Microsoft Earnings: Owning The Cloud At A GARP Valuation
Summary
- The recent layoffs and departure of the CIO only mean that the cloud team's importance will continue to grow.
- Like Oracle, Microsoft is transitioning from the legacy desktop and Windows business to the public cloud via Azure.
- The installed PC base is a huge competitive advantage.
- Microsoft retains the #2 market position in cloud behind Amazon Web Services.
Microsoft (NASDAQ:MSFT) is scheduled to report its fiscal Q4 '17 financial results after the bell on July 20th, 2017, and consensus EPS estimates have actually improved a bit over the last few quarters.
However, the recent news of the 3,000 layoffs may be making investors nervous as Microsoft's stock is down about 5% from its all time high between $73 - $74 that was hit in early June, just before the Nasdaq and the PowerShares QQQ (QQQ) started their most recent correction.
Even Microsoft's CIO decided it was time to leave the firm with these latest layoffs per this Seeking Alpha article.
However for longer-term investors who aren't interested in day trading and can sit with individual stocks for longer periods of time, the recent weakness in Microsoft should represent a good buying opportunity.
Let's go to the numbers:
| Q4 '17 (est) | Q3 '17 | Q2 '17 | Q! '17 | |
| 2019 EPS est | $3.71 | $3.67 | $3.67 | $3.56 |
| 2018 EPS est | $3.32 | $3.27 | $3.26 | $3.26 |
| 2017 EPS est | $3.03 | $2.98 | $2.97 | $2.94 |
| 2019 est EPS gro rt | 12% | 12% | 13% | 10% |
| 2018 EPS est gro rt | 10% | 10% | 10% | 9% |
| 2017 EPS est gro rt | 9% | 7% | 6% | 6% |
| 2019 P/E | 19(X) | 19(X) | 17(X) | 16(X) |
| 2018 P/E | 21(X) | 21(X) | 19(X) | 18(X) |
| 2017 P/E | 23(X) | 23(X) | 21(X) | 19(X) |
| 2019 est rev's ($'s bl's) | $111.7 | $111.6 | $111.0 | $106.2 |
| 2018 est rev's | $103.7 | $104.1 | $103.8 | $99.5 |
| 2017 est rev's | $96.2 | $96.6 | $96.5 | $93.8 |
| 2019 est rev gro rt | 8% | 7% | 7% | 7% |
| 2018 est rev gro rt | 8% | 8% | 8% | 6% |
| 2017 est rev gro rt | 5% | 5% | 5% | 2% |
Source: Thomson Reuters I/B/E/S estimates as of July 9th, 2017
Readers should note a few trends from a quick perusal of the numbers:
1) Forward EPS estimates have been steadily rising. Even with the 3,000 layoffs by MSFT which presumably will be in fiscal Q4 '17, EPS estimates rose again recently.
2) The last three quarters' forward revenue estimates have been stable to slightly lower. The bump likely came with the LinkedIn (LNKD) purchase but mid-single-digit revenue growth expectations are still pretty reasonable.
Microsoft has the #2 cloud market share position behind AWS (Amazon (AMZN) Web Services) and has maintained that position for several tears.
The key competitive strength to Microsoft today is that they are able to leverage the existing Office base and transition it to the cloud. Although I'm a small advisor, I've long been a PC and Windows / Office user and although I use another vendor for cloud storage, the Microsoft One Drive would be an easy transition, which I may do just to have another cloud storage device.
As a portfolio manager, I've always focused on numbers, trends, and valuation. So with technology stocks, some of the more specific technological aspects to both individual stocks and sectors have escaped me, or at least I wouldn't feel comfortable trying to discuss technology-related specifics in front of a group of engineers. I thought this article, published a few days ago, made a compelling and understandable case for Microsoft's cloud and Azure.
Technical analysis:
Valuation:
| MSFT | |
| 3-yr avg EPS gro rt | 10% |
| 3-yr avg rev gro rt | 7% |
| 3-yr avg P.E | 21(x) |
| Price-to-sales | 5.6(x) |
| Price-to-cash-flow | 14(x) |
| Price-to-free-cash-flow | 19(x) |
| Price-to cash-flow (ex cash) | 11(x) |
| Price to free-cash-flow (ex cash) | 15(x) |
| Dividend yield | 2.20% |
| Div as % of FCF (total dollars) | 40% - 50% ish |
| Free-cash-flow Yield | 5% |
| Total cash and investments (3/31/17) | $112 bl |
| Total cash held in the US | $3.0 bl |
| Cash (net of debt) per share | $6.37 |
| Total L-T Debt today | $78 bl |
| Total L-T Debt (6/30/13) | $20 bl |
| Debt to capital | 34% |
| Mstar intrinsic value | $83 |
Analysis / conclusion:
Just looking at the longer-term monthly chart for Microsoft, readers can see the breakout in the stock above the September 2000 highs and its continued march forward.
Most Street price targets are just walking up the stock as the cloud and Azure grow in importance.
Microsoft started to break out of its long bear market after the 1980's and 1990's bull market in April 2013, when ValueAct announced that the firm had taken a 1% stake in the software giant. Ballmer left Microsoft shortly thereafter and within a short period of time Satya Nadella was promoted to CEO and a new era for Microsoft was set to begin.
Today, Microsoft can be considered a GARP (growth-at-a-reasonable-price) cloud play which has the stable Windows and Office legacy businesses that generate slow, stable consistent growth as investors await the tipping point for the Commercial Cloud and Azure.
In fiscal Q3 '17 the Commercial Cloud grew 50% y/y ata 415.2 billion run rate, while Azure grew 83% year-over-year. The Intelligent Cloud (as it is classified in Microsoft's earnings release and 10-Q) is roughly 30% of Microsoft's total revenue and 40% of operating income. The last few quarters Intelligent Cloud grew 11% while operating income, which had been a drag, is now flat, so the next phase for the Microsoft's Cloud will be to have a positive contribution to operating income.)
What do I worry about regarding Microsoft? Look at the valuation table and the percentage of cash, both total and the amount held in the US (source: 3/31/17 10-Q).
Microsoft's long-term debt has risen to offset some of this dearth of US cash-flow, And while Microsoft's long-term debt isn't yet "Home Depot (HD)" like, I am hoping that some kind of tax reform does occur in the next 6 - 12 months to allow companies like Microsoft to repatriate cash and resume some kind of "tax normalcy" between US and overseas revenue.
Microsoft has been clients' #1 position for the last several years, and the stock has outperformed nicely since the ValueAct event in 2013:
| Calendar year returns | MSFT | SP 500 |
| 2017 thru 6/30/17 | 11.43% | 8.3% |
| 2016 | 16.49% | 13.59% |
| 2015 | 21.88% | 1.31% |
| 2014 | 28.4% | 14.56% |
| 2013 | 39.53% | 32% |
Basically Microsoft took 15 - 16 years to work off the phenomenal bull run from the mid 1980's to March of 2000.
Technicians will tell you this breakout in the last 12 months, that really took hold in earnest in mid-2016, could last for years.
I don't think any "repatriation-style" cash return is in the estimates yet in any form or fashion, although Morningstar is incorporating a lower corporate tax rate into its valuation models.
I've told clients for years now, with Microsoft, the client gets "cloud-like" growth and emerging growth, with a reasonable valuation and a dividend yield to boot.
Real tax reform will be an additional bonus.
This article was written by
Analyst’s Disclosure: I am/we are long MSFT, HD, AMZN. 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.
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