Episode 11 | Assessing Microsoft: Valuation, Balance Sheet, and Strategic Growth

In Episode 11 of "Market News with Rodney Lake," Rodney Lake, Director of the GW Investment Institute, analyzes Microsoft's current valuation and financial health. He discusses the company's slightly elevated valuation, which remains near its 10-year median, and highlights its robust balance sheet, characterized by strong free cash flow and a high interest coverage ratio. Lake commends Microsoft's strategic investments in Azure, AI, and key acquisitions, as well as the effective leadership of CEO Satya Nadella. Despite the higher valuation, Microsoft's strong fundamentals and growth potential make it a valuable long-term investment for the GW Investment Institute. Tune in to learn more!

Transcript

Thank you for joining Market News with Rodney Lake. This is a regular program for the GW Investment Institute where we talk about timely market topics. I'm Rodney Lake, the director of the GW Investment Institute. Let's get started. Welcome back to Market News with Rodney Lake. I'm your host, Rodney Lake. Today is episode 11. It's on Microsoft. We're coming to you from the Duquès family Innovation studio right here in the GW School of Business in Duquès Hall as well.

Thank you to the Duquès family. Let's get started. So the episode today is about Microsoft. Why Microsoft? It's one of our larger holdings. We talked about Apple in a prior episode. That's one of our largest holdings. We've talked about Nvidia. That's our largest holding at the GW Investment Institute. But now we're going to talk about Microsoft, another large holding and another company that's in that Mac seven that so many people talk about The Magnificent Seven.

So why is Microsoft important? Well for us it's obvious it's a large holding, but it's also a colossus in the tech world, in the business world. And so we're going to break it down. We're going to use the framework business management price valuation and balance sheet. And we're going to give you an overview of Microsoft. This is another company this semester that we're going to be asking our students this fall to say, hey, take a look at this. Make sure that we're comfortable with this position where we are. But let's look at all the metrics. Let's look at the business. Let's think about the management team. Let's evaluate where the valuation is right now. And let's get comfortable with the balance sheet. So today that's exactly what we're going to do on episode 11. So let's get started.

So diving right in Microsoft is a business. Many of you probably use Microsoft products, possibly even every day or every workday. You're using different. Maybe it's word, maybe it's Excel. Maybe it's some version of office that you have, maybe it's outlook. There are so many products that so many people use and the operating system, of course, windows has been dominant for decades now.

Microsoft has started way back in 1975 and it's on its third CEO. And we'll get to the management set. Yet you doubt Nadella in a second here the current CEO. But let's talk about the business of Microsoft. So what kind of business is this. Well it's a collection of many things. And we'll talk a little bit about some of the more recent acquisitions.

But generally speaking you're talking about a mostly a software business. Now they do have some hardware. They have laptops. They have the Xbox as example of hardware, but predominantly a software business. So when we talk about the business of Microsoft at a very high level, we say, okay, it's probably mostly a software company, so we should expect higher margins for that kind of company.

And when we look at that, the gross margins, when you talk about June 30th, 2024, you're looking at almost 70% gross margin. So yeah, that's a software company that is a great gross margin, by the way, for those playing along at home. So what are the net margins. Net margins of 36%. So that's on the high end too.

So you're talking about a fabulous business high profit margins and so many people are going to be trying to come after Microsoft and its business. Now. It's been trying to diversify away from the core business. And one of the things that we'll touch on, we talked about the management is it's diversification or really it's expansion into Microsoft Azure.

Now, that's the cloud business that I haven't mentioned yet, but that has been the source of growth more recently. And that has been a dominant business. It, along with Amazon Web Services and Google Cloud, has really been the dominant players in that market. AWS Amazon Web Services probably had something like a seven year lead in that business, which is almost unheard of.

But Microsoft got in. Satya Nadella really sort of supercharged that business and made that a primary focus for his time as CEO. That wasn't the case with Steve Ballmer before him. But Nadella is really said, you know, this is something we're going to go after. An AI is another thing which we'll get to as well. But that has really supercharged their growth, the demand for those type of services, what are called off prem cloud services, people getting rid of their servers, using Microsoft servers, using Azure.

It's not just, you know, blue it in Spanish, but it it really has been a significant growth engine. And credit goes to Nadella for really seeing that and investing in that and making sure that Microsoft was ready to scale that business and, you know, using that brand name. Lots of people want to go with a brand name.

If you're thinking about really sensitive data, really high security. So the government is one of their big clients and so really smart and really, you know, on the allocation of capital, which we'll get to on the management side here. Great job from management. So it's the collection of businesses. And that is probably the the highest growth engine in there.

So let's now talk about AI. So they have a partnership with open AI. They own 49% of that business. and that has gone fairly well. And they're integrating that into other products like Copilot. And really that puts Microsoft, you know, I would say near the front or at the front of the line. And what's happening in AI right now, open AI continues to be the leader.

You're certainly having other groups on the large language models coming along. for example, Claude, which is anthropic, and Amazon has been investing in that business. You have got two now that just got released, from ECS, X.Y, which is Elon Musk's startup in the AI space, and that has actually made a big jump between grok one and two.

If anybody has been using that on the image generation and the large language model just in general. And so the competition is heating up for sure. And OpenAI, though, has had the lead in that space, and it still looks like what's accessible to most people. The four O on OpenAI is still, and ChatGPT for AI is still the leader in that space.

Now, again, we've recently saw a great 1 to 2 make it make a big jump. And that's going to make a difference. But it still looks like for the moment, that it's there. it's in the lead. Now you also have Gemini. Gemini which is Google's or alphabet is the parent company is Google's platform, but that looks like it's a little further behind.

So Microsoft continues to be in that lead position with its partnership with OpenAI. And it's integrating those products into Copilot and other parts of the ecosystem. So, you know, a tip of the cap there to Nadella for saying the cloud business, which also enables, by the way, the AI business, because a lot of that training that's happening at OpenAI is happening on Microsoft Azure.

And when they did the deal, that's part of the deal that OpenAI gets access to those servers. And that's super important because when you talk about what do you need to really drive those large language models forward, you need training data, you need training time. And you need really supercomputers to run this. And you need, you know, Nvidia's GPUs as well.

By the way, the H100, that so many people are trying to get to, Microsoft obviously had those things ready to roll. Being able to scale. And that obviously is a great partnership with them. I'll mention another thing that just recently happened on the AI front with Microsoft. They they announced, along with Palantir, a partnership to use those products in the Microsoft ecosystem.

What does that mean? Hard to tell was a press release. well, we'll take some time to figure that out, but it looks like Palantir is going to be another big competitor that is really in the security world. And so it looks like, Microsoft is going to be a leader in there with that them on their platform.

And so again, another tip of the captain, Nadella, for having this partnership and creating this partnership with another leader in AI being Palantir. Now it's recent. It's a news release. We'll see what happens. We'll see you exactly what it means. But it looks like that Microsoft has been very clever, very forward thinking on those partnerships. OpenAI now, Palantir, we'll see where this goes.

But cloud AI, Microsoft sitting at the really at the front of the line on this stuff. Great job. on the management team. So we're kind of, you know, getting to management already here a little bit, but a few more things on the business. And so Microsoft has been acquisitive company. And so they bought LinkedIn. they have bought a Blizzard.

so they're, they're definitely getting to other things. And that's a, you know, Activision Blizzard was a, you know, 60 plus billion dollars acquisition. So you're talking about some really big acquisitions here. and you know, the so far it looks like that Microsoft has been able to digest those, acquisitions and things have gone, really well with respect to those acquisitions.

And so can they integrate, can they really drive, the revenue? It looks like they've been able to protect their margins as we've talked about. you're still looking at net margins at 36 gross margins of 70%. And so they're really not degrading their businesses. GitHub GitHub would be another one of those. And so you're really talking about they're buying companies that look like that they can fit in to, they're going to protect those margins.

So when you talk about ranking the quality from 1 to 10 of the business, you're still looking at eight, 9 or 10 on this business. And even with those large acquisitions, it looks like so far it's still early days that they've been able to integrate those things. The internal growth from Microsoft Azure has been fabulous. And then the partnerships that they're building around AI with OpenAI and now Palantir also look like it really puts them in the pole position for moving forward.

And so really great job. And so we've already been talking a little bit about management. Some of the talk about Nadella, we already mentioned this. But the focus around cloud first when he really took over has been a big success story. And that has really worked out for him. And that is one of the key drivers that put them sort of at that table to negotiate with open AI and really offer something besides money.

Opening at that point could have done a deal with really probably anybody. They were sort of being sought after because they really had the in-house expertise. They were really at the forefront, but they don't need just money. They could get money from a bunch of different people. The capital is out there, but what can they get? Well, they can get access to, all these servers.

They can get access to time on those, and they get access to quickly integrating that into an ecosystem that's already deployed and trusted in the work world. So that is something that, you know, it's a big chip for Microsoft to negotiate with when they're talking about talking to OpenAI in the early days of that partnership. So again, because Nadella put them in a position to be successful, led to an opportunity for Microsoft, and they seize that opportunity.

And again, time will tell. This business is changing. As I mentioned, Rock is moving on. Gemini is getting better. Claude from anthropic is getting better. Those are just a few. There's other players out there. Perplexity AI is another one. And so you're absolutely seeing the competitive landscape change in the AI world. But Microsoft's management team, led by Nadella, has done an excellent job of putting them in a position to be successful moving forward, and has quickly started to integrate those products.

Now we'll have to see in the next couple quarters, and this is something that we're going to get our students to pay attention to, is what is management saying about what they're going to do next, and what is management saying about how they're protecting those margins and making sure that they're maybe even expanding those? Because if they're really getting productivity gains from clients, they should be getting them in-house to from that AI.

So students will be paying attention to what management is saying. LED by Nadella and really, it's going to be important for us to pay attention, you know, not just in the short term, but over the next two, three, four, five, six quarters to make sure that this is really playing out as management has been talking about it and really hold holding them accountable for their actions.

But again, you're giving a really high score from 1 to 10 for Nadella and company. They've done a great job since his tenure at Microsoft. The allocation of capital has been fabulous. There's acquisitions, as I mentioned, work their internal investment into those projects like Microsoft Azure, the partnership. And so allocation of capital. You're going to give them a really great job.

The long term thinking, you know, that is something that's another part of that capital equation that we've talked about before. And some of the episodes that long term thinking has been there. They really put themselves in a position to win. And so you're probably going to give management eight 9 or 1010 being the best and thinking Nadella and company is doing it.

They're executing they're allocating that capital well and they're really taking care of shareholders. So let's move on, to the valuation side of this equation. And so when we talk about the valuation might you know, Microsoft having those high margins, probably should have, you know, a relatively high valuation to the S&P 500 as an example. So dive it in here.

And I'm using Bloomberg data and I'm using data from FactSet for this episode for everybody. So when you look at where the S&P 500 is so right now you're talking about a PE. And we're just in August here. you're talking about a PE of 25 times for the S&P five. Right. So for an average company S&P 500 you're talking 25 times Microsoft is trading at you know their Ford PE is 32 times.

well that's more obviously but not tremendously more than the S&P 500. And it's kind of right near their median just a little bit higher than their ten year median, their ten year meetings right around 30. That that current you know, forward is 32. So you wouldn't say that that's super expensive relative to the last ten years. And you certainly wouldn't say that super expensive relative to the S&P 500.

You would say definitely, it's higher priced. Traditionally that would be considered a high multiple, but what's going to happen when interest rates lower? You know, you're likely historically what has happened is that you get multiple expansion. Now, time will tell what we'll see what happens when rates start coming down and the fed is expected to start cutting rates in September.

They're out in Jackson Hole now having breakfast, you know, at the Frontier Bar and Grill wherever. And but they're going to be thinking about where are they, you know going to be by the end of the year. And likely that means, lower than they are now. And that likely means that the first cut's coming, in September.

And if that happens, that's going to start to be quickly priced in. And much of it's probably priced in already into the market for those cuts start coming. And the forward looking statements start coming after that point. The discount rate for the future cash flows is going down. So that means the present value is going up. So those cash flows are likely going up.

And again you wouldn't say that on the price versus the valuation right now that it's expensive. Another piece that we think about and we we challenge our students to think about on these higher valuation companies. We want to own quality. So you're going to pay up for those quality names. And we shouldn't be afraid to pay up. Now, you can't pay anything because you can't make money if you pay unlimited valuation.

But you have to know that the valuation for a high quality company is going to be higher than average. And in general, most people know that and it's going to be reflected in there. But what we have to understand is we want to hold these companies for a long time. These are endowment funds that are keeping our students focused on thinking long term, just like we want our management teams for these companies to focus long term, a concept called self-similarity and fractal geometry.

We want to make sure that we're thinking about this at least in the next 510 years. It's hard to think sometimes beyond that, but really we want to be thinking about that. So is this a high quality business? I would say in the case for Microsoft eight, 9 or 10 that we talked about. Absolutely, yes. So we should probably pay up for it or the margins.

Good. Is the management team good? Okay. Well that also means we're likely going to pay up for this. So you're already at higher quality business. You're already had a fantastic management team. So we should be willing to pay, to own shares in this company or to own a percentage of this company. And that's fine. And we did and we do, you know, but we bought these a while ago.

So, they have grown over time and we've done quite well in our investments at the GW Investment Institute in Microsoft. But we got to think about today, we got to think about tomorrow. So are we okay with owning it at this valuation. And that's one of the questions that we'll be asking our students to think about this coming semester.

Are we okay with this valuation? You know, a very abbreviated version, which we're doing in this episode. It looks like right now we are, again, based on the high quality business, the high quality management team. That hasn't changed. If something changes, then we have to revisit this, right? If Nadal is leaving and somebody else is coming in, that score for that management team, we're going to have to revisit.

Which then interrelates to the price valuation. What we're willing to pay for that, right. Is that really something where we want to be. So we have to, you know, think about that. All these things are interrelated on this structure. So we have to always consider them not just one by one, but one by one, and then, against each other and interlaced with each other.

So it looks like. So when you wrap up on the valuation here, you know, where is that between an A one and a ten. It's probably not eight, 9 or 10, but it's probably 6 or 7. You know, it's probably okay to, you know, slightly better than okay, at a 6 or 7, maybe it's a six and a half or six, seven, five, let's say, but where we're going to be willing to pay up for that, where we understand it's a higher valuation.

But historically for the last ten years, it's not a significantly higher valuation than the median for Microsoft. You're talking about 32 versus 30 right now. So that's okay. Again, maybe that's not great. Maybe we're you know, certainly when you talk about the grand view of the world that that wouldn't really fly. But when you talk about really more modern day Buffett, that's going to be just okay.

All right. So now we've talked about those things. And so we're in good shape. But the overall score here high quality business for that. So now let's dive into the balance sheet. So let's get comfortable with where Microsoft is on the balance sheet. So ideally we have you know net cash on the balance sheet Microsoft actually has a little bit of net debt as of June 30th but not a ton.

And they're generating we have 75 billion, in cash and cash equivalents and about 97 billion, in debt. So you're, you're talking a little over $20 billion in net debt, but, what's their net? what is their free cash flow? Their free cash flow is 75 billion. So we're certainly not worried about a number like 20.

And we talk when we talk about, okay, well, what is another ratio that we should all be looking at when a company has that. And in this case they have some net debt. What is the interest coverage ratio. And so what's interest coverage ratio. That is Ebit over interest. So earnings before interest and taxes over that interest.

And so how many times do we have for that. Right. So right now it's 37 times. So more than enough earnings to pay that interest. We're not concerned. it's not really a cyclical business. So if you have a really low number on that interest coverage ratio, that would be a concern, especially if it's a cyclical business. So if you think about a commoditized business that goes up and down with the business cycle, a cyclical business, you would be concerned if that number is lower, because what happens to earnings in a cyclical business?

Well, they tend to go up in the cycle and they go down on the cycle. So we we if we're at the top of the cycle and our interest coverage is three, well that's a big concern because if earnings are projected go down in a cycle, what that number is going to get lower. And the biggest risk for any company is going out of business and bankruptcy, not being able to service the debt at 37 times.

Not a cyclical business generating 75 billion in free cash flow. We are we are not really concerned about that, that we will sleep well at night. So the balance sheet is an eight, 9 or 10 depending on, you know, how conservative or aggressive you want to be with it. They've been very responsible, with that. And when you talk about the interrelation, their management team has been fantastic on the balance sheet here.

They've never been really in a position, of stress at Microsoft since really the inception of the company, maybe minus, the very beginnings in some other spots. But certainly in the last ten years, Microsoft has not been in any place where we would be concerned about the balance sheet. That remains to be the case today. So that's an eight, 9 or 10.

So when you talk about the general scores, you're really still talking about an eight out of ten for the whole thing. If you wait everything 25% and you kind of give everything an eight, nine and ten except for the valuation, you give that a six, seven, five. Maybe that puts you at a nine depending on how you score everything.

And again, we don't need to be overly precise. That's the Charlie Munger beat generally. Right then specifically wrong. So if you were playing at home and you want to count, you know, very specifically up, which we do in class, by the way. But what we generally want to do is be generally right. We want to know, okay, well, what's the overall score, using this framework where we're comfortable.

So this business management price valuation a balance sheet that's probably an eight, 9 or 10 overall depending on how you score it. Again, aggressively or more conservatively for each of those components. But Microsoft has been a fantastic business. It's been a good investment for the GW Investment Institute. The business, again, is a high margin business. They, you know, been investing in things like Microsoft Azure.

They're adding things like Activision Blizzard and LinkedIn and GitHub. And they built partnerships as well. So when you talk about the growth of the business, they're doing everything and those things around AI. So with OpenAI and now Palantir you have to keep watching this. You got to make sure you know what you're doing. the management team Nadella has been fantastic.

It looks like they'll continue to be fantastic. So you got to make sure that you're really, watching there. It doesn't look like there are any signs that he's going anywhere. And and his team with him is going anywhere. But we got to pay attention. The valuation remains, you know, again, close to the ten year average. And again, a super clean balance sheet that we can all sleep well at night.

So right now it looks like Microsoft will continue to be in our portfolio, will ask our students to check it out. this semester. Reminder this is a show. This is not investment advice. And this is all about our students and the funds that we manage of the investment Institute. So with that, I'll bid you farewell into the next episode.

See you next time. Disclaimer the content shared in the GW Investment Institute podcast is for informational and educational purposes only, and should not be considered investment advice. The opinions expressed in this podcast are those of the host and guest, and do not necessarily reflect the views of the GW Investment Institute or the George Washington University. Listeners should not act upon the information provided without seeking professional advice from a qualified financial advisor.

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