Microsoft reported Q218 revenues and earnings better than expected, excluding a one-time $13.8 billion charge on cash repatriation. Total revenues were up 12%, gross margin increased 12% and operating income was up 10%. Weaker US dollar benefited revenue by less than 1%. FCF was $5.3B, up 23%, of which $5.2B was returned to shareholders though dividends and buybacks. Strong cloud trends continue with commercial cloud revenue up 56%, reaching $5.3B (18% of revenue) and Azure revenue growth accelerating to +98% YoY. Commercial cloud drove about 60% of the revenue increase for the quarter. GM and operating margin outlook were increased as cloud margins improve. This is important to driving future earnings growth as cloud is lower margin and becomes a bigger piece of the pie. Geographically, U.S. and Western Europe performed best driven by commercial cloud sales. Overall they are seeing positive IT spending signals, a strengthening commercial PC market and growing demand for hybrid cloud.
Current Price: $94 Price Target: Under review
Position size: 4.4% TTM Performance: 49%
Thesis intact, highlights from the quarter:
- Productivity and Business Processes Segment (includes cloud-based applications like Office 365, Microsoft Dynamics and LinkedIn)
- $9B in Q2 revenue (31% of total revenue), up 25%. LinkedIn growth accelerated.
- LinkedIn added 4pts to top line growth and 4pts of gross margin growth.
- Intelligent Cloud Segment (public, private, and hybrid cloud services, including Azure)
- $7.8B in Q2 revenues (27% of total revenue), up 15%.
- Gross margin increased 7bps to 55%.
- Azure revenue growth accelerated to +98% YoY and is now at about a $6.8B annual run rate.
- Azure margins materially improved.
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- More Personal Computing Segment (Windows OEM licensing, search advertising and devices like the Surface and Xbox)
- $12.2B in Q2 revenue (42% of total revenue), up 2%; excluding phone, revenue grew 4%.
- Stronger than anticipated commercial PC market; consumer PC market “stabilizing.”
- Xbox was top selling gaming device over holiday.
- Xbox moving from a hardware console platform to a subscription software platform with recurring revenues and higher incremental margins.
- Gaming revenue grew 8% and is at a $9B run rate.
- More Personal Computing Segment (Windows OEM licensing, search advertising and devices like the Surface and Xbox)
- Commercial Cloud
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- This measure includes cloud revenues primarily from the first two segments – Office 365, Azure, Dynamics 365 and other cloud.
- Annualized run rate is annualized revenue from the last month.
- Current run rate is $21.2B, vs $20.4B in Q118 and $18.9B at FY17.
Outlook:
- Expecting Q3 revenue of $25.6B.
- Improved their full year guidance on gross margins and operating margins.
- At current rates, Fx will add 2pts to Q3 rev.
- Expecting a tax rate next year of 21%.
- They didn’t specify what they would do with the repatriated 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.
- Strong balance sheet ($142Bn gross cash) allows company to be opportunistic in current environment.
- Return of Capital: High FCF generation and returning significant capital to shareholders via dividends and share repurchases.
- Valuation is reasonable at a 4.6% FCF yield and a 1.7% dividend yield.