HJBC
Investment thesis
I think that Microsoft’s (NASDAQ:MSFT) recent quarter was misinterpreted as the company was sold off after the release of its financials. While the sentiment around the company turned negative, as I dived deeper into the company’s earnings, I saw that the company is very focused on its consistent approach to focus on key areas for the long-term growth of the company. For the weakness in Microsoft Azure, this was caused by an intentional strategy by management to help customers do more with less in the current difficult environment that will drive future market share gains for the company in the cloud space. While investors may not like that operating expenses was not dialed down in a slowing revenue growth environment, I think that this is consistent with the management’s strategy that they will continue to invest in the business despite the volatile and cyclical PC market and these investments are done for the long-term benefit, rather than short-term earnings, of Microsoft.
Review of the FY1Q23 earnings result
For Microsoft’s FY1Q23 earnings result, the revenues and earnings per share figures largely met investors’ expectations. However, there was a 1 percentage point miss in Microsoft Azure that led to increasing worries that there were some underlying weaknesses in demand for Microsoft Azure as a result of the weakening macroeconomic environment. While the consumer businesses were weak as PC demand fell and advertising spend was soft, these were largely expected.
While revenues were up 16% year on year in the quarter, operating expenses grew faster than revenues with an increase of 18% year on year. As I will elaborate later, management intentionally maintained operating expenses at the current levels due to its view that it should continue to invest in its key growth areas even in a weak PC market.
For the commercial business, growth was strong as a result of solid execution on renewals on both Azure and Microsoft 365 fronts. In fact, more than 50% of the $10 million in Microsoft 365 bookings actually came from E5. Also, there were some moderations in new deals, mainly in the smaller business segment.
Another thing that disappointed investors was the weaker than expected guidance for operating margins, which was guided down from roughly flat to down 100 basis points. This was a result of the higher energy costs resulting in lower Azure margins, and also the continued investments in its key future growth areas as the company continues to spend on operating expenses but this will significantly be reduced in the quarters to come.
Outlook commentary suggests management taking a long-term view
For most of Microsoft’s businesses, they expect the trends to continue into the next quarter. The consumer demand will remain weak as a result of significantly lower PC demand in recent quarters, and this will affect the Windows OEM and Surface devices business. As a result of lower advertising spend, advertising revenues from LinkedIn and Search and News will trend lower as a result of the softer market.
Microsoft’s commercial business will generate strong growth as the company continues to execute well and generate high volumes of large and long-term Microsoft Azure contracts.
As a result of the cyclical nature of the PC market and the relatively higher margin profile of the Windows OEM business, Microsoft expects to continue to invest in the business and take a long-term approach to focus on areas they think are key future growth areas.
At the same time, management is aware of the uncertain global macroeconomic environment and rising inflation environment we see today. While investing in the key focus areas, the company will also see significant moderation of operating expenses as we move through the fiscal year, as will be elaborated later.
Investors fail to understand the miss in Microsoft Azure
In the current first quarter 2023 results, there was a miss in Microsoft Azure by 1 percentage point. While this may just be a 1 percentage point miss, astute investors will know that this is the second consecutive miss on Microsoft Azure.
The base line, in my view, is that the difficulty in estimating and forecasting the Microsoft Azure is high due to the inherent volatility, as reiterated by management multiple times during the current quarter and previous earning calls. As a result, while we might be seeing a second consecutive quarter miss on Microsoft Azure, it seems that this is largely expected given the high volatility involved in the forecasting of Microsoft Azure. In fact, this volatility would have contributed to the prior beats in Microsoft Azure and on a net basis, I think that we have to accept that in some quarters management’s forecast may fall short due to the uncertainty involved.
The key thing is that the business is still growing at a fast rate at 42% in the current quarter and management has also commented that the growth is as per expected and across all segments and all geographical areas. The main moving pieces were the uncertain macroeconomic environment as well as continued focus by Microsoft to optimize their customers’ current workloads. Keeping in mind that these optimization of the current workloads of customers may bring growth down in the near-term, we also need to acknowledge that this is ultimately good for Microsoft in the long-term as its customer loyalty improves and customers add more workloads to Microsoft Azure. I think of the slower growth rate as essentially an investment into the business in the long run to ensure that Microsoft remains the top choice for customers when it comes to their digitalization journey.
This will add value to shareholders in the long-term and is the right step forward for Microsoft, in my view. As a result of optimization of the current workloads, this then will enable customers to make room for new workload. With this current focus on optimization of workloads in the current macroeconomic environment, I think that this makes sense as customers look to do more with less and leveraging on technology to drive efficiencies. This near-term optimization of customer workload is thus a short-term pain for long-term gain. This will eventually lead to gains in market share as customer loyalty improves given that customers realize the tangible benefits of using Microsoft Azure.
Deceleration of Microsoft Azure
Again, on Microsoft Azure, I think the sequential decline of 5 percentage points from 42% growth in 1Q23 to 37% in 2Q23 has rattled investors given that this is a larger deceleration than what many investors would have expected.
It is important to put this into perspective. Microsoft saw strong growth in bookings as well as RPO growth in the current quarter, signaling that demand remains strong for Microsoft Azure. The main factor driving the weakness and deceleration in the business is once again due to the focus to invest in the business. As a result of optimizations of workload, this has resulted in a guidance that implies a deceleration of 5 percentage points for the next quarter, while new workload will likely lag behind.
Once again, I would think that it is positive that the deceleration is caused more by workload optimization rather than any signs that demand is truly decelerating. As a result, I would see this as an investment into the future of the Microsoft Azure business and management looking to add long-term value for shareholders.
Weakness in small businesses and energy cost headwind
While the Microsoft 365 business saw strong renewal rates in the quarter and deals were getting done and in a timely manner, there is some moderation in new deals especially in the smaller business market.
The good news is that there is no evidence that this is spilling over to the larger enterprises as the trends for Microsoft 365 renewals remain strong for the larger enterprises and there has been successes in upselling these larger businesses to E5 as well.
Another point mentioned that was a headwind in the current quarter and expected to remain one for the fiscal year is the impact of energy cost on the business. This is expected to contribute to about $800 million in headwind for the business and most of the impact has yet to materialize as management expects this to affect the business mostly from 2Q23 onwards. This will undoubtedly have a negative impact on the operating margins in the near-term.
Taking a long-term view on operating expenses
While there are some questions about the decision not to cut down on operating expenses in the near-term to be able to meet margin guidance for the fiscal year 2023, after hearing management’s explanations, I think that Microsoft as a company is run by leaders who make decisions for the long-term rather than conform to meeting near-term quarterly guidance.
As the PC market is inherently cyclical, we saw that Microsoft benefited materially from the pandemic as a result of strong growth in the PC market as more people started to work from home. During that period of strong growth in the PC market, Microsoft did not ramp up on operating expenses and increase spend to match the above average growth rate in the PC market. This in turn resulted in significantly improved margins as the benefits flowed to the bottom line. Likewise, Microsoft is taking a similar approach in the current weak PC market as it looks to continue to be consistent in its operating expenses and maintain spend at a level that makes sense for the long-term growth of the business. As such, management did not slow down operating expenses in the quarter as this is a good opportunity for Microsoft in the commercial business as they are then able to gain customer loyalty and increase market share. As a result, I like that the management is taking a consistent and long-term approach when it comes to investing in the business.
At the same time, management will definitely be adapting the business to tackle the rising macroeconomic concerns as well as cost inflation. In the near-term at least, I think that we will see that operating expenses will start to trend downwards due to several factors. First, the company will be increasing headcount rather minimally in the next quarter for the focus investment areas of the company and over the year, we are likely to see improving productivity in the workforce as those headcounts start to ramp up in efficiency. Second, we will likely see that operating expenses come down in the second half of the fiscal year due to the higher base effects as a result of the acquisitions of Nuance and Xandr in 3Q22 and 4Q22 respectively.
Valuation
My 1-year target price for Microsoft uses an equal weighted of both the P/E multiple method and the DCF method. I assume forward P/E of Microsoft to be 25x, applying a 25% premium to the peer group as Microsoft has a rather durable growth profile as well as strong competitive advantages like its suite of end-to-end solutions. My assumptions for the DCF method include a discount rate of 8% and a terminal multiple of 16x.
As a result, my 1-year target price for Microsoft is $305. This target price represents 32% upside from current levels and implies 26x FY2024 P/E. I think that while there are near-term headwinds for the business, Microsoft remains structurally attractive as a company poised to generate outsized returns over the market while remaining relatively resilient in a difficult operating environment.
Risks
Weakening of IT spending
As Microsoft’s businesses rely on enterprises and small business IT spending, if the macroeconomic environment worsens materially, this might cause companies to scale back on this digital transformation journey and reduce IT spending. If so, this will affect the growth rate of Microsoft as the entire pie of IT spending gets smaller.
Slower cloud migration
While the deceleration of Microsoft Azure’s growth rate was explained by the optimization of the current workloads of its customers, there is a risk that its customers may be slowing the pace for cloud migration, which will imply demand side issues, at least in the near-term. This is negative for the highly watched Microsoft Azure business.
Competition
While Microsoft has a strong value proposition given its ability to provide end-to-end solutions to customers, there are many other players both big and small constantly innovating and bringing new technology to the market. If these competitors are able to compete and innovate meaningfully, this might change the industry dynamic and bring incremental risks to Microsoft.
Conclusion
While investors may view the recent FY1Q23 print as negative, I think of this as short-term negative but long-term positive for Microsoft. For Microsoft Azure, the company is investing in the future as it is forgoing current growth by optimizing workloads, but this will in turn drive new workloads, increased customer loyalty and ultimately drive share gains. The relatively elevated operating expenses tell a similar story as management remains focused on a consistent strategy focused on investments for the long-term even as the PC market is currently weak. As a result, I take the view that the current negative sentiment around the recent quarter as a misinterpretation of the company’s earnings, which bring an excellent risk reward opportunity to buy Microsoft at the current levels. As a result, my 1-year target price for Microsoft is $305.
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