Microsoft Corp. (NGS: MSFT). While Microsoft may not be immune from the effects of COVID-19, particularly the slowdown in tech spending from small and medium-sized enterprises, high unemployment, and general macroeconomic weakness, it is one of the few companies that has a product set aimed at enterprise efficiency, cloud transformation and collaboration, with a large and loyal installed base. We should also mention Microsoft’s large cash cushion and rock-solid balance sheet as important differentiators in this uncertain economic climate.
The company is also riding the positive secular trends of growing IT spending, particularly with regard to hybrid cloud solutions. Microsoft has about doubled its market share to 17% in the public cloud infrastructure business over the last few years. It remains in the number-two position, behind Amazon Web Services but still well ahead of other competitors. It does not compete with the clients of Microsoft Azure, the company’s cloud solution, in those clients’ core businesses – in contrast to cloud rival Amazon. Also, Microsoft has an integrated software stack that addresses client needs across the enterprise IT landscape from cloud to security to employee collaboration in both hybrid and cloud native environments.
Microsoft’s Teams collaboration software is a natural product extension that the company can market to its huge installed base, again with a focus on cloud-based subscription and usage-based models. COVID-19 lockdowns, which have led to substantial changes in how people work, should continue to fuel robust Teams growth. In the future, Mr. Nadella expects to leverage the company’s Azure cloud platform and Intelligent Edge computing to power the Internet of Things (IoT), as this category begins a strong secular ramp.
Besides returning Microsoft to its roots as a business productivity company, Mr. Nadella has opened up the company’s culture to push open-source code solutions and a myriad of partnerships. These themes are exemplified by the acquisition of GitHub and the placement of MS Office on the iPad and iPhone. Along the same lines, the company could move to integrate the Microsoft voice virtual assistant Cortana with Amazon’s Alexa and the Google Assistant.
However, MSFT shares fell about 5% in a down market on October 28 as some investors may have been disappointed by management’s December-quarter guidance.
First-quarter revenue rose 12% year-over-year to $37.2 billion. Negative foreign exchange effects shaved $108 million from revenue. Revenue growth was across the board, driven by strong growth in the Intelligent Cloud and Productivity and Business Processes segments, with a solid contribution from More Personal Computing. In Intelligent Cloud, 20% segment revenue growth was attributable to 48% growth in Azure revenue, driven by strong growth in its consumption-oriented business lines. In Productivity and Business Processes, 11% revenue growth was driven by strong growth from Microsoft 365, LinkedIn, and Dynamics. This more than offset a 30% decline in Office Commercial, which is being cannibalized by cloud services.
Operating income rose 25% to $15.9 billion. The operating margin also expanded by four percentage points to 43%, with two points attributable to the accounting estimate change and the remainder due to other factors, including greater-than-expected COVID-related savings and a timing shift in investments to future quarters. Diluted EPS rose 30% to $1.82.
On September 21, Microsoft agreed to acquire ZeniMax Media, the parent company of videogame publisher Bethesda Softworks, for $7.5 billion in cash.
With the console refresh, Microsoft has also begun to offer 24-month subscription installment plans of $34.99 for the Series X and $24.99 for the Series S, both including a Game Pass Ultimate (premium level) subscription. Given that the retail upfront costs are expected to be $499 for the Series X and $299 for the Series S, the two-year subscription offers a discount of $19 on the Series X and $59 on the Series S. Microsoft is thereby providing two incentives for players to take the subscription, both by avoiding the large upfront cost for a new console and by providing a discount over the term of the subscription. We see this as a shrewd strategic shift for Microsoft as it looks to build a more valuable long-term subscriber base, with recurring revenues, rather than opt for the one-time transactional revenue from console sales. As prices for videogames continue to rise, with new games moving to $70 (a $10 premium over the previous price point), players may find a subscription even more appealing. Add to this the increased value brought by the ZeniMax acquisition, and Microsoft may be in a good position to win share. Of course, much will also depend on the functionality of the new consoles and how that functionality is perceived by the market, particularly in relation to the PlayStation 5 – scheduled to be released on November 12, just one day after the Xbox consoles. We also have no doubt that Game Pass runs on Microsoft’s Azure cloud service in a nice bit of synergy.
Microsoft announced that TikTok owner ByteDance had rejected its acquisition offer in a terse blog post on September 13. In our view, Microsoft is well out of the deal.
EARNINGS & GROWTH ANALYSIS
CEO Satya Nadella’s vision is for Microsoft to empower businesses and consumers to become more productive worldwide. Mr. Nadella thinks that COVID-19 makes business process transformation that much more critical since business digitization leads to increased resilience. Given Microsoft’s continued robust performance over the last two quarters, the company’s clients may agree. Microsoft sees its Azure cloud as a competitive advantage for enterprise hybrid on-premise/cloud environments. Microsoft’s new software-as-a-service (SaaS) products from Office 365 to Azure also enable the company to reach small and medium-sized business customers – though this market segment looks to be suffering the most from COVID-19. Customers may initially come for Azure cloud computing power and storage, and then move on to the company’s AI-powered ‘intelligent edge’ platforms. Meanwhile, traditional stalwarts like Windows have faded and essentially been downgraded. Microsoft continues to ‘invest aggressively in strategic areas, most importantly Azure cloud, through building out global data centers and AI as well as multifarious growth businesses, GitHub, business applications, Power Platform, and LinkedIn, Microsoft 365, Teams, Security, Surface and Gaming.’
Office Commercial products and cloud services grew a lesser 9%, impacted by the continued sluggish SME segment. However, Dynamics revenue grew 19% and LinkedIn revenue rose 16%. Mr. Nadella noted that the company’s Teams enterprise collaboration platform had reached 115 million daily active users in 1Q21. What makes the Teams application so critical is its ability to integrate business process workflows through meetings, calls, chat, and content collaboration. Segment operating income jumped 19%.
The growth was driven by demand for the company’s hybrid cloud offerings. Server products revenue rose 21% in constant currency. In constant currency and the segment operating margin widened by a substantial 6 percentage points to 42%.
With better-than-expected Windows OEM Consumer, Surface, and Search revenue. Windows OEM Pro revenue fell 22% on a tough comparison with 1Q20, which benefited from the termination of Windows 7 support. The Windows Commercial business rose 12% in constant currency. Gaming revenue jumped 21% in constant currency. S
FINANCIAL STRENGTH & DIVIDEND
Total debt stood at $63.55 billion. Even adjusting for last year’s unusual tax payments, TTM free cash flow was up 44%.
Microsoft repurchased $6.7 billion of its stock in 1Q21.
While Microsoft has moved past the risk to its supply chain from the COVID-19 pandemic as hardware component assembly plants in China have reopened, the company remains exposed to macroeconomic risk and the risk that enterprises could cut back on technology spending in response to declining economic activity. Management has noted weakness in the SME segment, likely due to COVID-19 restrictions. Further, the company’s Bing search engine and LinkedIn professional networking website have much wider exposure to the collapse in advertising spending than other parts of the company, though advertising seems to be making a recovery from its March/April trough.
When Microsoft pulled out of the mobile smartphone market, the company gave up on a critically important vector of future growth that underpins the success of other tech titans Apple (iOS) and Google (Android). Microsoft has tiptoed back into phone hardware with a handset that runs on Android. Microsoft could one day find itself and its application ecosystem at the mercy of competitors who control mobile systems and devices.
While Microsoft may be the second-largest public cloud provider, its market share is dwarfed by industry leader Amazon Web Services. Amazon has achieved a scale which could make it difficult for Microsoft to reap a sustainable profit from its cloud services business.
MSFT trades below the peer median of 22.1.