Only six months ago, I wrote about the potential for Microsoft's (MSFT - Get Report) market capitalization to reach $1 trillion. It didn't take long to happen as the giant tech company exceeded this symbolic threshold at the beginning of July.
And with the excellent fiscal Q4 results released yesterday, the $1 trillion mark is now far behind it. To evaluate it as an investment now, let's have a closer look at some key aspects of the fiscal Q4 earnings before discussing the valuation.
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1. Operating Leverage Materializes
For several quarters now, management has insisted on the operating leverage associated with its revenue growth. This quarter is the perfect illustration of such a powerful concept. At constant currency, revenue, gross profit, and operating income increased by 14%, 17%, and 24% respectively.
However, the operating leverage won't take place during FY 2020. Despite the expected double-digit revenue growth, management forecasted a stable operating margin due to important investments.
In the long term, the development of lower margin, cloud-based businesses will put pressure on the gross margin. But other margin improvements will more than offset this headwind.
2. Strong Growth Despite High Revenue Base
The revenue growth was consistent across all regions and the scale of the company is becoming impressive. With approximately $12 billion in free cash flow, Microsoft generated in one quarter about the same level of free cash flow that giant tech companies like Cisco (CSCO - Get Report) and IBM (IBM - Get Report) achieve in one year. Another way to consider the scale of the business is that its revenue beat forecasts by almost $1 billion in the quarter.
Yet, despite the impressive scale, management still guided for double-digit revenue growth during the next fiscal year.
3. Some Limited Areas of Weakness
Gaming was the only declining product and service category during this quarter. And management expects Gaming to still decline during FY 2020. Yet, despite being a multi-billion dollar business, the impact of this decline isn't significant in the context of the company's scale. And synergies exist between gaming and Microsoft's applications and cloud platforms.
4. Azure's Revenue Growth Is Decelerating
It's worth noting that Azure's revenue growth is decelerating despite its strong 64% revenue growth during fiscal Q4 2019.
Considering the high growth over the last several quarters, this development isn't a surprise. Microsoft doesn't disclose the revenue that Azure generates. But following the pace of deceleration will be interesting to assess the strength of the cloud business against Amazon Web Services and other cloud vendors.
5. Return to Shareholders Becomes Less Attractive
Microsoft has a history of paying a dividend and buying back shares. For historical dividend-oriented investors, the regular dividend increases are attractive. But considering the higher stock price over the last few quarters, the returns have become less attractive for new shareholders.
Despite a dividend increase of more than 250% over the last decade, the dividend yield dropped to about 1.3%. And with the stock price increase, share buybacks become less and less accretive to shareholders. During FY 2019, Microsoft returned approximately $33 billion to shareholders. But this impressive amount represents only about 2.8% of the current market capitalization.
6. Priced for Strong Growth to Continue Over the Long Term
On Friday morning, the stock price rose to around $139 for a market capitalization of about $1.06 trillion. Based on FY 2019 revenue, the market values the company at an EV/Sales ratio of about 8x.
Because of exceptional tax items, I prefer to calculate an earnings estimate that corresponds to the real economic potential of the company. Applying a tax rate of 20% to the FY 2019 operating income, I estimate Microsoft generated a standardized FY 2019 net income of $34.95 billion.
With these assumptions, the market values Microsoft at a PE ratio of approximately 30x. Even when not taking into account the cash and equivalents of about $133.8 billion, the PE ratio ex-cash still exceeds 27x.
The strength of the business and the expected double-digit operating income growth during the next fiscal year justify a high PE-ratio. But the current valuation doesn't leave much room for stock price appreciation. And there's no margin of safety that will support temporary underperformance.
Thus, the stock price above $140 isn't a great opportunity to invest in the company despite Microsoft's results.