By Kris Rosemann
We couldn’t believe our eyes in mid-June after Microsoft (MSFT) agreed to acquire LinkedIn (LNKD) for more than $26 billion, “What?!?! Microsoft Acquires LinkedIn; NO!” Management must’ve had its head in the clouds.
Microsoft remains a 2%+ weighting in the Dividend Growth Newsletter portfolio, more than a double since it was added at ~$26 per share December 2011. Yes, we took some profits several weeks ago (think prudent reduction of outsize exposure within a portfolio context), but we continue to be extremely happy “playing with the house’s money” (a phrase used to describe a big winner where only the raw profits remain with the principal taken “off the table”). While others were snoozing about owning Microsoft in 2012-2013, calling it “dead money,” we were pounding the table on shares! In fact, we used the company as one of our best dividend growth ideas in nearly every dividend growth presentation across the AAII speaking circuit, from Chicago to Cleveland to Silicon Valley to Phoenix and beyond!
Following the firm’s fiscal fourth quarter report, released July 19, it appears as though management did have its head in the clouds, or cloud rather. Microsoft’s ‘Intelligent Cloud’ segment was the driving force behind its solid quarterly performance, and its commercial cloud annualized revenue run rate exceeded $12.1 billion in the quarter, putting it on track to achieve its goal of $20 billion in annualized revenue by 2018. Revenue from Azure, its enterprise cloud platform that provides businesses with cloud-based supercomputing power, doubled in the quarter on a year-over-year basis, as did the compute usage of the platform (more customers are buying the platform). The period marked the eighth consecutive quarter in which Azure premium services revenue at least doubled.
Customers of Microsoft’s Enterprise Mobility–a mobility solution designed to help manage and protect users, devices, apps, and data for businesses–nearly doubled from the year-ago period, and its installed base is almost 2.5 times as large as it was at this time last year. In addition to the recurring revenue potential in its ‘Intelligent Cloud’ segment, Microsoft’s commercial version of Office 365–its cloud-distributed, subscription-based productivity suite–continues to drive growth in its ‘Productivity and Business Processes’ segment. Office 365 commercial revenue leapt 54% in the quarter on a year-over-year basis, and Office consumer products and cloud services grew 19%.
The company continues to grab market share on all ends of the enterprise spectrum, evidence of which ranges from its 28-month streak of adding at least 50,000 small and medium business customers or GE (GE) adopting its cloud for its new Internet of Things approach. Nearly 60% of Fortune 500 corporations use at least three of Microsoft’s cloud offerings, and the scale associated with working with such large companies brings an attractive higher-margin aspect to the agreements. Cannibalization by its cloud business has been a key component of bearish arguments against Microsoft’s business transition, but management is quick to point out that its cloud services are doing things for companies, particularly the larger enterprises, that its servers could never do.
Microsoft’s transition from a traditional software sales model to a cloud-focused model flush with recurring revenue potential continues to show solid momentum. Subscription trends and growth in installed bases across its cloud-based, enterprise-serving platforms have been strong, despite lumpy GAAP results in recent quarters, and we like what such growth means for visibility into the firm’s future revenue stream. Its contracted-not-billed balance exceeded $25.5 billion at the end of the fiscal fourth quarter, and commercial unearned revenue advanced 8% on a constant-currency basis from the year-ago period. Bottom-line pressure may persist in the near term–non-GAAP operating income fell 3% on an as-reported basis in the fiscal fourth quarter of 2016 from the same period in fiscal 2015–due to ongoing strategic investments aimed at driving cloud-based revenues, but we expect such investments to pay dividends for the firm in the long run.
While we anticipate strategic, cloud-focused investments will benefit Microsoft in the long-run, our opinion of its literal dividend-paying strength is now tied to the board-room thinking that brought about its acquisition of LinkedIn, which it reportedly paid an extra $6 billion for as a result of a bidding war with rival Salesforce.com (CRM). Not only does LinkedIn look like a “winner’s curse” for Microsoft, but if the board is willing to throw more than $26 billion on an acquisition, will it do it again? And if so, what happens to Microsoft’s potential dividend growth? We don’t like the thinking that went into the LinkedIn transaction, even as we say Microsoft’s financial health remains pristine. Optimism and excitement is running high as it often does when deals are announced, but we’re also having a hard time envisioning how LinkedIn’s addition will drive material enough usage across its professional offerings to warrant such a lofty price tag (especially when Microsoft is essentially letting LinkedIn run as a standalone entity).
We’re doing well in both newsletter portfolios in part because we’re not taking on foolish risks in an overheated market, and we continue to feel that a reduction to the weighting in Microsoft in the Dividend Growth Newsletter portfolio several weeks ago was a prudent move, especially given our opinion of the LinkedIn deal and Microsoft’s full valuation (it’s still fairly valued, in our view). You’ll note that the beauty of the move is that we still retain exposure to Microsoft, which as fiscal fourth-quarter results revealed, remains attractive and is showing positive momentum in terms of adoption rates of its cloud-based services. We continue to hold Microsoft as we watch its story unfold with high hopes for its redefined business model. And yes, we’re still nervous about a meaningful impairment charge related to the LinkedIn acquisition down the road, but that may not mean much now. Most experienced investors are already writing it off…we are.
Microsoft delivers again.