Microsoft Stock A Long Term Pick Post Q2 2016 Earnings Beat

  • Microsoft stock surged after the company delivered a healthy Q2 2016 earnings report that exceeded analyst estimates both on the top and bottom lines.
  • Microsoft's Commercial Cloud revenue remains on track.
  • Meanwhile Microsoft's top line contraction caused by the cloud transition has begun moderating.
  • Microsoft's cloud transition appears to be working smoothly and Microsoft stock remains a good long-term pick.

Microsoft (NASDAQ:MSFT) shares surged more than 4% in after-market trading after the company announced upbeat Q2 FY 16 results that topped analyst consensus estimates. The Redmond giant reported non-GAAP revenue of $25.7B, a -2.9% Y/Y growth (decline), but $440M higher than consensus estimates. Microsoft's non-GAAP EPS of $0.78 topped analyst projection by $0.07. On a GAAP basis, Microsoft’s revenue for the quarter clocked in at $23.8B, a -10% Y/Y growth (decline) while GAAP net income of $5B, or EPS of $0.62, was 15% lower than last year comparable quarter’s. Microsoft is in the middle of a transition to the cloud, and as such, its non-GAAP revenue which takes into account deferred cloud revenue, gives a better picture of the company’s sales. Microsoft finished the quarter with unearned revenue balance of $25B, considerably higher than Microsoft’s guidance of $19.5B-$19.7B.

Microsoft’s Commercial Cloud was sharply in focus during the earnings call, and it did not disappoint. Commercial Cloud annual revenue run rate hit $9.4B by the end of the quarter, up from $8.2B during the prior quarter and $8.0B two quarters ago. Microsoft remains solidly on track to achieve its goal of hitting $20B in Commercial Cloud revenue by 2018, and might achieve its target earlier than projected if the company’s cloud growth continues on its current trajectory.

Microsoft’s Segment Performance was as follows:

  • More Personal Computing (Windows devices including Surface, Xbox and Bing) saw revenue decline by a relatively tame 5% Y/Y to $12.7B, compared to a much bigger 17% Y/Y decline during the first quarter. The revenue figure exceeded Microsoft’s guidance of 12B-$12.7B. This segment continues to be impacted by weak global PC sales, but the effect is moderating, with predictions that the PC market might finally stabilize by late 2016 or early 2017. Surface revenue increased a healthy 29% driven by healthy sales of recently launched Surface Book and Surface Pro 4. Bing Search revenue ex-TAC grew 21% partly aided by Windows 10 growth. Microsoft announced that Windows 10 had hit 200M downloads by the end of the quarter up from 110M during the prior quarter. Xbox Live MAUs grew 30% during the quarter to reach a record 48M. Microsoft's change of strategy in its phone business continued to impact on the segment with phone revenue declining 49%. Recent job cuts by Microsoft helped the segment’s operating profit to rise 33% to $2.04B.
  • Microsoft’s Intelligent Cloud (Azure, Server Products, and Enterprise Mobility Solutions) posted an 11% growth in revenue in constant currency, and 5% as reported, to $6.3B, coming at the higher end of Microsoft’s guidance of $6.2B-$6.3B. Azure revenue grew 140% Y/Y with Azure Premium revenue up close to 300%. Investors should note that the growth clip posted by Azure during the quarter was a considerable acceleration compared to 96% growth a year ago. Although Microsoft does not usually disclose Azure revenue numbers, analysts estimate that Azure has a 10% share of the $16B cloud market compared to AWS’ 30% share. But with Azure growing much faster than AWS, the gap between the two is narrowing down. AWS revenue grew 69% to $2.4B during the last quarter, or less than half Azure's growth rate. Meanwhile, Server Products and Cloud Services revenue was up 10% in constant currency. Investors should note that the decline in revenue by the segment slowed down from 8% recorded during Q1 2016 and should continue coming down and eventually reverse. The segment’s operating profit fell 1% to $2.58B.
  • Productivity & Business Processes (Office365, Dynamic CRM and Other Dynamic Apps) recorded a 2% decline in revenue, to $6.7B (up 5% in constant currency) due to the ongoing transition from up-front Office licenses to Office 365 cloud subscriptions. Microsoft announced that Office 365 revenue was up nearly 70% in constant currency with Office 365 users increasing to 20.6M. Dynamics revenue was up 11% in constant currency. The segment’s operating profit fell 8% to $3.31B. This could be partly because of the Office 365 discounts that Microsoft has been offering, but which analysts project will moderate in the coming quarters.

Forex headwinds had a 500 basis points impact on Microsoft’s non-GAAP revenue, while the company’s gross margin fell 320 basis points from 61.7% a year ago to 58.5%, due to the cloud transition. Microsoft’s job cuts led to an 8% decline in sales and marketing expenses to $3.96B.

Microsoft did not provide any guidance with the press release, but said it would do so during its earnings conference call and webcast.

Overall, it was a pretty solid quarterly report by Microsoft, as the company exceeded all its cloud targets. As I had indicated in my Microsoft earnings preview on Amigobulls, the one metric that investors will continue watching most closely is the company’s cloud growth, especially its Commercial Cloud segment. It’s particularly encouraging to note that the negative impact that the cloud transition has been having on Microsoft’s top line is beginning to moderate and should gradually improve and eventually reverse as the quarters roll on. So far all indications are that Microsoft’s decision to give away Windows 10 for free in a bid to accelerate the move to the cloud is paying off handsomely.

Microsoft stock remains a good long-term pick.

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