In recent notes, I’ve given you examples of world-leading businesses like Nike and Louis Vuitton Moet Hennessy that have defied any perception of macroeconomic headwinds. We have also seen the WAAAX index -27% since the September peak, and I remain cautious on highly valued profitless companies yet bullish and invested in what we consider undervalued, highly profitable companies that will compound over time. I still believe equity markets globally are becoming more discerning, behaving more like a “weighing machine”, than a “voting machine”. In my view, you’ll be better served being invested in companies with ultra-high barriers to entry, high returns on invested capital, profitable and strong free cash flow generative companies, rather than those the market “hopes” will generate those attributes in the future and will require more funding from investors (remember WeWork, $47 billion to $8 billion “valuation” in a month).
Microsoft (MSFT), the largest company in the world, exhibits all the highly attractive investment attributes mentioned above. MSFT is a large holding in the AIM Global High Conviction Fund, we don’t own it because it’s the biggest; we own it because it’s the best risk-adjusted investment we can find.
We look for companies that have the long-term ability to generate excess returns on capital and reinvest that capital at rates of growth greater than inflation. These are what we call compounders. MSFT is a classic example of a compounder.
I have written before on MSFT but I do want to run through some analysis of the Q1 result. MSFT is a trillion-dollar market capitalisation company. Revenues grew by +13.7% in the quarter v. PCP (previous corresponding period), beating consensus forecasts by +2.5%. That revenue growth alone is around 6x global GDP growth, even more in constant currency terms (US dollar strength was a headwind).
Positive JAWS was experienced as revenue growth (+13.7%) vastly outpaced cost growth (+5.1%). This saw gross margins rise to an enviable 68.5%. Further cost discipline supported operating margin expansion, leading to net profits rising +21% and EPS +21.9%, due to the effect of buybacks on reducing share count. This is a very impressive set of numbers.
Two key points from the result are worth highlighting:
- Azure (Microsoft’s cloud platform) growth of +59% (as reported, +63% in CC) remains incredibly strong. While Azure growth has been moderating for several years, we would argue that has a lot more to do with base effect than with a slowdown in demand. This is corroborated with the fact that MSFT clients are signing longer-term contracts for Azure engagements, which show up in the growing component of remaining performance obligations. Put differently, Microsoft has already signed revenue of $26 billion for the rest of this year and another $26 billion for the period beyond 12 months, which they simply haven’t yet invoiced – a high quality problem to have.
- Of the ~$11.6 billion commercial revenues, 91% is annuity revenue.
If I am right and equity markets are becoming more discerning in their behaviour (weighing machine), then free cash generation is going to be a highly important variable. MSFT generated 21% more free cash than in the PCP. Cash from operations was stronger than the numbers indicate, with a $3.5 billion cash tax payment related to the transfer of IP to a subsidiary driving only 1% year-on-year growth. If normalised, the actual growth in cash from operations was +27%. The FCFF number (+22%) is likely reflective of the true, underlying growth in profitability (and required investment to generate this growth), despite all the moving parts. Again, a business with a $125 billion+ revenue line and trillion-dollar market cap growing FCFF at +20% remains remarkable.
MSFT has the very high-quality problem of generating too much cash. They don’t need any more with a balance sheet like this below. That’s why we can look forward to higher dividends and increased buybacks.
Net Cash of $67 billion is up by ~12.5%. The ROE is marginally down on a T12m period but that’s more to do with the reduced leverage — the actual profitability of the capital deployed means the ROIC has ticked up modestly to 22%.
In terms of guidance, Q2 guidance came in above consensus estimates on revenue and below on costs. MSFT continues to expect double-digit growth for FY20 and improving operating margins.
All in all, this was an excellent set of numbers from a structurally strong global growth company. MSFT is a clear compounder in my opinion.
I’ll finish with a simple year-to-date comparison of the Australian WAAAX Index (WiseTech, Appen, Altium, Afterpay and Xero) and MSFT. While WAAAX (white line) has delivered +66%, MSFT (yellow line) has delivered +40.6% year-to-date. It reminds me of the fable of “the hare and the tortoise”. The hare could well be running out of puff and I’d rather back the tortoise.
WAAAX -v- MSFT
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.