Is Microsoft Overvalued?

Summary

  • Microsoft stock has been on a nearly unimpeded rally over the past two years and has beaten the S&P by a wide margin.
  • But in this time, Microsoft’s earnings haven’t grown much at all. Earnings growth is weighed down by declining margins, the strong U.S. dollar, and slowing emerging market growth.
  • At 19 times forward earnings, Microsoft stock is valued at levels not seen in years. As hard as this is to say, I think Microsoft is overvalued right now.

Tech giant Microsoft (NASDAQ:MSFT) has traditionally been one of the cheapest blue chip tech stocks. For many years, Microsoft was dogged for its over-reliance on the personal computer, and this pervasive bearishness kept its valuation multiples at low levels, frequently in the low double-digits.

That is, until recently. Thanks to the advancements Microsoft has made in growth areas like the cloud, investors have rewarded the stock with a lofty valuation multiple.

After a prolonged period of trading in a relatively tight range, Microsoft stock is up 26% in the past year, while the S&P is down 5% in the same time. Investors have recently become very enthusiastic about the future growth possibilities, but the reality is that Microsoft’s earnings growth hasn’t kept up with rising expectations. The result is that at this point, Microsoft trades for a higher valuation than it has at any point in the past five years.

I wrote about Microsoft several times in the past year, including this article in April and this article in July, in which I advised investors to buy the stock because of how cheap it was. Microsoft has performed strongly since those recommendations. Now that the stock is at $52, it’s no longer cheap. I believe buying at this level will set up investors for only mediocre annualized returns going forward. I can’t believe I’m saying this – but Microsoft appears overvalued.

Earnings Aren’t Keeping Pace With The Stock Price

To be sure, Microsoft is no longer the same company that traded for a 10-12 forward P/E. It has made demonstrable progress in breaking away from the PC, and has made huge inroads into higher-growth areas. Due to the success of cloud-based platforms like Office 365 and Azure, Microsoft’s commercial cloud revenue soared 96% in the fourth quarter of fiscal 2015, and has now exceeded an $8 billion annual run rate. Microsoft’s revenue growth in recent years has been impressive: the company grew revenue by 7.8% in fiscal 2015, and by 11% in fiscal 2014.

The problem is that Microsoft has had to spend increasing amounts of money to obtain this revenue growth. This has weighed on Microsoft’s margins and the result has been weak, almost non-existent earnings growth. Even when excluding the billions in impairment charges taken against GAAP earnings in the past few years, Microsoft’s adjusted non-GAAP earnings have flat-lined. For example, Microsoft earned $2.62 per share in 2013, $2.64 per share in 2014, and $2.63 per share in 2015.

Microsoft hasn’t gotten off to the best start in fiscal 2016 either. Revenue declined 6%, while earnings grew just 3% in the first quarter, year over year. Microsoft is getting hit by many of the same headwinds that are causing other tech stocks to plummet – namely, the strengthening U.S. dollar – and slowing economic growth in emerging markets like China. But while most other tech stocks are declining to reflect these challenges, Microsoft shares keep rallying. That should be a concern to investors buying at these levels.

Microsoft has beaten the S&P 500 by 37 percentage points in the past two years, despite virtually no earnings growth in that time. That has elevated Microsoft’s valuation to levels not seen in years. At 19 times forward earnings, expectations are simply too high. The other adverse effect of Microsoft’s bloated valuation is that it has lowered the dividend yield, to 2.5%. In other words, investors aren’t getting a very good buying opportunity at this price, either from a value or income perspective.

Microsoft: Good Company, Not-So-Good Stock

What made Microsoft such a compelling buy in my previous articles – its dirt-cheap valuation and 3%-3.5% dividend yield are no longer there. Microsoft remains a highly profitable company. But there are many cases in which a strong company can amount to a poor investment if too high a price is paid for its future earnings growth.

The great thing about buying great companies when they’re cheap is that the future expectations are so low that the company doesn’t have to get everything right in order for investors to earn decent returns. That’s why Microsoft stock was a much better buy when I wrote about it in previous articles. Expectations were very low, and the dividend yield was much higher, which meant the future return potential was greater. However, the flip side of this dynamic is also true: Microsoft now has higher expectations than at any point in the past five years.

At 19 times forward earnings, I believe the stock doesn’t offer much of a margin of safety. As a result, I’d wait for a decent pullback of 10%-20% – at least to a forward P/E multiple in the mid-teens – before jumping in.

Disclaimer: This article represents the opinion of the author, who is not a licensed financial advisor. This article is intended for informational and educational purposes only, and should not be construed as investment advice to any particular individual. Readers should perform their own due diligence before making any investment decisions.

The above article originally appeared on Seeking Alpha, written by Bob Ciura.

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XBOX ONE PRICE DROPS TO $299 FOR SPRING SALE

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Starting this Sunday, March 20, Microsoft has announced that Xbox One will drop to $299 – and $50 will be knocked off of all official Xbox One bundles – for a “limited time”.

Announced on the Major Nelson blog, the sale is the cheapest official price Xbox One has held and, for now, the price cut has no stated end date.

The price cut coincides with the Xbox Spring Sale – beginning on March 22 – which will discount over 150 items in the Xbox Store, including PC titles. It might well be worth checking out IGN’s top 25 Xbox One games to scope out some potential purchases.

Yesterday, Microsoft revealed two new special edition Xbox One controllers, Dusk Shadow and Copper Shadow.

Microsoft: What’s Up With Xbox?

Summary

Microsoft wants to end the console war for good – and might actually be able to succeed.

The individual pieces are in place, but MSFT has struggled to execute similar strategies in the past.

Xbox could slingshot ahead in the PC gaming space if the strategy works.

Introduction

Phil Spencer, head of Xbox for Microsoft (NASDAQ:MSFT), recently announcedthe shift to “Universal Windows Applications” and a world of Xboxes with “upgradeable” hardware. This would eliminate the need for console generations and convert Xbox into the same hardware utilization model enjoyed by PC gamers.

This is a huge shift in strategies and represents a unique opportunity for Microsoft to gain an advantage over Sony (NYSE:SNE). In actuality, this ends the console war (which is already over in favor of the PS4) and shifts the competitive landscape. Microsoft would be more at odds with Valve Software’sSteam platform, Blizzard (NASDAQ:ATVI) Software and League of Legends than the Sony PlayStation. If successful, this strategy could leave Sony behind, depending on how PlayStation adjusts to the new market dynamics.

In this article, I attempt to explain the nuance of this strategy as well as the pros and cons and what it means to Xbox in the future.

Source: Ars Technica

Consoles Versus PC Gaming

The typical (and longstanding) debate of which is superior – PC versus Console – goes something like this:

Consoles offer a “closed system” that is an inexpensive (compared to PC gaming) and reliable way to get into video games. Software is specifically designed to work on the console hardware, games (generally) run pretty well, and there is little to no major troubleshooting or technical fidgeting to get things working.

Additionally, the console offers about 5-7 years of life where you do not need to worry about upgrading the hardware. Developers generally design their games around whatever hardware limitations might exist. Generally, the console hardware is outdated at time of release compared to PC, and by the end of the console generation, the hardware is easily 3-4 iterations behind what is available to the average consumer in the PC market.

On the PC side, hardware costs are typically higher, but the user is offered a range of flexible options and a very “open” hardware ecosystem that can be upgraded over time. Games may or may not work on particular hardware depending on how outdated it is, but if you want the highest definition experience, you can upgrade into whatever works with your current configuration. Also, games are not tied to your specific machine, and if you upgrade to something better, you can take your library with you easily and play all of your old content.

Console games tend to be more expensive than their PC equivalents, and more physical copies are sold on the console versus the PC, which is dominated by various digital content delivery services. Steam and other digital distribution platforms occasionally run crazy sales where incredible deals can be found at prices consoles rarely ever see. Also, the library of games that a PC has access to is far larger than any console library. PC games can also include higher complexity that utilize the mouse and keyboard interface (PC gamers have been known to call console users “peasants” from time to time).

In years past, console exclusive software releases have played a major part in driving the sales of one machine over another, but in the current generation, the majority of games are released multi-platform (with the major exclusion of any Nintendo (OTCPK:NTDOY) or Sony first-party releases).

For more information on the typical PC versus console generational gap, please refer to the graphic below or this ExtremeTech article. As you can clearly see in the graphic, the PC performance graph takes a “linear” approach. The console is more of a “stair step” by generation. Essentially, Microsoft is positioning itself to convert Xbox from the console line to the PC line.

Breaking Down The Strategy – Key Concepts

The “immortal Xbox” strategy is clearly an attempt to convert the Xbox console into a “PC gaming” machine, but the early indications are the universal Windows application/Xbox ecosystem would be the only available content to play. It is unclear whether MSFT would eventually open the Xbox ecosystem to the Steam library or other non-Microsoft stores, but it is highly unlikely as it would seriously damage Microsoft’s ability to sell software through its own content distribution service.

In theory, Microsoft’s strategy makes perfect sense as the console/PC gap has been shrinking little by little every generation up to the present day where the Xbox One and PS4 are basically PCs in everything but name and operating system (even less so on the Xbox One which runs Windows).

The concept of upgradeable consoles is not new (and it has always failed in prior attempts) if you remember the days of the 16-bit era when Sega had the 32x and the 64-bit era when Nintendo released the 64DD for the N64. Those consoles were far different than the current generation which offers digital downloads and far superior scalability of software. If Microsoft handles this correctly, each game could have an “upgrade/downgrade” graphics option depending on what level of Xbox it detected, similar to the graphics option settings found in nearly every PC release. This would be far simpler for developers to build around.

Currently, Xbox One is far behind the PS4 in the console race. This strategy shift could put Microsoft back on equal footing and “one up” Sony sling-shotting Xbox ahead after an upgrade cycle or two (while the PS4 continues to chug on the original release hardware).

Sony will have a challenging time matching MSFT’s strategy as it does not have the giant Windows OS installed base. One option Sony could have would be a “PS4/2” with full backwards compatibility and compatibility with the Steam Linux marketplace. At some point in the future, all the consoles could be technically streamlined “Steam boxes” that may have console-specific exclusives as an incentive to purchase a particular brand.

Potential Pitfalls

There are some potential pitfalls to Microsoft’s strategy. One issue will be the PC gaming user base is heavily invested into the Steam store as well as other specific individual platforms, such as League of Legends or Blizzard’s various franchises. Valve has a huge share of PC game digital distribution, and owns a big chunk of the market share (around 15%). These users will have a hard time abandoning their content libraries and “open” PC hardware to shift to a “Windows store” if the Xbox hardware restricts access. Previous attempts by Microsoft to entice PC gamers into its content distribution platforms have not gone well (Games for Windows was an abomination), and the current Windows store also has major issues if it wants to compete.

If Microsoft thinks gamers will flock to the Windows store and it does not release a Steam-competitive content marketplace, the effort will most certainly flop. Also, the console user base prefers the console experience for a reason – it is reliable and inexpensive compared to alternative options. Adding the complexity of some games not working or suffering from inferior performance without the right “upgrades” will further fracture the user base and turn off the average console user. As I mentioned previously, the console upgrade concept was attempted previously by Sega, Nintendo, and Atari, and it did not go very well. Perhaps, Microsoft can overcome the marketing and technical failures of previous generations, but it should definitely be careful.

Upside Potential/What Does This Mean For MSFT?

The PC gaming market is estimated to be worth around $27b. If Microsoft successfully implements its strategy, it will give it a huge advantage in the next console cycle as the company will be removing Xbox from a head-to-head battle with the next-gen PlayStation. Bridging the console-PC gaming divide would be a major win if it was accomplished, especially if a best of both worlds result gave us flexible and open-ended hardware with the reliability and ease of use of the typical console. Microsoft may figure out the “Steam box” before Valve does.

MSFT could finally be leveraging its native advantage of Windows OS installed base over Sony, but we should be skeptical until further details of the strategy are revealed. The fusion of the PC gaming market and console market will give access to significantly more potential users and a strategic edge to Microsoft that would not be easily duplicated by any of its competition. Also, Xbox upgrades could give Microsoft a future advantage in the VR space if it provides an easier or lower barrier to entry for average users.

Currently, details are sparse, but the future success of Xbox hinges on Microsoft’s ability to execute. Be on the lookout for more news with special consideration for the content delivery restrictions and “hardware upgrade” specifics before placing a bet on the future of Xbox.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Article originally posted on Seeking Alpha

The Key To Holding Microsoft Stock

Summary

  • Microsoft’s $1 billion donation, over three years, includes software as well as cloud services.
  • The donation will tie thousands of thought leaders to the company’s software offerings.
  • It’s a good move that highlights just how much excess cloud capacity is out there.

microsoftMicrosoft (NASDAQ:MSFT) made headlines this week by saying it will donate $1 billion in cloud computing services to non-profits.

It’s a good thing to do, but it highlights just how much excess cloud computing capacity exists.

Ever since Amazon.Com (NASDAQ:AMZN) began reselling cloud capacity based on technologies originally pioneered by Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Yahoo (NASDAQ:YHOO), companies offering the new infrastructure have had to invest well ahead of demand. That’s why Amazon dominates the market, alongside Google and Microsoft itself. These companies have internal demands for cloud that help justify the huge capital expense – as much as $1/quarter – the technology demands.

The result has been a revolution but, for most, a revolution without profit. Major players, again led by Amazon, have gone through repeated price cuts, with prices starting at free, in order to squeeze out competitors and maintain market share.

The strategy has worked, despite the absolute imperative of cloud to major enterprise players. Hewlett-Packard’s (NYSE:HPQ) decision, before spinning off its Enterprise (NYSE:HPE) unit, to get out of public cloud is just one decision among many. Yahoo’s inability to compete is due to its lack of other revenue with which to subsidize expansion. Other companies, while advertising cloud platforms heavily, have nevertheless kept their investment (and thus their potential market share) down. In order to report a profit Rackspace (NYSE:RAX), which pioneered the modern cloud movement as the original sponsor of OpenStack, cut way back on new capacity investment.

Even today, no one in this market will tell you just how much of its cloud capacity is being occupied by customers at any one time. Load factors are a secret, and while the excuse is they’re constantly changing anyway, they could be estimated if providers wanted to do that.

My guess, based on an unscientific survey, is that it’s in the single digits. Most of the time, less than 10% of cloud capacity is in use. So giving it away costs nearly nothing.

The Microsoft move, first announced by President Brad Smith and CEO Satya Nadella, is to donate capacity over 3 years to a list of 70,000 non-profits, including 900 university researchers, through Microsoft Philanthropies. This will include not just the Azure cloud, but Microsoft’s CRM program and its Microsoft Office suite, meaning a lot of people are going to go out into the world dependent upon, and knowledgeable about, Microsoft’s software offerings.

Microsoft reports earnings next Thursday, and analysts are expecting earnings of 71 cents per share on revenues of $25.22 billion, although there’s a whisper number of 75 cents.

The stock has held up fairly well during the January market frost, down just 8.5%, and despite the fall its price/earnings multiple remains a robust 34. Whether it continues to gain this year depends heavily on whether Nadella can get hardware sales up, like the Surface Pro and Lumia Phone, while continuing to keep traffic moving through Azure with moves like the donation and yet-another recent price cut.

The key to continuing to hold the stock is recognizing that the Microsoft cloud is a successful loss-leader for software and services, a defensive move in a glutted market.

The above article originally appeared on Seeking Alpha, written by Dana Blankenhorn.