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Morningstar | Ever to Excel; Wide-Moat Microsoft Reports Another Robust Quarter for 1Q19; Maintaining $130 FVE

Microsoft reported another phenomenal quarter, exceeding both our earnings and revenue assumptions, and we are maintaining our $130 per share fair value estimate and wide moat rating. The past few quarters, we have witnessed broad-based strength across each of Microsoft’s businesses, propelled by Azure, Office, and LinkedIn, but supported by Xbox & Gaming, Surface, and Dynamics. Microsoft’s first quarter of fiscal 2019 continued that trend. We saw each of Microsoft’s segments (productivity & business processes, intelligent cloud, and more personal computing) outperform in terms of revenue, with all three growing at double-digit rates of 19%, 24%, and 15%, respectively. Microsoft shares continue to trade in 4-star territory, and the broader sell-off before earnings makes the name attractive.

Overall, Office 365 growth remains healthy as we saw 36% growth for the quarter on the commercial side. Previous Microsoft management had stated that at the end of 2017, 50% of Office users had transitioned from on-premises office to the cloud-based Office 365, with the goal to move toward two thirds by the end of fiscal 2019.

Microsoft Azure demonstrated growth of 76% year over year, which tracks exactly in line with our 76% expected growth for fiscal 2019. We have highlighted that Microsoft’s best advantage in the public cloud market is that it is not a direct competitor to its customers (unlike Amazon). We believe Satya Nadella has positioned Microsoft as an enterprise partner, and we think Microsoft’s Azure deal with Walmart (in the summer of 2018) underscores the firm’s ability to grow in the cloud.

LinkedIn demonstrated revenue growth of 33%, but what is more important in our mind is the firm’s 34% increase in sessions engagement, which equates to record engagement and job postings.

Overall, we continue to view Azure, Office 365, and LinkedIn as the growth engines of the business and core to our thesis.

Dynamics CRM was once considered the “forgotten child” of Microsoft’s business, but we expect the launch of Dynamics 365 to propel the product’s revenue. Management is making a conscious effort to grow the business amidst a growing CRM market. In our October 2018 piece, “Salesforce One: Clear Skies for Salesforce in CRM and Beyond,” we discuss how Gartner projects enterprise CRM spending to grow from $36 billion to $79 billion. Core Dynamics grew 20% year over year and Dynamics 365 grew a whopping 51%. We expect Dynamics 365 to benefit from the same long-term uplift as Office 365, as its subscription business model allows them to extract more revenue from the same customers.

In terms of Microsoft’s core Windows franchise, the segment saw 8% year-over-year OEM pro revenue growth. We posit that as Microsoft ends support for Windows 7 in 2020, it is forcing organizations to adopt Windows 10, which possibly serves as a catalyst for PC hardware purchases. Long term, we actually model declines for Microsoft’s Windows business as the operating system has already lost share when considering other form factors such as Apple’s iOS and Google’s Android. We think Microsoft’s management team is cognizant of this shift as it has de-emphasized Windows as a strategic priority, in favor of cloud infrastructure and applications.

A highlight of the quarter was actually Microsoft’s Xbox and Gaming division, although the segment had some uneven comps due to the launch of the Xbox One X in the fall 2017. The segment shone with 57 million monthly active Xbox live users (up from 53 million in first-quarter 2018), 94% hardware growth due to the launch of the Xbox One X, 44% gaming revenue growth, and 36% in Xbox software and services year over year. While the segment was about 10% of revenue in fiscal 2018, we see optionality to outperform ahead, due to management’s efforts to reinvest in the business.

Around E3 2018, Microsoft acquired four independent game studios (Ninja Theory, Playground Games, Undead Labs, and Compulsion Games), while opening a fifth (The Initiative), and a sixth studio was rumored earlier this month (Obsidian Entertainment). The firm already owns successful studios that produce games centered on the Halo, Gears of War, and Forza franchises, but outside of that trio, we have witnessed delays (Sumo Digital’s Crackdown 3), cancellations (PlatinumGames’ new intellectual property, or IP, Scalebound), studio closures (Microsoft closed Lionhead Studio’s the parent of the Fable series), and releases with tepid critical receptions (Rare’s Sea of Thieves, a new IP, which we believe received criticism for a lack of launch content) of other first party titles the past few years. This contrasts Sony’s approach for their PlayStation 4 console, where first-party exclusive content such as God of War, Horizon Zero Dawn, and Uncharted 4 have received both critical and commercial success. Thus, we view Microsoft’s five new studios as an indication that their current strategy is not working and that management is very cognizant that first party content serves as a differentiating factor (outside of hardware specs) when consumers choose whether to purchase a Sony PlayStation 4, Nintendo Switch, or to stick with PC gaming.

Microsoft’s Xbox and Gaming unit has slowly pivoted toward supporting subscription business model and away from a model where customers purchase expensive hardware (the Xbox One is currently $299 and Xbox One X, the higher-powered console is $499) and $60 games from first and third party developers. While this transition is in the very early innings, the subscription gaming playbook remains very similar to the Office license to Office 365 transition. We have seen three overarching announcements and innovations from Microsoft over the ensuing years, with each being natural extensions of each other. First, “Xbox Game Pass,” which can be described as the “Netflix of Video Games,” allows users to pay $9.99 per month to play unlimited titles from a select library of games. Second, Xbox All Access provides the physical console, Xbox live gold (the subscription necessary to play games with friends online), and Xbox Game Pass for $21.99 per month. Thus, this allows Microsoft to penetrate consumers intimidated by the large, upfront console costs. While we believe evidence suggests the penetration of these products is low, they underscore the movement toward subscription gaming.

Lastly, Microsoft’s “Project xCloud” represents the culmination of these two initiatives, and effectively marries Xbox with Azure. Microsoft had hinted at “game streaming” in our past conversations with the company, where customers may opt to not purchase a physical hardware and purely stream a game over the Internet. In early October and with additional commentary during this quarter, we received more clarity as “Project xCloud” was announced an initiative to create a multiplatform (mobile phones, tablets) game streaming service that delivers the same quality as a console or PC device. This is important, because Microsoft is uniquely positioned in its ability to leverage its Azure platform to deploy Xbox console racks in its data centers to deploy the service, unlike its gaming hardware rivals. We have witnessed an uplift in Xbox’s gaming segment from sales of the Xbox One X and believe subscription products (Game Pass and All Access) can help smooth the seasonality inherent in the hardware business model. However, longer-term, we ultimately believe that subscription services like Game Pass are only as good as the content library. Thus, we think Microsoft’s investments in five, or possibly six, additional studios to provide quality exclusive content is prudently timed. While we do not expect investments in Project xCloud to impact Microsoft’s financials in the near-term, as it will likely be hindered by consumer Internet bandwidth issues, longer term (likely past 2020) it offers Microsoft optionality for segment growth long term.

Ultimately, we continue to believe Microsoft is supported by a number of salient trends. While the firm is seeing current revenue growth from Office, LinkedIn, and Azure, all of which we see providing durable growth ahead, its whopping $14 billion in research & development spending for fiscal 2018 has allowed it to invest in the future. The firm has announcements around investments in Azure IoT, Azure AI, and Quantum Computing for the quarter and we expect these investments to bare fruits in the ensuing years.