Thesis in a Nutshell
Microsoft (NASDAQ:MSFT) crushed its Q3 2022 earnings in its latest earnings release on the 4th of May. Since then, most of the discussions are centered around Azure and have overlooked its second and third highest revenue growth sub-segments in MSFT’s Productivity and Business Processes segment – Dynamics products (including Dynamics 365) 365 and LinkedIn. I shared similar views with many of the analysts on Seeking Alpha regarding the growth and outlook on Azure. However, I believe the sub-segment growth of Dynamics products and LinkedIn is overlooked and will experience exponential growth in the coming years due to the current economic climate.
Those sub-segments currently account for less than 10 percent of MSFT revenue but they capture a small segment of the total addressable market (TAM) at the moment. Those sub-segments are expected to grow exponentially in the years to come as their market share increases and account for a significant portion of MSFT revenue in the coming years. Those trends are also briefly mentioned in MSFT Q3 earnings call.
Although MSFT’s revenue and earnings are expected to grow rapidly, my valuation model indicates that MSFT is fairly valued at the moment and does not offer an asymmetric risk-reward opportunity for investors even if it achieves the higher end of its guidance for Q4 2022.
Why The Growth Opportunity Exists
In a world of inflation, supply chain disruptions, rising costs, and upward salary pressure, companies operating expenses (OPEX) are projected to increase significantly. Moreover, the Federal Reserve anticipates 6 rate hikes till the end of the year, and several economists are predicting stagflation reminiscent of the 1980s. As a result, businesses need productivity software more than ever due to the deflationary impact it can provide. Despite all these headwinds, analysts are still projecting a linear increase in many companies’ top and bottom-line growth (including consumer discretionary). Although Wells Fargo project a recession as a base case, many analysts’ estimates are not revised and still forecast growth in revenue and EPS for most companies.
MSFT also made a specific mention of this trend in its Q3 2022 earnings call, it cites, “Power Platform has become the leading business process automation, and productivity suite for domain experts,” and “its revenue has grown more than 72 percent year over year, surpassing the two billion revenue mark.” Moreover, Dynamic products and cloud services revenue increased by 27%, driven by Dynamic 365 growth of 42%. MSFT CEO Satya Nadella also cites that he had “not seen this level of demand for automation technology to improve productivity because, in an inflationary environment, the only deflationary force is software.”
MSFT also recorded record engagement on its LinkedIn platform, and LinkedIn revenue increased by 38% for the nine months ended March 31, 2021. MSFT attributed the growth to strong demand for its Talent Solutions and Marketing Solutions business. MSFT CEO cites that the LinkedIn Marketing Solution business continues to offer advertisers high reach and ROI. MSFT’s CFO, Amy Hood, cites that she expects LinkedIn revenue growth to be in the high 20s.
Those two business segments are expected to grow rapidly in the current economic climate and prevailing market trends. Those two segments are currently capturing a small portion of their respective market, and there are tremendous growth opportunities for them. I expect them to grow bigger as a percentage of MSFT revenue in the coming years.
MSFT’s recent earnings also validated this trend, where the revenue of LinkedIn and Dynamic 365 comes in as the highest and second-highest sub-segment revenue growth, respectively. In the nine months ended March 31 2022, LinkedIn revenue increased 38 percent, while Dynamic products and cloud services revenue increased 27% (driven by Dynamic 365 growth of 42%) compared to the same corresponding period last year. LinkedIn is set to benefit from this trend as the market-leading B2B marketing platform. The Dynamic business solutions portfolio includes Dynamic 365, ERP, CRM, Power Apps, Power Automate, and others.
Business Process Automation and Productivity Software on the Rise
The macro trends outlined above indicate that businesses need productivity software more than ever due to the deflationary impact it can provide and the pressure to meet analysts’ guidance. In MSFT Q3 2022 earnings call, it cites that it is helping companies like Cracker Barrel and Unilever to predict supply chain constraints before they happen through Dynamics 365. Dynamics 365 is a product line of intelligent ERP and CRM business applications.
It is not surprising that Microsoft Dynamics 365 is growing faster than the MSFT business application market overall, with a growth rate of 42% for the nine months ended March 31, 2022, compared to the same period last year. MSFT’s Accounting Director Amy Hood also cites that there is still a lot of TAM left to go in automation technology in the most recent earnings call.
MSFT Dynamic is part of the Productivity and Business Processes segment, including a range of applications- Dynamic 365, ERP, CRM, Customer Insights, Power Apps, Power Automate, and others. MSFT Productivity and Business Processes segment include Office Commercial, Office Consumer, LinkedIn, server products, and cloud services revenue. The segment made $ 46.764 billion for the nine months ended March 31.
According to the 2021 Wisdoms of Crowd Market Intelligence Study (by Dresner Advisory Services LLC), the penetration of business intelligence remains low across multiple geographies- Asia Pacific and Europe, Middle East, and Africa (EMEA). Asia Pacific and EMEA regions reported a sub-10 percent penetration of 44 percent and less than 30 percent, respectively (Figure). Corporate spending on BI is also expected to increase with more than 45% of respondents saying they will increase their BI spending next year.
According to a 2022 Fortune Business Insights’ Market Research Report, the global BI market is projected to grow at an 8.7 percent CAGR from $24.05 billion in 2021 to 43.03 billion in 2028. According to the 2022 Gartner Magic Quadrant for Analytics and Business Intelligence Platform, MSFT is named the market leader in BI for the 15th consecutive year According to Trust Radius, Microsoft Power BI also commanded a 36 percent market share in 2021.
MSFT does not provide a revenue breakdown for its Dynamic, ERP, or CRM products in the latest earnings report. The last mention was in 2020 during the BMO Technology Summit Conference, where MSFT’s General Manager of Investor Relations, Mike Spencer, mentioned that MSFT Dynamics’ business revenue was above $3 billion in FY20. MSFT did not give a specific figure but an analyst from BMO Capital Markets, Keith Bachman, estimates MSFT Dynamics revenue to be 3 percent MSFT $ 143.015 billion revenue which translates to $4.29 billion.
MSFT Dynamics sub-segment grew by 25 percent in FY21 and grew by 27 percent in the nine months ended March 31, 2022, when compared to the same period ended March 31, 2021. Assuming MSFT Dynamics’ revenue grew by 27% in FY22, the projected FY22 revenue will be 6.81 billion. That is minuscule compared to the market size of BI, ERP, and CRM. Salesforce reported revenue of $26.49 billion for FY 22, while SAP reported a non-IFRS revenue of €28.232 billion (US $30.24 billion). This indicates there is currently a significant growth opportunity for MSFT Dynamics products. If MSFT continues to innovate and improve its competitive advantage, MSFT Dynamics and associated products will undoubtedly be another Azure in the making. I find MSFT progress reminiscent of Azure growth story in 2014 when Satya Nadella took over as CEO of Microsoft. Many see Microsoft Azure as inferior and ranked far behind Amazon Web Services (AWS) in Gartner Magic Quadrant for Cloud Infrastructure as a Service. Since then, Microsoft Azure has improved its standing on Gartner Magic Quadrant and became MSFT’s fastest-growing segment- Intelligent Cloud. Azure is only marginally behind AWS on the latest Gartner Cloud Infrastructure and Platform Services Review and Ratings.
The growth of the B2B marketing trend
The demand for enterprise software is expected to grow as companies seek to reduce their operating costs in a period of rising costs and improve their digital strategy. I believe enterprise software will capitalize on this trend through increased marketing spending on B2B marketing platforms. This trend is evident in multiple enterprise software companies such as Atlassian, Asana, and Monday.com. In May 2022, Atlassian and Monday.com reported an increase of 30% and 84% in quarterly revenue compared to the same quarter in the prior year. Atlassian Co-CEO Scott Farquhar further added, “we sell into a market that in good times or bad times requires the product that we sell” in their Q3 2022 earnings call. Monday.com also reported an 84% increase in sales and marketing spending to accelerate its customer acquisition effort.
As the spending on enterprise software increases, LinkedIn is set to become one of the greatest benefactors of this trend as the market leader in B2B marketing social media platforms. MSFT quarterly report also credited advertising demand in their Marketing Solution business as one of the factors behind the 38% LinkedIn revenue growth for the nine months ended March 31 2022 when compared to the same period last year.
LinkedIn is a platform with more than 830 million professionals using it, and its revenue grew 38% for the nine months ended March 31 2022 compared to March 31 2021. LinkedIn recorded a revenue of $10.104 billion for the nine months ended March 31 2022, and currently accounts for 6.9% of MSFT revenue. It grows at a rate significantly higher than MSFT’s overall revenue and is likely to increase its significance on MSFT’s total revenue.
I estimate MSFT will deliver the higher end of the Q4 2022 revenue guidance provided in its Q3 2022 earnings transcript. I will use the higher end of revenue, COGS, and operating expenses for my valuation model. Based on my model, MSFT will have annual revenue of $199.605B and an annual EPS of $9.749 for FY 2022. This will represent an 18.75 percent increase in annual revenue and a 21.11 percent increase in annual earnings growth compared to FY 21.
Income Statement (In billions, except per share amounts)
|Nine Months Ended March 31,||2022 FY Estimated Revenue|
|2022||Q4 2022 Guidance|
|Productivity and Business Processes||$46.76||$16.90||$63.66|
|More Personal Computing||$45.30||$14.95||$60.25|
|Less COGS and Operating Expense:|
|Income before income taxes||$63.23||$21.50||$84.73|
|Provision for income taxes||$7.23||$3.87||$11.10|
My valuation model will project an EPS growth of 20 percent annually from FY22 to FY25 at different PE multiples. MSFT currently has a PE multiple of 27.09, and I expect MSFT PE multiple to decrease in the coming years as the Federal Funds rate increases. MSFT PE multiple was around 25x in 2019 when the Federal Funds hovered between 1.5 percent to 2.25 percent. According to a recent Reuters poll of economists, most poll respondents expect the Fed funds rate to be at 2.5 percent to 2.75 percent or higher by the end of 2022. The market has not experienced a 2.5 percent to 2.75 percent Fed funds rate environment in the past 5 years and MSFT PE multiple might fall below 25x. I believe MSFT will revert back to a lower PE and PS ratio multiple in a high-interest rate environment coupled with recession fears.
|2022 FY Estimated Revenue||2023 FY Estimated Revenue||2024 FY Estimated Revenue||2025 FY Estimated Revenue|
|Net Income (in billions)||$73.63||$88.36||$106.03||$127.23|
|Weighted Average of Diluted Shares Outstanding (in billions)||7.552||7.552||7.552||7.552|
|Earnings Per Share (Diluted)||$9.75||$11.70||$14.04||$16.85|
|Forward PE (current share price-$ 259.62)||26.63||22.19||18.49||15.41|
Based on my model, MSFT is fairly priced and does not offer an asymmetric risk-reward. Even if MSFT achieves the top end of its guidance, it is still fairly valued as per my forecasted EPS for FY22 where there is a 1.73 percent upside and 6.12 percent if the PE multiple contracts.
Despite the rapid growth of its business segment, it is still not enough to justify its valuation unless its Productivity and Business Processes segment demonstrates significant growth in the upcoming quarters. Meanwhile, the MSFT revenue and earnings beat margin has been reducing since Q4 2021. It is evident from the table below that MSFT EPS and revenue surprises have fallen from 12.71 percent and 4.18 percent in Q4 2021 to 0.98 percent and 0.63 percent respectively in Q3 2022.
MSFT is poised to experience exponential growth in the Productivity and Business Processes segment driven by the growth in Dynamics and LinkedIn sub-segments. The current penetration rate of MSFT’s Dynamics products and the growth of the productivity and automation software sector present a huge opportunity for MSFT to grow its revenue rapidly. LinkedIn will also boost segment growth through increased ad spending by advertisers and a growing user base.
Although MSFT is expected to grow rapidly in the current economic climate, the stock is fairly valued at the moment according to our valuation analysis and does not offer a significant asymmetric risk-reward opportunity. I currently have a neutral rating on MSFT due to the weakness in the overall market and a limited upside based on next quarter’s guidance. It is unlikely the growth story outlined in my thesis will be achieved in the short term and therefore the coming few quarters are crucial to assessing the growth of those sub-segments. If MSFT demonstrates a huge growth in the sub-segments aforementioned in the coming quarter, it certainly is ripe for a rerate such as growth in PE and PS multiples.