(Published by Bob Ciura on April 30)
Tech giant Microsoft Corp. (MSFT, Financial) reported fiscal third-quarter earnings on April 27. Judging from the market’s reaction, Microsoft’s quarter was a disappointment. The stock fell 2% after reporting.
But it quickly reclaimed its losses as investors focused once again on the bigger picture: Microsoft is in growth mode.
The company’s cloud-based offerings like Office 365 and Azure are growing like weeds. These platforms represent the technology of the future and will fuel Microsoft’s growth for many years ahead.
In the meantime, Microsoft is an excellent dividend stock.
It is a Dividend Achiever, a group of 265 companies in the Standard & Poor's 500 Index that have raised their dividends for 10-plus years in a row.
You can see the full Dividend Achievers list here.
Investors should not be fooled by the market’s initial reaction: Microsoft’s quarterly report was anything but disappointing.
Its hardware sales came up slightly short of expectations, but more important its cloud platform continued its explosive growth.
Quarterly performance overview
The highlights of Microsoft’s fiscal third-quarter earnings are as follows:
- Revenue: $23.56 billion (up 6.3% year over year)
- Earnings per share: 73 cents (up 16% year over year)
Overall, Microsoft had a great quarter. The company generated growth in revenue, gross margin and earnings per share.
Source: Third Quarter Earnings Presentation, page 4
In terms of the expectations heading into Microsoft’s earnings, the company put in a mixed performance.
Microsoft’s revenue missed expectations by about $60 million while earnings per share beat estimates by 3 cents per share.
A revenue miss of $60 million – for a company that generated more than $23 billion for the quarter – is basically a rounding error.
The revenue miss was mostly due to weak performance in Microsoft’s More Personal Computing segment.
This segment includes Microsoft’s hardware businesses. Weak phone and Surface tablet sales caused segment revenue to decline 7% year over year. Surface revenue fell 26% for the quarter.
As a result, revenue in the More Personal Computing business of $8.84 billion missed analyst expectations of $9.22 billion.
Source: Third Quarter Earnings Presentation, page 12
However, there was good news even in this segment – for example, gaming revenue rose 4%, driven by continued success of the Xbox One console.
Plus, operating profit in the More Personal Computing business rose 20% last quarter, due to an 11% decline in operating expenses.
In the immediate aftermath of Microsoft’s earnings announcement, the stock fell 2%.
However, shares quickly recovered, and by the market close Friday were trading higher. The biggest reason for this was simply that investors came to their senses.
Growth prospects
Of far greater importance is Microsoft’s strong growth from the same quarter last year. The company continues to generate excellent results, particularly in its cloud-based businesses.
These are the segments that will fuel Microsoft’s future growth.
For example, Microsoft’s Intelligent Cloud operating segment generated revenue of $6.76 billion, compared with $6.60 billion expected by analysts.
Source: Third Quarter Earnings Presentation, page 10
Total Intelligent Cloud revenue rose 11% last quarter, thanks to 15% growth in server products and cloud services.
Highlights of Microsoft’s cloud businesses from last quarter include:
- Office 365 commercial revenue growth of 45%, 26.2 million subscribers.
- Dynamic 365 revenue growth of 81%.
- Azure revenue growth of 93%.
In particular, Azure is an extremely promising growth area for Microsoft. Revenue almost doubled last quarter.
Source: 2016 Deutsche Bank Technology Conference, page 4
Microsoft has a huge commercial cloud platform. Its client base is filled with blue-chip companies. More than 85% of the Fortune 500 list use the Microsoft Cloud.
Microsoft’s commercial cloud business has now reached an annual revenue run rate of more than $15 billion.
Going forward, Microsoft expects the strong growth rates in its cloud business will continue. The company forecasts Intelligent Cloud revenue in a range of $7.2 billion to $7.4 billion for the fiscal fourth quarter.
This compares with analyst forecasts of $7.22 billion.
In the fiscal fourth quarter of 2016, Microsoft had Intelligent Cloud revenue of $6.7 billion. This means the company expects current-quarter revenue growth of 7.4% to 10.4%.
Plus, Microsoft is only starting to realize the benefit of its $26 billion takeover of social networking platform LinkedIn.
LinkedIn offers Microsoft another avenue for expanding into the enterprise market through social media.
When Microsoft acquired LinkedIn, it had more than 400 million subscribers.
Last quarter, LinkedIn generated $975 million in revenue.
Dividend analysis
Microsoft has a current dividend yield of 2.3%, which is slightly higher than the average yield in the S&P 500 Index.
Microsoft is a strong dividend growth stock, thanks to its excellent free cash flow and pristine balance sheet.
Microsoft generated $10.66 billion of operating cash flow last quarter and $8.97 billion of free cash flow. Free cash flow rose 11% year over year.
Over the first three fiscal quarters, free cash flow reached $22.66 billion. This easily covered its shareholder returns including $8.84 billion of dividends and another $10.02 billion of share repurchases.
Cash flow continues to pile up on the balance sheet. Microsoft ended last quarter with $126.02 billion of cash, cash equivalents and marketable securities on its balance sheet compared with $76.22 billion of long-term debt.
Microsoft’s excellent balance sheet affords it a AAA credit rating from S&P. It is one of just two U.S. companies that has earned S&P’s highest rating. Health care giant Johnson & Johnson (JNJ, Financial) is the other AAA-rated company.
With such strong free cash flow and balance sheet, Microsoft can easily increase its dividend over time. Last year the company increased its dividend by 8%.
Microsoft’s dividend payments so far in fiscal 2017 made up just 39% of free cash flow. This is a fairly low payout ratio. It would not be unreasonable for investors to expect a dividend hike of 10% or more in 2017.
Final thoughts
Microsoft stock briefly fell after its quarterly earnings announcement but soon reclaimed the lost ground. There was little reason for investors to sell the stock even though the company slightly missed revenue expectations.
Microsoft is growing, thanks to its booming cloud businesses. It has an excellent balance sheet and pays a rock-solid dividend.
As a result, investors should not think twice about holding on to their shares of this high-quality dividend growth stock.
Disclosure: I am not long any of the stocks mentioned in this article.
Start a free seven-day trial of Premium Membership to GuruFocus.
