Microsoft (NASDAQ:MSFT)
Few firms can match Microsoft’s (NASDAQ:MSFT) level of excitement these days. Having OpenAI’s ChatGPT incorporated into everything from Azure to Bing and beyond is wonderful, and the business is still working hard to finalize its planned acquisition of Activision (ATVI). The company’s net cash position and ability to generate free cash flow are both quite healthy.
However, the stock is priced at 25 times the estimated fiscal 2024 profits. If artificial intelligence (AI) turns out to be as promising as some hope, the price might rise beyond current predictions. Despite the AI buzz, we expect Microsoft stock to remain range-bound for the foreseeable future, with current prices in line with our fair value assessment.
We continue to be big supporters of Microsoft’s dividend growth potential, which may be unrivaled, and have set our fair value estimate for Microsoft stock at $262 per share based on discounted cash flows. Our most optimistic fair value estimate has the share price at $314. Thus there is room for growth following a period of share price consolidation.
Poor Performance in the Calendar Fourth Quarter
We were disappointed by Microsoft’s second quarter fiscal 2023 earnings (calendar fourth quarter 2022 figures), which were revealed on January 24. Company sales increased by 1.9% year over year, and non-GAAP EPS for the second quarter was only marginally higher than expected. Microsoft’s operating and net income, which are not affected by GAAP, have decreased year-over-year by 3% and 7%, respectively.
Non-GAAP diluted EPS for the corporation declined by 6% compared to the prior-year quarter. Looking at the numbers in constant currency, the company’s “Productivity and Business Processes” business had a 13% increase in revenues, while the “Intelligent Cloud” division saw an increase of 24%. We saw strong sales growth in these segments, particularly in Azure and other cloud services. However, its “More Personal Computing” segment, which comprises Windows OEM and Xbox content, had a 16% decrease in revenue.
Moving forward, Microsoft will rely further on its cloud businesses, AI, and gaming to keep its investors happy. We approve of Microsoft’s strategic choice to invest heavily in OpenAI, the parent company of ChatGPT since the technology seems to complement Microsoft’s Windows OS, its search engine operations (Bing), and its Azure cloud service. We were pleased with ChatGPT during our first testing a few months ago, and we’re thrilled to see Microsoft establish itself as an AI industry leader.
Microsoft Remains A Powerful Source Of Free Cash Flow
Compared to the same time a year earlier, Microsoft’s free cash flow creation was worse in the second quarter of its fiscal 2023, coming in at $7.25 billion on a non-GAAP basis. With reduced net income, adverse adjustments in deferred income taxes and accounts payable, and increased capital investment, adjusted net cash flow from operations fell 7% in the quarter to $13.5 billion.
Microsoft is still a cash-generating juggernaut, despite a $2.36 billion hit to GAAP cash creation in the quarter due to a tax payment (TCIA capitalization of R&D provision). An integral part of our investment thesis is that Microsoft will provide massive amounts of free cash flow for shareholders.
Microsoft’s financial sheet at the end of 2022 showed approximately $100 billion in cash, cash equivalents, and short-term investments, compared to $48.2 billion in short- and long-term debt. This makes for a healthy net cash position right now.
While the company’s adjusted free cash flow measure covered cash dividends by a factor of 1.43 during the calendar fourth quarter, the free cash flow generated by Microsoft during the first half of its fiscal 2023 (the six months ended December 31) was more than covered the $9.7 billion in cash dividends paid during the same period.
Our analysis shows that Microsoft’s planned acquisition of Activision is fraught with risk in light of the Department of Justice’s recent crackdown on Alphabet’s valued search business. Whether or not that transaction closes, we remain committed Microsoft believers despite our expectation that the company’s stock will be volatile in the wake of its fiscal second quarter 2023 performance and more sober perspective on the technology industry as a whole.
Conclusions and Remarks
We remain bullish on Microsoft’s company, net cash position, significant free cash flow creation, and dividend growth potential. In our opinion, Microsoft’s participation in OpenAI ChatGPT is the frosting on the cake since the company’s use of AI should improve all of its services, from Azure to Bing and beyond. Our fair value estimate range for Microsoft is $200–$300, and although we anticipate some volatility in the short term, we believe there is significant upside potential in the stock. Earlier, we said that Microsoft stock is one of our favorite companies since it is one of the few that excites us. Currently, the dividend yield for this firm is at 1%.
Featured Image: Unsplash @ Mohammad Rezaie
