Please reference our recent editorial “Microsoft –AI Will Help Drive $100 Billion in Revenue by 2027” for more information on Microsoft’s AI positioning. The below information discusses in more detail our buy plan and what to look for with this AI leader.
Financial and Valuation Impact
The Q3FY23 earnings was better than expected. Microsoft’s Q3 FY23 revenue grew 7% YoY and 10% in constant currency to $52.9 billion. EPS came at $2.45 and was up 10% YoY and 14% in constant currency. The company beat revenue estimates by 3.6% and EPS estimates by 9.6%. All three main businesses – Intelligent Cloud, Productivity and Personal Computing – performed better than expected with Azure standing out.
Microsoft Azure grew by 31% YoY in constant currency and came at the higher end of the management guidance of 30% to 31%.
The management guidance for Q4 FY23 is $54.85 billion to $55.85 billion, representing a YoY growth of 6.7% at the midpoint. It was better than the consensus analyst's YoY growth estimate of 5.9%.
In the call, Satya Nadella also highlighted Azure gaining market share and the opportunities in AI.
“Azure took share as customers continue to choose our ubiquitous computing fabric from cloud to edge, especially as every application becomes AI-powered. We have the most powerful AI infrastructure and it’s being used by our partner, OpenAI, as well as NVIDIA and leading AI start-ups like Adept and Inflection to train large models.”
Interestingly, looking at the recent reported growth rates amongst the Cloud Big 3, suggests AWS is losing share to Azure and Google.
Meanwhile, Microsoft’s reported group operating margins of 42.3% are superior to Alphabet’s 25% and Amazon’s 3.8%.
Amy Hood, the CFO of the company, also highlighted the strong growth in AI and outlook for Q423. She said in the earnings call, “In our largest quarter of the year, we expect customer demand for our differentiated solutions, including our AI platform and consistent execution across the Microsoft Cloud to drive another quarter of healthy revenue growth. Last year, we had our largest commercial bookings quarter ever with a material volume of large multiyear commitments.”
“On that comparable, we expect growth to be relatively flat. We expect consistent execution across our core annuity sales motions with strong renewals and continued commitment to our platform as we focus on meeting customers' changing contract needs, which include shorter term, quick time to value contracts in this dynamic environment. Our key focus remains on delivering customer value.”
Against these tough y/y comps at a group level, Microsoft’s Q4FY23 Azure revenue guidance is 26% to 27% in constant currency, which includes roughly 1% from AI services. This indicates that Azure has barely scratched the surface and has plenty of room to grow.
Comps are getting easier
In the Q3FY23 call, Amy Hood also added, “Mark, maybe the one thing I would add to those comments is, we've been through almost a year where that pivot that Satya talked about from we're starting tons of new workloads, and we'll call that the pandemic time, to this transition post, and we're coming to really the anniversary of that starting. And so to talk to your point, we're continuing to set optimization. But at some point, workloads just can't be optimized much further. And when you start to anniversary that, you do see that it gets a little bit easier in terms of the comps year-over-year. And so you even see that in a little bit of our guidance, some of that impact from a year-over-year basis.”
Looking at quarterly eps estimates (calendar year adjusted)
Typically, Microsoft provides qualitative guidance for the next fiscal year at the Q4 earnings call which is upcoming. The current FY24 consensus forecasts about 11% sales and 14% earnings growth, which don’t appear to be aggressive. Microsoft’s AI story will unfold over multiple quarters. If we’re right, we expect a consistent pattern of better than expected earnings reports to emerge driven by continued growth in Azure and Intelligent Cloud coupled with a stabilization in Personal Computing.
Valuation:
In the case of Microsoft, we have used a sum-of-the parts valuation model alongside traditional metrics to determine a price target. The SUTP helps to separate and value the three main businesses – Intelligent Cloud, Productivity and Personal Computing – as each have different growth profiles.
Factoring in the AI/ML drivers we’ve described, we revisited our sum-of-the parts analysis. These drivers will have the biggest impact on the Productivity and Intelligent Cloud Businesses. The Productivity Unit consists of Microsoft Office Commercial and Consumer, LinkedIn, and Dynamics Business Solutions. Intelligent Cloud consists of Azure, other Cloud and Enterprise services.
We believe the implied market multiple assigned to the Intelligent Cloud and Productivity businesses still undervalues the potential revenue opportunities. As Microsoft continues to further integrate AI/ML into its offerings, this will further strengthen its core offerings and be the catalyst for new ones. This will provide new revenue opportunities from its installed Fortune 500 client base which we believe warrants a higher multiple.
Under our base case scenario, these drivers increase the SUTP by $40 per share and under the bull case by $70 leading to a total SUTP of between $360 and $390 versus the current price of $330.
Conservatively assuming that Microsoft’s group operating margins remain at current levels, a $100 billion increase in revenue could potentially add an additional in $40B in operating profit.
Based on this scenario, MSFT AI could earn $4.67 (vs MSFT consensus of $9.65 FY 2023). Placing a 30x multiple on gets you about $140 per share. So MSFT + MSFT AI = $485.
To be conservative for now, we can say MSFT AI may generate between $4.00 to $5.00 per share in earnings.
We can also take the avg of the 2 SUTP (390 + 485) for a SUTP value of about $440 over the next few years under the 100B AI scenario.
Buy Plan:
Considering where we are in the business cycle, it’s best to understand Microsoft within the context of the broader market. Our general market outlook is that the market will likely experience a bout of volatility into the summer. As long as the S&P 500 holds the 3900 – 3805 region, we can continue to see another swing higher into later 2023 before the recession starts to get priced into equities. Until the FED starts a fresh liquidity cycle, and we get eyes on the extent of damage the 2022 rate cycle caused in the economy, we expect choppy price action with a downward bias.
That being said, there are two general paths we are tracking in MSFT
Blue – As bullish as price action in Microsoft has been, we only have a 3-wave move off of the January low in Microsoft. This leaves the door open to the uptrend in 2023 being the corrective bounce in much larger corrective pattern that began in early 2022. The catalyst would likely be macro, as it relates to the manifestation of a credit cycle downturn that is not currently being priced into equities right now. We would need to see price break below $260.50 in the coming summer volatility. If this happens, then we will be targeting a retest of the January lows.
Red – On the other hand, this 3-wave move off the January low, can turn into a 5 wave move. This would require the summer volatility to hold within the green target box below, and then turn back up to make a fresh high. If this happens, then THE low is likely in for MSFT.
Our buy plan is to accumulate based on both scenarios playing out. So, we will start adding to our position in the $300 – $265 region.
The I/O Fund Analyst Team contributed to this analysis