We posted the following on the forum. If you scroll down, I’ve added additional commentary. This is primarily driven by personal computing which is expected to decline from $17.5 billion in the December quarter last year to $14.7 billion in the upcoming quarter, at the midpoint. Productivity and Business is expected to be soft by 7 points decel YoY and Intelligent Cloud softer by 3 points deceleration YoY.
Why Microsoft Sold Off After Earnings:
Microsoft is guiding down for next quarter with analyst expectations for the December quarter at $56.04 billion compared to management guidance on the call for revenue of $52.75 billion, at the midpoint. This represents 2% growth.
The primary reason for this decel was this comment from the CEO, which is the most comprehensive view we have of Microsoft’s expected deceleration in cloud:
“With that context, this quarter, the Microsoft Cloud again exceeded $25 billion in quarterly revenue, up 24% and 31% in constant currency. And based on current trends continuing, we expect our broader commercial business to grow at around 20% in constant currency this fiscal year, as we manage through the cyclical trends affecting our consumer business.”
That’s a 11% deceleration over the next few months. Some of this may be coming from Azure as the company is expected Azure to decline 5% next quarter for its current growth rate. This will be 37% growth on a constant currency basis, down from 42% this quarter.
From the CFO:
“Revenue will continue to be driven by Azure, which, as a reminder, can have quarterly variability primarily from our per-user business and from in-period recognition depending on the mix of contracts. We expect Azure revenue growth to be sequentially lower by roughly 5 points on a constant currency basis.”
Notably, Azure missed management’s guidance by one point, coming in at 42% on a CC basis compared to guidance of 43% on a CC basis.
This was preceded by this comment, which helps provide color but didn’t stop the AH price from slipping:
“In commercial bookings, continued strong execution across core annuity sales motions and commitments to our platform should drive solid growth on a moderately growing expiry base against a strong prior year comparable, which included a significant volume of large long-term Azure contracts.
As a reminder, the growing mix of larger long-term Azure contracts which are more unpredictable in their timing, always drives increased quarterly volatility in our bookings growth rate.”
The comment is primarily about bookings which were at 37% growth on a CC basis for fiscal Q2 of last year compared to 14% on a CC basis in fiscal Q1 of last year.
However, Azure as a revenue driver did not have high comps (to clarify the comment). Our records have Azure at 46% on a CC basis for fiscal Q2 ending in December with fiscal Q1 last year at 48% on a CC basis and fiscal Q1 was at 49% on a CC basis. The neighboring quarters were both higher.
The other thing to note is the FX headwinds result in more to unpack in this particular earnings report. Some articles online are reporting substantially lower EPS and a declining net margin – however, this is a wrong takeaway from the report. At a quick glance, it could appear that Microsoft saw a net margin decrease of 14% but net margin actually saw an increase of 11%.
The lower net margin and EPS is due to a one-time tax benefit of $3.291 billion in the year ago quarter, which resulted in unusually high net income of $20.5 billion. In all previous quarters, Microsoft had $16 billion to $18 billion in net income, and thus, the $17.6 billion from this quarter is actually in-line. Excluding the one-time tax benefit, the net income in the year ago quarter would have been $17.2 billion.
Therefore, the correct EPS comparison is actually EPS of $2.35 this quarter compared to EPS of $2.27 in the year ago quarter after adjusting for the one-time tax benefit. On an adjusted constant currency basis, this is 11% growth YoY.
Regarding the segments, the rest were in line except Azure’s 1% miss. Despite the slight miss, Intelligent Cloud came in as expected at 20%. What the market is concerned about is Azure being the leading indicator for the slowing Commercial Cloud growth that was stated at the beginning of the call by the CEO (the 11-point decel).
Productivity and Business saw a slight beat with growth of 15% on a CC basis compared to guidance of 12% to 14%. Personal Computing was in line at flat growth for $13.3 billion.
Interesting enough, the CFO reiterated FY2023 guidance as “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.”
Additional Commentary on Next Quarter’s Low Revenue Growth:
The 2% growth rate is being dragged down by personal computing. Here’s more on the breakdown of what to expect:
Personal Computing is expected to decline (19%) from $17.5 billion in the December quarter last year to $14.7 billion on CC basis in the upcoming quarter. This will be down from growth of 15% in the year ago quarter.
· The 19% deceleration is coming from PCs with Windows and Surface declining in the 30-percentile range.
· The segment is being held up (somewhat) by advertising with 6% growth.
· Gaming is expected to decline in the mid-teens
Productivity and Business is expected to be soft by 7 points decel YoY for growth of 11% to 13% and revenue of $16.75 billion on CC basis. This will be down from 19% in the year ago quarter.
· On-premise business is dragging down the results with a decline in the low to mid-30s
· Office 365 is expected to report seat growth and ARPU growth
· Office Consumer will decline single digits
· LinkedIn will grow low to mid-teens
· Dynamics will grow low double digits to low 20s, which is Microsoft’s business solutions and ERP such as for financials, operations and other business tasks. It’s also CRM similar to Salesforce designed for larger companies.
Intelligent Cloud will softer by 3 points deceleration YoY for growth of 22% to 24% and revenue of $21.25B to $21.55B on a CC basis. This is down from 26% growth on a CC basis.
· Azure is expected to decelerate by 5% to 37% growth on a sequential basis yet Intelligent Cloud is expected to be flat. Energy costs for Azure will be $250M per quarter. Notably, the company believes they will see more public cloud migrations from the rising costs of energy as the cost of on-prem is rising.
· Enterprise services will be in the low single digits
A note on Commercial RPO:
Commercial Remaining Performance Obligations have been oddly strong, and this was pointed out on the call. This quarter, Commercial RPO was up 31% YoY from $137 billion to $180 billion. 45% will be recognize the next twelve months and the remaining 55% will be recognized after 12 months.
This can certainly decelerate moving forward yet the management did call out that Azure tends to be volatile and so this is technically a sign of underlying strength despite the volatility. Commercial Bookings were (3%) due to FX yet was up 16% on a CC basis. This is up 2 points on a CC basis from last year.
Here is what was discussed in terms of Commercial RPO and how it translates to Azure growth:
Mark Moerdler:
Thank you. I'd like to follow-up on the last question on Azure specifically. So next quarter, you're guiding to sequential further slowing in the business. Is that the factor of optimization? Is it something else that's going on in here? How should we think about that specific component of the guidance, given the fact that you've got good bookings, strong RPO growth, et cetera?
Amy Hood:
Thanks, Mark. I'll – you're right. Let me go ahead and reiterate part of that, which is that this quarter, as you saw, we did have very good bookings growth. And within the RPO number that you're referring to, we had what we would call long-dated growth, which means we're having and seeing customers continue to sign commitments to the platform, and that goes really to what Satya mentioned is that the plans to invest here remain intact. And so, it's about both the optimization that you're talking about, and we are seeing and the guide includes that, and it also includes new workload starting. And those also may not be matched up one-to-one to see sort of a consistent pattern. And that does result in some volatility.
The other piece of it, Mark that we didn't talk on before because I was really focused on consumption is that there is per user headwinds as well, right, because we're getting and seeing some of these [loss] (ph) of large numbers in terms of the per seat business. So, there's a couple of things going on here Mark again, as you said, a very large base. So, it's not just the optimization to new workloads. It's also some per user work as well.
Translation:
It’s primarily loss of headcount affecting Azure and not renewals in contracts. It’s also not surprising that Microsoft is prioritizing optimization as the recent keynote at Ignite was about “Do More with Less.” We actually covered this early-on in this analysis here where we stated “increase in cloud spending and wanting to lower costs. This is differentiated from budget cuts, such as headcount. Most importantly, our slides showed that despite Gartner’s forecast for 2020-2021 shifting by $100 billion to what became actual spend (or essentially a pull forward). Pull forward might not be the right term, however, as cloud growth is not slowing down as a result, instead it’s predicted to be a tick higher from 2019 to 2022, if we remove the anomalous 2020-2021.
Therefore, we wanted to emphasize that the trend towards reducing costs should not be confused as being prohibitive to the trend for cloud adoption, rather, it can offer investors an edge if they identify what companies serve both needs.
As you can see from our portfolio, we are best-of-breed investors and I do not believe Microsoft is a best-of-breed company, rather they aggregate cloud services to help drive down costs. This is especially attractive for the Fortune 500 whereas startups, SMBs and mid-sized enterprises are likely to seek out and manage a larger portfolio of cloud services from various vendors. We can easily evidence this by Microsoft’s Fortune 500 penetration with 95% using Azure, which was achieved through hybrid computing where Microsoft was first-to-market on serving a mix of on-premise, private and public clouds for their large enterprise customers. Secondly, as this analysis is about, Microsoft is undercutting other services on price to win the aggregate, long-term contract.”
Microsoft Making Headway with AI:
Microsoft is a sleeping AI/ML giant. Google gets a lot of attention here yet I think they are equally prepared to serve this market. Maybe Microsoft even more so because of its penetration in the Fortune 500, which are the companies most likely to invest in AI/ML for the practical reason it requires a certain size budget. Here are some comments on the call:
“In Azure machine learning, provides industry-leading ML apps, helping organizations like 3M deploy, manage and govern models. All up, Azure ML revenue has increased more than 100% for four quarters in a row.”
To help Microsoft rival Google and DeepMind, the company has been investing in OpenAI, which is a large R&D operation that is breaking ground with AI algorithms that help computers to create images from text, reduce the amount of code that developers need to write, and to also help robotics think and act like humans, among other things. GPT-3 is the language generation model that has gotten quite a bit of attention for its ability to build websites and games using a language like English rather than a programming language. As of now, GPT-3 is known as the advanced text autocomplete program.
DALL-E is a “12-billion parameter” version of GPT-3 that creates images from text. The partnership with Microsoft will bring DALL-E to apps and services, including the Designer app and Image Creator tool in Bing and Microsoft Edge – this was announced earlier this month at Ignite. According to TechCrunch, 1.5 million users were using DALL-E 2 to create images with brands such as Nestle and Heinz piloting DALL-E for ad campaigns.
Here is what was said on the call:
Mark Murphy
Yes. Thank you, very much. Satya, this quarter, we're seeing an inflection in many of your AI breakthroughs, thinking of GitHub Copilot and the image generation in your designer product. What is it that's enabling you to innovate so rapidly and essentially to be first to market? I'm wondering if it’s the OpenAI relationship or maybe some of your inferencing capabilities or something else?
Satya Nadella:
“Thanks for the question. First, yes, the OpenAI partnership is a very critical partnership for us. Perhaps, it's sort of important to call out that we built the supercomputing capability inside of Azure, which is highly differentiated, the way computing the network, in particular, come together in order to support these large-scale training of these platform models or foundation models has been very critical.
That's what's driven, in fact, the progress OpenAI has been making. And of course, we then productized it as part of Azure OpenAI services. And that's what you're seeing both being used by our own first-party applications, whether it's the GitHub Copilot or Design even inside match […] The AI comment clearly has arrived. And it's going to be part of every product, whether it's, in fact, you mentioned Power Platform, because that's another area we are innovating in terms of corporate all of these AI models. So, yes, so I think AI is a place where I think we have differentiated capability at an infrastructure layer for training and inference and the model that sells or platforms for third parties and our first-party applications are getting better because of the use of those AI models.”
Side note: I know it’s hard to be excited about innovation right now but I do believe Big Tech’s AI fortresses will be built during a recession when other companies are comparatively weaker.