Microsoft was up 5% after hours yet this reversed due to comments on the earnings call.

Ultimately, the guidance on the earnings call was weaker than expected in a few key areas:

• Revenue growth for the March quarter had a slight miss.
• Intelligent Cloud for next quarter is marking a 6-point deceleration sequentially and a 10-point deceleration YoY.
• Azure is contributing to the deceleration in Intelligent Cloud with a 4-5 point deceleration sequentially from the exit rate in December (see below transcript for clarification from CFO). This puts Azure at 30% to 31% growth for the March quarter down from 38% this quarter and down from 49% on CC basis in the year ago March quarter. You may recall, the 5 point deceleration announced in the October report caused concern in the market. This is technically a steeper decel – comments from CFO clarifying this are below.
• Commercial Cloud growth guidance of 20% for Fiscal Year 2023 (provided on last two calls) was essentially pulled and CFO said would decelerate in H2. Overall FY2023 guidance was not provided, which is out of character for MSFT. CFO cited it was due to consumer.
• The consumer is weaker than expected. Not only did More Personal Computing miss this quarter but this segment is causing enough uncertainty that the CFO did not provide a fiscal year guide.

FINANCIALS:

The current quarter was in line across the board — except the Personal Computing miss – which led to a slight miss on the top line. Azure posted slightly-better-than-expected growth of 38% compared to guidance of 37%. GAAP EPS missed while adjusted EPS beat. FCF was down quite a bit from the previous year FQ2 due to one-time expenses and consumer weakness. We break the one-time expenses down below.

Microsoft reported revenue of $52.7 billion, which missed estimates of $53.2B or by about $500 million. The market overlooked this initially because the miss was driven by the PC/consumer segment whereas Intelligent Cloud beat. Notably, the revenue this quarter was in line with guidance from management.

The guide on revenue came in at $51B at the midpoint and $51.5B at the high end of guidance, which missed expectations of $52.6B or by about $1.5 billion. This represents 3.3% growth compared to 6.7% growth expected.

As noted, the full year guide was essentially pulled as the CFO did not state a FY2023 guide despite giving us one in the past two quarters. The understanding is that the full year revenue would “grow double digits.”

Here is what was stated on the earnings call in the previous quarter:

"At the total company level, we continue to expect double-digit revenue and operating income growth on a constant currency basis. Revenue will be driven by around 20% constant currency growth in our commercial business, driven by strong demand for our Microsoft cloud offerings. That growth will be partially offset by the increased declines we now see in the PC market.”

This was shared in the earnings call this evening but is pretty vague: “First, in our Commercial business, revenue grew 20% on a constant currency basis in H1. However, we now expect to see a deceleration in H2, given how we exited December.”

Below, I include more information from the transcript. However, the Commercial business decelerating in H2 indicates it’s not only consumer weighing on the full year guide.

The company reported GAAP EPS of $2.20 which missed estimates of GAAP EPS $2.28 – I believe this is due to the layoffs which had a $0.12 EPS impact. The adjusted EPS was in line at $2.32.

For the current quarter, the operating margin and net margin was weaker than last year although the CFO did reiterate the FY2023 operating margin would be down (1%) YoY. Here is what was stated:

“As a result, when excluding the Q2 charge and favorable impact from the change in accounting estimate, we expect full year operating margins to be down roughly 1 point in constant currency and roughly 2 points in USD, even with the headwinds from materially lower OEM revenue and higher energy costs.” Note: this is a pretty strong OM given the weakness in consumer implying Microsoft is very good at pulling the necessary levers to maintain bottom line strength.

The Q2 one-time charge related to layoffs negatively impacted gross margin by $152 million, operating income by $1.2 billion, and earnings per share by $0.12. Per our Pre-ER write-up, analysts are modeling annualized net of $2 billion per year from the layoffs moving forward.

There is also a new tax law that changes how R&D expenses are taxed, which you can read about here referred to as “Tax Cuts and Jobs Act” or “TCJA.” This tax payment was $2.35 billion.

In addition to these one-time headwinds, the segment weighing on operating income is the More Personal Computing segment down roughly 50% in Op Income whereas both Intelligent Cloud and Productivity grew double digits or more on Op Income (on a CC basis).

• Gross margin of 67% which was in line and flat YoY. On a CC basis, gross profit grew 8% YoY to $35.3 billion.
• GAAP operating margin of 38.8% and adjusted operating margin of 41% compared to GAAP OM of 43% in the year ago quarter. On a CC basis, the operating profit was flat with 0% growth for $20.4 billion in Op Income.
• Net margin of 31.1% compared to 36% net margin in the year ago quarter. On a CC basis, net profit was down (4%) year-over-year for $16.4B in net profit which resulted in GAAP EPS being down (3%) on a CC basis.

Cash Flow:

Cash flow was also affected by the TCJA R&D tax payment. Operating cash flow was $11.2B down (23%) year-over-year. Excluding the tax payment of $2.355 billion, Op Cash Flow was down (7%).

Free cash flow of $4.9 billion was down (43%) YoY. Excluding the tax payment of $2.355 billion, FCF was down (16%).

For next quarter, the company expects to make a TCJA R&D tax payment of $1.2 billion.

The company returned $9.7B to shareholders with $4.6B in share repurchases and $5.1B in dividends.

Earnings Call:

Below is one of the most important questions on the call as the analyst Karl K. got three important things out of the CFO: (1) the rate of deceleration in Azure as it was not clear from comment she made as to whether it’s based on the 38% FQ2 number or the 35% December exit rate number. (2) The question also got the CFO to admit they did not give FY2023 guidance and (3) it allowed the CFO to reiterate the operating margin would remain consistent even with consumer weakness.

Karl Keirstead

Thank you. This one for Amy. Amy, given the obviously tough environment, it sounds like reaching that full fiscal year 20% constant currency commercial revs guide would be tough. Is that also true for the soft guidance for 10%-plus total revenue growth for the year? And if I could just sneak in a clarification, Amy, just because it’s an important metric. When you talk about a 4-point to 5-point decel in Azure, that’s off of the 38% reported for December, right, not off the 35% exit rate? Thank you.

Amy Hood

It’s all – Karl, let me just – the first half of your question, give me a second. On the second half of your question, which is the guide of the exit rate – it’s off the exit rate on Azure of four points to five points, just to make sure that is clear. In terms of thinking about total year revenue, right, I did not comment on full year revenue as we continue, I think really just to watch the Windows PC market as it returns to pre-pandemic levels. Outside of that, as you can see, the trends are relatively consistent. So, in some points, it’s important because if you look at the operating income margin guidance that I talked about, the fact that we are guiding to really only one point of margin deceleration for the year on a constant currency basis with probably over $2 billion of headwind from the OEM business from what we had anticipated heading into the year, the focus on margins, the focus on prioritization, the focus on putting our investments into where we know they have high return, I actually feel quite good about the place that puts us in as we exit the year in terms of – and the right energy, right, or leaving the year in Q4 on leverage.

Side Note: I’ve corrected my forum comments to reflect the 35% December number instead of the 38% FQ2 number. Azure coming in 8 points lower instead of 5 points lower sequentially is important to note. It looks like the analyst originally thought the decel was off the 38% as did I.

Another important question was around the strong trend toward optimization, or basically current customers looking for where they can cut costs. As you’ll see, some of this is from the Covid bloat although I would argue that consolidation is partly responsible, which happens to every major tech trend, regardless of a pandemic. Consolidation happens because demand for a trend is extraordinary in the beginning as excitement and adoption soars, and then consumers/enterprises cut back to only what is necessary. In the past decade alone, consolidation happened to ad-tech circa 2014, mobile apps and gaming. You’ll hear me talk about this a lot moving forward because I want I/O Fund members to be prepared – depending on how deep the recession is, not all cloud companies will survive. This is the very nature of tech.

Consolidation wasn’t specifically called out but I believe the optimizations happening now will result in consolidation and more M&A activity (if the weaker companies are lucky).

What the CEO is saying is that outside of the massive headwind that inflation presents for growth … that higher prices cause lower spending = vicious cycle that drives down growth … that he believes tech will eventually overcome this and become a larger part of GDP. In the meantime, this will be the year for optimization, and Microsoft will come out stronger in the long-term due to their positioning in AI.

Here is what was said on the call:

Brent Thill

Thanks. Satya, can you give us your overall macro view? There were some comments you had made that concerned, I think many about the state of the U.S. spending environment. I am just curious if you could comment and follow-up on what you are seeing there just from a spend environment throughout the year. I think many came away with that you are seeming that you were saying it’s getting worse, not better. Can you just give us a little more color on that? Thank you.

Satya Nadella

Thank you, Brent. And first of all, I was making a comment which was sort of a global comment, not just a specific U.S. comment. I mean there is only – I always sort of subscribe to that there is only one law of gravity that I think all of us are subject to, which is inflation-adjusted economic growth in the world. And then how many times that do we grow, because as I have said in my comments that I fundamentally believe tech as a percentage of GDP is going to be much higher and on a secular basis. So, the question is how many times is it given the overall inflation-adjusted economic growth. So, that’s kind of how I look at it. Given that, I think the two things that we see, we commented on that even in the last quarter, and it’s even in the outlook, which is the thing that customers are doing is what they accelerated during the pandemic. They are making sure that they are getting most value out of it or optimizing it and then also being a bit more cautious on given the macroeconomic headwinds out there in the market. So, given those two things, the point is at some point, the optimizations will end. In fact, the money that they save in any optimization of any workload is what their cloud into workloads. And those workloads will start ramping up. And so one of the key things we are watching for, Brent, is to make sure that we are gaining share in this space through our value propositions, so and even build loyalty with our customers so that long-term, we are well positioned for share gains. So, that’s sort of fundamentally how we view it. And then the other aspect I would also say is simultaneously investing in this new AI trend, because I don’t think any application start that happens next is going to look like the application starts of 2019 or 2020. They are all going to have considerations around how is my AI inference performance, cost, model is going to look like, and that’s where we are well positioned again. So, that’s how I view it. The market, you all are better readers of, quite frankly, what’s happening out there. We can tell you what we see. What we see is optimization and some cautious approach to new workloads and that will cycle through, but we do fundamentally believe on a long-term basis, as a percentage of GDP, tech spend is going to go up.

OpenAI was discussed on the call, and the CEO said what I would expect him to say – which is that Microsoft is strong in many areas of AI. For example, Github CoPilot offers auto complete coding suggestions and has 1 million users.

Conclusion:

We continue to like Microsoft for its bottom line and its ability to sell into enterprises. I believe this is the key thing missing in many of the other mega cap companies with AI/ML and other related ambitions, which is Microsoft owns the perfect customer base to ramp AI applications – which is the large budgets of the Fortune 500. Startups drive this too but not at the scale of the Fortune 500 and Fortune 2K.

We want to build this position on any weakness although we want to be sensitive to timing as we’ve been discussing for some time now that cloud budgets may be the next shoe to drop. The lack of a FY2023 guide from the cloud bellwether, although citing consumer, didn’t provide much information in terms of what the CY2023 cloud budgets are looking like. I think reading between the lines, even without a fiscal year guide, Azure’s further deceleration next quarter isn’t painting the best picture of cloud budgets.

On a side note, I am not sure what the tax implications of TCJA will be for other companies in the tech industry given the industry’s large R&D spending. After reading about the Tax Cuts and Jobs Act, it certainly doesn’t seem like it will be isolated to Microsoft and rather it will affect R&D investments primarily made outside the United States (foreign versus domestic R&D). Perhaps other Big Tech earnings next week will help shed some light on what to expect.