Investors are hopeful that Microsoft's Azure will outshine and propel the stock further, but recent commentary from competitors dampen this thesis (more on this below). Nonetheless, looking out further than the next couple of quarters, Microsoft prospects are not being sufficiently appreciated.
What Matters Most Heading Into Earnings
Microsoft was one of the first companies after Apple (AAPL) - Get Report to acknowledge that its near-term results would be bumpy and likely to miss estimates. Indeed, back in February, Microsoft noted that its More Personal Computing segment, which makes up a third of its total revenues and includes Windows OEM and Surface revenues, would not meet analysts’ expectations.
However, more recently, investors have been quick to re-price Microsoft's shares back up as one of the "least bad" opportunities available. Even if Microsoft’s hardware distribution struggles and the company ends up missing analysts' consensus estimates, investors are on the lookout for Azure to see how the cloud business has performed.
Indeed, investors are hoping that Azure has performed well enough to not only support Microsoft’s present valuation but to demonstrate that Microsoft remains undervalued. However, here’s where the thesis gets complicated.
Will Azure Live Up To Expectations?
Earlier this week, IBM (IBM) - Get Report reported that it has seen its clients pause their IT spend and turn to capital preservation instead. IBM’s client base is concentrated amongst large enterprises and not very dissimilar from Microsoft's. Accordingly, if larger enterprises are feeling unsure about their own immediate prospects, smaller enterprises are going to be even more dramatically impacted, implying that the whole enterprise sector is getting significantly affected, albeit to varying degrees.
Consequently, for Microsoft, there are incredibly high expectations that Azure will delight investors as our work-from-home environment leads to a substantial surge in Azure’s revenues.
However, there is some uncertainty in my opinion. On the one hand, enterprises that relied on Azure should continue to do so given that Microsoft’s Azure is a recurring subscription business model. And Microsoft recently noted a huge surge in Teams and Windows Virtual Desktop, as users made calls and meetings as part of social distancing.
On the other hand, though, Microsoft’s valuation demands some growth to support the recent run-up in its shares. And some wide-ranging commentary from companies ranging from Salesforce (CRM) - Get Report to IBM note that enterprises are putting their digital transformation initiatives on hold. This is understandable, if companies are fighting for orders and survival, this may dampen their enthusiasm for elevated IT infrastructure spend.
Valuation - Why the Long-Term Is Critical
The reason why investors should look out further than this next one or two quarters is that these outcomes are totally unpredictable. Investors expect that Microsoft will do well near-term, and speculators have bid up Microsoft’s share price to reflect this newly found optimism.
And if Microsoft fails to live up to that expectation, investors will exit their investment. However, Microsoft is still one of the best companies in the world. It not only is well-diversified, but it is very well positioned to benefit from the rapid digitization of the world.
Furthermore, over its trailing twelve months, Microsoft generated $40.5 billion of clean free cash flow. And aside from being a strong free cash flow generating machine, Microsoft has a rock-solid balance sheet with more than $60 billion of net cash.
These together remind us that investors should not think of Microsoft as a quarterly trade but something longer-term such as over the next two quarters when things have calmed down. At that point, would investors not consider today’s valuation of just 30x trailing free cash flow a bargain opportunity? Note, these are not non-GAAP earnings but clean free cash flow which investors value significantly higher.
Indeed, Microsoft is set up to be one of a few companies that should come out stronger from our new normal, as its users increasingly work from anywhere.
Supported through share repurchases, Microsoft's bottom line EPS has been growing over the past three years with a compounded annual growth rate of 34%. Hence, paying 30x free cash flow is not expensive.
The Bottom Line
Microsoft is likely to report mixed results in Q3 2020, with Personal Computing struggling, while Azure drives the narrative forward. Moreover, Microsoft’s multiyear investment to be positioned at the cutting edge of our current world continues to pay dividends to investors.
Putting aside any immediate uncertainty, Microsoft priced at 30x trailing free cash flow is a strong and highly attractive investment opportunity.
Microsoft reports earnings this Wednesday after hours. Stay tuned.