Image Source: Mike Mozart
Microsoft continues to take advantage of strong demand for its hybrid cloud portfolio, and it is winning business from leading enterprise customers. Free cash flow generation remains strong despite significantly higher levels of strategic growth investments.
By Kris Rosemann
Shares of simulated Dividend Growth Newsletter portfolio idea Microsoft (MSFT) faced a bit of selling pressure following its fiscal second quarter report, results released January 30, as investors digested mixed quarterly results, a relative slowdown in Azure revenue growth, and roughly in-line guidance for the full fiscal year. We still like shares, and operating margin expansion and robust free cash flow generation drive optimism while management continues to focus on strategic growth investments.
Overall revenue growth in the quarter came in at 12% on a year over-year basis thanks to ongoing customer demand for its hybrid cloud portfolio as the company continues to ride favorable secular trends amid a rising IT spending environment. Commercial bookings rose 18% from the year-ago period in the quarter, and commercial cloud revenue leapt 48%. Microsoft continues to win business from leading enterprises across a wide range of industries.
Microsoft’s ‘Intelligent Cloud’ segment (~29% of total revenue in the quarter) led the company in revenue growth with a 20% year-over-year increase as server products and cloud services revenue growth of 24% was driven by Azure revenue jumping 76% from the year-ago period. This still robust rate of Azure revenue growth came in well below the 98% measure of the comparable quarter of fiscal 2018, but management was encouraged by an increase in larger, longer-term Azure contracts and a significant improvement in Azure gross margin. The acquisition of GitHub, which closed in the calendar fourth quarter, also boosted segment revenue.
The ‘Productivity and Business Processes’ segment (~31% of total revenue in the quarter) turned in 13% revenue growth from the year-ago period as Office 365 Commercial revenue advanced 34%, LinkedIn revenue climbed 29%, and Dynamics revenue grew 17%, the latest of which was driven by Dynamics 365 revenue growth of 51%. The segment’s gross margin faced a bit of pressure on a year-over-year basis as the benefits of improved LinkedIn and Office 365 margins were offset by increased cloud mix.
Microsoft’s largest segment, ‘More Personal Computing,’ (~40% of total revenue in the quarter) drove revenue growth of 7% on a year-over-year basis as strong Surface revenue growth (39%) helped offset a 5% decline in Windows OEM revenue. Management pointed to a delay in chip supply to its OEM partners as a constraint on an otherwise healthy PC ecosystem. Windows OEM Pro revenue declined by 2% from the year-ago period, a rate that roughly reflects the contraction of the commercial PC market, while Windows OEM non-Pro revenue fell by 11%. Segment gross margin contracted in the period as a result of a higher mix of lower-margin Surface and gaming revenue, the latter of which advanced at an 8% rate in the quarter on a year-over-year basis.
Company-wide gross margin was roughly flat at 62% in Microsoft’s fiscal second quarter, but its GAAP operating margin expanded by approximately two percentage points to ~32% in the period. Management cited focused investment, solid execution, and improving gross margins across key product areas as drivers of margin expansion, but a shift of some of its fiscal second quarter marketing budget into the subsequent quarter also helped keep operating expenses below previously anticipated levels. Non-GAAP diluted earnings per share advanced to $1.10 from $0.96 in the comparable period of 2017.
Microsoft continues to generate robust free cash flow, but it also investing in a material way for the future. Operating cash flow advanced 13% on a year-over-year basis in its fiscal second quarter, but a ~43% increase in capital spending resulted in a 2% decline in free cash flow to $5.2 billion. Through the first two quarters of fiscal 2019, free cash flow faced a similar decline from the comparable period, but the $15.2 billion in free cash flow generation was more than enough in covering cash dividends paid in the period of ~$6.8 billion.
As of the end of calendar 2018, Microsoft held ~$127.7 billion in cash, cash equivalents, and short-term investments (down from ~$133.8 at the end of fiscal 2018) and $73.2 billion in total debt (down from $76.2 billion at the end of fiscal 2018). The company is one of two firms that boasts a ‘AAA’ credit rating, and its Dividend Cushion ratio is an impressive 3.3 at last check. Shares yield ~1.75% as of this writing, and management has been aggressive in buying back shares of late, as it repurchased nearly $10.2 billion of its shares in the first half of the year. Our fair value estimate for shares currently sits at $114 each, so we think they offer a decent value proposition at this point.
Moving forward, management expects a strong US dollar to continue weighing on reported results, but strong customer demand, healthy bookings growth, and ongoing improvements in its commercial revenue annuity mix, which grew to 89% in the fiscal second quarter from 86% in the year-ago period, should continue to provide positive momentum in its commercial business in the near term. Its highly-watched Azure revenue is expected to reflect a balance between strong growth in consumption-based business and moderating growth in its per-user business, suggesting relative slowdowns may become more commonplace, but it is important to keep in mind the still-robust growth rates at increasing scale. Operating margin expansion is expected to be slight in the full fiscal year, including the impact of the GitHub acquisition.
We continue to highlight shares of Microsoft in the simulated Dividend Growth Newsletter portfolio, and it remains one of our favorite dividend growth ideas on the market. The company’s balance sheet health is simply tremendous as it boasts a net cash position of $54.5 billion, and free cash flow coverage of dividends paid remains strong. Shares are currently changing hands in the lower half of our fair value range, which is anchored by a midpoint of $114 per share.
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.