Disclaimer: please do not base your investment decisions on any other people’s opinions in the world except for yourself.
This has been a long weekend and I thought there is absolutely nothing else to do on Monday other than to seek a new investment opportunity. As I usually do, will try to be objective and concentrate on the figures. Microsoft is not (yet) in my portfolio of stocks.
I do sincerely apologise for the length of this post in advance - I am not particularly great at being concise. You could have a look at similar posts for Netflix and Facebook, they are much shorter in length.
You may have noticed the title saying Q4 whereas most of the US corporations have only reported Q2 earnings recently. Sometimes there are exceptions and this is the case - Microsoft ended its fiscal year last month and reported its financial results for 2018. Below we will have a look at how they are doing and why the share price did not go down after Facebook and Twitter (-20% and -30% shortly after their earnings releases respectively). Microsoft has three key segments which we will take a deeper look into.
Productivity and Business Processes
This segment includes MS Office, LinkedIn, Dynamics and other Business Management software.
Revenue for this segment increased by 18% in comparison to 2017, from $30.4bn to $35.8bn. Unfortunately, Microsoft does not disclose how much it earns from each of these products separately (only the growth, which is illustrated in the table below). Except for LinkedIn, which got the revenue of $5.1bn - 14% of the total within its segment.
The number of paid Office 365 subscribers increased by 16% over the year: from 27m to 31.4m people. The research company Gartner claims that Microsoft obtained $13.8bn via MS Office in 2016, while their closest competitor, Google, only got $1.3bn on Google Docs.
Operating profit increased by 8% from $11.9bn to $12.9bn. Interestingly, LinkedIn has an operating loss of $987m and there is no detailed information on the other products.
Revenue growth in the Productivity and Business Processes segment:
|Dynamics products and cloud services||11%|
|Office commercial products and cloud services||10%|
|Office consumer products and cloud services||8%|
This segment includes the Azure data processing service, Windows Server, and the Windows OS.
Revenue for this segment went 17% up this year, from $27.4bn to $32.2bn. Sooner or later, Azure will be Microsoft’s most significant product. Whilst the exact Azure revenue is not disclosed, we can make a very educated guess: for comparison, Amazon’s AWS raised $21.2bn last year, with an operating profit of $5.5bn. According to Canalys, analytical agency, Amazon has taken 31.8% of the market, and Microsoft got 13.9%. If this is correct, Azure’s revenue can be somewhere between $8bn to $10bn a year. More importantly, Azure’s revenue grows at least 80% each quarter in comparison to the same quarter a year ago - and this trend has already lasted for 12 (!) consecutive quarters.
Operating profit increased by 26%, from $9.1bn to $11.5bn.
Revenue growth in the Intelligent Cloud segment:
|Server products and cloud services||26%|
More Personal Computing
This segment includes search engine Bing, games, gaming software and hardware such as Xbox and Surface.
Revenue for the segment increased by 9% compared to 2017 from $38.7bn to $42.3bn. The most significant growth is due to Xbox. Who knows, perhaps Microsoft is so impressed by the success of the Nintendo Switch and will decide to create its own portable console too?
Operating profit increased by 28% from $8.2bm to $10.6bn.
Revenue growth in the More Personal Computing segment:
|Xbox software and services||36%|
|Search advertising excluding traffic acquisition costs||17%|
Overall Net Profit
The overall profit fell by 35% since 2017, from $25.5bn to $16.5bn. But that is not a cause for concerns, all thanks to the tax reform. Microsoft returned their cash equivalents from offshore companies back to the US and now the state took a tax chunk of $13.8 billion in the 2nd quarter of this year. This is not a systematic loss, so the market did not panic and sold off the shares. On the flip side, next year’s growth will most likely be abnormally high since the comparison will be to the year 2018.
In May, Microsoft agreed on the purchase of Github - a platform which I can hardly define properly… So I will just leave the explanation link. The deal is estimated to be finalised by the end of 2018. Github owners will receive $7.5bn in a form of Microsoft shares.
According to rumors, Github’s annual revenue is circa $300m - it is not much at all. Perhaps Microsoft will use it as a marketing platform or as part of some other product. The financial indicators of Github will most likely be displayed in the Intelligent Cloud segment.
Dividends and Shares Buyback
Microsoft paid $0.42 of dividends each quarter in 2018. The next payment will most likely increase again, as it has been the case with annual uplifts for the past 12 years.
Microsoft also has $30bn to buyback its own shares. $7.5bn will be paid for the deal with the Github and the rest of the money will most likely be used to buy shares from the market. This is an alternative (to dividends) way to pay the investors: fewer shares circulating in the market - higher dividends paid per share.
Microsoft’s and its close competitors’ Ratios
To evaluate a company, you need to compare its earnings figures to their competitors’. Microsoft has a lot of products, so let’s take slightly more competitors than usual:
- Outlook competes with Gmail; Bing with Google; Office 365 with Google Docs.
- Azure with AWS.
- Windows with Mac OS.
- Microsoft Dynamics with Oracle Cloud and IBM Cloud.
Ratios explained in detail (my personal gratitude to yourself if you are still reading up to this point)
- EV/EBITDA: The less, the better, close to or less than 10 is often a severe undervaluation. 10 rarely happens with Technology stocks as they are often valued by future potential than current performance.
- EV/CF: Same as EV/EBITDA but considers real cash flow instead of accounting profit. Once again, Technology are slightly diffirent to the other sectors and often have higher margins than other companies due to lower operational costs. Hence greater cash flows that usually exceed the profit from the Income Statement.
- Debt/EBITDA: At least how many years the company will need to repay the debts. Under 3 - usually fine. Over 5 - risky. Microsoft’s debt is more than reasonable hence the risk is fairly negligent.
- ROIC: Profitability. But excluding one-off costs and revenues (ever tried to “exclude from summary” one of your Monzo transactions? This is that). 15% and over is generally fine. Facebook’s is absolutely marvelous. More about ROIC here if interested.
Microsoft has a very wide range of products with significant revenues - Windows, Office, Azure, LinkedIn, Dynamics, Bing, Surface, Xbox and other software that did not make it to this list. It would be false to claim that they are all profitable - there are no figures disclosed for each of these products (except for LinkedIn - and it made a loss). However, Microsoft itself does not depend on any single product entirely, unlike its competitors:
- 62% of Apple’s revenue is iPhone
- 61% of Amazon’s revenue is Amazon Retail
- 86% of Alphabet’s revenue is advertising
- 98% of Facebook’s revenue is advertising
- IBM does not yet have breakthrough major projects that will help their revenue growth at all - not interesting for the US investors
- Oracle only recently separated their cloud solutions in a separate segment. They have a potential but no clarity yet
Evidently, with such a diverse range of products, Microsoft has its hands in most areas of the sector, hence should the recession get into any of those - Microsoft could always rely on other segments of its business model to sustain its normal operation and earnings growth.
As always, I could have missed some facts and figures, or they simply did not make it to the post due to the abundance of information available, which is why I am happy to hear what others think of Microsoft and its potential in the following years.
Another awesome write up Vlad, thanks for this! Tbh I’m still too traumatised by my experience using Microsoft Word & Excel + it’s obvious that their monopoly on office software is slipping so I would have never looked at Microsoft, if you hadn’t written something so easily digestible.
I’m really interested to see what they do with the Github acquisition. First of all, I hope that they don’t choke all of the goodness out of the service of course. But Github is basically one of the most popular platforms for open source projects - where developers collaborate to develop publicly available code, for mutual benefit. And although they have a revenue source already, with their service for corporations who want to host & manage their code privately, as far as I know, they haven’t monetised the public side of the service yet. So I think they have a lot of potential. There’s also some nice synergies with Azure. That’s just my two cents..
It is absolutely right that many people are into numbers and pages / Google docs (seems like yourself included ), mostly in London area. However, the rest of the country, as well as most other continents - especially public sector organisations all the way from the US to Asia are on MS Office. Considering how reluctant big organisations to changes are, I would not foresee MS Office going anywhere as yet.
I must confess, I have a very little understanding of Github and could not say much on it. But knowing that most of its users are Microsoft employees, I hope to believe there is a genuine benefit of owning it long term. And yes, hopefully they will not spoil whatever Github does at the moment
It’ll be interesting to see what happens to the Atom editor maintained by GitHub as MicroSoft have one that directly competes with that.
GitHub has some big names relying on GitHub Enterprise, so there’ll be opportunities to cross sell:
Microsoft buying github was the big thing that made me want to buy stocks, people have been asking them to get more involved with open source and they’ve taken that on board. Also how hard they’re pushing things on Xbox looks promising too, their “Netflix for games” game pass is something that’s given life back into the console for me.
Microsoft is going to buy back $40 billion worth of shares. It is also hosting an event on October 2nd to announce the latest updates for the Surface line
Microsoft just beat frontrunners Amazon to the Pentagon’s $10B cloud contract.
Open source software and the ultimate backup drive
Github was acquired by Microsoft for $7.5B. Without Github and open-source (OS) software we’d be living in a very different world. Netflix, Google, Uber, Microsoft (who used to be sort of against OS software in the 90s), etc etc all rely on OS code.
We all rely on OS software every day, as it sits in our devices and is used by service providers all around the world.
If you’re an iPhone or Mac user, then you technically use stuff built with open sourced Swift language and the LLVM compiler infrastructure.
Remember Netscape? When battling Internet Explorer (Microsoft) they open sourced its browser and set up the Mozilla Foundation prior to selling Netscape to AOL. Mozilla makes Firefox.
Android, Chromium, etc are all examples of open source software that “lives” on Github. Also, Linux and many more. Microsoft’s Edge browser is now Chromium-based.
I’m sure uses git and Github on a daily basis @Ian :
Here’s how Github archives important code the old-school way:
This is the Arctic World Archive, the seed vault’s much less sexy cousin. Friedman unlocks the container door with a simple door key and, inside, deposits much of the world’s open source software code. Servers and flash drives aren’t durable enough for this purpose, so the data is encoded on what look like old-school movie reels, each weighing a few pounds and stored in a white plastic container about the size of a pizza box. It’s basically microfilm. With the help of a magnifying glass, you—or, say, a band of End Times survivors—can see the data, be it pictures, text, or lines of code. A Norwegian company called Piql AS makes the specialized rolls of super-durable film, coated with iron oxide powder for added Armageddon-resistance. Piql says the material should hold up for 750 years in normal conditions, and perhaps 2,000 years in a cold, dry, low-oxygen cave.
Friedman places his reel on one of the archive’s shelves, alongside a couple dozen that include Vatican archives, Brazilian land registry records, loads of Italian movies, and the recipe for a certain burger chain’s special sauce. GitHub, which Microsoft bought last year for $7.5 billion, plans to become by far the biggest tenant. Eventually, Friedman says, GitHub will leave 200 platters, each carrying 120 gigabytes of open source software code, in the vault. The first reel included the Linux and Android operating systems, plus 6,000 other important open source applications.
Other open source veterans argue that the revolution was worth it. Small teams of scientists can now punch well above their weight thanks to GitHub shortcuts. Cancer researchers, to cite one of many, many examples, frequently borrow from Google’s open source machine-learning work in their hunt for better ways to screen for tumors. “I don’t know who is religious about open source anymore,” says Dave Rosenberg, a veteran software executive and investor. “I don’t think you can achieve the stuff we want without it.”
I can only imagine how painful things would be without git. I also value where commercial companies have taken it - the combined efforts are game changing.
Embracing open-source code
There were years I would’ve bet against this, hard.
Microsoft has positioned itself as a friend of software developers. Nadella pulled down the company’s walled-garden approach to software development and embraced open-sourced coding.
The company is the world’s strongest supporter of the Linux open source coding system and its purchase of GitHub for $US7.6 billion in 2018 gave it access to 36 million open source software developers.
And it worked:
There are always downsides, and one of them is regulatory:
No other company offers under one roof computing as a service, storage, productivity apps, front-office apps, core financials, data analytics, identity security, artificial intelligence and machine learning.
As Microsoft grows more powerful and its services and products become more pervasive across business and government, it is bound to catch the attention of regulators.
This is already happening, with German Chancellor Angela Merkel last week warning of potential “sovereignty” issues from the storage of data on Microsoft servers even though they are located in Germany.
BBC News - Microsoft makes ‘carbon negative’ pledge
Praise Tech Gandhi
Earnings beat powered by Azure, and showing growth across the company.
I have a thought, Microsoft should buy Atlassian.
Bill Gates leaves the Microsoft board.
He can finally install Arch Linux and use an iPhone.