Microsoft grows above the clouds

It’s a stark contrast to the first decade of the 21st Century, when Microsoft – shackled by regulation and reeling from the dot-com bust – was in danger of losing its market dominance as it failed to capitalise on digital trends. Satya Nadella, who took over as chief executive in 2014, has pioneered the group’s push into cloud and public internet hosting which has helped it regain favour among investors. But we still don’t think Microsoft is getting the credit it deserves for its turnaround, especially compared with some of its US tech peers. Stripping the group's cash out of the calculation, a price/earnings ratio of 24 times falls well short of the tech sector average, and that seems unfair considering Microsoft’s dominance in one of the fastest-growing areas of the tech industry.

Cloud computing has risen rapidly in the past few years, which helped boost Microsoft’s Intelligent Cloud revenues by a fifth in the year to June 2018. But industry specialist Chris Hertz thinks current demand is only “the tip of the iceberg”. Microsoft – which currently has about 20 per cent of the market – is in a particularly good place to benefit from the trends as organisations are expected to begin using multiple cloud platforms. That means those already using Amazon Web Services (currently 65 per cent of the market) are likely to add either Microsoft's or Google’s products on top. Thus, over the next four years, broker JPMorgan expects compound annual revenue growth of 11 per cent from Microsoft’s cloud division.

And it isn’t just the cloud business (Microsoft’s smallest) that is benefiting from investment in public internet hosting services. Revenues in the large productivity and business processes division were up 8 per cent at constant currencies in the final quarter of 2018 thanks to demand for cloud products and services. Management expects double-digit like-for-like sales growth from this division in the first quarter of the 2018-19 financial year. Meanwhile, Office 365 continues to benefit from its shift to a subscription service. With 31.4m subscribers, the software obtains a large proportion of its revenue from recurring sources, while a lot of customers pay for long-term subscriptions up front. This makes Office 363 very reliable and highly cash generative.

Investment in new software hampered the group’s cash generation in the final quarter of the 2017-18 financial year, but free cash flow still hit $7.3bn, while return on capital investment rose to 17 per cent, from 15 per cent in 2017. JPMorgan expects normal growth rates to resume in the coming years and has forecast free cash flow of $11.3bn in the final quarter of 2018-19 and $13.1bn in the following final quarter. This impressive cash generation supports Microsoft’s strong balance sheet – which boasted $62m cash net of debt in June – and its progressive dividend policy. Annual dividends have risen from $1.12 to $1.68 in the last five years, and in 2018 management also bought in over $2bn-worth of shares.