How Microsoft Corporation Stock Earnings Destroy the Bear Case

I admit it. I was wrong. I’ve spent most of the year arguing against Microsoft Corporation (NASDAQ:MSFT) stock, seeing the MSFT stock price as pricing in growth the company simply couldn’t drive. Microsoft Azure clearly has growth potential, and the Surface line seems poised to take market share. But the reliance on PCs and concerns about cannibalization, in my eyes, offset those positives.

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After a blowout first quarter earnings report last week, that argument seems pretty tough to make. Revenue rose 12% and margins expanded, with net income climbing 16% year-over-year. As recently as September, I remained skeptical of the claim that this “is not your father’s Microsoft anymore”. But with cloud strength growing, even this longtime bear has to admit that very well may be the case.

The Cloud and MSFT Stock

The bull case for Microsoft stock long has been based on the company’s cloud potential. And of late, the company has validated that case and then some.

Cloud computing platform Azure continues to soar, with revenue up 90% in Q1. That comes after 99% growth in fiscal 2017. That’s not a surprise. Though the level of growth, particularly against a tough comparison, is impressive.

But I’ve long argued that Azure, while a solid business, can’t necessarily be that big a part of the bull case for MSFT stock. Azure revenue (estimated by Jefferies analyst John DiFucci at a $5.4 billion run rate) is only about 6% of Microsoft’s total sales, even after the recent torrid growth. And Microsoft remains a distant second to, Inc. (NASDAQ:AMZN) in the public cloud battle, with Amazon’s cloud revenue rising a still-impressive 42% in its most recent quarter off a much larger base.

Beyond Azure, much of Microsoft’s cloud growth is coming simply from shifting existing customers, not getting new ones. For instance, Microsoft’s cited $20 billion-plus run rate from commercial cloud revenue includes Office 365. And as DiFucci pointed out in a recent note, “a large part [of Office 365] is not really a Cloud business…the Productivity Suite that everyone has is very similar, if not exactly like Office on-premise.” It’s the same product, simply delivered differently, which in theory should imply overall modest revenue growth.

The Shift Is Working

The product might be the same but the shift is growing Microsoft revenue. Office 365 commercial growth was a whopping 42% in Q1. Overall revenue, which accounts for customers shifted from license sales to cloud offerings, still grew 10%, much faster than I believed it would. It was an impressive rate in a zero- to low-growth PC sales environment.

In addition, Dynamics, a competitor to, Inc. (NYSE:CRM), is gaining traction, with cloud growth of 69% and overall growth of 13%. Overall, it’s not just Azure driving growth from cloud (or cloud-like) products, and that’s a big deal for MSFT stock. Microsoft effectively is charging higher prices for delivering similar software over the cloud as opposed to through the desktop. That seems to be driving growth in the ~75% of cloud revenue beyond Azure, the same revenue whose contribution to growth looked relatively minimal just a couple of quarters ago.

Still Concerns About the MSFT Stock Price

There’s simply a lot more opportunity for growth here than I thought. And after wavering on my bearishness back in September, the cloud strength in Q1 and Q4 eems to put to rest a lot of the concerns around MSFT stock.

That said, I do see some worries for Microsoft. The company’s second-place problem persists, with the company lagging Amazon in cloud, Salesforce in CRM, Sony Corp (ADR) (NYSE:SNE) in gaming and a host of rivals (including Apple Inc. (NASDAQ:AAPL)) in hardware. There’s still a heavy reliance on PCs in the overall product portfolio, though Office growth of late mitigates that problem.

And MSFT stock isn’t looking nearly as cheap as it used to. The current valuation suggests a P/E of about 22x FY18 EPS estimates, even backing out roughly $7 per share in net cash and investments. That’s a multiple that incorporates quite a bit of growth going forward for some time.

Of course, Microsoft is showing that kind of growth, and a 2%+ dividend yield sweetens the bull case. If the recent strength in cloud (and not just Azure) continues, there may be even more upside. At the least, Microsoft has proven its ability to adapt to the new tech environment. That seems to make it very unwise to keep betting against MSFT stock.

As of this writing, Vince Martin has no positions in any securities mentioned.

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