(Note: The author of this fundamental analysis is a financial writer and portfolio manager.)
Microsoft Corp.'s (MSFT) resurgence in recent years has been driven largely by soaring revenue growth in its cloud business, helping to propel the company’s market capitalization to one of the world's highest -- at more than $800 billion. Investors expect CEO Satya Nadella to report that cloud sales, again, enabled Microsoft to post strong earnings and revenue growth in its fiscal 2019 second quarter. Investors also will want to know how Microsoft's cloud business if faring against formidable rivals such as Amazon.com (AMZN). Microsoft reports on January 30.
Microsoft's cloud service, which generates growth across several business units, accounted for 29% of revenue in the latest quarter and illustrates the company's successful transition to the world of Internet-based computing. The company also has seen strong growth in other businesses such as its Windows, xBox and video game product lines.
Analysts estimate that earnings grew almost 14% on a 12% gain in revenue to $32.5 billion in the latest quarter. Estimates for earnings and revenue have been trending higher since Microsoft reported fiscal first quarter results in October.
Strong Growth Driven by The Cloud
Microsoft's outlook is bright beyond the latest quarter. Analysts forecast revenue and earnings growth will be strong over the next two years, with earnings rising an estimated 15% on a 13% increase in revenue to $124.6 billion in fiscal 2019 ending June.
The substantial revenue and earnings growth of late is mostly the result of the company success in its cloud business, which grew by 24% to $8.6 billion in the fiscal first quarter. While Microsoft has become one of the dominant cloud players, it faces major challenges in fending off arch-rival Amazon. Its web services unit, known as AWS, is quickly gaining ground on Microsoft’s cloud business. Microsoft’s future success will be determined in large part by how far its cloud business can continue to grow.
One of the most significant drawbacks for Microsoft investors is the stock's valuation. The equity currently trades at a PE ratio for fiscal 2020 at 21.5. That is a higher PE ratio than the broader S&P 500, which stands at roughly 16. Additionally, when adjusting the stock for its earnings growth rate, the PEG ratio is also high at 1.6. It makes the stock slightly overvalued given analysts’ current growth forecasts.
The options for expiration on February 15 indicate low volatility for the stock following results. The long-straddle option strategy suggests that the equity may rise or fall by 7% from the $105 strike price. That would place the stock in a trading range of $98 to $112 by the middle of February. However, it's worth noting that the number of bullish calls outweighs the bearish puts at the $105 strike price by nearly 2 to 1, with roughly 20,000 open call contracts. A buyer of those calls would need the stock to rise to nearly $109 by expiration in the middle of February to earn a profit.
Microsoft's technical charts look much weaker than the options data. The chart shows that the stock has been trending lower since peaking in early October. Should the stock fall, it is likely to drop to technical support around $97. That is the price the stock fell to during the steep stock market sell-off in late 2018.
Another negative sign for the stock is that the relative strength index has been trending lower since reaching overbought levels above 70 in November 2017. It has created a bearish divergence, and that would suggest that the shares are likely to continue to decline in the future.
So while the outlook for Microsoft's cloud business is robust, it's a very different story for the stock. The company may need to post faster growth in the cloud or other units to boost Microsoft's shares. Should the company disappoint by the slightest bit, the stock could pull back sharply short term.
Michael Kramer is the Founder of Mott Capital Management LLC, a registered investment adviser, and the manager of the company's actively managed, long-only Thematic Growth Portfolio. Kramer typically buys and holds stocks for a duration of three to five years. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Past performance is not indicative of future performance.