Microsoft Q1 2016 Earnings Preview

  • Microsoft Q1 2016 earnings are scheduled for release on Oct. 22 after market close.
  • The company is expected to report somewhat muted top and bottom lines as it continues to transition to the cloud.
  • The company has however lined up a flurry of new products to be launched over the next 12 months which will drive growth for the company in the not-so-distant future.
  • Microsoft shares are cheap while the company remains cash-rich which will give the shares strong upside potential.

Software giant Microsoft (NASDAQ:MSFT) is scheduled to report Q1 FY 16 earnings on Oct. 22 after market close. During its last earnings call, Microsoft guided to revenue of $20.7 billion-$21.3 billion and EPS of $0.58 for the quarter, both of which are roughly in line with analyst consensus estimates. FX headwinds are expected to continue wreaking havoc on Microsoft’s growth. The company said that it expects revenue from its Commercial segment, the company’s largest revenue segment accounting for 44% of overall revenue, to come in at $9.1 billion-$9.2 billion, roughly flat Y/Y. Without the negative currency effects, Microsoft said that revenue from the segment would grow 7% Y/Y.

Microsoft has managed to beat consensus earnings estimates for the last four consecutive quarters.

Microsoft Earnings Surprise History

Fiscal
Quarter End
Date
Reported
Earnings
Per Share
Consensus
EPS* Forecast
%
Surprise
Jun2015 07/21/2015 0.62 0.56 10.71
Mar2015 04/23/2015 0.62 0.51 21.57
Dec2014 01/26/2015 0.77 0.7 10
Sep2014 10/23/2014 0.54 0.49 10.2

Source: NASDAQ

Cloud Transition a Short Term Headwind: Lessons from Adobe

Microsoft stock price performance has been anemic lately due to the company’s shrinking revenue and profits. MSFT shares are up a mere 1.4% YTD after languishing in the red for much of the year.

MSFT stock chart

Source: Microsoft stock price data by amigobulls.com

Microsoft’s woes are being orchestrated by, ironically, the very reason by which the company has managed to re-invent itself--the cloud. Microsoft reported a 5% drop in revenue to $22.2 billion during the last quarter and a worrying EPS of -$0.40. Part of Microsoft’s massive loss during the quarter was due to the company’s $7.6 billion write down of its Nokia purchase. But earnings for the whole year were not pretty either--net income was down 43.7% in fiscal 2015 compared to the previous year.

Microsoft’s shrinking revenue and income are as a direct result of the company’s transition to the cloud. Investors can easily draw parallels between Microsoft and Adobe Systems (NASDAQ:ADBE). Adobe recently became the first old-line software company to successfully complete a transition to the cloud. Adobe began shifting from a company that sells perpetual software licenses to one that charges monthly subscription fees for its cloud products in 2011. Its net income shrunk from $833 million in 2011 to $268 million in 2014. During 2015, however, Adobe’s net income started growing in triple digits as the company started harvesting the benefits of its much larger customer base.

Adobe was able to complete the move to the cloud much quicker than companies such as Microsoft and Oracle (NYSE:ORCL) because the company has a much leaner revenue structure with much fewer products in its portfolio. Microsoft is a very large company with about 20 times Adobe’s revenue base. Its diverse products and revenue segments as well as its sheer size dictates that it will take longer to complete the move into the cloud.

Microsoft already has numerous cloud products including Office 365, Azure, Dynamics CRM, and others in the cloud. Microsoft offers Windows 10 mostly for free, but will offer future upgrades for the OS only through the cloud. And, there is a strong possibility that the company will in future charge for Windows 10 upgrades.

Future looks promising for Microsoft

But, Microsoft investors might not have to wait for years before they can start reaping the benefits of Microsoft’s cloud transition. Although Microsoft’s earnings are expected to grow a mere 2.87% during the current fiscal year, the average net income CAGR over the next five years is expected to clock in at 8.02%.

Microsoft is due to launch a flurry of new products over the next 12-month period that will drive growth for the company. These include Office 2016, Windows Server/SQL, Win10 enterprise, Halo 5, Office 365 E5 bundle, Surface 4 and other products. Coupled with Azure’s triple-digit growth, it won’t be long before the company starts growing its top line again.

Takeaway

Microsoft’s transition to the cloud is coming at a cost as the company’s shrinking top and bottom lines aptly demonstrate. But Microsoft’s cheap valuations will limit the downside potential. As Microsoft continues moving to the cloud, its free cash flow will increasingly become the center of focus for investors as is usually the case with cloud companies. Microsoft’s current enterprise value/free cash flow multiple of 12 is very cheap compared to cloud companies. As long as the company keeps throwing off so much cash, the shares will at some point have to break out.

MSFT-120

Source: NASDAQ

Microsoft stock has a consensus of Strong Buy on the street and this appears well-deserved.

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