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The Science of Hitting
The Science of Hitting
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Microsoft: A Strong Start to Fiscal 2021

A look at the tech giant's first quarter financial results

October 29, 2020 | About:

Microsoft (NASDAQ:MSFT) reported financial results for its first quarter of fiscal 2021 on Tuesday.

It was another quarter of double-digit growth, with revenues up 12% to $37.2 billion. All three of Microsoft's business segments reported revenue growth in the quarter, with Intelligent Cloud leading the way (+20% to $13.0 billion). Operating income grew at a faster pace than revenues, with margins expanding by more than 400 basis points to 43%. Adjusted for the impact of an accounting change, margins would've expanded by roughly 200 basis points. As shown below, Microsoft's profit margins have increased considerably over the past few years, with trailing twelve months EBIT margins in the first quarter up by nearly 1,000 basis points from four years ago (the first quarter of fiscal 2017).

The combination of double-digit revenue growth and meaningful margin expansion, as well as help from below the line items, led to a 30% increase in net income to $13.9 billion. Diluted earnings per share grew at a slightly faster pace due to a 1% year-over-year decline in the share count.

When Microsoft first outlined the long-term opportunity in their commercial cloud businesses, their objective was to reach $20 billion in run rate revenues by the end of fiscal 2018. They achieved that goal ahead of schedule - as shown below, run rate revenues were $27.6 billion at the end of 2018 - and have kept charging forward ever since. Run rate commercial cloud revenues in the quarter crossed $60 billion for the first time. Amazingly, despite comping off a larger and larger base of business, commercial cloud revenues increased by 31% year-over-year in the first quarter.

Digging into the segment results, Productivity & Business Processes revenues increased by 11% to $12.3 billion. Strong customer additions continued for Office 365 Commercial (15% paid seat growth), with average revenue per user (ARPU) tailwinds from continued mix shift to higher value offerings (like E5) leading to 21% revenue growth in the quarter. Microsoft 365 Consumer continues to grow as well, with 45.3 million subscribers at quarter end (up 27% year-over-year, with an acceleration in the growth rate likely helped by shelter in place and work from home).

Strength in Dynamics continued, with revenues +19% year-over-year due to 38% growth from Dynamics 365 growth of 40%. Finally, LinkedIn revenues and sessions increased by 16% and 31%, respectively, marking another quarter of record engagement among the service's more than 720 million global members (up roughly 10% year-over-year). In addition to double-digit revenue growth, Productivity & Business Processes operating margins expanded by more than 300 basis points, resulting in high-teens growth in segment operating income to $5.7 billion.

As mentioned earlier, Intelligent Cloud revenues increased 20% in the quarter, led by another strong print from Azure (+47%, and at a run rate of roughly $25 billion a year). In addition to outsized revenue growth, Intelligent Cloud segment margins expanded by nearly 600 basis points in the quarter (with a material benefit from the useful life accounting change mentioned earlier), resulting in a nearly 40% year-over-year increase in operating income to $5.4 billion.

In More Personal Computing (MPC), revenues increased 6% to $11.9 billion, as much of the segment benefited from work, learn and play from home. A notable example was Surface revenues, which were up 37% year-over-year, as well as 31% growth in Windows OEM non-Pro revenues.

In the first quarter, after adjusting for discrete tax items in the year ago period, cash flow from operations increased by 12%, with adjusted free cash flow increasing at a low-single digit rate (after accounting for continued growth in CapEx as the company invests to capture growth opportunities). Microsoft returned $9.5 billion to owners in the quarter between repurchases and dividends, up 21% from the year ago period. At the end of September, Microsoft held more than $140 billion in cash and investments, or $78 billion net of all outstanding debt (roughly $10 per share of net cash).

As I've stated for many years, the balance sheet positioning remains incredibly conservative given the fact that this business expects to generate $50 billion a year in free cash flow in the near future. That said, I do not really expect Microsoft, or its large cap tech peers who are in a similar position, to meaningfully change their approach to financing and capital allocation in the coming years.

Conclusion

I'll leave CEO Satya Nadella with the last word:

"Today, as a percentage of GDP, tech spend is 5%. We think it will double in the next 10 years. And if anything, this pandemic, perhaps, has accelerated that. And in that context, what's the largest, most secular need? It's the need for distributed cloud infrastructure; it's both needed for modernizing existing applications… by the way, that's 20% penetrated, so there is more 80% that needs to move. But more importantly, there is going to be new application starts, which need infrastructure. And so, if you add those up, I think that we are still in early innings. There will be between quarters volatility, all of the points that Amy made even earlier. But we think distributed cloud infrastructure is the most important layer. But the way, we have approached it is to not just think of that layer in isolation, but the data layer work we do composes, the AI layer composes, and more importantly, our SaaS applications where there are business applications, Power Platform, Microsoft 365, all reinforce that same modern tech stack. So, I would still say that digitization with this new tech stack is in its very infancy."

Disclosure: Long Microsoft

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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