This Big Tech stock could be a hedge against a recession in 2024, UBS says

Published Sun, Oct 22 20238:04 PM EDT

Microsoft could act as a defensive stock if the U.S. enters a mild recession next year, according to UBS analyst Karl Keirstead. The investment bank's economics team forecasts a mild recession in the United States next year, which could pressure broader equity markets. "I would definitely characterize Microsoft as more defensive rather than cyclical," said Keirstead, managing director of software equity research at UBS, in a video recording to clients on Oct. 13. He cited the company's diverse business lines and steady subscription revenue model. Why Microsoft? Unlike more focused software companies, Microsoft has "full geographic coverage across all industry verticals," Keirstead said. That makes Microsoft less susceptible to downturns in any one sector or region. MSFT YTD line Microsoft also relies heavily on recurring subscription revenues, not "episodic revenue recognition events that can get hurt or rally" along with the economy, he added. Microsoft cloud and productivity services, which include the Azure Cloud Computing platform and Office 365, had risen to 74.2% of total revenue in June, up from 56% in 2016, according to FactSet data. The more cyclical personal computing revenue shrank from 44% of total sales to just 25% today. Key driver for stock On top of that, Microsoft is aggressively expanding its artificial intelligence capabilities. In recent months, it has splurged on expensive Nvidia GPU chips that power AI workloads. But Keirstead believes those investments will pay off in the long run as customers begin paying Microsoft to use its AI services. "We are now getting closer to the point where AI spending is beginning to kick in," said Keirstead, who is based in California. He expects Microsoft to see returns on its investments within a few weeks, if not months. Microsoft is set to make its Copilot AI tool available on Nov. 1, which could be a near-term boost for the company's Office business. Enterprise evaluations of Copilot are already underway, and Keirstead expects associated revenues to start flowing through in the March 2024 quarter. "Even in a tough macro, Microsoft has some powerful idiosyncratic catalysts in the form of AI," he said. "Capex today is a signal that Microsoft is seeing significant AI demand tomorrow," he said. "I think that's a tolerable trade-off." Interest rates While higher interest rates pressure valuations across the tech sector, the UBS analyst expects Microsoft to benefit disproportionately if rates decline in 2024. The company's strong free cash flow generation also makes its stock less rate-sensitive than some of its tech peers, according to Keirstead. "The tech sector tends to be reasonably rate sensitive, and so in a declining rate environment, the tech sector will be one that a lot of investors will gravitate to," he said. "I think that notion of inverse sensitivity to rates is more powerful than the impact of rates on Microsoft's cash balance." Microsoft currently trades at a forward free cash flow multiple of 34x, which Keirstead views as reasonable given its growth prospects. His $400 price target implies 44x free cash flow in 2024, a premium he believes is "fair relative to the peer group."