Having beaten the market over the past year (and up more than 22%), Redmond, Wash.-based Microsoft Corp. (Nasdaq:MSFT) is no longer priced as though the company will never again grow its free cash flow. Keep in mind it took the resignation of its CEO, a restructuring, the acquisition of Nokia Corp's (NYSE:NOK) handset business, and good cloud/SaaS growth to do it. Microsoft continues to look undervalued on the basis of its free cash flow (FCF) generation capacity, but absent strong revenue growth investors are going to need to be patient to see that value come to the surface.

Above Expectations

Microsoft beat expectations for its fiscal third quarter. As is often the case, bulls pointed to the results as proof of Microsoft's underlying strength in the face of Street skepticism, while the bears sniffed that the expectations bar had been set low enough that outperformance doesn't mean much.

Revenue was down less than 1%, and just very slightly ahead of expectations. Windows OEM revenue was up 4% despite a weak PC environment and consumer Office revenue was up 15%, but overall devices and consumer licensing (D&C) revenue was up just 1%. Much better hardware revenue (up 41%) helped propel overall D&C revenue growth of 12% as the company saw a sizable increase in Xbox revenue. Commercial revenue rose 7% as Windows, server products, Office 365, and products like SharePoint and Lync all enjoyed double-digit growth. Billings grew 6% for the quarter, down from the prior quarter's double-digit growth, but still meaningfully better than reported revenue.

Margins were mixed – better than expected, but not exactly strong. Gross margin declined almost six points from last year, but came in a point higher than expected. Operating income declined 8% with a two-point decline in margin, but was about 8% higher than expected.

Still Seeding The Cloud

Microsoft continues to see solid results from its focus on cloud offerings. Azure is more than holding its own with Seattle-based Amazon.com, Inc.'s (Nasdaq:AMZN) Amazon Web Services and making available Redwood City, Calif.-based Oracle Corp. (NYSE:ORCL) products, such as its database offerings, certainly is not doing any harm to its popularity. It's pretty much all-out war now between Amazon, Microsoft, and Menlo Park, Calif.-based Google (Nasdaq:GOOG), but Microsoft has done a commendable job of adding features at a steady pace. By virtue of its first-to-market status and its seeming willingness to take lower margins, Amazon still calls the tune on pricing, but Microsoft is at least making it clear that it has no intention of letting cloud IaaS (infrastructure as a service) chew up its legacy business without participating in the market.

Consumer Still In Flux

Microsoft probably doesn't get the credit it deserves on the server/tools and cloud side, but its consumer business is a different story. There are legitimate issues here, as the negative response to Windows 8.0 seems to have really caught management off guard. It is likewise unclear whether the company may be overreaching on shifting to a cloud/subscription model on Office, though the 15% growth this quarter doesn't suggest mass abandonment.

Phones are another matter. Not unlike Santa Clara, Calif.-based Intel Corp. (Nasdaq:INTC), Microsoft's approach to phone OS may be flawed. Cupertino, Calif.-based Apple Inc. (Nasdaq:AAPL) and Google have staked out a large swath of territory. Likewise on handsets, Apple is showing no particular signs of losing momentum on the high end. Microsoft's long-term competitiveness against Korea's Samsung Group or China's Lenovo Group Ltd. (OTC Pink:LNVGY) in the global middle-market may be in doubt, even if Lenovo has yet to prove it can be a top-five contender outside of China.

Modest Expectations Still Dominate

It wasn't so long ago that Microsoft was priced as a no-growth or even FCF contraction story. Those expectations have improved since, but Microsoft only needs to grow FCF at a rate of 2% going forward to justify today's price, and that is with a double-digit discount rate. Give the company a target of mid-single digit FCF growth and a fair value in the high $40s comes into play.

The Bottom Line

Microsoft seems undervalued on multiple metrics, but the reality is that low revenue growth is often a big obstacle to multiple appreciation in tech stocks. As Microsoft seems disinclined to split itself into smaller growth and income-oriented businesses, investors considering these shares need to be prepared to wait out the sometimes frustrating delays in seeing the company's underlying value reflected in the stock price.

Disclosure – As of this writing the author owns shares of Lenovo.

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