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  1. Home
  2. / Investing
  3. / Stocks

Microsoft Valuation Moves Well Beyond $1 Trillion on Strong Earnings

MSFT's results are justifying its massive market cap.
By KEVIN CURRAN Jul 19, 2019 | 08:56 AM EDT
Stocks quotes in this article: MSFT, T, HPE, IBM, GOOGL, AMZN, SNE

Microsoft stock (MSFT) is soaring to record heights after stating a strong case that its lofty valuation is justified following its fiscal fourth quarter earnings release Thursday night.

Microsoft said adjusted non-GAAP earnings for the three months ending in June rose 21.2% from the same period last year to $1.37 per share, blowing away the Wall Street consensus forecast of $1.21 per share. Meanwhile, revenues rose 12% to $33.717 billion, beating estimates by about $1 billion.

The acceleration well beyond expectations took shares about 3% higher in pre-market hours, implying an open that would represent an all-time high for the company and would add billions to its already massive market cap.

"It was a record fiscal year for Microsoft, a result of our deep partnerships with leading companies in every industry. Every day we work alongside our customers to help them build their own digital capability -- innovating with them, creating new businesses with them, and earning their trust," CEO Satya Nadella said in the release. "This commitment to our customers' success is resulting in larger, multi-year commercial cloud agreements and growing momentum across every layer of our technology stack."

He added that the record acceleration in businesses is only giving way to more growth ahead.

Investors and analysts were very encouraged by the results that confirm the excellent execution under Nadella and justifies its status as the most valuable company in the world.

"We think Microsoft's quarter justified its incredible year-to-date outperformance, as this company continues to fire on all cylinders with beats across every reporting segment and the better-than-expected quarterly guide," Jim Cramer's Action Alerts PLUS portfolio team, which holds Microsoft as one of its biggest weightings, said. "That's how you deliver amid lofty expectations...the stock of this $1 trillion company never seems to ever come in."

Soaring Through the Cloud

Maybe most prominent in terms of outperformance for the quarter was the strength of the company's cloud business.

"Our Commercial Cloud business is the largest in the world, surpassing $38 billion in revenue for the year, with gross margin expanding to 63%," Nadella told investors. "I'm proud of what we have accomplished over the last 12 months, and I'm energized by the tremendous opportunity ahead."

The cloud business that has remained a key growth factor for the company among analysts was particularly strong, positioning it well to compete with Amazon (AMZN) , Alphabet (GOOGL) , HPE (HPE) , IBM (IBM) , and others.

Revenues from the cloud division rose 21% on a constant currency basis to $11.4 billion, even as the growth rate of Azure "slowed" to 64%.

Even for slowing Azure growth due to a larger revenue base and strong saturation, analysts were very encouraged by the results and see room to run ahead.

"We note record multi-million dollar Commercial Cloud wins including massive strategic commitments from the likes of AT&T (T) and 'line of sight' to many more," Credit Suisse analyst Brad Zelnick said on Friday morning. "We still remain in the early days of public cloud adoption, in our view, and expect MSFT will continue to benefit from its hybrid strength and longstanding enterprise relationships."

BMO Capital Markets analyst Keith Bachman added that the growth rate for Azure even at a tempered pace far surpasses the quarterly revenue growth from AWS.

"Without a doubt, Azure remains the dominant hybrid cloud ecosystem and we continue to believe that it will gain market share as businesses around the world increasingly shift toward cloud computing, with a clear preference for a hybrid-cloud environment, the best of which is Azure," the Action Alerts PLUS team concluded.

The other key cloud play for the company in Office 365 remains strong as well, generating stronger than expected revenue per user.

The segment grew 23% year over year which, while slower sequentially, saw expansion in average revenue per user (ARPU).

Looking into its 2020 fiscal year, Microsoft said it sees overall cloud segment generating between $10.3 billion and $10.5 billion for the three months ending in September, and double-digit operating income growth.

Free Cash Flow

Analysts were eager not to obscure the other positives in the print with the cloud growth however, namely in terms of the company's cash generation.

"MSFT had upside across the board, including revenues and margins. However, what may be overshadowed was very strong FCF performance," BMO's Bachman noted. "Given ongoing double-digit revenue growth, with the potential to grow margins y/y in FY20, we continue to like the stock."

On the back of this trend, he raised his price target to $160 from $153 and retained his "Outperform" rating.

"Cash flow from operations increased 41% year-over-year driven by strong cloud billings and collections and roughly 8 points of benefit from tax payments made in the prior year," company CFO Amy Hood said, highlighting the raw data. "Free cash flow was $12 billion and increased 62% year-over-year, reflecting strong operating cash flows and the timing of cash payments for PP&E."

Gaming is About the Only Thing Not to Gain

Amidst the stellar results, there was only one significant sore spot, that being in the OEM business tied specifically to gaming.

Gaming revenue declined 8% in the fiscal fourth quarter, exacerbated by a lack of a console upgrade that promoted a nearly 50% drop in hardware revenues, as hardware revenues fell 47%. The decline in hardware sales outweighed increases in Xbox Live subscriptions.

"Gaming revenues missed our forecast and was guided below our model driven by weaker hardware sales and plateauing engagement on Fortnite," Morgan Stanley analyst Keith Weiss noted, highlighting the tough comps ahead for Fortnite engagement as well.

Still, the expected release of Xbox 2 later this calendar year may encourage some optimism, though tough competition from Sony's (SNE) PlayStation 5 might make this an uncertain expectation.

"We expect revenue to decline year over year at a similar rate to Q4 as we move through the end of this console generation and a challenging Xbox software and services comparable from a third-party title in the prior year," Hood conceded. "Double-digit growth in Xbox Software and Services will be offset by declining console sales."

Still, these hiccups do not obscure the overall story in gaming growth and should not distract from the key areas of more significant growth.

"We believe a better long-term view is on the number of subscribers (which grew in the quarter) and Xbox Live monthly active users, which increased 14% to 65 million," Jim Cramer's team commented. "While hardware sales may be episodic and the company is moving through the end of this console generation cycle, engagement remains strong."

Bottom Line

Overall, the team was very encouraged by its decision to hold the stock over the past two years, and remains confident in its decision to keep the weighting in the portfolio.

However, with the valuation at eye-popping levels, they suggested it might not be time to chase.

"A not-so-cheap anymore valuation and an impressive multiyear run keeps our rating at a TWO for now as we seek a pullback opportunity to upgrade this back to a ONE," they concluded.

(Microsoft, Alphabet and Amazon are holdings in Jim Cramer's Action Alerts PLUS member club. Want to be alerted before Jim Cramer buys or sells MSFT, GOOGL or AMZN? Learn more now.)

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TAGS: Earnings | Investing | Stocks | Software & Services | Technology | Technology Hardware & Equipment | Gaming | Analyst Actions | Bill Gates | Stock of the Day

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