I've always thought of Microsoft (NASDAQ:MSFT) as a company with a strong consumer franchise that sort of edged into applications almost by accident. Now, you are asking your readers to believe that the future of MSFT is in its commercial business. Can a middle-aged leopard really change its spots all that much?
Many investors still consider Microsoft as a company with strong franchises in a declining market. Torrents of electrons course from the pens of analysts to the eyes of investors regarding the latest jiggle or enhancement of Windows or enhancements that will allow developers to create an even larger ecosystem. The latest developers conference, Build, was primarily about biometric authentication coupled with an emphasis on speech recognition/natural language processing. Sometimes analysts talk about the annuity stream that MSFT has created for itself with Office 365. A fair proportion of the literate and numerate population of the globe continues to pay for the product and its many options as a utility.
But beneath the surface so to speak, Microsoft has been becoming a company that concentrates on the commercial marketplace. I will discuss some of the details of the transformation with a bit of granularity below, but the fact is that the TAM in the commercial space for Microsoft, really the TAM for its Azure cloud offering, is far greater than the TAM is for Windows or for operating systems or for anything else it might sell to the consumer. Of course, the company's consumer products and software and hardware revenues remain important. They are a long-term annuity for this company. But as most investors are aware, and have been aware, those markets are in long-term secular decline. Microsoft might be able to find stability from its personal productivity business segments at some point, but any sustained or significant growth appears unlikely.
If Microsoft is going to achieve significant and steady growth, it is because it is becoming an enterprise software company that derives most of its revenues by selling enterprise solutions to enterprise users. I think that some observers felt that the company's results last quarter were a significant milepost that the butterfly was emerging from its chrysalis. That's one thing important to note. Microsoft's transition is difficult to see and will remain difficult to see for some time to come. The published results for MSFT's commercial business are depressed because more and more revenues are ratable and much of the success the company is enjoying is essentially sitting in unbilled backlog. Last quarter saw commercial bookings rise 19% in constant currency, but commercial revenues rose 5%. Obviously, that same phenomenon is going to impact the operating profits as well.
Microsoft's shares were mired in their own private bear market since the days of the dotcom bubble at the turn of the century. From the start of the century all the way through until 2013, the shares hovered in a range that was centered just a little below $30. In the last three-plus years, the shares have more than doubled partially because the company's financial model has changed to one that emphasizes subscriptions and partially because it has been willing to return a far greater proportion of its free cash flow to investors through a combination of dividend increases and not an insubstantial level of share repurchases which reached 3.7% of MSFT's enterprise value in the last fiscal year.
I think that the recognition of the company's cash-generating capabilities and its financial engineering have probably done about all that they can do for the shares at this point. The company's EV/S is no longer in value territory at over 4X for the current fiscal years (ends 6/30/16) and at 3.9X for fiscal 2017. The company has a P/E based on consensus non-GAAP earnings of 20X for this year. Its free cash flow yield for the current fiscal year is likely to be approximately 6.5%. Those are not deep value numbers, and to sustain further share price increases is going to require some real growth. The growth isn't going to come from what MSFT describes as personal computing although that segment actually has achieved grown this fiscal year, albeit at some modest percentage. It more or less has to come from the company's commercial segments.
I think that there is a case to be made that the company has been moving to become an enterprise software company now a dozen years or more, and it is finally starting to produce some numbers and projections to validate that point. I think that despite its current valuation, the shares are still a reasonable investment, not so much because of its value status as because the company should be able to achieve a sustainable level of modest growth going forward.
The Old Grey Lady Of Seattle Isn't All That Grey These days!
Microsoft reported its earnings for its fiscal Q2 on January 28. Many analysts considered the earnings to be a sort of break-out. Overall reported revenues were down a bit although marginally ahead in constant currency. The commercial components of the company's business, what Microsoft calls Productivity and Business Process, increased by 5% in constant currency and the business segment that MSFT calls Intelligent Cloud, which should not be confused with Azure, its public cloud offering, rose by 11%. The company's PC business unit declined by 2% in constant currency. The kudos that Microsoft received was for its 23% growth in non-GAAP, constant-currency EPS and a very strong performance that constituted an upside surprise of 10% from anticipated levels.
So far as it goes, despite the significant earnings beat, company guidance for the full year did not change materially. Consensus revenue growth expectations for this year are still negative, and revenue growth expectations for fiscal 2017 are only 5%. EPS growth expectations are a little bit better. The current consensus forecast shows EPS rising 12% this year and 11% next year. There is self evidently a significant disconnect between published consensus estimates and the company's current valuations. Over the past four quarters, the company has produced upside EPS surprises ranging between 7% and 20%. I have to imagine, that at the least, analysts who have increased their ratings on this name in the past months have done so with the expectation that the company will soundly beat estimates. As it is, MSFT has a relatively low consensus recommendation on the Thomson/First Call scale of 2.3. Again, my expectation is that most of those ratings were put in place during the time of the company's consistent and relatively large-sized declines in its personal productivity segment that were not being offset by growth in its commercial and cloud offerings.
Again, if this company is to be a successful investment from this point, it can only be so because the commercial and cloud segments show accelerated growth and improved margins. I don't think that such a conclusion is a new one, but it has more urgency at this point after the shares have doubled based on massive capital returns over the past three years.
The company generated operating cash flows of $29 billion in its last fiscal year. It paid out $10 billion in dividends, and it bought back $14 billion in stock. It also had capex of $6 billion, so there is simply not enough cash available to return more cash to shareholders without borrowing in the US. Of the company's cash flow during fiscal 2015, "adjustments to net income" more than doubled last year to over $9 billion or 32% of cash flow. That is not a new sustainable source of operating flow. It will likely decrease this year. I think it is relatively plain that Microsoft cannot continue to increase returns to shareholders without a significant improvement in the cash flow that is derived from the operating segments of its business. Of course, Microsoft has a significant net cash balance of $62 billion or about $8/share, but like most IT vendors, most of its cash is offshore, and to increase its capital returns, it would have to increase borrowings in the US. In order to try to increase its returns to shareholders, I doubt that is really going to happen.
I Still Want To Hear About How That Leopard Has Changed Its Spots
There has been lots written, mainly critical and perhaps deservedly so, about Microsoft's former CEO, Steve Ballmer. He certainly did not embrace many of the changes in the IT world enthusiastically, and both employee morale and the pace of innovation from MSFT slowed during his tenure. That being said, Microsoft has spent the better part of the last two decades in becoming an enterprise software company with offerings that appeal to most sizes of enterprises. It is probably fair to say that the prior management was not as consistently committed to the strategy of the company becoming an enterprise software company.
Microsoft has developed a variety of consumer products of various merits along the way and whether they have been successful or not they ultimately have been a diversion from the only strategy that can restore the company to growth. But that is the past and Microsoft is now led by Satya Nadella, who replaced the former CEO a bit more than two years ago. Mr. Nadella has spent most of his Microsoft career either working on Web projects or in leading the Business Solutions group which was the forerunner of Dynamics. By 2011 he got another promotion to the presidency of the Service & Tools Division. Fortunately, the Sever & Tools division was the home of the Azure cloud platform. There are many things that one can say about the tenure of Mr. Nadella, but he has obviously embraced new thinking for this company despite the fact that he has worked there for 24 years.
Needless to say, it helps that the current CEO came up through the commercial and Web components of the Microsoft business. As mentioned earlier, Microsoft's commercial business is actually significantly stronger than the headline numbers might suggest. In point of fact, as the company sells more of its products on the cloud, its balance of commercial deferred revenues will continue to rise. And beyond the deferred revenue that is actually on the balance sheet, Microsoft, like salesforce.com (NYSE:CRM) and many other cloud-based software vendors, has built a significant balance of what is described as "contracted not billed balance" which reached an all-time high of $25.5 billion.
The company actually had a bookings increase of 19% in commercial in constant currency but much of that bookings increase is going into both deferred revenues which were up by 8% in the commercial silos year on year to just under $20 billion and into the contracted not billed balance. Further, what Microsoft reported that its commercial annuity mix, which is essentially the amount of revenues coming through long-term subscription arrangements, increased by 5 percentage points to 83%. While it may not be totally recognized, MSFT has the same issues in terms of reporting the health of its commercial business as is the case for many other cloud/subscription software companies.
Long before Mr. Nadella took the reins, there had been signs of life in some of the company's enterprise business units. Indeed, Gartner now shows that Microsoft has displaced Oracle (NYSE:ORCL) from that company's long-held position as the most capable database (Oracle still is No. 1 by market share - mainly because its database solutions cost so much more than everyone else. MSFT probably has the most actual users).
Gartner talks about the company's recent enhancements to Azure DocumentDB, the managed NoSQL database in the cloud, and SQL Server's hybrid capabilities to run on-premises and in the cloud. Gartner went on to write about Microsoft's vision for in-memory computing across products, hybrid cloud implementations and a "cloud first" strategy (Readers - I'm simply the messenger here - make no claims to have independent firsthand knowledge as to whether the Microsoft DB offerings are better than those of Oracle. But I have to start somewhere and Gartner is typically thought to be the most pervasive of the market research sources that are available). The takeaway is that Oracle, which has been in the top spot of the Gartner MQ seemingly forever, is now No. 2. I will comment later in this article as to how open source products are eating into the database market as a whole. The fact is that the database market is rapidly commoditizing, and the value add/price that any branded vendor can enjoy is likely shrinking.
For the last several years, Microsoft and its Dynamics product suite have enjoyed some level of parity with both Oracle and SAP (NYSE:SAP) in the ERP market, at least judged by market share. Dynamics is still mainly found in the SMB market, but the SMB market is large enough and Oracle has never wanted to play in that sandbox. Dynamics is a far less complex solution than what SAP offers. Needless to say, Dynamics offers smaller users, some of whom may actually still be using Excel spreadsheets, the look and feel of other Windows applications.
Sometimes, management chooses to conflate Dynamics with Microsoft's CRM offering. All that being said, before the switch to cloud really got underway, say all the way back in 2014, Dynamics was thought to be a business running at $2 billion/year. It is perhaps 20% larger these days with only CRM competing in the cloud space. It appears that most of that business has already migrated to the cloud. Management said that more than 75% of its CRM customers are deploying in the cloud and that CRM online is driving continued triple-digit seat growth. Dynamics has not yet been released for cloud deployment. Somewhat surprisingly to me, Dynamics actually enjoyed an 11% constant-currency growth rate this past quarter, all of it on-prem.
Microsoft has been in the BI space for the past decade or so. It has taken quite a long time, but at this juncture, at least from a product functionality standpoint and at least using Gartner's MQ analysis, MSFT in analytics has gotten to the top of the tree. Again, I just use Gartner as a baseline - some readers have different opinions and I'm certain that will be the case - I do not know what I might use that is more objective. And whatever else is true, MSFT is now considered by Gartner to be the absolute best vendor for BI and analytics which is a significant change from earlier surveys. Gartner also publishes a survey for what it calls advanced analytics. Microsoft was said to have the best technology in that space, a significant jump from the 2015 survey. That being said, MSFT still has a way to go before catching IBM (NYSE:IBM) and SAS Institute, the two leaders in terms of execution capability.
This leopard has a whole new configuration of spots from that of just a few years ago.
Lots More Sun Than Clouds
But really the transformation process for Microsoft is all about the cloud. Overall, what MSFT describes as its intelligent cloud business grew just 5% to $6.34 billion last quarter. So cloud now represents a bit less than 25% of total revenues. The way MSFT defines things and Oracle defines things, in the last quarter Microsoft had 10X the revenue coming from the cloud compared to ORCL and the percentage of total revenue coming from cloud was 3.5X greater than it was for Oracle. Within the intelligent cloud bucket, server revenues grew by 10% and Azure revenues grew by 140%.
The commercial cloud annual run rate has now risen to $9.4 billion or about 9% of total MSFT revenues. Obviously, the commercial cloud is the most appropriate measure of revenue comparable to the other vendors in the space and is a subset of the intelligent cloud. I'm not sure that if there is any other company that I either follow or know about that has quite as many definitions and buckets as this one, although I doubt it is deliberate. It just tends to hide things. Microsoft's management has articulated a goal of reaching $20 billion in revenues in the commercial cloud by 2020. That seems to be quite a modest goal. Commercial cloud apparently grew by 70% in the last quarter. Reaching $20 billion in revenues by 2020 would represent a CAGR of around 20% through that period, which is far less than I think is a reasonable projection. I would look to the performance of that category specifically to generate significant upsides to the current consensus.
Compared to the other dinosaurs in the race, MSFT seems to be building a significant advantage. Azure, with a market share of about 17% in the public cloud space, is inching up on AWS which has a 27% share. In a recent report I published, I commented that Amazon (NASDAQ:AMZN) has some built-in advantages in the race for top dog position in the public cloud. Microsoft has some of the same advantages. It is and will continue to build very large and very low cost data centers that drive down the costs for what it sells in the cloud. But Microsoft also has a huge number of users who are going to migrate to the cloud and would prefer to continue to stay with MSFT as a total solutions provider. As I wrote earlier, by this time 60% of Microsoft's application customers also are buying Azure. That is a significant leg up in the race for position in the public cloud market.
I do not think that anyone can realistically opine on exact comparisons in cloud market share statistics because each company uses different definitions to talk about the same things. There is no company with a legacy business that will not have a certain amount of transformational issues. It is just my contention that MSFT is handling its own transformation better than most of the legacy vendors, and I think that the trend is likely to continue.
As some observers might point out, MSFT has taken some unnatural steps to get its customers signed up for Azure. Most MSFT commercial users have enterprise agreements that price all of the products that Microsoft sells. Again, dating back to 2014, MSFT would get users to sign up for the cloud and pay for it by discounting the prices for the other parts of the EA. That meant that the company could count the customers, Azure users, and count the revenue for the commercial cloud. That meant Microsoft had loads of cloud "customers" and cloud revenue that was counted even though the users weren't actually using the Microsoft cloud at all.
Starting about a year ago that really started to change significantly. Microsoft significantly tweaked its comp plans such that what's called "consumption" became very important to sales people and they were assigned a quota for it. If sales people were unable to reach consumption quotas, they were at danger of losing their bonuses even if their revenue attainment was on quota. In some extreme cases, MSFT's sales people got fired. In all, the motivation seems to have done the trick.
This past quarter, the company reported that Azure SQL database usage grew by 5X on a year-over-year comparison - that is basically part of the metric that Microsoft calls consumption and not revenue dollars. As mentioned above, CRM seat usage in the cloud trebled. I think that it is underappreciated, the extent to which Microsoft had to chew through a fair amount of Azure credits that had been created when users signed up for the cloud but didn't use what MSFT calls consumption credits. How much that might have been will never be known, but I think that the current numbers and data points suggest that the company has gotten its customers moving workloads to the cloud and that the customers it is reporting are buying real solutions and are not just the product of marketing hype. Overall, the cloud attach rate on EAs has reached 60% up from 45% 12 months ago and commercial cloud GM have reached 46% up from 37% in the prior year's period.
I think it is also worth noting that unlike the more recent results of Oracle in particular, as well as IBM, that overall commercial bookings which include cloud and everything else were up 19% in constant currency. I think that in evaluating Microsoft, it's important to note that the trade between its legacy businesses and cloud is reasonably positive which is currently not the case for either Oracle or IBM and is just barely the case for SAP. I think that the message is, if you want to play with the dinosaurs, this is the dinosaur you ought to be playing with.
What Is All Of This Regarding TAM Doubling? How Can A Mature Company Like This Actually Believe That It Can Double Its TAM Just Based On The Cloud?
While Microsoft hasn't been quite the pioneer when compared to Amazon in the cloud, it started to make its investments early enough such that it is enjoying the benefits of a substantially different market structure. For example, when looking at just the database segment, Microsoft has been able to embrace Linux and what is called NoSQL (non-relational) databases more effectively when compared to other legacy competitors. CEO Satya Nadella described the expansion of the TAM on the ground this way:
"IaaS growth comes because people already have existing code that they want to move over and then they start extending by writing more PaaS because it's sort of more efficient for them to write new code and new apps in PaaS... If you're starting new you will have PaaS, which is going to be the first thing you do, but then you'll always find the need to integrate with something already existing."
I think another way of looking at the vast increase in the TAM is that Azure is open to run workloads from anyone which includes open-source workloads, Linux workloads, even Oracle and SAP workloads. So Azure and the cloud are adding a new dimension to customers that MSFT can solicit. Oracle databases and apps have been completely closed. Obviously, SAP apps could always run on Oracle databases, but with SAP's HANA, that was supposed to come to an end.
Nowadays, people are able to use the Azure cloud and move Oracle workloads to that and write new codes to integrate with those apps without reference to ORCL. It is a brave new world, and Microsoft will have a significantly greater market to compete for than it has enjoyed. Again to quote CEO Nadella:
"The enterprise is heterogeneous. It had been homogeneous. We participated only in a portion of it. Whereas with Azure we can participate, we can participate (sic) as the total open platform. And that's how we (think) about it and that's what we're executing on."
When the CEO says that the opportunity is the greatest that MSFT has ever enjoyed, that is what he is talking about.
For a long period of time, MSFT has been thought of as a traditional value investment with relatively strong cash flow and limited growth opportunity. But for the first time in multiple years, the company has positioned itself to cash in on a high-growth market, and the early signs of its execution capability are strong.
A Few Final Thoughts!
Microsoft like almost all of the old-line software companies is in the midst of a substantial transition that will take it further and further away from its Windows roots. More than all of the company's future growth is going to come from commercial and cloud-based revenues. While the headline number of Microsoft's public cloud offering Azure shows revenue growth of 140% year on year, it is equally important still to look at the growth in commercial bookings, which rose 19% in constant currency, far greater than modeled by most analysts and yet still an understatement of the actual growth MSFT enjoyed in the space.
Microsoft's reported numbers mask the strong growth its commercial operation is achieving because of both the switch to ratable revenues and the impact sales of cloud applications. Unlike some cloud-only companies such as CRM that make the exercise very easy, it is hard because of the lack of transparency of the company's financial disclosure to figure out what is actually happening on an apples basis. But the same pattern of rising orders that are not reflected in current period revenues is at work for this company as is the case of other significant cloud vendors.
Microsoft through the years had improved the functionality of its commercial offerings significantly, and under the new CEO, it has become much more open in terms of how it approaches partnerships with vendors that are notionally competitors. The company, at least in the Gartner surveys, now leads all of the other application vendors in terms of database and analytics. It is experiencing a rapid uptake of its cloud-based CRM solution, and I imagine that when the balance of its Dynamics ERP product is released in the cloud shortly, it will enjoy some significant success in that space as well.
Even though Microsoft is a relatively old software vendor, it has been far more successful with its transition than most of the other older software vendors. It has, to be sure, seen some fall off in some of its legacy offerings, but the transition has really been a good trade for Microsoft. In answer to a particular question, CFO Amy Hood responded:
"Our enterprise workloads across Windows, SQL, Systems Center, etc., grew double digit. And some of the decline you asked about is in the non-annuity and very transactional business which happened to impact Windows Server a bit more than other workloads..."
Microsoft has not and probably never will enjoy the type of growth rates associated with pure cloud vendors. It has its boat anchor, and it is a company in transition. But it is enjoying some of the increase in overall volume that is associated with even the strongest of the business application vendors.
While the company no longer enjoys the deep value metrics it did a few years ago, it is on the cusp of seeing accelerated growth in the top line and continued improvement in operating margins as well. As the transition to cloud gathers team, I think that it will become more and more apparent that Microsoft's shares deserve some - but of course not all - of the valuation metrics that have been achieved by the best of the pure cloud vendors.
Disclosure: I/we 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.