Microsoft can ride its software business past $1 trillion

Although Microsoft first became a member of the trillion-dollar valuation club in April, it didn't stay there long — that is, until June, when Microsoft's stock price soared and has stayed high.

Where will the company's next growth spurt come from？

Long-time Microsoft bull Keith Weiss of Morgan Stanley says that the company's hopes rest on the fundamental software that it sells to businesses and developers, not the fancy cloud stuff that's driven so much of the company's recent growth.

This concept has some serious implications for Microsoft's near-term profitability, too.

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In April, Microsoft became just the third company ever to be worth $1 trillion dollars, after Amazon and Apple — but it quickly wobbled below that valuation until last month, when shares started hitting one record high after another.

On June 24, shares hit nearly $138, and although they are back to about $135, that's enough to bring it over the trillion-dollar market cap by a tad.

How does Microsoft grow from here？

Long-time Microsoft bull Keith Weiss of Morgan Stanley believes that it's not Microsoft's fancy new businesses that will do it, like cloud computing, the internet of things, or AI.

Rather, he sees growth in Microsoft's old-fashioned enterprise software as the engine that will drive shares to his predicted target price of $145. He's gives Microsoft an “overweight” grade, too, akin to a “buy” rating).

Weiss predicted Microsoft would soar to $130/share and a trillion-dollar valuation about a year before it happened, saying back then that it was Microsoft's cloud growth that would push it over the edge. That makes it interesting that he's now calling out some of Microsoft's more traditional areas of business.

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“A key debate on Microsoft continues to be the durability of growth in Microsoft's on-premise server products and tools, and recent weakness seen in other on-premise infrastructure software vendors (Cloudera, Pivotal, VMware) likely further stokes the debate. We forecast durable low-single digit revenue growth powered by SQL Server market share gains, adoption of premium SKUs across server products, and Azure Hybrid Benefits,” Weiss writes in a note to clients on Monday.

To decode that a little, he's saying that while other companies that sell traditional licensed software are being squeezed by the move to cloud computing, Microsoft is about to make even more money from its classic software business.

That's because Microsoft's flagship database product, SQL Server, is doing really well these days. Microsoft allows SQL Server to run on Linux, not just Windows, and it's got a bunch of powerful features while still being priced lower than market leader Oracle. Weiss quotes research from IDC that shows Oracle has about 32% market share but lost some ground in 2018, while Microsoft has 17% of the market, but gained share.

And, he notes, an old version of SQL Server is about to expire forcing Microsoft's foot-dragging customers into upgrading.

Most importantly, Microsoft offers its customers Azure Hybrid Benefits, a program that allows their software contracts to cover both the traditional software version and the cloud-hosted version of Microsoft's database (and other software).

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He sees similar reason to believe Windows Server will grow, too. And as SQL Server and Windows Server grow, he expects other Microsoft products, like its server management tools System Center, to grow too, in line.

And Weiss thinks that Microsoft is doing a good job keeping developers using Microsoft's software development tools including Visual Studio and its recently-acquired GitHub, so he predicts growth in those areas as well.

The reason growth in these old-fashioned areas is important is because these software tools are very profitable, and they help offset the lower margins Microsoft may be earning on its Azure cloud.

With cloud products, Microsoft has to pay to develop the new features, just like with its software, but it also must pay all the costs of running the software in its own data centers — and building new data centers, too.

And this worry over how profitable Azure can be, especially if it eats Microsoft's classic software business, has caused some bearish sentiment. John DiFucci at Jefferies wrote in his recent research note, according to SeekingAlpha, that Microsoft shares are “materially overvalued.”

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“Azure will probably never see the margin broadly expected due to cultural and technical factors, and a recent unprecedented boost to cash flow from Windows may not persist,” DiFucci warned.

But, Weiss, the analyst that successfully predicted Microsoft's rise to the trillion-dollar zone, sniffs at that idea, and sees the software business as staying strong for the foreseeable future and sees profits per share reliably growing annually in the mid-teens.

“Confidence in the durability of low-single digital growth in the $19 billion high margin Server & Tools division is foundational to our mid-teens EPS forecast,” Weiss explains.