Microsoft: A Quarter To Remember As The Company Returns To Growth Status

Summary

• Microsoft reported the results of its first fiscal quarter last week.
• The results were better than had been anticipated and the guidance was better than had been feared. The shares spiked.
• Microsoft can no longer be considered a value name - it can better be thought of as a name that embodies GARP expectations.
• The company had many green shoots that were visible in terms of its revenue growth.
• The company continues to achieve outstanding success in terms of growing Azure. But there are many other cloud businesses that are noteworthy as well.

Microsoft’s quarter-Come on in-the water’s fine

Microsoft (NASDAQ:MSFT), as almost everyone connected with the investment business is aware, announced the results of what was its fiscal Q1 late last week. The results were a significant beat - a blow-out really. The shares responded as might be expected, rising by more than 6% on Friday and are now up by 12% over the past month. I don’t imagine that readers need me to provide a calculation of the gains in MSFT shares. What this article is going to try to do is to synthesize some of the reasons for the success of the company in the last several quarters and to address the question as to whether it can sustain a more rapid cadence of growth. I do hold the shares in my portfolio, but I have different expectations for Microsoft’s share price performance as compared to other, high-growth holdings that I own.

It is important to note at the outset that Microsoft, as opposed to the FANG vendors, is both mature and not really likely to sustain hyper growth. Indeed, Microsoft is perhaps one of the more conservative ways in which to invest in the information technology space. The other day I wrote about Amazon (AMZN), and the difficulty of using normal quantification techniques to value its shares. Microsoft is a different animal. It has and will continue to generate significant levels of reported earnings and cash flow. It does pay a modest dividend, although probably not quite great enough to qualify as an income investment. It does have a substantial capital return program which undergirds valuation, to an extent.

Writing about Microsoft can be a bit complicated. The company operates in so many different segments within the IT space and it reports results in many different buckets that all have differing growth rates and different demand drivers. It would be tedious to attempt to review its performance in all of these spaces and it really isn’t totally necessary. I confess that my own evaluation of Microsoft’s gaming strategy is not likely to provide insights that are not available elsewhere. But overall, Microsoft shares are not without their detractors, and it can be a service to readers to attempt to address what are seen as issues regarding investing in the company’s shares.

Some specifics of Microsoft’s quarterly performance that lead to the share price spike

Microsoft reported revenues of $24.5 billion, up by 12% from the prior year. Some of this growth is not organic, and comes from the acquisition of LinkedIn last December. Operating income reached $7.7 billion and was up by 15%. Diluted non-GAAP EPS for the quarter was $.84, 17% greater than the level of a year ago. The prior consensus, at least as published by First Call, had been for revenues of $23.52 billion with EPS of $.71. It is rare to see a company of this size and this vintage show a beat of the magnitude just reported. Part of the beat is due to MSFT’s normally conservative guidance. But the level of the beat is such as to suggest that the company itself was surprised by the strength of its business.

The company provided relatively conservative guidance with a quarterly revenue forecast bracketing the prior consensus. That said, essentially most of the covering analysts raised their forecast for the current quarter and almost all analysts raised their EPS estimates for both this full fiscal year and for fiscal 2019 as well. That relates to a far more rapid increase in gross margins than had heretofore been expected by the company and therefore by most analysts.

In fact, gross margins rose from 64% to 66.5% on a GAAP basis year on year. This performance which was several hundred basis points above prior expectations, and for the most part related to the strong performance of Microsoft’s cloud operations. Azure is seeing more of a take-up of its higher margined premium services, in particular. The commercial cloud revenue run rate has now reached $20 billion, or about 20% of total revenues. Overall, the gross margin gains in this segment wound up accounting for more than 60% of the total margin gains. It seems likely that margin trends in the commercial cloud will persist over the next several quarters simply based on scale as well as improved operating expense ratios.

The operating expense ratios were more or less flat in Q1 compared to a year ago. Overall, GAAP operating expenses were 31.4% of revenues last quarter compared to 30.6% of revenues in the year earlier period. The company invested heavily in sales and marketing expense which increased from 14.6% of revenues in the prior year to 15.5% of revenues in this past quarter. The research and development spend ratio was consistent year on year while general and administrative costs showed a modest improvement compared to the prior year. It is consistent with past practice to see MSFT hire significantly for its enterprise sales teams at the start of the fiscal year and the sales and marketing expense ratio typically peaks during Q1. I doubt that other than normal seasonality, MSFT can materially improve its operating expense ratios, either through the balance of the year or beyond.

In addition to the outperformance of the commercial cloud, some of Microsoft’s ancillary businesses showed some surprising progress. These businesses show up in the More Personal Computing sector which still represents 38% of the company’s total revenue - although most of the revenues in that sector remain a function of sales of Windows.

While I'm not a world expert on gaming as I made clear earlier (I confess to never having played a video game in my life although I once gave an X-Box console as a Christmas present.), this is a focus business segment for the company. I have no idea about the appeal of Playerunknown's Battlegrounds, but apparently its exclusive partnership with MSFT is perceived as a major coup. During the conference call the CEO called out his expectation that the growth of software and services would be a leading indicator of the opportunity in gaming. While gaming revenue as reported grew by but 1% last quarter, sub-headline numbers showed that gaming software and services grew by 20% and engaged users grew by 13%.

Other significant areas of growth not usually considered in a Microsoft analysis include the company’s search business and its PC offering, Surface. The company doesn’t report the specific revenue dollars of these business segments and so it is not feasible to project just how much they might add to growth. But collectively, I believe that their continued expansion does have the potential to move the top-line growth meter by 100-200 hundred basis points, a number perhaps not really baked into analyst expectations or consensus forecasts.

Of particular interest to me was the success of Dynamics and Dynamics 365 this last quarter. While Microsoft has a long history of trying to sell applications to its customers, it has not really been successful. Since the advent of Azure, Microsoft has had an initiative to become competitive in selling a cloud-based ERP application, i.e. Dynamic 365, as part of an entire suite which includes Azure, security, data base, artificial intelligence and applications. Dynamics 365 grew by 69% last quarter while Dynamics products and cloud services grew by 13%. Overall, it appears to me that Microsoft is actually growing as fast or faster in the ERP space than the other competitors such as Oracle (ORCL) and SAP. (SAP) It is hard to measure Microsoft’s growth vis-à-vis competitors such as Salesforce (CRM) and Workday (WDAY) but at the least MSFT has certainly become a far more formidable competitor in applications - particularly cloud-based applications - than had been the case a few years ago. This provides the company with a substantial growth opportunity that's probably unrecognized in the current growth rate consensus.

The company continued to achieve strong results in terms of the growth of Azure with revenues rising by about 90%. Actually, that kind of growth was considered to be more or less in line by most observers and provoked little comment. Microsoft’s hybrid cloud vision appears to be in the mainstream of user preferences at this point and is probably a factor in this rapid growth. Azure growth is slowly declining in percentage terms although it is still rising in dollar terms. I think that the concept of a seamless experience in the hybrid cloud is a saleable concept that should be able to extend market share gains for Azure over the next several years. Microsoft does not yet break out Azure specifics in terms of the dollar amount of revenue and actually operating margins. I expect that at some point, revenues from Azure will reach a level where disclosure becomes both desirable and necessary in order to maintain a reasonable level of transparency for investors.

At the end of the day, the reason most analysts raised estimates and price targets as well, related to the strong level of gross margin performance in the commercial cloud segment. The revenue beat was not quite strong enough to result in wholesale upward estimates for near-term revenues.

The leverage in the commercial cloud segment is now visibly greater than had been previously been projected. This had been an area of debate among institutional investors and analysts. Seemingly, with this set of numbers, capping a long period of triple-digit growth in premium services, most analysts will agree that the profit potential for Microsoft’s commercial cloud is substantial and will help drive EPS growth at a more rapid level.

The company’s cash flow from operations rose by 7.7% last quarter. Cash flow growth was constrained by a decline in “other current liabilities." This is almost surely a one-time event that will be reversed before the end of this fiscal year. It is reasonable, I believe, to expect that CFFO will grow a bit more quickly reported earnings over the balance of the year. The company’s free cash flow rose at a faster percentage rate this past quarter as capex was stable year on year.

Microsoft is not really a cash flow story as that term is generally used. Most analysts will use some kind of cash flow multiple to value the shares and to set price targets, but cash flow and reported earnings are not going to show major divergence on a full year basis.

The company does generate CFFO that is greater than reported income in most quarters. It has made a large enough investment in data centers and other property such that depreciation is a major factor in cash flow. But its capex is at a level such that free cash flow is, and will remain, roughly consistent with the company’s operating profits. The company is generating enough free cash flow so that it can consistently increase dividends and maintain a robust share buyback program into the foreseeable future.

Microsoft vs. Amazon

Many investors like to contrast and compare the two companies - as investments and in terms of who is winning the battle between Azure and its various services against AWS and its flock of offerings. I have written about this comparison in an earlier article. I think by this point it should be obvious that the competition between AWS and MSFT is not necessarily a zero sum game. Because Amazon has its finger in many pies through its retail business, it is going to be shut out of some AWS opportunities. But, on the other hand, Microsoft is a software company and as such it competes with potential customers who are looking for a platform on which to host their software, either globally or in more remote geos. An example of the former is self-evidently Wal Mart (WMT) while an example of the latter is Salesforce (CRM). It is likely that these structural issues will be more of a handicap to Amazon than Microsoft, although measuring that would not be an easy undertaking. In this last call, the CEO Satya Nadella announced that Costco (COST) had chosen Microsoft as its hybrid cloud platform. It would have been more or less inconceivable if Costco had chosen arch-competitor Amazon for that role.

Microsoft’s CEO articulates a very specific vision for the cloud that he maintains provides users with a differentiated experience. In this last conference call, his script focused on the advantages of Microsoft’s hybrid cloud value proposition. He maintains that users need a consistent stack across the public cloud and the edge. “Azure provides this consistency across the entire stack, inclusive of identity, data, app platform, security and management at the edge and in the cloud.” Being able to drive this vision is one of the primary reasons why this CEO was hired and one of the strong capabilities that he brings to Microsoft. There are no doubt substantive advantages to the Microsoft approach of providing potential clients with a one-stop shop that includes almost everything one can possibly do with IT.

Microsoft is currently focused on migrating its on-premise SQL Server clients to the cloud. As might be anticipated, current focus also is on AI with the ability to run AI close to the data with languages called R and Python. (Just for the record - I really have nothing more than surface knowledge about these languages but they are apparently the languages that data scientists use for preparing data analysis solutions.) And the company has recently introduced Cosmos DB, a database designed to be used with apps written for the IoT and other so-called “serverless” applications. And again, not terribly surprisingly, the latest versions of Azure have AI based security built in. If much of this functionality sounds familiar, it is because lots of it is part of the latest Web enabled version of Oracle’s DB technology that was introduced last month.

Are these advantages of significant value such that they will propel Microsoft to a leadership position in the cloud? There are some observers who look at the 90% growth rate that Microsoft reports for Azure and conclude that it is winning its war with Amazon. My own conclusion is a bit more nuanced. I believe that AWS with 42% growth and a current revenue run rate of $18 billion is growing about as fast as can be managed efficiently without the wheels coming off.

One of the lessons of the dot.com bubble was that companies that tried to grow too fast at scale were unable to build infrastructure that was adequate to run themselves. AWS literally can’t run faster than it is doing without damaging its ability to serve customers effectively and damaging its ability to develop the internal control and measurement systems that it needs for long-term performance and user satisfaction. Anecdotally, I hear from time to time, that AWS simply lacks a professional sales organization that understands much about software sales - some of the leadership has risen far beyond the level of its ability. And still, it is enjoying 42% growth which obviously speaks to the momentum it enjoys and the stature that AWS has developed.

But that said, Amazon continues to add features to its offering at an astounding rate. And its ecosystem, unburdened by the issues of competing with the center of the web, is not something that will ever be readily matched by Microsoft.

The market for web services is huge - it is consistently under-estimated by most market research analysts who keep raising their forecasts. It isn’t necessary, or even productive, to forecast the coronation of Microsoft as the winner in order to recommend the shares. I'm inclined to believe that the web will have several winners and that and that even web services will be less of a winter-take-all environment than is true for many other elements of it. Amazon has shown that it is willing enough to invest in aggressive pricing action, rapid infrastructure development and deployment, and bringing to market a broader and more feature-rich offering than competitors, even including Microsoft, find economical to exactly mimic. It is not nearly necessary to suggest that Microsoft is going to overtake Amazon in the cloud in order to build an effective investment case for the company.

Valuation

Over the course of this year, various commentators on this site and analysts have suggested that MSFT shares are overvalued. About 25% of the analysts who cover the name have rated it as a hold, at least according to the published ratings from First Call. As the shares have risen by 40% over the past year, questions regarding valuation will inevitably arise, and I do not believe that the current valuation is congruent with published guidance/growth estimates.

Microsoft has a current market capitalization of $655 billion based on its reported outstanding share count of 7.8 billion and the current market price of $84/share. Its enterprise value is about $600 billion. The 12-month forward consensus revenue forecasts are currently at around $111 billion. So, the EV/S is 5.4X. That is not a bargain number, to be sure, and certainly not if 8% growth is close to a reasonable estimate for top-line performance. As I tried to point out, there are enough tailwinds, some of them as yet under-appreciated, that can turn the current 8% estimate into double digits, and that is going to need to happen to support the EV/S valuation of the shares.

The company is forecast to have forward 12-month earnings per share that will approach $3.50. So, the forward P/E is about 24X, a relatively reasonable value for that metric. It is reasonable to speculate that the P/E can expand if the earnings growth continues to substantially exceed both guidance and the consensus of analyst estimates. In fact, that is the scenario that I expect to drive the shares higher over the coming months and quarters.

I have mentioned earlier in this article that I believe Microsoft’s free cash flow will continue to closely track its reported earnings. So that implies that Microsoft will deliver free cash flow of about $27 billion over the coming year. That in turn calculates to a free cash flow yield of 4.5%. Again, that is not a huge bargain unless the cadence of earnings growth/cash flow growth accelerates.

Microsoft is likely to remain acquisitive. It has reported that LinkedIn has exceeded operational forecast so far this year and is achieving the kind of synergies in terms of cross selling, in particular, that it was hoping to achieve. I think with the LinkedIn merger as precedent, Microsoft will find many targets to augment its strategy. The newly enhanced focus on AI is likely to be an area that attracts Microsoft and the company could always expand the Dynamics stack substantially. But it has plenty of cash as ammunition and can readily borrow to finance larger acquisitions.

There are readers and investors who value MSFT because of its dividend and its capital return program. It is, I think, self evident that Microsoft is in a position to raise its dividend substantially. Last quarter, the company’s dividend payout was a very modest 46%. Certainly, this company can up its payout ratio without disturbing its financial strategy. I think it is reasonable to expect more substantial increases in the dividend going forward, regardless of the company’s acquisition strategy.

Should investors buy Microsoft in the wake of its spike? I think the case to add to MSFT shares remains. While the proximate cause of the share price hike had to do with better gross margin progress, that is not likely to be a longer term element in Microsoft’s earnings growth. Instead, what I took away from the quarterly numbers was increasing confidence that Microsoft’s transition to growth is ahead of schedule. I think the many green shoots seen in areas such as Dynamics 365, Office Commercial and Search advertising coupled with the growth of Xbox software ought to be the key takeaways. I think this company can achieve low double-digit top-line growth consistently and I expect to see that realized over the next 12 months. That is the foundation for a continued positive view of the shares and their ability to generate positive alpha going forward.

Analyst’s 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.