Fitch Ratings has upgraded the Long-Term Issuer Default Rating (IDR) for Microsoft Corporation to ‘AAA’ from ‘AA+’. The Rating Outlook is Stable. The Short-Term IDR has been affirmed at ‘F1+’. The ratings affect $64 billion of debt.
Microsoft is well-positioned for cloud computing services, leveraging its legacy strengths in software applications that benefit from strong network effects. Fitch expects Microsoft’s cloud-based products, including Office 365, Dynamics 365, Azure and server products, to continue to provide robust growth to mitigate the secularly weaker and cyclical PC-related products. In addition, the adaptation of the Office suite of products to the cloud delivery model effectively decouples Office products from personal computers (PCs), enabling continuing growth of Office products in spite of the secularly weaker PC industry. The coronavirus pandemic has boosted both software and hardware products for Microsoft, as remote work has increased demand for overall IT products.
Microsoft’s $64 billion of outstanding debt is manageable, supported by the company’s $132 billion of readily available cash and equivalents and normalized annual FCF of over $30 billion. Fitch expects Microsoft to have sufficient capacity to continue retiring bonds at maturity, maintaining dividend payments, repurchasing shares and making strategic acquisitions. As of December 2020, Microsoft’s gross leverage was 0.8x. The operating and financial profiles of the company are consistent for the ‘AAA’ rating category.
KEY RATING DRIVERS
Cloud Services Driving Growth: Fitch expects operating performance will remain solid, driven by robust cloud products growth; these include Microsoft’s Azure cloud services, cloud infrastructure software and productivity products that have been adapted for the cloud environment. Fitch expects Microsoft to remain a leading cloud services provider over the intermediate term, with an integrated offering across infrastructure and software services, benefitting from its established footprint in legacy Windows OS and Office productivity products. Fitch projects revenue growth in the low teens over the intermediate term.
Highly Diversified Revenue Streams: Fitch expects the more profitable cloud services growth to diversify Microsoft’s revenue base and increase profitability while reducing its dependency on PCs. While Microsoft’s More Personal Computing segment still represents approximately 35% of GAAP revenues, it constitutes less than 30% of operating profits. Fitch expects operating EBITDA margins to remain at approximately 50% over the intermediate term, supported by the favorable product mix shift. With the rising scale of Microsoft’s cloud-based products, revenues and profits from these products should increasingly eclipse personal computing products.
Resilient Demand Supported By Network Effect: Microsoft benefits from network effect due to its broad installed base of Windows OS and Office products that are de facto standards for computer software and productivity tools. The standard software enables users to efficiently share applications and information. The cloud adaptation of Office enables Microsoft to extend its strong position as customers increasingly migrate to cloud environment. Given the ubiquitous installed base of these products and the benefits of network effect, Fitch expects Microsoft to maintain its dominance in these areas. Cloud-based delivery of software applications also decouples these products from specific hardware platforms, further cementing the adoption of the products.
Significant Cash Position and Strong FCF: Fitch expects revenue growth and strong profitability will result in over $30 billion of annual Fitch-calculated post-dividend FCF through the intermediate term. In conjunction with the $132 billion of readily available cash and equivalents on the balance sheet as of Dec. 31, 2020, Fitch expects Microsoft to have ample capacity to repay maturing debt, continue dividend payments, make acquisitions and repurchase shares.
Competitive Enterprise Cloud Market: Enterprise cloud services are dominated by Amazon Web Services (AWS), Microsoft Azure and Google Cloud Platform. While Microsoft has established a solid position as the number-two provider in the current environment dominated by Infrastructure-as-a-Service (IaaS), competition from AWS and Google Cloud is fierce. In addition, smaller cloud-service providers, including IBM and Oracle Cloud, remain relevant in the growing market. Given the overall industry trend toward cloud services, Fitch expects IaaS competition to remain fierce. Fitch believes Microsoft holds a strong defensible position in the Software-as-a-Service (SaaS) segment relative to peers, anchored by its legacy strength in enterprise and productivity applications.
Fitch’s ratings are supported by its view that Microsoft’s cloud-based products will remain a key growth driver as adoption of cloud services continues to grow. Microsoft’s Intelligent Cloud segment, including server products and Azure, should continue to experience robust growth. In addition, Microsoft’s adaptation of its legacy perpetual-license-based productivity products to cloud-based SaaS products increases the lifetime value of customers over the long term. In conjunction with Microsoft’s strong relationships with enterprises and consumers, Fitch believes the company’s cloud-based product offerings are balanced across IaaS and SaaS, and competitive in the evolving IT industry.
Declining PC industry trends should continue to limit growth for Microsoft’s More Personal Computing segment as demand for Windows OS weakens despite the recent strength from pandemic-driven demand. As more workloads migrate to the cloud, complex applications can be run without powerful edge devices such as PCs; PC utilization has been gradually displaced by mobile devices powered by alternative OS, such as Android and iOS. Fitch expects this trend to continue as cloud adoption continues to grow.
Microsoft has been retiring its bonds as they matured since the Tax Cuts and Jobs Act of 2017 was enacted, while maintaining its dividend payments and share repurchases. Given the strong financial position of the company, Fitch expects Microsoft to continue to reduce debt at maturity through the forecast. In conjunction with EBITDA growth, Fitch estimates Microsoft’s gross leverage to trend toward 0.5x and remain below 1.0x through the forecast.
Microsoft’s scale, customer diversification, profit profile and leverage compare well against peers in the ‘A’, ‘AA’ and ‘AAA’ rating categories, including Intel Corporation (A+/Stable), Amazon.com, Inc. (A+/Positive), and Walmart, Inc. (AA/Stable).
Fitch’s Key Assumptions Within Our Rating Case for the Issuer Include
–Revenue growth in the low teens;
–EBITDA margins remain approximately 50% through fiscal 2024;
–Dividend payments growing in line with profits;
–Average of $5 billion of acquisitions per year;
–Debt repaid at maturity through fiscal 2024;
–Share repurchases of $25 billion annually through fiscal 2022, rising to $30 billion through fiscal 2024.
Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade
–Fitch does not expect positive rating action in the long term.
Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade
–More aggressive financial policies, reflected by absence of debt repayment resulting in Fitch’s expectation of gross leverage sustaining above 1.0x;
–Cash flow from operations minus capex/total debt with equity credit sustaining below 50%;
–Eroding competitive positions within core operating segments, reflected by zero or negative revenue growths and sustained operating margin compression.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
LIQUIDITY AND DEBT STRUCTURE
Robust Liquidity: As of Dec. 31, 2020, the company had $132 billion of cash, cash equivalents and short-term investments. Fitch’s expectation of over $30 billion of annual post-dividend FCF through fiscal 2022 and rising to over $35 billion thereafter also supports liquidity.
Total debt at Dec. 31, 2020 was $64.6 billion and consists of senior notes with maturities from fiscals 2021-2057. The recent debt exchange has extended maturities to 2062.
–$500 million senior unsecured notes due fiscal 2021 (repaid during fiscal 3Q21);
–$8.0 billion senior unsecured notes due fiscal 2022;
–$2.75 billion senior unsecured notes due fiscal 2023;
–$5.25 billion senior unsecured notes due fiscal 2024;
–$47.7 billion senior unsecured notes due after fiscal 2024.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of ‘3’. This means ESG issues are credit neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch’s ESG Relevance Scores, visit www.fitchratings.com/esg.