Current Price: $174 Price Target: Increasing to $195 from $170
Position size: 6.7% TTM Performance: 58%
Microsoft reported solid Q2 results, beating street high estimates on both revenue and EPS. The beat was broad based with better than expected growth in all segments. Double-digit top and bottom line growth, driven by the strength of commercial cloud. Q1 revenue was $37B (+15% YoY), gross margin dollars were up 25%, op income was up 39% and EPS was $1.51(+41%). Commercial Cloud business was up 41% constant currency and saw continued margin improvement, helping to drive op income up 39%. Counted w/in that is Azure, which was up 64% constant currency. They are taking share from Amazon’s cloud offering, AWS. This should continue as they are better positioned as more large enterprises, that are longtime customers, move to the cloud. Given their enterprise customer base, recent partnerships with SAP, VMware and Oracle, and superior Azure hybrid architecture, the company is uniquely positioned to capitalize on the growing demand for cloud services.
Key Takeaways:
· FY 2020 revenue guidance reiterated at up double-digits and op margins guidance increased to +200bps from “increase slightly.”
· Company Q2 gross margin was 67%, up 5 points YoY, driven by favorable sales mix and improvement across all three segments.
· Solid growth across all 3 segments:
o Productivity & Business Processes, up 19% YoY, $11.8B – driven by strong performance in Office commercial and LinkedIn
o Intelligent Cloud, up 28% YoY, $11.9B – driven by continued strong growth in Azure, +64%. Suggests annualized Azure revenue of ~$17B.
o More Personal Computing, up 3% YoY, $13.2B.
§ Ahead of expectations as better-than-expected performance across Windows businesses more than offset lower than expected search (+7%) and Surface revenue (+8%).
§ Weakness in gaming with lower console sales as we approach the next Xbox launch – revenues declined 20% constant currency. The lower console sales benefited gross margins.
· Q1 Commercial Cloud (consisting of O365 Commercial, Azure, Dynamics Online, and LinkedIn Commercial – this includes some revenue from the first two segments above) was $12.5B, up 41% constant currency in the quarter. Commercial cloud gross margin percentage increased 500bps, driven by material improvement in Azure gross margin.
· Within Commercial Cloud, Azure growth accelerated to +64% constant currency, from +63% last quarter.
· Recently announced exclusive partnership with SAP makes Azure the preferred destination for every SAP customer. Large customers mentioned on call include Accenture, Coca Cola, Rio Tinto and Walgreens.
· Ambitious new sustainability commitment: Microsoft will be carbon-negative by 2030. And by 2050, they say they will remove all the carbon they have emitted since the company was founded in 1975. And their $1 billion Climate Innovation Fund will accelerate the development of carbon reduction and removal technologies.
· Returned $8.5 billion to shareholders through share repurchases and dividends.
Valuation:
· Trading at a 3-4% FCF yield –still reasonable for a company with double digit top line growth, high ROIC and a high and improving FCF margins.
· They easily cover their 1.2% dividend, which they have been consistently growing.
· Strong balance sheet with about $134B in gross cash, and about $47B in net cash.
Investment Thesis:
· Industry Leader: Global monopoly in software that has a fast growing and underappreciated cloud business.
· Product cycle tailwinds: Windows 10 and transition to Cloud (subscription revenues).
· Huge improvements in operational efficiency in recent quarters providing a significant boost to margins which should continue to amplify bottom line growth.
· Return of Capital: High FCF generation and returning significant capital to shareholders via dividends and share repurchases.
$MSFT.US
[category earnings]
[tag MSFT]
Sarah Kanwal
Equity Analyst, Director
Direct: 617.226.0022
Fax: 617.523.8118
Crestwood Advisors
One Liberty Square, Suite 500
Boston, MA 02109