Is Microsoft Corp (NASDAQ:MSFT) really so unique that its stock can permanently sustain a price-to-earnings (PE) ratio of well into the thirties? Mathematics warns us that the higher stocks are rated today, the lower their 10-year returns will be. Also, its size – now a $1.8 trillion (£1.3 trillion) company – will eventually restrain growth and mean the stock becomes more retrained.
Nearly a decade ago, when I liked Microsoft as a classic ‘big unfashionable company’ at $20.75, its earnings multiple was below 9x. A new CEO since 2014 has worked wonders to transition the group towards cloud services and refresh growth for the legacy Windows and Office 365 software. They have also advanced the Surface laptops, which enjoy a good reputation.
After its latest stonking results in respect of the final quarter of 2020, every analyst appears to have capitulated on any sense of caution – to universally recommend Microsoft as a ‘buy’. In the last two days, the stock has advanced 4% to $242 where its PE tests 36x.
By contrast, Apple (NASDAQ:AAPL) has seen its stock ease 4% to $138 on a PE of 37x, after reporting a similarly impressive quarter. Pre-Christmas is traditionally Apple’s strongest time, when a third of its sales are made.
Reports claim the reason is Apple continuing to avoid revenue guidance since the pandemic struck, although buyer fatigue in response to record results more normally reflects a bull market top.
It will be interesting to see if caution creeping into Apple traders has implications for ‘peak sentiment’ in Microsoft.
Both these tech behemoths have enjoyed a purple patch – amid renewed lockdowns, persisting for the first few months of 2021 at least. More working from home has reinforced companies’ digital transformation, hence driving 50% revenue growth for Microsoft’s key Azure cloud computing service.
Individuals have also upgraded their Microsoft Surface and Apple MacBook laptops, using spare funds from curtailed spending on social life. A new iPhone and accessories or Apple TV are seen as necessary treats for many.
Both Apple and Microsoft have just delivered 34% overall earnings per share (EPS) growth on late 2019, hence a PEG ratio (dividing into the PE multiple) around 1 is fair pricing for growth stocks.
Current spending on this kind of tech may prove compressed, however. Vaccines’ deployment should enable some kind of normality to begin from summertime. While both companies look set to maintain superior growth relative to most industry, and on fabulous margins, latest reporting looks exceptional and I concur with Apple investors prudently locking in some gains.
All of Microsoft’s key segments are roaring
I have never seen even a modest-size growth business so comprehensively beat expectations. The 17% revenue growth in the fourth quarter of 2020 (Microsoft’s second fiscal quarter) was 7% ahead of consensus and EPS were 24% ahead. Being so far ahead of guidance set with analysts only three months ago, in the US quarterly reporting culture, is remarkable.
As is Microsoft’s group operating margin, up from 37.6% to 41.5% over the previous 12 months. It recalls microchip designer ARM Holdings in its best years, when listed. Besides the calibre of management needed to deliver this, it does however beg the question of whether ‘big tech’ enjoys excess pricing power – something the Biden administration is meant to address.
Even its legacy software suite – Office 365 – is showing strong revenue growth, up 21%, helped by a wide subscriber base and rising revenues per user. It seems virtually unassailable now that most organisations default to using products such as Microsoft Word and Excel, and its subscription model bakes in high-quality revenues. Windows 10 enjoyed 10% growth.
Market snapshot: Microsoft results bode well for tech sector
Commercial cloud revenues leapt 23% to nearly a third of group revenues, within which Azure enjoyed 50% growth and affirms Microsoft with a commanding global position along with Amazon AWS. Such revenues should also be quasi-annuity, in the sense that, like Office 365, subscribers are effectively captured.
The question is whether such an oligopoly in cloud will consolidate. Or, like in anti-virus software provision from Norton and McAfee, they get undermined by new entrants and high-quality free software.
But switching your anti-virus software annually, to take advantage of first-year pricing, is very different to having all your documents and photos stored in a cloud.
Given this quality of earnings, enough investors may be prepared to pay some extent of exclusivity premium for Microsoft. I think it is way too late to buy on a long-term view until the tech bubble bursts, which it will.
Hold Microsoft only if you can stomach medium-term commercial risk of modest downturn, and potentially a sharp one in the stock market.
Apple similarly disproves ‘elephants don’t gallop’
This was the late Jim Slater’s quip in his growth stock classic The Zulu Principle some 30 years ago, to argue in favour of specialising in small caps.
Yet Apple’s quarterly revenue has sprinted 8% ahead of expectations, and EPS was an 18% beat. A 30% operating margin is up from 27.8%, like-for-like.
Part of this success is the iPhone’s ongoing appeal, where a few years ago there were fears Apple would become a victim of its success – the proverbial ‘one-product company’.
The stock has also benefited from a major expansion of its multiple, from 12.5x seven years ago when it started a major refreshment cycle for its products.
Management has teased a loyal customer base with more expensive models – the latest figures benefiting from the iPhone 12 launch – while attracting new ones with lower-priced models.
Thus, iPhone revenues beat expectations by 9% to constitute 59% of total. Mind, sales by way of unit numbers actually peaked in 2015, but since then the average iPhone price has risen from $809 to $873. Possibly that is another reason for edginess in Apple stock.
Wearables, home and accessories were a 10% beat and iPad 11%. Mac computers provided the only expectations/reality check, with a 2% miss, linked to component shortages and customers waiting for new models.
Bulls of Apple cite a customer base with 1.65 billion devices, including over 1 billion iPhones and 620 million paying subscribers. I would agree that its innovation implies a long-run winning business. However, in terms of the stock, financial history has shown this can coincide with periods of poor investment returns.
Microsoft has relatively better defensive qualities
Both stocks are exposed to some deceleration in tech spending, post-pandemic, and deflation of the current hysteria affecting Nasdaq stocks. That is why I downgraded them last year from ‘hold’ to ‘take profits’ without an outright ‘sell’ stance.
On a 10-year view, those who continue to hold may be well ahead of returns from cash. The question is what happens in between, and potentially quite soon.
Economic bulls such as Goldman Sachs reckon US GDP growth will soar to 10% in the second quarter of 2021 now vaccinations are ramped up and the infection rate is diminishing.
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That assumes Covid-19 variants will not add to challenges and travel will not need curtailing to prevent their spread.
With US Treasury secretary Janet Yellen pushing for $1.9 trillion fiscal stimulus, well-practised from her monetary stimulus years at the Federal Reserve, plenty of this will find its way into consumer/business spending and equities.
If that pans out, then my recent caution towards Microsoft and Apple shares may remain premature.
But if the market breaks over the next six months – especially if inflation rears its head while Covid-19 retains its overall grip on humankind – then I regard Microsoft as the better potential ‘buy’ for its underlying strengths.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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