Heading into this round of quarterly earnings, a pervasive fear swirled around technology giant Microsoft (NASDAQ: MSFT). A number of factors contributed to this.
First, the strong U.S. dollar has hit large multinational corporations, such as Microsoft, exceptionally hard. Over the past year, the rising dollar has negatively affected companies that conduct a significant portion of business overseas. That’s because international sales are worth less when those revenues are converted back into the domestic currency.
Second, Microsoft whiffed on earnings last quarter, and the stock crashed 8%. This set a disturbing precedent that, perhaps, another miss was in store. But not only did its earnings meet estimates, the company handily beat expectations.
Here’s how Microsoft managed it.
The company’s strategic growth initiatives led the way last quarter, as they have for several quarters. Commercial cloud revenue more than doubled last quarter, driven by continued strength in sales of Office 365 and Azure. Its commercial cloud revenue has now reached a $6.3 billion annualized revenue run rate.
But Microsoft also performed well in its other businesses. Devices and consumer revenue grew 8% year-over-year. Tablet revenue soared 44%, thanks to a strong quarter for the Surface Pro 3. Separately, Microsoft’s newest console, the Xbox One, racked up more than 30% growth in Xbox Live subscriptions.
Phone hardware revenue reached $1.4 billion, as Microsoft sold 8.6 million Lumia phones last quarter. Last but not least, search revenue jumped 21%, as Bing market share grew 150 basis points in the U.S.
In all, Microsoft’s revenue rose 6% last quarter. Diluted earnings per share declined 10%, due mostly to foreign exchange. Excluding currency fluctuations, revenue and gross profit would have increased a much more impressive 9% and 4% year-over-year, respectively.
Microsoft enjoys a tremendously profitable business model, as it’s able to produce its products and services with very low capital expenditures. This creates a great deal of free cash flow. For example, it generated more than $8 billion in free cash flow last quarter alone.
It then returns the bulk of this cash to investors through dividends and share buybacks. Last quarter, it paid $2.5 billion of dividends and spent $5.1 billion buying back its own stock. Microsoft’s current dividend yield is 3%, which is very high for a technology company.
The money used for stock buybacks was a major contributor for Microsoft’s earnings spike. When a company retires its own shares, it reduces the number of shares outstanding. In turn, this helps boost earnings per share, since the denominator in the EPS gets smaller.
But even with such aggressive cash returns, there’s still a lot of cash left over. This is why Microsoft has a mountain of cash that is piling up on its balance sheet. It now has $95 billion in cash, cash equivalents and short-term investments.
Microsoft enjoys a fantastic financial position. The company has a very conservative 30% long-term debt-to-equity ratio. In fact, it’s one of only three U.S. companies to hold the coveted triple-A credit rating from Standard & Poor’s.
Despite fairly modest growth, Microsoft stock gained more than 10% on Friday after the company reported earnings after Thursday’s closing bell. Investors were clearly relieved, as the pervasive sentiment is that things could have been much worse.
Currency is a brutal headwind right now, but it was a decided show of strength to post growth anyway. This is an important sign that Microsoft’s underlying products and services are still seeing strong demand. Investors likely understand that currency has an artificial effect, and that currency movements fluctuate from year to year.
Another factor working in Microsoft’s favor heading into earnings is that the stock is cheap. Shares of Microsoft exchanged hands for just 16 times earnings prior to its quarterly report. That is a significant discount to the overall market. The S&P 500 trades for 20 times earnings.
Microsoft is enjoying solid growth, the company has a bulletproof balance sheet and the stock is still cheap. These are the ingredients for a long-term winning investment.
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