What’s the world’s highest quality structural growth stock?

Chief Investment Officer and founder of Aitken Investment Management
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Microsoft reported an incredibly solid set of numbers to close out their 4Q19/FY19, with revenue and earnings beats relative to consensus and their guidance from top to bottom line. Some of the revenue strength (and related margin upside) was due to a pull-forward of demand related to tariff concerns but the bulk of the upside was from enterprise contracts where businesses opted for higher priced plans (particularly Office 365), or extended both the terms and scope of existing engagements to incorporate more Microsoft solutions into their internal business digitization plan.

Particularly noteworthy is the ongoing margin expansion as Azure (cloud) scales, with CFO Amy Hood referring (yet again) to ‘significant improvement in Azure gross margin’ driving Commercial Cloud gross margins 600bps higher. Another positive is the extremely strong pipeline of business already secured: contracted revenue (but not yet recognised in the income statement) was $91bn – up 25% from June 2018. Given that clients are signing longer-term contracts, only about 50% of that will be recognised in the next year.

Revenue growth of ~12% was driven mostly by strong momentum in Intelligent Cloud (+18.6%) and Productivity and Business services (+14.3%), whilst More Personal Computing (+4.3%) came in ahead of expectations.

A strong US dollar reduced the top-line by ~2% (and closer to 3% from a diluted headline EPS growth perspective.) Gross and operating margins expanded at a corporate level. Intelligent Cloud operating margins contracted, but this is driven by a mix shift to the currently lower-margin Azure segment; as it grows, the margins will expand, meaning the long-term outlook remains attractive.

More Personal Computing (the name of their personal computing revenue segment) outperformed consensus as channel partners opted to stock up on inventory in the event of an adverse outcome in the US/China trade negotiations (i.e. distribution channels ended up buying more laptops/PCs to stock up in advance of any potential disruption). This

boosted Windows OEM revenues but has left the channel with above-average inventory. I would expect this segment to underperform in 1H20, on the assumption that the channel de-stocks (and trade tensions don’t escalate). Equally, several pieces of software (Windows 7, SQL Server and Windows Server 2008) going end of support in 1H20, meaning the business is currently enjoying the benefits of a refresh cycle as enterprises spend to migrate to the newer supported offerings.

There was a one-off charge this quarter that resulted in a net tax benefit of $2.6bn, making the net profit growth look stronger than it actually is; the normalised number for net profit growth is +21.1%. This translated into incredibly strong cash from operations (growth of 41% YoY) and FCFF (30% YoY growth), largely driven by the very strong expansion in Unearned Revenue.

Guidance for 1Q20 and FY20 was also above expectations:

  • 1Q20 revenues are expected to grow around 10.2% YoY to $32.05bn, with a gross margin of ~66.8%, an operating margin of ~35.1%., implying EPS of around $1.26 (compared to consensus around $1.19)
  • Full-year guidance called for ‘double digit revenue growth’, ~11.5% operating expense growth and ‘stable margins’, translating to double digit operating profit growth. I think the latter may prove to be conservative – they have guided operating margins to be flat year-on-year (and beat it) for an extended period of time now. I would venture the margin expansion in Azure is strong enough to offset any mix shift to lower margin segments.

If I had to point to some areas of weakness, Windows OEM non-Pro revenues (-8%) remains an area of concern, given pressure at the low end of the consumer PC market. Gaming (-10%) was also weak, but this is likely a combination of a tough base (4Q18 was when Fortnite really took off, driving console sales and attach rates), a lack of new titles (to be addressed later this year), and the fact that the current console generation is now nearly 5 years old. Microsoft is beginning to test xCloud, which is their play in the streaming games on demand theme (think Netflix for games); combined with Xbox Live Game Pass, I think they are moving to a more sustainable gaming monetization model, which can speak to a much larger addressable market; this will be enhanced when the next generation console launches in 2020. Finally, Search volumes and revenues were also weak, only growing by 10%.

Azure growth has slowed to only +64% (+68% in constant currency) year-on-year, but I think that’s more a function of the increasing size of the base than any softness in demand.

In valuing the business, I make the following assumptions:

  • FY20: +12% revenue growth, 66% gross margin (+10bps year-on-year), 35.3% operating margin (+120bps year-on-year), all equating to operating profit growth of ~14%, and diluted EPS (earnings per share) growth of +13.3% (when normalising for the tax rate in 4Q19). This equates to FCFF (free clash flow to firm) growth of 17.4%.
  • Beyond FY20, a revenue CAGR (compound annual growth rate) of 7% (from roughly 12% p.a. for FY21 to FY22, then beginning to moderate to mid-single digits by FY24) and ongoing operating margin expansion (+400bps over from FY21  to FY24 to ~40%, thereafter only ticking marginally higher to 41%) driving FCFF compounding at 8% out to FY29.
  • WACC (weighted average cost of equity) of 9% (cost of debt: 2.4%; cost of equity: 9.7%), terminal growth rate of 3%

Normalised WACC of 10.85% (cost of equity of 11.7%) for the buy-at price.

Using these assumptions, I value the business as follows:

Target price:      $148.70

Fair value:          $142.00

Analysts upgrades FY20 consensus earnings per share from $5.10 to $5.21 as illustrated in the chart below.

Investment thesis

Microsoft is a play on the ongoing transition of business IT workloads from the on-premises, licensed-based enterprise model to the cloud-based (public or hybrid) ‘as-a-service’ delivery model. Given its enterprise IT experience, breadth of offering, strong incumbency status, and reinvigorated strategic vision, we believe Microsoft is exceptionally well positioned to maintain its share of IT budgets as they transition, whilst also capturing new spend via offerings such as Azure and Windows 365.

For this transition to play out, we would expect ongoing double-digit growth in Commercial Cloud revenues, with legacy on-premises offerings declining slowly. This transition was at first margin dilutive, but we believe we are now beyond the trough driven by the mix shift to lower margin cloud businesses. As revenues grow and the cloud businesses scale, we expect margins across the business to expand, driving strong profit and free cash flow growth. The latter gives Microsoft optionality to continue to invest in new initiatives, whilst also having a healthy capital return programme (via both dividends and share repurchases.)

Key risks

In the near term, the biggest risk to the business is likely worsening of economic conditions, negatively impacting enterprise IT budgets. This would likely cause near-term downside but would not materially impact the competitive position.

The single biggest risk to our valuation is a material disappointment in Azure growth, driven either by competitive dynamics or aforementioned material economic slowdown curtailing IT spending. (Given that, in most cases, a cloud/as-a-service transition reduces costs to enterprise CIOs, the latter may prove somewhat resilient in a downturn). Should the IaaS landscape become vastly more competitive on price – likely due to AWS dropping prices – it would mean a) a potential for revenue disappointment, as AWS grows faster, and b) substantially less margin expansion, due to the lack of operating leverage as Azure grows in the mix. In the long term, the biggest risk to Azure is that margin assumptions are too high – that Amazon, being the largest public cloud provider – can enjoy wider margins, or compete to ensure Microsoft never reaches their margin levels.

From a bigger picture perspective, the biggest risk to Microsoft is ceding its dominant incumbent position in enterprise IT to competition – particularly vertical players who could look to address specific niches (Zoom vs. Skype, Slack vs. Teams, etc.) We think this is a remote risk, though worth monitoring.

And finally, in terms of the DOJ antitrust investigation in the search, social media and retail online vertical against dominant platforms (read Alphabet, Facebook and Amazon),  I feel Microsoft is largely out of the scope of these investigations (or will at worst be exposed via LinkedIn, which is not overly material to the investment case).

MSFT remains one of the world’s highest quality structural growth stocks.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.

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