Why Upside in Microsoft Corporation Stock Is Limited

Although I was once a huge bull on Microsoft Corporation (NASDAQ:MSFT), those days have come and gone.

Before Satya Nadella took the reigns back in 2014, Microsoft stock was being priced for a slow and gradual death. Then Nadella offered the vision of Microsoft leveraging its huge scale and deep resources to turn the company into a cloud giant. At that time, the proposition looked attractive. MSFT stock was dirt cheap with potentially breakout growth prospects.

But when I look at Microsoft stock now, I don’t see much of what made me love the stock back in 2014.

Those breakout growth prospects that Nadella was talking about in 2014 are already here. Operational results won’t get that much better from here on out. Meanwhile, Microsoft stock is trading at 16 times trailing EBITDA. Back in 2014, this was a seven-times EBITDA stock.

Put it all together, and MSFT stock is pretty expensive with the best of its growth narrative in the rearview mirror.

I don’t like that combination. I think it’s a recipe for tough times ahead for Microsoft stock.

Things Won’t Get Much Better From Here

Microsoft is firing on all cylinders right now.

Its cloud businesses are booming. Azure revenues nearly doubled last quarter. Office 365 commercial revenues grew 41%. Dynamics 365 revenues jumped 68% higher. The digital advertising business is doing surprisingly well, with Bing search ad revenue up 15%.

The gaming business is benefiting from secular growth in that market, and gaming revenue was up 8% last quarter. LinkedIn is also doing well and contributed $1.3 billion in revenue last quarter.

And despite that robust and wide-spread growth across most of the company’s secular growth businesses, total revenue growth at MSFT was just 12%. Margins aren’t zooming higher (they are actually compressing somewhat), so operating profits rose just 10%.

And that is about as good as it is going to get for this company.

Azure revenue growth can’t stay red-hot forever as competition in the public cloud services market is only intensifying.

Office 365 commercial revenue growth is slowing (last year at this time, the growth rate was 49%, 8 percentage points higher). Bing can continue to gain market share, but this is still a market almost wholly owned by Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG). Gaming will continue to post nice gains, but that is a small part of Microsoft’s business.

Overall, big growth rates will be tough to come by for Microsoft. Just look at the analyst estimates. Next quarter, they are looking at 9% revenue growth. This year? 11% revenue growth. Next year? 8% revenue growth.

So when you look at Microsoft and see last quarter’s 12% revenue growth rate, that is about as good as this story is going to get. You could argue that total company margins will naturally improve as the higher-margin cloud businesses continue to comprise more and more of the total pie, so that is a forthcoming catalyst that has yet to fully hit (margins are still flattish).

But that boost won’t be that big, and revenue growth is expected to come down. Assuming margin expansion and slowing revenue growth offset one another, then Microsoft’s future profit growth prospects should look a lot like today’s profit growth.

Operating profits rose just 10% last quarter. But MSFT stock is trading around 24.5 times forward earnings. That gives Microsoft stock a price-to-earnings/growth (PEG) ratio of over 2. The market is at a PEG ratio of 1.1.

Bottom Line on Microsoft Stock

If markets head higher (as I expect them to), then Microsoft stock will grind higher.

But it won’t outperform its big tech peers. MSFT stock is just too richly valued with too little growth. The FANG names, Apple Inc. (NASDAQ:AAPL), and Nvidia Corporation (NASDAQ:NVDA) are just a handful of tech stocks which should outperform MSFT stock over the next 12 months.

As of this writing, Luke Lango was long GOOG and AAPL.

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