David Garrity on CNBC’s “Fast Money” – MSFT Hits All-Time High

MSFT FY17Q4 Results May Signal Turn Toward Accelerating EPS Growth:

Under CEO Satya Nardella, MSFT has rationalized underperforming portions of its solution portfolio and with its rapidly expanding cloud computing offerings plus the LinkedIn acquisition is now in a strengthened secular position. From FY12 to FY15, MSFT EPS contracted at a -1% CAGR. With its present business portfolio, expectations are from FY16 to FY19 MSFT EPS should expand at a better than +10% CAGR. Accelerating EPS growth typically supports P/E multiple expansion. This is the backdrop against which investors assess MSFT’s FY17Q4 results (Street revs $24.3bn, +7.2% y/y; EPS $0.71, +2.9% y/y). Most important for MSFT growth prospects is the accelerating market adoption of its cloud computing offering Azure which is well positioned relative to AMZN’s AWS (see: G2 Crowd IaaS Grid Report).

The two major questions investors will want MSFT management to address are:

– 1) As MSFT’s Commercial Cloud operations reach scale (FY17 $12bn+ from Office 365 (O365), FY18 $16bn+ from O365 and Dynamics 365), what is the opportunity to grow average revenue per user (ARPU) at better than the +7-10% rate seen over the last 4 quarters and in the process increase gross margins? and
– 2) What is MSFT management’s confidence in maintaining operating expense discipline to allow for profit margin improvement during a period of increased data center investment?

Once 2Q17 Earnings Season Over, Investors Should Focus on Names With Rising Profit Margins Off Increasing Sales:

Coming out of the June 2017 tech pullback, we note that the sector benchmark Technology Select Sector SPDR ETF (XLK) is up +3.14% since 6/12/17, continuing to lead the broader S&P500 (+1.89%) with 5 stocks (AMZN, FB, GOOGL, MSFT, NFLX) outperforming by a wider margin (+10.85%). Factors supporting both the tech sector and broader market gains have been the prospects for: 1) regulatory reform, 2) corporate tax rate reduction, 3) overseas profit repatriation, and 4) higher GDP growth. We caution that diminished political prospects may cap the sector’s rebound once 2Q17 earnings season is past and that investors should be selective.

Meanwhile, to that end, the table below shows the current next quarter growth forecast for sales and earnings for tech sector leaders along with the percentage decline of their shares from their respective 52-week highs and the P/E/G (price/earnings/growth rate) ratio contrasting the current 2017 P/E ratio with the EPS growth rate over the 2016-2018 timeframe. With possible concerns around economic growth, it is important investors consider those names where profit margins are expanding (i.e. EPS growth greater than sales growth) over names where profit margins are under pressure or where EPS are seeing outright declines. When faced with uncertainty, selectivity is critical to preserving capital and, along with it, performance.