Analysis: MSFT LUV AMZN GOOGL ATVI GME AAPL ADBE

We will purchase 200 shares of Microsoft (MSFT) at roughly $83.63 after you receive this Alert. Following the trade, MSFT will represent 0.59% of the portfolio. 

We are calling up MSFT out of the bullpen and into the portfolio as our sale of Southwest Airlines (LUV) last week has made room for this name. You can read our bullpen Alert on Microsoft here and the company's fiscal 2018 first-quarter earnings release here

Microsoft's business can be broken into three main segments: productivity and business processes, intelligent cloud and more personal computing. Before looking at each segment, it's important to note that while many refer to the Microsoft cloud as Microsoft Azure, the two are not the same. While the cloud is where all programs and services are located, including Office 365, Xbox Live and just about every other internet-based service the company offers (including Azure), Azure is the company's hybrid cloud computing service, designed for developing, testing, deploying and managing applications and services by providing services such as software as a service (SaaS), platform as a service (PaaS) and infrastructure as a service (IaaS). We feel this is an important distinction to make as Azure is the part of Microsoft's business that goes head-to-head with Amazon's (AMZN) AWS and the Google (GOOGL) Cloud, competing for companies' data center business. 

Within productivity and business processes (about 33.5% of fiscal-first-quarter 2018 revenue), there are commercial and consumer office products such as Office 365, dynamics products such as Dynamics 365 and the previously acquired LinkedIn business. In Microsoft's fiscal first quarter (ended Sept. 30), driven by 42% commercial revenue growth for Office 365, we saw office commercial products and cloud services revenue grow 10% year over year (also 10% on a constant currency basis, i.e. CC). As for office consumer products and cloud services revenue, we saw 12% revenue growth (10% CC), driven by a 28-million-subscriber increase for consumer Office 365.

The LinkedIn platform is up to 530 million users as of last quarter and management is seeing record levels of engagement. The platform has achieved four consecutive quarters of 50%-plus session growth, and is on track to eclipse 21 billion sessions this year. Visitors are using the platform, both on desktop and mobile, to search for jobs, update their feeds and send messages at a fast-growing clip, and management believes they are ahead of their plan of having LinkedIn give a positive contribution to EPS ex purchase accounting for fiscal 2018.

Lastly, within dynamics products and cloud services, we saw 13% revenue growth (12% CC), driven by 69% revenue growth (69% CC) for Dynamics 365. Tying this all together, productivity and business processes saw 28% revenue growth (28% CC) in the fiscal first quarter.

Looking to the Intelligent cloud (about 28.2% of fiscal-first-quarter revenue), arguably the most important business segment, this is where the company's Azure revenue is reported. In the fiscal first quarter, the company saw 17% revenue growth (also 17% CC) for server products and cloud services revenue, driven by a whopping 90% year-over-year increase (89% CC) in Azure revenue. Premium services revenue for Azure grew by triple digits for the 13th quarter in a row as of the last earnings release. Also driving growth in this segment was a 68% increase in the Enterprise Mobility install base, which now sports over 55 million users. All in, this segment saw 14% revenue growth (13% CC) in the quarter. 

While Amazon Web Services is the leader in the public cloud space, we believe the Microsoft cloud to feature many significant factors that can aid in helping the company gain market share both domestically and on the international front. For starters, MSFT has more data center regions (each with multiple data centers) around the globe than both Amazon and Alphabet combined, with 36 current regions and another six in development. This compares to Amazon's 16 current regions and another six under development and Alphabet, which has 12 current locations with another five under development.

There are several reasons why more data centers globally play to Microsoft's advantage, but there are two key factors we believe deserve members' attention. First, more data centers mean companies can physically be closer to their data. By being in proximity, the time it takes for data to travel and be accessed diminishes. While this may not be a major factor for individuals, for companies that require access to massive amounts of time-sensitive information, this can be a major factor in the decision process for which cloud service provider to use.

Second, by building out more data centers globally, Microsoft can address regulatory and jurisdictional issues, such as those requiring certain types of companies to keep data domestic (i.e., away from foreign entities) or situations where a company may want to keep user data (such as emails) from being exposed to requests for access from foreign governments/courts. 

In addition to the diversity of data center region locations, we would also note that unlike its competitors, Microsoft is building out roughly 50% of its locations (as opposed to Amazon, which leases most locations). This gives us a bit more visibility into Microsoft's vision for the cloud as building locations requires significantly more lead time than bringing a leased location online (think years vs. under a year). In fact, according to analysts at Bernstein, "Microsoft has built-in data center square footage to support double their current commercial cloud revenue." 

Finally, moving to more personal computing (about 38.3% of fiscal-first-quarter revenue), revenues were relatively unchanged year over year (down 1% on a constant-currency basis) as revenue growth in Search (up 15% year over year) and Surface (up 12%, 11% CC) was offset by a decline in phone-related revenues. Within this segment are more familiar line items such as Windows, Xbox (including Live services), Search and device revenues from laptops (including the Surface) and mobile devices. On that note, Windows OEM Pro revenue saw 7% growth (7% CC); Windows commercial products revenue also saw 7% growth (6% CC). Within gaming, an important subsegment as we can use it to read through to our Activision Blizzard (ATVI) holding, total revenues increased 1% year over year (0% CC), driven by a 21% growth (20% CC) in Xbox software and services and a 13% rise in monthly active users for Xbox Live.

During GameStop's (GME) earnings call last week, management noted that the recently released Xbox One X "is off to a very strong start," an encouraging sign for sales during the holiday season. Also, we like the performance of MSFT's growing Xbox service revenue. While it cannot compare in size to Apple's (AAPL) business, rising active users and the shift toward digital adoption are strong indications of future growth.

Finally, while all segments are important to the overall story (especially as this segment makes up the largest operating segment for the company), we want to remind members that our investment thesis is largely based on growth within the company's cloud and Azure business and less so on hardware device sales housed in this segment, as we see the market opportunity for productivity and business processes and the intelligent cloud as much larger than that of more personal computing. 

Improving margins were a strong theme for the company last quarter, signaling that it has moved past an era of heavy investment in all areas of the business. During the last earnings call, management noted that overall gross margins and operating margins are trending "a bit better" relative to its initial full-year outlook of down 1%. Management said they expect operating margins ex LinkedIn to be up year over year "even as we increase investment to support long-term top-line growth in commercial cloud, AI, mixed reality, quantum, new hardware launches, and the continued transformation of our sales team." Driving the higher gross margins are improvements in Azure, Office 365, a stronger PC market and an FX tailwind. 

Microsoft also stands to be one of the biggest beneficiaries of tax reform and a one-time tax repatriation holiday. In its last earnings release, the company listed that it holds about $138 billion in cash, cash equivalents and short-term investments, and of that figure, $132 billion is held by foreign subsidiaries and is eligible for repatriation. By making these funds available for deployment in the U.S., Microsoft can use this windfall to further commit its investment to the data center, or could choose to use it to boost shareholder returns. Microsoft's commitment to returning value to shareholders is strong, as evident by the $4.8 billion returned to shareholders through $3.2 billion in dividends and $1.6 billion in share repurchases last quarter. In the event that tax reform does not occur, we would still be buyers of Microsoft today, as we believe the company is fully investible without the benefits from Washington due to the above-mentioned reasons. 

Lastly, as with all our initiations, we expect to strategically scale into a full position in Microsoft over time, taking advantage of any down days. We are initiating Microsoft with a One rating and price target of $94, which represents roughly 25x consensus fiscal 2019 earnings per share (which may be on the conservative side). We see years of upside as the company is showing strong growth in its cloud and Azure businesses and, importantly, has made a significant shift to subscription-based software and services over the past few years, a change from the traditional perpetual license sales.

Longtime members may recall that the shift away from perpetual licenses (where users pay a large upfront fee and then wait years before purchasing an upgrade from the company) to subscription-based ones is one of the main reasons we have long been fans of past portfolio holding Adobe (ADBE) as it provides a constant and transparent revenue stream. On that note, as of the fiscal first quarter, Microsoft achieved over $20 billion in commercial cloud (which includes Azure, Office 365, Dynamics and other CRM tools) annual recurring revenue, a two-year goal set out to be achieved by the fourth quarter of 2018 and achieved three full quarters ahead of schedule. 

Action Alerts PLUS, which Cramer co-manages as a charitable trust, is long GOOGL, ATVI and AAPL.