Quick Thoughts: GOOG and MSFT Hit a Speed Bump

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–          GOOG and MSFT missed 2Q after beating 1Q, triggering a pull back, but more indicative of short-term issues than a change to their long term potential

–          Google sales were strong – up 22% YoY adjusting for currency. EPS was short, with operating expenses up 200bp QoQ on justifiable investment in attractive new opportunities

–          Microsoft has big opportunities in the cloud, but its exposure to plummeting PC sales and weak enterprise data center spending took a bigger bite this quarter than last.

–          Both huge companies still posted double-digit growth and are amongst the very best positioned players for the future of TMT. This is a significant buying opportunity.

It was an important day in tech earnings with two juggernauts, Google and Microsoft reporting. For Google it was FQ2 of 2013 and for Microsoft, this earnings cycle represented the end of its 2013 fiscal year. The names have both had a good run so far this year, returning 28.7% and 32.7% to investors respectively YTD and both were trading at near all time highs. Though they each delivered earnings misses and were down in after hours, both businesses are strongly positioned and the after hours sell-off looks like a significant over-reaction.

First, let’s talk about Google, still shy of its 15th birthday, which reported some impressive milestones like 900M Android activations and 750M chrome users. While worrywarts will perseverate over a modest set-back in cost-per-click as the mobile search market moves inconsistently forward, a dramatic increase in the total number of paid clicks drove very strong sales. Revenue at $14.1B was up 19% YoY, fell a tad short of consensus expectations at $14.4B, but took a $400M hit from currency affects. Non-advertising revenues were particularly strong, with ad sales falling from 96% of revenues to 92% from the year before, excluding Motorola.

Google is making progress monetizing other areas such as hardware with the Chromebook, content with Google Play, and the enterprise with Google Docs and Cloud Services. The increase of non-advertising revenue is a big deal for Google – a sign that it is beginning to take advantage of its strategic positioning in almost every corner of the evolving TMT landscape. Researching the key change themes across the entire sector, it is rare to find a topic to write about that doesn’t touch on the company. It leads in digital advertising, pioneered consumer apps in the cloud, now designs its own hardware devices such as Chromebooks and Android phones, serves media via YouTube and Google play, is an ISP with Google Fiber, and has the most robust cloud data center architecture of any technology company in the world.

But these ambitions don’t come for free, and the growing spending on R&D and marketing ate into margins during the quarter. R&D now makes up 14% of revenue as Google invests to extend its advantage in data center architecture, software platforms, and cloud applications, while pursuing opportunities in new business areas from Google Glass to self-driving cars. Marketing has become a new focus, with a steady advertising presence around its software platforms and a plan to support its upcoming Moto X smartphone with a $500M marketing campaign. Google is investing to give its advertising clients more value added services, like brand building with enhanced campaigns.

It is also investing to expand and improve its already world-best and biggest cloud infrastructure, the source of much of its competitive advantage vs. its rivals in software platforms, applications and services. Capex spend for the quarter was up more than 50% YoY, an immediate drain on cash flow but a wise long term investment. Unfortunately for Google, Wall Street doesn’t seem willing to give Larry Page the same free pass that it gives Jeff Bezos, but with 20% sales growth and wide gross margins, we do not expect the profitability squeeze to last very long.

Microsoft, who just last week introduced a sweeping organizational change, grew revenue by 10.1% YoY for the quarter and 5.5% for the year. Revenue was off by only 1% of expectations, but each business unit realized revenue growth in the quarter and the fiscal year. Even the PC exposed Windows division reported revenue growth in the mid-single digits. Microsoft has been handling the declining PC market fairly well. While the Business division saw consumer revenue for Office down 27% due to an upgrade offer, newly installed CFO Amy Hood disclosed the company has made strong progress with moving consumers to the cloud and adopting Office 365, which now has over 1M subscribers representing a $1.5B run rate. Business division revenue overall was up 14%.  The company’s server and tools division, which still grew by 9% was off from mid double digit guidance with weakness in data center spending as enterprises increasingly look to the cloud. Incidentally, the hosting business is reflected in this division as well and reported a 16% increase in unearned revenue offsetting data center weakness. This is a positive sign for the Azure infrastructure business. Mister Softy’s Entertainment (XBox) and Online Services (Bing) divisions also grew revenue by 8% and 9% respectively. We expect entertainment to do well with the launch of XBox One a couple quarters away. Notably, online services is still in the red, but has been narrowing its losses.

Like Google, Microsoft’s quarterly troubles were related to expenses. Windows division operating margins were negatively impacted by a write down of Windows RT and marketing costs for growing Windows, the latter which we see as a critical expense for Microsoft. The company also saw a 7% increase in R&D due to greater headcount. As the company shifts to a more unified OS across devices, the 12% increase in sales & marketing for promoting Windows 8, the Surface and Office is a necessary investment in the future. Other than the Surface RT, whose price decline was announced last weekend and spurred a $900M write down, nothing was really out of left field. While Ballmer’s track record over the last decade has been checkered, he has made some important strategic decisions over the past couple of years we believe have positioned the company well for the future.

For our full research notes, please visit our published research site.

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