Microsoft: A Smart Investment Choice

Microsoft has been a household name since the 1970s and has experienced unprecedented growth since its founding in 1975. The company has a strong track record of growth over the past three and a half decades, with a market capitalization of over $2 trillion. In recent years, Microsoft has diversified its revenue streams, expanding into cloud computing, remote work apps, video games, and artificial intelligence. The company's cloud offerings include Azure infrastructure services, Office 365 productivity software, and Dynamics enterprise software. It also owns LinkedIn, Skype, and GitHub. Microsoft's stock has been on a roll, rising by 55% in 2021 and witnessing a 441% price increase in the past five years. The company's cloud division, Azure, has been a significant driver of its recent success, with revenues growing by 50%. Analysts expect Microsoft to continue its winning streak in 2022 and beyond, driven by continued cloud adoption and the company's strong market position.

Microsoft's cloud services are growing

Microsoft's cloud services are experiencing notable growth, with the company investing heavily in this area. In the second quarter of the 2023 fiscal year, Microsoft Cloud revenue was $27.1 billion, representing a 22% increase year-over-year. This growth continued into the third quarter, with Microsoft Cloud revenue reaching $28.5 billion, a 25% increase year-over-year.

The Intelligent Cloud segment, which includes Azure and other cloud services, has been a key driver of this growth. Azure is Microsoft's cloud computing service that enables the creation of scalable solutions and competes with Amazon Web Services (AWS) and Google Cloud. Azure's revenue growth stood at 31% in the third quarter of the 2024 fiscal year, contributing significantly to the overall Intelligent Cloud revenue.

Microsoft's cloud offerings have expanded globally, with the company announcing seven new data centres in Asia, Europe, and Latin America. This expansion is supported by substantial investments, with the company spending $5.4 billion in capital expenditures in the last quarter to meet the growing demand for cloud services.

The transition to a subscription-based model for its cloud services has been a successful strategy for Microsoft. The company's cloud-based Office 365 offering has seen increased adoption, with revenue growth driven by Office 365 Commercial. Additionally, the shift to cloud-based services has increased the lifetime value of each customer, enhancing Microsoft's competitive position in the market.

The growth in Microsoft's cloud services is expected to continue, with analysts forecasting revenue increases of about 14% over each of the next two years. The company's strong market position, differentiated cloud architecture, and synergies with its other services, such as Windows and productivity software, further solidify its prospects for sustained growth in the cloud services market.

The company has a strong track record of growth

Microsoft has a strong track record of growth over the past three and a half decades. If you had invested $1,000 in the company from its IPO in 1986, those shares would now be worth more than $4 million. The pace of growth has re-accelerated in recent years, particularly since Satya Nadella became CEO in 2014. Since then, the company's share price has gained more than 700%.

Microsoft's annualised 5-year revenue growth rose to 13% by 2020/21, while its earnings per share (EPS) climbed by a compound annual growth rate of 25% over the same period. Analysts expect this growth to continue, with revenues expected to grow by about 14% over each of the next two years. EPS is expected to climb by 14% to $10.54 in 2022/23, with a further increase of 18% to $12.42 per share in 2023/24.

The company has regularly exceeded analysts' estimates on both revenues and earnings. According to data from Seeking Alpha, the average earnings surprise for the past 12 quarters is 11.9%. Quarterly revenues have also exceeded analysts' estimates by 3.3% over the same period.

The momentum in its cloud and enterprise-facing businesses will likely see Microsoft achieve robust growth in the years ahead. The shift towards cloud-based services, or Software as a Service (SaaS), is viewed by analysts as an up-sell of the company's legacy perpetual-license software. This is because the shift to a subscription-based software licensing and delivery model increases the lifetime value of each customer.

Microsoft's cloud offering, Azure, experienced a small acceleration in growth last quarter, with revenue increasing by 48%, excluding currency. Azure is one of only a few cloud service providers with the global scale to serve large corporate customers, which puts Microsoft in a solid competitive position. The company continues to expand its cloud footprint globally, recently announcing seven new data centres in Asia, Europe, and Latin America.

The pandemic accelerated the move toward cloud deployment, and the market is expected to reach $1 trillion by 2030. Microsoft, which ranks second in the cloud sweepstakes, is fast closing the gap with market leader Amazon. Importantly, it is doing so not by siphoning customers away from Amazon but by bringing new ones to the market.

Microsoft's balance sheet is also looking strong, with an operating income figure that is trending upwards and stockpiled cash reserves. Analysts have forecast good things for the tech giant in the future, with a majority giving Outperform ratings for the stock and forecasting a price increase.

It has diversified revenue sources

Microsoft's revenue comes from a variety of sources, and the company has a wide economic moat. Its three business segments are: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.

The Intelligent Cloud segment is the largest and fastest-growing source of profit for Microsoft. It includes public, private, and hybrid server products, as well as cloud services for businesses, such as Azure, SQL Server, and GitHub. In 2023, this segment generated $87.9 billion in revenue, a 17% increase from the previous year.

The Productivity and Business Processes segment includes Microsoft's Office software suite and business solutions products such as Dynamics 365 and LinkedIn. In 2023, this segment brought in $69.3 billion in revenue, a 9% increase from the previous year.

The More Personal Computing segment includes products and services such as the Windows operating system, Surface devices, gaming products, and search and news advertising. In 2023, this segment generated $54.7 billion in revenue, a 9% decrease from the previous year. However, in the third quarter of 2024, revenue increased by 17% year over year.

Microsoft's diverse revenue streams allow it to better cope with exogenous supply and demand shocks, such as the pandemic, supply disruptions, or changes in market trends. The company has a strong market position and benefits from long-term competitive advantages that protect its market share.

Microsoft has a wide economic moat

Morningstar, a well-known investment research firm, assigns Microsoft a wide economic moat based on the competitive success of its Office suite and cloud products. Finance professor Robert R. Johnson of Creighton University's Heider College of Business argues that Microsoft has not just an economic moat, but a comprehensive one, possessing four out of five types of economic moats. These are switching costs, the network effect, efficient scale, and intangible assets.

Microsoft's moat is strengthened by its high switching costs. The company ranks second in global market share for operating systems across all device platforms, with a nearly 78% worldwide share in the PC operating system market. The high switching costs associated with Microsoft's products make it difficult and costly for consumers and businesses to switch to alternative options.

Additionally, the network effect plays a crucial role in Microsoft's wide economic moat. Its products, such as the Office suite and LinkedIn, benefit from powerful network effects due to their leading market positions and vast user bases. The more users on these platforms, the more valuable and challenging it becomes for competitors to displace Microsoft's position.

Microsoft's size also brings economies of scale, allowing the company to spread developmental and operational expenditures over a larger service base. This has resulted in improving operating margins over the years, with EBIT margins rising from 32.5% to 44.1% in the last five years.

The combination of high switching costs, network effects, economies of scale, and intangible assets contributes to Microsoft's wide economic moat, protecting it from rivals and enabling its large profits.

The company has a stable outlook

Microsoft has a stable outlook for several reasons. Firstly, the company has a long history of growth and success, dating back to its founding in 1975. Microsoft's software became the industry standard for early PCs, giving it a crucial first-mover advantage. This advantage has been sustained over time, and Windows remains the dominant operating system for non-Apple computers, with over 76% of the desktop market share worldwide.

Another reason for Microsoft's stability is its diversified revenue streams. While Windows is still a significant source of revenue, the company has expanded into new areas such as cloud computing, remote work apps, and video games. This diversification reduces the risk of relying too heavily on a single market segment or product.

The company's financial health also contributes to its stability. Microsoft has strong cash flow and a solid balance sheet, with cash and short-term investments exceeding financial debts. This financial strength enables the company to invest in new products, make acquisitions, and return value to shareholders through dividends and buybacks.

Additionally, Microsoft has a strong market position and a wide economic moat. Its entrenched position in operating systems, productivity software, and cloud services creates natural synergies and a seamless experience for customers. This makes it difficult for competitors to displace Microsoft's market share.

Finally, Microsoft has a history of innovation and adapting to new technologies. Under the leadership of CEO Satya Nadella, the company has embraced cloud computing and artificial intelligence, ensuring that it remains relevant and competitive in an evolving market.

In summary, Microsoft's stability is underpinned by its long-standing success, diversified revenue streams, strong financial health, dominant market position, and ability to innovate and adapt to new technologies. These factors contribute to a positive outlook for the company's future prospects.

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