There are reasons to at least suggest caution toward Microsoft (NASDAQ:MSFT) stock at the moment. With the MSFT stock price at an all-time high, valuation could be a concern. It was only a few years ago that Microsoft stock was trading at something like 13-times earnings. That multiple now has doubled.
To be sure, I’d expect the gains in Microsoft stock will moderate. The MSFT stock price has rallied 45% so far this year, adding nearly $350 billion in market value in less than 11 months. It’s difficult to see that repeating over the next ten-plus months.
Still, before Microsoft’s fiscal Q1 earnings report last month, I asked what could stop the rally in Microsoft stock. The two most likely answers were the company’s Azure cloud platform and a reversal in U.S. stocks as a whole. The news right now looks positive on both fronts. And that suggests the gains in MSFT stock could, and indeed should, continue.
The Boost from Azure
The importance of Azure to the MSFT stock price likely is greater than some investors realize. Microsoft still hasn’t broken out exact revenue for the platform, but one analyst estimated fiscal 2019 revenue of $13.5 billion.
That figure no doubt is higher after Azure grew a healthy 63% year-over-year in the first quarter of fiscal 2020. That growth rate is down from the 90%-plus rates Azure was posting just a few quarters ago. But in the context of the space and the sheer size of the business it’s still impressive.
To be sure, Azure has a long way to go to catch the cloud leader, Amazon.com (NASDAQ:AMZN). But Azure is taking market share. According to Amazon’s 10-Q, Amazon Web Services revenue increased 37% year-over-year in its third quarter (which matches Microsoft’s fiscal first quarter).
Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) doesn’t break out its cloud revenue, but CFO Ruth Porat said on her company’s third conference call that “other” Google revenue rose 39%, thanks to Google Cloud and Google Play. Growth rates from smaller rivals like Oracle (NYSE:ORCL) and IBM (NYSE:IBM) too seem to lag that of Azure.
And that growth matters to Microsoft stock. Amazon Web Services is on track for roughly $33 billion in revenue in calendar 2019. Azure should clear $20 billion in Microsoft’s fiscal 2020, which ends six months later.
Yet analysts value AWS at as much as $550 billion. At a similar revenue multiple, Azure would be worth in the range of $300 billion. And that impacts the overall valuation of MSFT stock, even with a market capitalization that now exceeds $1.1 trillion.
Share Gains Can Further Help Microsoft Stock
Meanwhile, Microsoft has catalysts to keep taking share, and keep driving impressive growth in Azure. Microsoft’s win of the federal government’s Joint Enterprise Defense Infrastructure (JEDI) contract over Amazon is a significant catalyst to growth. A Wedbush analyst argued the win by itself could add at least $10 to the MSFT stock price.
JEDI also establishes Microsoft as the clear number two, at worst, to Amazon Web Services. And it sets up a path where Microsoft could take the lead. One of the risks to Amazon’s cloud business is that many potential customers won’t want to work with a competitor, no matter how attractive the product is. And Amazon’s reach is so vast that it likely will limit AWS revenue in industries like retail, grocery, and media.
So, the obvious question for MSFT stock (and for AMZN stock) is, what happens if Azure wins? It’s then that Azure is worth $550 billion and AWS $300 billion (or something in those ranges). And even with a combined market cap between the two companies of roughly $2 trillion, that kind of swing is material to valuation.
The MSFT Stock Price and the Broad Market
Again, Microsoft stock isn’t cheap. Even backing out net cash of about $9 per share, the stock trades at nearly 26-times fiscal 2020 consensus earnings per share estimates. That’s the highest multiple the company has received since early last decade.
But Azure changes those calculations. Again, Microsoft hasn’t detailed revenue or profit from the business. But it’s likely Azure will account for well less than $1 per share in Microsoft’s fiscal 2020 earnings. Even 30% operating margins, above those of AWS, would suggest an EPS contribution this year in the range of 65 cents — and again, that’s likely an aggressive estimate.
If Azure is worth $300 billion (admittedly a rough estimate), then the rest of Microsoft simply isn’t valued all that highly. Backing out approximately $67 billion in net cash and the $300 billion assigned Azure, the rest of the company trades at a roughly 20-times price-to-earnings multiple.
That multiple hardly seems aggressive given Microsoft’s dominance in software and potential hardware growth from the Surface line. And it creates a path for upside in MSFT stock if investors value Azure more highly, as could be the case after the JEDI win, and apply a higher multiple to the rest of the Microsoft business.
That said, it’s worth noting that the other risk — broad market weakness — persists. U.S. stock markets are at all-time highs at this writing, but there are external risks. But MSFT stock likely would take a hit in a pullback, as it did during last year’s fourth quarter. And even with Apple (NASDAQ:AAPL) having passed Microsoft as the world’s most valuable company, index fund selling alone can move the MSFT stock price given its huge level of passive ownership.
But of course, most stocks have the same downside risk; in fact, most stocks likely have greater risk in this market. And, the potential rewards still are worth those risks. Barring a significant market pullback, MSFT stock still has upside left.
As of this writing, Vince Martin has no positions in any securities mentioned.