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.

Related Articles
  1. Investing News

    Is Amazon Prime Still The Best Deal In Tech?

    If you asked that question a week ago, when Seattle-based Amazon.com, Inc. (Nasdaq:AMZN) raised its annual fee for Amazon Prime to $99 from $79, you might have heard a far different answer.
  2. Investing

    5 Up and Coming Social Media Startups

    Although the days of Facebook's dominance aren't close to being over, here are some new creative platforms gaining traction on the worldwide web.
  3. Investing News

    Public Vs. Private Tech Valuations: What's Driving the Divide?

    The gross valuations over the past five years are more indicative of the market than the true value of the company itself.
  4. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  5. Investing

    Why Does Amazon Let Its Competitors Use AWS? (AMZN,NFLX)

    Amazon allows dozens of its competitors use AWS. Is this a strategy to earn revenue or something more?
  6. Investing

    Cybersecurity Startups Are an Emerging Trend

    As cybersecurity spending across both government and private sectors continues to increase amid rising concern of security threats, the potential for cybersecurity startups has never been greater. ...
  7. Stock Analysis

    Top 5 Companies Owned By Microsoft (MSFT)

    Find out about Microsoft's most newsworthy acquisitions. Microsoft acquired Skype in 2011 to expand its footprint in the online telecommunications sector.
  8. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  9. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  10. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
RELATED FAQS
  1. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. Is Apple Pay safe and free?

    Apple Pay is a mobile payment system created by Apple to reduce the number of times shoppers and buyers have to pay for goods ... Read Full Answer >>
  3. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  4. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  5. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  6. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center