Why Is Microsoft (MSFT) Down 8.5% Since Last Earnings Report?

A month has gone by since the last earnings report for Microsoft (MSFT). Shares have lost about 8.5% in that time frame, outperforming the S&P 500.

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

Microsoft Q2 Earnings Beat Estimates, Azure Strength Drives Top Line

Microsoft reported second-quarter fiscal 2020 non-GAAP earnings of $1.51 per share, which beat the Zacks Consensus Estimate by 14.4%. The figure also surged 37% on a year-over-year basis (up 41% at constant currency or cc).

Revenues of $36.096 billion improved 14% from the year-ago quarter (up 15% at cc). Further, the figure surpassed the Zacks Consensus Estimate of $35.711 billion.

Robust execution and better-than-expected demand from customers for commercial cloud offerings drove the quarterly results.

Moreover, strong Commercial business positively impacted earnings and revenues. Commercial bookings surged 31% (30% at cc), courtesy of robust renewal implementation and increase in the Azure contracts. Commercial remaining performance obligation came in at $90 billion, up 30% year over year at cc. Commercial revenue annuity mix was 89%, flat year over year.

Commercial cloud revenues were $12.5 billion, surging 39% year over year (41% at cc).

Segmental Details

Productivity & Business Processes, which includes the Office and Dynamics CRM businesses, contributed 32% to total revenues. Revenues increased 17% (up 19% at cc) on a year-over-year basis to $11.83 billion.

Office Commercial business (products + Office 365 & related cloud services) revenues were up 16% from the year-ago level (up 18% at cc). Office 365 commercial revenues climbed 27% (30% at cc), driven by strong installed base growth and average revenues per user (ARPU) expansion. Office 365 Commercial seat improved 21% on a year-over-year basis.

Office Consumer products and cloud services revenues increased 19% (up 20% at cc). Office 365 Consumer subscribers came in at 37.2 million, up from 35.6 million reported in the prior quarter.

Dynamics business improved 12% (up 15% at cc). Dynamics 365 revenues surged 42% (45% at cc). Dynamics adoption is improving with companies like AEP Energy and Canada Goose, selecting the application to digitize critical business processes.

LinkedIn revenues advanced 24% from the year-ago quarter (up 26% at cc). LinkedIn sessions were up 25%, reflecting acceleration in engagement.

Microsoft is benefiting from expanding user base of different applications like Microsoft 365 and Teams. Both solutions continue to witness strong adoption. Notably, Microsoft Teams boasts of more than 20 million daily active users.

Intelligent Cloud segment, which includes server, and enterprise products and services, contributed 32.2% to total revenues. The segment reported revenues of $11.87 billion, up 27% (up 28% at cc) year over year.

Server product and cloud services revenues rallied 30% year over year (up 32% at cc). The high point was Azure's revenues, which surged 62% year over year (up 64% at cc).

On-premise server products revenues increased 10% (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 35% to more than 127 million seats.

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

More Personal Computing segment, which primarily comprises Windows, Gaming, Devices and Search businesses, contributed 35.8% to total revenues. Revenues were up 2% (up 3% at cc) year over year to $13.21 billion.

Windows OEM pro revenues, contributing 40% to total Windows revenues, improved 26% on a year-over-year basis, primarily due to better-than-expected Windows 10 demand and growth in Windows 7 end of support. Moreover, inventory levels ended the reported quarter in the normal range.

Windows OEM non-Pro revenues, contributing 20% to total Windows revenues, increased 4% year over year, primarily owing to favorable timing of license purchases from the company’s OEM partner.

Windows commercial products and cloud services revenues, contributing 30% to total Windows revenues, increased 25% year over year (up 27% at cc), on the back of higher customer adoption of Microsoft 365 offerings that led to higher mix of revenue recognition in the reported quarter.

Gaming revenues declined 21% (20% at cc), due to lower sales volume from console.

Xbox content and services revenues declined 11% (down 9% at cc) year over year.

Surface revenues increased 6% (up 8% at cc) from the year-ago quarter.

Search advertising revenues, excluding traffic acquisition costs (TAC), grew 6% (up 7% at cc).
 
Operating Results

Non-GAAP gross margin of 67% expanded 500 basis points (bps) on a year over year, driven by higher commercial cloud margins and favorable sales mix.

Productivity & Business Process gross margin increased 2 points 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 1 point year over year, attributable to favorable mix of Azure IaaS and PaaS revenue offset by material improvement in Azure gross margin.

More Personal Computing gross margin increased 7 points year over year on account of favorable sales of higher-margined products.

Commercial cloud gross margin was 67%, up 5 percentage points year over year, due to improvement in Azure gross margin.

Operating expenses of $10.7 billion were up 9% from the year-ago quarter (up 9% at cc) on the back of higher investments in cloud and AI engineering, and LinkedIn.

Operating margin expanded 600 bps on a year-over-year basis to 37.6%.

Productivity & Business Process operating income grew 29% (up 33% at cc) to $5.2 billion. Intelligent Cloud operating income surged 38% (up 42% at cc) to $4.5 billion. More Personal Computing operating income rallied 41% (up 45% at cc) to $4.2 billion.

Balance Sheet & Free Cash Flow

Microsoft ended with cash and short-term investments balance of $134.25 billion, down from $136.6 billion from the previous quarter. Long-term debt (including current portion) came in at $69.6 billion compared with $69.5 billion from the previous quarter.

Operating cash flow during the reported quarter came in at $10.7 billion compared with $13.8 billion reported in the previous quarter. Free cash flow during the quarter came in at $7.1 billion, down from $10.4 billion reported in the prior quarter.

In the reported quarter, the company returned $8.5 billion to shareholders in the form of share repurchases and dividends.

Guidance

For third-quarter fiscal 2020, Productivity and Business Processes revenues are anticipated between $11.5 billion and $11.7 billion, driven by double-digit growth in Dynamics, Office commercial and LinkedIn.

Intelligent Cloud revenues are anticipated between $11.85 billion and $12.05 billion. Azure's revenue growth is likely to reflect continued strength in the consumption and per-user based services.

More Personal Computing revenues are expected between $10.75 billion and $11.15 billion. Management noted that the wider guidance for the segment takes into account the uncertainty pertaining to coronavirus crisis in China. The company expects OEM revenues to grow sequentially backed by robust commercial demand for Windows 10. Surface revenues are anticipated to improve slightly year over year. Search advertising revenues, excluding TAC is expected to be in line on a sequential basis.

Gaming revenues are anticipated to be down year over year on declining console sales.

Management expects COGS between $11.05 billion and $11.25 billion, and operating expenses between $11.2 billion and $11.3 billion.

For fiscal 2020, management now expects operating expenses to increase 10-11% on a year-over-year basis, compared with prior guided range of 11-12%.

How Have Estimates Been Moving Since Then?

In the past month, investors have witnessed an upward trend in estimates review. The consensus estimate has shifted 7.07% due to these changes.

VGM Scores

At this time, Microsoft has an average Growth Score of C, however its Momentum Score is doing a lot better with an A. However, the stock was allocated a grade of D on the value side, putting it in the bottom 40% for this investment strategy.

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

Outlook

Estimates have been trending upward for the stock, and the magnitude of these revisions looks promising. It comes with little surprise Microsoft has a Zacks Rank #1 (Strong Buy). We expect an above average return from the stock in the next few months.

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