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The Science of Hitting
The Science of Hitting
Articles (524) 

Updating My Thoughts on Microsoft

A look at the company following 3rd-quarter financial results

April 26, 2019 | About:

Microsoft reported financial results for the third quarter of fiscal 2019 on Wednesday afternoon, and it was another stellar performance for the tech giant. Revenues increased 14% to $30.6 billion, with net income ($8.8 billion) and diluted earnings per share ($1.14 per share) both up roughly 20% year-over-year.

As CEO Satya Nadella noted on the call, “It was another strong quarter with double-digit top-line and bottom-line growth, the result of picking the right secular trends, accelerating innovation and most importantly, relentlessly focusing on our customers’ success.”

Run rate commercial cloud revenues exceeded $38 billion in the quarter, an increase of 43% from the year-ago period. Commercial cloud continues to benefit from scale and increasing adoption of premium services, most notably from Azure, with gross margins up 500 basis points year-over-year to 63%; as a result, gross profit dollars increased more than 50% to $6.0 billion.

Digging into the segment results, Productivity & Business Processes reported a 15% increase in revenues to $10.2 billion. Office 365 Commercial continues to fire on all cylinders, with 31% revenue growth driven by 27% seat growth (to more than 180 million monthly active users) and higher average revenue per user (ARPU) from the continued mix shift to E3 and E5. Dynamics reported another quarter of double-digit revenue growth, led by a 44% increase for Dynamics 365. Finally, LinkedIn revenues increased 29%, with another quarter of record engagement among its 630 million members. In addition to mid-teens revenue growth, Productivity & Business Processes operating margins have expanded 330 basis points to date; as a result, segment operating income has increased by 26% to $11.9 billion.

Revenues in the Intelligent Cloud segment increased 24% to $9.7 billion, with Azure leading the way (revenues increased 75% year-over-year, which compares to 76% growth year-over-year growth in the prior two quarters). This marked another period of solid performance in the segment, with revenues up 22% and operating profits up 24% through the first nine months of the year.

In More Personal Computing (MPC), a strong PC market led to impressive numbers for Windows, resulting to high-single digit revenue growth in the segment (to $10.7 billion). Limited growth in operating expenses led to 28% operating income growth for MPC in the quarter.

Through the first nine months of the fiscal year, Microsoft’s reported revenues increased 15% to $92.1 billion, with cash flow from operations up 11% to $36.1 billion. After accounting for $10 billion in capital expenditures (up 29% year-over-year), the company has generated $26 billion of free cash flow. Over the same period, it has spent $14.9 billion on share repurchases, $10.3 billion on dividends and $2.1 billion on acquisitions.

At the end of March, Microsoft held $132 billion in cash and short-term investments. After accounting for $73 billion in long-term debt (including the current portion of long-term debt), the company has $60 billion in net cash (roughly $8 per share). Considering the strength of the business and its significant cash generation, the balance sheet positioning remains incredibly conservative. We’ll see if that changes over the coming years.

Conclusion

I’ll close with two quotes from CEO Satya Nadella and Chief Financial Officer Amy Hood that capture the opportunity that still lies ahead for Microsoft.

First, from Satya: “I’m energized by our progress and incredibly optimistic about our opportunity ahead. Across all of our businesses, we are delivering differentiated value for customers and creating new categories of growth that position us well for the future.”

And now Amy:

“Overall, we feel very good about the progress we’ve made thus far in fiscal year 2019. Our decision to invest with significant ambition in high growth areas coupled with strong execution has resulted in material revenue growth at scale and a stronger position in many key markets. As fiscal year 2020 approaches, we again see tremendous opportunity to drive sustained long-term growth … At the same time, we will continue to drive improvement and efficiency as our business scales. This consistent approach of investing in future growth while delivering strong operating performance will result in double-digit revenue and operating income growth in fiscal year 2020 with stable operating margins.”

As long time readers know, I’ve owned this stock for many years. I've learned through the transition from a hated "dinosaur" that traded at a single digit price-earnings multiple to a beloved growth stock that now trades at a mid-20s forward price-earnings multiple. While I struggle at times with the valuation, I’ve been investing for long enough to have learned that high-quality businesses with huge addressable markets and best-in-class leadership are rare birds (and that’s before considering the company’s fortress balance sheet). While I have not bought shares for some time, I continue to be comfortable holding a sizable position in Microsoft for the long run.

Disclosure: Long Microsoft. 

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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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