Three trillion-dollar tech giants walk into an earnings season…

Over the last week or so, three of the four most valuable companies in the world have reported financial results for their most recent respective fiscal quarters. We will spend some time in this post looking at the key findings in the reports of Microsoft, Apple and Alphabet. The time and effort spent is worthwhile not only because these businesses are massive in scale and value, with operations that are important to billions of people around the world, but they are also holdings in the Montaka long portfolio.

Microsoft, Apple and Alphabet are quite the collection of companies. Microsoft is the world’s largest enterprise software company; Apple is the world’s leading premium smartphone company; and, Alphabet is the world’s largest internet search engine (through Google) and digital advertising company. At times their products and services work together and other times they are fierce competitors. They have an aggregate market capitalization of around US$2.8 trillion (ok, none of them are currently worth exactly a trillion US dollars, but close enough) and their aggregate revenue in the past 12 months was more than half a trillion US dollars. Let’s see what they’ve been up to lately and how that figures into the investment case for the stocks.

Microsoft’s Q3 2019 Result

Microsoft reported strong growth – yet again. Revenues were US$31 billion, up 14% compared to the same period last year. This growth represented acceleration from 12% reported last quarter. Profits increased even quicker, growing 25% to more than $10 billion, as Microsoft continues to earn more on each incremental dollar of sales. The strength was broad based.

Source: Company reports; Bloomberg; Montaka

In the Productivity and Business Processes segment, which is known for the suite of Office applications (Word, Outlook, Excel and many more), revenue grew 14% to $10.2 billion and earnings were up 28% to $4 billion. PBP benefitted from the Office 365 cloud product sold to commercial customers which continues to grow at more than 30% year over year.

In the Intelligent Cloud segment, known for the Azure cloud business, revenue grew 22% to $9.6 billion and earnings were up 21% to $3.2 billion. Azure is now a $16 billion annualized revenue business and still growing at 75%. And as it scales its profitability keeps improving. We estimate Azure’s gross profit margins have risen by more than 20 percentage points to around 50% in the past year.

The most interesting comments management made related to the increasing addressable marketplaces for each of the Office 365 and Azure franchises. Microsoft’s cloud focus in both these segments is allowing the company to reach new users and capture more of their workloads. This bodes well for strong growth to persist and shareholder value to accrue for many years to come.

Microsoft share price over the past five years

Source: Bloomberg

Apple’s Q2 2019 Result

After a surprisingly weak performance for iPhone sales in China at the end of last year, the most recent quarterly report from Apple was watched especially closely. Apple reported improving conditions for the iPhone in China, but its services business stole the show again.

For the quarter Apple’s revenue was $58 billion, 5% lower than the same time last year. The decline was driven (more than) entirely by the iPhone and mostly by iPhone sales in China. Total Apple sales in the region fell 21% this period. But this represented a turning-of-the-corner somewhat. Management reported that the year over year declines have been narrowing. Indeed, sales growth in China has now turned positive on a 2-year basis. We expect this recovery to continue.

Apple’s services business, which includes the App Store, iCloud, apple Music and other services, grew a robust 16% to $11.5 billion and gross profit margin expanded 2 percentage points to 64%. This means that services gross profit was more than $7 billion, up 20% from last year, and made up around a third of total company gross profits

Interestingly some commentators pointed to the moderation in services growth (from previous rates above 20%) as a problem. They may have missed the fact that the services business was being compared to growth of 40% in the year-ago period – a very strong comparison to be lapping.

Apple’s growth year-on-year by key segment

Source: Company reports; Montaka

With new services being introduced during the quarter across TV, news, games and credit cards we think Apple is well placed to penetrate its user base of 1.4 billion devices for years to come. Services will continue to scale and as it does the division will leverage its fixed cost base to drive Apple’s value higher.

Apple’s share price over the past five years

Source: Bloomberg

Alphabet’s Q1 2019 Result

Alphabet’s result was characterised by strong revenue growth, but the market’s focus was on deceleration. Alphabet generated total revenue of $36 billion in the quarter, up 17% on the prior year. However, revenue growth had recently been sustained at rates above 20% (I know, it sounds very much like Apple’s services business) and the shortfall was a concern for the market. We dug deeper.

Alphabet’s revenue growth moderation was driven by a slowdown in the key advertising services business (over 80% of company revenues). While still strong, growth in advertising services revenue slowed to 15% and fell below 20% for the first time in seven quarters. There are some caveats that investors need to be aware of.

Firstly, currency headwinds – translating non-US dollar revenues into US dollar revenues at unfavourable exchange rates – represented a 3 percentage-point headwind in the current quarter and were a strong tailwind in the year-ago quarter. We can clearly see the bump up in growth around Q1 2018 in the chart below, and the dip in growth this quarter. Looking through this, the average growth across two years is still around 20% and is in line with recent trends.

Alphabet’s advertising services revenue growth year-on-year (blue) and year-over-two-year (orange) average

Secondly, we were aware that Alphabet was faced with some controversies this quarter relating to content on YouTube. Marketers were reported to have pulled advertising against some videos and Alphabet has had to come up with product fixes. Product changes in other areas also contributed to the quarterly softness. The key point here is that one quarter does not make a trend and the nature of business is that changes and responses occur all the time. A little lumpiness around that doesn’t necessarily change the earnings power of the business.

The market’s myopic focus on Q3 2019 ad revenues may mean investors are missing a hidden (giant) gem: Alphabet’s own cloud business. Following in the footsteps of Amazon’s AWS and Microsoft’s Azure, we estimate that Google Cloud is now a $10 billion-plus annualized revenue business. Alphabet still doesn’t break this business out in its financial disclosures and while it continues to scale it is probably a drag to profit margins. But its big, and powerful, and valuable.

Worldwide cloud infrastructure spending and annual growth

Source: canalys

We think Alphabet’s advertising services business is still growing powerfully and investors will benefit from many other businesses that may not be obvious just yet.

Alphabet’s share price over the past five years

Source: Bloomberg

Notwithstanding expected lumps and bumps, we think the most recent quarterly results from Microsoft, Apple and Google demonstrate strong revenue and profit growth at each business, and powerful value-drivers for shareholders over many years.

Montaka owns shares in Facebook, Alphabet and Microsoft 

 Christopher Demasi is a Portfolio Manager with Montaka Global Investments.
To learn more about Montaka, please call +612 7202 0100.

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