Microsoft (MSFT) reported second quarter results for fiscal 2018 on Wednesday. It has been awhile since I've talked about the company in detail, so I thought I’d share some of my thoughts.
Revenues were $28.9 billion in the quarter, a low double digit increase over the year-ago period. Excluding the $1.1 billion in incremental revenues from LinkedIn (which I do to try and get a sense for the organic results), revenues increased by 8%. Top-line growth was driven by Productivity & Business Processes (+10% excluding LinkedIn) and Intelligent Cloud (+15%).
As I noted in my year-end review, the commercial cloud business has been growing at an astounding pace and recently passed management’s projection for $20 billion in run rate revenues ahead of schedule. That growth continued in the second quarter, with commercial cloud revenues of $5.3 billion – an increase of 56% over the year ago period. Azure, Office 365 Commercial and Dynamics 365 reported revenue growth of 98%, 41% and 60%, respectively. It’s worth noting that Office 365 reported a 30% increase in paid seats, reflecting continued improvement in ARPU.
The company is seeing benefits from economies of scale, with commercial cloud gross margins climbing to 55% – an increase of roughly 700 basis points from the second quarter of fiscal 2017. As noted on the call, gross margins increased for each of the company’s cloud services in the quarter, with the most significant margin improvement from Azure (undoubtedly helped by another quarter of triple digit growth for premium services).
Operating income increased by a comparable rate as revenues in the quarter, despite digesting an incremental quarter of a billion dollars in amortization expense from the LinkedIn acquisition. The headline numbers mask a meaningful improvement in the Intelligent Cloud division, where segment profits increased 24% and segment margins expanded 240 basis points to 36.3%.
Diluted earnings per share (adjusted for the impact of the Tax Cut and Jobs Act) increased by roughly 20% in the quarter, reflecting a lower effective tax rate and the impact of repurchases on the share count (the number of diluted average shares was -1.5% year-over-year to 7.71 billion).
Through the first six months of the fiscal year, Microsoft has generated more than $20 billion in cash flow from operations (+14%). Even after accounting for CapEx ($4.7 billion), repurchases ($4.6 billion), dividends ($6.2 billion), and acquisitions ($200 million), there’s excess cash left over. That helped push the total cash balance (including equity investments) to nearly $150 billion at quarter end. After backing out the debt, Microsoft has $61 billion in net cash (or approximately $8 per share).
By my math, Microsoft should earn somewhere around $3.60 per share in fiscal 2018 (just to be clear, that’s a rough estimate; I don’t waste my time trying to guess earnings per share down to the penny). At the current price, even if you back out the net cash, Mr. Market is asking you to 24x forward earnings – not the kind of multiple that gets me excited. With that said, I think Microsoft could report double-digit per-share earnings growth over the next couple of years. In addition, the company has the financial flexibility to do just about anything it could think of. Finally, I think we're dealing with a best-in-class management team that will create significant value for shareholders in the long run.
I’ll restate what I said in my year-end review (link):
“I think the bias of most value investors (myself included) in this situation is to head for the exits a bit prematurely. I am not sure that's the correct course of action, particularly if that means incurring a significant tax liability. I like the idea of being Satya Nadella's business partner for the long-term, even if I'm not in love with the price I'm being asked to pay for that privilege. For that reason, I feel comfortable being "slow" to recognize gains and continue holding a sizable position in Microsoft.”
After reviewing the financial results, I still believe that is a reasonable course of action.
Disclosure: Long MSFT
