Microsoft Stock: Bulls Are Still Standing On Shaky Legs (NASDAQ:MSFT)

Thesis

I have been cautious going into Microsoft Corporation’s (NASDAQ:MSFT) fiscal Q2 2023 report, and I continue to be cautious after. Microsoft’s results for the December quarter were mixed. But the company clearly warned investors about a somewhat worse than expected outlook going into the calendar year 2023. And notably, the negative outlook was also anchored on soft expectations for the cloud business, Azure.

Reflecting on a challenging growth outlook, I now downgrade my EPS expectations for Microsoft Corporation through 2025, and based on a 8.75 cost of equity, I now model a fair implied share price for MSFT equal to $211.06/share.

For reference, MSFT stock is now a relative underperformer: shares are down approximately 18% for the past twelve months, as compared to a loss of only slightly less than 9% for the S&P 500 (SP500).

Microsoft’s December Quarter

During the period from September to end of December 2022, Microsoft generated total group revenues of about $52.75 billion. Although revenues are up by approximately 2% versus the same period one year earlier ($51.7 billion), Microsoft failed to meet consensus analyst expectations by about $405 million ($58.15 billion estimated, according to data compiled by Refinitiv).

Operating income for the period came in at $20.4 billion, representing a 9% year over year contraction as compared to $22.25 for the same period in 2021. Net-income was recorded, $16.4 billion ($2.20/share), which is a 15% contraction respectively. Analysts had expected earnings to be anchored around $2.27/ share, according to data compiled by Refinitiv.

Revenues from “Productivity and Business Processes” was $17.0 billion (7% year over year growth), with “Office Commercial products and cloud services” and LinkedIn pushing up sales by 7% and 10% respectively. Revenues from Microsoft’s “More Personal Computing” came in at $14.2 billion, a 19% decrease as compared to Q2 2022, driven by Windows OEM revenue being down 39% and Xbox content and services revenue being down 12%. Revenue in “Intelligent Cloud” was recorded at about $21.5 billion, growing 18% year-over-year.

Guidance Softer Than Hoped, With Cloud Disappointing

Microsoft forecasted that revenues for the upcoming quarter are likely to fall somewhere between $50.5 billion and $51.5 billion. This is around $1.5 billion less than what analysts had predicted at midpoint, and would represent only a 3% year over year increase as compared to Q3 in 2022.

The weaker than expected outlook was strongly anchored on a decelerating demand environment for Microsoft’s cloud services. Notably, in Q2 2023, revenue from Azure cloud services had already slowed by approximately 4 percentage points as compared to Q1 2023, ending the year with about 38% year over year growth. However, management also acknowledged that the slowdown has worsened towards the end of 2022: Amy Hood, chief financial officer, commented that growth for Azure has now fallen to the “mid-30s.” Moreover, she also said that revenues could likely to fall another 4-5 percentage points in the second half of Microsoft’s FY 2023.

Microsoft’s cloud business has arguably become the company’s most important growth driver, and Azure plays a key role why MSFT’s is valued at a x20 EV/EBIT, as compared to a x10 – x15 EV/EBIT for other tech firms. And accordingly, I see the sharper than expected slowdown as a warning signal that MSFT stock might reprice to lower multiples.

Little Commentary About ChatGPT

Unfortunately, there was little direct commentary in MSFT’s earnings results, including the analyst conference call, on MSFT’s ambitions with ChatGPT. This is unfortunate, as positive commentary surrounding the partnership with ChatGPT might have supported investor sentiment. However, Satya Nadella clearly hinted to the opportunities that a partnership with ChatGPT might bring (emphasis added):

The next major wave of computing is being born, as the Microsoft Cloud turns the world’s most advanced AI models into a new computing platform …

… We are committed to helping our customers use our platforms and tools to do more with less today and innovate for the future in the new era of AI.

And responding to a question from Brent Thill, from Jefferies, about the current environment for tech investments/ innovation, Nadella commented (emphases added):

And so, we fully expect us to sort of incorporate AI in every layer of the stack, whether it’s in productivity, whether it’s in our consumer services. And so we are excited about it. But I think that we are also excited about OpenAI zone innovation, right. So, they commercialize their products. We are excited about the Chat GPT being built on Azure and having the traction it has. So, we look to both, there is an investment part to it and there is a commercial partnership. But fundamentally, it’s going to be something that’s going to drive, I think innovation and competitive differentiation in every one of the Microsoft solutions by leading in AI.

Valuation Update: Lower TP

On the backdrop of a softer than expected profitability outlook, I lower my EPS expectations for Microsoft Corporation in 2023. I now estimate that MSFT’s EPS in 2023 will likely fall to somewhere between $8.75 and $9.50. Moreover, I also lower my EPS expectations for 2024 and 2025, to $11.50 and 14.20, respectively.

I continue to anchor on a 3.5% terminal growth rate (one percentage point higher than estimated nominal global GDP growth) and a 8.75% cost of equity requirement.

Given the EPS updates as highlighted below, I now calculate a fair implied share price for MSFT of $211.06 as compared to $220.17 prior.

Below is also the updated sensitivity table.

Conclusion

Microsoft Corporation’s Q2 2023 results and outlook disappointed against market expectations–causing a 4% drop in MSFT shares on the next trading day’s opening auction. The disappointment was especially bitter given a worse than expected demand environment for Microsoft’s cloud business.

Reflecting on a challenging growth outlook, I now downgrade my EPS expectations for Microsoft Corporation through 2025, and based on a 8.75 cost of equity, I now model a fair implied share price for MSFT equal to $211.06/share.