Microsoft kicks off Big Tech’s earnings alongside AMD and Alphabet, with AI in the spotlight as the company posted a sizable beat last quarter while seeing “higher-than-expected AI consumption.” Revenue and EPS estimates have inched higher, with the current revenue estimate of $61.1 billion slightly above management’s guide for $60.9 billion, highlighting the optimism the Street has on AI-related tailwinds.
Azure and Copilot will be closely watched, as Intelligent Cloud drove $850M of Microsoft’s ~$2 billion beat in fiscal Q1 due to AI tailwinds, while analysts are optimistic on Copilot creating a new stream of revenue over the next few fiscal years. Microsoft has been a big investor in scaling its data center and AI capabilities, and the Street is looking for these investments to bear fruits in Q2.
Notably, as stated in our AMD write-up, keep an eye out for a PC super cycle which could occur in H2 2024. Microsoft will be a clear beneficiary of this given Windows is expected to get its most important upgrade in many years (decades?) with many AI features.
Revenue and EPS:
Microsoft is currently expected to report $2.77 EPS on $61.13 billion in revenue, representing 19.3% and 15.9% YoY growth respectively. This would mark a significant acceleration in revenue growth, from 8.3% in fiscal Q4 to 12.8% in fiscal Q1. To put this in perspective, revenue growth estimates for fiscal Q2 were just 10.6% in October, with Q1’s beat and guide leading to a 530 bp acceleration.
Revenue growth rates are expected to hover around 15% through fiscal Q1 2025 as Microsoft captures AI related growth in Azure and Copilot. However, Microsoft’s guide for operating margins look to be weighing on EPS estimates, which are pointing to growth decelerating to the low single-digit range in fiscal Q4.
Margins:
Fiscal Q1 saw Microsoft post strong operating margin expansion, rising 440 bp from 43.2% to 47.6%, driven by a 450 bp margin expansion in Intelligent Cloud. However, Microsoft guided for operating margin of 42.4% in fiscal Q2 and flat for the full year.
The concern here is that margins continue to deteriorate through the end of the fiscal year. Last quarter’s guide for flat YoY operating margin suggests FY24’s margin will hover around 41.8%, or a ~320 bp decline over the next two quarters. Management explained that the flat guide “speaks to the pace at which we're delivering AI revenue with the increasing cost expense and capital investment ahead with the demand we see.”
There may be some room for margin expansion in Intelligent Cloud should Microsoft remain disciplined within its spending as it progresses with Azure’s AI transition. There is potential upside to operating margins on better-than-expected integration of the Activision acquisition and Microsoft’s continued efforts to improve Azure and Microsoft 365 gross margins, given recent Copilot subscription launches.
What to Watch: Azure and Copilot
Microsoft will give the first insight into Copilot’s revenue this quarter, after launching commercial subscriptions on November 1 for its AI assistant. We highlighted previously that Copilot was among one of six levers that could drive an additional $100 billion in revenue for Microsoft by 2027.
Microsoft has ~160 million users on 365 Enterprise plans, meaning that it needs just 18% adoption of Copilot to reach a $10 billion annual revenue run rate. For the consumer Copilot, priced at $20/month compared to $30/month for enterprises, just over 5% adoption from its ~77 million user base is needed to reach a $1 billion revenue run rate.
Analysts are similarly bullish on Copilot, with Citi highlighting how “a 5% adoption rate by its 77M customers using Microsoft 365 could add $925 million in revenue by fiscal year 2025. An adoption rate of 15% could add $2.7 billion in sales.”
The immediate impact of Copilot is likely to be minimal to start given the timing of the launch, while any clues as to the initial adoption rate among enterprises will be watched closely.
Microsoft’s predominant stream of AI-related revenues at the moment stems from Azure, as it is powering a handful of the largest LLMs and AI assistants on the market, from OpenAI’s ChatGPT to Meta’s Llama and Llama 2 to Microsoft’s own Bing Copilot.
A consumption pricing model offers tailwinds to Azure, as a majority of OpenAI’s APIs for ChatGPT were all new workloads for Azure over the last twelve months. In addition, Azure Open AI Services has been adopted by 18,000 organizations, which allows companies to use OpenAI’s APIs for new development purposes. Essentially, OpenAI is helping drive growth for Azure even if startups or companies are not direct Azure customers.
Q3 saw Azure’s growth inflect whereas Google Cloud’s growth decelerated, reflecting the benefits of this consumption pricing model. Microsoft’s CFO Amy Hood explained last quarter that Azure’s “growth was ahead of expectations, primarily driven by increased GPU capacity and better-than-expected GPU utilization of our AI services as well as slightly higher-than-expected growth in our per-user business.”
What will be key for Microsoft is a sequential acceleration in Azure in fiscal Q2 – this confirms the bull thesis that AI is driving stronger revenue growth in the early innings of monetization while rivals AWS and Google falter, and the long-term thesis that AI will drive tens of billions in additional revenue. However, if Azure decelerates even slightly, such as by 1 percentage point QoQ, Microsoft’s stretched valuation leaves it vulnerable to the downside with no room for error.
Capex:
Capex commentary will be watched closely as well, given that Microsoft is estimated to have devoted 13% of Capex to AI in 2023, the most among the top cloud service providers. CFO Amy Hood said last quarter that “Capital expenditures, including finance leases were $11.2 billion to support cloud demand, including investments to scale our AI infrastructure. … We expect capital expenditures to increase sequentially on a dollar basis, driven by investments in our cloud and AI infrastructure. As a reminder, there can be normal quarterly spend variability in the timing of our cloud infrastructure buildout.”
Capex here is important as it not only allows Microsoft to rapidly deploy and scale its AI infrastructure, but it opens the door for further leverage in the future. Management explained that for “every capital dollar we spend, if we optimize revenue against it, we will have great leverage. Because wherever demand shows up in the layers, whether it's at the SaaS layer, whether it's at the infrastructure lower, whether it's for training workloads, we're able to quickly put our infrastructure to work generating revenue.”
Being able to meet high consumption and demand for AI regardless of where it is in the stack serves as a crucial tailwind in that it should allow Microsoft to fare better than its peers whenever budgets are optimized, for short or extended periods of time. To do so, Microsoft has to spend quite aggressively – its Capex to revenue ratio is nearing the highest level in 33 years, at 0.145 compared to a peak at 0.148 in March 1991.
Management may not provide a concrete capex number this quarter, given the commentary last quarter was fairly vague in terms of sequential increases. What’s critical for the company will be showing how this elevated capex spend can flow directly through to the cloud and Azure.
Valuation:
The primary risk here is that Microsoft’s valuation is back at peak levels, opening up downside risk should it show any hint of weakness, whether that surfaces in margins, EPS forecasts, Azure growth, or overall cloud revenue.
Microsoft is trading at all-time highs just below $410 after rallying more than 11% since January 5. Shares are trading at a PE of 39.7x and a forward PE of 36.5x, levels that it has historically failed to hold, with the most notable being 2021’s top. Shares are also trading at a large premium to its 5-year median PE of 31.6x.
A look at sales-based valuation metrics shows a similar trend. Microsoft is trading at 14x sales and 12.5x forward sales, both far above the 5-year median of 10.9x. Microsoft historically has struggled to hold a forward PS above 12.9x, suggesting that shares are closing in on a top if the report is nothing less than stellar.
Conclusion:
Microsoft kicks off a jam-packed week for Big Tech and AI, with the focus likely to be primarily on initial revenue generation for Copilot and any outlook provided (if any) as well as Azure’s growth and if AI can drive a meaningful sequential increase in growth. Microsoft is demonstrating that it has multiple levers within its product suite to capture AI growth and multiple outlets to capture AI growth via Azure. Fiscal Q2 is expected to start a multiple quarter streak with revenue growth near the 15% range, but EPS estimates raise concerns that margins may weigh on the bottom line. Microsoft’s valuation leaves little room for error, with shares at peak valuations and hard-to-hold levels historically. Yet, AI has been a powerful trend – let’s see if Microsoft’s AI commentary can push the stock higher, or perhaps Microsoft will instead be a reminder of just how far the Mag 7 has come in price in a brief period of time.
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