Microsoft stock a buy ahead of Q4 earnings (NASDAQ: MSFT)

Microsoft Stocks (NASDAQ: MSFT) slipped 4% on Tuesday, bringing the company’s year-to-date losses to around 25%. Inflation and the appreciation of the US dollar are currently the main challenges for American companies, including Microsoft. However, Microsoft’s cloud business is resilient and should benefit from growing customer adoption despite economic headwinds. I think Microsoft represents deep recession value at the current valuation and the stock is a buy before earnings!

Why Microsoft Might Submit a Strong Revenue Map for FQ4’22

Microsoft will release results for FQ4’22 in approximately two weeks on July 26, 2022. Microsoft is expected to report Q4 EPS of $2.30, which would show year-over-year growth of approximately 6% . In terms of revenue, Microsoft is expected to see $52.4 billion, implying a 14% year-over-year growth rate.

I think Microsoft will provide a strong earnings card, despite near-term headwinds from the appreciation of the US dollar. The market also had more than enough time to assess currency headwinds – which was the main reason Microsoft updated its guidance for FQ4’22 in June – but I think strong trading performance, in particularly in the cloud sector, could potentially provide a lag to a stronger dollar.

After years of aggressive investments in the cloud business, Microsoft’s Intelligent Cloud business finally overtook the previously dominant personal computing business in the third quarter of 2021. The Personal Computing business, which is still highly relevant with revenue of $14.5 billion in Q3’22, generates revenue from Windows OEMs as well as hardware sales. However, personal computing is no longer as important to Microsoft as the cloud business.

Intelligent Cloud is now Microsoft’s largest business, generating $19.1 billion in revenue in Q3’22, and it’s also the fastest growing business with year-over-year growth 29% at FQ3’22 (constant currency basis). Microsoft’s cloud revenue, due to accelerating market demand for cloud solutions and growing customer adoption, has grown 3.4x since FQ1’16 and the long-term trend of cloud segment revenue growth is uninterrupted.

The transition to cloud products and services has been a great success for Microsoft and has helped the company achieve a cloud revenue share of 37% and an operating profit share of 38% (based on the figures YTD FY 2022). Intelligent Cloud’s revenue share increased to 39% and operating income share to 41% during the third quarter of 2022, showing continued momentum in this business segment. Based on current growth rates, Intelligent Cloud could generate about half of Microsoft’s revenue within three years and also be responsible for about 50% of segment profits.

For FQ4’22, I expect cloud segment revenue to approach $20 billion (and possibly even exceed $20 billion for the first time) and an even higher cloud revenue share between 40% and 41%.

But Intelligent Cloud offers Microsoft investors more than peak growth rates and billions of dollars in quarterly revenue: a buffer against the recession. Microsoft’s Intelligent Cloud business is expected to grow even during a recession due to growing customer adoption and growing demand for IT infrastructure. Businesses are looking to cut costs and achieve efficiencies during recessions, and cloud platforms allow businesses to scale.

Since the cloud segment is already the biggest growth engine within Microsoft in terms of contribution to revenue and operating income, a strong cloud business could also offset other headwinds in the business, such as short-term currency headwinds.

Lower EPS and currency headwinds factor into Microsoft’s valuation

Microsoft has downgraded its outlook for the fourth quarter due to continued strength in the USD. The technology company lowered both its revenue and its EPS forecast in June: fourth-quarter revenue is expected to reach $51.94-52.74 billion, from $52.40-53.20 billion. dollars, while EPS is now expected to be in the lower range of $2.24-2.32. from $2.28 to $2.35. The forecast was specifically lowered due to currency headwinds.

As a global company, Microsoft is exposed to currencies other than the US dollar. Microsoft bills its customers and incurs expenses in other currencies such as Euro, Japanese Yen, British Pound, Canadian Dollar and Australian Dollar. Microsoft derives around 50% of its revenue outside of the United States, a percentage that has remained stable over time. During the third quarter of 2022, Microsoft generated $24.8 billion in revenue in the United States and $24.6 billion in revenue outside the United States, giving the United States a revenue share slightly above 50%.

With 50% of Microsoft’s revenue base tied to foreign currencies, continued short-term dollar strength could impact Microsoft’s earnings outlook beyond the fourth quarter of 2022, but these headwinds are relatively insignificant. given the strong and enduring business trends that Microsoft sees especially in its cloud business. .

Microsoft gave an estimate of the impact of a strong USD on its earnings: a 10% decline in exchange rates – equivalent to a 10% appreciation of the USD – should translate into headwinds on profits totaling $6.7 billion. .

Microsoft’s business is cheap

It’s unfortunate that currency headwinds are distracting investors from the healthy nature of Microsoft’s business. Microsoft is expected to grow revenue at an average annual rate of 14% between 2022 and 2026. By 2026, Microsoft is expected to generate $335.4 billion in revenue and $17.16 in EPS. At that time, Microsoft’s cloud business could generate more than 50% of Microsoft’s consolidated revenue. Microsoft is the fastest growing large technology company, based on 2022 growth expectations, with an estimated revenue growth rate of 18.4%.

Microsoft shares currently have a PE ratio of just 20.4X despite a significant free cash flow value. Google (GOOG) (GOOGL), as the dominant company in search, cloud, and digital marketing, represents deep recessionary stock…just like Microsoft.

Risks with Microsoft

The significant increase in consumer prices remains a major concern for American businesses and although inflation figures for the last month have not yet been released, it is likely that inflation has in fact accelerated in June. A hot inflation report could lead to significant near-term headwinds for US stocks, including Microsoft.

What I see as a bigger risk for Microsoft, from a business perspective, is a slowdown in the company’s most expensive asset: the cloud business. A deterioration in key metrics such as revenue growth, customer adoption, or margins would create additional headwinds for the stock and force me to reevaluate my recommendation for Microsoft.

Final Thoughts

Microsoft shares are a buy before the company submits its Q4 earnings card, as the cloud business likely saw continued momentum in Q4 2022 and could offset USD appreciation. Microsoft’s long-term cloud growth trends are unlikely to be significantly affected by inflation or near-term dollar strength. Given that the cloud now determines the direction of Microsoft’s business, I think the tech company also has great recessionary value!