“…Microsoft flexed its free cash flow generating muscles in the first quarter of fiscal 2017. The software giant reported free cash flow of just under $9.4 billion, an increase of nearly 25% from the year-ago period despite capital expenditures jumping approximately 60%. Such strong free cash flow generation helped the firm advance its net cash position, excluding long-term equity and other investments of ~$10.5 billion, to an impressive $62.2 billion, up from $59.8 billion at the beginning of the quarter.” – Kris Rosemann
By Kris Rosemann
Microsoft (MSFT) reported a strong quarter October 20, both in terms of financial performance and in terms of ongoing momentum in the transformation of its business. Non-GAAP revenue, which takes into account revenue deferrals from Windows 10, advanced just over 3% in the first quarter of fiscal 2017 thanks to a 6% revenue increase in ‘Productivity and Business Processes’ segment revenue and an 8% advance in ‘Intelligent Cloud’ segment revenue from the year-ago period. The firm’s largest segment in terms of revenue, ‘More Personal Computing,’ reported a revenue decline of 2% on an as-reported basis.
Headlining the overall revenue growth for Microsoft was its Azure enterprise-grade cloud product suite more than doubling revenue from the first quarter of fiscal 2016; Azure’s compute usage more than doubled in the quarter as well. Microsoft’s Azure is now the most compliant cloud-based product line, with 49 certifications, more than any other cloud provider. Such a display of reliability has helped the firm advance its commercial cloud annualized revenue run-rate past the $13 billion mark and kept it on track to achieve its goal of reaching the $20 billion mark in fiscal 2018. In addition to the impressive growth of Azure, we love the double-digit growth we’re seeing in server products and cloud services revenue, which is driven by attractive double-digit growth in annuity revenue.
Office 365–Microsoft’s cloud-distributed, subscription-based productivity suite–continues to drive positive momentum in its ‘Productivity and Business Processes’ segment as Office 365 commercial revenue leapt more than 50% on a year-over-year basis. Office 365 consumer subscriber growth remained robust as well, growing to 24 million at the end of the first quarter of fiscal 2017 from 23.1 million in the fourth quarter of fiscal 2016 and 18.2 million in the first quarter of fiscal 2016.
While the non-GAAP numbers more appropriately highlight the momentum in Microsoft’s business, in our opinion, GAAP figures do not show such a bright picture. GAAP revenue was roughly flat on a year-over-year basis, while GAAP operating income fell nearly 10%. Earnings per diluted share fell to $0.60 from $0.61 in the first quarter of fiscal 2016 despite a reduction of more than 200 million in diluted weighted average shares outstanding. Buybacks will continue as management works to close out a $40 billion repurchase program at the end of 2016, only to begin another $40 billion program after the year’s end.
However, Microsoft flexed its free cash flow generating muscles in the first quarter of fiscal 2017. The software giant reported free cash flow of just under $9.4 billion, an increase of nearly 25% from the year-ago period despite capital expenditures jumping approximately 60%. Such strong free cash flow generation helped the firm advance its net cash position, excluding long-term equity and other investments of ~$10.5 billion, to an impressive $62.2 billion, up from $59.8 billion at the beginning of the quarter.
Microsoft’s start to fiscal 2017 is a great display of what we love about the company. The momentum in its business transformation to a next-generation, cloud-based software company has been strong, and we love the higher-margin and recurring-revenue characteristics of a meaningful portion of its cloud business and what such visibility means for its ability to remain one of the most dynamic and dependable dividend ideas on the market today. On a related note, the firm has continued to generate significant amounts of free cash flow and maintained its balance sheet strength throughout its transformation. Further, we have little concern that management will neglect its shareholders in terms of cash returns, “Microsoft Remains Committed to Returning Capital to Shareholders.”
Our position in Microsoft in the Dividend Growth Newsletter portfolio isn’t going away anytime soon, even as shares continue to run ahead of our fair value estimate. We should make mention that at this point we are “playing with the house’s money” after having taken significant profits in our outsize position in Microsoft in June 2016, “What?!?! Microsoft Acquires LinkedIn; NO!” The most recent quarter has done little to alter our opinion on the company, though we remain concerned about the impact the LinkedIn (LNKD) deal will have on its balance sheet and overall financial health both in the near term (in terms of a rising debt load) and over the long-run in terms of potential impairment charges down the road.
We continue to view Microsoft as one of the more attractive dividend payers on the market. Its dividend is fully funded by internal cash flow–unlike MLPs and REITs who are dependent on capital markets to maintain a competitive and growing distribution/dividend–and shares remain fairly valued unlike many high-PE consumer staples entities with similar payout yields and dividend growth histories. Microsoft currently yield ~2.7%. We continue to expect strong dividend growth at the company.
Note: Microsoft is another example of the flexibility of the Valuentum methodology in practice. First, while the framework for a company to be included in the Dividend Growth Newsletter portfolio is not as dependent on valuation as the Best Ideas Newsletter portfolio, valuation is still a consideration in the management of both portfolios. In the case of Microsoft, however, its “fair” valuation consideration (shares are trading modestly above our fair value estimate) is not enough to cause us to completely remove the company from the Dividend Growth Newsletter portfolio at this time, particularly in light of the lack of other exciting dividend growth choices on the market that also have better valuation opportunities. In many cases, when it comes to stock selection, there are relative trade-offs, and Microsoft in this case still makes the cut. We’ve been mighty pleased to let this “winner” run — the “entum” in Valuentum…