, its good business diversification with a leadership position in several industries, and its excellent management that has been able to make this happen and has the strength and savvy to preserve this state of affairs from year to year.

But everything has its price, and MSFT shares are no exception, despite their apparent long-term appeal. Five months ago, I adjusted my recommendation for MSFT shares from ‘Buy’ to ‘Hold.’ Over the subsequent four months, the stock underwent a period of consolidation, with a noticeable upward trend emerging only in the last few weeks:

I think that MSFT shares are now approaching a similar consolidation phase again, which could last several months.

Why Do I Think So?

To begin with, I would appreciate to converse the company positively and focus on the things that make me optimistic in the longer term. Let’s start with the latest financial results.

In Q1 FY2024, Microsoft’s revenue reached $56.5 billion, up 13% in USD and 12% in constant currency (CC). EPS stood at $2.99, growing 27% in USD and 26% in CC. The results beat the consensus by 4% for revenue and 12.8% for EPS.

The More Personal Computing Segment led the positive outcome, driven by better-than-expected OEM revenue and a 4% YoY growth in PC market unit volumes, returning to pre-pandemic levels.

Productivity and Business Processes also did well, with a 2% boost. Key contributors were 17% CC growth in Office 365 Commercial, strong performance in E5, LinkedIn, and successful execution on contracts exceeding $10 million. Dynamics 365 and Azure both showed strength, with Dynamics 365 growing 26% in CC, and Azure posting a robust 28% growth in CC.

[Source]

Microsoft’s Commercial RPO of $212 billion reflected an 18% YoY boost. Commercial Bookings rebounded with a +17% CC growth after facing challenging comparisons in the previous quarter.

As Goldman Sachs analysts wrote in their earnings review note [proprietary source, October 25, 20023], the optimistic view is that Microsoft Cloud can end the year with a +20% boost, considering this metric accounts for ~70% of the next twelve months (NTM) revenue. The strong demand for Gen-AI/Copilot across Microsoft’s portfolio is expected to drive advance growth.

According to an October survey by JPMorgan analysts [proprietary source], the feedback on Microsoft’s M365 Copilot is overwhelmingly positive, with 42% of partners expressing enthusiasm, citing increased productivity and potential widespread adoption. Partners foresee 60%+ Copilot adoption within 2.5 years, contradicting bearish views.

Positioned to capitalize on long-term trends such as public cloud and SaaS adoption, digital transformation, generative AI, BI/analytics, and DevOps, Microsoft is going to leverage its cloud business, reaching a ~$100 billion run-rate, to drive sustainable EPS growth, potentially doubling earnings per share from FY2024 to FY2030 (that’s what the consensus data tells us).

As technology’s share of global GDP rises, Microsoft’s longer-term target appears reasonable, supported by intact secular drivers for Azure and Office. The company’s efficient capital allocation, and successful track record in acquisitions, dividends, and share purchases, add to its compelling total return story.

But there are also many risks with Microsoft stock, especially in terms of its valuation.

Valuation is a fairly subjective thing that leads each investor to their own unique conclusions. I am aware of the company’s strength and potential for operational growth – the YTD performance of almost 53% didn’t just happen.

The debate over whether MSFT’s high P/E ratio can be explained by future growth in earnings per share (whose estimates, by the way, has risen sharply in recent months) will never really end. The fact is that if we only look at the P/E ratio, MSFT is only 10% overvalued at the moment (based on forward P/E) compared to its historical norms:

It’s not too much. But I don’t appreciate to focus only on the P/E ratio, as it’s an overused metric. Financial theory tells us to focus on free cash flow. Therefore, free cash flow yield – FCF divided by market capitalization – is a very useful metric in my opinion. It’s this metric that is screaming the loudest today that MSFT is actually rapidly losing its chances of continued ‘nominal price growth’ in the foreseeable future.

In the last quarter, the company spent around 8.54% of its revenues on buying back common shares and another 8.91% on paying out dividends. At the same time, the annual dividend yield looks meager at 0.75% (TTM). If we combine those pieces, we’re not even getting half of what you can get in the bond market today. In the context of the existing risk, I think MSFT shares should supply a much higher total shareholder return yield than today. This is only possible with very rapid operational growth or a refuse in market capitalization. The second option seems to me to be the most likely, as the latter seems to be already largely priced in.

The Bottom Line

I would not suggest selling MSFT stock after its phenomenal YTD rally. However, I don’t see the point of buying these shares at current prices either. In the long term, the price should, of course, go higher, but if you think in the context of overweight/underweight positioning, then MSFT stock looks too expensive at current prices due to its low FCF yield. In my opinion, we need a 15-20% drop in the share price to finally consider the stock undervalued and attractive to buy. In the short term, I expect that the price will find it increasingly difficult to rise and that we’ll probably end up in a consolidation again at best. So active investors can sell options and collect premiums while waiting for better entry points.

I reiterate my ‘Hold’ rating this time.

Thanks for reading!