Microsoft: the growth story is not over

Microsoft (“Wide Moat”) reported strong first quarter 2023 results, including revenue and earnings per share (EPS) ahead of the midpoints of guidance.

The outlook, however, was worse than our consensus-line model predicted.

Macroeconomic pressures continue to weigh on the company’s performance.

Optimistic investors may point to good commercial bookings growth and remaining commercial performance obligation for near-term comfort, while pessimists will no doubt point to Azure’s slowdown and weaker-than-expected guidance.

We continue to find encouragement in Azure, the migration from Office E5, and the momentum of the Power platform for long-term value creation, but we believe that short-term pressures will not be exhausted over the next trimester.

It’s premature to say that Azure’s growth story is over despite the downturn.

We believe the results reinforce our thesis centered on the proliferation of hybrid cloud and Azure environments, as the company continues to use its on-premises dominance to allow customers to move to the cloud at their own pace.

Based on guidance from the company, we have lowered our forecast for revenue growth and operating margin for fiscal 2023 and 2024, and thereby lowering our estimate of fair value for Microsoft from $352 to $320 ($ ) per share.

We view equities as attractive.

Good growth over the quarter

For the September quarter, revenue increased 11% year-over-year, or 16% in constant currency, to $50.12 billion, versus the midpoint of guidance of $49.75 billion. and the FactSet consensus of $49.76 billion.

Compared to the prior year period, Productivity and Business Process, or PBP, is up 9%, Intelligent Cloud, or IC, is up 20%, and Personal Computing, or MPC, is remained stable.

Compared to forecasts, PBP and MPC performed well, while IC lagged.

We expected more pressure on LinkedIn, Windows, Bing and games given their exposure to advertising and consumers.

Key pillars of our growth thesis for the quarter included constant currency year-over-year growth of 42% for Azure and 32% for Dynamics 365.

Azure slowdown

Key growth drivers showed decelerating growth both sequentially and year-on-year.

Commercial bookings were up 16% year-over-year in constant currency, bringing the remaining performance obligation to $180 billion. Driven by the continued strength of Azure transactions, Microsoft generated $25.7 billion in cloud revenue.

That said, forecasts called for 43% growth in constant currency for Azure, versus 42% achieved. The company engaged in successful campaigns to help customers optimize their workloads, which ironically may have contributed to this slight shortfall.

Ultimately, the market is huge and slight variations from forecast in any given quarter are not of concern in our view.

While large deals were good, deals with small and medium businesses continue to show signs of fatigue, especially outside of the migration to Office’s E5 system.

Margin down

Operating margin was 40.8%, compared to 43.0% last year, due to macroeconomic revenue pressures and several one-time expenses during the quarter, including the integration of Nuance and rising electricity costs for data centers.

We continue to see a path of margin expansion from already strong levels over the next five years, which we believe will be driven by Azure’s gross margin rate progression, even if the company suffers a short term pressure.

Caution for the second trimester

The December quarter forecast calls for revenue of $52.35 billion to $53.35 billion, or $52.85 billion at the midpoint, versus $56.22 billion for the FactSet consensus.

Revenue growth at the midpoint of the forecast is 2% year-over-year, as noted, which includes an expected currency headwind of 500 basis points.

We are seeing further deterioration in advertising and consumer-related revenue, such as Bing, LinkedIn and games.

Management also provided a full-year outlook, calling for “double-digit” revenue growth, with a 500bps unfavorable currency impact, a 100bps margin reduction operations and a moderation in spending levels throughout the year.

Additionally, as energy costs skyrocket, Microsoft began facing higher energy expenses for its data centers during the quarter.

This is expected to continue throughout the year, adding an additional $800 million in spending, which is included in general guidance for fiscal year 2023.

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