As I noted in my year-end 2016 portfolio review, Microsoft was my second-largest equity position at year-end (that's still the case). I haven’t talked about the company in detail for some time so I figured it’d be worthwhile to share some thoughts on the results.
Adjusted for the impact of Windows 10 deferrals, Microsoft's (MSFT) revenues increased by 6% in its fiscal third quarter. Growth was largely attributable to the Productivity & Business Processes segment, which benefited from $975 million in LinkedIn (LNKD, Financial) revenues; as adjusted, revenues for the segment increased midsingle digits, driven by continued growth from Office and Dynamics. The commercial version of Office exceeded 100 million monthly active users (MAU) in the third quarter with the number of seats and O365 commercial revenues increasing 35% and 45%. The consumer version of Office 365 continues to perform solidly as well with the number of paying subscribers reaching 26.2 million in the third quarter (up 4 million from the year-ago period). Office consumer revenues increased midteens year over year.
Revenue growth was also driven by the Intelligent Cloud segment, where $6.8 billion in sales was up double digits from the year-ago period. Azure continues to shine with revenues nearly doubling from third-quarter fiscal 2016.
Azure premium services revenue grew more than 100% for the 11th consecutive quarter, reflecting Microsoft’s ability to sell high-level services to cloud customers. As CEO Satya Nadella said on the call, this is just the beginning:
“Azure is pretty strategic for us, not just for the attachment of high-level services, but the all-up digital transformation opportunity. That's how Amy and I even think about our margin structure. We need to improve in each one of the elements, but all up we need to improve because we think that increased opportunity is what's unique about our approach.”
More Personal Computing (MPC), which includes Windows, Surface, Search, Phone and Gaming, reported a 7% decline in revenues. Adjusting for Phone, which has been an unmitigated disaster for Microsoft (Steve Ballmer’s final act as CEO), MPC was roughly flat year over year. While I’d love to see solid results in the segment, I’m not overly concerned with the short-term results: Microsoft’s future (and most of the business value) depends on the first two segments.
As we move down the income statement, we’re still looking at a business in transition. While operating income is growing, it still trails revenue growth (with a loss of ~$400 million from LinkedIn making the comparison more difficult). This is starting to change as the cloud business and SaaS offerings scale: in the third quarter, commercial cloud gross margins increased 600 basis points to 51%. Expect this trend to continue in the years ahead. (By the way, commercial cloud run rate revenues exceeded $15 billion in the third quarter – up more than 50% from the year-ago period.)
Through the first nine months of fiscal 2017, Microsoft has generated $28.5 billion in cash flow from operations. It has spent $5.8 billion on capital expenditures, $10.0 billion on repurchases (but only $2.0 billion in the third quarter) and another $8.8 billion on dividends. At the end of the quarter, Microsoft had roughly $57 billion in net cash and investments, or roughly $7 per share.
For the year, Microsoft is on pace for earnings of $3 per share or so. Based on recent results in Productivity & Business Processes and Intelligent Cloud, there’s a strong argument that earnings growth should accelerate strongly over the coming years. Unsurprisingly, Mr. Market has started to price this in: the earnings multiple has increased significantly over the past few years.
I’ve been slow to reduce my position in Microsoft, only because Nadella and the management team have a vision and strategy for the future. They have competitive advantages and the financial resources necessary to make it happen. Even if I trim my position, I’m likely to own some shares for a long, long time; the days of calling Microsoft a "tech dinosaur" are clearly over.
Disclosure: Long Microsoft.
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