In a recent article, fellow GuruFocus writer Thomas Macpherson said something that really struck a chord with me; when a reader suggested that the stock touted in Mr. Macpherson’s article was a bad one because it had fallen after earnings, he responded with the following:
"As a long term value investor we would look at a one day return (either up 14% or down 14%) as an interesting data point – nothing more or nothing less. How Wall Street reacts to corporate earnings is their own interpretation and response. We simply look at our assumptions and test to see if our investment thesis is still valid.”
After watching a holding get pummeled, our natural instinct is to panic (losing a lot of money isn’t much fun); but rather than an emotional response, what an investor really needs to do is see if their investment thesis is still valid. I think Mr. Macpherson’s approach is spot on.
Which brings us to Microsoft (MSFT). After reporting earnings last Monday, MSFT fell more than 9%, erasing more than $30 billion in market value; year to date, the stock has fallen 13%. Of course, that doesn’t mean much in a vacuum (as Mr. Macpherson’s said, how Wall Street reacts is their own interpretation and response). Personally, I didn’t see much in the report that surprised me (that’s a good thing); in addition, the move to the downside will enable Microsoft to purchase millions of more shares in the ensuing 24 months (more on that shortly).
The headline figures for the quarter were $26.5 billion in revenues, $7.8 billion in operating income and $0.71 per share in earnings. Adjusted for incremental income tax expense resulting from an IRS audit adjustment ($0.04) and integration and restructuring expenses for NDS ($0.02), EPS was roughly in-line with the prior year. (A quick clarification: I don’t necessarily agree with removing integration & restructuring expenses, particularly for companies that are continually engaging in M&A; with that said, I also think the justification for backing out those costs in any given quarter – a blurred year-over-year comparison –Â makes sense. I like the middle ground –Â apply an average to the income statement when working towards normalized earnings.)
Device and consumer
Looking at the individual segments, the device and consumer division reported 8% revenue growth in the quarter, with an explosion in D&C hardware revenues (+41%); this was entirely due to the Nokia (NOK, Financial) acquisition. Adjusted for the deal, D&C hardware revenues fell more than 10% in the quarter. Strong revenue growth for surface (up 24% year over year and crossing $1 billion in quarterly revenues for the first time) was offset by the tough comparison for Xbox, which was facing the holiday launch for Xbox One in the prior year (with revenues -20% this quarter).
D&C licensing struggled as well in the quarter, with revenues off by a quarter; the removal of Windows Phone revenue (vast majority previously came from Nokia), as well as the decline in Windows OEM and Office Consumer revenues (Office 365 Home & Premium doesn’t show up in D&C Licensing) impacted results. The decline from Windows Phone was expected, and Office Consumer revenue was impacted by PC results and the shift to Office 365 (discussed in a moment), so let’s focus on the results for Windows in D&C Licensing.
Windows Pro and non-Pro revenues both fell low double digits in the quarter. The Pro piece is explained by a return to “end of XP support” levels: consider that Pro revenues were up more than 10% from the second quarter through the end of fiscal 2014, compared to a PC market that was flat / slightly down; we’re getting back in line with PC unit growth. In addition, Pro was impacted by an increased mix of lower priced licenses for academic customers, impacting ASP’s; the larger component of the two was the tough XP comp. While we’re certainly talking about a big number (-13%), I don’t find anything in the numbers that points to a larger issue; combining the result with the prior year Pro number (+12%) paints a more realistic picture. This will continue in the coming two quarters, when Pro revenues came in at +19% and +11%.
On the non-Pro side, the shift in licensing strategies on low-priced (“opening price point”) devices has obviously impacted ASPs – the main driver in non-Pro revenue declines; I didn’t find management’s declaration that the move has resulted in growth in that market segment for Windows too encouraging either (I take “growth” to mean low single digits). Management also pointed to the prior year VAT increase in Japan, noting that the region has relatively high attach rates for Office as well; considering that the VAT increase didn’t hit until April, we’re going to see an even tougher comparison in the third quarter for both product lines.
The remainder of the segment (D&C other) includes Microsoft’s search advertising business, first party video game / resale revenues, and the results for the Office 365 consumer offerings; each of the lines within “other” reported revenue increases of more than 20% in the quarter.
Search advertising revenue increased 23%, with Bing nearing 20% search share in the U.S. (per comScore); while I’m unhappy with the pace of gains, the trend is still in the right direction. The team continues to do a nice job improving the product, and we’re seeing continued integration within Microsoft’s other offering (including Office and a big role in Windows 10 via Cortana).
Office 365 Home & Premium also continues to shine, with more than 2 million net new subscribers added over the past 90 days (bringing the total to 9.2 million).
Commercial
All in, the commercial business reported 5% revenue growth in the second quarter, to $13.3 billion; the company was lapping a strong second quarter in the prior year, where commercial revenues rose 10%. Revenues in the quarter for the commercial business were $1.75 billion higher than they were two years ago; on a cumulative basis, that’s a more than 15% increase – not too shabby for a business that will have more than $50 billion in revenues in fiscal 2015.
Digging deeper, let’s start with “commercial other” (primarily Enterprise Services and Commercial Cloud –Â Office 365 Commercial, Dynamics CRM Online, Azure and Enterprise Mobility Suite): revenues increased 46% in the quarter to $2.6 billion (with guidance calling for 40%+ again in the third quarter); Commercial Cloud grew by 114% (the sixth consecutive quarter of triple digit revenue growth) and is now on an annualized revenue run rate of $5.5 billion.
Importantly, this growth is starting to reflect economies of scale for Microsoft: gross profits for commercial other more than doubled in the quarter, with the growth rate for gross profits outpacing the revenue gains more than two-to-one for the fifth consecutive quarter. “Other” gross margins came in at 34.7% for the second quarter – compared to 15.6% two years ago.
“Commercial licensing” revenue fell 2% in the quarter, which gave Wall Street a good scare; coming off a strong quarter in the prior year, I didn’t find the result too surprising. Looking back two years, Commercial Licensing revenues for the second quarter increased ~$550 million – or at a compounded annual growth rate of 2.65%. In the prior three quarters, Licensing has reported growth rates of +3.4%, +5.6%, and +2.7%; at the midpoint of guidance for the third quarter (adjusted for currency), management expects another small decline in Licensing revenue over the next ninety days; we’ll see where the numbers end up when we get there.
Take it for what it’s worth, but my opinion is that the concerns about the commercial business are more reflective of the transition to Cloud offerings and the impact of the XP refresh than anything related to the health of the underlying business. As on the Consumer side, weakness in Japan (and currency headwinds) were partly to blame. Problems in China – which Satya Nadella called “a set of geopolitical issues that they’re working through” – also impacted results.
As it relates to commercial as a whole, this comment from CFO Amy Hood says it all:
“Annuity revenue remained strong growing double-digits and renewal rates remained high. Customers are continuing to move from transactional purchasing to long-term annuity contracts as they showed increased commitment to our product roadmap.”
Forget the noise that arises with each earnings release – this is what investors should really be focused on; if you go back and look at Microsoft’s results for the last decade (Commercial under the current convention and split between Microsoft Business Division and Server & Tools under the prior reporting), you’ll start to see why I’m so confident in this business going forward.
Conclusion
Microsoft ended the quarter with ~$104 billion in cash, equivalents, and equity / other investments; adjusting for total debt, the company has more than $75 billion in net cash. That’s equal to ~$9 per share – more than 20% of the company’s entire market cap.
Investors have been clamoring for that cash; with ValueAct taking a board seat, we’ve been waiting for action. On the call, Satya Nadella addressed the company’s capital allocation plans:
“Earlier today, we announced our intention to complete the existing $40 billion share repurchase authorization by December 31, 2016. This is another step in our ongoing commitment to increase capital return for our shareholders while investing in the growth of our business. It too shows our optimism for the future growth of Microsoft. As we move forward we will certainly continue to be thoughtful in our capital return decisions balanced across dividends and share repurchases.”
While I’m not a fan of blanket repurchases at any cost, I’m happy to see that Microsoft will spend the remaining ~$31 billion on their authorization over the next 24 months – more than doubling the pace of repurchases in fiscal 2014, and ~3x the pace in the two years before that. If the stock continues to struggle I’ll be a happy guy: $31 billion at $40 per share will allow Microsoft to repurchase 775 million shares – enough to reduce the number of shares out by 9.3% (gross) over the next two years. If those repurchases are completed at an average cost of $47 per share (around where Microsoft was trading to start the year), they would take out 660 million shares – reducing the number of shares out by less than 8.0%.
As I noted in my year-end review, I sold some of my MSFT shares in 2014 in the mid-40’s, and was likely to sell more if we crossed $50 per share. Now that we’re moving in the other direction, I might reverse course: if we start moving back towards the low 30’s (where Microsoft traded as recently as September 2013), I’ll consider adding to my position once again.
