Seeking Alpha
Long/short equity, special situations, value
Profile| Send Message|
( followers)  

Summary

  • Investment public is happy with incoming CEO Satya Nadella.
  • Focus on cloud and other new products is paying off, although the contribution is still limited.
  • If expected erosion in the core business is limited, Nadella has a shot to transform the business while it continues to grow.

Microsoft (NASDAQ:MSFT) pleased its investors by releasing a solid set of third quarter results last week. The quarter was the first under the helmet of incoming CEO Satya Nadella.

Investors are pleased with the increased focus on the cloud, sense of urgency and other new products. I give Nadella the benefit of the doubt and am a buyer on dips.

Topline Results

Microsoft generated GAAP revenues of $20.40 billion in the first quarter which is essentially unchanged compared to last year. Last year's revenues saw a $1.66 billion one-time jump on the back of revenue recognition practices. After correcting for this, revenues were up by 8%.

Operating earnings rose by 4% to $6.97 billion on an adjusted basis. As a result, adjusted earnings per share advanced by 5% to $0.68 per share, coming in at $5.66 billion.

Looking Through The Businesses

Microsoft is developing some new fast growing businesses which are still relatively small but do create the opportunity for the business to grow. If they gain sufficient scale they might be able to change the markets perception of the company from a value play to a growing business again.

Commercial licensing revenues inched up by 3.4% to $10.32 billion as gross margins came in at an incredible 91.3%. Windows licensing performance was solid while new solutions like Lync and SharePoint performed well.

Other commercial revenues rose much quicker, increasing by 31.3% to $1.90 billion. This business unit includes commercial cloud service revenues, Office 365 revenues and Azure revenues with each of these businesses reporting revenue growth of over a 100%. Gross margins of this business unit came in at 25.0%, up nearly 7 percent points compared to last year.

The devices and consumer licensing business reported a merely 0.7% increase in revenues to $4.38 billion as margins were under pressure. Despite this margin pressure, margins still came in at an impressive 89.1%.

The consumer hardware and device business reported a healthy 40.7% revenue growth to $1.97 billion while gross margins plunged by nearly 15 percent points to 13.1% of revenues. Strong Xbox One as well as Surface sales boosted revenues drove headline results although margins took a beating.

Other consumer devices fared much better in terms of profitability. While revenue growth of 17.8% has been less impressive, margins rose by 1.8% to 27.7% of revenues. Office 365 Home added 1 million subscribers in just three months time, now having 4.4 million users. Results from search engine Bing have been relatively solid as well.

Financial Powerhouse

At the end of the quarter Microsoft held an incredible $88.4 billion in cash, equivalents and short term investments. Against this stands merely $22.7 billion in debt, resulting in a very solid net cash position of nearly $66 billion.

Revenues for the first nine months of the year came in at $63.5 billion which is up by 9.5% compared to a year ago. Earnings rose much more modestly as Microsoft is stepping up research and development investments. Earnings rose to $17.5 billion for the period.

These very strong cash flows and solid financial position allowed Microsoft to raise its quarterly dividend to $0.28 per share, providing investors with a 2.7% dividend yield.

Nokia Deal Has Finally Closed

In conjunction with the earnings report, Microsoft announced that its acquisition of Nokia's Device and Service business has finally closed with an effective closing date of Friday, April 25. This came after the company announced the $7.2 billion bid for the phone unit of the Finnish company back in September of 2013.

While many analysts and industry insiders question the rationale behind the deal, Microsoft claims that the deal will boost its market share and the profitability of smart phones running on Windows. Even after the deal Microsoft will be dominated by operating systems and phones produced by Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) and Samsung.

To avoid head-on competition Microsoft will focus on smart phones in emerging markets, an area in which Nokia's market position was relatively strong after falling out of favor in developed markets.

With the acquisition Microsoft can avoid the development and marketing fees it paid to Nokia, being the owner now of the franchise. A Time article claims that profits on each smart phone could increase by a factor of four, while the unit is expected to report continued losses. Nokia's unit reported revenues of 10.7 billion Euro in 2013 which was down 29% on the year before, while reporting an operating loss equivalent to 5.5% of total revenue. Important to know is that the finalized deal does not include factories held by Nokia in India and Korea.

As Microsoft has cut its Windows licensing fee to zero for mobile phones and tablets, other OEMs might be more inclined to run its software. The fact that Microsoft receives very little licensing revenues excluding Nokia results in relatively minor revenue risks for the company.

Takeaway For Investors

At current levels around $41 per share Microsoft commands a market valuation of roughly $338 billion. Excluding the net cash position of roughly $66 billion, operating assets are valued around $272 billion.

Given the reported numbers for the first three quarters of this year, revenues could come in around $86 billion for this year including the contribution of Nokia's business for little less than a quarter. Earnings are seen around $22-$23 billion. Based on these estimates the valuation of operating assets comes down to 3.2 times annual revenues and 12 times earnings.

Revenues could easily grow to $100 billion next year, although profit growth will undoubtedly trail revenue growth due to the dilutive effect of the Nokia transaction.

While the core-businesses will undoubtedly see pressure at some point in the future, the focus of Microsoft on the cloud and diversification efforts are to be applauded. A quick erosion of the hugely profitable core businesses might still hurt investors badly. However the increased focus on the future combined with strong growth in promising areas should mitigate this pressure in the long run.

So with Satya Nadella being the right person on the steering wheel investors have become enthusiastic again. With a quick erosion in the core businesses not being extremely likely at this point in time, investors are more confident about the company's future. Even if erosion hits the licensing business, the high margins might mitigate the impact of topline revenue declines on the bottom line.

Investors including myself have increased confidence that Nadella might just succeed in his ambitions to drive further earnings growth and reignite the company's growth prospects.

Source: Microsoft - Nadella Has A Decent Shot To Transform The Business While Continuing Its Growth