Long-Term Investors Should Continue To Hold Microsoft Ahead Of Thursday’s Earnings – Seeking Alpha

I have followed Microsoft closely as an investor since mid-November 2012. Since that time, an investment in Microsoft has produced a total return of approximately 210%. More than double that of the S&P 500’s 96% over the same period. With the stock at all-time highs, current investors may be asking themselves whether they should continue to hold Microsoft ahead of Thursday’s Q4 earnings or not. While I do not claim to have any insight on whether Microsoft will “miss” or “beat” consensus earnings expectations, I do believe the company’s shares remain an attractive investment for the long-term investor.

Based on my bottom-up product group estimates discussed below, I believe the company is currently priced to provide investors with an approximately 15% annual return over the next 3 years. Assuming an 8.5% discount rate, which I believe is conservative for such a high-quality company with 10-year debt yielding 2.8%, my current fair value for Microsoft’s shares is approximately $86.

Source of Historical Estimates

Microsoft is a challenging company to follow given its many different product groups, business segments, and somewhat limited and inconsistent financial disclosures. Over the past nearly 5 years, I have developed a bottom-up financial model by each of the company’s key product groups in an attempt to deal with this complexity. I derived these estimates from language within the company’s quarterly financial press releases, presentations, and 10-Qs/Ks.

For example, the company’s disclosure in its most recent 10-Q that “Office Commercial revenue increased $347 million or 7%” can be used to estimate that Office Commercial’s prior year Q3 revenue was approximately $4.95 billion ($347 million divided by 7%) and approximately $5.3 billion this year ($4.95 billion plus $347 million).

Despite the fact that these estimates aren’t perfect due to Microsoft’s rounding of reported growth rates, I do believe they’re generally “in the ballpark” and give us a solid base to work from. With these rough estimates, and using trends specific to each of these product groups, we can attempt to make more accurate long-term forecasts for each of the company’s business segments and hopefully, for the company as a whole.

Productivity And Business Processes Segment

Microsoft’s most important segment from a profitability perspective is the Productivity and Business Processes (P&BP) segment. The company’s products and services within this segment consist primarily of Office Commercial, Office Consumer, Microsoft Dynamics, and LinkedIn. Office Commercial is the most important sub-segment within P&BP. Office Commercial generates revenue primarily from software licenses or cloud subscriptions to Office, Exchange, SharePoint, Skype for Business, and related Client Access Licenses (CALs).

While the company is well on its way to transitioning Office Commercial to a subscription-based model, I believe that many investors still do not fully appreciate just how long this growth runway remains. I estimate that the company’s Office 365 Commercial business will surpass its legacy Office Commercial licensing business in revenue for the first time during FY2018.

Despite its increasingly large size, Office 365 Commercial revenue should continue to grow rapidly (it grew 45% YOY in Q3) for many years to come due to continued strong Office 365 Commercial seat growth (I expect total Office 365 Commercial seats to exceed 200 million by the end of FY2020 versus 100 million in Q3) and higher ARPUs as more customers upgrade to premium workloads.

This growth will more than offset the mid-teens declines the company has been experiencing in its legacy Office Commercial licensing business, especially as that business continues to shrink as a percent of revenue. As a result, I believe total Office Commercial products and cloud services revenue growth could accelerate into the low-teens range from the high single-digit range in the quarters to come.

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding)

A second key component of the P&BP segment is the Office Consumer sub-segment, which primarily generates revenue from retail Office software licenses and Office 365 subscriptions. Unfortunately, the company has not been as successful in transitioning its Office Consumer business to the cloud as it has been its Office Commercial business. I estimate that the company’s Office Consumer Licensing business has declined from more than $4 billion in revenue in FY2012 to approximately $1.6 billion in FY2017 while the Office 365 Consumer business has grown from nothing to approximately $1.7 billion in FY2017.

This has led the Office Consumer business to decline from more than $4 billion in revenue to approximately $3.3 billion in FY2017. The decline in gross profit dollars during this time has likely been even worse given that the cloud has lower gross margins than traditional software licenses. However, I estimate that the business should grow modestly going forward given that Office 365 Consumer revenue is now larger and gaining more revenue dollars than the legacy licensing business is losing.

If the company can re-accelerate Office 365 Consumer subscriber additions to 2-3 million per quarter, instead of the recent 1 million per quarter run rate, it’s likely that my Office 365 Consumer revenue estimates will prove too conservative.

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding)

The company’s Dynamics business is a third key sub-segment of the P&BP segment. Dynamics primarily generates revenue from on-premises software licenses and cloud subscription services to the company’s Dynamics ERP and CRM products. Dynamics revenue growth has been solid for years and has recently begun to re-accelerate as their cloud transition takes hold (Dynamics 365 revenue grew 81% YOY in Q3).

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding)

LinkedIn, which the company acquired in December 2016, is the final sub-segment of the P&BP segment. LinkedIn primarily generates revenue from sales of its Talent Solutions, Marketing Solutions, and Premium Subscriptions services. To the casual observer, it would appear that LinkedIn’s revenue growth rates are declining significantly since the acquisition.

However, this is being caused by purchase accounting rules related to Microsoft’s acquisition of the company and the requirement that the company write down LinkedIn’s deferred revenue (see this Journal of Accountancy article for a good overview of the subject). Assuming Microsoft can retain LinkedIn’s customers, this “disappearing revenue phenomenon” should begin to reverse itself in mid-FY2018 and LinkedIn’s reported revenue growth rates should revert back to the 20% level.

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding, estimates for FY2016, Q1-Q2 of FY2017, and FY2017 include stand-alone LinkedIn revenue prior to acquisition)

On the costs of goods sold (COGS) side, total P&BP COGS have increased significantly in recent years. However, a significant driver of the year-over-year increase has been associated with LinkedIn (more than half of which is non-cash amortization expense that will decline over the coming years). I believe the increase in COGS due to LinkedIn is masking improving underlying contribution margins for the company’s P&BP cloud businesses as they begin to scale the significant cloud infrastructure investments made in recent years.

The following slide from the company’s Financial Analyst Briefing in May demonstrates that the company’s Commercial Cloud business, which Office 365 Commercial represents more than 2/3rds of, has high contribution margins. These high contribution margins are driving increased gross margins as the company continues to scale its significant cloud infrastructure investments and associated fixed costs.

Using the rough numbers provided in the chart, a 50% gross margin on $14.8 billion of Commercial Cloud revenue would imply $7.4 billion of gross profit in FY2017, up approximately 72% from the $4.3 billion implied for FY2016. The $3.1 billion increase in gross profit on a $5.3 billion increase in revenue would imply Commercial Cloud contribution margins of nearly 60% in FY2017. This compares to approximately 46% contribution margins implied for the Commercial Cloud business in FY2016 versus FY2015.

The year-to-date increase in P&BP operating expenses (OPEX) in FY2017 versus FY2016 has also been significantly impacted by the company’s acquisition of LinkedIn. OPEX excluding those related to LinkedIn (which also includes significant non-cash amortization) grew only 1% in Q3. The company, under CFO Amy Hood’s watchful eye, has been extremely diligent in managing expenses in recent years. I expect this same discipline to continue going forward and the recent sales force reorganization is further evidence that it should.

Excluding operating losses related to LinkedIn (again, these loses are almost entirely caused by non-cash amortization charges related to the acquisition), I believe the company’s P&BP segment would have achieved 6% operating income growth in Q3 versus the 7% decline reported on a GAAP basis.

Moving forward, I expect growth in P&BP’s COGS and OPEX to moderate significantly as the cloud business continues to scale, expenses are managed carefully, the company laps the one-time bump in expenses related to the LinkedIn acquisition, and amortization related to LinkedIn begins to decline. The net result is that I expect total P&BP operating income to grow very significantly through FY2021.

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding, and estimates for FY2016, Q1-Q2 of FY2017, and total FY2017 include actual LinkedIn contributions and not stand-alone estimates)

Intelligent Cloud Segment

Microsoft’s second most important segment from a profitability perspective is the Intelligent Cloud (IC) segment. The company’s products and services within this segment consist primarily of the company’s public, private, and hybrid server products and services. Server products and cloud services are the most important sub-segments within the IC segment. Server products and cloud services includes SQL Server, Windows Server, Visual Studio, System Center, and related CALs, as well as Azure.

Revenue from the company’s on-premises server products has remained incredibly stable in recent years despite fears it would be cannibalized by Azure’s rapid growth. I believe this is a testament to the strength and competitive value proposition of the company’s various premium private and hybrid server offerings. I believe Server product revenue will remain relatively stable over the coming years given the high amount of annuity revenue as well as continued strong demand for the company’s premium private and hybrid server offerings.

This will be offset by continued declines in transactional revenue related to low-end server products. The company’s Azure business continues to grow rapidly and gain market share, which I expect to continue going forward, though at a moderating rate given how large the business has already become. I believe that Azure is currently growing faster than Amazon’s (NASDAQ:AMZN) AWS when it was at a similar scale.

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding)

Enterprise Services is the other sub-segment within IC and consists primarily of Premier Support Services and Microsoft Consulting Services. Enterprise Services revenue has been decreasing recently due to declines in custom support agreements for Windows 2003, which should continue to be a headwind for the next several quarters before the underlying growth in Premier Support Services and consulting begin to show through.

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding)

As previously mentioned, the company has been investing aggressively to increase its cloud infrastructure capacity to meet the growing demand and capabilities of their cloud offerings. This has caused IC’s COGS to increase rapidly in recent quarters. While I expect these investments in cloud infrastructure to continue, their rate of growth should decrease as Azure scales and is able to leverage some of its existing investments as we have seen Amazon do with AWS.

The company has also been investing aggressively in cloud sales capacity and engineering. This rate of investment should also begin to moderate somewhat over the next year as the recent sales force reorganization suggests it will.

I expect relatively stable Server product and Enterprise Services sales, combined with continued rapid growth for Azure, to lead to double-digit IC revenue growth through at least FY2021. Improving Azure gross margins, combined with its rapid revenue growth, should help grow total gross profit dollars at a relatively high rate as well. Strong gross profit dollar growth, combined with careful expense management, should drive double-digit operating income growth through at least 2021.

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding)

More Personal Computing

More Personal Computing (MPC) is Microsoft’s third business segment. This segment consists of the company’s Windows, Devices, Gaming, and Search businesses. I won’t spend too much time covering the Devices, Search, and Gaming businesses as they are not key drivers of the segment’s (or company’s) profitability. In general, I expect each of these three sub-segments to continue experiencing moderate revenue and operating income growth over the coming years.

The key driver of MPC’s profitability is the Windows business, which consists primarily of OEM licenses, volume licenses, and patent licensing. I estimate that Windows generates gross margins in excess of 90% and contributes more than 80% of MPC’s total gross profit. This is despite the fact that total Windows revenue has declined from roughly $22 billion just a few years ago to approximately $18 billion in FY2017. Windows OEM revenue has remained relatively stable over the past year or so as Windows 10 adoption has been fairly good.

I expect the Windows OEM business to continue to outperform the overall PC market over the next year or so and then perform more in-line with overall PC sales (currently declining at about 3% annually). Despite inroads made by Apple (NASDAQ:AAPL), enterprises remain committed to Windows with total volume licensing revenue increasing from approximately $3 billion in FY2012 to $4 billion in FY2017. Stable enterprise demand, in addition to increasing interest in upgrading to Windows 10, should help drive modest volume licensing growth for many years to come.

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding)

I expect growing Device, Gaming, and Search revenues to offset slightly declining sales from the Windows sub-segment. MPC gross margin have been improving recently due to the company’s decision to exit the Phone business, strong Windows results, and improving Surface, Gaming, and Search margins. MPC OPEX has been decreasing significantly due to the company’s decision to exit the money-losing Phone business, a legal settlement, and lower Windows 10 and Surface launch-related expenses from a year ago.

Going forward, I expect Search, Gaming, and Devices gross margins to increase slightly with their modest revenue growth. The growth in gross profit dollars from these three sub-segments should more than offset the slight revenue declines in the high-margin Windows business. With continued diligent expense management, combined with modest gross profit dollar growth, I believe MPC operating income can grow at a mid single-digit rate through FY2021.

(Note: These are estimates, growth rates may not match those reported by Microsoft due to rounding)

Consolidated Financials

Bringing each of the business segment estimates together, each of which were derived using what I believe (and hopefully you agree) were reasonable product group estimates, Microsoft should be able to achieve low-teens adjusted operating income growth through FY2021. It’s important to note that this adjustment (i.e. reversing the “Corporate and Other” charge) is virtually entirely related to Windows 10 revenue deferrals where the company collects the cash upfront but recognizes it as revenue over approximately 3 years.

Thus, Microsoft’s adjusted operating income is more comparable to “cash operating income” than GAAP operating income is. Unlike many technology peers, Microsoft’s adjusted operating income does not include any adjustment for stock-based compensation, which is a legitimate business expense. Assuming moderate levels of annual share repurchase, I believe the company can generate high-teens or better annual growth in EPS, Adjusted EPS, and FCF per share through at least FY2021.

Valuation

Based on these estimates, as well as Microsoft’s significant net cash and non-core equity investments, I value the company’s stock at approximately $86 per share today versus its price of roughly $73. Owning Microsoft at today’s price should provide long-term investors with a 3-year internal rate of return (IRR) of approximately 15%. While Microsoft certainly isn’t as cheap as it was in late 2012, a potential 15% 3-year IRR strikes me as very attractive for such a high-quality company in an environment where the 10-year treasury is yielding 2.25% and the company’s own 10-year bonds are yielding approximately 2.80%.

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