Microsoft Stock: How do they keep increasing their margins? (NASDAQ: MSFT)

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Investment thesis

Microsoft (NASDAQ: MSFT) has been a dominant leader in the tech industry for several decades at this point. They started out as an operating system software company, and the overwhelming success of Microsoft Windows and Office catapulted them to the top of the tech industry. They have since expanded into many different branches (cloud service, productivity and collaboration tools, games, etc.). They are one of the truly dominant companies with many competitive advantages.

Recently, due to inflationary pressure and rising labor and supply costs, many companies have seen their margins squeezed. However, Microsoft continues to find new ways to increase its margins. The current global turmoil and economic uncertainty have taken their toll on the stock market, and in particular on tech growth stocks. This volatility has created a rare opportunity to grab Microsoft shares at a bargain price. I think Microsoft is a great option for a long-term investor because:

  • Microsoft announced a resounding result in the 2nd quarter of 2022 with substantial revenue growth and an increase in the profit margin.
  • Microsoft has steadily increased its margins since 2019 by focusing on more lucrative segments of the business, while maintaining steady growth in the legacy business.
  • Additionally, they continue to expand their dominance through substantial organic growth and key acquisitions.

Blowout 2Q 2022 (4Q 2021) Microsoft Results

Microsoft released Q2 2022 (Q4 2021 for the rest of us) results at the end of January, and it was a resounding result. They easily exceeded high and low expectations. Revenue was $51.7 billion, up 20% year-on-year, and operating income was $22.2 billion, up 24%. All segments grew significantly from the same quarter last year, with LinkedIn, Dynamics products and cloud services leading the growth. LinkedIn revenue increased 37% and Dynamics products and cloud services revenue increased 29%.

As an investor focused on business fundamentals, I was very pleased to see an increase in operating margin. The operating margin increased from 41.5% last year to 43.0% this year. This is a remarkable result, especially as many companies are experiencing squeezed margins due to inflation, rising labor costs and supply chain pressure. supply. A margin expansion of this magnitude is a clear indication of product superiority and shrewd business focus on the part of management. I will discuss how they expand their margins in the following sections.

Microsoft FY22 Q2 Financial Summary

Second Quarter FY22 Financial Summary (Microsoft Investor Relations)

Focus on the good deals

The first secret to expanding their margin – focus on the right business. Tracking the operating margins of each segment (Productivity and Business Process, Intelligent Cloud, and More Personal Computing), Productivity and Business Process and Intelligent Cloud clearly achieve higher profitability than Personal Computing.

Operating margins 2018 2019 2020 2021
Productivity and business process 36% 39% 40% 45%
smart cloud 36% 36% 38% 43%
More personal computing 25% 28% 33% 36%

Operating margins by segment Microsoft. Table generated by the author. Data Source: SEC Filings

Since 2016, Microsoft has focused heavily on revenue growth in Productivity & Business Processes (Office, Dynamics, and LinkedIn) and Intelligent Cloud (Azure, associated cloud services, and platform). You can clearly see the stronger trend of growth in Productivity and Business Processes and Intelligent Cloud, both of which outpace the More Personal Computing business around 2019.

Microsoft revenue and revenue growth trend

Microsoft revenue and revenue growth trend (Microsoft Investor Relations)

The growth of Productivity & Business Process has largely been achieved by offering superior products and capturing synergies between products. Microsoft has dominated the operating system and desktop software market for several decades at this point, so the installed base of this software is huge. In addition to the large installed base of operating systems and desktop software, Microsoft offers new products that work seamlessly with other software/platforms, and this synergy further fuels cross-selling and, therefore, revenue growth. Dynamics 365 for Talent with LinkedIn is a great example of the synergistic effect between Microsoft software.

Growth of the Intelligent Cloud platform is achieved through superior AI technology and economies of scale. With the new remote work environment, companies have accelerated their digital transformation, and Microsoft is providing key technologies and infrastructure to achieve this transformation. Additionally, using their vast global footprint and resources, Microsoft has created an extensive network of data centers that provides three major benefits for economies of scale; much cheaper data centers in terms of compute; data centers that provide excellent data coordination and aggregation across diverse customer, geographic and application demand patterns; and data centers that reduce application maintenance costs. With these advantages, their Intelligent Cloud segment is growing at a truly incredible rate, and I expect that to continue for the foreseeable future.

Develop their competitive advantage

The other key element that has driven Microsoft’s growing margin is their constant effort to increase their competitive advantage. Since 2016, they have steadily increased their capital expenditures, increasing from $8.9 billion in 2016 to $24.2 billion in 2021. Additionally, they have consistently spent around 20% of their gross profit in R&D ($22 billion in the last twelve months) . With this kind of investment to increase capacity and improve products, it’s no surprise that their products stay on top for a long time.

Microsoft capital expenditures

Microsoft capital expenditures (Microsoft Investor Relations)

In addition, Microsoft has not hesitated to acquire key businesses to strengthen its competitive advantage. More recently, they caused a stir with the acquisition of Blizzard. I think it’s a great decision to acquire top talent in the gaming industry as well as great gaming franchises that will drive future growth. The detailed breakdown of the deal is explained in this article. In 2021 alone, Microsoft has entered into 14 deals, including Two Hat, Clear Software, Peer5, and CloudKnox. These acquisitions will provide key technology and talent to fuel future growth, while increasing revenues.

Estimated intrinsic value of MSFT shares

I used the DCF model to estimate the intrinsic value of Microsoft. For the estimate, I used EBITDA ($90.8 billion) as the cash flow indicator and the current WACC of 7.5% as the discount rate. For the base case, I assumed 20% EBITDA growth (Seeking Alpha Consensus) for the next 5 years and zero growth thereafter (zero terminal growth). For the bullish and very bullish case, I assumed EBITDA growth of 22% and 24%, respectively, for the next 5 years and zero growth thereafter. Given their rapid growth due to existing tailwinds and additional growth from Blizzard and other acquisitions, I think EBITDA growth of 22-24% is quite reasonable. In addition, their expanding margin will contribute positively to EBITDA growth.

The estimate revealed that the current share price is up 15-25%. This estimate shows that the current market volatility provides a rare opportunity to buy Microsoft stock at a bargain price, and I think investors should take advantage of this opportunity.

Price target

Upside down

Base case

$311.83

11%

Bullish case

$335.63

20%

Very bullish case

$360.97

29%

The assumptions and data used for the price target estimation are summarized below:

  • WACC: 7.5%
  • EBITDA growth rate: 20% (base case), 22% (bullish case), 24% (very bullish case)
  • Current EBITDA: $90.8 billion
  • Current stock price: $280.07 (03/11/2022)
  • Tax rate: 15%

Risk

Acquiring businesses always involves risk. Especially a company the size of Blizzard can absorb a lot of financial, time and human resources to complete. Even after completion, the cost synergies and increased revenue should be significant enough to justify the cost of acquisition. Additionally, Blizzard has had cultural issues within the company and is exposed to legal issues. Therefore, the investor should closely monitor the news regarding the acquisition process.

There is a lot of turmoil in the world, creating a lot of uncertainty. War, inflation, economic growth rates and supply chain issues all rock the stock market wildly on a daily basis. In this market, it is really difficult to maintain a long-term perspective and not be swayed by short-term market fluctuations caused by headlines. Therefore, the investor must remain committed to a long-term investment.

Conclusion

Microsoft has been an incredible investment for several decades at this point. Market dominance, technological superiority and management’s relentless drive for growth have combined for exceptional profitability and superb long-term growth. I expect this trend to continue for the foreseeable future. I see 15-25% upside from the current level.

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