An Upside Hidden Deep In Microsoft's Numbers

Summary

• Microsoft's cloud computing foray has given rise to some interesting side-effects.
• One of these is the leverage they now have because of one particular metric.
• What is this metric, and how does it strengthen Microsoft as a cloud company?

Microsoft’s (NASDAQ:MSFT) ascent in the market capitalization charts has been swift since the time the company started concentrating on the cloud computing market. With growth rates accelerating over the last four quarters, there is a fair chance for the company to keep moving up the ladder. But there is one metric that all but the most diligent of investors will fail to see as an upside: operating margins.

A Brief Look at Segment Margins

Before we can get into the details of why Microsoft’s operating margins make a huge difference, let's take a closer look at Microsoft’s three segments: Productivity and Business Processes, Intelligent Cloud and More Personal Computing and their impact on the company’s overall performance.

During the third quarter Microsoft reported $22,090 million in revenues: $23,557 million from the three segments, with a loss of $1,467 million booked under Corporate and Other. Of that $23,557 million, More Personal Computing accounted for 37.51%, followed by Productivity and Business Processes at 33.78%, and Intelligent Cloud the remaining 28.71%.

Source:Microsoft Q3-2017 Press Release

Despite its second-placed position in terms of revenue, Productivity and Business Processes, which includes cloud software (Software as a Service, or SaaS) applications such as Office 365, Dynamics 365 and LinkedIn Sales Navigator, posted an operating income of $2,783 million, followed by Intelligent Cloud with $2,097 million and More Personal Computing segment with $2,097 million.

The two cloud-based segments have high operating margins, and accounted for 70% of combined operating income.

The Productivity and Business Processes segment has been a huge winner for Microsoft on the operational front, as margins stayed well above the 40% mark for the past several quarters before contracting to 34.97% during the third quarter. The addition of LinkedIn to the segment reduced the margins during that quarter.

Microsoft CFO Amy Hood told analysts during the earnings call:

“Operating expenses increased 44% and 45% in constant currency, with 43 points from LinkedIn, including $153 million of amortization expense. Operating income declined 7% and 4% in constant currency, with 13 points of impact from LinkedIn.”

Source: Microsoft Quarterly Earnings Press Release

Despite the hit, the operating margin was nearly 35%, and it shows how profitable Office 365 and Dynamics 365 products have been for Microsoft. The Intelligent Cloud segment is no slouch either, clocking above 30% margins with ease for the last seven quarters. This segment includes Microsoft’s revenues from its infrastructure service, Microsoft Azure, along with server products and enterprise services.

Source: Microsoft Quarterly Earnings Press Release

On the operating margin front, both these segments trounce More Personal Computing, which includes Windows, gaming, search and device revenues, by a wide margin. More Personal Computing remains the weakest link in Microsoft’s arsenal, declining 7% during the third quarter 2017, while Intelligent Cloud grew by 11% and Productivity and Business Processes grew 22%.

Source: Microsoft Quarterly Earnings Press Release

The Bigger Picture

All of that shows us how strong Microsoft is, but if we really want the bigger picture behind Microsoft’s operating margins, especially in its cloud-related segments, we necessarily have to look at how its numbers fare against the king of cloud infrastructure - Amazon’s (AMZN) AWS.

Microsoft and Amazon are running neck and neck when it comes to cloud revenues. During the third quarter Microsoft said that its Commercial Cloud annualized revenue run rate exceeds $15.2 billion, while Amazon Web Services reported $3.661 billion in revenue during the quarter, giving it an annual run rate of $14.644 billion.

Though their revenues are close, when it comes to margins from cloud businesses, Microsoft is way ahead of Amazon, which has been reporting operating margins in the sub-30% range for AWS during the last several quarters.

Source: Amazon Q1-17 Financial Results

That gives us a better perspective of Microsoft’s strong position in cloud, and its prospects for future growth in this area.

Microsoft’s most profitable segment is also its fastest growing segment, and there are many reasons why the above-average profit margins of Microsoft’s cloud-based revenue streams from Productivity and Intelligent Cloud have put Microsoft in a hugely advantageous position.

Why Margin Matters

The competition in the cloud industry has intensified in the last year, and we now have five players in the fray, Microsoft, Amazon, IBM (IBM), Google (GOOG) (GOOGL) and Oracle (ORCL). Though pricing will not always sway a prospective client's decision, it definitely is one of the important factors. If all the five companies resort to a pricing war, Microsoft is the one that has the most bandwidth to handle such a situation.

Microsoft's Productivity segment clearly its most profitable one, and Office 365 has been growing at a phenomenal rate.

“Office commercial products and cloud services revenue increased 7% (up 8% in constant currency) driven by Office 365 commercial revenue growth of 45% (up 45% in constant currency)

Office consumer products and cloud services revenue increased 15% (up 14% in constant currency) and Office 365 consumer subscribers increased to 26.2 million” - Microsoft Q3-17 Press Release

MSFT Free Cash Flow (TTM) data by YCharts

As cash flow keeps increasing, Microsoft will prioritize its investments, and would ideally want its best performer to grow as fast as it can. Microsoft expanded Office 365 services significantly in the past, and will continue to do so in the future as well.

“With Office 365, we are trying to expand the appeal of Office 365 on multiple dimensions. A lot of what we are still seeing in play is the rapid adoption or the increased adoption of Office 365 E3, which is what I think is driving a lot of the growth, the ASP growth.

Now we have a good start with what is at the high end of the enterprise value, which is E5, some of the value we have. Whether it's voice or analytics and security, it resonates. And we're learning, we're improving, and we're pushing forward on that front.” - Satya Nadella Q3-2017 Earnings Call

That ‘pushing forward’ has resulted in the recent launch of Microsoft 365, a holistic cloud-integrated solution for enterprise and business users (two variants) that includes Windows 10, Office 365, Dynamics 365 integration with Sales Navigator from LinkedIn, and several of Microsoft’s security and mobility solutions. This is going to be a big boost for all of their cloud services, including infrastructure from Azure, which will undoubtedly be offered as an up-sell.

There’s another big reason why strong operating margins offer up a hidden gem for the diligent investor: Microsoft is slowly but surely weaning itself away from Windows, devices and gaming revenues.

Microsoft is targeting $20 billion in annual cloud revenues by 2018, and there’s no reason to doubt that it will achieve that goal. But operating margins provide a much wider and longer growth runway to maneuver around on, giving the company and its CEO the crucial leverage they need against the competition.

Analyst’s 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.