As I noted in my review to start the year, Microsoft (MSFT) is the second largest position in my portfolio, behind Berkshire Hathaway (BRK.B). While I talked a bit about Satya Nadella (the company’s new CEO) and the addition of Mason Morfit to the Board of Directors in an article back in February, I didn’t talk much about the business; looking back, I couldn’t find an article that addressed this topic in at least six months. As such, I figured it was worth taking a closer look at the company’s recent results, as well as discussing some recent updates at the company.
Across the board (revenues, operating income, EPS), the company reported solid mid-high single digit gains for the quarter; this is largely comparable to the results for the first nine months of the year. For the most part, I’ll focus on the year to date figures in this report.
Through the first nine months of the year, the Commercial business has put up solid numbers – a continuation of what the company has done for many years (a part of the business Satya was responsible for prior to being named CEO); Commercial revenues exceeded $36 billion in the first nine months of the year, and were ~9% higher than the same period in FY13 (operating income grew slightly faster). The Commercial Licensing division has reported 6% growth to date, with revenues approaching $31 billion; this growth has largely been driven by Server results (+10% year to date), as well as by Commercial Windows (+9%).
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The other component of the Commercial business, aptly named Commercial Other, is home to Microsoft’s Enterprise & Cloud Services offerings. Year to date, this business has reported $5.2 billion in revenues - an increase of 29% from the first nine months of 2013; this pace accelerated in the third quarter, with sales of $1.9 billion up 31% from the year ago period. While still small (~2.5% of the total), this is a rapidly growing addition to Microsoft’s reported gross margin.
This growth is captured beautiful in two numbers: Commercial Office 365 revenue more than doubled from a year ago, with the number of commercial seats up by a similar amount; Azure decided to one-up Office 365, with revenue growth in the quarter exceeding 150%.
On the Device & Consumer side of the business, sales have increased by 10% year to date; this growth is overwhelmingly driven by hardware sales, which have exploded due to the Xbox One launch in November 2013, as well as 50% growth in Surface revenues year on year. D&C Other also reported solid revenue growth, driven by continued growth at Bing (search advertising revenues increased 38% due to share gains and improved revenue per search), as well as Consumer adoption of Office 365 (which now has 4.4 million subscribers). The idea that people will no longer purchase the Office productivity suite continues to be refuted by the numbers.
On a less positive note, D&C Licensing has reported a 4% decline in revenues year to date, with gross margin off by a similar amount (I do not believe that the Upgrade Offer had a material impact on the year to date numbers based on my interpretation of the quarterly filing); declines in the segment, mainly in OEM non-Pro revenues, were offset by 33% growth in Windows Phone through the first nine months of the year. Consumer Office revenues were also strong in the quarter, with help from Japan (strong purchases ahead of an increase in the national sales tax); even after adjusting for that impact, Consumer Office outpaced PC sales (higher attach).
As a whole, despite the 10% revenue growth mentioned above, the shift to lower margin hardware sales has resulted in a 9% reduction in D&C gross margin to date. GAAP operating income for the D&C segment is down mid-teens from the first nine months of fiscal 2013.
Satya Nadella participated in the quarterly call, which was a nice change of pace. I didn’t hear anything too groundbreaking, beyond reassuring what I’ve stated previously: I believe Satya is quite different than Mr. Ballmer; I think he brings a personal sense of humility to his role, as well as Microsoft’s role in the world going forward (“our industry does not respect tradition – it only respects innovation”). I do not believe he will mistakenly write off competitors with irreverence, as Steve Ballmer did with Apple and the iPhone in 2007 (a line-up of phones behind Mr. Ballmer during press interviews at the time look like relics from another era). Jeff Ubben (Trades, Portfolio) of ValueAct put it perfectly in a recent interview: “This is a different company with [Satya’s] leadership”.
Year to date, Microsoft’s cash flow from operations exceeded $22 billion (down marginally from a year ago); even after accounting for $4.1 billion in capital expenditures (up 70% from FY13 due to continued investments in cloud infrastructure), and another $12.7 billion in cash returned to shareholders between dividends and share repurchases, Microsoft is still left with $6 billion in excess cash (that’s a good problem to have).
I’ll end with a quick discussion that relates to the prior paragraph: Microsoft’s astronomical cash hoard. At the end of the third quarter, Microsoft held $11.6 billion in cash and equivalents, plus another $76.9 billion in short term investments (with the vast majority in U.S. Government and Agency securities). In addition to that $88.4 billion, Microsoft also has $14.8 billion in Equity & Other Investments on the books; in aggregate, these funds exceed $103 billion in value. As things currently stand, I think they could easily dispose of $50 billion while hardly impacting their financial position; the cash balance has increased by that amount in four short years ($36.7 billion in cash and equivalents at the end of fiscal 2010).
This compares to $22.6 billion in total debt, on which the company pays an average effective interest rate of ~3%; more than a third of this debt does not come for at least a decade.
After backing out the $22.6 billion, the company has more than $80 billion in net cash; with 8.367 billion shares outstanding, this amounts to ~$9.50 per share in net cash. This is equal to one-quarter of the stock price as of Friday’s close. I don’t know when or how these funds will ultimately be used (or borrowed against), but I’m much more confident that the timetable has moved closer and the use will be well thought-out now that ValueAct is part of the conversation.
I certainly don’t like the stock as much as I did in the high $20’s, but I also believe intrinsic value has increased quite substantially in the years since I initially took a stake in the company; at current levels, I don’t feel any need to act. If we start to get in the mid-$40’s, that may change.
In the interview referenced above, Jeff Ubben (Trades, Portfolio) made an interesting statement that has since gone unreported: when Satya was hired, ValueAct added to their position. They are clearly confident in his leadership going forward, and likely believe the board will be receptive to their opinions; Nokia will be an early test of that theory, with Mr. Ubben saying that “there are a lot of tough discussions still to go around the device strategy.”
As of Friday, the Nokia purchase has closed.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with a handful of positions accounting for the majority of the total. From the perspective of a businessman, I believe this is sufficient diversification.