Microsoft: Post-Earnings Analysis – Seeking Alpha
On July 12, Microsoft (MSFT) reported its fiscal Q4 earnings, beating expectations on revenue and EPS, and the stock price soared by 4% during post-market trading hours, reaching the level of $77 per share. It can be noticed the stock price has shown a strong positive growth since the election, and solid Q4 results inspired investors’ expectations.
However, during the pre-market trading on July 21, the stock gave out the previous day’s gains, opening near the level of $73.5. While this drop can represent usual profit-taking, I tried to analyze the earnings in order to evaluate the situation in the company. Therefore, this article provides the analysis of Microsoft’s earnings.
First of all, let us look at the numbers.
In Q4, the corporation generated $23,317 million in revenue, which represents 13% growth year over year. The primary profit drivers were Intelligent cloud and Office products. Hence, server products and cloud services revenues increased by 15%, with the Azure growth of a strong 97%, while Office 365 commercial revenue soared by 43%, with a 74% growth in Dynamics 365.
(Source: Microsoft Current Report)
As a result, Microsoft demonstrated a robust 5.4% revenue growth in FY 2017, partly offsetting the loss of FY 2016. The revenue dynamics is presented by a picture below.
Another positive takeaway from the earnings is the growth in margins. Thus, operating margin increased from 23.65% in FY 2016 to 24.82% in FY 2017. The main reason for this is a clear switch to the cloud business and higher portion of subscription revenue:
This quarter, our commercial cloud gross margin percentage was 52%, up 10 points year-over-year, with positive gross margin in each cloud service.
(Source: Q4 Earnings call)
At the same time, the situation is not expected to be so positive in FY 2018. The company claims margins are likely to decrease at least by 1 point because of a full year of LinkedIn amortization and the launch of Xbox One X, a new gaming hardware.
Another important fact is the tax rate. The company received a tax benefit of almost $1 billion in Q4, which led to the fact the effective tax rate for full FY 2017 amounted to about 8%. This situation appeared due to the fact that Windows 10 revenues are not recognized at the time the license is sold. Jonathan Webber explains the situation with the tax rate in Q4 in his article in detail.
Moreover, the full-year tax rate reflects a negative impact from prior years’ losses from Microsoft’s phone. As a result of the tax item, Microsoft’s earnings per share for FY 2017 increased by $0.23, meaning the actual result from the operating business is less blowing than the numbers shown in the headlines.
It is also worth noting Microsoft’s revenue in More Personal Computing decreased 2%. Why is it important for the corporation? Primarily because Microsoft derives the largest portion of revenue from this segment. Hence, in Q4 2017, $8.8 billion was generated by Personal Computing, $8.4 billion by Productivity and Business Processes, and $7.4 by Intelligent Cloud.
(Source of data: Microsoft Current Report)
Therefore, it is clear if the trend continues, it will be harder for Microsoft to maintain the growth rate shown in FY 2017.
Overall, Microsoft’s future looks bright, even despite some headwinds from the Personal Computing segment. The primary reason for the decline in PC was a decrease of 2% in Surface sales and “lower phone revenue.” As the company transitions towards being a software and cloud solutions provider, slowing hardware sales should not be a big problem for Microsoft. The future of the cloud business looks favorable, especially in light of such deals as the collaboration with Baidu (NASDAQ:BIDU) on autonomous driving.
Moreover, the new Surface devices (Surface Laptop and Surface Pro) have been available worldwide only since June 15, which means this product lineup did not contribute to FY 2017 results. The new products attracted a lot of attention in media, especially the new Surface Laptop, which received positive reviews. Therefore, it is likely Surface sales should demonstrate solid performance in FY 2018.
At the same time, investors should be aware that the company’s future depends heavily on the cloud business and Office 365. Therefore, if the company faces intensified competition from Amazon’s (AMZN) AWS or other players’ solutions, the growth can slow in the future. Moreover, the tax advantage of FY 2017 should be taken into account while analyzing Microsoft’s performance. It can be expected tax rate will gradually increase in the coming years to a more reasonable 23%, which is a ten-year average rate.
In the previous article, I valued the company using DCF modeling, estimating the fair price for the stock to be $67. I have updated my calculation, taking into account the recent events. Overall, the assumptions for the model are the following:
1. The average annual revenue growth rate over a horizon period of 5 years is estimated to be around 6.6%, with a 7.2% increase in FY 2018 and 7.8% increase in FY 2019. The numbers comply with the average analysts’ expectations provided by Yahoo Finance. I have raised my assumption here because of the exceptional performance of the cloud business and good expectations from sales of Surface Laptop. The average EBITDA margin will be around 34.5%, with the drop in FY 2018 and a steady increase from FY 2019.
2. I have also incorporated the new levels of debt and cash on the balance of Microsoft, according to FY 2017 results.
3. My assumption for the WACC remains on the level of 10.25%, with the cost of equity to be 11.1% and the after-tax cost of debt of 3.8%.
As a result of the recalculations, the model shows $562 billion equity value under the base scenario, which assumes the EV/EBITDA multiple will decrease to 15.5 by the end of the horizon period (FY 2022). In this case, the fair value of the stock is $72.8, which is close to the current price.
The sensitivity analysis shows a range of possible outcomes that will be driven by actual results of the corporation. In light of this, the fair price range is $70.9-74.7.
At the same time, the stock still looks overvalued versus other tech giants, which can be explained by the fact that investors’ expectations are rather high at the moment.
Overall, in FY 2017, Microsoft demonstrated solid results that inspire investors. Revenues increased by more than 5% and Azure cloud demonstrated stellar development. While there are still certain concerns associated with the decrease in the PC segment and with the issue of the tax rate, the future of the company remains positive.
At the same time, the current stock price does not provide enough margin of safety for cautious investors. A drop below $70 would be a more reasonable moment to invest in the company. This is also backed by the fact that a point of support can be recognized near the level of $69.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.