The thing which investors crave more than anything else is steady, predictable double-digit growth -- this neatly sums up Microsoft (MSFT - Get Report) . Moreover, Microsoft's present valuation is cheap enough to warrant a margin of safety, and despite being one of the largest companies on the Nasdaq, Microsoft still has a large runway ahead to reward investors.
The graph below highlights why I believe Microsoft's shareholders can be richly rewarded.
As we can see, Microsoft's three reporting segment each generate roughly a third of its total operating income. Said another way, Microsoft is very well diversified, and if in any quarter one of its reporting segment should report volatile results, the other two segments are meaningful enough to smooth out Microsoft's overall operating income. And this ultimately translates lower down its income statement as a predictable and stable earnings per share number.
For instance, as of the most recently reported Q1 2019 quarter showed, within Microsoft's "More Personal Computing" segment, Windows was only up 6% year-over-year, and turned out to be an underperformer this quarter. Nevertheless, given Microsoft's well-diversified portfolio, its bottom line EPS number was still up a solid 36% to $1.14 of diluted EPS.
To summarize, the key driver of total shareholder returns stems from Microsoft's asset-light, well-diversified portfolio of business.
Why Azure Will Continue to Drive Future Growth For Microsoft
Let's say you're the head of an IT department coming up with a budget to ensure your entire workforce can reliably come to work and be productive. Would you look to cut corners and invest in any other software package other than Office? I very much doubt you would, it would simply not be worth the risk. If anything goes down with Office, nobody is going to blame you. Furthermore, most bugs will be reported online and fixed easily and quickly.
This is where the essence of why Microsoft will continue to be the foundation of the modern workforce lies. As businesses become increasingly digitalized, Microsoft and its seamless platforms will be there to assist them.
This drives home why Microsoft is a top investment: it has strong competitive advantages over its peers. The fact that Microsoft's packages are expensive are of little concern. The fact that Office 365 commercial is now a recurring annual membership cost to your business makes little difference at the end of the day; it is simply another cost of ensuring that your business can operate day in, day out, from anywhere.
Now that I've explained why Microsoft's distribution channel is largely incapable of being disrupted, allow me to lay out Microsoft's next leg of growth: to sell businesses its cloud platform, Azure, to enterprises.
Microsoft already has the trust of the modern workforce as a reliable workhorse. And although Microsoft has had to play catch up to Amazon's (AMZN - Get Report) AWS, Azure continues to play to its strengths of not negotiating on price.
Moreover, according to Amazon's head of investor relations, Dave Fildes, the company has reduced the cost of AWS approximately 70 times since it was originally launched, in order to continue to command strong market share in this high growth space. On the other hand, although the cloud space continues to be intensely competitive, Microsoft has gained the trust of end users, ensuring that Azure has strong competitive advantages over other cloud offerings.
Jim Cramer's Action Alerts Plus team, which owns Microsoft, is similarly bullish on Azure's prospects.
"We continue to view the cloud as a secular growth area and believe Azure to be, currently, the only real competition to Amazon's AWS," they write. "Moreover, we reiterate that while AWS may be the public cloud leader, Azure, thanks to Microsoft legacy server business and ability to provide the same 'stack' used in the public cloud, to companies for their on-premise data centers, remains the best name in the hybrid-cloud space." (To read Jim and his Action Alerts PLUS team's full analysis of Microsoft, click here).
While these business insights may be well-known to investors, they are evidently not being priced in to Microsoft's valuation.
Given the recent sell-off in tech over the past two months, it should come as no surprise that many tech stocks are now starting to emerge as interesting investment opportunities. However, what distinguishes Microsoft from the rest of its peers are the facts which I have laid out above.
Microsoft is not reliant on a single product or service to provide shareholders with a strong return. For example, we have all seen over the month of December and into January 2019 how viscerally investors have sold-off from Apple (AAPL - Get Report) as news that its key product, the iPhone, is starting to see a slowdown in sales. Once again, investors have no need for this level of concern with Microsoft, as its portfolio of business units is well diversified and to a large extent without meaningful competition.
Finally, given that Microsoft's top line continues to grow at roughly mid-teens, paying up 17.6 times cash flow from operations goes a long way to demonstrate that in spite of being a household name, Microsoft is no way overpriced at the moment.
Microsoft is an asset-light, free cash flow generating machine. Ironically, despite having numerous alternatives to its products in the marketplace, some of which are totally free, users still prefer to pay up for reliability. Therefore, at the present valuation of roughly $790 billion market cap and trading for 17.6 times cash flows from operations, I argue that Microsoft remains undervalued and should reprice higher over the next two to three years.