Microsoft: Buy After Earnings

| About: Microsoft Corporation (MSFT)


Satya Nadella delivered strong results in his first quarter as CEO, boosting shares after hours.

Windows showed mild growth as PC sales seem to have stabilized, particularly on the enterprise side.

Xbox One and Surface showed solid revenue growth, but the company must outline a path to profitability for hardware.

Cloud revenue doubled year over year, and these services further entrench Microsoft in enterprise IT spending.

Shares should trade 15x earnings, which translates to a fair value towards $55 when adding in its $88 billion cash hoard.

On Thursday afternoon, Microsoft (NASDAQ:MSFT) reported its quarterly results, and Wall Street was generally pleased, as shares traded up about 2.5% after-hours. This quarter is also an important one for the company as it was the first one where Satya Nadella was CEO. It looks like Mr. Nadella got off on the right foot with pretty solid results across the board. Investors will be looking closely at Mr. Nadella's remarks over the coming weeks and months to see what direction he guides Microsoft. I expect him to focus increasingly on the cloud, where Microsoft has built a solid high-growth business; and on expanding into mobile, where Microsoft has consistently been lagging.

In its third fiscal quarter, Microsoft earned $0.68 on $20.4 billion in revenue (all financial and operating details available here). While revenue was in line with expectations, EPS beat by a nickel. On an adjusted non-GAAP basis, EPS was up 5%, while revenue was up 8%. Microsoft generated some growth pretty much across the board with commercial revenue up 7% to $12.23 billion, while device and consumer revenue were up 12% to $8.3 billion. Microsoft's reliance on PC sales for Windows revenue will certainly slow growth in coming years, but the company is successfully building other businesses that can provide solid growth.

It also must be noted that the death of the PC has been overstated. While tablets, and to a lesser degree smartphones, are lessening the need for PCs, businesses in particular continue to rely on PCs for certain functions, and Windows continues to be a major profit driver for Microsoft. Windows OEM revenue was up 4% compared to last year. Microsoft also saw business PC growth, sending Windows OEM Pro revenue up a solid 19%. Commercial licensing, which accounts for half of revenues, increased sales by 10%, with Windows volume jumping 11%.

Microsoft's Xbox One continues to be a popular seller. Microsoft sold 2 million consoles in the quarter, including 1.2 million Xbox One consoles. Thanks to the strength of the launch last fall, Xbox revenue was up 45% year over year. Xbox gives Microsoft a foothold in consumers' living rooms, and Microsoft is working tirelessly to make the console an all-in-one entertainment device, not just a video game console. While the Xbox is generating solid growth, it still runs losses, and Microsoft will need to use it as a springboard for more interaction with consumers to justify its investment. Similarly, Surface revenue was up 50%, but still a paltry $494 million. Surface is doing better, but its sales are dwarfed by Apple's (NASDAQ:AAPL) iPad.

Thanks to the Xbox One and Surface, Microsoft's consumer hardware revenue jumped 41% to $1.97 billion, but gross margin fell by 34% to $258 million due to the higher costs of new models. Nadella will have to show that hardware can deliver not just revenue growth but profit growth for the company to justify continued investment. On Friday, Microsoft will finalize its acquisition of Nokia's (NYSE:NOK) handset unit, which will further entangle MSFT in consumer hardware. Xbox in particular has significant potential as a platform by which MSFT interacts with consumers. At some point, these ventures do need to generate net income. I expect investors to give Nadella at least a 12-month honeymoon period before demanding a clear path to profitability from these units.

Finally, investors should focus on a business segment entitled "Commercial Other." This segment is doing so well it may soon deserve a name better than "other." This unit house Microsoft's cloud business, which grew revenues by 101%. Cloud revenue came in at roughly $730 million, thanks to strong demand for Commercial Office 365. Microsoft is quietly building a cloud juggernaut, and given Mr. Nadella's background, I expect continued emphasis on cloud offerings. Microsoft Azure, which competes with the likes of (NASDAQ:AMZN) and Oracle (NASDAQ:ORCL), increased revenue by an even faster 150%. Overall, this segment grew revenue by 31% to $1.9 billion, and gross margins were up an even more impressive 80% to $475 million.

Put simply, Microsoft had a strong quarter. Windows and Office are showing stabilization as the PC market is finding its footing. In fact, business PC demand appears to have grown a bit. Xbox One shows continued growth, but at some point, Nadella will need to outline a strategy to make hardware profitable. Finally, Microsoft is growing its cloud business at a brisk pace, which will ensure the company maintains a strong foothold in Enterprise IT.

Investors should also note that MSFT has a cash hoard of $88.4 billion, up $11.4 billion year to date. Microsoft is using its cash hoard to buy back shares, and its diluted average share count is down by 62 million shares over the past year to 8.367 billion shares. I expect Microsoft to continue to buy back shares and increase its dividend to eat away at its cash hoard. Microsoft remains on track to earn $2.90-$3.00 in fiscal 2015. With some growth, investors should be willing to pay 14-15x earnings or $42-$45. Add in its $11 in cash per share, and MSFT is quite cheap at current levels. After these numbers, I would continue to be a buyer of MSFT.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.