With the recent increase of the stock price, Microsoft (MSFT) - Get Report is getting closer to be the next tech giant to reach the symbolic threshold of a $1 trillion market capitalization. The company is building its success in the cloud business with a focus on the enterprise, while consumer products are becoming less and less important.
The Growing Cloud Business
Since Satya Nadella announced the shift to the cloud when he took over as CEO in 2014, the cloud business has been growing at a fast pace. For instance, the intelligent cloud segment grew by 20% year over year during the fiscal second quarter of 2019. And within this segment, the cloud infrastructure part, represented by Azure, grew by 76%. Commercial cloud revenue, which includes Microsoft Office 365 commercial, Microsoft Azure, the commercial portion of LinkedIn, Microsoft Dynamics 365, and other commercial cloud properties, increased 48% to reach $9.0 billion.
Against the strength of Amazon.com (AMZN) - Get Report in the public cloud area with AWS, Microsoft has some advantages. It's not a coincidence Nadella started the fiscal second quarter press release with the following statement:
"Our strong commercial cloud results reflect our deep and growing partnerships with leading companies in every industry including retail, financial services, and healthcare."
Due to the ambitions of Amazon in the three areas Microsoft's CEO listed, many enterprises in those industries will avoid choosing Amazon as their cloud provider. The deal between Microsoft and the giant retailer Walmart(WMT) - Get Report and the agreement between Microsoft and Albertsons show the importance of Microsoft's neutrality towards these businesses. The potential conflict of interest the Amazon business model involves offers Microsoft with extra opportunities for its cloud portfolio.
Focus on the Enterprise
The focus on the enterprise segment is also part of the success. In fact, the enterprise and the cloud businesses reinforce one other. Microsoft is building on the success of its legacy on-premises products to develop a strong cloud offering. Office, SQL, and other enterprise solutions are now, of course, an important part of the Microsoft cloud portfolio.
Also, the company demonstrated its ambition in the enterprise by acquiring LinkedIn and GitHub for $26.2 billion and $7.5 billion, respectively. The debate around the prices Microsoft paid for these acquisitions is valid. But the 610 million users base of LinkedIn and the 31 million GitHub developer accounts are important for Microsoft to reinforce its moat in the enterprise segment and fuel the growth of the cloud business.
As a result, the "More Personal Computing" segment, which is related to direct consumers, is growing at a slower pace compared to the enterprise-oriented two other segments.
In this context, it is difficult to assess the future of the company in the "consumers" area. The gaming business showed good results with a growth of 8% year over year. But the segment is isolated from the other businesses and the synergies seem limited. Even the newly announced wearable holographic computer, called HoloLens2, targets the enterprise segment as Microsoft listed many enterprise-related use cases for this new product.
Impact on Valuation
At $112 share, the PE ratio is more than 25. This elevated ratio corresponds to solid growth expectations.
Different studies point to the strong double-digit growth of the cloud market. With the synergies that Microsoft proposes with its enterprise businesses, the tech giant is in a position to gain market share in this segment. And with scale, improved operating margins will increase profit.
To get to a market cap of $1 trillion, the stock price must exceed $130.40, which corresponds to an increase of about 16% from the current stock price of $112. The table below shows the PE ratio ex-cash corresponding to the $1 trillion market capitalization is still below 25.
Considering the strength and the growth of the businesses in the cloud and in the enterprise, the company has the potential to reach this symbolic $1 trillion dollars. But as a value investor I prefer to invest in companies when the market offers a margin of safety to my estimation of fair value. Thus, considering Microsoft's profile, I'll wait for the opportunity to buy at a PE ratio below 20, which corresponds to a stock price of about $88.
The author doesn't own any of the stocks discussed.