Microsoft - What a real turn-around looks like
Many times in the wake of a strong quarter for a large enterprise, the temptation of an analyst is to list all the superlatives. Microsoft (NASDAQ:MSFT) reported its earnings last evening and it proved to be a strong quarter. I know it is for me, and I imagine it is the same for many other observers and commentators. I will, to be sure, list a few of the more salient data points that convey the achievement this company had in its fiscal Q1 but the purpose of this article or any other article I write is an effort to call stocks.
Calling stocks in not necessarily the same as calling companies as we as both investors and analysts have been taught time and time again. (Well, at least I have - the lesson often doesn't stay learned.) But I think there were a couple of specific attainments in the quarter that go beyond the headline numbers that should result in Microsoft shares continuing the trend they have shown in after-hours trading and which are likely to allow the shares to achieve positive alpha for some time to come. I recognize, in reading this article back, that it is a bit dense for some tastes. I think that is inevitable if you are trying to search for "why" and whether trends continue. But in the interest of some readers who want to see the chase before the cut, I think this quarter Microsoft validated the positive investment thesis that I - and many others - have espoused for some time. I think there is plenty of positive alpha that remains available and that this management is steadily remaking the company into a growth engine. A different kind of growth engine than in the past with far more emphasis on commercial than on the consumer and emphasis on apps more than infrastructure, but a solid growth engine nonetheless.
One thing worth noting is that at this point, almost all software companies, including this one, are in the process of infusing AI into their offerings. AI is like a few other over-arching trends in the IT space such as the Internet of Things and of course, the cloud. In the next few quarters, investors will hear about AI to the point where they want to strange speakers. But the fact is, that the AI offered by vendors is not a useful differentiator at this point. That will come but most everything to date has been in the nature of trials and experimentation. And on a personal note, the AI in the latest edition of word can drive this writer crazy and I wish, at times, to exercise it.
The key in terms of share price performance isn't that companies have AI as they all will, but the effectiveness of AI implementations and the ability AI has to drive competitive success. I won't cover that in this article; for the time being, MSFT has what it ought to have and that is about all that can be usefully said. I will simply add that modifiers are not evil and that deep learning ought to pick up on the style of authors. But that is a whole different discussion.
Earlier this week, IBM (NYSE:IBM) shares seemingly beat and yet the stock compressed. As I have been at pains to point out, the quarter for IBM was filled with ambiguities - OK I used strong phraseology. But there were no ambiguities here and the company management chose to say the right things in the right way. MSFT shares have increased a few percent after hours to an all-time high-even exceeding the bubble peak of 1999 when the company was still in its Windows monopoly phase and PC growth was not an oxymoron. There have been some commentators on this site who have addressed themselves as to why IBM with an apparent beat has seen the shares decline by a few percent. I have been part of that debate but leave it where it is to focus on this company.
There was little in this earnings presentation that needed for which anyone needs to make a detailed explanation or a tendentious defense. This company beat handily on revenues (by about 3% overall despite a small currency headwind), it beat on earnings by more than 10% without the help of unusual tax rate accruals (although it did accrue a lower tax rate, which is supposed to be the tax rate for the full year) or surprising sales of IP and it has guided for fiscal year earnings that are both conservative and yet above prior consensus forecasts to beat prior analyst expectations. The company's expectations for Q2 are muted due to some specific factors that are not part of any thesis and will probably not cause much concern to investors. With the beat and the guidance in hand, I imagine that the consensus expectations for this fiscal year will probably be in excess of $96 billion for revenue and may reach $3.00 in EPS. And the company is also expecting strong cash generation this year as might be anticipated given the strong performance of annuity revenues, which often lead to higher deferred revenue balances. It should be noted, however, that Q1 enjoyed a one-time benefit in terms of CFFO of $1.3 billion and that the company is forecasting accelerated capex for the balance of this fiscal year. And in turn, that is going to change the valuation calculus to a degree that will allow the shares to continue to appreciate and to add to their after-hours gain.
MSFT shares have not enjoyed any unanimity of opinion. Currently, the recommendation rating from First Call has been 2.3 or between buy and hold. I would be surprised if there weren't a few observers who upgraded the shares and I expect many - perhaps most analysts will take their price target from the current average of just shy of $60/share. I wrote my first article on this name for this site back in April. Since that time, the shares, counting after-hours trades in the wake of the current earnings release, are up 9%. The IGV is up by 10%. So, conceptually, there is plenty of room for the shares to outperform and to make up for the fact that while the business is self-evidently growing at a faster cadence than it was back in April, the shares have done little and in fact, the shares have done little this year and not just since April.
I'll discuss valuation a bit later in this article, but raising price targets in the wake of accelerating growth in the segments of MSFT's business that have enormous potential is logical and ought to be the course of least resistance. Many large, older tech names have the same prospects as those hoary jokes about a mother-in-law. MSFT, perhaps a bit uniquely, has found some growth legs on which it can walk. No, it isn't likely to grow at double digits even as the negative phase of its transition recedes, but then again, looking at the competitors in the growth sweepstakes in its space, it doesn't need that. But I do see this company winning that sweepstakes and producing strong relative growth into the future.
As mentioned earlier, Microsoft reported the results of its fiscal Q1 that ended 9/30 earlier this afternoon. It was a quarter marked by strong execution and, in particular, exceptional growth for Azure cloud services and what might be described as a breakout quarter for the company's Dynamics products (application software). Overall, the company's intelligent cloud, where the results of Azure are reported, grew by 10% to $6.4 billion, a beat of a couple of hundred million or more compared to the prior consensus as compiled by Briefing.com. Azure revenue growth accelerated some to 121% (it was only 102% last quarter) and is probably in the range of or slightly higher than $1 billion/quarter, or still just 15% of the intelligent cloud and less than 5% of total company revenues. The runway potential remains substantial and the opportunity for Azure to noticeably move the growth needles is accelerating.
But it is easy to get over-enthusiastic. It is a great opportunity for a company to have a 5% business that is doubling, and there are obviously margin implications as well over time - but it is still a 5% business. Needless to say, there were segments in the intelligent cloud that must have seen revenue declines in order to show the segment with an overall growth of 10%. But for modeling purposes, I think that Azure has become just large enough to ensure that this segment will sustain double-digit growth. As of the last market share survey data released in August, MSFT remained at about one-third the size of Amazon (NASDAQ:AMZN) (11% for MSFT; 31% for AWS) but the results of this quarter will probably have some impact on the comparisons - poor Amazon only grew by 56% last quarter, or about half the percentage rate of Microsoft - although still a bit faster in dollars and most likely resource constrained in terms of sales capacity.
The other major growth driver and one that is still under-appreciated is Dynamics apps. Dynamics is included in productivity and business processes, which achieved an 8% constant currency growth. The segment is 30% of company revenues.
The company is seeing significant adoption of Office 365, which is proving popular with both commercial and consumer subscribers. While there was some level of cannibalization, the company's overall growth reached high single digits offsetting the 14% decline in Office 365 on-prem. The gain of 40% in seat count is impressive at this point in the evolution of the product. The same trend showed up in consumer where overall growth was 8% with consumer subscribers now at 24 million.
Windows growth was essentially flat. Phone revenues declined 72% and gaming revenues slipped 5%. Encouragingly, although of far less importance than some of the other categories, search revenues were up 10% in constant currencies. Overall Dynamics revenues showed an increase of 13% made up of rapid growth of sales of Dynamics apps in the cloud and a decline in Dynamics on-premise revenue. So far, lots of the growth has come from the company's CRM business, which is enjoying very rapid growth but the opportunities in the rest of the Dynamics suite are larger still. In percentage terms, Dynamics growth doubled from the prior quarter and the mix of the business is more than 70% on-line for new users.
What's important and what doesn't need to be analyzed
Let me say at the outset that while Microsoft's transparency is better than some, it is hardly perfect. I do not know the precise revenue contribution of Azure although loads of other industry analysts provide guesses. I do not know the revenue contribution of Dynamics, although that too is often guessed at. Overall guesses suggest that Dynamics is perhaps running at a quarterly rate of $2+ billion, less than Azure, but quite substantial. Putting the jewels into settings where their sparkle can be muted by the performance of other offerings makes sense at one level but can be frustrating.
I think two of the biggest opportunities that Microsoft has going forward are in applications and in its cloud revenues. Microsoft, along with many other companies, reports its cloud revenues in many different buckets. Azure, because of its nature, and its gaudy growth rate, gets the most press. But from a financial perspective, the growth rate in overall commercial cloud, which includes Azure, and includes the cloud component of MS Dynamics, is probably the most significant. The run rate for commercial cloud exceeded $13 billion last quarter, its margin contribution improved by 800 basis points and it grew by 59%. Commercial cloud is still just 15% or so of run rate revenues for MSFT as a whole, but more than all of the growth that one might reasonably expect from MSFT in terms of both revenues and particularly, gross margin dollars is going to come from the growth of the commercial cloud and the improvement in its gross margins. It is really the metric on which the most focus should be given.
Before leaving this part of the discussion I want to acknowledge that the company has other growth pockets. Surface revenues grew by 39% last quarter. There were some signs of life in the gaming sector despite its decline in reported revenues. But in terms of analysis, these are more distractions that do not have the potential to move the meter.
Microsoft's special sauces - its recipe is still under appreciated or the investment case for the shares
I will try, to the extent it is possible to do so, to suggest the competitive advantages that Microsoft offers in these areas. I do not want to suggest, regardless, that Microsoft is going to rule the world and indeed the assumptions regarding growth that I and others will make certainly don't suggest such an outcome. It is interesting to some and perhaps germane to a share price discussion to speculate when if ever, Microsoft overhauls Amazon. As mentioned earlier, there are certainly surveys that have been done that suggest that such as outcome is in the offing. For what it is worth, I think there is more than enough TAM such that one can readily forecast that both Amazon and Microsoft can achieve their growth objectives and avoid excessive price competition. The jury is still out regarding Google and the other cloud participants, such as IBM seem likely to find their market opportunities somewhat constrained.
Microsoft CEO Satya Nadella talks about the company's "global hyper-scale", which is really not a differentiator but a prerequisite to play in the enterprise cloud market. The company offers a focus on hybrid cloud support, which is probably the closest thing it has to a secret condiment. My guess is that a significant amount of the hyper-growth that MSFT has been achieving is coming from its leadership in hybrid cloud, which is what most mainstream users want to buy at this point. It has been a significant advantage over Amazon and probably is one reason why MSFT growth has been strong than that of Amazon in percentage terms. The recent announcement of collaboration between Amazon and VMware (NYSE:VMW) to develop a robust set of hybrid cloud capabilities, unlike many other collaboration, is likely to be of more than passing significance but I don't think it is likely to change expectations for the growth of Azure in the near future. Hybrid is the core of the MSFT architecture, but in the nature of things it is more likely to be a special condiment than a special sauce. Condiments can be replicated; it is harder to build special sauces. See below for the special sauce recipe.
Users are interested in cloud services that enable the development of IoT applications as well as the development of advanced analytics and machine-learning capabilities. Is Microsoft ahead of Amazon and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and others in these capabilities? It would be a very difficult thing to measure at this point. For now, the recipe that the company has is more than adequate to support growth expectations at very high levels for Azure. Microsoft has developed a long list of mobility services in the cloud and that has been a portion of the success it has enjoyed; again, I am not terribly sure that its mobility services are all that much better endowed than competitive offerings like IoT and AI, mobility is one of the prerequisites that some users will have in choosing a cloud vendor.
But I think self-evidently the special sauce that this company offers relates to having an approach in which the cloud is the back bone of a distributed computing fabric that the company is building. The company uses the strength of Office 365 and Dynamics as part of that vision. Users, or some significant cohort of them, seem to want to get their entire cloud fabric from a single source and at this writing, it appears that everything that is offered in the Commercial Cloud by Microsoft is the closest most users can find to a unified offering. It is a massive differentiator when compared to either Amazon or Google and until Oracle (NASDAQ:ORCL) really has a competitive IaaS offering in the field, it isn't in that game either. Even though I have recommended and owned these shares heretofore, I had some mental second guesses about the strategy. This is about as clear as a proof point as one is likely to see. Ultimately, selling the entire solution that includes Azure, Dynamics, and Office 365 will speed up the growth rate of all of the components and will lead to higher margins and there has been evidence that the trend is starting to unfold. CFO Amy Hood said, "IT's really about capturing the opportunity of selling more complete solutions, which include Dynamics and Office plus some components of Azure, which is, I think, really the trend you'll see us talk about from here on out." That is a recipe that is unique to MSFT at this point and which would be hard to copy for the other large cloud competitors.
A deeper dive into some financials
I present a look at the company's overall financials. But remember, there are lots of moving pieces. The company has three major revenue sources. Changes in revenue from one source to the other will have significant implications on specific line items in the P&L. The rapid growth of commercial Cloud will initially mask the overall strong margin performance and will certainly mask its gross margin improvement of close to 800 bps seen last quarter. The margin story at MSFT is unfolding as one might hope to see. As is customary for me, the foregoing ratios are all in GAAP terms although Microsoft uses little in the way of stock-based compensation, which is just more than 3% of revenues. And the company's revenue growth remains clouded in GAAP terms because of the deferral of Windows 10 revenue recognition. That will be changing in one year with the implementation a new FASB rule and will help to address some of the optical issues in the P&L. Overall, using the non-GAAP presentation, which most people will, revenues for the quarter were $22.3 billion as compared to $20.4 billion. The company had a 5% increase in revenues, non-GAAP at constant currency, operating income was up 4% and EPS rose by 13%, the later benefited by a lower effective tax rate.
Gross margins for Q1 were a bit less than 62% overall, as compared to a bit less than 65% in the prior-year A1. This is a function of a substantial change in the revenue mix as indicated above. Research and development costs were about 15% compared to 14.5% the prior year. Sales and marketing costs declined both as a ratio and in absolute dollars and were 15.8% this year compared to 16.4% in the prior year. And general and administrative costs also fell both absolutely and as a ratio to 5.1% from 5.3%. Operating margins, therefore, fell to 25.5% from 28.4% but the difference was made up by an increase in other income. The prior year had seen some losses on derivatives and on translation adjustments, which have to be included in GAAP but are not shown non-GAAP. This depressed results that were reported in 2015 by a relatively minor amount.
The company's cash flow increased by a noticeable amount and grew faster than reported net income. Overall, the CFFO margin topped 50% up from 42% in the prior year. Some of the improvement relates to receivable balances as billings are far closer to revenues when most of the revenue is subscription-based. But half of the change came from a previously mentioned cash settlement which allowed the change in other liabilities to fall to $361 million from $2.024 billion. Overall, free cash flow for the quarter came to $9.4 billion compared to a reported $7.4 billion in the prior year. Excluding the one-time effect of the cash payment, free cash flow would have grown by about 10%, more or less in line with net income. Free cash flow might be expected to maintain that trend or show a small reversion during the balance of the year. Last year, free cash flow reached $25 billion and I expect it to reach $27 billion this year, a margin on expected revenues of 28%.
In Q1, the company paid out the preponderance of its free cash flow after excluding the one-time cash payment. Dividends and share repurchases totaled $7.1 billion compared to $8.1 billion of adjusted free cash flow. I expect that the company will keep a consistent tempo with regards to share repurchases and the dividend increase that is expected will most likely take place 11 months from now.
At $96 billion of revenues and an enterprise value of $411 billion, the company has an EV/S of 4.3X expected revenues for the current year. Expected growth for 2017 had been 6% and the consensus is likely higher now. I expect the consensus for 2018 revenues to be about $103 billion, which produces an EV/S 0f just less than 4X. The current dividend yield is 1.56%. The current P/E in the wake of current estimate increases is just below 20X and the P/E that is based on likely 2017 earnings estimate increases should be less than 18X. The free cash flow yield based on my estimates is a strong 6.5%. These are reasonable valuations for a company now reaching a growth inflection point and with many levers of growth acceleration looking forward. I think there is significant positive alpha available even as the shares have made an all-time high.
Disclosure: I am/we are long MSFT.
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.