Microsoft
Review of Quarterly Results
Introduction
In an earlier post, we noted that we had taken an unplanned two-month break from writing this substack. We missed the entire US quarterly reporting season. We will belatedly review the results from some companies starting with Microsoft (MSFT). MSFT reported its numbers for the three months ending 30th September 2023 on 24th October 2023.
In summary, these were excellent results. The stock has risen 10% in the eight weeks since the report.
We last wrote about Microsoft on the 1 May 2023 and that report can be read here.
Our conclusions at that time were as follows:
Microsoft has been our favourite large cap tech stock for the last three years.
It has performed very strongly in the last ten years and the most recent results continue the trend. The company looks set to grow in many established businesses especially the Cloud and is the best placed large tech company to benefit from developments in AI.
The current valuations (Forward P/E ratio of 29 times and Free Cash Flow Yield of 2.5%) do not indicate that the stock is cheap but given the profitable growth opportunities, we may add a little to our position.
The Q1 2024 Results
Microsoft results are broken into three divisions as shown below:
Productivity and Business Processes have the core Office (Word Excel and PowerPoint. Exchange, SharePoint, Microsoft Teams etc) which is now christened Office 365. Also included in this segment are LinkedIn and Dynamics 365.
Intelligent Cloud includes fast growing cloud hosting business Azure as well SQL Servers. New AI investments will probably be included in this segment as Github is here.
More Personal Computing is mainly the Consumer facing businesses and includes Surface devices and X-box Gaming. The recently acquired gaming company Activision will be placed in this segment.
In 2018/2019, the financial breakdown between divisions was easy to remember. Total Annual Revenue was US$120bn and each business segment accounted for one third (about US$ 40bn each). The operating margin was 30% and so operating profit was about US$ 36bn.
The quarterly run rate for total revenue was US$30bn (~ US$10bn in each segment) and quarterly operating profit run rate was US$ 9bn.
Since then, things have changed as the Intelligent Cloud segment has grown much more rapidly while More Personal Computing growth has stagnated. In the most recent quarter, the revenue for each segment was as follows:
Intelligent Cloud- US$ 24.3bn (+19%)
Productivity and Business Processes- US$ 18.6bn (+13%)
More Personal Computing- US$ 13.7 bn (+3%)
The growth rate of the most recent quarter, compared with the same quarter in the previous year, is shown in brackets.
Intelligent Cloud is now almost double the size of More Personal Computing and continues to grow at a much faster pace.
The summary results for the quarter were as follows:
Quarterly revenue grew by 13% to US$ 56.5 bn.
Operating income was $26.9 billion and increased 25%.
Net income was $22.3 billion and increased 27%.
Diluted earnings per share was $2.99 and increased 27%.
Cash flow from operations increased by 32% (y-o-y) to US$ 30.6bn
Free Cash flow from operations increased by 22% (y-o-y) to US$ 20.7bn.
US$ 9.1bn was returned to shareholders due to share buybacks and dividend payments
The Net Cash held by the company increased from US$ 46bn to US$ 54bn.
The company also noted that gross margins increased by 2% points to 71.2%.
These are impressive numbers with continuing operating leverage - a 13% growth in the topline was translated to a 27% increase in both net profit and EPS and a 32% increase in cash flow from operations.
The acquisition of Activision Blizzard closed on October 12th and those numbers will be incorporated in next quarter’s numbers.
The Post-Earnings Conference Call.
The conference call focused on the numbers in more detail and on recent developments in AI.
As noted above, Intelligent Cloud grew 19%. Within this segment Cloud Services grew by 29%. As a point of comparison, their main rival, Amazon’s AWS grew by 12% over the same period. This suggests Microsoft is winning the Cloud race.
Operating margins increased roughly 5 points (year-over-year) to 48%. This was driven by improved operating leverage through cost management and a higher gross margin. Headcount at the end of September was 7% lower than a year ago which shows the serious cost control being practiced.
The Outlook
In Productivity and Business Processes, they expect revenue to grow 11% -12% or $18.8 billion to $19.1 billion.
In Intelligent Cloud, we expect revenue to grow between 17% and 18%. Within that, Azure revenue growth is expected to be 26% to 27% in constant currency, with an increasing contribution from AI.
The numbers for More Personal Computing will be boosted by the inclusion of Activision. They expect revenue of US$16.5 billion to $16.9 billion.
The above indicates Microsoft does not see any slowdown in the rate of growth of revenue.
The company also hinted the current higher margins will be maintained in the next quarter.
Highlights of the post earnings conference call.
The integration of Activision will put pressure on margins, but the company is confident they can offset this as they are forecasting stable overall margins.
Their priorities are “investment in commercial cloud leadership and leading the AI wave.”
The CEO emphasised their approach to AI is a “full stack approach”. There is just one large AI model that was trained (in the past) and that model being used for inference across all their offerings as well as in the Azure Cloud AI offerings,
“We are not running a conglomerate of businesses… it is all one tech stack up and down.”
Azure has the most comprehensive cloud footprint with 60 datacentres worldwide.
More than 18,000 organizations now use Azure OpenAI services, including new to Azure customers.
They continue to see more cloud migrations with Azure Arc. They now have 21,000 Arc customers, up 140% year-over-year, including many new to Azure.
They are the only other cloud provider to run Oracle's database services (other than Oracle). Many potential customers who have been running Oracle databases in their in-premises infrastructure are now talking to them about migrating workloads to Azure.
Companies are looking to consolidate their data in one place. 73% of the Fortune 1000 use three or more of their data solutions today. They are well placed to benefit from the data consolidation.
The number of developers using GitHub has increased 4x since Microsoft’s acquisition of Github five years ago. They added new capabilities to GitHub Copilot Chat, which is used by enterprises to boost the productivity of their software developers.
Microsoft have over 1 million paid Copilot users and more than 37,000 organizations have subscribed to Copilot for business, up 40% quarter-over-quarter.
More than 126,000 organizations have all used Copilot in Microsoft Power Platform to date.
40% of the Fortune 100, are using Copilot as part of an early access program. It is now available to all. The company says early feedback is very positive.
Company believes they will win many new AI Workloads and these jobs will boost demand for their Azure infrastructure.
Even an established product like Office 365 Commercial saw a 20% plus increase in the number of seats or users. This was attributed to strong demand from Small and Medium Sized Enterprises.
Conclusion.
This was a very strong set of results that justified the positive investment thesis we outlined on 1st May 2023.
The company showed double digit revenue growth and demonstrated strong operating leverage.
The company has done well to boost margins by changing business mix and cutting costs.
The strong growth of Azure Cloud business was impressive especially when compared with the much slower growth of their biggest rival, Amazon’s AWS. This suggests they are winning the race to be the leader in Cloud hosting.
The company has introduced AI in Azure AI and through Co-pilot in their desktop software and other platforms. The recent issues at OpenAI raises some questions given Microsoft close association with them. Whatever happens at OpenAI. Microsoft is well placed to be a leader in AI.
The stock has risen 53% this year and looks set to continue to make progress.
The company is likely to grow net profits at least 15% over the next two years with operating margins and Return on Equity of at least 43% and 40% respectively.
Given these prospects, the current forward price /earnings multiple of 30.7 times looks good value.
Microsoft is the largest holding in our portfolio. We added to the position after the results and continue to hold for the long run.