La Canada High School
Young Investors Society
Microsoft Corporation
Software and Cloud
Computing
Symbol: MSFT
Recommendation: BUY
COMPANY STATISTICS
Market Cap ($ Bn):
Enterprise Value ($ Bn):
52-Week Range: $238 - $349
Dividend Yield:
Free Cash Flow Yield (NTM):
P/E (NTM):
EV/EBITDA (NTM):
Return on Equity (2021):
Return on Invested Capital:
Source: The Walt Disney Company
Ma y 1 5, 20 2 2
Research Analysts:
Headquarters: Redmond, WA USA
Shant Koutnouyan, Cameron Lay
Current Price: $261
shantkout@gmail.com
Target Price: $374
clay23@mylcusd.net
Company Overview
$2319 We believe that Microsoft will yield consistent returns while having minimal downside.
$2274 Microsoft’s business consists of three segments: Productivity and Business Processes,
Intelligible Cloud, and More Personal Computing. Productivity and Business Processes is
made up of Office Commercial, LinkedIn, and Dynamic. This segment has seen consistent
0.95%
growth from 2018 to 2020 with an annual revenue growth rate of 20% and is likely to continue
3.6% its growth due to an increase in Microsoft Teams usage. Secondly, Microsoft’s largest
27x revenue generating segment is Intelligible Cloud, which is its fastest growing and most
promising segment. Microsoft’s server product Azure is becoming increasingly competitive
20
with AWS and saw a revenue growth of over 50% last quarter. Lastly, Windows OS and
48% Surface fall under the More Personal Computing segment, which is likely to generate steady
33% revenue in a maturing PC industry. A sizable portion of Microsoft’s Cloud and Business
Revenues (which combined make up two-thirds of total revenues) are recurring; these
offerings are integral to operating businesses and we believe clients are unlikely to cancel
during economic weakness. Close to 50% of Microsoft’s revenue is generated from the United
States; we feel confident that consumer spending, and GDP growth will increase in the U.S.
and that the U.S. will remain a leading player in the technology sector.
Sales by Geography: United States 50%, International 50%
Market Position: MSFT is a market leader in each of the segments it operates. MSFT’s cloud
segment is the second largest in the world in terms of revenue, trailing only Amazon Web
Services. Microsoft’s operating system serves along Apple’s offerings as a duopoly in the
personal computer space. MSFT also operates a robust gaming segment which has
continually grown revenue, and with the acquisition of Activision Blizzard, MSFT is able to
control the game development and game distribution through Xbox. Lastly, MSFT’s
commercial offerings provide a reliable source of reoccurring revenue, with a lack of
competition for a complete suite of Business-to-Business products.
Shareholders: Institutional investors hold the majority of Microsoft’s shares at about 65% of
total shares outstanding. The top three institutional shareholders are Vanguard, BlackRock,
and SSgA.
INVESTMENT THESIS
We rate Microsoft (MSFT) as a Buy with a base case Target Price of $418. Our
recommendation is driven by the following key points:
• High growth yet defensible business – MSFT has nearly tripled revenue over the past
decade, and its cloud business segment, including Microsoft Azure, is expected to
continue growing above 25% a year for the next several years. We believe there is
considerable room for upside for both revenue growth and margin expansion, particularly
in MSFT’s business offerings and cloud segments.
• Wide competitive moat – Microsoft has developed a large ecosystem of products which
allows it to continually cross-sell to customers while simultaneously making it increasingly
difficult to steal MSFT’s customers. MSFT has its software installed on over 74% of
laptops and it manufactures a sizable amount of hardware as well, essentially having
monopolistic control of which service offerings can be used on their platforms.
• Competent management and large upside in future acquisitions – Over the past
decade, management has made a series of accretive aquitions, including LinkedIn,
 Page 2 Microsoft Corporation

• Competent management and large upside in future acquisitions – Over the past
decade, management has made a series of accretive acquisitions, including LinkedIn,
Skype, and GitHub, all of which have seamlessly integrated with their existing product
offerings, fueled further revenue growth, and contributed to MSFT’s 33% ROIC. We
believe management will achieve the same level of success with the Activision Blizzard
acquisition as well as future acquisitions, through which they will be able to return
substantial capital to shareholders.
• Cheap Valuation – Based on an average of our fair value target prices using relative
valuation and a DCF, we believe there is 43% upside to fair value.
• Industry Analysis
• Cloud Market – The global cloud computing market is projected to grow at an CAGR of
16% for the next five years, from 445B USD to 947B USD. The COVID pandemic only
accelerated this growth, and we believe that economic reopening will not hurt the growth
of the market. In fact, COVID has provided opportunities in the space, with Microsoft
announcing healthcare offering in order to improve workflow efficiency and help analyze
date for healthcare organizations.
Microsoft is the second largest cloud provider globally with a 20% market share, trailing
only Amazon (32%) and followed by Google (9%), Alibaba (6%), IBM (5%) and
Salesforce (3%). Amazon’s cloud offerings are growing at a slower rate compared to
those of Microsoft; we project that Microsoft can overtake Amazon Web Services in terms
of revenue over the next decade if they continue to expand their cloud gaming business.
• Business Productivity Software Market – The global business productivity market is
expected to grow at a CAGR of 13% until 2028. We believe that blockchain technology
as well as new data analytics tools will be used in businesses of all sizes, helping drive
growth in the market. We believe MSFT will be able to use its large cash pile to be at the
#1 forefront of innovation in this sector and continue to remain ahead of the competition.
• Clients in the business productivity market tend to remain with their provider for extended
periods of time and do not offer switch from one service to another. This is because
#6 integration with a customer’s business and that company’s employees requires
#10 11 #13 #19 considerable effort and training. Therefore, once MSFT gains a new customer, it is
000 extremely likely that they will continue to pay MSFT for the years to come, ensuring that
MSFT continues to remain the leading player in the industry.
Competitive Positioning
Moat Analysis: Wide-Moat
Source of Competitive Protections:
• Necessity- Cloud storage and B2B software are essential for businesses and hence
they cannot forgo the service without substituting it. Therefore, in a recession, it is
unlikely that customers would cancel their Microsoft subscriptions.
• Lack of competition + substitutes- Smaller competitors do not have the entire
suite of cloud offerings MSFT has. There is one other computer operating system
that has sizable market share and that is Apple which is mostly for graphic design
and some personal computing. Large corporations rely heavily on MSFT operating
systems as well as its cloud offerings.
• Scale – MSFT has been able to increase their gross margins over the years to 70%,
allowing it to have a commanding position in a hypothetical price war.
• Recurring Revenues - As of 2021, 2/3 of MSFT’s revenue is recurring, anchored by
the commercial portion of the business. This makes MSFT less susceptible during
times of economic uncertainty and further solidifies MSFT as a great asset as the
business is not “hit-driven.”
• Long term contracts – MSFT has multiple long-term contracts which ensure a
substantial portion of revenue in the coming years. For instance, MSFT has a 22B
contract with the United States government for AR headsets.
• Proprietary Data - For years, MSFT has collected user data from billions of
computers allowing it to continually better its offerings. Not only do competitors do
not have the same number of financial resources to spend on R&D to outcompete
Microsoft, but they do also not have the necessary data points to create a seamless
software offering.
 Page 3 Microsoft Corporation
Page 3

Figure 4: Porter's Five Forces

Porter’s Five Forces:
Bargaining Bargaining Power of Customers – Low (3 out of 5) Microsoft’s three segments all feature
Power of
Customers
competitive alternatives with moderate to high costs (which vary for corporate clients
5 compared to individual consumers), meaning customers are not motivated to switch
4
3 from Microsoft’s products. Further, Microsoft’s products have become a part of
Intensity of
Barriers to 2
Competitive customers’ daily lives; hence, they are unlikely to cancel their MSFT service.
Entry 1
Rivalry
0
Intensity of Competitive Rivalry – Moderate (2 out of 5): Microsoft’s cloud segment is
competitive with other service providers like AWS, Google, and Salesforce, all of
Bargaining
Threat of
Power of which are investing capital into their cloud products. However, Microsoft has been
Substitutes
Suppliers increasing its cloud market share, coming up to 20% in 2020. Microsoft also
experiences competition from Sony and PlayStation products against their Xbox
ecosystem.

Bargaining Power of Suppliers – Low (3 out of 5): Microsoft codes its own software, and
since it is primarily a software company, suppliers do not significantly affect tis
LEGEND business. Although the current chip shortage gives hardware suppliers leverage,
Microsoft’s scale mitigates this.
0 High threat
1 Significant threat
2 Moderate threat Threat of Substitutes – Insignificant (4 out of 5): There are switching costs for
3 Low threat substitutes, but Microsoft’s products are reliable, and MSFT offers a more complete
4 Insignificant threat product suite compared to any of its competitors. MSFT’s product suite has become
5 No threat
more of a necessity for customers over the years, making it less likely that clients will
cancel their services without finding a replacement.

Threat of New Entrants – Insignificant (4 out of 5): Significant capital is needed to start
a technology company and develop its brand, preventing many companies from
posing a significant challenge to Microsoft.

Revenue Drivers
Below are the main drivers behind Microsoft’s revenue growth:
• New IP developments – MSFT has enough engineers and financial resources to
continually develop new IP and be at the forefront of innovative technology in all of their
business segments, allowing them to fuel future revenue growth and expand their market
share.
• Mergers and Acquisitions – Microsoft’s management has demonstrated that they are
competent in being able to conduct accretive acquisitions which align with the company’s
vision. Management can purchase businesses with large future growth runways at
multiples which are cheaper than what MSFT stock is trading at and are able to achieve
high returns on capital and equity.
• Pricing Power – Because of MSFT’s strong brand and ecosystem, the company has
consistently been able to raise subscription prices above inflation. For instance, MSFT
raised prices up to 20% for commercial clients in 2021. We believe MSFT commands
similar pricing power across all its business segments, and as a result, it will continue to
improve its margins.
• Microsoft Azure – Microsoft Azure continues to grow at over 30% a year and has
operating margins of over 40%. We believe Azure, along with the rest of MSFT’s cloud
offerings will continue to comprise of a larger portion of MSFT’s overall revenue in the
coming years. Microsoft is looking to increase usage of its cloud products through
government contracts, such as those issued by the US Department of Defense, that have
been until now been dominated by Amazon (AWS).
Page 4 Microsoft Corporation

Financial Analysis

Above are financial statements for Microsoft. Our forecasts for Microsoft’s revenue growth,
margins, and other key forecasts are included in our DCF attached on pages 7-9.

Profitability: Overall, the company has decent and stable margins – Gross profit margins
have been above 60% for the past five years and are increasing steadily. Operating margins
have also increased during this period, rising to over 40%. ROE is at 48% and ROIC is at
33% as of Q4 2021.

Growth: The company has delivered a revenue CAGR of ~9% for the last decade. MSFT
has reaccelerated its growth from 2016 onward due to investment into cloud infrastructure
and offerings.

Balance Sheet:
With 333 billion dollars in assets compared to 191 billion dollars in liabilities, Microsoft has
enough cash to withstand a short-term economic downturn. Microsoft also has over $45
billion in net cash and will likely generate over $62 billion in unlevered free cash flow in
2022.

Valuation
Our fair value target price is $374 per share for MSFT, which represents 43% upside from
the current share price. I arrive at my target price through the following assumptions:

• We first used comparative company analysis to screen MSFT (inserted on page 5), and
we realized that it traded favorably on a relative basis to its competitors in the data
analytics, cloud computing, and commercial software sectors. Microsoft outperforms the
industry average in all metrics besides current FCF yield. This can be explained by
MSFT’s large amount of Capex, mostly spent on developing new software. Since
Microsoft can generate high returns on capital and investment(30+%), we believe
elevated levels of Capex relative to its peers allows MSFT to continue to remain a
dominant player in all sectors which it operates in, ultimately leading to increased
shareholder returns over the long term. We decided to determine MSFT’s relative
valuation using EV/EBITDA since it better reflects the earning potential of the core
business compared to EPS. Based on the NTM EV/EBITDA metric, Microsoft is
undervalued by 35%, trading at 20x 2022 EBITDA instead of 27x; hence, based on our
comparative analysis, we believe, Microsoft should be trading at $353.
Page 5 Microsoft Corporation
Page 5

Comparable Company Analysis:

• We then built a discounted cash flow model to determine our expected return and price
target for MSFT. We forecasted out our projections for MSFT for the next ten years. Our
estimates included at bull, base, and bear case. For our bull case, we factored in
Microsoft’s ability to make accretive acquisitions, utilizing its $125 billion cash position. If
Microsoft deploys its cash while maintaining its ROIC of over 30%, it can sustain
heightened real revenue growth. We believe Microsoft can continue to increase margins
as it scales and take advantage of synergies from its acquisitions. Our bear case assumes
increased competition from companies like Google and Salesforce, as well as new entrants
into the industry. Our bull, base, and bear case have weights of 30%, 50%, and 20%, and
are factored into our price target.

o We then calculated MSFT’s WACC by using a weighted average for its cost
of equity and cost of debt.

o We then calculated our price targets for a 5 year and 10-year DCF. Our
primary forecast is our 10 Year DCF because we believe MSFT continues
to have considerable growth runway. However, by also creating a 5-year
DCF, we were able to determine that MSFT is also an attractive investment
for investors with a shorter-term investment horizon or for those who are less
optimistic about MSFT’s ability to sustain revenue growth. For both our 10
year and 5-year price target projections, we used an average of our price
target from using a perpetuity growth method and a target terminal multiple
method. For our 10-year DCF we used a 17x FCF multiple and for our 5-
year forecast we used a terminal multiple of 22x FCF. We determined our
target terminal multiples by calculating an average FCF multiple based on
the current FCF multiples of MSFT’s competitors that are growing at the
same rate MSFT was in the final year of our projection. Although we believe
MSFT deserves a premium to its competitors, we followed a conservative
approach and did not factor such a premium in. Moreover, the stock market
as whole has sold off in recent months and returned to historic valuation
multiples, mitigating fears of a market-wide bubble which would decrease
the effectiveness of our method of determining the terminal multiples. We
assumed a 5% perpetuity growth rate for both estimates.
Page 6 Microsoft Corporation

o Based on our 5-year DCF, we received a fair value of $335 using the terminal
multiple method and $364 using the perpetuity growth method. The average is
a fair value of $350.

o Based on our 10-year DCF, we received a fair value of $345 using the terminal
multiple method and $448 using the perpetuity growth method. The average
price target is $396. Since we believe that MSFT can sustain growth for the next
decade, our price target from our 10-year DCF is our primary DCF projection.

• We also calculated our IRR for the projected investment periods and determined that we could
return 15% annualized based on our 5-year DCF and 16.5% based on our 10-year DCF.

• We determined our final price target, $374, by taking an average of our 10y DCF “fair
value” forecast ($396) as well as our “fair value” target price based on our comparative
company analysis ($353).

Valuation analysis: Microsoft’s stock is currently trading at 20x EV/ NTM EBITDA, compared
27x for its peers. Further, we believe MSFT is a higher quality and more robust business
compared to most of its peers and will be able to sustain earnings growth for an extended period,
partially due to their acquisition strategy and high returns on capital. Based on our DCFs, we
conclude that an investor can outperform the market by holding MSFT stock for the next decade,
and we believe MSFT is significantly undervalued at current prices. We aimed to forecast every
aspect of MSFT’s business in our DCFs in order to reduce ambiguity and increase our confidence
in our target price.

Investment Risks
The following are the main investment risks for Microsoft:
• Recession – A recession may decrease consumer spending and as a result decrease
MSFT’s revenue. However, due to the necessity of MSFT’s products, we believe consumers
are unlikely to cancel MSFT’s services, even during economic hardship, as demonstrated in
the past. MSFT’s revenue growth during the recession following the dot com bubble and only
slightly decreased in 2009 before quickly rebounding in the coming years. Margins also
continued to expand during the financial crisis.
• Forex risk- Since half of MSFT’s revenue is from outside the US, MSFT is exposed to Forex
risk. However, politically unstable countries make up a small portion of MSFT’s revenue and
its largest customer outside the US is Europe, which has a stable and reliable currency, the
Euro. For instance, the recent decline in the Russian Ruble did not significantly affect
MSFT’s earnings because the company was sufficiently diversified and only made 7B rubles
worth of revenue in 2019 (a couple hundred million USD).
• Antitrust – Although there is antitrust risk from the US government, we believe it is the least
likely out of the other big tech firms to be broken up because it already has faced and
overcome antitrust litigation in the past, such as in 2001. If MSFT were to be broken up, we
believe that will actually be value accretive to shareholders based on a SOTP valuation. We
believe each of MSFT’s segments can remain separate and continue to dominate their
respective industries.
• Increase in Capex – We believe an increase in CAPEX would only fuel growth, and
although it may hurt margins in the short term, we believe Management will increase
shareholder value by investing in modern technologies and growth avenues to maintain
MSFT’s dominant market positioning.
• Economic reopening after COVID– MSFT was able to grow and execute in a pre and post
pandemic environment as its services are necessary in the digital world we live in today;
therefore, we believe it will thrive regardless of the state of the pandemic.
Page 7 Microsoft Corporation
Page 7

Management & Governance

Microsoft’s management has had an integral role in the company’s success. CEO
Satya Nadella rose from Microsoft’s cloud sector and has led the development of Azure and
oversaw the acquisition of GitHub in 2018 which was purchased for $7.5 Billion, GitHub has
increased Microsoft’s capacity to write its own software and has seen an influx of users
during the pandemic. Nadella also acquired LinkedIn for 26.2 billion in 2016 and has
successfully integrated it into the Productivity and Business Process Segment, almost
doubling its annual revenue to eight billion in 2020. Amy Hood attended Harvard Business
School and worked successfully at Goldman Sachs before becoming Microsoft’s CFO.
Former McAfee CEO Christopher Young is now the Executive Vice President of Business
Development, working to strengthen Microsoft’s internet and device security.

• Major Shareholders – Institutional investors own the majority of Microsoft’s shares,

about 65% of total shares outstanding. The top three institutional shareholders are
Vanguard, BlackRock, and SSgA. The top 3 individual shareholders are Satya Nadella,
Executive Chairman and CEO of Microsoft, who owns ~0.007% of the company’s total
shares outstanding; Bradford Smith, President, who owns ~0.01%; and Amy Hood, EVP,
and CFO, who owns ~0.005%. As the top shareholders control a relatively small
percentage of the outstanding float, MSFT’s stock is exposed to low concentration risk,
allowing for high liquidity in the asset.

• Independence – The board of directors consists of twelve members, ten of which are
independent (non-company executives). There are no red flags in the company with
related party transactions, shady accounting, or poor allocation of capital.

ESG Considerations
MSFT, as well as its peers, are high performers in terms of ESG ratings. Microsoft ranks in the
96% percentile in a pool of more than 28,400 companies around the world that are followed
Source: CSRHub by CSRHub, which is a database website dedicated to tracking and rating companies ESG
performance.
Environment
• Environmental Conservation: Microsoft’s AI for Earth Project uses Microsoft’s
resources to aid humanitarian and environmental efforts around the world, such as using
the Ocean Data Platform to track shipping and pollution in oceans or using Azure and
artificial intelligence to protect deforestation in the Amazon.

• Energy Efficiencies: Microsoft has been carbon-neutral since 2012 and is actively
removing carbon in order to account for emissions taking place in its supply chain.

Society
• Charitable Giving: Microsoft donated $1.4 billion in 2021, including $750 million for
affordable housing in the Puget Sound region.
• Increase Economic Opportunity: Microsoft Airband has given 2.1 million Americans
broadband access to Internet. LinkedIn and GitHub have helped thirteen million learn
crucial development with the Global Skills Imitative.

Corporate Governance

• Corporate Governance Guidelines and Standards of Business Conduct are in place

to oversee the behaviors of all the employees including the management team and board
directors. Regular training is provided to promote these virtues.
• Security – Microsoft’s Digital Crimes Unit has collaborated with multiple countries’ law
enforcement and rescued over five hundred million devices from cyber-attacks.
• Diversity and Inclusion – The composition of the board of directors reflects the diversity
of the company’s shareholders, employees, customers and guests, and the communities
in which it operates. Microsoft offers the Leap Apprenticeship Program to increase
diversity throughout the technology industry.
Page 8 Microsoft Corporation

Appendix: DCF Model

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Page 9
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