MSFT - Microsoft Corp.: You Don't Need To Dig Deep For Positive Signs

• Microsoft released its Q4 earnings this week.
• Short-term negative developments impacted the company.
• Microsoft is well-placed to support a digital transition.
• CEO Nadella says the company will invest despite headwinds.

Microsoft released its earnings this week, and I will discuss positive growth trends behind the near-term headwinds.

Microsoft Corp. released its Q4 earnings this week

Microsoft Corporation ( MSFT ) released its FY Q4 earnings this week, and the stock saw a gain of over 4% in post-market trading. The company missed Wall Street estimates and even fell short of its own revised guidance as economic headwinds hit the company.

The company reported $51.9 billion in sales in the quarter to June 30, up 12 percent from the previous year, and profit was 2% higher at $16.7 billion.

"We're obviously incredibly bullish on just about everything else that we have," Chris Capossela, Chief Marketing Officer, had said after the previous guidance was released.

That was released on June 2nd, when the U.S. dollar index traded at 102 and has since touched 109. The continued strength of the U.S. dollar is an issue, but it is one that is appearing in almost every earnings release this season.

Short-term negative developments impacted the company

The U.S. dollar was one (possibly) short-term disadvantage that impacted this earnings call, but there were others that took a bite from the bottom line.

In the U.S. dollar, it was a significant $595M foreign exchange headwind, compared to the previous expectation of $460M.

Adding to the near-term problems was a $300M sales hit in China due to the recent Covid-19 lockdowns and $100M on reduced ad spend. Another $113M was spent on employee severance expenses, and $126M was needed to scale back operations in Russia.

That's over $1.2 billion, and much of that can show up in the next earnings release.

If we look at the overall trend in Microsoft earnings, then we can see that quarterly revenues have been on a significant uptrend since 2016. Quarterly growth started to pick up following the 2020 work-from-home phase, and the current headwinds are taking a bite from the growth element, but the revenue picture is still strong.

Net earnings per share have also been on a steep uphill climb since the end of 2017, from $1.75 to $9.58. These trends are occurring because of the company's pivot from hardware to cloud computing and other "customer solutions."

It was those new products that are growing more rapidly, as seen in the 'Productivity and Business Processes' revenue of $16.6 billion - an increase of 13% (17% in constant currency).

• Office Commercial products and cloud services revenue increased 9% driven by Office 365 Commercial revenue growth of 15%.
• Office Consumer products and cloud services revenue increased 9% and Microsoft 365 subscribers grew to 59.7 million.
• LinkedIn revenue increased 26%, which is being helped by the newsletters product.
• Dynamics products and cloud services revenue increased 19% driven by Dynamics 365 revenue growth of 31%.
• Revenue in Cloud was $20.9 billion and was higher by 20%.
• Server products and cloud services revenue increased by 22% driven by Azure and other cloud services revenue growth of 40%.

Microsoft also saw an improvement in its gross margins for the period, and free cash flow improved by 9% Y-o-Y to $17.8bn.

The company is well-placed to support a digital transition

The market for digital solutions is likely to continue powering ahead, and we should ignore the near-term issues of currency and lockdowns to focus on the underlying segments at the business.

Looking to the future, Chris Cassopella said in that previous Jeffries software conference that he sees three key areas for growth: Security, data, and gaming.

"We're in essentially 10 different businesses that we call customers solutions... but I'll pick two that I think are somehow under-talked about... that we're very excited about. One would be security and you look at vendor's consolidation. Average Fortune 1000 probably had 30 security vendors that they're paying.

And so when times get hard and people are looking at vendor consolidation, security is an obvious place. And our end-to-end security portfolio that was really, really expansive, and it's not focused on Microsoft tech. It's focused on customers' tech. So we secure other clouds... I think security for me is one that as I look into FY2024, it's probably one of the biggest, most exciting opportunities."

Cassopella went on to discuss the data and analytics space, saying:

"For us, I would say it's not just data, but it's also analytics and it's also governance. And we've put these three things together into what we call the Microsoft Intelligent Data Platform... But I think the data estate is where so many more companies are now realizing they have to start as they digitally transform, start with your estate and they're turning to fewer and fewer companies for help bringing that to the cloud and modernizing it."

Deciding to add a third space for future growth, the CMO added gaming.

"There are 3 billion people on the planet who plays a digital game and our opportunity to bring that experience across devices, not just the console... But if you look at all the consoles sold, compared to all the iPhones sold a very small number. So bringing gaming to iOS, Android, and many, many other devices and having it be cloud-powered, we're one of the few companies that have this cloud platform... You can stream Fortnite. So just about any device, and that's us putting Fortnite in our data center and letting you play it in 5 seconds just, that's five years ago, that would have been unthought, unheard of."

On the security side, that will come down to the streamlining of vendors. Microsoft can improve its security offerings and grab more revenue as companies look to consolidate their security, which will likely move further into the cloud and away from the hardware that Microsoft recently served.

IDC predicted that cloud spending will top $1.3 trillion in 2025 from $706B in 2021. Overall, that can boost Microsoft revenues in all of its business segments that are embracing the digital transformation.

On the gaming side, that is also a relatively easy target, as Microsoft can move to provide mobile solutions to its current games that would like to play on the move in a reliable cloud solution.

Full steam ahead despite economic uncertainty

Microsoft CEO Satya Nadella said in an earnings call that the company will still invest to hunt for market share and build new businesses despite the headwinds, but will do so with "intense execution."

Nadella also pointed to growth in the number of deals at $100M and over $1B that were signed this year as a sign of strength in the Azure platform.

Businesses are beginning to embrace digital transformation and that has room to grow further with the blue-chip firms, but we are then likely to see a wave of small-to-medium businesses catch up after that. This will continue to support Microsoft and investors can continue to look beyond the near-term headwinds that the company is now well aware of and can possibly mitigate.

On the valuation front, Microsoft trades at 27x earnings, but that is down from 35x previously. Price-to-sales is on the high side at 10x but underlying growth means it is not a problem. The company also returned $7.8B to shareholders over the year and $4.6B in dividends. The next quarterly dividend at $0.62 goes ex-dividend on August 18 and is payable in September. The stock is currently priced around the $250 level and I don't see much downside beyond $200 if the economy weighs on stocks into year-end.

Conclusion

Microsoft's pullback this year is an opportunity for investors to get involved at a better valuation. This company is well run and is delivering rewards to shareholders in the form of dividends and buybacks, but is still improving its cash reserves and investing in growth. That growth is powering ahead and unlike many other tech businesses, the company is not seeing big volatility in its subscriptions and orders due to Covid-19 or the current headwinds.

The recent market problems have affected all companies, and Microsoft can shrug off around $600M from short-term headwinds and hope that the U.S. dollar improves. The company is now well aware of that as a headwind and can look to mitigate some of the damage. Large corporations are spending big on the Microsoft digital platforms, and orders are holding up as the economy lurches towards a recession. That will provide a springboard when companies are feeling optimistic again, and the company is also sizing up new opportunities in areas such as security and mobile gaming.

For further details see: