Image Source: Mike Mozart
By Callum Turcan
On Wednesday October 23, Dividend Growth Newsletter portfolio holding Microsoft Corporation (MSFT) reported first quarter results for fiscal 2020 (period ended September 30) after the market close that saw shares of MSFT move higher the next day. The tech giant beat consensus estimates on both the top and bottom line due to sustained momentum at its cloud offerings, with growth led by Azure and Office 365. During the first quarter, Microsoft’s Office 365 commercial monthly active users passed 200 million. We continue to like Microsoft’s free cash flow growth potential and see the firm sporting a great dividend growth trajectory given its pristine balance sheet and quality cash flow profile. Shares of MSFT yield ~1.5% as of this writing.
Strong Sales Growth and Improving Margins
Microsoft’s GAAP revenue climbed 14% year-over-year to $33.1 billion, while its GAAP gross margin shot up almost 260 basis points to 68.5% during the first quarter of fiscal 2020. The firm’s gross margins benefited from its customers shifting towards Microsoft’s higher margin businesses. Growth was led by Microsoft’s cloud offerings with management noting that Azure posted strong growth in the $10+ million contract space.
During Microsoft’s prepared remarks, management mentioned that the firm’s commercial cloud revenue grew by 36% year-over-year, or 39% on a constant currency basis, hitting $11.6 billion. Furthermore, Microsoft noted this segment’s gross margins expanded due to operational improvements at Azure. Going forward, Microsoft expects its commercial cloud gross margins will continue to improve on a year-over-year basis.
During Microsoft’s quarterly Q&A session with analysts, management was asked about the driving forces behind Azure’s impressive margin improvements. Here’s what CFO Amy Hood had to say (emphasis added):
“Let me start by saying, in general at the commercial cloud gross margin what you’re seeing is revenue growth that for the past almost two years has vastly been faster than our capital expenditure growth. So, if you start at the top of the frame, what we’re seeing is overall gross margin improvement across the portfolio, and improving — and that comes from a couple of things, which is where you’re getting to on Azure.
It comes from structural improvement on sort of cost per unit, but it also comes from mix shift of revenue to premium services, from being able to sell more SaaS-like services [Software-as-a-Service] and consumption services or even premium data services that really do have both more margin but also are quite consistent in terms of their growth, and you see then that represented as improving targets for us…
Now, as you continue to see the mix shift to the consumption-based Azure services, the overall cloud gross margin won’t improve at the same rate, and we’ve said that, and you’ll continue to see that on a go-forward basis as well. But we do continue to expect Azure, especially on the consumption side, gross margins to improve, and they still have room to improve,especially as we start to see some of these premium services both being made available and being utilized at higher rates.”
Microsoft’s GAAP operating margin rose by 415 basis points year-over-year in the first quarter of fiscal 2020 on the back of gross margin improvements and controlled operating expense increases. For instance, R&D expenses rose by 15% year-over-year, roughly in-line with revenue growth. The company spent roughly 14% of its revenues on R&D, which funds the investment in innovation required for Microsoft’s cloud offering to keep performing well in such a crowded but lucrative market. G&A expenses declined 8% year-over-year, which we appreciate, while sales & marketing expenses rose 6% year-over-year. Due to its ongoing share buyback program, Microsoft’s outstanding diluted share count fell 1% year-over-year last quarter, helping grow its GAAP EPS by 21% year-over-year to $1.38.
The company remained tremendously free cash flow positive last quarter, as expected, with free cash flows of $10.4 billion easily covering $3.5 billion in dividends and $4.9 billion in share repurchases, allowing for some debt reduction on a net basis. Microsoft’s net cash position stood at $67.1 billion inclusive of short-term debt at the end of its first quarter, an improvement from $61.6 billion at the end of its fiscal 2019 (period ended June 30, 2019).
Concluding Thoughts
We continue to like Microsoft in our Dividend Growth Newsletter portfolio and value MSFT at $166 per share at the top end of our Fair Value Range. Its cloud growth story continues to yield great results, and its free cash flow profile is nearly impossible to replicate save for a few of Microsoft’s big tech peers. Add in a massive net cash position and Microsoft is well prepared to ride out any potential turbulence in economic activity.
Software Industry – ADBE ADSK EBIX INTU MSFT ORCL CRM
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Callum Turcan does not own shares in any of the securities mentioned above. Microsoft Corporation (MSFT) and Oracle Corporation (ORCL) are both included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.