Microsoft - Nadella Continues To Appeal To Investors, Be Cautious After The Strong Momentum

| About: Microsoft Corporation (MSFT)


Microsoft shares trade at fresh post-dot com highs.

Nokia took out $0.08 per share in earnings, although Microsoft expects the unit to break-even by 2016.

Investors continue to applaud Nadella's moves, cutting losses at Nokia and focusing on the cloud and enterprise markets.

Still, the valuation is fair at 14 times ex-cash, given the challenges ahead in its core business to catch up with changing business models.

Investors in Microsoft (NASDAQ:MSFT) were pleased with the company's progress in its cloud-based offerings and the recently announced job cuts, which aim to stop the bleeding at the acquired Nokia business within two years' time.

Given that Nadella continues to drive appeal among investors, the valuation and expectations have steadily risen in recent times. I would be a bit more cautious at these levels, given that much more work is ahead.

Fourth-Quarter Headlines

Microsoft posted fourth-quarter revenues of $23.38 billion, up 17.5% compared to the year before. Sales came in ahead of consensus estimates, at $23 billion.

Reported GAAP earnings came in at $4.61 billion, which was down by 7.1% versus the final quarter of last year. Thanks to modest share repurchases, Microsoft was able to limit the fall in GAAP earnings to some extent. Earnings were down by four cents to $0.55 per share, which compared to consensus estimates at $0.61 per share.

Non-GAAP adjusted earnings, which excludes the contribution of Nokia and other items, came in at $0.66 per share, which beat consensus estimates by two cents.

Looking Into The Results

Microsoft's largest commercial licensing business performed just fine, posting sales of $11.22 billion, which is up by 5.6% compared to last year. Gross margins came in at a very impressive 91.8%, up 80 basis points compared to last year. The transition to Office 365, as well as strong growth at SQL Server, System Center and Window Server was doing fine.

Devices and consumer licensing sales came in at $4.69 billion, up by 9.5%. Gross margins of 93.9% are very impressive as well, improving by 340 basis points compared to last year.

Devices and other consumer sales improved by 20.3% to $1.88 billion, with margins improving to 23.7%. Search revenues rose by 40%, as Bing's market share improved to 19.2% in the US. The adoption of Office 365 Home offerings were good, with a million subscribers added to a current total of 5.6 million.

Commercial & other sales were up by 43.7% to $2.26 billion, thanks to cloud operations, among others. Commercial cloud revenues were up by 147% to $564 million, driven by Office 365 and Azure, having a run rate of $4.4 billion in annual sales. The run rate is obviously based on bookings, and not current reported revenues.

Computing and gaming hardware sales came in at $1.44 billion, up 23.5% compared to last year on Xbox and Surface sales. The unit posted very modest gross margins of $18 million vs. a big loss of $647 million as reported last year. Of course, the margin improvements were driven by the big inventory charge taken last year related to the inventory of Surface tablets.

The phone hardware business acquired by Nokia posted sales of $1.99 billion versus no contribution last year, of course. Gross margins of $54 million were very modest, resulting in rather steep GAAP losses. The unit sold 5.8 million Lumia smartphones and 30.3 million non-Lumia phones.


At the end of the quarter, Microsoft held $85.7 billion in cash, short-term investments and equivalents. Total debt of $22.6 billion results in a very comfortable net cash position of about $63 billion.

Over the past year, Microsoft posted sales of $86.83 billion, on which it reported net earnings of $22.07 billion. At $45 per share, equity in the business is valued at $371 billion. This values operating assets at about $308 billion, the equivalent of 3.5 times annual sales and roughly 14 times earnings.

Looking At The Past To Gauge The Future

Despite Microsoft being a stagnant stock over the past decade, until recently, the company managed to steadily grow the business. Sales have more than doubled, and grew at a compounded annual growth rate of about 10% between 2004 and 2014.

Earnings have kept up pace, as well as further margin increases in already high software margins were offset by an increased focus on hardware products such as Nokia phones, Surface tablets and of course, the Xbox. In total, the company managed to repurchase 20%-25% of its shares outstanding over this time period, adding to earnings per share growth.

Note, of course, that the acquisition of Nokia Devices and Services was only completed on April 25 of this year in a $7.3 billion deal. As such, the deal will continue to add to revenue growth going forward, although the unit is reporting losses at the moment. Operating losses came in at $692 million for the quarter, diluting earnings by eight cents.

To offset some of these losses, Microsoft announced some 18,000 job cuts last week, of some 12,500 jobs expected to disappear at Nokia. In total, Microsoft expects to take a $1.1-$1.6 billion charge related to his move the coming year. These job cuts are aimed to stop the bleeding at the so far dramatic acquisition. These moves should cut costs by a billion per year and allow the unit to break-even in 2016.

The return to break-even is applauded by investors as the company issues a very weak guidance for the first quarter. Revenues at Nokia are seen between $1.9-$2.3 billion in the first quarter. Note that the $1.99 billion in revenues reported for the fourth quarter was based upon just a little more than two months, given that the deal closed on April 25. The guidance also implies that sales are cut in half on an annual basis.

Final Takeaway

Investors grow increasingly comforted with Satya Nadella, but frustration is increasing regarding the Nokia deal, which is reporting annualized losses approaching $3 billion at the moment.

So basically, the earnings report is not revealing many surprising things. Hardware sales are up significantly on Surface, Xbox and of course, Nokia, but it is not profitable. Software sales continue to increase at a steady pace, while posting impressive margins. This, as the cloud-based initiatives continue to demonstrate their momentum, although their contribution is still quite low. Investors appear to be pleased with the annualized cloud revenue rate of $4.4 billion accompanied by triple-digit growth rates.

So far this year, shares have risen 20%, while they are up 43% on a year-over-year basis. Given the relatively stable net cash position over this time period, this means that the changes in the market valuation for the operating assets are much greater. Much of this is driven by a market rally and the fact that investors like Nadella's strategy of focusing on the cloud and the core enterprise business.

As such, a lot of the good news has been priced in, with shares trading at their highest levels since the dot-com bubble. Shares now trade at roughly 14 times earnings after backing out the cash position, which of course, is still cheaper than the entire market. It should be noted that Microsoft overall is posting modest revenue growth, while there is uncertainty about the company to compete and operate in a rapidly changing technology world. Fortunately for investors, Nadella has boosted confidence among investors that the company can move along and make this transition.

Given the momentum, the fair valuation and challenges ahead, I remain cautious at this point in time.

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