Let’s be real, the Nasdaq has rallied more than it has in its 52-year history off fairly unimpressive top line growth in the tech industry and minimal to no earnings growth.
Although fellow growth investors have greatly benefited, we shouldn’t be surprised if the buying is exhausted at the moment. The reaction to Microsoft’s earnings is a clue that this could be the case.
Microsoft was in line for this quarter. However, the guide was a tad weak at $52.3 billion compared to $54.5 billion. It’s also important to note that estimates had been coming down going into the ER. We had consensus of $54.9 billion a month ago.
The operating margin of 43.3% is expected to be flat moving forward, which is good news for AI chip investors such as ourselves, because some of the capex is going toward data center buildouts and outsized AI demand. Also, Microsoft has a strong margin right now so flat is certainly acceptable. Part of Microsoft’s strong margins comes from extending the useful life of their servers and equipment, which we’ve covered in the past.
Psychologically, Azure dipping below Google Cloud revenue growth rate for the first time is not ideal. The reality is that Azure is growing at a similar growth rate on a much higher revenue base, but headlines will take hold of these oversimplified percentages. Within Azure, AI contributed 2% and management stated this is the number to watch moving forward. Regardless, if optimizations end and we see recurring software from AI kick-in, we should see Azure bottom and accelerate in growth in calendar year H1 2024. This is key for MSFT investors. Reference more notes below.
Copilot 365 is among the top reasons to remain invested in Microsoft. For $30/per user per month, enterprises can increase developer productivity by 40% to 50%. It sounded like this will be in general availability by FYH1 with results showing in FYH2 (which is calendar year H1 2024). Having deep pockets to acquire GitHub, and then rolling-out CoPilot 365 is an example of AI being a winner-takes-all market; which is that these acquisitions were carefully placed years ago.
Similar to our note on Google last night, Microsoft’s capex comments spell good things for our particular holdings in the semi-industry. With this level of exposure, these comments are arguably more important for IOF Members than Microsoft’s individual results. The market will go up (and down), but as long as capex increases, we should be in good shape with our current holdings.
There are additional questions from analysts noted below about when optimization will potentially end, when Azure will increase its growth rate, and when AI will start to affect revenue. All of these are important to note, and the pertinent Q&A is highlighted for you below.
Scorecard:
Figures are for FYQ4 ending in June and year-over-year, unless otherwise stated:
Revenue and EPS:
- Consensus earnings of $2.54 versus $2.70 EPS Reported
- Midpoint guidance of $55.35B (+7 y/y) and Consensus of $55.42B versus $56.2B Reported
- FY24 Q1 consensus of $54.53B versus FY24 Q1 Guidance of $54.250B
Microsoft sales guidance by division
- Azure & other cloud – +26-27% y/y in constant currency, includes about 1% from AI services versus 26% Reported and 2% from AI Services
- Productivity & Business Processes – $17.8B to $18.28B, +8.7% midpoint. CC guidance is 10% to 12% versus $18.3B up 10% and 12% on CC Basis
- Intelligent Cloud – $23.6B to $23.9B up 13.6% midpoint, CC guidance is 15-16% versus $24 billion, up 15% and 17% on CC Basis
- Personal Computing – $13.35B to 13.75B, (-5.6%) y/y at midpoint versus $13.9 billion (-4%) and (-3%) on CC Basis.
Margins
- Q4FY23 MSFT gross margin of guidance of 69.5% vs Q323 of 69.5% actual vs Q223 of 67% actual versus 70.1% Reported
- Q4FY23 MSFT operating margin of guidance of 42.1% vs Q323 of 42.3% actual vs Q223 of 41% actual versus 43.3% reported
Cash flow + Cash
- Q3FY23 operating and free cash flow was $24.5B and $17.8B respectively versus $28.7B and $19.8B
- Q3FY23 cash stood at $104B and $48B in debt versus $111.3B in cash
Earnings Call:
The number 1 question is this — when will Microsoft begin to realize strong growth from AI? Given AI has been the primary driver in this historic Nasdaq rally, we want to make darn sure there is AI revenue on the way (and soonish). I think some investors are going to get burned by piling AI stocks far too early, for example. But for Microsoft, we are a mere 9-12 months out. I’m including the quote below because this analyst is unfiltered in terms of how exciting the modeling can become:
Karl Keirstead
Okay, great. Amy, if I could double-click a little bit on the exciting news around M365 Copilot as everybody on the line looks to layer that opportunity into our models, I just wanted to get your views. Are there any guardrails you'd offer us to sort of keep us in line? Is there a degree of gross margin pressure in the Office segment? In other words, is it a fairly cost-intensive new product that we should keep in mind? And also, could it pull along Azure in the sense that you need Azure AD and perhaps some of the other cybersecurity products? So a little color there might help everybody with their modeling exercise tonight and in the coming weeks.
Amy Hood
Thanks, Karl. I think maybe I'll first start with the process we have when we release new products. And I absolutely understand we are excited, too, by the demand signal, the customer reaction, really the requests we're getting to be in the paid preview. It's all encouraging. As you know, we've — last week, we announced pricing, then we'll continue to work through the paid preview process get good feedback. Then we'll announce the general availability date, then we'll get to the GA date. Then we'll, of course, be able to sell it and then recognize revenue.
And that is why I continue to say that I am just as excited as everyone else about this, and it should be more H2 weighted. And we've, I think, given you some sizing opportunities. And I think I would use all that. But I do think this is really about pacing. And of course, we've still got to get our Security Copilot and some of the Dynamics workloads priced and released. And we'll continue to work toward that.
My note: this is calendar H2, so within 9-12 months, we should have a decent start on what AI can do for Microsoft on recurring software.
This is a brief comment on when cloud optimizations will end—which should be the perfect storm if we can get cloud to resume growth and then AI layered on top: “I think, in the next couple of quarters, what is the last catch-up optimization.” My note: I imagine this also means 9-12 months out.
Similar to Google, the comments on capex were bullish:
“To support our Microsoft Cloud growth and demand for our AI platform, we will accelerate investment in our cloud infrastructure. We expect capital expenditures to increase sequentially each quarter through the year as we scale to meet demand signals.”
Later, it was also stated:
“And we do expect, as you asked and Satya talked about, the pace of this adoption curve, we do expect to be faster. So you're seeing the CapEx spend accelerate in Q4 and then again in Q1, and we've talked about what it should look like the rest of the year” and then also: “So it's why I do comment quite often that it's both overall Commercial Cloud demand and building out capacity for AI. It's both.” My note: That’s bullish for AMD, as well, in terms of CPUs.
The CEO also stated this, which I think is interesting for our particular holdings, which is that the rate of investment is higher than the Cloud growth rate right now. “Yes. And I think just for perspective, I think it's sort of always good to think about it, right, where we have, what, 111 [billion] commercial cloud business growing at, what, 22% year-over-year. And then you had a CapEx growth, which is around the same number, 23%, 24%. So in some sense, it's sort of replacement capital plus some new capital that is going to drive new growth.” My note: keep it coming on the capex! ☺
Lastly, Microsoft expressed they believe they are the best data platform on the market. Of course, this is biased but I want to earmark this for as we go along because the argument the CEO is making is important:
“I mean to give you a flavor for it, right, so you have your data in an Azure data lake. You can bring SQL Compute to it. You can bring Spark to it. You can bring Azure AI or Azure OpenAI to it, right? So the fact is you have storage separated from all these compute meters, and they're all interchangeable, right? So you don't have to buy each of these separately. That's the disruptive business model.”
Conclusion:
I chose to cover Google quickly last night because Microsoft (as always) came in as-expected. This is not a dramatic stock to own, rather is a good choice for those who prefer their drama comes elsewhere, and outside of their pocketbook.
The Nasdaq is due for a breather and I’m kinda hoping for a selloff so we can load up at lower prices in the Fall and Winter. Amy Hood has archery-like skills when she provides guidance – she hits the bullseye on her numbers frequently. Because it’s coming from her, I have it written in ink to expect AI revenue to appear in calendar H1 of 2024. The remaining question of how to best position (and when) will be answered through Knox’s notes and trade alerts on Advanced Market Signals.