Agile Giant
This week, we are not selling any stocks from the portfolio, as we await the Federal Reserve’s policy decision and outlook and focus on their effect on markets. In addition, all Smart Portfolio stocks have performed well in the past week, with no stock flashing a warning sign of any significance.
In this edition of the Smart Investor newsletter, we examine the world’s second-largest company (which looks set to become the biggest in the world). But first, let’s delve into the latest Portfolio news and updates.
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Portfolio Updates
❖ Amazon (AMZN) announced a restructuring process to streamline operations and cut bureaucracy. AMZN’s CEO, Andy Jassy, wrote in a note to employees that he wants the company to “operate like the world’s largest startup.” The move is expected to “remove layers and flatten organizations,” (i.e., eliminate unnecessary managerial positions) by the first quarter of 2025 and improve Amazon’s convoluted chain of command.
❖ Oracle (ORCL) stock reached a record high following its blockbuster earnings report, an announcement of a new partnership with Amazon’s AWS, and a revenue guidance raise. Analysts from leading Wall Street houses, including UBS, Argus Research, Piper Sandler, Barclays, J.P. Morgan, Evercore ISI, Bernstein, Jefferies, and others, lifted their price targets on ORCL.
❖ According to Wedbush analysts, the beginning of the Federal Reserve’s rate-cutting cycle provides a bullish signal for stock markets in general and AI stocks in particular, reviving risk sentiment. They said that “the stage is set for tech stocks to move higher into yearend and 2025,” adding that they foresee a $1 trillion of capex will flow into AI-related areas in the next several years, significantly boosting growth. Wedbush believes that Nvidia and Microsoft will remain central to AI advancement. The unprecedented spending surge will spur many players along the supply chain, from chips to software, infrastructure, smartphones, and more. According to the report, many companies – including Smart Portfolio components Oracle (ORCL), Dell (DELL), and Salesforce (CRM) – are already being lifted by the “AI wave,” with many others still to follow.
❖ Broadcom (AVGO) CEO Hock Tan outlined his views following the company’s increase of its AI sales guidance for fiscal 2024. AVGO works in a market segment directly connected to the hyperscalers’ drive to develop AI models and advanced-tech data centers. Tan said that “these hyperscalers have very strong incentive, ambition to towards building continually, investing in large language models to create models that are smarter and smarter,” which means that their demand for Broadcom’s technology will accelerate.
❖ Arch Capital Group (ACGL) was one of the largest gainers of the Smart Portfolio over the past month, far outpacing the financial sector’s and the insurance industry’s performance. The company’s stock has surged since it reported blockbuster earnings last quarter and raised its earnings guidance. While analyst opinions on ACGL are split, investors view it as a best-in-class insurance stock, displaying a very positive sentiment. Technical indicators point to a strong positive momentum for the stock.
❖ Adobe (ADBE) reported its fiscal Q3 2024 results on September 12th. The company’s revenues and earnings by far surpassed analyst projections, with the top line and the remaining performance obligations reaching a record. Its net new annual recurring revenue for the digital media segment also hit a new high, exceeding consensus estimates by a notable margin. However, the stock tumbled as the software giant produced an underwhelming current-quarter revenue outlook. Still, most analysts reiterated their bullish price targets, noting that Adobe’s projections look too conservative given the projected boost to earnings from the increased AI monetization as the company continues to broaden its portfolio of AI-enabled solutions.
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Portfolio Stocks Under Review
❖ Super Micro Computer (SMCI) remains under review despite its strong rebound in the past week. The upswing followed a turbulent period for the stock, which included strong hits to investor sentiment stemming from a short-seller’s report and an SEC filing delay. Although Supermicro confirmed that there would be no changes to its financial results or forward guidance, many analysts – including JPMorgan, Bank of America, and Barclays – have cut their price targets, citing heightened uncertainty. On the other hand, the stock was strongly lifted by GlassHouse Research’s report, dismissing Hindenburg’s allegations and saying that the filing delay is “a precautionary measure.” The forensic accounting firm announced a long position in SMCI “for the foreseeable future,” stating a highly favorable risk-reward ratio and valuation. The Smart Investor’s long-term thesis regarding SMCI’s immense long-term potential remains intact; we believe the current difficulties to be temporary. However, we are focusing on the company’s provision of clear communication about compliance questions, which we see as key to its ability to overcome negative sentiment weighing down the stock.
❖ Vertex (VRTX) remains under review following its underwhelming Q2 results, which included an EPS miss. The company reported a wider earnings-per-share loss than was expected. Notably, the negative EPS is a one-time event brought on by expenses associated with an acquisition of Alpine Immune Sciences, as well as increased investments to support launches of new therapies. The biopharma giant raised its full-year product revenue guidance, citing growth in sales of its cystic fibrosis (CF) treatment and the soon-to-launch gene therapy Casgevy. The stock fell from its all-time high following Q2 underperformance, though not by a large percentage. Vertex’s stellar finances and cash-producing capabilities, along with its strong portfolio of existing and prospective treatments, provide a strong argument in favor of the company. Meanwhile, the main factor against holding the stock, according to analysts, is VRTX’s high valuation, which could limit its near-term upside. We are waiting for news regarding the company’s trials on portfolio candidates, as well as investor sentiment trends.
❖ We are placing Regeneron (REGN) under review for possible deletion from the Portfolio. The biotechnology company’s shares reached an all-time high at the end of August, falling directly afterward as investors fretted about their overvaluation. While REGN’s strong portfolio and promising pipeline are highly positive factors in the assessment of the stock’s potential, its current valuation calls for faster earnings growth than the company has displayed in recent quarters. Wall Street top analysts currently rate REGN as a “Strong Buy.” However, their average price target implies a mere ~6% upside for the stock in the next 12 months. We are following the company’s updates, watching for news that could justify price-target upgrades that would be required to retain the stock in the Portfolio.
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Portfolio Earnings and Dividend Calendar
❖ The Q2 2024 earnings season is officially over, with no Portfolio companies scheduled to release their results until mid-October.
❖ The ex-dividend date for Salesforce (CRM) is September 18th, while for Broadcom (AVGO) it is September 19th.
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New Buy: Microsoft (MSFT)
Microsoft Corp. is a U.S.-based global technology conglomerate, offering an array of software, services, and solutions, as well as devices like personal computers, tablets and gaming consoles, and cloud computing solutions.
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The Making of a Giant
Microsoft was founded by Bill Gates and Paul Allen in 1975 and became the dominant PC software player thanks to the release of the MS-DOS operating system in 1981 and the introduction of Windows a few years later. The release of a conceptually new system with a user-friendly interface propelled Microsoft to outright PC market supremacy.
In the years that followed, MSFT maintained its hold on the PC OS market through continuous new system releases and other innovations, as well as expansion to various markets and spheres. Thus, in 1989 it introduced the Office suite of productivity applications, which quickly captured the market. In 1995, Microsoft began to redefine its offerings and expand its product line into computer networking and Internet browsing. An early start in the new realm of the World Wide Web gave the company a significant competitive advantage.
In the 2000s, Microsoft’s presence in the hardware business, previously confined to the production of computer mouses, significantly expanded. It expanded into the video game console market, previously dominated by Sony and Nintendo, with its Xbox console, and introduced additional products, such as the best-selling wired keyboard and webcam. In 2008, Microsoft entered the cloud computing market with the launch of the Azure cloud computing platform. In this period, it introduced its mobile phone operating system, Windows Phone, and launched or upgraded numerous advanced products and services, such as SQL Server, Visual Studio, Bing engine, Outlook Webmail, Kinect, etc.
In addition to the internal R&D investments that led to the development of a wide array of products and services, Microsoft grew and expanded through multiple strategic acquisitions. Over the years, the tech behemoth acquired over 220 companies, purchased stakes in 65 companies and made 25 divestments. The most notable company buyouts in the past two decades included Skype in 2011, Nokia’s devices and services division in 2013, LinkedIn in 2016, GitHub in 2018, ZeniMax Media in 2020, Nuance Communications in 2021, and Activision Blizzard in 2022.
Microsoft’s IPO in 1986 valued the company at $520 million. Today, Microsoft is the second-largest company in the world by market capitalization after Apple, at times even overtaking the iPhone maker. Its annual revenue of $245.12 billion placed it #13 on the Fortune 500 list.
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The Top of the AI League
MSFT has purchased stakes and made significant investments in multiple businesses. Perhaps the most consequential of these investments is OpenAI, the creator of the Generative Artificial Intelligence (GenAI) tool ChatGPT. Microsoft’s initial 2019 investment into a then-unknown start-up was $1 billion; since then, its total investments in the firm have amounted to over $13 billion.
OpenAI’s rise to global fame since the release of its first ChatGPT version in 2022 speaks volumes about Microsoft management’s strategic vision and the ability to recognize opportunities early on. The strategic partnership is mission-critical for both parties: at OpenAI, it facilitated and accelerated the creation of advanced tech, while enabling Microsoft to become the leader of the AI race. OpenAI has become the core of Microsoft’s development strategy, with its AI technology incorporated across MSFT’s products and services portfolio.
This close cooperation has propelled MSFT to the top of the AI leadership league, allowing it to compete in areas where it previously lagged. Thus, the AI-powered Bing search engine and Edge internet browser can now take on MSFT’s largest competitor in these areas, Google parent Alphabet. Meanwhile, the inclusion of GenAI tools in products such as Windows, Office, and GitHub further cements the giant’s leadership in these niches. Importantly, Microsoft also develops in-house AI offerings such as Copilot.
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Up in the Clouds
Notably, Microsoft also offers OpenAI technology on its Azure cloud platform, where thousands of its business customers can use it to develop their own AI models. Azure is Microsoft’s fastest-growing business segment, which continues to gradually increase its market share, competing with Amazon. While the latter’s AWS retains the largest market share, 31%, Azure Cloud’s share has risen to 25% of one of the most lucrative and fastest-growing global markets. A significant part of Microsoft’s success is due to the fact that Azure is the only public cloud platform allowing customers to use its LLMs for building generative AI applications. Currently, 85% of Fortune 500 firms use the Azure cloud.
The company’s CEO, Satya Nadella, has made AI one of the top priorities for the firm, signaling that the roll-out of the advanced tech features in its products will not slow down. The other top priority for Microsoft is cybersecurity, which supports Azure’s rising popularity among business customers. The firm’s focus on security is gaining notable traction: for example, its “Defender” for cloud contributes $1 billion in quarterly revenue. MSFT’s GenAI security tool, Copilot for Security, is projected to further cement Microsoft’s leading position in the cloud cybersecurity market.
According to analysts, Microsoft and Amazon (a Smart Portfolio holding) are best positioned to win the AI arms race thanks to their immense intellectual and financial “war chests” that are artfully deployed at the right time and place.
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The Best-Run Company in the World
In 2023, Microsoft was ranked as the most effectively managed company in the world by the Wall Street Journal, holding the top spot for the fourth consecutive year. Case in point: Microsoft is the only tech giant at the moment not involved in antitrust lawsuits or regulatory scrutiny among its fellow Magnificent Seven companies. The tech leader also scored well across a wide range of measurements, including innovation, customer satisfaction, and financial strength.
Indeed, MSFT’s financial health is more than stellar, despite all the acquisitions and heavy investments. It has a flawless balance sheet with a solid track record, carrying zero net debt (it holds more cash than its total liabilities) and earning more interest than it pays. Moreover, Microsoft carries best-in-class metrics in terms of capital efficiency and profitability. Its ROIC and gross margin rank in the top 15% of software firms, while its ROE, ROA, operating, FCF, and net income margin make the top 3%.
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Expected Growth Acceleration
In the past five years, Microsoft has grown its revenues at a CAGR of 15%, and its earnings-per-share rose at a rate of 19%. While these rates are more than solid for a company of its age, size, and reach, Microsoft refuses to see itself as a mature slow-growth giant. The company’s forays into the most advanced technological areas are widely expected to propel its growth rates, and it is already beginning to monetize its massive AI investments.
The vast amounts of cash produced by the company are deployed to growth-inducing areas such as AI, cloud, data infrastructure, and more. Since Microsoft is one of the most effective cash machines in the world, it can easily outspend its competitors. Although currently, it falls behind Amazon, Alphabet, Meta, and Apple in terms of R&D investment, this doesn’t include the massive OpenAI stake or its global venture portfolio consisting of dozens of AI and other advanced tech startups.
In the fiscal year 2024 (ended June 30, 2024), the company reported revenue growth of 16% year-on-year, as well as a 24% increase in operating income and 22% growth in net income and EPS. Azure revenue led the growth, surging by 33%, fueled by the growing demand for AI services. Importantly, Microsoft is already reporting that its newly introduced Copilots, the GenAI assistants integrated across the company’s platforms, are gaining traction. By the end of FY 2024, 60% of the Fortune 500 firms have adopted Copilots, while 65% use Azure OpenAI Service.
More importantly, Microsoft’s current strong momentum is slated to accelerate in FY 2025, supported by the accelerated demand for AI and security solutions, particularly in the cloud segment, as well as its strategic collaborations. For example, Microsoft’s recent cooperation agreement with Palantir is expected to expand the Azure Cloud’s integration with government projects, such as national security missions, expanding MSFT’s reach and benefitting its top line. Microsoft maintains long-term strategic partnerships with leaders of all industries, such as Nvidia, Accenture, Palo Alto Networks, Workday, and many others, including Smart Portfolio firms Salesforce, Adobe, Amazon, and Check Point.
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Now is the Right Time
Until recently, analysts were undecided whether Microsoft would be able to quickly monetize its massive AI investments and speed up its revenue and earnings growth. After the FQ4 earnings release, the company’s stock declined, as investors fretted over its plans to ramp up spending on AI infrastructure, leading to a surge in capex over the next several quarters. However, it now seems quite apparent that the best-run company in the world is set to win the AI and cloud race.
Azure is now the fastest-growing cloud platform among hyperscalers, slated to display an over 30% year-over-year revenue growth in FQ1 2025. Moreover, in FQ4 2024, various AI tools contributed 9% of total Azure revenue, reflecting the increasing importance of AI in cloud platform customer adoption and revenue growth. In addition, the company’s recent release of new collaboration, automation, and Office Copilots is expected to further strengthen its leadership in AI monetization at the application layer. Moreover, OpenAI has recently introduced a new “reasoning” ChatGPT model, which, once exiting the beta stage, is expected to be integrated into Microsoft’s Excel, GitHub, and other platforms used in research, analysis, and development applications.
Besides AI and cloud, Microsoft is seeing significant advantages from its Activision Blizzard acquisition, finalized in 2023 and integrated into the Xbox ecosystem. The buyout has made a notable contribution to a 44% year-over-year growth in gaming revenue in FQ4, making the firm’s gaming division one of the industry’s revenue growth leaders. Growth acceleration is expected to continue well into FY 2025.
Moreover, the recent news coming from Microsoft’s fiscally conservative management confirms the company’s belief in the continuation of its success. This week, the company announced that it would increase its quarterly dividend by nearly 11%, starting with December’s payout. MSFT also approved a massive new buyback program, allowing the company to repurchase up to $60 billion of its outstanding shares. These announcements came as a relief, convincing investors that Microsoft can balance its rising AI and cloud capital investments with shareholder compensation.
While these announcements have added to the MSFT stock’s recent strong performance, it remains well below its July record high. In addition, the previously-mentioned advancements have led analysts to raise their earnings growth estimates, decreasing its forward valuation. While Microsoft understandably carries a notable premium over average Technology sector valuations, its forward PE comes at the middle of the range for the Magnificent Seven cohort. MSFT trades at a good value compared to the U.S. Software industry’s average current PE. Moreover, when taking into account Microsoft’s monumental expected cash flows, it appears undervalued by about 25%. Wall Street analysts currently see a ~15% upside for the stock in the next 12 months; barring a tech sector stock decline or a general market crash, we believe it may surprise on the upside.
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Investing Takeaway
Microsoft is one of the most valuable companies on the planet, featuring consistent market dominance in various spheres along with steady revenue and earnings growth. As a result of its proactive approach, MSFT is well-positioned to capitalize on the surging demand for cloud and AI solutions. Thanks to its massive cash flows and best-in-class management, MSFT can successfully balance its large investments in AI and other technologies needed for growth acceleration, with generous shareholder compensation, including consistently rising dividends and large buybacks. Overall, Microsoft is projected to keep rewarding shareholders for years to come, and as such, we view it as an attractive long-term investment.
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Smart Investor’s Winners Club
The 30% Winners Club includes stocks from the Smart Investor Portfolio that have risen at least 30% since their purchase dates.
Our list of Winners still holds 16 stocks, with minor lineup changes versus last week. The Club stocks are GE, AVGO, ANET, ORCL, EME, TSM, SMCI, PH, CHKP, TPL, GD, APH, HWM, ITT, AMAT, and VRTX.
The next in line to enter the lucrative club is now PNR with a 26.4% gain since its purchase on June 26th. Will it close its minor gap to 30%, or will someone else outrun it to the finish line?
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Disclaimer
The information contained in this article represents the views and opinions of the writer only, and not the views or opinions of TipRanks or its affiliates and should be considered for informational purposes only. TipRanks makes no warranties about the completeness, accuracy, or reliability of such information. Nothing in this article should be taken as a recommendation or solicitation to purchase or sell securities. Nothing in the article constitutes legal, professional, investment and/or financial advice and/or takes into account the specific needs and/or requirements of an individual, nor does any information in the article constitute a comprehensive or complete statement of the matters or subject discussed therein. TipRanks and its affiliates disclaim all liability or responsibility with respect to the content of the article, and any action taken upon the information in the article is at your own and sole risk. The link to this article does not constitute an endorsement or recommendation by TipRanks or its affiliates. Past performance is not indicative of future results, prices, or performance.
