This Is One Cloud Investment You Don’t Need to Worry About

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Sometimes you don’t have to look all that hard for a great investment in a hot sector. Especially when that sector is cloud computing, a growth market that I recently spoke about in detail.
This is especially true when the company in question is already a major force to be reckoned with, yet continues to execute better than expected. This is exactly the scenario I see playing out with Microsoft (NASDAQ: MSFT) today.
Microsoft needs no introduction. The software, hardware and services firm has been around for 40 years. Even if you don’t yet know how Microsoft is embracing the cloud, I’m sure you’re familiar with its Microsoft Windows operating system and Microsoft Office productivity software, which includes Excel, Word and PowerPoint.
Even though the company is well-known, brand power alone hasn’t always translated into a rising share price. The stock has yet to recover fully from the dot-com bubble. And 2002 to 2012 was a lost decade, as the stock generated zero return, outside of dividends.
Big ships turn slow, and Microsoft is a very big ship indeed. The $400 billion market cap company had a virtual monopoly on PC software with Windows, and a dominant enterprise software business. It didn’t think it had to do that much to keep on moving. But it was wrong.
In the middle of the last decade Microsoft fell behind as the competition raised the bar. Many new devices, such as those from Apple (NASDAQ: AAPL) and Google (NASDAQ: GOOG), didn’t need Microsoft’s operating system. And these devices were superior to Microsoft’s in virtually every way. Google crushed Microsoft in Internet search too.
New operating systems weren’t all that great either. By most accounts the release of Windows Vista in 2007 was a flop, as many enterprises and consumers elected to stick with Windows XP and avoid the myriad issues that Vista created.
Despite a nice dividend, shares of Microsoft were not all that enticing for a long time. But that’s changed.
Microsoft is stepping up its game and embracing the cloud for both commercial and consumer products. For the average consumer it’s easiest to understand Microsoft’s push into the cloud by simply looking at Office 365, a cloud-based version of the company’s most popular applications.
The consumer version includes Word, PowerPoint and Excel. It also offers online storage and 60 Skype calling minutes per month. The enterprise version adds in Outlook and other networking services important to business users.
The key innovation with Office 365 is that it is designed to work across all devices. That means it works with Apple iPads, iPhones and MacBooks, as well as devices that run Android. This is a huge deal, because it finally allows virtually everyone out there to use Windows again.
Microsoft has priced Office 365 for perfection too. A single user license costs just $6.99 per month for one PC or Mac, one tablet and one phone (a household subscription for multiple devices costs $9.99 per month).
That pricing seems extremely reasonable, especially when one considers that Microsoft gets $179.99 for a traditional Microsoft Office license. The ability to pay monthly or annually, as well as use Office across all devices, is a clear win for consumers.
But it’s a win for Microsoft as well.
Microsoft’s typical Office license lasts about six years. That means the company gets around $30 per license in annual revenue ($2.50 per month). In other words, with Office 365 for a single user, Microsoft stands to make 2.8 times more money per month.
Despite the reality that they are paying more, Office 365 is still a good deal for consumers. The fact that the product works across all devices adds considerable value. And consumers appear to agree.
Last week Microsoft delivered fiscal third-quarter 2015 results that smashed the Street’s expectations. Revenue rose by 6.5% to $21.73 billion (beating by $670 million), while EPS of $0.61 beat by $0.10.
Granted, expectations were low after the company reported a 9% decrease in fiscal second-quarter earnings. But this time the joke was on the Street as Office 365’s subscriber base grew by 35% sequentially (to 12.4 million subscribers) and Commercial Cloud revenue grew by 106% year-over-year.
Battling against a rampant run in the dollar that trimmed 3% off the quarter’s revenue growth, Microsoft still knocked one out of the park, largely because it has embraced the cloud.
The report kicked shares into high gear and they rallied over 10% the next day.
Now, clearly there is a lot more to Microsoft than just Office 365 and Commercial Cloud. The company should generate $93 billion in sales this year. But its shift toward the cloud should accelerate revenue and profit growth in the years ahead, and the impact should be long-lasting and extremely beneficial to shareholders.
In a typical year Microsoft will generate around $4 billion in revenue from home-based consumers that use Office. With the release of Office 365, that number could climb to $13 billion. And with Commercial Cloud revenue growing at over 100%, that segment should generate well over $6.3 billion this year.
Combined, cloud initiatives should help Microsoft return to double-digit earnings growth in 2016, when I see the company earning over $3.05 per share.
Again, just looking at Office 365 we can easily see that the company is working hard, and succeeding, at recapturing the massive user base that drifted away in the middle of the last decade.
The announcement that the company won’t charge for users to upgrade from Windows 7 and 8 to Windows 10 is yet another sign of its commitment. And perhaps most importantly, it shows that the strategy we see unfolding with Office 365 is part of a longer-term strategic advance to move toward the cloud.
Microsoft is still the cash-gushing company that investors have always viewed as a core technology holding. It’s just better at doing it now. And I expect that Microsoft’s current annual dividend of $1.24 (which equals a 2.5% yield) is only going to grow as business improves.
Factoring in the strong dollar, I expect revenues will grow at 5% to 10% annually over the next two years. And earnings will be flat this year, but jump to 7% to 10% annually in 2016 and 2017.
At that rate, the stock is a very good deal today. Trading at just under $50 per share, Microsoft’s forward P/E is a mere 16. That discount to the S&P 500 should evaporate in the coming year as Microsoft’s accelerating growth warrants a premium valuation.
The stock could easily trade up to a forward P/E of 18 based on my forward EPS estimate of $3.05. That implies 12% near-term upside in the stock, with ample upside potential in the coming years.
While it isn’t the pure ultra-growth stock that aggressive investors often seek, I firmly believe that every investor should own Microsoft right now. The upside potential is just too attractive, while the downside risk seems extremely limited.
I see Microsoft as a company that has finally gotten back in the game because of its cloud initiatives. It’s a cloud investment that you can buy and hold, and not worry about.
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