I have been impressed with Microsoft's (MSFT) revenue and earnings growth for a while. Over the past few quarters, I have openly questioned whether the company could keep the growth up, given its size. For the quarter-ended March 2019, cloud services was the star again, yet other segments also showed strength.
The Cloud Continues To Deliver
Microsoft used to be highly dependent on its computer licensing business for top-line growth. While the licensing business still serves as a valuable source of cash flow, the sizzle is now being delivered by the cloud. For the quarter-ended March 2019, total revenue of $30.6 billion was up 14% Y/Y. This followed a double-digit rise in the previous quarter.
Revenue from the Commercial business was up by double digits, driven by the commitment to the commercial cloud. Commercial bookings were up 30%, spurred by large, long-term Azure contracts. Azure is widely considered to be the first cloud service to offer a secure platform to protect the confidentiality of data while in use. Microsoft's advanced features for identity protection and information protection could be key selling points for the product. Commercial cloud revenue was $9.6 billion, up over 40% Y/Y. Commercial cloud gross margin was 63%, up 5% Y/Y. This is important as some suspect Microsoft's total gross margin could be stymied by lower margins for the cloud over time.
Revenue from the More PC segment was up 8%. Windows OEM revenue grew 8%, while Windows commercial products and cloud services revenue was up 18%. Surface and gaming revenues were up 21% and 5%, respectively. Gaming revenue had been growing by double digits. It now has over $2.2 billion of quarterly revenue, which could make future double-digit growth difficult to come by.
According to Gartner, worldwide PC shipments fell nearly 5% in Q1 2019. The PC refresh that took hold in mid-2018 may have run its course and could potentially have a negative impact on Microsoft's PC segment by the second half of 2019.
Intelligent Cloud revenue of $9.6 billion was up 22%, making it Microsoft's fastest-growing segment. It represented 31% of total revenue, up from 29% in the year earlier period. Server products and services revenue grew 27%, driven by Azure's growth of 73%. Microsoft has been winning cloud services business from Amazon (AMZN) competitors like Walmart (WMT), Walgreens Boots Alliance (WBA) and Albertsons; this phenomenon could last for a while. Once Microsoft gets large institutions within its ecosystem, it can potentially better help them analyze their data or cross-sell other services like artificial intelligence ("AI").
Microsoft's Leverage Shows Up In Margin Expansion
The ability to grow revenue without sacrificing pricing power should be reflected in a company's margins. In that regard, Microsoft has tremendous leverage in its operations, leading to out-sized margin expansion. The company's gross margin was around 67%, up 200 basis points from the year earlier period. The fact that cloud services revenue is growing faster than other segments and gross margin is improving is a good thing. It implies cloud services growth is not dragging down margins.
Operating income of $10.3 billion was up 25%, far outpacing the company's 14% revenue growth. Microsoft received additional leverage in R&D and SG&A expenses. R&D and SG&A expenses were a combined 33% of total revenue this quarter, down from 35% in the year earlier period. In addition, EBITDA margin also improved by 200 basis points.
Management guided on Q4 revenue in the $32.2 billion to $32.9 billion range. The low end of the range would reflect about 9% revenue growth Y/Y. The company should have to hold growth in operating expenses below 9% in order to grow margins again. Investors could turn on the company if they do not believe cost containment efforts can lead to double-digit growth in operating income.
A P/E of 28x appears justified for MSFT given earnings growth potential. The melt-up in financial markets could end sans more government stimulus. MSFT is up over 30% Y/Y. Volatility in broader markets due to trade wars or worries over the global economy could stymie the stock. I rate MSFT a hold.
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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.