Published by Nick McCullum on July 23rd, 2017
Microsoft’s recent fourth quarter earnings release was far superior to the company’s third quarter results, which were announced on Thursday, April 27th and saw the company’s stock decline by 2% in the ensuing trading.
This time around, Microsoft’s stock closed trading slightly higher. More importantly, the company’s fundamental business continues to grow at a torrid pace. Microsoft’s sustained growth has resulted in a steady stream of rising dividends for the company’s shareholders.
In fact, Microsoft is a member of the Dividend Achievers, a group of dependable dividend stocks with 10+ years of consecutive dividend increases. You can see the full list of all 265 Dividend Achievers here.
Microsoft’s strong earnings release indicates that the future remains bright for this high-quality dividend stock.
This article will analyze Microsoft’s earnings release and business model in detail.
Business Overview, Current Events & Growth Prospects
Microsoft is a technology giant and the largest independent developer of software in the world. The company was famously founded by Bill Gates in 1975 and has grown steadily over the years to its current eye-popping size.
At ~$572 billion, Microsoft is currently the third largest corporation in the Unied States based on market capitalization, behind Apple (AAPL) and Alphabet (GOOG) (GOOGL).
Microsoft currently reports in three operating segments:
- Productivity & Business Processes: $8.4 billion of 4Q17 revenue
- Intelligent Cloud: $7.4 billion of 4Q17 revenue
- More Personal Computing: $8.8 billion of 4Q17 revenue
There was a lot to like about Microsoft’s fourth quarter earnings release.
Specifically, the following metrics stand out:
- Revenue: up 10% on a constant-currency basis
- Operating Income: up 16% on a constant-currency basis
- Diluted Earnings-Per-Share: up 43% on a constant-currency basis
It is very impressive for a company of Microsoft’s size to deliver such strong fundamental profit growth. Remember, this is not a small technology startup we’re talking about – Microsoft has a market capitalization of $500+ billion and is the third-largest corporation in the United States.
If you’re interested in seeing additional details about Microsoft’s quarterly financial performance (such as each segment’s contribution to GAAP or non-GAAP financial performance), the following slide is a good place to start.
Source: Microsoft Fourth Quarter Earnings Presentation, slide 4
Aside from revenues, operating income, and earnings-per-share, Microsoft’s financial performance was robust on a number of measures.
The company continues to be very shareholder-friendly. In the quarter, Microsoft returned $4.6 billion to shareholders through a combination of dividend payments ($3.0 billion) and share repurchases ($1.6 billion).
Importantly, the company’s capital returns were very well covered by its free cash flow, which is growing at a very rapid pace.
Microsoft’s quarterly free cash flow of $8.7 billion was a 50% increase over the same period a year ago, caused by operating cash flow growth of 30% and a reduction in overall capital expenditures.
Source: Microsoft Fourth Quarter Earnings Presentation, slide 6
So what has caused Microsoft’s strong fundamental growth?
There are three main contributors.
The first is the continued integration of the LinkedIn business social network, which Microsoft acquired in December after announcing the deal in the summer of 2016.
While LinkedIn continues to generate negative operating income because of the heavy investments and restructuring that Microsoft is executing, the segment generated an impressive $2.3 billion of revenue in the full-year of fiscal 2017.
Source: Microsoft Fourth Quarter Earnings Presentation, slide 7
LinkedIn’s financial performance is reported in Microsoft’s Productivity and Business Processes segment, which was the second meaningful contributor to the company’s strong quarterly results.
This segment, which is responsible for the Microsoft Office software products, is growing rapidly thanks to Microsoft’s switch from one-time purchase software products to a more sustainable, subscription-based business model.
The new subscription-based model – called Office 365 – is growing at a rapid pace, with 31% year-on-year commercial seat growth in the company’s most recent quarter.
Additional details about the strong performance of Microsoft’s Productivity and Business Processes segment can be seen below.
Source: Microsoft Fourth Quarter Earnings Presentation, slide 9
The third large contributor to Microsoft’s strong growth is its continued leadership in the cloud computing industry.
Microsoft’s cloud products – called Microsoft Azure and reported under the Intelligent Cloud segment – saw revenue grow by 11% (12% in constant-currency) in the most recent quarter. Operating income grew even faster, with growth coming in at 15% (18% in constant-currency) with the difference being attributed to disciplined expense management.
Source: Microsoft Fourth Quarter Earnings Presentation, slide 11
All said, Microsoft’s business appears to be firing on all cylinders. The company’s LinkedIn, Productivity & Business Processes, and Intelligent Cloud segments will likely be the largest contributors to future growth moving forward.
Competitive Advantage & Recession Performance
Microsoft’s primary competitive advantage comes from creating and distributing some of the most important software products of our time.
Simply put, worldwide productivity would be significantly impacted if Microsoft’s products (particularly Microsoft Office and the Windows operating system) were permanently removed from the market.
Microsoft’s ubiquitous business model means that the company tends to perform reasonably well during recessions. For evidence of this, consider Microsoft’s fundamental performance during the 2007-2009 financial crisis:
- 2007 adjusted earnings-per-share: $1.42
- 2008 adjusted earnings-per-share: $1.87 (31.7% increase)
- 2009 adjusted earnings-per-share: $1.62 (13.4% decrease)
- 2010 adjusted earnings-per-share: $2.10 (29.6% increase)
- 2011 adjusted earnings-per-share: $2.69 (28.1% increase)
Microsoft’s adjusted earnings-per-share declined by just 13.4% during the financial crisis, and rebounded to new highs shortly afterward.
Microsoft’s recession performance is impressive, and the company is one of the few to hold an AAA credit rating from Standard & Poor’s (with the other being Johnson & Johnson). This shows the durability and creditworthiness of the company’s business model.
Accordingly, this company can be seen as a relatively recession-resistant stock for the portfolio of the individual investor.
Valuation & Expected Total Returns
Microsoft’s fundamental business is very appealing from an investment perspective. Unfortunately, the same cannot be said for the company’s valuation.
Microsoft reported adjusted earnings-per-share of $2.79 in fiscal 2016 and is expected to report adjusted earnings-per-share of approximately $3.02 in fiscal 2017.
The company’s current stock price is $73.79, which indicates a price-to-earnings ratio of 26.4 and 24.4 using 2016 and 2017’s earnings, respectively.
These valuations are high on an absolute basis. In general, it is best to buy dividend stocks at valuations no higher than 20. However, it’s important to consider a historical valuation before blindly making the decision to avoid a stock.
Microsoft’s current earnings multiple is compared to its average earnings multiple in the following diagram.
Source: Value Line
Microsoft’s current valuation using either 2016 or 2017 earnings is significantly high than it’s long-term average price-to-earnings ratio of 19.2 (which even includes the company’s incredibly high valuations during the dot-com bubble of the early 2000’s).
Accordingly, this company’s valuation suggests that investors should wait on the sidelines for a better entry point, although existing investors should likely continue to hold the stocks if their position has a cost basis below today’s market price.
Final Thoughts
Microsoft’s recent quarterly earnings release gave investors plenty to be happy about, including strong revenue growth, excellent expansion in operating income, and diluted earnings-per-share up nearly 50% from the same period a year ago.
Unfortunately, the business is sporting a valuation well in excess of its historical averages (even after taking into account its extreme overvaluation during the dot-com bubble).
Microsoft continues to be a hold for existing investors, while prospective investors should continue to wait for a more appealing buying opportunity.
