Description

I am recommending MSFT ($108) as a long.  While stock performance has been strong, I believe that MSFT’s transformation is still underappreciated.  The business trades at a reasonable absolute valuation:  12.3x EV / FY 2020 EBITDA and 16.2x FY 2020 FCF (ex net cash).  MSFT’s fiscal year ends in June.  What I like most about the business is that it is steadily becoming more of a subscription business.  These businesses trade well in excess of 25x FCF.  The crux of my thesis is the following:

• A company once known for selling software in lumpy product cycles is steadily becoming an annuity/subscription company:  54% of total revenue is annuity/subscription-like currently, growing to ~60% by FY 2020.

• Tremendous tailwind in cloud (Azure) revenue growth, with margins inflecting higher due to economies of scale

• Over 3 years, revenues have grown from $420 million (FY end June 2014) to $7.4 billion (FY end June 2018)

• For the quarter ended June 2018, revenues grew by 98%

• Company believes over time, an operating margin of 30% (similar to Amazon’s AWS business) is achievable

• Channel checks have been extremely encouraging, particularly regarding MSFT’s hybrid cloud strategy, where MSFT has seamlessly integrated their on-premise servers to their cloud offering

• Companies can choose what parts of their business they want to remain on premise and what to migrate to the cloud, enjoying a uniform computing experience

• MSFT is uniquely advantaged here due to their massive installed base of on-premise servers today and enterprise salesforce

• Increasingly, customers are wary of using Amazon to be their cloud partner due to Amazon’s own encroachment into a wider array of industries (retail, healthcare, financial)

• Microsoft Office is becoming a cloud/subscription business

• Office 365 is in the midst of a subscription transition:  well over 50% of its total revenue is now coming from subscriptions (vs traditional license revenue)

• Office overall should grow ~10% for the foreseeable future, through healthy seat growth (gaining solid traction selling to front-line workers like cashiers and factory workers for low-end products such as email access) and ARPU growth (as companies migrate up the value stack to incorporate more premium services, such as enhanced security and collaboration tools), offset by declining traditional licenses

• Microsoft Office, together with Dynamics (MSFT ERP/CRM software suite that is experiencing the same success transitioning to subscription, has a growth algorithm similar to ADBE and ADSK.  Those companies trade at valuations well north of 25x FCF. 

With continued solid growth at Office and Dynamics (with increasing exposure to subscriptions), and the cloud business continuing robust growth with margins inflecting higher, I believe revenue can grow high single digit % and EBITDA can grow low to mid teen % over the next several years.

Attractive current valuation:

12.3x EV / FY 2020 EBITDA

16.2x FY 2020 FCF (net of “net cash”)

I believe that MSFT will earn a multiple more commensurate with subscription-oriented businesses, such as Adobe and Autodesk, which trade well in excess of 25x FCF (net of cash).  MSFT will never be 100% subscription, and they do have roughly 20% of EBIT still coming from Windows, which is a flattish business.  The good thing here is that 20% exposure should go down every year as the rest of the business grows and as profitability inflects in the cloud business.  Net-net, I do not think it is heroic to assume that MSFT should deserve a 22x FCF (net of cash) multiple, particularly for a company with such a healthy balance sheet, growing revenue in the high single digit % range, and margins trending in the right direction.  At 22x, MSFT would be worth $141, or 33% upside including the dividend.  

Catalyst

• Cloud margins continue to inflect
• Exposure to Windows franchise continues to decline