(Published by Nick McCullum on July 24)
Microsoft Corp.'s (MSFT, Financial) recent fourth-quarter earnings release was far superior to the company’s third-quarter results, which were announced on April 27 and saw the company’s stock decline by 2% in the ensuing trading.
This time around, Microsoft’s stock closed trading slightly higher. More importantly, the company’s fundamental business continues to grow at a torrid pace. The company's sustained growth has resulted in a steady stream of rising dividends for its shareholders.
In fact, Microsoft is a member of the Dividend Achievers, a group of dependable dividend stocks with at least 10 years of consecutive dividend increases.
Microsoft’s strong earnings release indicates the future remains bright for this high-quality dividend stock.
Business overview, current events and growth prospects
Microsoft is a technology giant and the largest independent developer of software in the world. The company was famously founded by Bill Gates (Trades, Portfolio) in 1975 and has grown steadily over the years to its current eye-popping size.
At $572 billion, Microsoft is currently the third-largest corporation in the U.S. based on market capitalization, behind Apple (AAPL, Financial) and Alphabet (GOOG, Financial) (GOOGL, Financial).
Microsoft currently reports in three operating segments:
- Productivity and business processes: $8.4 billion of fourth-quarter 2017 revenue.
- Intelligent cloud: $7.4 billion of revenue.
- More personal computing: $8.8 billion of revenue.
There was a lot to like about Microsoft’s fourth-quarter earnings release.
Specifically, the following metrics stand out:
- Revenue: up 10% on a constant currency basis.
- Operating income: up 16% on a constant currency basis.
- Diluted EPS: up 43% on a constant currency basis.
It is very impressive for a company of Microsoft’s size to deliver such strong fundamental profit growth. Remember, this is not a small technology startup we are talking about – Microsoft has a market capitalization of over $500 billion and is the third-largest corporation in the U.S.
Additional details about Microsoft’s quarterly financial performance (such as each segment’s contribution to GAAP or non-GAAP financial performance) are displayed in the following slide.
Source: Microsoft Fourth-Quarter Earnings Presentation, slide 4
Aside from revenues, operating income and earnings per share, Microsoft’s financial performance was robust on a number of measures.
The company continues to be very shareholder-friendly. During the quarter, Microsoft returned $4.6 billion to shareholders through a combination of dividend payments ($3.0 billion) and share repurchases ($1.6 billion).
Importantly, the company’s capital returns were very well covered by its free cash flow, which is growing at a very rapid pace.
Microsoft’s quarterly free cash flow of $8.7 billion was a 50% increase over the same period a year ago, caused by operating cash flow growth of 30% and a reduction in overall capital expenditures.
Source: Microsoft Fourth-Quarter Earnings Presentation, slide 6
So what has caused Microsoft’s strong fundamental growth?
There are three main contributors.
The first is the continued integration of the business social network LinkedIn, which Microsoft acquired in December after announcing the deal in the summer of 2016.
While LinkedIn continues to generate negative operating income because of the heavy investments and restructuring Microsoft is executing, the segment generated an impressive $2.3 billion of revenue in full-year 2017.
Source: Microsoft Fourth-Quarter Earnings Presentation, slide 7
LinkedIn’s financial performance is reported in Microsoft’s productivity and business processes segment, which was the second meaningful contributor to the company’s strong quarterly results.
This segment, which is responsible for the Microsoft Office software products, is growing rapidly thanks to the switch from one-time purchase software products to a more sustainable, subscription-based business model.
The new subscription-based model – called Office 365 – is growing at a rapid pace, with 31% year-over-year commercial seat growth in the company’s most recent quarter.
Additional details about the strong performance of Microsoft’s productivity and business processes segment are below.
Source: Microsoft Fourth-Quarter Earnings Presentation, slide 9
The third large contributor to Microsoft’s strong growth is its continued leadership in the cloud computing industry.
Microsoft’s cloud products – called Microsoft Azure and reported under the intelligent cloud segment – saw revenue grow  11% (12% in constant currency) in the most recent quarter. Operating income grew even faster with growth coming in at 15% (18% in constant currency), with the difference being attributed to disciplined expense management.
Source: Microsoft Fourth-Quarter Earnings Presentation, slide 11
All said, Microsoft’s business appears to be firing on all cylinders. The company’s LinkedIn, productivity and business processes and intelligent cloud segments will likely be the largest contributors to future growth moving forward.
Competitive advantage and recession performance
Microsoft’s primary competitive advantage comes from creating and distributing some of the most important software products of our time.
Simply put, worldwide productivity would be significantly impacted if Microsoft’s products (particularly Microsoft Office and the Windows operating system) were permanently removed from the market.
Microsoft’s ubiquitous business model means the company tends to perform reasonably well during recessions. For evidence of this, consider Microsoft’s fundamental performance during the 2007-2009 financial crisis:
- 2007 adjusted EPS: $1.42
- 2008 adjusted EPS: $1.87 (31.7% increase)
- 2009 adjusted EPS: $1.62 (13.4% decrease)
- 2010 adjusted EPS: $2.10 (29.6% increase)
- 2011 adjusted EPS: $2.69 (28.1% increase)
Microsoft’s adjusted EPS declined by just 13.4% during the financial crisis, and rebounded to new highs shortly afterward.
The company's recession performance is impressive, and it is one of the few to hold an AAA credit rating from Standard & Poor’s (with the other being Johnson & Johnson (JNJ, Financial)). This shows the durability and creditworthiness of the company’s business model.
Accordingly, this company can be seen as a relatively recession-resistant stock for the portfolio of the individual investor.
Valuation and expected total returns
Microsoft’s fundamental business is very appealing from an investment perspective. Unfortunately, the same cannot be said for the company’s valuation.
Microsoft reported adjusted EPS of $2.79 in fiscal 2016 and is expected to report adjusted EPS of approximately $3.02 in fiscal 2017.
The company’s current stock price is $73.79, which indicates a price-earnings ratio of 26.4 and 24.4 using 2016 and 2017’s earnings.
These valuations are high on an absolute basis. In general, it is best to buy dividend stocks at valuations no higher than 20. It is important to consider, however, a historical valuation before blindly making the decision to avoid a stock.
Microsoft’s current earnings multiple is compared to its average earnings multiple in the following diagram.
Source: Value Line
Microsoft’s current valuation using either 2016 or 2017 earnings is significantly higher than its long-term average price-earnings ratio of 19.2 (which even includes the company’s incredibly high valuations during the dot-com bubble of the early 2000s).
Accordingly, this company’s valuation suggests investors should wait on the sidelines for a better entry point, although existing investors should likely continue to hold the stock if their position has a cost basis below today’s market price.
Final thoughts
Microsoft’s recent quarterly earnings release gave investors plenty to be happy about, including strong revenue growth, excellent expansion in operating income and diluted EPS up nearly 50% from the same period a year ago.
Unfortunately, the business is sporting a valuation well in excess of its historical averages (even after taking into account its extreme overvaluation during the dot-com bubble).
Microsoft continues to be a hold for existing investors, while prospective investors should wait for a more appealing buying opportunity.
Disclosure: I am not long any of the stocks mentioned in this article.
