Microsoft Corporation (NASDAQ:MSFT) is in a very sweet spot at the moment. Even though the software cloud giant has no play in the smartphone market, it still found success in the sector. The company kicked off its fiscal first quarter with glowing results. Investors may only expect more positive developments ahead.
Microsoft reported revenue growing 12% Y/Y to $24.5 billion, led by the Productivity and Business Processes unit. The net income of $6.6 billion is a 16% improvement over last year. Cloud revenue is so big that Microsoft is now breaking down the quarterly revenues. On its earnings presentation, the company saw commercial cloud revenue soar to $5 billion, up from $3.2 billion last year. The sales far-exceed that of the last three quarters.
Investors should note that the pace of growth for bookings may slow. The uptick is due to expirations but in Q2, a drop of roughly 20% in expiration dollar volume will have an impact on Microsoft’s commercial bookings growth. It forecast a 7% sequential drop in unearned revenue for Q2. Despite the seasonal weakness, the company will keep up its historical gross margins rates.
Microsoft is disciplined. Instead of chasing Amazon.com, Inc. (NASDAQ:AMZN) by slashing prices to gain market share, it will cut costs or add value for customers. The cloud unit is still a small part of revenue and Microsoft is more than happy to grow its unearned revenue. All the while, it will sustain high commercial cloud gross margins — it was 57% in Q1, up from 49% last year.
Azure, Office 365 and Dynamics 365 gave gross margin the strong lift. Customer adoption of these products, along with customer acquisitions, will only ensure Microsoft reaches an annualized $20 billion in revenue as a baseline.
MSFT’s Solid Financial Performance
Microsoft’s quarterly results should impress value investors. The company returned $4.8 billion to its shareholders, through $3.2 billion in dividends and $1.7 billion in share buybacks. Free-cash flow grew 10% Y/Y to $10.3 billion. It would have been up 27% had unsettled cash equivalent positions of $1.3 billion been excluded.
Microsoft’s exit from the phone business actually took away the working capital commitments in the phone hardware. Together with strong billings and customers paying on time, investors should expect FCF going up for the rest of the year (excluding seasonality).
MSFT Makes Up For Lost Phone Market
Without the hardware component in smartphones, Microsoft is hardly doomed. Office 365 revenue increased 10%, while commercial revenue grew 42%. The productivity suite’s reach does not stop at the PC desktop at the office or home. Users may download Word, Excel, and PowerPoint apps to edit their documents stored in the Office 365 cloud. If they want more features, file management, and editing capabilities, users must pay for a monthly subscription.
The Office 365 and Dynamics reaches extends further. Microsoft has a potential customer base of LinkedIn users. In fact, it forecasts revenue of $1.2 billion from LinkedIn, helped by a strong sales team.
The refresh in the Surface line-up will validate Microsoft’s strategic decision to exit the phone business and to focus on computing. In Q2, Microsoft expects revenue ticking up slightly. A transition to a new Surface Pro, Surface Laptop, and Surface Book 2 will all add meaningfully to the revenue line for this hardware. Without the phone business dragging the Devices unit, the company will report double-digit year-over-year revenue growth.
Bottom Line on MSFT
As a leaner, focused software company with only a few profitable hardware businesses (Xbox and Surface), the discount on MSFT stock shrinks. It trades at a forward P/E of under 22 times. With cloud revenue growing quickly, the stock deserves a higher multiple.
Disclosure: Author holds no shares in the companies mentioned. Follow Chris on Twitter.
