Microsoft Cloud Grows in Q2 With Strong Free Cash Flow

Microsoft (MSFT) reported its fiscal Q4 (calendar Q2 ending June 30) financial results on July 26 with strong revenue, operating income, and free cash flow growth. This was powered by the strength of its Cloud products and Azure. Moreover, the stock looks undervalued even after rising since the earnings were released.

Revenue was up 12% in its fiscal Q4 over the prior year and its operating income was up 8%. However, net income was up just 2% and earnings per share were up 3% YoY. Net income and earnings per share are not as important anymore given the huge amount of non-cash charges.

Powerful Free Cash Flow

For example, Microsoft's operating cash flow, which excludes these non-cash expenses, rose by 8% to $24.6 billion on a YoY basis in Q4 to $24.6 billion. This is also noteworthy since it represents an astoundingly portion of revenue, which was $51.9 billion. In effect, the operating cash flow margin was 47.4% of revenue.

Following on from that, after deducting capital expenditures, its free cash flow (FCF) for the quarter was also very high at $17.8 billion. This was up 9% YoY and also represents a very high margin - 34.3% of sales.

By the way, Microsoft has started relating its revenue and earnings numbers in what it calls “constant currency.” This is designed to take out the effects of the strong US dollar. The only problem is that you can't spend constant currency numbers. It is a theoretical construct. That is why it is more important to focus on what is driving free cash flow.

Most of its growth this quarter came from its Cloud products and offerings. 

Cloud Growth

Microsoft said that its Cloud revenue was $25 billion, up 28% YoY. You can also see that this was much faster than the total company growth of 12%.

It also represents 48.2% of total revenue and is likely to keep growing as a percent. For example, last quarter its Cloud revenue was 47.4% of revenue ($23.4b / $49.1b total revenue).

Microsoft defines its Cloud revenue as its Azure platform (enterprise cloud server products), Office 365 commercial, and the commercial portion of LinkedIn, Dynamics 365, and other cloud products.

So slowly the company is transitioning from just offering Office products software.

Shareholder Value Actions

Microsoft returned $12.4 billion to shareholders in the form of share repurchases and dividends in the fourth quarter of fiscal year 2022. This was 19% more than what it did during the fourth quarter of the fiscal year 2021.

Most of this was in the form of share buybacks. For example, in the last year, the company spent $32.7 billion on buybacks, vs. $27.4 billion last year, an increase of 19%. But it spent just $18.1 billion on dividends, although this was also 9.8% higher than the $16.1 billion in dividends last year.

As a result, its share count is falling, which allows the company to pay more in dividends per share. As a result, it has raised its dividend in each of the last 18 years. It is likely to do so again in mid-September.

The Stock Reaction 

In the last 3 days, since the earnings release, MSFT stock is up over 13% to $280.74 per share. It could easily continue to rise significantly as the stock is still down 16% YTD. Moreover, it s its FCF keeps growing I estimate that Microsoft's value could rise 14.3% to $320.88 per share. This is based on a 10% gain in FCF and a 3% FCF yield metric.

Bottom line: MSFT stock is still undervalued.

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