We recently wrote about Microsoft’s $100B revenue opportunity in AI and the potential valuation impact of its strategic AI initiatives that go beyond traditional valuation metrics. One approach treated the opportunity as a separate business unit aka Microsoft AI. Using conservative margin assumptions under this approach, we estimated that MSFT AI could earn $4-5 in eps and our bull case price of MSFT + MSFT AI is about $485 (+40%).
As you know, we are incredibly bullish on AI and these are starting points, not ending points. Specifically for Microsoft, we stated that it’s enterprise customer base would propel the company forward as an AI leader because enterprises are the perfect customer for AI. This is because enterprises can drive down costs and increase productivity for immediate ROI whereas consumers may be slower to adopt AI and/or see how it benefits them directly. The ability to directly monetize enterprise customers with AI features faster than peers is materializing with the $30/month CoPilot 365 plan.
MSFT is just beginning to incorporate AI into its core offerings – starting with Microsoft Bing Chat enterprise and Microsoft Co-Pilot 365 – which by its own estimates AI will only contribute 1% to its Azure division in q4. For example, based on an analysis done by Macquarie bank, AI could add $14B to sales in its first full year.
We anticipate that MSFT will build upon its momentum from Q3 into Q4FY23. Meanwhile, 1hFY24 comps will also be supportive. MSFT’S commentary on the AI potential across its businesses in FY24 will be a clear, key focus. The upcoming quarters will be important to follow the growth and stability in Azure, Productivity and Intelligent Cloud businesses, as well, while looking for signs of the bottom in the Personal Computing division.
Fundamentally, we will monitor the impact on revenues and over time the margin impact on these units.
Here are the Q4 estimates going into earnings announcement on 7/25 (amc).
EPS
- Q4FY23 consensus earnings of $2.54
- Q1FY24 consensus of $2.60
Group Sales
- Q4FY23 MSFT midpoint guidance of $55.35B (+7 y/y) vs Consensus of $55.42B
- Q1FY24 consensus of $54.9 – we will want commentary on FY2024 in the call, not sure if CFO will provide as recently MSFT has pulled full year guidance given uncertainty in PCs
Microsoft sales guidance by division
- Azure & other cloud – +26-27% y/y in constant currency, includes about 1% from AI services
- Productivity & Business Processes – $17.8B to $18.28B, +8.7 y/y at the midpoint. CC guidance is 10% to 12%
- Intelligent Cloud – $23.6B to $23.9B up 13.6% y/y at the midpoint, CC guidance is 15-16%
- Personal Computing – $13.35B to 13.75B, (-5.6%) y/y at midpoint
Margins
- Q4FY23 MSFT gross margin of guidance of 69.5% vs Q323 of 69.5% actual vs Q223 of 67% actual
- Q4FY23 MSFT operating margin of guidance of 42.1% vs Q323 of 42.3% actual vs Q223 of 41% actual
Cash flow + Cash
- Q3FY23 operating and free cash flow was $24.5B and $17.8B for a margin of 46% and 34%, respectively
- Q3FY23 cash stood at $104B and $48B in debt
Here are the things we’ll be looking for:
- Microsoft Bing Chat and Microsoft Co-Pilot 365 – further insights into AI products, how it expects to impact sales, how it may evolve and the “domino” effect it may have on its other businesses
- Big Tech has prioritized higher ROI capex (i.e., AI infrastructure) in 2023 calendar year. Analysts may ask CFO about FY2024 capex.
- FY24 and Q124 guidance – MSFT will likely provide qualitative 2024 FY and financial Q1FY24 guidance. Meanwhile consensus is estimating a decline in sales in q4/q1. Anything better will be viewed positively. Consensus is forecasting FY2024 sales and eps growth 11.8% and 14.2%, respectively. Neither of which appear to be demanding given the underlying secular demand drivers.
- FY2024 profitability outlook – In FY2023, MSFT pulled several levers to manage its margins from corporate restructurings to accounting change to equipment useful life. We will look for the key drivers that will drive FY2024 margins.
- Azure and cloud competitive dynamics and growth – is MSFT taking market share in its Azure cloud related businesses and what is the growth outlook. Plus, comments on the overall corporate IT spending environment.
- Current PC environment, the channel inventory situation and if it’s closer to the bottom. Macro and how it’s impacting its consumer related businesses
- Update on Activision merger – recently Microsoft and Activision Blizzard jointly agreed to extend the merger agreement deadline from July 18, 2023, to October 18, 2023, to allow for additional time to resolve remaining regulatory concerns.
Here’s what analysts are saying
Stifel raised the firm's price target on Microsoft to $380 from $320 and keeps a Buy rating on the shares. The firm believes Azure should post "solid upside" to management's 26%-27% year-over-year constant currency growth guidance given strong enterprise checks, management's commentary that implied optimization activity should begin to abate as customers lap initial efforts and the firm's expectation of greater than expected AI contribution. The firm expects new Cloud project go-live growth to stabilize as customer's return to reinvesting into cloud migrations
Citi raised the firm's price target on Microsoft to $425 from $340 and keeps a Buy rating on the shares. The analyst remains positive on the shares into the company's fiscal Q4 results. Citi's reseller survey shows improving target achievement levels and an expected acceleration in growth into fiscal 2024, the analyst tells investors in a research note. To reflect signs of improving channel partner inputs and generative artificial intelligence tailwinds, the firm raised estimates "more substantially" across Office 365 Commercial and Azure.
Mizuho analyst Gregg Moskowitz raised the firm's price target on Microsoft to $420 from $390 and keeps a Buy rating on the shares. The big news from day one of Microsoft Inspire came in the form of a $30 per user per month add-on for Microsoft 365 Copilot, the analyst tells investors in a research note. The firm estimates the cumulative incremental revenue from Microsoft 365 Copilot by the end of fiscal 2025 could exceed $9B using a 20% attach rate, and approach $19B using a 40% attach rate. It remains confident that Microsoft's growth opportunities over the medium term and beyond are "greater than many realize."
JPMorgan raised the firm's price target on Microsoft to $385 from $350 and keeps an Overweight rating on the shares. The analyst left the company's Inspire conference "incrementally positive" on its category leadership in artificial intelligence. The announced M365 Copilot pricing of $30 per user per month is an "upside shocker" versus investor expectations closer to $10, the analyst tells investors in a research note. The price point aligns with the perspective that Copilots are far exceeding expectations in the private preview stage
BofA analyst Brad Sills raised the firm's price target on Microsoft to $405 from $340 and keeps a Buy rating on the shares. BofA expects Microsoft to report "healthy 1% upside" to the firm's Q4 revenue estimate of $55.45B, based on Azure and O365 strength. The firm also expects upside to its Azure estimate of 27% year-over-year constant currency growth due to better AI/ML workloads and baseline migration strength, the analyst tells investors in an earnings preview note. BofA forecasts double digit constant currency FY24 revenue growth guidance, assuming "conservative" low 20s percentage Azure growth, low/mid-teens O365 growth and Windows OEM growth of 2%.
Bernstein analyst Mark Moerdler notes that Microsoft announced Bing Chat Enterprise and Microsoft 365 Copilot pricing earlier, which is higher than the firm expected, at $30 per user per month for Microsoft 365 E3, E5, Business Standard, and Business Premium editions. This is a price uplift of 53% to 240%, to list price of these SKUs, depending on what Microsoft 365 edition being used. The price lift is similar to that of Microsoft GitHub Copilot. It is important to note that this announcement is only for Microsoft 365 and not Office 365, Bernstein notes. While Microsoft offers Office 365, their go-to-market focus has been in driving the Microsoft 365 bundle, Bernstein has an Outperform rating and a price target of $380.
The I/O Fund Analyst Team contributed to this analysis