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Morningstar | Microsoft Delivers Strong F3Q Results; Increasing FVE to $143

Microsoft reported results that were ahead of our consensus expectations, with solid revenue upside driving better margins. A slightly lower tax rate helped drive material earnings per share, or EPS, upside. Management offered a bullish stance on the call, repeatedly saying that various metrics were ahead of plan. Overall, results continue to reinforce our thesis, centering on customer adoption of hybrid cloud environments with Azure. Microsoft continues to use its dominant position of on-premises architecture to allow customers to move to the cloud easily and at their own pace, which we believe will continue. Adoption of cloud services in the form of SaaS, PaaS, and IaaS remains robust for Microsoft, and the company has passed inflection points where cloud revenues are strong and margins continue to improve. We maintain our wide moat rating and are raising our fair value estimate to $143 per share, from $125, after upward adjustments to our revenue growth and margin assumptions. The shares have had a strong run year to date and are incrementally more cautious on near-term valuation.

For the fiscal third quarter, revenue grew 14% year over year to $30.6 billion, while EPS was $1.14 compared with a $0.95 a year ago. Intelligent Cloud and More Personal Computing were ahead, while Productivity and Business Processes was slightly light.  Revenue growth in the intelligent cloud segment, which contains Azure, accelerated year over year for the tenth consecutive quarter, which is good, but given the law of large numbers and a difficult comparison, we expect this to end in the June quarter.  Still, on-premises server results were strong in the face of 73% growth of Azure growth. The chipset shortage noted last quarter eased, allowing Windows to come in ahead of expectations

In line with our thesis, operating margins continue to expand as Microsoft’s cloud-driven offerings scale. This quarter, overall gross margins expanded by 130 basis points year over year as rapidly improving commercial cloud gross margins, which were up 500 basis points compared with 2018, were offset by the ongoing mix shift to cloud, which still has gross margins below the corporate average. A passing uptick in on-premises server licences helped drive a better mix shift, as did better Windows, higher transactional sales in Japan, and lower Xbox hardware revenue. Operating margin expanded by 290 basis points year over year, with leverage coming mainly from lower sales and marketing, and general and administrative outlays. We think there is more room to run over several years, as historical peaks in gross and operating margins suggest 1,000 and 700 basis points, respectively, of expansion is possible over the next few years, according to our model.

Next quarter’s guidance for revenue of $32.2 to $32.9 billion fell just slightly shy of our own, and street, expectations. Considering all other elements, guidance implies an EPS range of $1.15 to $1.23, which is effectively in line. We view guidance as supportive of our thesis regarding the ongoing shift to the cloud driven by Azure, Dynamics 365, LinkedIn, and Office 365, which should continue to play out for years to come, rather than in any one quarter.