Still climbing the Wall Of Worry in great companies like Microsoft
The US S&P 500 Index has rallied ~6% from mid-August lows to be back at all-time highs. This is a classic example of the equity market climbing the wall of worry.
Back in August, all the Twitter headlines were about “inverted US yield curves”, “worsening China-US trade war”, “hard Brexit”, “Hong Kong riots”, “spiking overnight cash rates” and “pending weak US third-quarter earnings” to name a few.
To be fair, they were all reasons for short-term concern, and I understand why investors were nervous. However, what happened amongst all these headlines? The Federal Reserve lowered the cash rate for the 2nd time this year, and moved by another -25bp this week.
I am reminded yet again of the saying, "don't fight the Fed". Central banks have limitless firepower, no benchmark and unlimited duration. It has proven unwise to attempt to “short them” as such.
What we have also seen since the mid-August lows is the US yield curve move back into positive territory (albeit a small positive), the China-US trade war thaw half a notch (i.e. not get worse), hard Brexit become less of a risk, Hong Kong riots lessen in intensity (no PLA Tanks in HK), overnight cash rates re-trace due to the on market actions of the New York Fed, and US 3rd quarter earnings broadly better than expected.
Today we have lower cash rates than in mid-August, yet all the macro pressures that were weighing on equity markets at that time have dissipated a notch (or two), but have not disappeared.
We tend to see macro and headlines dominate short-term sentiment in between US quarterly earnings seasons. However, when we start getting some bottom-up earnings facts from major corporations, the true state of the world economy is easier to judge. With ~40% of S&P 500 having now reported, the blended growth rate stands at (3.7%), better than the (4.0%) expected at the end of the quarter. Roughly 80% have beat consensus EPS expectations, which is better than the 74% one-year average. Generally, companies are pointing to the difficult macro backdrop and trade uncertainties as headwinds, but companies are not forecasting a US recession in their outlook statements.
World leading businesses like Microsoft, Nike and Louis Vuitton Moet Hennessy continue to power along, despite these macroeconomic headwinds. However it is interesting to see the WAAAX index -27% since the September peak. I remain cautious on highly valued profitless companies yet bullish and invested in what we consider undervalued, highly profitable companies that will compound over time. I still believe equity markets globally are becoming more discerning, behaving more like “weighing machines”, than “voting machines”. In my view, you will be better served being invested in ultra-high barrier to entry, high return on invested capital, profitable and strong free cash flow generative companies.. rather than those the market “hopes” will generate those attributes in the future and will require more funding from investors (remember WeWork, $47b to $8b “valuation” in a month).
At AIM, we look for companies that have the long-term ability to generate excess returns on capital and reinvest that capital at rates of growth greater than inflation. These are what we call compounders. Microsoft (MSFT) is a classic example of a compounder. It is the largest company in the world and exhibits all the highly attractive investment attributes mentioned above.
I have written before on MSFT, but I do want to run through some analysis of the Q1 result. MSFT is a trillion-dollar market capitalisation company. Revenues grew by +13.7% in the quarter v. pcp, beating consensus forecasts by +2.5%. That revenue growth alone is around 6x global GDP growth, even more in constant currency terms (USD strength was a headwind).
Source: AIM estimates
MSFT experienced positive JAWS as revenue growth (+13.7%) vastly outpaced cost growth (+5.1%). This saw gross margins rise to an enviable 68.5%. Further cost discipline supported operating margin expansion, leading to net profits rising +21% and EPS +21.9% due to the effect of buybacks on reducing share count. This is a very impressive set of numbers.
Two key points from the result are worth highlighting:
- Azure growth of +59% (as reported, +63% in CC) remains incredibly strong. While Azure growth has been moderating for several years, we would argue that has a lot more to do with base effect than with a slowdown in demand. This is corroborated with the fact that MSFT clients are signing longer-term contracts for Azure engagements, which show up in the growing component of remaining performance obligations. Put differently, Microsoft have already signed revenue of $26bn for the rest of this year and another $26bn for the period beyond 12 months, which they simply have not yet invoiced - a high quality problem to have.
- Of the ~$11.6bn Commercial revenues, 91% is annuity revenue.
If we are seeing equity markets becoming more discerning in their behaviour (weighing machine), then free cash generation is going to be a highly important variable. MSFT generated 21% more free cash than in the PCP. Cash from operations were stronger than the numbers indicate, with a $3.5bn cash tax payment related to the transfer of IP to a subsidiary driving only 1% YoY growth. If normalised, the actual growth in cash from operations was +27%. The FCFF number (+22%) is likely reflective of the true, underlying growth in profitability (and required investment to generate this growth), despite all the moving parts. Again, a business with a $125bn+ revenue line and trillion-dollar market cap growing FCFF at +20% remains remarkable.
MSFT has the very high-quality problem of generating too much cash. They don’t need any more with a balance sheet like this below. That’s why we can look forward to higher dividends and increased buybacks.
Source: AIM estimates
Net Cash of $67b is up by ~12.5%. The ROE is marginally down on a T12m period, but that's more to do with the reduced leverage - the actual profitability of the capital deployed means the ROIC has ticked up modestly to 22%.
In terms of guidance, Q2 guidance came in above consensus estimates on revenue and below on costs. MSFT continues to expect double-digit growth for FY20 and improving operating margins.
All in all, this was an excellent set of numbers from a structurally strong global growth company. MSFT is a clear compounder in my opinion.
I’ll finish with a simple year-to-date comparison of the Australian WAAAX Index and MSFT. While WAAAX has delivered +66%, MSFT has delivered +40.6% ytd. It reminds me of the fable of “the hare and the tortoise”. The hare could well be running out of puff and I’d rather back the tortoise...
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Charlie is the founder and CIO of Aitken Investment Management. He has spent 28 years working in equity markets and has seen many market cycles. He and his team focus on a strategy of investing in high-quality cash-generative businesses to grow...