Microsoft MSFT is set to release its fiscal third-quarter earnings report on April 30. Here’s Morningstar’s take on what to look for in Microsoft’s earnings and stock.
Key Morningstar Metrics for Microsoft
• Fair Value Estimate: $490.00
• Morningstar Rating: ★★★★
• Economic Moat: Wide
• Morningstar Uncertainty Rating: Medium
Earnings Release Date
• Wednesday, April 30, after the close of trading
What to Watch for in Microsoft’s Q3 Earnings
• We are looking at a macro impact, as the dollar was strengthening abruptly a quarter ago and is now weakening, which should be a tailwind to guidance. Tariffs are causing issues and could crimp demand.
• There are not yet tariffs on software and related services, but there is no reason there couldn’t be retaliatory tariffs if this trade war goes on long enough. Since Microsoft makes Surface tablets and Xbox consoles, the direct impact from tariffs, while immaterial, is not zero.
• Guidance will be more important than usual, since there are so many moving parts.
• We are looking for information on artificial intelligence and related data points.
• Azure has been generally strong but capacity-constrained. Management has been talking about these capacity issues fading in this quarter and the next.
• Reports have surfaced in the last couple of months that Microsoft is slowing its capex plans.
Fair Value Estimate for Microsoft
With its 4-star rating, we believe Microsoft’s stock is undervalued compared with our long-term fair value estimate of $490 per share, which implies a fiscal 2025 enterprise value/sales multiple of 13 times and adjusted price/earnings multiple of 38 times.
We model a five-year compound annual growth rate for revenue of approximately 13% inclusive of the Activision acquisition. We envision stronger revenue growth ahead as Microsoft’s prior decade was bogged down by the downturn in 2008, the complete evaporation of mobile handset revenue from the disposal of the Nokia handset business, as well as the onset of the model transition to subscriptions (which initially results in slower revenue growth). However, we believe macro and currency factors will pressure revenue in the near-term.
Read more about Microsoft’s fair value estimate.
Economic Moat Rating
For Microsoft overall, we assign a wide economic moat, arising primarily from switching costs, with network effects and cost advantages as secondary moat sources. Based on the company’s segments, we believe the productivity and business processes, or PBP, and intelligent cloud, or IC, segments have earned wide moats, and the more personal computing unit warrants a narrow moat. We believe Microsoft’s moat will probably allow the company to earn returns in excess of its cost of capital over the next 20 years.
We believe customers value Microsoft’s products as stand-alone solutions and for the company’s immense product breath, and these applications are tightly integrated with one another. In our opinion, the strength of these products is crucial but should not overshadow the importance of all the solutions being offered under one umbrella by Microsoft as customers are usually looking to consolidate vendors. These factors combine to reinforce our wide moat. As Microsoft offers a wider set of related and compelling solutions, we believe it becomes more deeply entrenched in its customers as they adopt multiple products
Read more about Microsoft’s economic moat.
Financial Strength
We believe Microsoft enjoys a position of excellent financial strength arising from its strong balance sheet, growing revenue, and high and expanding margins. As of June 2024, Microsoft had $76 billion in cash and equivalents, offset by $52 billion in debt, resulting in a net cash position of $24 billion. Gross leverage is at 0.5 times fiscal 2024 EBITDA. Our base case assumes that revenue grows at a healthy pace, driven by Azure public cloud adoption, Office 365 upselling efforts, AI adoption, and broader digital transformation initiatives. We see strong margins improving further over the next several years. Free cash flow margin has averaged 30% over the last three years, which we expect to generally improve over time.
Read more about Microsoft’s financial strength.
Risk and Uncertainty
We assign Microsoft a Morningstar Rating of Medium. Microsoft faces risks that vary among the products and segments. High market share in the client-server architecture over the last 30 years means significant high margin revenue is at risk, particularly in OS, Office, and Server. Microsoft has thus far been successful in growing revenues in a constantly evolving technology landscape and is enjoying success in both moving existing workloads to the cloud for current customers and attracting new clients directly to Azure. However, it must continue to drive revenue growth of cloud-based products faster than revenue declines in on-premises products.
Read more about Microsoft’s risk and uncertainty.
MSFT Bulls Say
• Public cloud is widely considered to be the future of enterprise computing, and Azure is a leading service that benefits the evolution first to hybrid environments and ultimately to the public cloud.
• Microsoft 365 continues to benefit from upselling into higher-priced stock-keeping units as customers are willing to pay up for better security and Teams Phone, which should continue over the next several years.
• Microsoft has monopoly like positions in various areas (OS, Office) that serve as cash cows to help drive Azure growth.
MSFT Bears Say
• Momentum is slowing in the ongoing shift to subscriptions, particularly in Office, which is generally considered a mature product.
• Microsoft lacks a meaningful mobile presence.
• Microsoft is not the top player in its key sources of growth, notably Azure and Dynamics.
This article was compiled by Gautami Thombare.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
