Analysis: MSFT

Wednesday evening, shortly after the closing bell, Microsoft (MSFT) reported mixed results with its fiscal 2Q19 earnings results (note: all growth rates on a constant currency basis). On the top line, revenues of $32.47 billion (+13% YoY) came up just short of expectations of $32.54 billion. On the bottom line, non-GAAP earnings of $1.10 per share (+14% YoY) exceeded estimates of $1.08 per share. Furthermore, operating income of $10.26 billion (+18% YoY) edged out expectations of $10.25 billion margins.

On the release, CEO Satya Nadella stated: "Our strong commercial cloud results reflect our deep and growing partnerships with leading companies in every industry including retail, financial services, and healthcare. We are delivering differentiated value across the cloud and edge as we work to earn customer trust every day."

Operating Results

Before digging into the individual segment performance, we want to take a quick look at company-wide operating metrics. Commercial bookings increased 22% YoY while commercial unearned revenue increased 20% YoY to $25.3 billion.

Commercial cloud revenue increased 47% YoY (48% when accounting for the impact of foreign exchange rates) to $9.0 billion, up from $8.5 billion in the previous quarter and $6.1 billion in the same period last year. Additionally, while commercial cloud gross margins were flat sequentially at 62%, this represents a 500bps improvement from the year ago period, driven primarily by Azure gross margin expansion. This is a crucial aspect of the release as ongoing strength in the company's Azure business lies at the core of our investment thesis. Additionally, while free cash flow pulled back 2% YoY due to cloud related an investments (not a surprise given that the growing demand for cloud services inherently requires additional infrastructure related investments), cash flow from operations advanced 13% YoY "driven by higher collections from customers, partially offset by higher supplier and tax payments. Regarding the decline in free cash flows, we note that capital expenses of $3.9 billion to support growth in cloud offerings included $3.7 billion in cash payments for property and equipment.

Speaking on the release, EVP & CFO Amy Hood stated: "Our solid execution delivered another strong quarter, with commercial cloud revenue growing 48% year-over-year to $9.0 billion. We continue to make strategic investments to capture expanding market opportunities to drive growth across our businesses." We believe Microsoft's willingness to invest should be viewed positively as the cloud space remains in the early innings and earlier Microsoft can pull new customers on to the Azure the platform (and others), the more engrained they will become in the ecosystem and the more reliable the associated recurring revenue streams will ultimately become.

Capital Allocation

On the capital return front, Microsoft returned a total of $9.6 billion to shareholders in its fiscal second quarter with $6.1 billion coming in the form of share repurchases and $3.5 billion via dividend payments. Additionally, Microsoft ended the quarter with roughly $127.66 billion worth of cash, cash equivalents, and short-term investments.

Segment Results

Looking to the individual segment results, which we remind members includes the impact of the GitHub acquisition that closed in the quarter, Productivity and Business Process sales increased 19% YoY to $10.1 billion, a tick above expectations of $10.09 billion as Office commercial products and cloud services revenue increased 11% YoY, Office consumer products and cloud services revenue advanced 2% YoY, LinkedIn revenue jumped 30% YoY and Dynamics products and cloud services revenue increased 17% YoY. Lastly, segment operating income crushed expectations, coming in at $4.02 billion versus consensus of $3.79 billion.

Breaking these results down further, Office commercial products and cloud services were aided by a 33% gain in Office 365 commercial revenues, while Office consumer products and cloud services revenues were bolstered by Office 365 consumer subscribers increasing to 33.3 million, up from 32.5 million in the prior quarter. Dynamics products and cloud services revenues were helped out by a 50% YoY surge in Dynamics 365 revenue, while LinkedIn saw strong momentum across the board with record levels of engagement and job posting as sessions grew by 30% YoY.

Source: FY2Q19 Earnings Release

Within the Intelligent Cloud segment, sales increased 21% to $9.38 billion, ahead of the $9.29 billion analysts were looking for. Within the segment, Server products and cloud services revenue advanced 24%, driven by 76% growth in Azure revenue (in-line with the annual rate of advance seen in the prior quarter), 4% growth in Server products revenue "driven by continued demand for premium versions and hybrid solutions, and the inclusion of GitHub." Additionally, the Enterprise Mobility installed base grew 57% to over 94 million. In Enterprise Services, sales increased 7% from the same time last year benefiting from growth in Premier Support Services and Microsoft Consulting Services. Segment operating income increased to $3.28 billion, short of the $3.48 billion consensus.

Source: FY2Q19 Earnings Release

In More Personal Computing, sales increased 7% YoY to $12.99 billion, however, came up short of the $13.08 billion the street was looking for. Driving the top line number was a 5% YoY sales decrease in Windows OEM, which itself saw a 2% YoY decline in OEM Pro sales and an 11% YoY falloff in OEM non-Pro revenue. However, offsetting the Windows OEM decline, Windows commercial products and cloud services sales increased 14% due "continued customer adoption of premium offerings." Gaming revenues increase 8% YoY as software and services revenues advanced 32% from the same time last year thanks yet again to third party title strength - on the conference call, Nadella noted that "Xbox Live monthly active users reached a record 64 million, with the highest number of mobile and PC users to date. Xbox Game Pass subscribers and Mixer engagement also hit new all-time highs." Surfaces revenue surged 41% YoY while Search advertising revenue excluding traffic acquisition costs (TAC) increased 14% from the same time last year. Segment operating income came in at $2.96 billion, roughly in line with expectations.

Source: FY2Q19 Earnings Release


On the conference call, management provided their outlook for next quarter. Productivity and Business Processes is expected to see revenues between $9.9 billion and $10.1 billion, slightly below consensus of $10.13 billion. On the call, Hood noted her expectations for Office commercial and Dynamics to see double-digit growth and for Linked to see healthy growth "on a strong prior year comparable." Additionally, Office consumer sales are expected to see low single digit growth "as growth in Office 365 will be partially offset by the continuation of the consumer PC market headwinds."

In the Intelligent Cloud, revenue is expected to be between $9.15 billion and $9.35 billion, in line with expectations into the release of roughly $9.28 billion with "hybrid demand continuing to drive strong growth in server products and cloud services," according to Hood.

More Personal Computing revenue is expected to be between $10.35 billion and $10.65 billion, exceeding consensus into the quarter of $10.36 billion at the midpoint, with the revenue mix expected to shift toward Surface and gaming.

Adding up all three segments, we come to top line guidance of $29.4 billion to $30.1 billion, roughly in line with expectations of $29.86 billion in sales in FY3Q19.

In addition to the segment revenue guidance, Hood also called out that she expected foreign-exchange headwinds "to decrease revenue and operating expense growth by approximately 2 points and decrease COGS growth by approximately 1 point," adding that at the segment level, she expects to see "about 2 points of negative FX impact on revenue growth in Productivity and Business Processes and Intelligent Cloud and 1 point in More Personal Computing." Additionally, Hood expects cloud gross margins to improve on an annual basis, noting that a "material improvement in Azure gross margin will again be partially offset by the mix of revenue toward Azure consumption-based services." Lastly, Hood expects capital expenditures to increase sequentially due to continued investments required to support increasing demand.


All in, despite the muted reaction, which may in part be due to management leaving full fiscal year guidance unchanged and calling out that foreign-exchange rates, if left unchanged will pose a ~2% headwind to revenue growth but only a ~1% offset to dost of goods and operating expense growth, we believe the quarter was solid and serves to support our view that the cloud space remains in secular growth mode.

We continue to view Microsoft's Azure as the dominant player in the hybrid cloud space thanks to the continuity it provides customers due to management's efforts to provide the same "stack" on-premises that is used in the public cloud. As Nadella noted on the call, "Azure is the only hyperscale cloud with a consistent computing stack that extends from the datacenter to the edge. And customers across every industry recognize this architectural advantage." As a result, our Azure-based investment thesis remains unchanged and reiterate our $118 price target.