Strong Upside Potential for Microsoft Despite Negative Growth
- By Shudeep Chandrasekhar
Microsoft (MSFT) surprised many analysts with its fourth-quarter earnings, which came out on July 19. Microsoft reported non-GAAP revenues of $22.6 billion and non-GAAP per share profit of 69 cents beating analyst estimates of $22.14 billion and 58 cents. With stock movement after earnings results of late being extremely reliant on the deviation from analyst consensus estimates, Microsoft's stock saw a nice jump to the $56 level.
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The intrinsic value of MSFT
It would be a bit of an understatement to say that Microsoft fired on all cylinders, as the company posted some solid growth numbers on several products including search advertising and Windows OEM revenues.
The numbers speak for themselves
Commercial cloud annualized revenue run rate (calculated by taking revenue in the final month of the quarter multiplied by 12 - for Office 365 commercial, Azure, Dynamics Online and other cloud properties) reached $12.1 billion during the fourth quarter this year compared to $8 billion during the fourth quarter last year, which means quarterly earnings from commercial cloud is now at $3.025 billion compared to $2 billion last year, a growth of 51%.
Microsoft is targeting a $20 billion run rate or $5 billion quarterly by 2018, which means this segment now only needs to grow at a CAGR of 28% for the next two years, and it's home free. Considering the rate at which the industry itself is growing, however, I would be surprised it Microsoft doesn't get to that target before 2018 - especially with Microsoft Azure clocking 100%-plus growth rates for the last two quarters.
If you looked a bit deeper into the numbers, you would have noticed that Microsoft's revenue slide has yet to be arrested. Let's take a closer look at what is causing that.
Underneath the negative growth
Negative revenue growth, which started around the fourth quarter of last year, has continued to date. Microsoft needs another year start posting revenue growth. During the fourth quarter of 2016, Microsoft posted total revenues of $20.614 billion, down 7.06% compared to $22.18 billion posted last year. In 2015, Microsoft's annual revenues were reported at $93.58 billion; this year it only posted $85.32 billion, and most of that slide was contributed to by Windows 10 deferrals.
Microsoft's GAAP and non-GAAP revenues differed by more than $6 billion for the year, a huge gap by any standard, and it was caused mainly due to the accounting methods that are used to calculate Windows 10 revenues.
"With the launch of Windows 10 in July 2015, Windows 10 customers receive future versions and updates at no additional charge. Under current revenue recognition accounting guidance, when stand-alone software is sold with future upgrade rights, revenue must be deferred over the life of the computing device on which it is installed. This is different from prior versions of Windows, which were sold without upgrade rights, where all revenue from original equipment manufacturer ("OEM") customers was recognized at the time of billing, i.e., upfront.
"When Microsoft adopts the new revenue standard, predominately all Windows OEM revenue will be recognized at the time of billing, which is similar to the revenue recognition for prior versions of Windows. Additional information regarding the new revenue standard is provided below. Microsoft reflects the recognition of Windows 10 revenue at the time of billing in "As Adjusted (non-GAAP)" revenue to provide comparability during the short period of time where Windows 10 will be recognized over the estimated life of a device, i.e., ratable, rather than at the time of billing." - Q416 Earnings Press Release
It's clear that Microsoft's underlying business has started to grow, and that's why the market didn't react adversely to the negative revenue growth that Microsoft posted during the last few quarters. What is also heartening to see is that all the different product divisions have started to move upward, and even search engine advertising revenues have been growing at double-digit rates for the last four quarters.
Microsoft stock has run up quite a bit since the lows set in September last year and is now trading at 52-week highs with a PE ratio (TTM) of 26.14 - not a number you would normally associate with a company that is decades old. But Microsoft has lot of future-ready business lines such as cloud, Dynamics, Office suite, Xbox and so on so the market seems to be assigning a high valuation.
Microsoft is still a good buy for the long term and, if the stock keeps running to higher ground, look at adding small positions during dips.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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This article first appeared on GuruFocus.
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The intrinsic value of MSFT
