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The Science of Hitting
The Science of Hitting
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Microsoft: Commercial Cloud Growth Continues

A look at the software company's 2nd-quarter results

January 31, 2019 | About:

Microsoft Corp. (NASDAQ:MSFT) reported financial results for the second quarter of fiscal 2019 after the market closed on Wednesday. For the period, revenues increased 12% to $32.5 billion and operating income increased 18% to $10.3 billion. Non-GAAP net income and diluted earnings per share were $8.6 billion and $1.10, both of which were up mid-teens relative to the year-ago quarter.

The company reported another solid quarter in commercial cloud, with revenues increasing nearly 50% year over year to $9 billion. Microsoft is now at a $36 billion run rate, compared to the target it set in April 2015 of crossing $20 billion by the end of fiscal 2018. As CEO Satya Nadella noted on the call, “These results speak to us picking the right secular trends in large and growing markets - many of which are still in their infancy - as well as focused innovation and execution. Leading companies in every industry are partnering with us to build their own digital capability to compete and grow… Every company is becoming a digital company and they are looking for a trusted partner to help them build tech intensity. Microsoft is that partner.”

Revenues in the Productivity & Business Processes segment increased 13% to $10.1 billion. The company’s transition to Office 365 continues to gain traction, with Commercial revenues up 33% in the first quarter (revenue growth continues to outpace seats, reflecting higher average revenue per user as customers move to higher value offerings). On the consumer side, Office 365 has added 4.1 million customers over the past year, ending the quarter with 33.3 million subscribers (up 14%). In addition, Dynamics revenues increased 17%, driven by a 50% increase in Dynamics 365 revenues (over 90% of new Dynamics CRM customers in the quarter chose the cloud offering).

Revenues in Intelligent Cloud increased 21% to $9.4 billion, led by 76% growth at Azure. Microsoft doesn’t break out Azure revenues, but analysts at Goldman Sachs estimate run rate sales are approaching $13 billion. Azure was also a primary driver of growth in commercial bookings (up 22% in constant currencies) due to the signing of larger, longer-term contracts.

We’re continuing to see the benefits of scale in the income statement, with commercial cloud gross margins up five points from a year ago to 62% (as noted on the call, management expects commercial cloud gross margins to continue to improve). Operating margins for Productivity & Business Processes increased nearly 300 basis points to 40% in the first half of the year. Over the same period, margins expanded 100 basis points in Intelligent Cloud to 35% (resulting in profit growth of 25%). For Microsoft as a whole, operating margins increased 200 basis points in the second quarter.

Revenues in More Personal Computing (MPC) increased 7% to $13 billion, with strength in Gaming (Xbox Live users up 8% to 64 million monthly active users), Surface and Search offset by declines in the Windows OEM business (with Pro and non-Pro down 2% and 11%).

Through the first six months of the year, Microsoft has generated $22.5 billion in cash flow from operations (up 11% year over year). After accounting for $7.3 billion of capital expenditures (up 55% year over year to support continued growth in customer demand in Microsoft’s cloud offerings), the company generated $15.2 billion of free cash flow in the first half of fiscal 2019.

Microsoft returned $9.6 billion to shareholders through repurchases ($6.1 billion) and dividends ($3.5 billion) in the quarter, with $16.9 billion in capital returns through the first six months of the year. However, due to the impact of $7.5 billion acquisition of Github (which was paid for with equity), the diluted share count increased 1% to 7,768 million shares. Microsoft ended the quarter with $130 billion in cash and investments, compared to $72 billion in total debt (roughly $7 per share in net cash). The company continues to have a fortress balance sheet, with significant flexibility to engage in repurchases, dividends or opportunistic acquisitions.

I’ll close with an answer Nadella gave during the question-and-answer section of the call:

“The opportunity for our shareholders has never been better. When I look at every business becoming a digital business and then take that opportunity and map that to our capability, we have the broadest platform of anyone in the tech sector to really help every customer in every country become that digital business. And we have a business model that aligns with them and their interests. Therefore, from a secular perspective, we're all in on making sure that we invest in our Commercial Cloud as well as our investments in things like gaming and going after the opportunity that is there in front of us. And you even think about Microsoft 365, the value proposition of Microsoft 365 transcends Windows and Office. We think about the relevance of our applications across all device sockets. We think about the security, identity management, information protection, and all that value across all device sockets. I feel very, very good about the product investments and the go to market investments we are making to really help our shareholders realize the growth potential that's available in what is going to be an increasingly digital world.”

Disclosure: Long MSFT.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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