August 22, 2016

Microsoft’s Confidence In The Cloud Signals Equity Upside Potential


Summary

  • Microsoft Corporation is expected to experience marginal declines in Adjusted ROA levels, but management’s confidence in the strength of their cloud platform implies that this is unwarranted.
  • MSFT is trading at a 21.1x V/E’, near historical averages, but at the high end of recent valuations.
  • At these valuations, the market is pricing in expectations for a relatively flat ROA’, marginally declining from 25.2% in 2015 to 24.2% in 2020, accompanied by 4.6% Asset’ growth.
  • Macroeconomic tailwinds and management’s confidence in the strength of their cloud offerings relative to peers indicate that market expectations may be unwarranted, and that equity upside is likely.

MSFT - PVP - 2016 08

MSFT has historically seen stable Adjusted ROA (ROA’) performance, ranging between 25%-46% levels from 2000-2015. However, ROA’ has declined in recent years, from 35.5% in 2011 to 25.2% in 2015. Adjusted Asset (Asset’) growth, while aggressive in the firm’s early years (averaging around 24% from 2000-2003), has tapered off significantly. Asset’ growth has remained in a low range of 1%-10% since, with the exception of -9.6% in 2007 when the company completed a material share buyback, and 22.9% in 2009 when the company made a number of acquisitions, including BigPark, DATAllegro, and Zoomix.

Performance Drivers – Sales, Margins, and Turns

It can be helpful to break down ROA’ into its DuPont formula parts, Earnings’ Margin and Asset’ Turns, which are the cleaned up margins and turns metrics used to calculate ROA’. The chart below details both Earnings’ Margin and Asset’ Turns historically, to help us better understand the drivers of the firm’s profitability and performance.

MSFT - SMT - 2016 08

Valuation Matrix – ROA’ and Asset’ Growth as Drivers of Valuation

When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential overvalued or undervalued prices for MSFT at various levels of profitability (in terms of ROA’) and growth (Asset’ growth.) Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.

MSFT - VM - 2016 08


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