Microsoft's (MSFT 0.37%) stock price rose 5% during after-hours trading on Tuesday, April 26, following the release of its third-quarter earnings report.
The tech giant's revenue rose 18% year-over-year to $49.4 billion, which beat analysts' estimates by $350 million. Its net income grew 8% to $16.7 billion, or $2.22 per share, but missed analysts' expectations by $0.25.
Those headline numbers were mixed, but the market's response suggests its strengths offset its weaknesses. Let's examine five green flags for Microsoft's future, and see if they make its stock a worthwhile investment.
Image source: Microsoft.
1. Stable growth across all three businesses
Microsoft splits its business into three segments, which each bring in roughly a third of its revenue.
The Productivity and Business Processes division houses its Office, LinkedIn, and Dynamics services. The Intelligent Cloud division handles its server products and its cloud infrastructure platform Azure. The More Personal Computing division sells its Windows licenses, Xbox consoles, Surface devices, and online ads through its search engine and portal sites.
All three of those businesses generated robust double-digit sales growth in fiscal 2021 (which ended last June) and the first three quarters of fiscal 2022:
|
Revenue Growth (YOY) |
FY 2021 |
Q1 2022 |
Q2 2022 |
Q3 2022 |
|---|---|---|---|---|
|
Productivity and Business Processes |
16% |
22% |
19% |
17% |
|
Intelligent Cloud |
24% |
31% |
26% |
26% |
|
More Personal Computing |
12% |
12% |
15% |
11% |
|
Total |
18% |
22% |
20% |
18% |
Data source: Microsoft. YOY = Year over year.
2. Its total cloud revenue continues to soar
Microsoft's total cloud revenue, which includes all of the cloud-based services across all three business segments, rose 32% year over year to $23.4 billion -- or 47% of its top line -- in the third quarter. That closely watched growth rate has consistently remained above 30% over the past year.
That cloud segment's core growth engines are Azure, the world's second-largest cloud infrastructure platform after Amazon (AMZN -1.64%) Web Services (AWS); Office 365 Commercial; and Dynamics 365. Here's how those three growth engines fared over the past five quarters:
|
Revenue Growth (YOY) |
Q3 2021 |
Q4 2021 |
Q1 2022 |
Q2 2022 |
Q3 2022 |
|---|---|---|---|---|---|
|
Azure |
50% |
51% |
50% |
46% |
46% |
|
Office 365 |
22% |
25% |
23% |
19% |
17% |
|
Dynamics 365 |
45% |
49% |
48% |
45% |
35% |
|
Total Cloud |
33% |
36% |
36% |
32% |
32% |
Data source: Microsoft.
Azure's strong growth indicates that plenty of larger companies, especially retailers, don't want to feed Amazon's most profitable business. Additionally, Canalys estimates that Azure's global market share increased two percentage points year over year to 22% in the fourth quarter of 2021, while AWS' market share only grew by a single percentage point to 33%.
The steady growth of Office 365 indicates it's successfully transformed its desktop-based Office software into cloud-based services, while Dynamics continues to grow faster than its larger rival Salesforce (CRM -0.18%) in the cloud-based customer relationship management (CRM) market.
3. Stable gross and operating margins
When CEO Satya Nadella aggressively accelerated Microsoft's cloud-based expansion eight years ago, the bears claimed that ambitious transformation would crush its margins. However, Microsoft's margins eventually stabilized after it lapped its initial spending spree and economies of scale kicked in.
That stability persisted in its latest quarter, as both its gross and operating margins remained steady on a sequential and year-over-year basis:
|
Period |
Q3 2021 |
Q2 2022 |
Q3 2022 |
|---|---|---|---|
|
Gross Margin |
68.7% |
67% |
68.4% |
|
Operating Margin |
40.9% |
41.5% |
41.3% |
Data source: Microsoft.
In other words, Microsoft's earnings miss in the third quarter wasn't actually caused by declining margins. Instead, it attributed its weaker-than-expected net income growth to its losses from its equity investments, which are less concerning than a contraction in its gross or operating margins.
4. Healthy shareholder returns
Microsoft's healthy margins enable it to generate stable profits and return plenty of its cash to investors. Its free cash flow (FCF) increased 17% year over year to $20 billion during the third quarter, and it spent $12.4 billion of that total on buybacks and dividends.
That stable cash flow growth should insulate Microsoft from inflation and rising interest rates, which usually generate fiercer headwinds for unprofitable companies with negative cash flows. Its forward yield of 0.9% might not attract any serious income investors, but its strong FCF growth indicates it still has plenty of room for future dividend hikes.
5. A rosy outlook with a reasonable valuation
Analysts expect Microsoft's revenue and earnings to grow 18% and 16%, respectively, this year. The stock's 20% pullback this year, which was mainly caused by macro issues instead of micro ones, has also reduced its forward price-to-earnings ratio to 25. That reasonable multiple -- which seems more appropriate for a consumer staples company than a growing cloud software company -- should limit its downside potential.
It's tough to find any major flaws with Microsoft's business, and it remains a well-diversified play on the secular growth of the cloud and gaming sectors. Its stock could remain volatile in this choppy market for tech stocks, but investors who tune out the noise could be well-rewarded in the future.
