Microsoft Will Likely Shine On Earnings Day Again

Summary

• Microsoft will report fiscal fourth quarter earnings on July 27, and Wall Street's expectations are aligned with management's guidance.
• Expect to see a continuation of recent trends: cloud transition and stay-at-home forces driving strength in cloud infrastructure and business applications.
• Beyond the results of the most recent quarter, the bull case on MSFT is based on the company's longer-term prospects that remain intact.
• Looking for a helping hand in the market? Members of Storm-Resistant Growth get exclusive ideas and guidance to navigate any climate. Learn More »

rvolkan/iStock Unreleased via Getty Images

The date has been set: on Tuesday, July 27, Microsoft (NASDAQ:MSFT) will deliver fiscal fourth quarter results. Wall Street is looking for top-line growth of 16.5% and EPS of $1.92 which is very much aligned with management's guidance.

With analysts choosing not to set the bar too high ahead of earnings day, I believe that Microsoft will deliver its tenth consecutive all-around beat. At the same time, I do not think that the bull case on the stock is primarily a function of the most recent quarter's results, but of the company's longer-term prospects that remain intact.

A preview of fourth quarter results

The table below summarizes Microsoft's outlook for the fourth quarter shared with analysts and investors about three months ago. Clearly, the company expects cloud and business applications to perform best, while personal computing, gaming and the alike will probably take a back seat this time.

Source: DM Martins Research, data from earnings call

Although not officially reported, I believe the first two segments to have the highest mix of recurring revenues, which partly explains why growth rates will remain in the high teens at least. In both cases, I think that the cloud transition and the lingering effects of the pandemic (i.e. stay-at-home habits, etc.) will be responsible for lion's share of the revenue growth.

Expect Office 365, Dynamics 365 and LinkedIn to shine in fiscal fourth quarter at the expense of on-premise software, in a continuation of recent trends. In cloud infrastructure, Azure is certain to grow robustly, but the question is what happens to the growth pace (see trend below, stated in percentage points). More PC should suffer from tough comps and supply constraints, although the segment will likely still benefit from strength in laptop and tablet demand, and from the most recent gaming console refresh.

Source: DM Martins Research, data from company reports

An important topic of conversation will be margins. Judging by the management team's guidance, Microsoft's earnings should benefit from opex rising only 7% YoY (e.g. COVID-19 savings, closure of Microsoft's physical stores) against higher top-line growth of 16%. Also, gross margin expansion should be a byproduct of the cloud-based business model allowing for gains of scale, plus a heavier mix of cloud revenues this quarter.

MSFT is a "buy and hold"

My investment thesis on Microsoft is not grounded primarily on above-consensus, near-future results driving share price higher – although the company has a solid track record of beating Wall Street's revenues and earnings expectations each season since at least 2018. In fact, the stock has reacted poorly even after Microsoft delivered its signature all-around beats in the past four quarters at least:

• Down 4% the day after fiscal fourth quarter 2020 earnings
• Down 5% the day after fiscal first quarter 2021 earnings
• Flat the day after fiscal second quarter 2021 earnings
• Down 3% after fiscal third quarter 2021 earnings

For this reason, I would not be surprised to see MSFT sell off once again, even if fiscal fourth quarter numbers come in ahead of consensus. This is particularly true this time, as the stock has been up 17% since the start of the second quarter, well ahead of the S&P 500's 7% gains.

Instead, I believe that MSFT is a long-term buy and hold due to the company's leadership position in sectors that are likely to continue to grow robustly for years: cloud infrastructure, business productivity applications, gaming, among others. The cherry on the cake is the cloud-based business model that allows for stability and predictability in revenues and earnings, making MSFT less of an earnings season stock and more of a steady climber.

Data by YCharts

To be clear, valuations continue to rise. Current year P/E of 33 times is about seven turns higher than it was this time last year (see chart above). Of the few reasons not to buy MSFT, valuation continues to be the key pillar of the devil's advocate argument, in my view – one that should not be dismissed.

But I also believe that Microsoft can grow earnings into its rich valuation. Case in point, MSFT currently trades at a forward multiple of 20 times 2025 consensus EPS (if Microsoft continues to consistently beat consensus expectations, this multiple is then likely in the teens). Absent a major market shock or loss of market relevance that I find improbable, it is hard to imagine this stock commanding such a low multiple in the next few years – suggesting that there is more upside to the share price ahead.

Disclosure: I/we have a beneficial long position in the shares of MSFT either through stock ownership, options, or other derivatives. 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.