Microsoft’s (NASDAQ:MSFT) ability to continuously surprise investors and analysts alike is truly amazing. The company once again showcased exceptional growth in its most recent results. Microsoft’s Cloud segment, in particular, has not only managed to sustain solid growth during a very tough macroeconomic environment, but Microsoft’s rapid developments in AI are set to gradually further boost the segment’s financials and sustain double-digit growth ahead.
Overall, under the helm of Satya Nadella, Microsoft seems like an unstoppable force, giving investors the opportunity to have exposure to all of the exciting technological developments (such as AI) along with the safety that comes with a well-run, irreplaceable enterprise tech behemoth. That said, with investors fearing potentially losing the underlying opportunity that Microsoft presents, the stock has already rallied by a significant 37% year-to-date.
Therefore, while I do remain highly optimistic regarding Microsoft’s future prospects, I am concerned about the potential impact the stock’s significant valuation expansion could have on investors’ future total returns. Accordingly, I am now switching my MSFT stock rating from a Buy to a Hold.
Closing Fiscal 2023 on a High Note, Driven by Cloud Strength
Microsoft’s most recent results closed the company’s Fiscal 2023 on a high note, despite the underlying challenges that persisted over the past 12 months. Even in the face of a shaky business environment in which enterprises are employing cost-cutting measures due to rising rates, Microsoft showcased remarkable growth across all fronts, with its cloud offerings leading the way.
In particular, Microsoft’s Cloud revenues surged to an impressive $30.3 billion, representing a remarkable 21% increase (or 23% in constant currency) that surpassed the expectations of both management and analysts. This surge in revenue was driven by strategic advancements on multiple fronts, solidifying the company’s position as the preferred choice for the world’s leading enterprises.
Azure, for instance, continues to excel by capturing substantial market share as customers migrate their workloads and invest in innovative projects. Additionally, Azure Arc’s remarkable success, a platform enabling companies to develop apps in Azure, resulted in an astonishing 150% increase in customers, reaching 18,000 companies. Notable industry leaders such as Carnival Corp. (NYSE:CCL), Domino’s Pizza (NYSE:DPZ), and Thermo Fisher Scientific (NYSE:TMO) have all embraced this cutting-edge technology.
In parallel, Microsoft has been successful in productizing its advancements in AI, which opens up tons of opportunities for up-selling and cross-selling additional products to its existing clients. Just take a look at Azure’s adoption across Microsoft’s OpenAI Service’s traction, with over 11,000 leading firms, including renowned names like IKEA, Volvo Group, and Zurich Insurance, already leveraging AI. This figure translates to 100 new customer additions daily during Q2, highlighting the swift pace of Microsoft’s AI onboarding.
With Mercedes-Benz integrating ChatGPT through Azure OpenAI into over 900,000 vehicles in the U.S., enhancing their in-car voice assistant to be more intuitive, and Moody’s constructing an internal copilot to boost productivity for their 14,000 employees, it becomes apparent that AI adoption is becoming indispensable for companies aiming to stay ahead in the competitive landscape.
Contrary to concerns about Microsoft’s Cloud division potentially slowing down after a decade of widespread adoption, the recent advancements in AI have instead paved the way for a vast and exciting “new” phase of growth.
Economies of Scale Expand Margins, Profits Higher
Microsoft’s business model benefits from excellent economies of scale, allowing the company to enjoy expanding margins and, thus, even more impressive net income growth over time. This is particularly evident in Microsoft’s Cloud division, where, as I just mentioned, the company can cross-sell and up-sell its advancements without incurring equally-high costs (e.g., lower customer acquisition costs). Indeed, Microsoft’s Cloud gross margin expanded by about three percentage points (300 basis points) year-over-year to 72%.
This theme was prominent across Microsoft’s consolidated income statement, with Q4-2023 gross, operating, and net income margins landing at 69.8%, 41.1%, and 35.7%, respectively. These numbers compare to 68.3%, 39.6%, and 32.3% over the same period last year, respectively. Therefore, even though Microsoft’s revenues grew by 10% in constant currency, in Q4, its operating profit and net income actually grew by 21% and 23% due to the underlying margin expansion occurring.
Now, add Microsoft’s lofty share repurchases, which amounted to $22.2 billion over the past 12 months and further reduced the company’s share count, and earnings per share landed at $2.69 in Q4, up by an even larger 23% in constant currency. Accordingly, Microsoft achieved earnings per share (adjusted for some severance and hardware-related impairments) of $9.81 in Fiscal 2023, up 7% or 12% in constant currency – marking another all-time-high result.
Microsoft’s Expanded Valuation Impact On Future Returns
Microsoft achieved record earnings in Fiscal 2023. However, shares actually rose at an even faster pace, essentially resulting in the stock’s valuation experiencing a multiple expansion. While Wall Street forecasts another year of thriving performance in Fiscal 2024, with earnings-per-share expected to grow by about 12.3% to $11.02, the stock’s current price of ~$330 implies a rich forward P/E of about 30x.
Of course, the reason that this multiple is notably higher than the S&P 500’s (SPX) multiple of 20.6 is that the market expects Microsoft to continue growing at an above-market-average pace. However, with the Fed remaining persistent with interest rate hikes, the current valuation could be a little too ambitious. Also, while I don’t bash investors’ willingness to pay a premium for Microsoft’s qualities and incredible growth story, I do believe the stock’s future total-return potential may have shrunk.
Is MSFT Stock a Buy, According to Analysts?
Regarding Wall Street’s sentiment, Microsoft maintains a Strong Buy consensus rating based on 31 Buys, one Hold, and one Sell assigned in the past three months. At $392.97, the average Microsoft stock price projection implies 18.6% upside potential.
If you’re wondering which analyst you should follow if you want to buy and sell MSFT stock, the most accurate analyst covering the stock (on a one-year timeframe) is Alex Zukin from Wolfe Research, with an average return of 32.4% per rating and a 97% success rate.
Final Thoughts
While Microsoft continues to impress with its exceptional growth and advancements in AI, investors should be cautious about the stock’s significant valuation expansion. Despite the company’s strong performance, the current price of ~$330 implies a rich forward P/E of about 30x, which may impact future total returns given the current trajectory of interest rates. Therefore, while I remain optimistic about Microsoft’s prospects, the stock’s high valuation leads me to switch my rating from a Buy to a Hold.
