Analysis: MSFT

Microsoft (MSFT) on Tuesday evening, shortly after the closing bell, reported a top- and bottom-line beat with its fiscal fourth-quarter earnings. On the top line, revenue of $46.2 billion (+21% year-over-year, +17% in constant currency or "CC") exceeded expectations of $44.221 billion. On the bottom line, adjusted earnings per share of $2.17 (+49% YoY, +42% CC) crushed the $1.92 per share estimate. 

"We are innovating across the technology stack to help organizations drive new levels of tech intensity across their business," said CEO Satya Nadella, on the press release. "Our results show that when we execute well and meet customers' needs in differentiated ways in large and growing markets, we generate growth, as we've seen in our commercial cloud -- and in new franchises we've built, including gaming, security, and LinkedIn, all of which surpassed $10 billion in annual revenue over the past three years."

"As we closed out the fiscal year, our sales teams and partners delivered a strong quarter with over 20% top and bottom-line growth, highlighted by commercial bookings growth of 30% year over year," added CFO Amy Hood. "Our commercial cloud revenue grew 36% year over year to $19.5 billion."

Before digging into the individual segment performances, we want to take a quick look at company-wide operating metrics.

Gross Margin came in at 70.0%, better than the 68.8% expected.

Commercial bookings increased 30% YoY (+25% in constant currency), "significantly ahead" of management's expectations "driven by strong execution across our core annuity sales motions, and an increase in the number of larger long-term Azure contracts." Commercial remaining performance obligations advanced to $141 billion, up from the prior quarter's $117 billion figure and up 32% YoY (+31% CC).

Commercial cloud revenue rose 36% YoY to $19.5 billion, up from $17.7 billion in the prior quarter and $14.3 billion in the same period last year. In addition to the revenue growth, commercial cloud gross margins managed to expand four percentage points, year over year, to 70%, despite "revenue mix shift" to Azure. That was driven by improvement across all cloud services on a prior year comparable impacted by strategic investments made to support significant customer engagement and usage in remote work scenarios. We should also note that "roughly one point" of the margin improvement can be attributed to a previously implemented accounting change in which Microsoft extended the depreciable life for server and networking equipment assets in the company's cloud infrastructure.

Microsoft saw operating expenses increase to $13.1 billion (+6% YoY, +4% CC), in line with the team's expectations. Capital expenditure in the quarter was $7.3 billion and used to support growth in the company's cloud offerings.

Cash Flow from Operations came in at $22.7 billion (+22% YoY), well above expectations of $20.318 billion while Free Cash Flow came in at $16.3 billion (+17% YoY), ahead of the $13.979 billion consensus. 

As for liquidity, Microsoft ended the quarter with $130.334 billion worth of cash, cash equivalents, and short-term investments on the balance sheet.

On the capital return front, Microsoft returned a total of $10.4 billion to shareholders in the quarter with $6.2 billion coming via share repurchases and $4.2 billion resulting from dividend payments.

Here we will look at performance for each segment during the quarter:

Productivity and Business Process

Sales in this segment increased 25% YoY (+21% CC) to $14.7 billion, a beat vs. expectations of $13.927 billion.

Breaking the segment revenue down, Office Commercial products and cloud services revenue advanced 20% YoY (+15% CC) with Office 365 Commercial revenue increasing 25% YoY (+20% CC), driven by Office 365 Commercial seat growth of 17% YoY "with an acceleration in small and medium business and frontline worker offerings, and growth in revenue per user." Office Commercial products revenue declined 8% YoY (-11% CC), "reflecting continued customer shift to cloud offerings, as well as a lower prior year comparable impacted by slowdown in transactional licensing."

Office consumer products and cloud services revenue grew 18% YoY (+15% CC) with Microsoft 365 Consumer subscribers increasing to 51.9 million, up from 50.2 million in the prior quarter.

Additionally, LinkedIn continued to rebound from the pain of a tough jobs market and lower hiring needs as revenue surged 46% YoY (+42% CC). That's a massive acceleration from 25% (+23% CC) in the prior quarter. On the call, Nadella commented that the platform surpassed $10 billion for the first time this fiscal year and that in the past five years since Microsoft acquired LinkedIn, "revenue has nearly tripled and growth has accelerated."

Nadella also called out that "LinkedIn has more than 774 million members who are more engaged than ever. Sessions were up 30% this quarter compared to a year ago. And LinkedIn's advertising business surpassed $1 billion in revenue this quarter for the first time, up 97% year-over-year, growing three times faster than the category."

Dynamics products and cloud services revenue rose 33% YoY (+26% CC) and Dynamics 365 revenue increased 49% YoY (+42% CC) "with strong momentum in PowerApps and Power Platform reflecting growing demand for [Microsoft's] modern solutions to build apps and automate work flows. 

Intelligent Cloud

In this segment, sales increased 30% YoY (+26% CC) to $17.4 billion, a solid beat against the $16.394 billion consensus.

Within the segment, server products and cloud services revenue grew 34% YoY (+29% CC) while Enterprise Services revenue increased 12% YoY (+9% CC).

As for Azure, revenue growth came in at an incredible 51% YoY (+45% CC) compared the prior quarter's 50% (+46% CC) result, in line to better than the street expectation for a low- to- mid-40% Azure growth rate "Driven by strong performance across our core and premium consumption base services." (note that FactSet does not provide a consensus estimate for Azure growth so we source from as many sell-side analysts as we can to come up with a ballpark range for expectations). On the call, Nadella stated, "we exceeded expectations across our consumption and per user Azure businesses as well as in our on premises server products business."

More Personal Computing

In this segment, sales increased 9% YoY (+6% CC) to $14.1 billion, again a strong beat against the $13.783 billion consensus.

Breaking this business down further, revenue for Windows OEM Pro declined 2% year over year, while Windows OEM non-Pro revenue decreased 4% YoY. Windows commercial products and cloud services revenues advanced 20% (+14% CC), "driven by demand for Microsoft 365 with an increase of multi-year agreements that carry higher in-quarter revenue recognition." Surface revenue fell 20% YoY (23% CC), coming in at $1.376 billion "driven by supply chain constraints, on a strong prior year comparable." Not much surprise here given the well broadcast supply constraints in the semiconductor industry.

Gaming revenues advanced 11% YoY (+7% CC). Within gaming, Xbox content and services declined 4% YoY (-7% CC), with growth in Xbox Game Pass subscriptions and first-party titles more than offset by declines from third-party titles on a strong year comparable. Xbox hardware sales surged 172% (+163% YoY) thanks to the Xbox Series X's launch and demand that continues to exceed supply. These consoles are the fastest selling in the company's history, said Nadella on the call, "with more consoles sold live to date than any previous generation."

Regarding the dynamic that led to the Xbox content and services, we believe main thing for members to focus on is the growth in Game Pass subscriptions as title releases, be it first-party or third-party, will always be a bit lumpy. But that subscription growth is what the street places a higher importance on due to the increased visibility it provides. 

Elsewhere, search advertising revenue excluding traffic acquisition costs (TAC) increased 53% (+49% CC) from the same time last year as customers advertising spend improved.


The results were fantastic and the guide for the first fourth quarter was just as good, maybe better. 

In More Personal Computing, revenue is expected to be between $12.4 billion and $12.8 billion, an outlook that at the midpoint of $12.6 billion was roughly in line expectations of $12.673 billion.

The team "estimated the Q1 impact" of the required Windows 11 revenue deferral that will shift to second quarter to be approximately $300 million, said Hood on the call.

Given this dynamic, the in line guide appears to be stronger than the pure numbers indicate.

The Productivity and Business Processes segment is expected to see revenues between $14.5 billion and $14.75 billion, an outlook that on the low-end came in above expectations of $14.066 billion. 

In the Intelligent Cloud segment, revenue is expected to be between $16.4 billion and $16.65 billion, an outlook that even on the low-end outpaced expectations of $15.707 billion.

Adding up all three segments, we come to revenue guidance of $43.3 billion to $44.2 billion, which even on the low-end breezes by expectations of $42.504 billion.

On the other side of the coin, management expects the cost of goods sold -- or COGS -- to come in between $13.55 billion and $13.75 billion, above the $12.952 billion expected. Additionally, operating expense is expected to be between $11.6 billion and $11.7 billion, below the $11.886 billion consensus.

Bottom Line

This was a very strong release with the guidance to match. While shares initially traded lower on the print, they quickly reversed course as management provided forward guidance during the call. This is a dynamic we have called out multiple times before and once again represents a clear example as to why we place so much importance on the conference calls (even when guidance is provided on the release, ahead of the call) as the information learned during these calls is often more important as it relates to the path ahead, which for investors is often more important than backward looking results.

On that note, as we look to the future, while the near-term remains a bit uncertain because of the pandemic, the longer-term path ahead as it relates to computing is abundantly clear -- companies have learned through the pandemic that they can either move workloads into the cloud (hybrid or public) or be left in the past. As a result, while the stock's valuation may be up there from a historical perspective at ~34.5x forward earnings (though we expect earnings estimates to go up following tonight's release), we believe the higher multiple to be more than well-deserved given the company's incredible transformation under Nadella, which has made the Microsoft absolutely critical to the productivity of nearly every industry on the planet - just imagine where we would be had the pandemic hit just 10 years ago, before companies had broad access to cloud computing products such as Azure and Office 365.

Nadella closed out his prepared remarks commenting, "going forward, every person and every organization, will require more digital technology to be more resilient and to transform. We are innovating across the entire deck stack to ensure our customers succeed in this new era."

We couldn't agree more and believe Microsoft to be one of the best positioned companies to help others as we progress through the fourth industrial revolution.

Our price target and rating are under review.

Action AlertsPLUS, which Cramer co-manages as a charitable trust, is long MSFT.