Market & Earnings Review - April 29, 2023
Market commentary, portfolio company earnings results, and closer look into Microsoft (MSFT)
Market
To the chagrin of many traders, the S&P 500 continues to push forward.
The index is up 9% YTD and continues to show momentum and technical strength, clearly above both the 200-day and 50-day moving averages. The 200-day moving average seems to have formed an inflection point and is now trending upward.
While the technical picture may be bullish, expect resistance as the market challenges the prior high of $416-417 reached in early February.
These past few weeks have been action-packed with earning announcements.
Investors were eager to hear from regional banks to assess the damage. First Republic Bank reported earnings on Monday April 24th. The stock cratered (again) and seems to be on its final lifeline.
Battling the aftermath of Silicon Valley Bank’s demise and sharing a related customer base, First Republic faced a significant run on the bank. They revealed the $72 billion of outflows they faced in Q1 – that is after 10 large national banks had joined forces to infuse the bank with $30 billion of liquidity.
Once a prestigious bank providing white glove service for HNWIs, First Republic has now lost 97% in value since its high in Jan 2022.
First Republic may be seized by the FDIC soon. Big banks, some of which participated in the cash infusion such as JP Morgan, may be interested in buying it.
Another major theme was big tech earnings. Microsoft, Google, Meta, and Amazon all reported this week. Given their immense scale, these companies give insight into the shifting landscape across many industries including advertising, e-commerce, productivity, and cloud computing.
Amazon, Microsoft, and Google are the three leaders in cloud services. The trends that can be picked out from their reports are looked at closely to try to determine an inflection point, a return to acceleration in cloud spending. At face value, their earnings reports gave hope that things had turned around. The commentary in earnings calls revealed that monthly momentum continues to decelerate, causing markets to give back some of the euphoric gains in after hours trading.
Since all 4 of those are portfolio companies, we’ll discuss more details below.
As for other indicators, inflation continues to subside.
Yields have been range bound after the steep drop resulting from the bank failures
The Fed’s May meeting is coming up next week – another 0.25% rate hike is expected. Markets are pricing in a pivot starting as soon as September.
Q1 2023 Earnings
Over the last few weeks, 13 portfolio companies reported earnings.
Our healthcare-focused companies are looking upbeat.
UnitedHealth Group (UNH) has had steadily rising expectations and continues to beat. Revenue is growing at 15% y/y and earnings guidance was raised slightly for the year.
Intuitive Surgical (ISRG) was met with a very positive market reaction, as they expect surgeries to continue accelerating throughout the year. Revenue is growing at 15% y/y. Procedure growth, previously expected at 12-16% for 2023, was upped to 18-21%. While things seem positive, ISRG is looking pricey at this level.
Payment processing companies V & MA as well as financial information companies SPGI, MCO, & MSCI continue to perform smoothly and steadily.
The big news was in big tech, many of which surprised to the upside.
Microsoft (MSFT) was the first to report and set a positive tone. More details to come below.
Alphabet (GOOGL) followed. Exceeding top and bottom line expectations, Google showed a possible inflection point in ad spend as they returned to positive growth of 2% y/y. Google Cloud Platform has positive earnings for the first time. They continue investing heavily in AI, reinforcing Bard and bringing into their various product lines. GOOGL also authorized a $70 billion share buyback, representing nearly 5% of their market cap.
Meta (META) reinforced the positive news for advertising as they too returned to growth, posting revenue +3% y/y. Meta continues to focus on their core offerings and driving efficiency. User engagement is growing. Expenses are dropping fast, which will translate into higher operating and free cash flows. They are focusing innovation on new product lines, such as WhatsApp Business and ads that click to WhatsApp.
Amazon (AMZN) showed encouraging results for consumer spending and e-commerce, posting higher than expected sales. Profitability was also strong for the quarter. The initial numbers gave hope of an inflection point in cloud compute spending, driving up nearly all cloud providers in after hours trading. The hope quickly faded during the conference call as executives shed light on monthly trends. The specific comment: “Customers continue to evaluate ways to optimize their cloud spending in response to these tough economic conditions in the first quarter and we are seeing these optimizations continue into the second quarter with April revenue growth rates about 500 basis points lower than what we saw in Q1."
Higher-growth cloud infrastructure Cloudflare (NET) confirmed the challenging cloud environment, citing sales efficiency and longer sales cycles.
Cloud spending still seems to be in an optimization phase. It is expected to accelerate, and when it does, that inflection point will boost many players in the space.
Microsoft (MSFT)
Microsoft is one of the largest companies in the world with a market capitalization of roughly $2.3 trillion.
Founded by Bill Gates and Paul Allen in 1975, Microsoft got started with their Windows line of operating systems, expanded into Microsoft Office suite, and helped accelerate the internet with their Internet Explorer browser.
Microsoft has come a long way and evolved with the times.
Satya Nadella joined Microsoft in 1992 as a technical marketing manager running excel demos. After 22 years with the company, in 2014, he became Microsoft’s CEO and drove Microsoft’s transformation. I highly recommend his book, Hit Refresh.
While Microsoft continues to drive their Windows operating systems and Microsoft Office productivity suite, they have since shifted from building a closed platform (where their software only runs on their operating systems) towards offering their solutions across platforms (Microsoft Office running on Macs and iPhones).
They have continued their push into developer tools and productivity, building out commonplace tools like VS Code and purchasing critical software companies like Github (purchased in 2018).
Microsoft Azure has become a competitive cloud computing platform, second only to Amazon’s AWS.
Microsoft has made headlines as an early partner behind OpenAI, the company that launched Chat GPT and ignited the AI race. Microsoft is quickly embedding the technology across their offerings. As the most clear example, they embedded generative AI into their Bing search engine to challenge Google.
Microsoft is organized around 3 areas:
Productivity and business processes (32% of revenue) – Microsoft 365 productivity offering including Office, Teams, Security, Viva for employee engagement, and more; Dynamics 365 their CRM offering; LinkedIn, the professional networking site
Intelligent cloud and intelligent edge platform (38% of revenue) – Microsoft Azure platform
More personal computing (30% of revenue) – Windows OS, Microsoft Edge, hardware such as Surface line of products, and gaming including Xbox & Activision (tentative acquisition)
A summary of their latest financials:
Revenue accelerated y/y to 7% as Microsoft beat expectations for the quarter. The q/q of 0% is also a positive, given the seasonality of prior FQ2-FQ3 reports. This could possibly be an inflection point, showing a return to growth.
TTM revenue is growing at 8% y/y, declining from 20% y/y growth a year ago.
Gross margins for the quarter ticked up to 69%, demonstrating efficiency gains.
Opex costs are holding steady at 27% of revenue.
EBITDA margins are holding steady at 52%, towards the higher end of their historical range.
Operating cash flow conversion is strong at 109%, as operating cash flow of $24.4 billion exceeds operating income or EBIT of $22.3 billion. Microsoft brings in more cash than their earnings may indicate.
Free cash flow, however, has continued to tick down, now at 28% from a peak of 34%. This is primarily due to capital expenses (capex) which have increased from ~4-5 billion to a steady 6+ billion. Microsoft is likely investing in data centers and related infrastructure to build out capacity for AI.
Cash continues to build, with Microsoft now holding $56 billion in net cash.
Shares outstanding are slowly decreasing.
On efficiency: Microsoft’s EBITDA ROC ~40% and FCF ROC ~21% are very impressive and demonstrate their competitive advantage. For every $100 dollars Microsoft uses, they generate $21 of FCF per year.
The market met Microsoft’s latest release with enthusiasm, driving the shares up double digits to over $304. The outlook and charts both look bullish, as momentum tends to build in the market.
As for the valuation:
From a sales perspective, 11x revenue is pricey for such a large company. As an aside: Many smaller, faster growing companies such as DDOG, PAYC, CRWD, and ZS are trading for less – if they’d trade at 11x revenue after some 20 years of growth, that would yield spectacular results.
In terms of cash flow, the EBITDA multiple of 21x is most reasonable. FCF multiple of 40x is high, due to the investments being made.
High quality companies will always fetch a premium. Microsoft is essentially a conglomerate that is able to deliver consistent, steady results. That being said, it does seem expensive versus other options.
While momentum may take Microsoft higher in the short term, growth over the next few years seems to be priced in.
Closing
Expectations have generally been coming down over the last quarter, as the market expects an impending recession. Markets, however, have been holding up well, as the lower earnings have been countered by the expectations of slowing rate hikes. As rates steady, or even begin to drop, equities become relatively more attractive than bonds.
Big tech has been driving the market reaction. Given the uncertainty, their strong balance sheets have given investors comfort. Some such as Google and Meta have been attractively valued and compelling opportunities. Others such as Microsoft are showing momentum and have gained quickly. As major constituents of the market, these companies significantly influence the indices. Apple’s report next week will shed more light.
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Torre Financial is an independent investment advisory firm focused on emerging and established compounders.
Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
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