Growth Stocks: Microsoft

Microsoft (MSFT.US) updated its outlook for the fourth quarter of 2022 last week. It did so lower, lowering its revenue guidance and EPS due to a stronger dollar. The impact of orientation, however, is minimal. Microsoft's (Azure) cloud business and free cash flow is where the value is.

Microsoft shares suffered another drop in June, making the software and cloud company even more undervalued. Microsoft released a revised outlook for the quarter last week that caught some investors by surprise. Although Microsoft lowered its guidance for its top line (more positive outlook) as well as its EPS due to a stronger dollar, from a cash flow standpoint and valuation Microsoft represents an excellent value stock.

IMPORTANT: Microsoft is doing better than other tech stocks

Microsoft experienced a 20% price drop in 2022, but did better than other high-growth companies in the “trillion dollar club.” Tesla maintains the corrections lead with the biggest year-to-date drop of 33%. Amazon is down 27% so far this year and while Alphabet is down 21%.

source: Seekingalpha

What does the new guidance say for the fourth quarter of 2022?

Microsoft lowered its Q4 2022 revenue and EPS expectations last week. The software and cloud company said it expects between $51.940 million and $52.740 million in revenue in the next quarter compared to previous guidance of $52.4 billion and $53.2 billion, while earnings per share guidance was lowered from 2.28 $ and $2.35 per share to $2.24 and $2.32 per share. Microsoft shares tumbled after the new outlook was released, but it appears the market is overreacting to the updated guidance as the net effect is minimal: Microsoft lowered its earnings guidance by less than 1%, while that EPS guidance was reduced by less than 2%. While not an ideal result, the revenue and EPS effects are very small and hardly warrant a fundamental reassessment of Microsoft's results and free cash flow potential.

source: Microsoft

The perfect example of a distraction

Instead of worrying about how currency market effects could reduce Microsoft's revenue and earnings by 1-2% in the fourth quarter of 2022, investors should focus on the real story and fundamental pillars of Microsoft: the cloud strength and the value of free cash flow. Microsoft's cloud business is soaring, and the recent price drop has made Microsoft stock even more attractively priced.

Microsoft cloud grew 29% year over year to $19.1 billion in the third quarter of 2022, in constant currency. Cloud is the largest contributor to Microsoft's revenue with a 39% revenue share, the fastest-growing business for the software company and hugely profitable: it held its gross margins steady at around 70% in the last year.

source: Microsoft

Within the cloud, Azure is driving Microsoft's revenue growth. Azure is Microsoft's cloud computing platform that enables users to build, run, and manage applications across clouds, helping businesses scale their digital transformations. Azure and other cloud services saw revenue growth of 49% in the third quarter of 2022 (in constant currency), which is the fastest revenue growth of any segment for Microsoft. Due to strong market demand for cloud-based solutions, growth has remained strong over the past year with growth rates at the top never dipping below 45%.

source: Microsoft

Microsoft's second great strength: its cash flow

Microsoft is an incredibly profitable cloud and software company. In the third quarter of 2022, Microsoft generated $20 billion in free cash flow in a single quarter on revenue of $49.4 billion, which works out to an incredible 40.6% FCF margin. Total free cash flow was $63.6 billion and Microsoft's free cash flow margin was 33.1%. Microsoft is one of the strongest companies even outside of the technology sector, in terms of free cash flow, and the FCF gives the company considerable resources even to buy back shares.

source: Seekingalpha

Microsoft is expected to increase its revenue guidance to $332.8 billion for the fiscal year 2026 target, implying 13.7% annual growth over the next four years. Assuming that the company generates free cash flow margins of 33-35% by then, the company would expect to realize an annual free cash flow of $110,000 to $116,000 million.

source: Microsoft

It has all the ingredients to buy back more shares

In the third quarter of 2022, the software company returned $12.4 billion to shareholders, $4.6 billion as dividends and $7.8 billion as share buybacks. Microsoft continues to steadily buy back shares in the market, and the drop in the company's valuation this year makes share buybacks even more attractive from a shareholder standpoint. Microsoft has reduced the number of shares outstanding by more than 10% in the past decade and the company is likely to buy back more shares in 2023.

source: Seekingalpha

Let's consider the risks of Microsoft

While the stronger dollar will have a (minimal) impact on Microsoft's revenue and profits, the software company's core business is doing well. Microsoft is going strong in the cloud, which is the growth market of the future. However, risks to top-line growth and the continued appreciation of the US dollar are an issue for companies that generate a lot of foreign sales.

Tecnhical Analysis

Although the short-term trend remains, the bearish channel, the recent lows have reached the main support zone of its guideline since 2015. Therefore, it is important that it does not lose that level that it has maintained since the last 7 years.

In the short term, the price of the company founded by Bill Gates is likely to be framed between support at $216.8 and resistance at $281.74 per share.

Conclusion

Because of Microsoft's huge free cash flow, the company has to be seen as a value stock. The company had a good year in the first quarter, revealing significant revenue momentum in its business, especially in the cloud, which has become a growth engine in recent years.

Darío García, EFA
XTB Spain