Microsoft (NASDAQ: MSFT) has had quite a year: its stock is up 46% (YTD) and it has won two government contracts, worth a total of $17.6B over the next ten years, to provide the federal government its dominant hybrid cloud product. Azure, its cloud system, is the competitive advantage that, along with the unique breakdown of Microsoft\u2019s revenue, transforms the company from just a \u201cbandwagon\u201d buy to a calculated investment. I will analyze both of these points in the rest of the article.<\/span> Figure 1<\/p><\/div>\n A Deeper Dive Into The Business Microsoft\u2019s revenues and operating income are both up 21% (YoY) this year, but what makes this growth more impressing than that of, say, Apple, is the structure: while over 52% of Apple\u2019s revenues come from the iPhone, Microsoft\u2019s cash flows stem almost perfectly evenly from three segments: \u201cProductivity and Business Management\u201d, \u201cIntelligent Cloud\u201d, and \u201cMore Personal Computing.\u201d This even distribution of income greatly reduces the risk of revenue loss from a single product, putting the firm in the best position for the long run.<\/span><\/p>\n This brings us to the main focus point of the article, Microsoft Azure, which currently accounts for 32.8% of Microsoft\u2019s revenues. Running on a 36% operating margin, revenues and operating income from Azure are both up 21% (YoY) thanks to the strong hold Microsoft has on the cloud market, with a market share of 17.7% in 2018 and 18.2% in 2019. As mentioned before, Microsoft has also secured two contracts with the federal government for its hybrid cloud system, adding $633.6M to its annual operating income over the next 10 years. The hybrid cloud allows users of Azure with sensitive information to secure most of their information on the cloud system but keep certain bits of the data offline to prevent Microsoft, hackers, and other third-party users from accessing the information. By fixing this issue, Microsoft has opened its cloud system to hundreds of potential clients who may have previously been hesitant to storing their data on Azure.\u00a0<\/span><\/p>\n An analysis of the market for cloud supports this. As Gartner reports <\/span>[1]<\/span>, the annual revenue generated from cloud activities across the market is predicated to grow from $214B in 2019 to $331.2 by 2022, a 55% increase.\u00a0<\/span><\/p>\n Figure 2<\/p><\/div>\n <\/p>\n Valuation<\/b><\/p>\n In the first two segments, not much is expected to change for Microsoft save for the release of the new Xbox in 2020. Since Microsoft\u2019s margins are surprisingly low on the Xbox hardware<\/span> [2]<\/span>, the release of the new Xbox will not have a significant impact on the net cash flows to the company and gaming EBIT will continue to mostly stem from subscriptions and games, which are not subject to much change. For this valuation, despite the impressive growth in Productivity and Business Management and More Personal Computing segments (average growth of 24% and 23% respectively), I will assign a conservative 20% annual growth to those segments through 2022.<\/span><\/p>\n Finally, the cloud business. According to the aforementioned market forecast data, total revenue generated in the cloud business grew 17.5% from $182B in 2018 to $214B in 2019. In the same year, Microsoft\u2019s cloud revenue (and EBIT) grew 21%, asserting its dominance over the cloud market. Due to Microsoft\u2019s strong hold on the market, it is reasonable to expect this trend of beating the cloud market to continue. Below is a numerical summary of figure 2 along with Microsoft\u2019s expected revenue from its (linearly) growing market share as well as Microsoft\u2019s expected EBIT (using it\u2019s consistent 36% operating margin) which also includes the annual $633M income from its two government contracts.<\/span><\/p>\n Figure 3: all raw values are in billions of dollars<\/span><\/i><\/p>\n As the model suggests, Microsoft\u2019s operating income from cloud will double by 2022. Using this value and the expected growth in the other two segments, I predict Microsoft\u2019s future EBIT as follows:<\/span><\/p>\n
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![\"\"](\"https:\/\/sites.williams.edu\/williamsinsight\/files\/2020\/03\/Screen-Shot-2020-03-22-at-9.15.07-PM.png\")
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\n Segment\/Year<\/span><\/td>\n 2018<\/span><\/td>\n 2019<\/span><\/td>\n 2020<\/span><\/td>\n 2021<\/span><\/td>\n 2022<\/span><\/td>\n<\/tr>\n \n Total Market Revenue<\/span><\/td>\n 182.4<\/span><\/td>\n 214.3<\/span><\/td>\n 249.8<\/span><\/td>\n 289.1<\/span><\/td>\n 331.2<\/span><\/td>\n<\/tr>\n \n MSFT Market Share\u00a0<\/span><\/td>\n 17.70%<\/span><\/td>\n 18.20%<\/span><\/td>\n 18.70%<\/span><\/td>\n 19.20%<\/span><\/td>\n 19.70%<\/span><\/td>\n<\/tr>\n \n Microsoft Rev<\/span><\/td>\n 32.23<\/span><\/td>\n 38.99<\/span><\/td>\n 46.7126<\/span><\/td>\n 55.5072<\/span><\/td>\n 65.2464<\/span><\/td>\n<\/tr>\n \n EBIT (with gov contract)<\/span><\/td>\n 11.52<\/span><\/td>\n 13.92<\/span><\/td>\n 17.45<\/span><\/td>\n 20.616<\/span><\/td>\n 24.122<\/span><\/td>\n<\/tr>\n \n Growth (YoY)<\/span><\/td>\n <\/td>\n 21%<\/span><\/td>\n 25%<\/span><\/td>\n 18%<\/span><\/td>\n 17%<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n