Patrick Xia CIEC

Microsoft Corporation ($MSFT)

Research Analyst:

Monmouth County, New Patrick Xia

Jersey

patxia06@gmail.com

Company Name: Microsoft Recommendation: Long Market Cap: 1.88T

Corporation

Technology: Software and Current Price: $249.07 (as of

Infrastructure 6/4/21)

Ticker Symbol: $MSFT Target Price: $299.23 (+16.6%) CEO: Satya Nadella

Business Overview:
Microsoft is a well-known technology company. Most consumers are familiar with its windows
operating system, which has a 75% desktop OS market share as of 2020. Its Microsoft Surface
Laptop, which the Company advertised aggressively, and its Office 365 productivity suite, which is
commonly used in schools and businesses alike.
The Company’s operations can be broken up into 3 broad categories: Productivity and Business
Processes (32.44% of revenue), Intelligent Cloud (33.82% of revenue), and Personal Computing
(33.74% of revenue).

Productivity and Business Processes:

This segment includes Microsoft's Office product line, LinkedIn, and Dynamics.
Office saw stellar growth during the pandemic. In Microsoft's 10-K filed in June of 2020, Office
revenue grew by 4.5B or 15% YoY. Office accounts for 64.63% of this segment's revenue. However,
the Office produce line isn’t expected to be the main growth driver in the future. Its main competitor,
Google's productivity suite, has put significant margin pressure on this product line. Even though the
commercial sales are likely to remain stable, Office’s consumer sales will likely be negatively
affected by Google's free product offering. Despite the competitive pressure, the Office product line
managed to grow its 2020 revenue by 1.3B or 20% YoY and currently accounts for 14% of this
segment's revenue. The switch to SaaS offering (Office 365) from traditional license model also
offers revenue visibility. The growth achieved in 2020 signals that there is renewed growth potential
which is often overlooked by the majority of investors.
LinkedIn has the perfect model in a world where data’s value is rising. Users willingly provide:
current place of residence, age, current place of work, past working experience, prior education,
your interests, what skills one has, etc. This is a data is a goldmine. All the information Google
spends billions on developing algorithms to infer about you is offered up to Microsoft by over 740
million members. The growth potential is enormous once Microsoft figures out better ways to
monetize the data. In the first quarter of 2021, LinkedIn saw a revenue increase of 16%.
 Patrick Xia CIEC

Finally, there's Microsoft Dynamics. It has fierce competitors who dominate the entire CRM industry
(one of them is Salesforce with 19%+ market share)

Intelligent Cloud / Azure:

This is what many people end up talking about the most when it comes to growth drivers for
Microsoft. As someone with a pretty decent amount of cloud knowledge, I can say with confidence
it'll be a two-horse game in the future with AWS and Azure dominating. The challenge with AWS is
the fact that they're a subsidiary of Amazon!
If you're a retailer and you're looking to pick a cloud provider, you can't use AWS because you'll be
supporting a direct competitor of yours. As a result, many of these companies will end up taking their
business to Microsoft. It's also worth noting that the government has shown a preference to use
Azure in the past, especially on military contracts, due to security concerns.
Healthcare AI-assisted bots, manufacturing, and e-commerce in retail all rely on cloud computing.
The worldwide end-user spending on public cloud services is predicted to grow 18.4% in 2021 to a
total of $304.9 billion, from $257.5 billion in 2020.
Azure has consistently outperformed its budget for years. In FY 2014 (July-June), Microsoft reported
that its commercial cloud revenue hit a $4.4 billion annual run-rate. Within a year, that number
exceeded $8 billion. Microsoft then set a target of achieving $20 billion in commercial cloud
annualized revenue run-rate in FY 2018. By FY 2016, its annualized revenue run-rate had already
surpassed $12.1 billion, and FY 2017 witnessed the figure cross $18.9 billion. Microsoft’s
commercial cloud business delivered more than $23 billion in revenue in FY 2018, surpassing
expectations months before predicted. During 2019, $38 billion in revenue was posted while FY
2020 witnessed its commercial cloud surpass $50 billion in revenue for the first time. 

Personal Computing:
This segment includes Windows OS, the Surface Laptop, Xbox, and their search engines.
This segment is a stable revenue source with limited growth expected. Windows is expected to
continue growing by 2-4% per annum. Its search engine is expected to stay stagnate. Furthermore,
Xbox is under significant competitive pressure from Playstation. However, FY 2021 saw Xbox
services and content revenue increased 30%. Microsoft has shown efforts to adapt by expanding
their Xbox Game Pass and game streaming capabilities as it replaces the traditional model of selling
individual games. Lastly, Surface's growth has been and is expected to stay slow.

Integrated Visual Augmented System (IVAS):

IVAS is an augmented reality system currently being developed by Microsoft. Their prototype is
known as HoloLens and has a multitude of functions. The United States Military recently signed a
contract with Microsoft which can be worth as much as $21.88 billion over the next 10 years. This
contract requires Microsoft to provide the US Military with 120,000 headsets for soldiers in the field.
This means that Microsoft will have to push the IVAS from prototype into production, leading to major
developments on the retail side of augmented reality.

Government Contracts:
As stated earlier, Microsoft has two main government contracts. One contract is specifically with the
military to provide IVAS headsets, while the other contract is regarding Azure. Amazon lost to
Microsoft for the $10 billion Joint Enterprise Defense Infrastructure (JEDI) cloud contract. In addition
to the obvious monetary benefit of these contracts, it shows that Microsoft is deemed more
trustworthy by governments as well as third-party companies, signaling future growth in many fields.

All in all, Microsoft’s future business growth will be driven by Azure, LinkedIn, Xbox, and IVAS.

Revenues:
 Patrick Xia CIEC

Microsoft brought in revenue of 153.28B in FY 2020. This represents a 14.18% gain YoY, a 48.90%
3 year gain, and a 74.02% increase from 5 years ago. These increases are very impressive
considering the age and size of Microsoft.
Switching over to Net Income, we see a 2020 total of 51.31B. This is up 15.77% YoY, 271% in the
last 3 years, and up 338% since 5 years ago. My takeaway here is similar to the one I made for
revenue. The key difference here is that NI has been much more inconsistent.

Margins:
Microsoft currently has a net margin of 33.47%, the highest it's been in more than 15 years. This
margin compares well with other blue-chip stocks like Apple's 21.73%, Amazon's 5.53%, Netflix's
11.05%, and Google's 22.06%. The only FAANG company that has a higher margin than Microsoft is
Facebook with a 33.90% margin. Seeing as Facebook operates as a software company only, it is not
surprising to see them in this position.

Assets/Liabilities:
Total Cash on
Total Liabilities Long-term debt
Assets Hand

Value ($) 304B 174B 132B 55B

Microsoft currently has a Debt/Equity ratio of 0.42 and a current ratio of 2.58.  A current ratio of over
1.5 is generally considered good.
It's also worth noting that Microsoft's Cash on Hand can cover its short-term liabilities, which is
always a plus.

Free Cash Flow/Buybacks:

As of 6/30/20 (per the most recent 10K), Microsoft generates 45.25B in Free Cash Flow [ for what
period?]. This represents an 18.22% gain YoY, a 44.16% 3 year gain, and a 90.67% 5 year gain.
Because Microsoft pays a below-market dividend, they end up spending that Free Cash Flow on
share buybacks. Since FY 2019, Microsoft has spent more on share buybacks than they have on
dividends and has netted shareholders billions.

Price Ratios/Other:

Ratio Microsoft Apple Google Amazon "Good Value" for Sector

PE Ratio (TTM) 34.33x 32.50x 34.53x 73.62x <30x

P/B Ratio 13.34x 30.42x 6.14x 16.58x <7x

P/S Ratio 11.78x 7.28x 8.17x 4.11x <7x

P/FCF Ratio 35.79x 26.53x 34.75x 51.15x <30x

90.59
ROE 42.19% 19.03% 27.07% >25%
%

Leverage 2.5x 4.6x 1.4x 3.4x Depends

3-year revenue 23.06

48.90% 64.66% 116.85% Depends
growth %
 Patrick Xia CIEC

PE Ratio:
A "good" number for the sector was under 30x. An optimal number would be 15-20x, but you do
have to pay for growth. In this section, nobody was under this threshold. Considering the market is in
a mature bull market, I can't say I'm surprised. With that being said, Microsoft narrowly beat out
Google to have the second-lowest PE at 34.33x.
P/B Ratio:
A good P/B Ratio for this sector was under 7x. However, investors must keep in mind these are good
values for the technology sector. That being said, only Google came in under my good value while
the rest weren't even close. Microsoft had the second-lowest P/B at 13.34x. 
P/S Ratio:
A good P/S ratio here would be under 7x (same as the P/B cutoff). This time, the market saw both
Google and Amazon qualify with Apple narrowly missing the cutoff. Microsoft ended up having the
highest P/S ratio at 11.78x. Overall, P/S ratios were decent.
P/FCF Ratio:
Under 30x to be a good multiple for this sector. Sadly, with only Apple qualifying and the rest being
pretty far off. Microsoft had the second-worst P/FCF ratio at 35.79x.
ROE/Leverage/Revenue Growth:
Even though Microsoft has poor price ratios, they are extremely efficient at generating capital. A
42.19% ROE while maintaining reasonable leverage considering their revenue growth rate is
impressive. This is one area where Microsoft looks pretty attractive.
Apple: The numbers for Apple are not eye-popping. They appear over-levered and a future
slow-grower.
Google: They have the lowest ROE of the bunch, but they're also the least levered. Considering the
amount of growth they've had, the only way investors could get behind this little leverage would be if
management expected stagnation over the coming years.
Amazon: Amazon is very solid in this area. They have a reasonable amount of leverage considering
expected future growth and are pretty efficient at generating capital.
Overall, Microsoft is good at generating capital and is well-levered considering both past and
expected growth rates.

Moderate DCF Valuation:

Assuming a 12.7% 5-year revenue CAGR, an 8% discount rate, a 4% perpetual growth rate, and a
46% EBITDA Margin, Microsoft has an FV of $219.57 (upside of -11.8%).

Bull Case:
In a bull case, assuming Microsoft successfully monetizes LinkedIn, and Azure growth is faster than
expected. Assuming a 17% 5-year revenue CAGR, an 8% discount rate, a 4% perpetual growth rate,
and a 47% EBITDA Margin. Using these parameters, we got an FV of $299.23 (20.1% upside).
The FV is most likely between the current price and this bull case.

Management:
Microsoft has seen a relatively flat stock price since the dot com bubble, Bill Gates stepping
down from CEO, and throughout the tenure of former CEO Steve Balmer. Microsoft grew
complacent with the profits generated by their PC operating system. This narrow-minded
thinking held the company back from expanding into mobile and cloud computing. This all
changed when Satya Nadella was chosen to be Steve Balmer’s successor. His personal
experiences from his son with cerebral palsy and previous work at Microsoft brought a culture
change that led to the recent success. He brought a growth mindset and flexibility that unified
the company. Instead of internal competition, Nadella championed “One Microsoft”, which came
with a new era in Microsoft and the tech sector.
 Patrick Xia CIEC

Major Risks:

1. Office loses market share: This is the most likely scenario of risks. The average
consumer is going to prefer the Google Productivity Suite over Office because it's free
and offers products equivalent in quality. If this were to happen, Office Commercial
(Office for businesses and schools) would probably remain relatively intact.
2. Azure loses market share: As stated in the previous section, we find this scenario
very unlikely. For this to occur, AWS would have to grow dramatically more than their
servers can handle. In addition, many companies purposely choose to avoid Amazon
due to their aversion to supporting a competitor. Along with that, GCP would have to
rectify its many problems, which is unlikely due to how low Google values it compared
to their other products.

ESG Considerations:
Microsoft has always been a high performer in terms of ESG, and aims to continue this over the
next several years. On the EcoAct Dow Sustainability Rankings, Microsoft has been ranked as
the #1 company across all indices for three consecutive years.

By 2025, they aim to operate off 100% renewable energy as well as protect more land than they
keep in use.

Microsoft has also worked towards protecting our elections, promoting human rights issues, and
combating racial injustice, investing over 150 million to promote inclusion and strengthen
relationships in their communities.

The CPA-Zicklin Index of Corporate Political Disclosure and Accountability named Microsoft one
of the leaders in political discourse and accountability.

Microsoft has been a champion of the environment, enriching the lives of millions, while
promoting and protecting freedoms and democracies. A champion of the future, Microsoft has
shown to invest in people and the planet.

Valuation:
Microsoft remains a strong and safe blue chip stock that has shown the ability and willingness to
innovate to stay relevant in future markets. Microsoft has a diverse stream of revenue such as
LinkedIn, Microsoft Azure, Xbox, and Microsoft Office. Microsoft is also sitting on assets with low
debt, giving it flexibility to acquire or startup a new company/project. We believe that the market
is underpricing Microsoft and therefore pitch a strong Buy. Microsoft's potential paired with its
pricing among other blue chip tech stocks gives us confidence to be bullish on the stock.
Microsoft is on pace to easily surpass our $299.23 target price.