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Morningstar | Microsoft Firing on All Cylinders; Azure Continues to Shine; Increasing FVE to $155

Microsoft reported results that were ahead of consensus expectations, with meaningful upside to revenue, operating margin, and normalized EPS. All three segments contributed approximately equally to revenue strength. Similar to last quarter, management struck a confident tone on the call while offering guidance that was essentially in line. 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 revenue is strong and margins continue to improve.

We are raising our fair value estimate to $155 per share, from $143, after rolling our DCF model and making a variety of minor adjustments. We believe wide-moat Microsoft is firing on all cylinders and remains a safe harbor in a sea of rich software valuations.

For the June quarter, revenue grew 12% year over year to $33.7 billion, while normalized EPS was $1.37 compared with $1.13 a year ago. Intelligent cloud was once again the highlight, with Azure growing 64% year over year (68% in constant currency), which was in line with our expectations. On-premises server units remain strong as well, bolstered by strong demand ahead of end of life support for a couple products. Management called out bigger deals as contributing meaningfully to revenue strength here. Earlier this week, the company signed its largest Azure deal ever, for $2 billion, and CEO Satya Nadella said that Microsoft “had a line of sight to many more such deals.” We estimate Azure generated $13.1 billion in revenue in fiscal 2019, and we are looking for approximately $21 billion in fiscal 2020.

In line with our thesis, operating margins continue to expand as Microsoft’s cloud-driven offerings scale. This quarter, overall gross margins expanded by 150 basis points year over year as rapidly improving commercial cloud gross margins, which were up 600 basis points compared with fiscal 2018, were offset by the ongoing mix shift to cloud, which still has gross margins below the corporate average. Similar to last quarter, a mix shift toward commercial licenses and original equipment manufacturers provided a gross margin boost as well. Operating margin expanded by 230 basis points year over year, with leverage coming mainly from lower sales and marketing outlays. We think there is more room to run over several years, as historical peaks in operating margins suggest 500 basis points of expansion is possible, with our model showing 300 basis points of improvement over the next five years.

Next quarter’s guidance for revenue of $31.7 to $32.4 billion was better than we expected but generally in line with the Street. Considering all other factors of the outlook, guidance implies a GAAP EPS range of $1.17 to $1.28, which is a few cents ahead of consensus. 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.