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Surprise, surprise. Microsoft Corporation (NASDAQ: MSFT ) keeps grinding higher. Alongside other big tech names, Microsoft stock has had a hot start to 2018. It's up 3% in less than 2 weeks.
But while that 3% move higher in such a short time frame might seem like a strong rally, it's actually the smallest gain among big-tech peers. Alphabet Inc (NASDAQ: GOOG , NASDAQ: GOOGL ) is up more than 5% in 2018. Facebook Inc (NASDAQ: FB ) has rallied nearly 7% to start the year. Amazon.com, Inc. (NASDAQ: AMZN ) has soared nearly 9% higher. Netflix, Inc. (NASDAQ: NFLX ) is up a whopping 13%, while NVIDIA Corporation (NASDAQ: NVDA ) has done even better, up 16% in the new year.
In other words, a lot of money has gone into big tech to start 2018. But a lot more money has gone into the likes of Facebook, Amazon, Netflix, and NVIDIA than Microsoft.
Maybe because Microsoft stock is nearing a valuation peak and because this company doesn't have the robust growth prospects of other big tech names, investors aren't willing to pump up the valuation to overstretched levels.
Consequently, I feel a top is near in Microsoft stock.
Microsoft Cloud Is Booming
First, lets go over the positives.
At the heart of the bull thesis is Microsoft's huge and burgeoning cloud business. Admittedly, this is an exceptionally attractive part of Microsoft that has huge long-term growth prospects. Moreover, it's only getting more attractive.
According to recent data from Jefferies, Microsoft is the second largest cloud player in the IaaS/PaaS market behind Amazon.com, Inc. (NASDAQ: AMZN ). Including SaaS, Microsoft has the largest total cloud business in the world with 31% market share.
But more than size, Microsoft's cloud business also has robust growth. In the IaaS/PaaS market, Microsoft's 89% growth lags only Google and Alibaba Group Holding Ltd (NYSE: BABA ). Including SaaS, Microsoft's growth, again, only lags Google and Alibaba. In both cases, Microsoft's cloud business is bigger than Google and Alibaba's cloud businesses combined.
All in all, Microsoft's cloud business is big - with big growth prospects too.
Microsoft Stock Is Maxing Out
Unfortunately, the rest of Microsoft's business doesn't have big growth prospects.
Revenue growth over the past several quarters has hovered around 4% to 11%. Granted, overall revenue growth is accelerating and that is due to the cloud comprising a bigger portion of the revenue pie. But in the big picture, 11% growth still isn't that great.
Worse yet, that 11% revenue growth will come down over the next several years, because Microsoft's cloud business will naturally slow.
Over the past several quarters, Azure revenue growth has gone from 120% to 90%. That is a natural slowdown for such a big growth rate, but it is, nonetheless, a slowdown that will continue as the base gets larger (just look at Amazon Web Services, which is growing at 42%). If Azure revenue growth continues to track down to the 40% range that Amazon is currently in, then Microsoft will naturally experience slower overall revenue growth.
From this perspective, Microsoft is likely to experience revenue growth of less than 10% per year over the next several years. I'm modeling for somewhere around 8% per year, slightly lower than Street estimates on Microsoft .
Margins will expand during that time frame, but I don't see any big margin drivers kicking in over the next several years. Rather, I think the current margin drivers will persist. Over the past several quarters, profit growth has been roughly 5 percentage points higher than revenue growth. If that trend persists, then Microsoft is looking at 13% earnings growth over the next several years.
The S&P 500 is trading at an 85% premium to its multi-year earnings growth prospects (21 times this year's earnings for 11.3% projected growth). Microsoft stock easily deserves a 100% premium given its large moat and strong balance sheet. That implies a fair price-to-earnings multiple of 26.
A 26 multiple on this year's earnings estimate of $3.40 implies a "fair" value of between $88 and $89.
Bottom Line on Microsoft Stock
Microsoft stock just isn't as exciting as the FANG group. Consequently, current valuation really matters when it comes to Microsoft stock.
And today, Microsoft stock is approaching fair-value territory. Above $90, this stock becomes overvalued.
As a result, the rally in Microsoft stock will start to top off around $90.
As of this writing, Luke Lango was long FB, AMZN, NFLX, GOOG, NVDA, and BABA.
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