- The market's reaction to Microsoft's Q2 2021 (calendar year) or Q4 FY 2021 (fiscal year) earnings was relatively muted, as MSFT had a mixed quarter.
- I think that Microsoft's earnings are expected to rise in the near future, but probably at a slower pace than the growth expectations implied by its current valuations.
- Microsoft stock remains a Hold for me, after the company's recently announced earnings.
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I continue to assign a Neutral rating to Microsoft Corporation (NASDAQ:MSFT).
My initiation article on MSFT was published on May 18, 2021, and Microsoft's stock price has increased by +16% in the past two and a half months from $245.18 as of May 17, 2021 to $284.91 as of July 30, 2021.
The market's reaction to Microsoft's Q2 2021 (calendar year) or Q4 FY 2021 (fiscal year) earnings was relatively muted, as MSFT had a mixed quarter. I think that Microsoft's earnings are expected to rise in the near future, but probably at a slower pace than the growth expectations implied by its current valuations.
In conclusion, Microsoft stock remains a Hold for me, after the company's recently announced earnings.
Microsoft Q2 Earnings
Microsoft announced its Q2 (calendar year 2021) earnings on July 27, 2021, and it is noteworthy that the market's reaction to MSFT's recent quarterly financial results has been relatively muted, despite the fact that the company's financial performance beat consensus estimates. Microsoft Corporation's share price declined marginally by -0.1% from $286.54 as of July 27, 2021 to $286.22 as of July 28, 2021, and MSFT's shares eventually traded -0.5% lower to close the week at $284.91 as of Friday, July 30, 2021.
I review Microsoft Corporation's Q2 2021 (calendar year) or Q4 FY 2021 (fiscal year ended June 30) earnings results below to see what are the possible reasons for the stock's muted share price performance post-results.
Microsoft Corporation's overall financial results in the final quarter of fiscal 2021 appeared to be very good. MSFT's quarterly revenue grew by +21% YoY from $38.0 billion in Q4 FY 2020 to $46.2 billion in Q4 FY 2021. The company's Intelligent Cloud, Productivity & Business Processes, and More Personal Computing business segments witnessed YoY revenue growth rates of +30%, +25% and +9%, respectively in the fourth quarter of fiscal 2021.
The company delivered an improvement in profitability in the recent quarter, with its gross profit margin and net profit margin expanding by +210 basis points YoY and +620 basis points YoY to 69.7% and 35.7%, respectively. Positive operating leverage played a key role in Microsoft's higher profit margins on a YoY basis in Q4 FY 2021. Notably, the company's research & development expenses and sales & marketing expenses as a proportion of total revenue contracted by -1 percentage points and -2 percentage points, respectively in FY 2021. As a result, Microsoft Corporation's earnings per share jumped by +49% YoY to $2.17 in Q4 FY 2021.
Microsoft's quarterly financial numbers also came in above what the market was expecting. MSFT's Q4 FY 2021 revenue and earnings per share were +4% and +13% higher, respectively as compared to the market consensus' forecasts.
However, if one goes into the details of Microsoft's recent quarterly financial results, the company's performance in the last quarter is rather mixed.
On the positive side of things, Microsoft Corporation's financial performance was good across the company's Intelligent Cloud, Productivity & Business Processes, and More Personal Computing business segments. Actual segment revenue for MSFT's three businesses in Q4 FY 2021 all came in above market expectations. More significantly, Microsoft expects the robust growth momentum in Q4 FY 2021 to be carried on into Q1 FY 2022. The mid-point MSFT's Q1 FY 2022 revenue guidance is about +4% higher than the market consensus' estimates.
On the negative side of things, there were pockets of weakness.
Certain sub-segments of Microsoft Corporation's More Personal Computing business did not perform that well in the last quarter. Surface revenue contracted by -9% QoQ from $1,504 million in Q3 FY 2021 to $1,376 million in Q4 FY 2021, while the YoY revenue growth for Xbox turned from a positive +32% on a constant currency basis in Q3 FY 2021 to a negative -7% in Q4 FY 2021. It is likely that MSFT's Xbox and Surface sales were negatively affected by both the semiconductor chip shortage, and an easing of Work-From-Home related demand.
Also, Azure's YoY revenue growth slowed slightly from +46% (adjusted for foreign exchange effects) in Q3 FY 2021 to +45% in Q4 FY 2021. Notably, Azure's constant-currency sales growth has already slowed from +50% YoY in Q4 FY 2020 to +47% YoY and +48% YoY in Q1 FY 2021 and Q2 FY 2022, respectively. Although this appears to be a very marginal moderation in revenue growth for the recent quarter, Azure is a very important component of the growth story for Microsoft. In my May 18, 2021 article, I emphasized that the increase in Azure revenue is "a validation of the strong client demand for cloud computing services", and I noted that MSFT is "an appealing investment candidate in the long run considering the company's growth prospects in cloud." Microsoft attributed the differences in Azure revenue for Q3 FY 2021 and Q4 FY 2021 to "seasonality" and timing differences in terms of "revenue recognition." But it is reasonable that any slowdown in revenue growth for Azure will be closely watched by investors.
Is Microsoft Stock Expected To Rise?
As mentioned earlier in this article, Microsoft's shares are up by about +16% in the last two months or so, although its shares have been relatively flattish post-results announcement.
In assessing Microsoft Corporation's future growth prospects (which in turn affects its share price), the commercial bookings metric is a key forward-looking indicator. MSFT's commercial bookings increased by +25% (in constant currency terms) in Q4 FY 2021, which is great on an absolute basis. Microsoft's +25% YoY commercial bookings growth in the recent quarter was also much better than the company's Q4 FY 2020's commercial bookings growth of +12% and its Q1 FY 2021's commercial bookings growth of +18%. Furthermore, Microsoft Corporation's commercial remaining performance obligation rose by +32% YoY from $107 billion in Q4 FY 2020 to $141 billion in Q1 FY 2021. This bodes well for the company's future growth outlook.
MSFT defines the commercial remaining performance obligation metric as the "commercial portion of revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods" in its prior 10-Q filing.
On the other hand, Microsoft's commercial bookings growth moderated from +38% YoY in Q3 FY 2021 to +25% YoY in Q4 FY 2021. This clearly raises questions and concerns from certain investors. At MSFT's Q4 FY 2021 earnings call, one of the attendees questioned whether the company's current strong growth momentum is "a pull forward of demand" (relating to the pandemic) or an indicator of "durability in this acceleration on a go-forward basis." In response, Microsoft emphasized that it views the current growth trajectory as "durable" based on industry forecasts that expenditure on technology will grow from the current 5% of global GDP to 10% in the future.
Although I do not doubt Microsoft's long-term growth prospects, I see a slow-down and normalization of growth in the short-term as inevitable. According to market consensus data sourced from S&P Capital IQ, Wall Street expects MSFT's revenue growth to slow from +17.5% in FY 2021 to +13.4% and +12.6% for FY 2022 and FY 2023, respectively. The moderation in top line expansion will have an even greater impact on the bottom line. Sell-side analysts estimate that Microsoft Corporation's normalized earnings per share growth will go from +38.4% in FY 2021 to +9.9% in FY 2022 and +14.1% in FY 2023.
In summary, I think that Microsoft's earnings are expected to rise in the near future, but probably at a slower pace than the growth expectations implied by its current valuations. This translates to more modest capital appreciation potential for the stock in the near term, in my opinion.
Is MSFT Stock A Buy, Sell, Or Hold?
In my opinion, MSFT stock stays as a Hold.
Microsoft's earnings will continue to rise as explained earlier, but it might not be able to live up to the lofty growth expectations that the stock's valuations suggest.
MSFT is one of the most expensive stocks among its peers, as per the peer valuation comparison table below. In contrast, Microsoft's expected revenue growth rates in the next two years are much closer to the average of its peers i.e. low-to-mid teens top line expansion. In other words, there seems to be a mismatch between Microsoft's current valuations and its future sales growth. If Microsoft Corporation's financial numbers in subsequent quarters come in below expectations, a valuation multiple de-rating for the stock is very probable which could offset earnings growth to a large extent. This supports my Neutral rating for Microsoft.
Microsoft's Peer Valuation Comparison
|Stock||Consensus Current Fiscal Year Normalized P/E Multiple||Consensus Forward One Fiscal Year Normalized P/E Multiple||Consensus Current Fiscal Year Top Line Growth||Consensus Forward One Fiscal Year Top Line Growth||Consensus Current Fiscal Year ROE Metric||Consensus Forward One Fiscal Year ROE Metric|
|Adobe Inc. (ADBE)||50.7||44.6||+22%||+15%||42%||40%|
|Facebook, Inc. (FB)||25.4||22.7||+39%||+19%||29%||25%|
|VMware, Inc. (VMW)||22.1||20.1||+9%||+9%||32%||23%|
|Oracle Corporation (ORCL)||18.9||17.0||+4%||+4%||276%||133%|
|International Business Machines Corporation (IBM)||13.2||11.9||+2%||+2%||45%||43%|
Source: S&P Capital IQ
The key risk for Microsoft remains that the company's future growth does not meet investors' huge expectations, as evidenced by its premium valuations.
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