Microsoft - something old, something new

Posted by Liz Rees in Latest insights category on 07 Nov 19

Third quarter results reported by US companies have been closely watched for pointers of how the world economy is faring. Multi-nationals dominate a wide range of industries and rely on global demand. Highly valued companies which disappoint are seeing their share prices harshly punished. However, one company that stands out as a beacon of steady growth is Microsoft. Here we take a look at the broader picture for US corporates as well as what Microsoft seems to be doing well compared to others.

A mixed picture for US corporates

So far, results suggest a mixed picture for US earnings although there are definitely some bright spots. Weakness has been concentrated in energy, materials and technology sectors yet a number of well-known bellwether stocks have also fallen short of analyst’s expectations and issued cautious outlook statements. This highlights that stock selection is vital for good fund performance.

McDonalds, a supposedly defensive share, reported lower sales growth in the US as it came up against stiffer competition. Less surprisingly, construction equipment firm Caterpillar reported third-quarter revenues and profits well below analyst’s predictions, blaming trade wars and general uncertainty.

Trade tensions are having an effect and weaker demand from China is a common theme. Aircraft maker Boeing’s third-quarter fell short of expectations and the company warned that it was reducing production of some planes, mainly in response to falling orders from China. Toymaker Hasbro said new tariffs have prompted retailers to cancel orders, ahead of the important Christmas period.

Even within a sector, fortunes can differ. In semiconductors, Texas Instruments, which makes a wide range of chips for cars to communication devices, fell short of target, blaming trade wars for a slowdown. Meanwhile, Intel returned to growth due to exposure to cloud computing.

Some tech stocks, such as Twitter and Netflix, were marked down as their high ratings left little room for slippage. Tesla’s shares, however, soared by 20% after it issued a bullish outlook. Earnings exceeded the top of the range and its SUV model should launch ahead of schedule. Even mighty Amazon saw its share price fall when it missed profit forecasts due to heavy investment in next day delivery services. Most of the business is still doing well.

Microsoft vies with Apple for the title of the world’s largest company, so is keenly followed by many investors. It released impressive Q3 figures across all divisions, particularly cloud computing. Revenue climbed 14% to $33.1bn in the quarter, while earnings per share rose 21% to $1.38.

A case study in growth

Microsoft was founded in 1975 by computer programmers Bill Gates and Paul Allen. They launched the Windows operating system in 1985 before going on to develop the Microsoft Office Suite, comprising applications such as Word and Excel. Microsoft was the only established company nimble enough to be a leading player in the internet revolution from the beginning, launching the internet explorer web browser in 1990.

Steve Ballmer, who succeeded Gates as Chief Executive in 2000, was behind successful hardware products including the Xbox video game consoles and touchscreen personal computers. However, after an acquisition spree the company lost its way somewhat and encountered problems with Windows 8.

Satya Nadella took over from Ballmer in 2014 to steer the company back on course. Since then, Microsoft has scaled back hardware, focused on cloud computing and bought LinkedIn, the social media platform for professionals. The business has made its products widely available on non-Windows platforms and is set to exploit opportunities in the Internet of Things (IoT). Successful execution has helped power the shares to record highs.

Cloud computing requires large amounts of capital and having substantial cash balances is advantageous - not many competitors have net cash in excess of $60bn and ongoing strong cash inflows. Microsoft has committed to invest $5bn in IoT and intelligent edge (connecting systems and devices), technologies that are transforming industries worldwide. Amazon may currently be market leader but Microsoft is hot on its heels.

Partnerships the way forward

To facilitate growth the company has entered a number of partnerships. In August 2018, it began a relationship with Toyota Tsusho to create fish farming tools using the Microsoft Azure application suite for IoT technologies related to water management.

It has joined forces with Novartis, in one of the biggest tie-ups ever between big pharma and big tech, to apply Artificial Intelligence (AI) to healthcare. Microsoft will develop tools to improve the speed and precision of new drug research and development.

Growth should be bolstered further by a recent 3-year deal with SAP, Europe’s biggest technology company. The German company’s customers will move onto the Microsoft platform while utilising SAPs cloud tools.

In the last few weeks, Microsoft has beaten Amazon, IBM and Oracle to a highly sensitive US defence contract, worth $10bn, following a protracted and complex bidding process. It was the only contender that could provide sufficiently secure encryption to meet confidentiality requirements.

This Joint Enterprise Defence Infrastructure Project (known as JEDI) will entail the company taking responsibility for a significant part of the department’s data and communications operations. Furthermore, it puts them in a strong position to win similar contracts from governments and major enterprises in other countries.

What is Microsoft doing differently?

So how has Microsoft remained at the top of its game for so long? The company still has huge revenues from Windows and, unlike Amazon, does not rely on its cloud business for the majority of its profit. This works to its advantage as it generates the cash needed to reinvest in the new economy. Importantly, the brand and reputation attracts and retains both customers and a highly skilled workforce.

Azure, its cloud computing brand, is seeing impressive momentum and is still in the early days of been rolled out across the company's huge installed customer base. As it scales up and takes on board larger customers, it has the potential to achieve higher gross profit margins with the benefits flowing down to earnings.

Although the valuation looks high on a current price/earnings (PE) ratio of around 27x, this is predicted to fall rapidly. Moreover, whilst the yield is currently a modest 1.4%, there is scope for generous dividend increases. With a growing amount of forward contracted income to boot, the company ticks many boxes for investors seeking high quality, defensive growth and reliable income.

Which funds back Microsoft?

Microsoft has been at the forefront of several major leaps in technology so it is not surprising the shares form a core holding in many funds. Technology tracker funds currently have the biggest exposure - L&G Global Technology Index has around 14% of its assets invested in the company.

Many US funds have exposure to the shares. It is currently the biggest position in Morningstar Bronze-rated Artemis US Select, with a 6.1% weighting, while in in silver-rated T. Rowe Price US Large Cap Growth Equity it accounts for nearly 8% of the fund currently.

Microsoft is prominent in some popular global funds too with Morningstar gold-rated Fundsmith Equity currently having a 5.9% weighting. The potential for dividend growth also makes it attractive to income funds and silver-rated M&G Global Dividend maintains a position of around 5%.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.