Microsoft Pre-ER: Will We See Evidence of a Bottom?

Microsoft will report its Q3 FY23 results on April 25th. The company is one of the most anticipated earnings reports in determining cloud trends. The company’s overall revenue in Q2 was in line except for the personal computing miss (which was substantial, but is also well-known).

Azure posted slightly-better-than-expected growth of 38% compared to guidance of 37%. However, the Azure guidance for Q3 is for 30%-31% growth, which marks a sharp deceleration. The CFO also pulled fiscal year guidance, which is unusual for Microsoft. One key metric that could make or break Microsoft’s report will be if Azure has bottomed or if there is further decline.

What we are watching:

Revenue guidance for March quarter missed slightly by about $1.5 billion for a guide of $51 billion at the midpoint. This represents 3.3% growth compared to 6.7% growth expected. The guidance for the next quarter will be in focus.

Consumers are weaker than expected. Not only did More Personal Computing miss in Q2 but this segment is causing enough uncertainty that the CFO did not provide a fiscal year guide. Any insights in the earnings call are to be watched.

Azure guidance is 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. We are keenly watching if Azure will bottom by not reporting sequential deceleration.

Customers exercised caution in the commercial cloud business. The company’s CFO Amy Hood said in the last earnings call. “In our commercial business, we delivered strong growth in line with our expectations. However, as you heard from Satya, we are seeing customers exercise caution in this environment and we saw results weaken through December. We saw moderated consumption growth in Azure and lower-than-expected growth in new business across the standalone Office 365, EMS and Windows commercial products that are sold outside the Microsoft 365 suite.”

Management comments in the commercial business are to be watched. The management in the previous earnings call provided guidance for the commercial business to grow 20% in the FY 23. They did not give a guidance in Q2 and instead said that revenue grew 20% in H1 and management expects it to further decelerate in H2.

Financials

Estimated Revenue:

Below, you can see that Microsoft is expected to bottom on growth. We talked about the H2 rebound in our most recent webinar. To some extent, the market is front running this rebound as anything can happen in the upcoming earnings reports. Regardless, Microsoft is a safer bet than others that revenue will rebound given its cloud suite drives down costs for enterprises.

· Q3 FY 23E (Mar 23): 3.41%

· Q4 FY23E (Jun 23): 5.82%

· Q1 FY24E (Sept 23): 9.09%

· Q2 FY24E (Dec 23): 10.44%

On a FY basis, Microsoft is expected to report the following – again, we are seeing evidence the next two quarters *should* be the bottom for Microsoft. We will want confirmation of this in the upcoming ER.

· FY June 2022 Actuals: 17.96%

· FY June 2023E: 5.37%

· FY June 2024E: 11.52%

· FY June 2025E: 13%

Microsoft has some of the strongest margins across the FAAMG stocks. For EPS, Microsoft is expected to report:

· Q2 FY 23 (Dec 22A): $2.20

· Q3 FY 23 (Mar 23E): $2.24

· Q4 FY23 (Jun 23E): $2.47

· Q1 FY24 (Sept 23E): $2.57

· Q2 FY24 (Dec 23E): $2.66

Cash Flow:

Cash flow was affected by the TCJA R&D tax payment of $2.355 billion. There is 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.”

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%).

Operating cash flow margin was 21.18% and adjusted excluding the tax payment was 25.65% compared to 28% in the same quarter last year. Free cash flow margin was 9.29% and adjusted excluding the tax payment was 13.75% compared to 16.65% in the same period last year.

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

The company returned $9.7 billion to shareholders with $4.6 billion in share repurchases and $5.1 billion in dividends. The company had cash and investments of $99.51 billion and debt of $48.12 billion at the end of the December quarter.

Noteworthy:

The management had highlighted in the last earnings call that the company is well positioned to capture the opportunity in AI. Satya Nadella said, “We have the most powerful AI supercomputing infrastructure in the cloud. It’s being used by customers and partners like OpenAI to train state-of-the-art models and services, including ChatGPT.”

We had written about the company’s dominance in AI before Chat-GPT3 was released and the market was buzzing about AI. We had said in our premium article in October last year, “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.”

“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.”

Margins:

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. We would like to see consistency in the margins.

· Gross margin of 67% which was in line and flat YoY. The management guidance for the next quarter is 69%.

· GAAP operating margin of 38.8% and adjusted operating margin of 41% compared to GAAP OM of 43% in the year ago quarter. The management guidance for the next quarter is 40%.

Microsoft is looking to maintain the bottom line despite the weakness in consumer. The company’s CFO said in the last earnings call, “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.”

According to the preliminary results by IDC, there was a YoY decline of (29%) in the shipments of traditional PCs in Q1 2023 due to weaker demand and excess inventory. IDC expects growth after 2023. So, we expect that the Personal Computing Segment will be weak in the March quarter. Below is the management guidance for the various segments in the next quarter:

· Productivity and Business Processes is 8% YoY at the mid-point. (11% to 13% YoY in CC).

· Intelligent Cloud is 14.7% YoY at the mid-point. (17% to 19% YoY in CC).

· More Personal Computing a YoY decline of (16.7%) at the mid-point.

· Microsoft Azure is 30% to 31% YoY growth in CC.

We believe that there are chances for Microsoft to bottom first in Cloud before AWS or Google Cloud since Microsoft aggregate cloud services help to 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. Microsoft is a hybrid cloud leader which attracts large enterprises and its ability to reduce costs with its tech stack.

Recent Headlines and updates:

The company announced last month that the new AI-powered Bing and Edge has a good response. The company crossed 100 million daily active users of Bing. “Of the millions of active users of the new Bing preview, it’s great to see that roughly one third are new to Bing. We see this appeal of the new Bing as a validation of our view that search is due for a reinvention and of the unique value proposition of combining Search + Answers + Chat + Creation in one experience.”that roughly one third are new to Bing. We see this appeal of the new Bing as a validation of our view that search is due for a reinvention and of the unique value proposition of combining Search + Answers + Chat + Creation in one experience.”

The company introduced Microsoft 365 Copilot last month. It is the productivity tool that combines large language models (LLMs) with the data in Microsoft Graph and Microsoft 365 apps. The use cases of Copilot in Word include giving the users the first draft while saving the time on sourcing, writing, and editing the content. Similarly, Copilot in PowerPoint will help to create presentations based on the previous content. Copilot in Excel can analyze trends from the data, create charts, and helps to make informative decisions.

The company announced in February that is has previewed two AI-powered services that are designed to manage telecom networks. Jason Zander, executive vice president of strategic missions and technologies at Microsoft said, “What we’re doing is taking our native cloud work and making it specific to this telecom operator network space. I think a really great example of that is all the AI ops work that we are introducing into the system."

The company showed a demo to ad agencies on how the company plans to monetise the new Bing search. One of the ad executive noted, “The company said it is taking traditional search ads, in which brands pay to have their websites or products appear on search results for keywords related to their business, and inserting them into responses generated by the Bing chatbot.”

The UK’s Competition and Markets Authority after receiving feedback from industry participants have dropped some of the key concerns in the Microsoft and Activision deal. The CMA is expected to make a final decision on April 26.

What Analysts are Saying/Channel Checks:

Wedbush analyst Daniel Ives raised the firm's price target on Microsoft to $315 from $290 and keeps an Outperform rating on the shares. The firm's recent checks have been positive around overall cloud deal flow and momentum for Microsoft in the quarter and thinks the company should see at least low 30% Azure growth. He also believes that Microsoft could be in a position to take market share from Amazon AWS over the next 12 to 18 months. “There have been spots of softness, particularly in the financial space, but federal deals look to be strengthening, as Amazon (AMZN), Google (GOOG) (GOOGL), Oracle (ORCL) and IBM (IBM) have also seen a surge of Beltway cloud deal activity this year as the federal government enacts a major shift to the cloud.” Wedbush believes ChatGPT will be the next gear of growth for Microsoft over the coming years. The analyst further said, "We continue to believe the first step for MSFT was Azure/Office 365 with the next step ChatGPT/AI monetization on both the consumer and enterprise fronts combined adding $20 per share to MSFT's sum-of-the parts valuation as this execution story plays out,"

UBS analyst Karl Keirstead lowered the firm's growth estimates for Microsoft's Azure cloud segment, saying that recent trends have continued into Q1. The analyst, who made no change to the firm's Neutral rating or $275 price target, feels the Street's estimates for Azure are too high and concludes that customer efforts to optimize/trim their cloud spend will be deeper and last longer than most think based on calls with AWS/Azure customers and partners. UBS contends that the potential for a worse-than-Street-consensus Azure growth outlook creates some downside risk into the print.

Morgan Stanley says the firm's most recent CIO survey points to stable IT spending and suggests "favorable Microsoft-specific fundamentals." The firm sees several forward looking indicators in the CIO survey that support Microsoft's "strong relative positioning" if 2023 budgets come under further pressure, noting that Microsoft widened its substantial lead in expected IT wallet share gains. The firm, which calls Microsoft "increasingly well positioned" based on its survey work, has an Overweight rating and $307 price target on the shares.

Oppenheimer analyst Timothy Horan raised the firm's price target on Microsoft to $310 from $280 and keeps an Outperform rating on the shares. With the company now having introduced AI Co-Pilot betas across all Office, Cloud, and PC segments, the firm's initial estimate is approximately 3-5 points of incremental annual revenue growth ramping in 2025. This estimate balances the transformative nature of GPTAI, Microsoft's relationship with OpenAI, and large synergy opportunities as Microsoft has purposely understated pricing to spur early adoption.