Thinking of buying Microsoft? Here’s what you need to consider

The technology sector continues to stumble around the ring after absorbing multiple punches in recent months and that includes Microsoft (Microsoft Stock Quote, Charts, News, Analysts, Financials NASDAQ:MSFT), which is off about 22 per cent since the start of the year. 

Investors might be thinking the stock is now in Buy territory, but there are a number of considerations at play, says portfolio manager Teal Linde. Even with the company still showing strong growth, Linde isn’t sure how the market is going to react to MSFT, the $2-trillion market cap company which despite the rough patch over the past six months is still in the black for the past 12, unlike much of the big American tech names.

“Microsoft has certainly been having a great run,” said Linde, manager at Linde Equity Fund, who spoke on a BNN Bloomberg segment on Monday. “Their business model is quite different from, let’s say, Google and Facebook in that they actually offer software and they have a tremendous amount of recurring revenue. And so, they don’t really rely on advertising, so from that respect it’s an enviable business to own.”

“Whether it’s going to have much more downside, that’s a good question to ask,” he said.

The past half-year has clearly been a challenging time for technology investing, as market sentiment has shifted away from embracing growth stocks and pandemic-friendly names in industries such as e-commerce, IT and software and sought shelter in more defensive and value plays. Rising interest rates are part of the picture but they don’t tell the whole story. The unprecedented flow of money into the markets over 2020 and 2021 must also be taken into account, when investing in anything with a pulse seemed like a solid approach.

Now, with government stimulus receding and the pandemic seemingly in retreat we have the dawn of a new day and with it the hangover and regret of all that excess. The result is a general market pullback and one which has hit technology extra hard. Currently, the tech-heavy NASDAQ is down by a full 25 per cent year-to-date compared to the broader S&P 500 which is off a still substantial 16 per cent.

And it’s those shifts in sentiment over the past year that make it tough to figure out the new normal when it comes to valuations in tech stocks like Microsoft.

Linde said, “Microsoft ten years ago was trading around 13x-14x earnings and the run-up was not just with earnings and revenue growth but there’s been considerable multiple expansion where the stock has gone up to about 30x earnings.”

“And what you’ve seen with the stock market over the last several months is multiple compression — multiples have been shrinking across the across the board for many companies and Microsoft has been susceptible to part of that,” he said. “So, you don’t know. Right now, the valuation is in the mid to upper 20s. Could the P/E ratio drop to 20x or 18x? You just don’t know.”

Microsoft released its most recent quarterly numbers in late April where its fiscal third quarter 2022 showed revenue up 18 per cent year-over-year to $49.4 billion and net income up eight per cent to $16.7 billion. EPS was up nine per cent to $2.22 per share. Both the top and bottom lines were a bit better than expected, as the consensus calls were for revenue of $49.05 billion and EPS of $2.19 per share.

Microsoft’s cloud computing segment which includes Azure saw revenue rise by a full 46 per cent over the Q3.

“Going forward, digital technology will be the key input that powers the world’s economic output,” said Satya Nadella, chairman and CEO in a press release. “Across the tech stack, we are expanding our opportunity and taking share as we help customers differentiate, build resilience and do more with less.”

Linde says if Microsoft can maintain its growth rate, that could justify considering the stock to be cheap at current levels, but if there’s a slowdown in the company’s revenue and earnings growth, say, from somewhere in the teens to single digits, it could result in multiple contraction.

“It’s a difficult stock because it’s hard to tell how many more companies out there are going to be buying Azure and what the pipeline is,” Linde said. “That’s why we like retail stores, for example, like Aritzia. You know how many stores they have, you see how many stores a company can get to and you can sort of see what the runway is and the visibility. With Microsoft we still haven’t figured it out.”

“We talk to people in the industry and try to get an idea of how much more growth there is, how much more capacity and how much more appetite that companies have for their software. Once we get a better idea on that maybe we can make a decision,” he said.