Source: Johannes Marliem Via Flickr
Yet nearly all of the substantial appreciation — which has added a quarter of a trillion dollars to MIcrosoft’s market capitalization — has come from expanding cash flow and earnings multiples.
Adjusting out one-time factors, Microsoft’s per-share earnings have been remarkably consistent (or stubbornly stagnant, depending on your point of view). Earnings per share over the past five years have been $2.73, $2.65, $2.63, $2.46 and $2.79 (in FY16).
Clearly, investors are pricing in a re-acceleration of earnings growth going forward. And there are reasons for optimism on that front. The most notable is Microsoft’s Azure cloud platform, a major cause of the current optimism toward MSFT stock. But Microsoft also has growth opportunities in gaming, search and other categories.
10 Best Stocks for Retirement Investors
Still, it looks from here like the optimism toward MSFT stock might be a case of “too far, too fast.”
The acquisition of LinkedIn, which closed earlier this month, should provide an earnings boost — although 2016 estimates of $1 billion in EBITDA  imply only roughly 10 cents in incremental EPS to Microsoft. Beyond that deal, the categories it’s targeting for growth through its “mobile-first, cloud-first” strategy all have large, successful incumbents — who in most cases have a head start on Microsoft.
So while Microsoft does have opportunities, it will have plenty of competitors fighting it tooth and nail. To support the current price of MSFT stock — let alone any upside — Microsoft will have to start winning more battles in verticals like cloud and gaming.
The problem is that MSFT already seems to be playing from behind.
Microsoft Has Many Challengers
It’s not as if the legacy products that have driven Microsoft revenue are collapsing, but expecting much in the way of growth seems optimistic. Even Microsoft stock bulls would admit that.
Windows 10 now is installed in over 400 million devices, according to the Q1 conference call , and Office 365 adoption continues to impress: constant-currency revenue increased 8% for Office consumer products in the first quarter. Gross margins in 365, however, are lower than under the traditional version, and Windows OEM revenue was flat in Q1 and -1% in fiscal 2016.
Microsoft needs to drive growth elsewhere, and it does have avenues to do so … but it will have to defeat some solid rivals to get there.
The Greatest Opportunity for MSFT Stock
The largest opportunity for Microsoft is its Azure cloud platform. The company still doesn’t break out figures for Azure revenue or profits, but Q1 growth was 116% year-over-year after a 113% increase in fiscal 2016.
Microsoft’s biggest opportunity, however, sits where it faces its largest and toughest competitor: Amazon.com, Inc. (NASDAQ: AMZN ). And in the early going, Amazon has a huge lead.
Estimates from MKM Partners suggest that Azure sales are just over $2 billion annually. In contrast, Amazon Web Services is on track to drive nearly $12 billion in revenue this year. AWS sales have increased 59% year-over-year through the first nine months of 2016. That’s a lower growth rate than Azure, but its larger base is such that AWS’ dollar growth in 2016 should be nearly double Azure’s total revenue.
Amazon and Microsoft aren’t alone: Alphabet Inc (NASDAQ: GOOG , NASDAQ: GOOGL ) has a billion-dollar business of its own. Legacy providers like Oracle Corporation (NYSE: ORCL ) and International Business Machines Corp. (NYSE: IBM ) are transitioning to cloud as well. To be sure, there may well be enough growth to go around as cloud takes revenue away from hardware manufacturers. But Microsoft needs to capture a good deal of that growth to support current expectations. If a rising tide lifts all boats, then cheaper shares, such as ORCL and IBM, seem more likely to outperform.
Microsoft’s Mobile
Microsoft infamously bought the hardware division of Nokia Corp (ADR) (NYSE: NOK ) in a deal that closed in early 2014 and almost instantly turned into a failure. In fact, Microsoft’s $7.2 billion investment turned into just $350 million barely two years later.
It does appear that Microsoft is taking one more shot at the mobile hardware market, with a Surface Phone reported to be released in 2017. Considering the success of Surface tablets (and the recent unveiling of the admittedly impressive Surface Studio), there may be some optimism toward Microsoft’s second go-around in mobile.
Next Page