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Microsoft (MSFT) Up 1.2% Since Last Earnings Report: Can It Continue?

Zacks Equity Research

A month has gone by since the last earnings report for Microsoft (MSFT). Shares have added about 1.2% in that time frame, underperforming the S&P 500.

Will the recent positive trend continue leading up to its next earnings release, or is Microsoft due for a pullback? Before we dive into how investors and analysts have reacted as of late, let's take a quick look at the most recent earnings report in order to get a better handle on the important drivers.

Microsoft Q3 Earnings Beat Estimates, Azure Strength Drives Top Line

Microsoft reported third-quarter fiscal 2020 non-GAAP earnings of $1.40 per share, which beat the Zacks Consensus Estimate by 10.2%. The figure also surged 23% on a year-over-year basis (up 27% at constant currency or cc).

Revenues of $35.02 billion improved 15% from the year-ago quarter (up 16% at cc). Further, the figure surpassed the Zacks Consensus Estimate by 3.4%.

Robust execution and better-than-expected demand from customers for commercial cloud offerings drove the quarterly results. Solid uptick in Teams on the back of coronavirus-led work-from-home, stay-at-home, telehealth and online learning wave, remained noteworthy.

Moreover, strong Commercial business positively impacted earnings and revenues. Commercial bookings increased 7% (12% at cc), courtesy of robust renewal implementation. Commercial remaining performance obligation came in at $89 billion, up 24% year over year at cc. Commercial revenue annuity mix was 92%, increasing 2% year over year.

Commercial cloud revenues were $13.3 billion, surging 39% year over year (40% at cc).

Segmental Details

Productivity & Business Processes segment, which includes the Office and Dynamics CRM businesses, contributed 33.5% to total revenues. Revenues increased 15% (up 16% at cc) on a year-over-year basis to $11.74 billion.

Office Commercial business (products + Microsoft 365 & related cloud services) revenues were up 13% from the year-ago level (up 15% at cc). Office 365 commercial revenues climbed 25% (27% at cc), driven by strong installed base growth and average revenues per user (ARPU) expansion. Office 365 Commercial seats improved 20% to nearly 258 million, driven by improving mix from Microsoft 365.

Office Consumer products and cloud services revenues increased 15% (up 17% at cc), driven by growth in Office 365 subscription revenue and Office 2019. Office 365 Consumer subscribers came in at 39.6 million, up from 37.2 million reported in the prior quarter, benefiting from the coronavirus crisis-led increased demand courtesy of work-from-home wave.

Dynamics business improved 17% (up 20% at cc). Dynamics 365 revenues surged 47% (49% at cc). Dynamics adoption is improving with companies like C3.ai, Patagonia and American Express, selecting the application to securely digitize critical business processes.

LinkedIn revenues advanced 21% from the year-ago quarter (up 22% at cc) to $2.05 billion. LinkedIn sessions were up reflecting acceleration in engagement. However, slowdown in advertising limited growth.

Microsoft is gaining from expanding user base of different applications like Microsoft 365 and Teams. Both solutions continue to witness record adoption. Notably, Microsoft Teams boasts of more than 75 million daily active users, up from 20 million daily active users reported in the prior quarter. The uptick can be attributed to coronavirus-led work-from-home, stay-at-home, telehealth and online learning wave.

Windows 10 has more than 1 billion monthly active devices, up 30% on a year-over-year basis, with significant demand for Windows 10 PCs.

Intelligent Cloud segment, which includes server, and enterprise products and services, contributed 35.1% to total revenues. The segment reported revenues of $12.28 billion, up 27% (up 29% at cc) year over year.

Server product and cloud services revenues rallied 30% year over year (up 32% at cc) to $10.49 billion. The high point was Azure's revenues, which surged 59% year over year (up 61% at cc), driven by robust growth in consumption-based business.

On-premise server products revenues increased 11% (up 12% at cc), driven by customer demand for hybrid solutions, and premium server versions. Further, robust demand from end of support for Windows server 2008 was a positive.

Further, enterprise mobility installed base revenues improved 34% to more than 134 million seats, driven by continued benefit from Microsoft 365.

Moreover, enterprise service revenues increased 6% (up 7% at cc) in the reported quarter, on account of growth in Premier Support Services. However, delays in consulting limited growth.

More Personal Computing segment, which primarily comprises Windows, Gaming, Devices and Search businesses, contributed 31.4% to total revenues. Revenues were up 3% (up 4% at cc) year over year to almost $11 billion.

Windows revenues increased 5.6% to $5.22billion backed by growth in Windows Commercial. Windows commercial products and cloud services revenues increased 17% year over year (up 18% at cc), on the back of higher customer adoption of Microsoft 365 offerings and robust improvement in advanced security solutions.

Windows OEM pro revenues improved 5% on a year-over-year basis, primarily due to better-than-expected Windows 10 demand. Increase in demand from remote work and online learning wave also contributed to the upside. However, supply chain constraints in China limited growth.

Windows OEM non-Pro revenues decreased 10% year over year, primarily owing to coronavirus crisis-led supply chain constraints in China.

Search advertising revenues, excluding traffic acquisition costs (TAC), grew 1% (up 1% at cc) to $1.99 billion. Reduced spend on advertising from the industries highly impacted by coronavirus-induced economic crisis limited growth.

Surface revenues improved 1% from the year-ago quarter to $1.34 billion, driven by remote work and online learning-led demand increase. However, supply chain constraints in China limited growth.

Gaming revenue decreased 1% to $2.35 billion. Xbox hardware revenue declined 20%, owing to a decrease in price of consoles sold. Xbox content and services revenue increased 2%(up2% at cc) year over year. The increase was driven by increased engagement led by stay-at-home wave.

Operating Results

Non-GAAP gross margin of 69% expanded 200 basis points (bps) on a year over year, driven by higher commercial cloud margins and favorable sales mix.

Productivity & Business Process gross margin increased 1 point year over year primarily due to improvements in LinkedIn and Office 365 margin expansion, which more than offset unfavorable cloud mix.

Moreover, Intelligent Cloud segment gross margin was up 2 points year over year, attributable to material improvement in Azure gross margin which was more than offset by growing mix of Azure IaaS and PaaS revenue.

More Personal Computing gross margin increased 2 points year over year on account of favorable sales of higher-margined products.

Commercial cloud gross margin was 67%, up 4 percentage points year over year, due to improvement in Azure gross margin and gains from coronavirus-induced supply chain constraints.

Operating expenses of $11.1 billion were up 10% from the year-ago quarter (up 9% at cc) on the back of higher investments in cloud and AI engineering, and LinkedIn. Notably, reduced spend on travel and marketing in March led to lower expenses.

Operating margin expanded 320 bps on a year-over-year basis to 37%.

Productivity & Business Process operating income grew 20% (up 23% at cc) to $4.79 billion. Intelligent Cloud operating income surged 42% (up 46% at cc) to $4.56 billion. More Personal Computing operating income rallied 15% (up 17% at cc) to $3.63 billion.

Cash Flow

Operating cash flow during the reported quarter came in at $17.5 billion compared with $10.7 billion reported in the previous quarter. Free cash flow during the quarter came in at $13.7 billion, compared with $7.1 billion reported in the prior quarter.

In the reported quarter, the company returned $9.87 billion to shareholders in the form of share repurchases and dividends.

Guidance

For fourth-quarter fiscal 2020, Productivity and Business Processes revenues are anticipated between $11.65 billion and $11.95 billion, backed by low-double-digit growth in Dynamics, low-single-digit revenue growth in Office consumer and mid-single-digit revenue growth in LinkedIn. Weak job market and lower spend on advertising are likely to weigh on LinkedIn and Search revenues.

Intelligent Cloud revenues are anticipated between $12.9 billion and $13.15 billion. Azure's revenue growth is likely to reflect continued strength in the consumption-based services. However, delays in consulting business and increasing size of the installed base are anticipated to limit growth.

More Personal Computing revenues are expected between $11.3 billion and $11.7 billion. The company expects OEM revenues to improve in “low to mid-single digits.” Windows commercial products and cloud services revenues are expected to grow “mid-single digit” amid weakness in transactional business. Surface revenues are anticipated to increase in the “low-teens” year over year on strong demand. Search advertising revenues, excluding TAC are anticipated to decline “in the mid 20% range.”

Gaming revenues are anticipated to be up in the high-teens year over year on momentum in user engagement.

Management expects COGS between $11.55 billion and $11.75 billion, and operating expenses in the range of $11.8 billion to $11.9 billion.

How Have Estimates Been Moving Since Then?

In the past month, investors have witnessed an upward trend in fresh estimates.

VGM Scores

At this time, Microsoft has an average Growth Score of C, however its Momentum Score is doing a bit better with a B. Charting a somewhat similar path, the stock was allocated a grade of C on the value side, putting it in the middle 20% for this investment strategy.

Overall, the stock has an aggregate VGM Score of B. If you aren't focused on one strategy, this score is the one you should be interested in.

Outlook

Estimates have been broadly trending upward for the stock, and the magnitude of these revisions looks promising. It comes with little surprise Microsoft has a Zacks Rank #2 (Buy). We expect an above average return from the stock in the next few months.



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