Winning in Games

Sector: Technology Dave Novosel September 29 , 20 20 [email protected]

Winning In Games

♦ Microsoft (MSFT), although apparently a much better match than Oracle, lost out on the bidding for TikTok. But it may have saved itself some headaches, given the political interference in that situation. After losing that opportunity, the company turned immediately and announced the acquisition of ZeniMax Media, the parent company of Bethesda Softworks. Bethesda develops and publishes video games, including The Elder Scrolls, Doom, and Fallout. The deal expands Microsoft’s game studios from 15 to 23, strengthening its position in the rapidly expanding gaming market. The timing is good as Microsoft is about to launch its eagerly awaited Xbox Series X and Series S in time for the holiday season. In addition, Microsoft bolsters its line-up to attract more users to its Xbox Game Pass. Microsoft is paying $7.5 billion in cash to acquire ZeniMax Media. ZeniMax is privately held, but speculation is that annual revenue was less than $1 billion, implying that EBITDA was less than $300 million. Therefore the deal could be viewed as quite expensive. But Microsoft has such tremendous financial flexibility that it really won’t have much of an impact on the credit profile. The company has close to $14 billion in cash and another $123 billion in short-term investments. In addition, the company generated more than $30 billion of free cash flow in the fiscal year that just ended June 30 th . ♦ Microsoft posted revenue of $143 billion last year, so the acquisition’s financial impact on operations is minimal. Presumably, the transaction will add some growth. But it is not as if growth is sorely needed. Revenue soared nearly 14% last year, with gains of 13% and 15% over the last two quarters. That followed growth of 16% in fiscal 2019. Revenue is amazingly balanced among its three reporting segments. However, the recent growth has stemmed mostly from the Intelligent Cloud segment. Revenue in this segment surged 24% last year, including a gain of 47% for Azure in the fourth quarter. We expect another year of robust growth in Intelligent Cloud, where the company remains #2 behind Amazon Web Services. But we expect growth to slow to a high teens pace. We estimate that growth in the Productivity and Business Process segment will recede to roughly 8% this year compared to nearly 13% last year. The More Personal Computing unit should deliver growth of 2% to 3% this year, reflecting the declining trends in the PC industry . Cumulatively, we are projecting revenue growth of approximately 9% in fiscal 2021. While not as impressive as the last couple of years, that is quite robust. Meanwhile, operating margins have been ramping nicely. They have risen from the 29%-31% range in fiscal 2016, 2017, and 2018 to 37% last year. Margins have benefited from the greater mix of Intelligent Cloud revenue, which is more profitable. We estimate margins will increase by at least 100 basis points in fiscal 2021. ♦ Microsoft used some of the extraordinary free cash flow to slash debt by more than $5 billion in fiscal 2020. Combined with the substantial increase in EBITDA, leverage dropped to 1.0x from 1.3x the previous year. We estimate that free cash flow will increase to close to $31 billion this year. Based on the pace of the past two years, we anticipate share repurchases of roughly $20 billion. The ZeniMax transaction and possibly another small deal or two could amount to about $10 billion. We assume that debt will remain relatively unchanged. But the improvement we expect in EBITDA should result in a decline in leverage to 0.9x. ♦ It is hard to find much fault with a company that is posting substantive revenue increases, rising margins, massive free cash flow, and very low leverage. While the pandemic could hinder future growth, it has helped of late. Admittedly, spread tightening may be limited at this point. Yet we think spreads will hold firm in various economic environments. We are initiating coverage of Microsoft with a buy recommendation. The 2027 issue is trading at a spread of +62 to the 5- year Treasury.

Gimme Credit LLC Analyst's Data Sheet ($ in millions)

Microsoft Corporation Dave Novosel, CFA Date Produced: September 29, 2020

Y/Y fiscal year ends in June 2021E 2020 Change 2019 2018 Sales 156,350 143,015 9.3% 125,843 110,360 Adjusted Gross Profit 107,930 96,937 11.3% 82,933 72,007 Adjusted EBITDA 73,880 65,755 12.4% 54,641 45,319 Adjusted Operating Income 60,280 52,959 13.8% 42,959 35,058 Interest Expense 2,600 2,591 0.3% 2,686 2,733

Cash Flow from Operations 66,900 60,675 10.3% 52,185 43,884 Capital Spending (18,200) (15,441) 17.9% (13,925) (11,632) Dividends (17,914) (15,137) 18.3% (13,811) (12,699) Free Cash Flow 30,786 30,097 2.3% 24,449 19,553

Cash 17,362 13,576 16,172 11,946 Total Debt 63,327 63,327 72,178 76,240 Net Debt 45,965 49,751 56,006 64,294 Shareowners' Equity 118,304 118,304 102,330 82,718 Book Leverage 35% 35% 41% 48% Net Leverage 28% 30% 35% 44%

Ratios and Margins: Debt/EBITDA 0.9 1.0 1.3 1.7 EBITDA/Interest 28.4 25.4 20.3 16.6 Gross Margin 69.0% 67.8% 65.9% 65.2% EBITDA Margin 47.3% 46.0% 43.4% 41.1% Operating Margin 38.6% 37.0% 34.1% 31.8% Cash Flow from Opers/Debt 106% 96% 72% 58% Free Cash Flow/Debt 49% 48% 34% 26%