Microsoft (MSFT) Q1 Earnings Beat on Strong Azure Growth

Microsoft Corp.MSFT reported first-quarter fiscal 2018 earnings of 84 cents per share, which beat the Zacks Consensus Estimate by 12 cents. The figure rallied 16.7% on a year-over-year basis.

Revenues of $24.54 billion increased almost 12% from the year-ago quarter (up 11% in constant currency or cc). Further, the figure exceeded the Zacks Consensus Estimate of $23.53 billion. Favorable foreign exchange positively impacted revenues by one point. LinkedIn contributed 5 points of revenues growth.

Microsoft stated that better-than-expected performance in large markets like France, Japan and the U.K. and stable results in Brazil and Russia drove top-line growth.

Commercial unearned revenues were $21.5 billion, up 19% year over year and significantly higher than Microsoft’s expectation, primarily due to higher Software Assurance billings and FX benefit.

Annuity mix was 89%, while commercial bookings grew 14% (9% at cc). New Commercial cloud business revenues exceeded $5 billion, growing 56% year over year.

Shares were up 4.6% in after-hour trading. Microsoft has returned 31.4% year to date, slightly outperforming the 31.2% rally of the industry .

Azure, Office 365 Drives Growth

Productivity & Business Processes includes the Office and Dynamics CRM businesses. Revenues jumped 28% (up 28% at cc) on a year-over-year basis to $8.24 billion.

The Commercial business (products + Office 365 & related cloud services) revenues were up 10% from year-ago level (up 6% cc). Office 365 commercial revenues grew 42% (44% at cc) driven by strong installed base growth and average revenues per user (ARPU) expansion.

Office 365 adoption remained strong, with companies like Lowe’s and Devon Energy choosing the product during the quarter. Office 365 Commercial seat growth declined 800 basis points (bps) on a year-over-year basis to 32%.

The Consumer business revenues advanced 12% (10% at cc) year over year in the quarter. Office 365 consumer subscribers are now at 28 million, up from 27 million in the previous quarter.

Dynamics business grew 13% (12% at cc). Dynamics 365 revenues soared 69% (same at cc). Microsoft added the U.S. Department of Veterans Affairs and the Seattle Seahawks to its customer base.

LinkedIn contributed revenues of $1.1 billion, better than management’s guidance of $1.05 billion. LinkedIn sessions were up more than 20% for the fourth consecutive quarter.

Moreover, engagement across the platform is strong, with 65% year-over-year growth in jobs, visitors across mobile and desktop, 60% growth in feed update views and nearly 40% growth in messages sent.

Intelligent Cloud includes server and enterprise products and services. The segment reported revenues of $6.92 billion, up 13.5% (13% at CC) year over year.

Commercial cloud annualized revenue run rate reached $20.4 billion, achieving the company’s goal set in fiscal 2015.

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Server product and cloud services revenues went up 17% year over year (same at cc). The high point was Azure revenues, which soared 89% at CC on a year-over-year basis. Microsoft noted that Azure premium revenues grew triple digits for the 13th consecutive quarter.

Adoption remains strong as evident from the growing customer base. Azure has been selected by the likes of Costco, Symantec SYMC , Bank of America Corporation BAC , TD Bank and Sumitomo Mitsui Banking Corporation.

Data center expansion continues with Azure now in 42 regions globally, more than any other cloud provider.

Meanwhile, enterprise service revenues slipped 1% (flat at CC) in the reported quarter, due to declines in custom support agreements related to Windows 2003.

More Personal Computing comprises mainly the Windows, Gaming, Devices and Search businesses. Revenues were almost flat year over year at $9.38 billion. Excluding phone business, revenues grew 3% (same at CC).

Windows OEM pro revenues increased 7% (up 1% at CC) on a year-over-year basis. Windows OEM revenues increased 4% (up 4% in constant currency), ahead of the overall PC market. Moreover, windows commercial products and cloud services revenues increased 7% on a year-over-year basis (6% at CC) driven by annuity revenues growth.

Windows 10 Commercial monthly active devices grew 90% year over year.

Adoption remains strong among the enterprises with notable names like The Coca-Cola Company KO , Her Majesty Revenue & Customs and Rogers Communications choosing Windows 10 for its intelligent security features and advanced management capabilities.

Gaming revenues increased 1% (flat at CC) as strength in Xbox software and services (20% at CC) offset lower hardware revenue. Xbox Live monthly active users were up 13% to 53 million active users.

Surface revenues increased 12% (11% at CC) from the year-ago quarter primarily due to higher sales of the new Surface Laptop in both the commercial and consumer segments.

Search excluding traffic acquisition costs (TAC) revenues grew 15% (same at CC) as both search volume and revenues per search (RPS) improved.

Operating Results

Microsoft’s gross margin of 66.3% expanded 2 points from the year-ago quarter, primarily owing to favorable revenues mix along with commercial cloud margin improvement. LinkedIn contributed almost 5 points of gross margin growth.

Commercial cloud gross margin was 57%, up 800 bps year over year.

Operating expenses of $8.55 billion were up 16.1% from the year-ago quarter. FX added 1 point of growth to operating expenses. As percentage of revenues, operating expenses increased 120 bps from the year-ago quarter.

LinkedIn contributed 14 points of growth, including $154 million of amortization of acquired intangible expense.

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As a result, operating margin expanded 80 bps on a year-over-year basis to 31.4%. LinkedIn negatively impacted operating margin by 4 points. Excluding the cost of amortization of acquired intangibles, LinkedIn contributed $78 million to operating income.

Balance Sheet

Microsoft ended with cash and short-term investments balance of $138.5 billion, up $5.5 billion from the previous quarter. The company returned $4.8 billion to shareholders in the form of share repurchases and dividends in the reported quarter.

Guidance

For the second-quarter of fiscal 2018, Microsoft expects foreign exchange to increase revenues growth by 1 point, COGS growth by 1 point and operating expenses growth by 2 points.

The company anticipates that solid renewal and increasing customer demand for Microsoft’s hybrid cloud services and new cloud solutions like Microsoft 365 will continue to drive commercial business growth.

Management expects dollar volume of EA expirations to decline 20% in the second quarter, which will hurt commercial bookings. Microsoft anticipates commercial unearned revenues to decline 7% sequentially. Improvement is anticipated in commercial cloud gross margin.

Microsoft expects margin to improve on a year-over-year basis. Sequential growth is expected to be at par with fiscal 2017 growth pattern.

Moreover, capital expenditure is expected to increase in the quarter.

Productivity and Business Processes revenues are expected between $8.75 billion and $8.95 billion. Office 365 commercial growth will continue to outpace the transactional decline. Management expects a more moderate rate of growth in Office consumer business. Dynamics revenue is expected to grow double digit, driven by the ongoing shift to Dynamics 365. LinkedIn revenues are projected to be $1.2 billion.

Intelligent Cloud revenues are projected between $7.35 billion and $7.55 billion, with another quarter of double-digit revenue growth across server products and cloud services. Management expects Enterprise Services revenue growth to be similar to last quarter, driven by Premier Support Services offsetting declines in custom support agreements.

More Personal Computing revenues are anticipated between $11.7 billion and $12.1 billion. Windows OEM revenues should track roughly in-line with the overall PC market. Specifically, OEM Pro revenue growth should be more aligned to the commercial PC market.

Surface revenues expected to be up slightly on a sequential basis, as the transition to the new Surface Pro, Surface Laptop and Surface Book 2 continues. Management expects double-digit revenues growth in search ex-TAC, reflecting continued strong performance in both rate and volume.

Gaming revenues are anticipated to grow due to the launch of the Xbox One console and continued healthy growth of software and services revenue. Higher mix of Gaming hardware revenues will significantly impact both segment and the company’s gross margin percentages.

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Microsoft expects COGS between $11 billion and $11.2 billion, in the normal range for a holiday quarter with new device launches and including 1 point of FX headwind. This includes approximately $400 million of LinkedIn COGS, of which $220 million is related to amortization expense.

Management projects operating expenses of $9.1 billion to $9.2 billion, which includes 2 points of FX headwind. This includes $1.1 billion of LinkedIn expenses, of which $154 million is related to amortization.

For the fiscal year 2018, Microsoft expects FX to increase revenue, COGS and operating expense growth at the company level by 1 point. Management now expects operating expense growth, excluding LinkedIn, to be between 4% and 5%.

Management now expects operating margin, ex-LinkedIn, to be up year over year, despite increasing investments on commercial cloud, artificial intelligence (AI), Mixed Reality, quantum, new hardware launches and the continued transformation of the sales team.

Microsoft now expects LinkedIn, ex-purchase accounting, to be accretive to earnings in fiscal 2018.

Zacks Rank

Microsoft currently sports a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here .

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