Microsoft: A Return to the Dot-Com Era

Jul. Jul 8, 2022 5:07 PM ETMicrosoft Corporation (MSFT)1 Comment7 Likes

Summary

• Microsoft is a tale of market irrationality. Over the years, the stock traded at both enormous premiums and enormous discounts.
• Microsoft's earnings declined for years after the dot-com bubble, highlighting how ruthless cyclicality can be. Could cloud prove cyclical as well?

·         We project a long-term return of 6% per annum for MSFT shareholders, but the story doesn’t end there.

 

The stock of Microsoft (NASDAQ:MSFT) is an example of market irrationality. Despite massive tailwinds, excellent management, and valuable software, Microsoft traded at a P/E ratio of only 20 in 1990. This was not your normal, loss-making IT firm. Microsoft was an aggressive rival on the verge of monopolizing the computer operating system and internet surfing industries with its Internet Explorer. In retrospect, the firm was terribly undervalued.

Moving ahead ten years to the dot-com bubble, Microsoft traded at 60 times earnings. Despite its exorbitant price, Microsoft's growth prospects were substantially weaker than they had been ten years before. This level of fervor could not be sustained, and the bubble popped.

Data by YCharts

After a losing decade for US equities, Microsoft was back on the negotiating table. From 2009 to 2012, the company's P/E ratio stayed around 10. The market had no clue that the cloud would rescue the day, nor did it recognize Xbox and Microsoft Office's endurance and competitive qualities. The rest is history, as Microsoft skyrocketed to over 40 times profits in 2021. What comes next? Let's get started.

The dissertation

What many people forget during the dot-com boom is that not only did tech stocks drop, but so did their earnings. According to a 2001 New York Times story, "Microsoft Profits Fall 42 Percent," the cause was investment losses and declining PC sales. Microsoft's net income did not hit rock bottom until 2002, and it took years to recover:

Data by YCharts

Are today's tech titans immune to such a fall? We think the answer is no. We may sit about extrapolating the past and injecting massive growth rates into our discounted cash flow models, but that's not how the actual world works.

Earnings are cyclical in all nations, sectors, and situations. The cause is simple: capitalism. When earnings continue to rise over several years, it draws competitors. Swarms of new entrants went public between 1999 and 2021, capturing enormous quantities of money from investors. The issue is that new entrants increase competition, which reduces profits. Consumer purchasing is also cyclical; there is a hangover effect when everyone buys a brand new vehicle or laptop at the same time. They won't make another buy for a long time.

MSFT is expected to yield 6% per year over the next decade.

Cloud Computing's Future

The worldwide cloud market is expected to develop at a 15.7 percent annual rate through 2030. This projection was confirmed by multiple study teams. We predict the cloud industry will develop quicker in Asia and emerging regions since adoption is still in its early phases. The United States has already seen widespread adoption of cloud computing, resulting in massive growth in Microsoft Azure and AWS over the last five years.

Microsoft commands a commanding market position.:

Market Share of Global Cloud Businesses (Synergy Resource Group )

Microsoft has a greater network impact than Amazon's (AMZN) AWS. While AWS frequently competes with the businesses to whom it provides cloud services, Microsoft merely supports such businesses. Microsoft is entwined with companies all over the world, and it can combine its cloud services with Microsoft Office to offer a very compelling value proposition. As a result, Microsoft's cloud share is increasing while Amazon's remains stagnant.

We believe that, over the next ten years, the growth prognosis is more favorable for cloud businesses such as Alibaba (BABA) and Tencent (OTCPK:TCEHY), who have a longer runway to gain worldwide market due to the aforementioned under-adoption. These businesses are expanding their reach throughout rising Asia. Because its market share is concentrated in slower-growing countries, Microsoft will have to work to keep it. Azure's margins may potentially fall as additional competition joins, but the value proposition should endure.

The Past and Future of Growth

Data by YCharts

Since 2000, Microsoft's profits and operational cash flow have risen at a compound annual rate of 9.5 percent. The organization has seen both quick and slow growth during the last five years. Cloud is what has driven the tremendous growth over the last five years, but like PCs in the late 1990s, this growth might stagnate. Large corporations find it extremely difficult to develop at a rate faster than 10% per year for an extended length of time.

Analysts predict that Microsoft will earn $12.05 per share in 2024:

Microsoft EPS Estimates (Nasdaq)

Long-Term Gains

Our price prediction for MSFT in 2032 is $438 per share, implying a 6% annual return with dividends reinvested.

After examining Microsoft's growth engines, we feel it is prudent to predict Microsoft's growth will revert to its long-term average. If we expand Microsoft's 2024 profits per share by 9.5 percent every year, we receive $25 per share in 2032. We used a terminal multiple of 17.5 for a company that would compound slower as it grows in size but has extraordinarily long-lasting competitive advantages.

Conclusion

A look at Microsoft's past reveals not just the risk and reward for MSFT shareholders, but also for the larger market. Earnings have been shown to be cyclical in all nations and industries; it is simply the nature of capitalism and our modern economy. At times, both the high and low sides of the market are exceedingly illogical. Microsoft had previously traded at a P/E of 10x earnings and 60x earnings. Cloud computing is the era's sector, but Microsoft's cloud expansion will ultimately halt. Despite this, we've estimated a 6-percentage-point annual return using cautious assumptions. This return should outperform both the treasury and the market, thus we rate the stock as "hold." Microsoft shareholders may rest easy. MSFT has been a fantastic investment throughout the years, and the company's strong tailwinds and competitive advantages should lead to long-term compounding.