Microsoft – Another Move, Addressing Healthcare

When Microsoft acquired ZeniMax in September 2020 in a $7.5 billion deal, I concluded that the company was adding to its diversified growth empire. Half a year later, the company is announcing another huge deal, as the company is spending nearly $20 billion to acquire Nuance, but more importantly, key AI technology for healthcare. I like what Microsoft has been doing as the company has seen great operating performance so far this year amidst double-digit revenue growth and real operating leverage.

I like what the company has been doing and while earnings growth is spectacular this year, I simply have to conclude that I have been a bit too cautious in the past, yet I continue to maintain discipline here.

The Thesis

When Microsoft acquired ZeniMax last year, the $7.5 billion deal looked large in dollar terms but was just a rounding error for the company, equivalent to just around half a percent of the enterprise value of the company, with the purchase price being equal to just a dollar in terms of Microsoft’s shares. The steady growth and diversified growth engine, certainly the (all-weather) business model, and low interest rates pushed shares up to levels around the $210 mark at the time.

The deal marked a clear bet on gaming as Microsoft has had exposure to this rapidly growing industry as well with Xbox, of course. With the purchase, Microsoft would add another 2,000 workers on its payroll, with the company responsible for a few great (historic) titles like Doom, Quake, and Wolfenstein.

The company had just reported its 2020 results in July as Microsoft reported a 15% increase in sales to $143 billion. GAAP operating profits rose $10 billion to near $53 billion, for margins equal to 37% of sales! Net earnings came in at over $44 billion, or $5.76 per share, as this worked down to a 36 times earnings multiple at $210 per share. Net cash of $73 billion worked down to a $9 per share net cash position, although this is just a rounding error at the time. Operating assets revealed a 34 times earnings multiple with real momentum in the business seen, and thus a lower forward-looking earnings multiple.

This is still a high multiple if we look at valuations in the past, yet Microsoft has simply become a much better and diversified business. The company has moved away from relying on its office monopoly and has built up good franchises in a lot of (adjacent) markets without becoming a fat conglomerate. Other high-fliers within the portfolio include Teams, LinkedIn, Azure, among others, as some of this growth came from deals including the $7.5 billion purchase of GitHub and mostly the $26 billion acquisition of LinkedIn, op top of the deals mentioned earlier in this article.

Lower interest rates have certainly helped as well. Believing that earnings could come in at $6.25-$6.50 per share, a 4% earnings yield looked compelling, as this and some net cash left me to conclude to become a buyer at around the $170 mark.

More Quality Priced In

In the roughly half a year period since I looked at the situation in September, shares have risen from essentially $210 to $260, another big 25% move higher in a relatively short period of time. This is of course driven by record stock markets, yet interest rates have inched up by much, but investors seem to be relieved that is for the right reasons, as the rather violent move in interest rates has not triggered too much jittery in the stock market.

The company has seen solid operational results. In January, it reported a 17% increase in sales to $43 billion as all the segments posted revenue growth, with notable strength seen in Dynamics 365, Azure, and Xbox. Each of these segments posted growth in excess of 30% and multiple other segments posted strong sales growth as well. This growth has been accompanied by near-zero expense growth which resulted in rapid growth in earnings per share. Reported earnings for the second quarter rose from $11.6 billion to $15.5 billion, for earnings which topped $2 per share for the three-month period.

At this rate, the company is earning close to $8 per share at this point in time. This is much more impressive than I believed, as based on my thinking in September that a 4% earnings yield + net cash looked compelling, I think appeal is seen here at $210 per share on the back of improved earnings power.

Net cash of $72 billion works down to nearly $10 per share and this continued and very strong financial footing lies at the base of another M&A deal, this time another sizable acquisition.

Adding Nuance

In April Microsoft announced the purchase of Nuance Communications in an all-cash deal valued at $19.7 billion. The deal takes place at a 23% premium, as Microsoft is attracted to Nuance’s cloud and AI software which it has accumulated over the past decades.

With this added expertise, Microsoft aims to accelerate efforts to provide specific cloud offerings in response to disruption opportunities including healthcare which has become a real spear point for the company last year. This huge industry is not only growing but is in desperate need for transformation as well.

Nuance is notably strong in ambient clinical intelligence and clinical speech recognition. Of interest is that both companies have been working together since 2019 as that partnership has been a success and has benefited the company already.

Nuance will add about $1.5 billion in sales as this really is a strategic deal as the acquisition will add less than a percent to overall sales. Nuance is modestly profitable, although the forfeited interest income makes that the deal really does not have an impact on the bottom line for Microsoft, and is all about strategic and thus organic growth pace of the business in the future.

Very hard to say, yet with a $20 billion acquisition price, this deal would likely be very important or transformative in any other case – still, with Microsoft’s equity valuation at nearly $2 trillion here at $260 per share, it is just a rounding error.

A Final Word

Truth is that it remains very impressive what Microsoft is doing as the company continues to make solid ”bolt-on” acquisitions, at least for a company of its size. The company has been showing another year of great operating leverage and with earnings trending at $8 per share here, the same 4% earnings yield and added net cash works down to appeal at $210 as shares trade around 30 times earnings here which is a steep multiple, as we have to keep in mind that interest rates have risen a bit as of recent, yet also that margins have been very high on a historical basis.

That said, I have to give credit where credits are due as Microsoft is a great business and I have been a bit too conservative, chasing upon the investment case here. At these levels, I continue to run behind the facts, yet I continue to act disciplined here even as I have to congratulate management with what seems to be a decent strategic bolt-on deal.