Microsoft Fiscal Second Quarter Earnings: A Positive Step For The Future (NASDAQ:MSFT)

Business Overview and Investment Thesis

Microsoft Corporation (NASDAQ:MSFT) is one of the biggest and leading technology companies worldwide, providing services including licenses, and sale of software, consumer electronics, personal computers, cloud computing services, etc. The company is best-known for its products which include the Windows operating system, the Microsoft Office Suite, Microsoft Azure, and the Xbox gaming console.

I believe MSFT remains an attractive investment opportunity. The company has a well-diversified product offering, it is cutting costs with a 5% workforce layout, while at the same time investing heavily for the future with a $10 billion investment in Open AI. Further to this, the cloud computing segment continues to show robustness, with operating income above 40% and revenue growth in the high double-digit teens. Let’s take a look at the fiscal second quarter results.

Microsoft 2Q-23 Results

We need to start with the fact that during the second quarter of FYE 2023, MSFT recorded its slowest revenue growth in more than 5 years. Revenue growth stood at 2% and was driven by its cloud computing segment which saw an increase of 17.8% or $3.2 billion. Revenue growth was largely offset due to a slowdown in the personal computing segment as a result of declines in Windows (-27%), Devices (-39%), and Gaming (-13%).

Operating expenses increased by 19% driven by employee severance expenses as a result of layoffs, investments in cloud engineering, and the Nuance acquisition. Research and development expenses increased $1.1 billion or 19% driven by investments in cloud engineering. This led to an operating income decreased to $20.4 billion compared to $22.2 billion during the same period last year. Despite higher operating expenses, MSFT still recorded healthy operating and profit income margins at 38.7% and 31.1%, respectively.

MSFT recorded a free cash flow of $4.9 billion. This free cash flow generation was not sufficient to cover shareholder returns, which amounted to $10.5 billion. As such, cash and cash equivalents decreased to $99.5 billion. For reference, cash and cash equivalents during the previous quarter stood at $107.2 billion.

Intelligent Cloud Segment

MSFT Intelligent Cloud segment continued its growth path and increased by 17.8% to $21.5 billion. Despite a slowdown compared to the same period last year, this is still a robust growth experienced by the segment. The segment posted a healthy 41.4% operating margin and currently accounts for ~41% of total revenues. Operating margin did decrease compared to the same period last year with the decrease driven by higher operating expenses of $1.6 billion.

Expenses were due to employee severance expenses, investments in Azure, and the Nuance acquisition. Important to note that Nuance is a leader in conversational AI and ambient intelligence across industries including healthcare, financial services, retail, and telecommunications. This will help the Intelligent Cloud segment strengthen MSFT capabilities across these industries. Additionally, the layoffs and investments in cloud capabilities will help decrease costs in future quarters.

Search and News Advertising

Many readers may be wondering why I am so focused on Search and News Advertising. The reason for this is because management has been vocal about wanting to ramp up this business to $20 billion. As such, I believe it is crucial to closely monitor the performance of this revenue stream. In addition to the management commitment to grow this business, MSFT also recently confirmed the investment of $10 billion into OpenAI, the creator of ChatGPT. In my opinion, this suggests MSFT is making a strategic move to challenge the dominant position held by Alphabet (GOOGL) in the web search market. Finally, this investment in Open AI has the potential to enhance MSFT search engine, Bing, through potential synergies.

During the second quarter, Search and News Advertising revenue increased by $159 million or 5.2% to $3.2 billion and accounted for 6.1% of total revenues. Although at a slow rate, this revenue stream continues to grow its influence in the company’s overall top line. While the year-on-year growth is not impressive, it is a positive highlight for the quarter when compared to the decreases seen in Windows (-27%), Devices (-39%), and Gaming (-13%).

News to Digest:

During the second quarter of FYE 2023, MSFT management was faced with major decisions. The first major decision to discuss is the layoff of nearly 5% of MSFT workforce. This will have a short-term financial impact in the company’s financials due to employee severance expenses. However, in the medium to long term, the company will be able to operate in a more efficient manner and also assert more control over costs.

Secondly, MSFT announced a major investment in the field of artificial intelligence with the $10 billion investment in OpenAI. Note that MSFT had already invested $1 billion in OpenAI in 2019. This strategic move will help the company with synergies across its different products and services offered. Furthermore, it will give MSFT the right tools to better compete in this field with Google, Amazon (AMZN) and Meta Platforms (META). It is worth noting that OpenAI will use Azure as its cloud provider, which in essence will enhance MSFT Intelligent Cloud segment.

Finally, MSFT huge bet on the gaming industry remains to be cleared by the regulatory bodies. The Federal Trade Commission blocked Activision Blizzard (ATVI) acquisition and management did not comment to much about it during the earnings call. However, it did indicate that it continues to work to obtain the required regulatory approvals.

Bottom Line

I believe Microsoft Corporation remains an attractive long term investment opportunity. The company continues to have outstanding fundamentals, it is cutting costs with a 5% workforce layout while at the same time investing heavily in the artificial intelligence field with a $10 billion investment into OpenAI.

It is important to look at the bigger picture, the artificial intelligence market is set to grow above $400 billion by 2028. This investment will position Microsoft Corporation to take advantage of this growing market. The cloud computing segment continues experiencing robust growth and healthy operating margins. Finally, if Microsoft Corporation is able to close the Activision Blizzard acquisition, it will give it a dominant position in the gaming market which is set to grow to $390 billion by 2027.