Is Microsoft Stock A Buy, Sell, Or Hold After Recent Earnings?

Summary

• Microsoft exceeded expectations on both its fiscal third quarter performance as well as current quarter guidance, extending confidence to investors in an overall risk-off environment for equities.
• Cloud demand remains strong as corporate spending on digital transformation shows no signs of slowing despite an inflationary environment.
• Microsoft's software-focused business model has also provided insulation from supply chain challenges that remain in a fluid state due to the evolving nature of COVID outbreaks and the Russia-Ukraine war.
• Robust growth demonstrated across all business segments underscores Microsoft's steadfast leadership in the digitization era. The business continues to show no signs of buckling even under an increasingly clouded economic outlook.
• Instead, the critical role Microsoft plays in the global digital fabric continues to provide for further sustained growth and robust valuation prospects ahead.

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It has been a tough year for equities across the board, including software titan Microsoft (NASDAQ:MSFT). The stock has lost about a fifth of its value this year prior to reporting fiscal third quarter ended March 31st on Tuesday (April 26th) after the bell. But a solid sales and earnings beat across the board continues to underscore Microsoft's market leadership in cloud-based software solutions and related hardware despite a cloudy macroeconomic outlook that has dampened consumer sentiment and spooked investors this year. The reassuring results have inadvertently driven a solid rally for the stock, supporting gains of more than 4% in extended trading Tuesday and increasing the likelihood of ending in the green by the end of Wednesday's regular session.

General outperformance across the business has compensated for investors' aversion of risky assets like high-growth tech stocks amidst a potential economic slowdown in the near-term. Commercial demand, especially for cloud-based services provided by Azure as well as Office 365, has remained robust. The bullish commercial demand environment has continued to provide partial insulation for Microsoft from any "consumer slowdown", assuaging investors' monthslong fears that the increasingly complex macroeconomic environment might result in a pullback in corporate IT budgets and backfire on the business' growth outlook. In fact, industry peers including Google and IBM have reported strong cloud sales during the calendar first quarter, indicating "healthy demand for corporate software", which makes favourable tailwinds for Microsoft.

The company's software-heavy business has also helped it dodge much of the supply chain snarls that protracted pandemic disruptions and the Russia-Ukraine war have threatened to worsen. Even Microsoft's product sales have regained some footing during the fiscal third quarter after succumbing to supply shortages last year. Xbox market share has continued to expand for the second consecutive quarter and is currently the leading "next gen console" across North America and Western Europe, while Surface sales continue to be buoyed by strength from the commercial sector. Although Microsoft has warned that "supply chain constraints could become more impactful" to its product sales performance if the recent pandemic-related lockdowns in China extend into May, a concern that has been echoed by other domestic corporate peers like electric vehicle upstart XPeng (NYSE: XPEV) and technology giant Huawei, the company's continued prudence in building hardware inventory as observed in frontloaded supplier payments is expected to help it offset some of the "uncertainty in the supply chain".

Microsoft's steadfast market leadership in providing critical software to both the commercial and direct-to-consumer markets, alongside robust momentum with Azure in addition to other growth drivers make it an attractive long-term investment pick still. Especially under the current market climate, the inflation-resistant nature of Microsoft's business model, paired with its robust balance sheet, attractive shareholder returns, and sustained growth across all segments makes it one of the safest picks in the current risk-off environment for equities.

Recap of Microsoft's Q3'22 Financial Performance

Microsoft's consolidated revenues grew 18% y/y to $49.4 billion in the fiscal third quarter, beating both consensus estimates and its previously provided guidance of $49 billion and $49.3 billion (upper range guidance), respectively:

• Intelligent Cloud: Much of Microsoft's topline growth during the March quarter was driven by the company's Intelligent Cloud business segment, with Azure demand stealing the show once again. Intelligent Cloud revenues totalled $19.1 billion during the March quarter, up 26% y/y and beating consensus estimates of $18.9 billion. Specifically, Azure revenues increased by 46% y/y (+49% y/y on constant currency basis) thanks to continued strength in its consumption-based service sales, as well as an additional $111 in sales consolidated from the acquisition of Nuance which closed on March 4th. The rise in demand for secure and integrated cloud-based collaborative and productivity tools from the commercial sector has also continued to underpin success for the company's latest Microsoft 365 E5 offering, which enhances overall security, compliance, voice and analytic capabilities. Continued transition from the previous E3 to E5 suite is still in early innings with significant opportunity to grow still, while also contributing to further expansion of average revenue per user ("ARPU") over the longer-term. Looking ahead, Intelligent Cloud revenues are expected to remain the driving force for Microsoft's consolidated growth. Management has guided Intelligent Cloud sales between $21.1 billion to $21.35 billion for the current June quarter, up 21% to 23% y/y and beating consensus estimates of $20.9 billion. Azure is expected to be the primary contributor to the segment's performance this quarter, as management guides related revenue growth deceleration by only two points to +47% y/y on a constant currency basis.
• Productivity and Business Processes: The segment, which houses sales generated from its cloud-based productivity solutions like Office 365 Commercial and Dynamics, as well as ads and services through LinkedIn, saw revenues increase by 17% y/y during the March quarter to $15.8 billion which is consistent with average consensus estimates. Commercial subscription to Office 365 remained robust, with related revenues showing accelerated growth of 20% y/y on a constant currency basis compared to 19% during the December quarter. Meanwhile, Dynamics sales grew 22% y/y, driven by strong Dynamics 365 subscriptions that have outpaced expansion of the overall business applications market during the March quarter. The company's expansion into metaverse solutions like Digital Twins and Connected Spaces as discussed in our previous coverage has also continued to support industrial demand. Meanwhile, LinkedIn's record-setting engagement volume with more than 830 million members have encouraged a rise in demand for its Talent Solutions and Marketing Solutions during the fiscal third quarter. Specifically, a strong jobs market has contributed to Talent Solutions sales growth acceleration for the sixth consecutive quarter at +43% y/y. The strong results were also corroborated by stronger-than-expected U.S. jobs data in March, which showed an addition of 431,000 jobs while the unemployment rate fell to 3.6%, nearing pre-pandemic levels. For the current quarter, management has guided revenue growth of 13% to 15% y/y to $16.65 billion to $16.9 billion range for the Productivity and Business Processes segment (consensus estimate: $16.7 billion). Office 365 suite subscriptions are expected to remain robust, with growth compounded by increased ARPU. LinkedIn revenues are also expected to grow in the high-20% range y/y buoyed by continued strength in the jobs hiring landscape.
• More Personal Compute: More Personal Compute segment revenues grew 11% y/y to $14.5 billion during the fiscal third quarter, beating consensus estimates of $14.3 billion. Windows sales increased by 11% y/y despite softening consumer spending thanks to robust commercial demand for Windows 11, which is also priced at a higher ARPU. Meanwhile, sales related to Search and News Advertising increased by 23% y/y despite the business' exit from Russia following its assault of Ukraine in late February, and softening ad spend by advertisers due to related uncertainties in Eastern Europe. On the product front, Surface and Gaming sales continued to show positive growth thanks to "better-than-expected supply" under the currently constrained environment. Specifically, Surface devices sales grew 13% y/y, while total Gaming revenues grew 6% y/y driven by robust demand for related content and services, as well as Xbox consoles as discussed in earlier sections. For the fiscal fourth quarter ending June 30th, management is guiding More Personal Compute segment revenues in the range of $14.65 billion to $14.95 billion, up 4% to 6% y/y. The expectations consider increasing supply chain pressures due to pandemic uncertainties in China, which is expected to drive further headwinds for Surface and Gaming device sales even though related demand remains solid. On the software front, Windows revenues are expected to increase by low-to-mid single digits y/y, with much of the momentum buoyed by Windows Commercial "driven by Microsoft 365 and advanced security" demand. And Search and News Ads are expected to contribute a revenue increase of 20% y/y.

Azure Remains the Star of the Show

Based on the company's latest financial results, its bullish thesis remains fixated on its continued strength in Azure cloud-computing and critical cloud-based productivity software like Office 365. During the fiscal third quarter, Microsoft saw the "number of $100+ million Azure deals more than double year-over-year", which continues to corroborate "broad-based acceleration in [cloud] consumption". A closer scrutiny of Microsoft's Azure performance in recent periods would also reveal that the world's second largest public cloud service provider has grown at an impressive rate of 46% to 50% y/y in each of the past seven quarters, becoming a core revenue driver for the company. In addition to Azure, Microsoft also continues to benefit from robust commercial demand for its cloud-based productivity solutions like Office 365 / Microsoft 365 / Dynamics 365 despite macroeconomic uncertainties ahead.

Building a digital fabric remains a critical mission for the commercial sector in order to ensure "improved productivity in the inflationary environment", meaning IT spending on migrating workloads to the cloud and other digital transformation projects will remain strong. Specifically, tech spending contribution to GDP growth is expected to double by 2030, as software becomes a key "deflationary force" going forward by driving "better economic outcomes". This makes strong tailwinds for Microsoft's growth prospects over the longer-term, especially considering only 11% of the global corporate landscape currently feels confident that their legacy business models will be "economically viable through 2023" and another 64% raising the need to step up on digitization plans to remain financially and operationally competitive. More than half of the corporate scene have expressed that they would rather "tighten the belt" in other parts of the business than to miss out on digital transformation, which is considered a strategic investment in differentiating themselves from competitors, while also enabling cost efficiencies.

Microsoft's recent acquisition of Nuance, a "leader in conversational AI and ambient intelligence", will also complement the company's continued build-out of its cloud-computing capabilities. The consolidation of Nuance will accelerate Microsoft's efforts in enabling customers with "security-focused, cloud-based solutions infused with powerful, vertically optimized AI", which are crucial to improving productivity and delivering better economic outcomes. The integration of Nuance into Microsoft's roster of cloud-based solutions is expected to drive further capitalization of fast-growing digitization opportunities ahead, especially as it enables cross-selling of new and improved solutions to existing customers, while also supporting penetration of new markets.

What is Microsoft's Long-Term Outlook?

Adjusting our previous forecast for Microsoft's actual Q3'22 results, as well as its Q4'22 guidance based on recent developments specific to its cloud-computing aspirations, we are projecting total revenues of $199.3 billion (+19% y/y) for full fiscal year 2022. The topline is expected to further advance at a compounded annual growth rate ("CAGR") of 10.8% towards annual revenues of $378.4 billion by fiscal 2027, which is consistent with Microsoft's continued outperformance across the board, buoyed by unwavering market leadership in critical cloud-based software ahead of an accelerating digitization cycle in coming years.

Consistent with the foregoing analysis, much of Microsoft's performance will continue to rest on its cloud-based service sales, alongside other revenue growth drivers such as the sale of personal computing and gaming devices. Intelligent Cloud revenues are expected to expand at a CAGR of 15.9% from $75.6 billion by the end of fiscal 2022 towards $190.9 billion by fiscal 2027, and represent a greater portion of the company's consolidated sales mix over the longer-term. Productivity and Business Processes segment sales, which captures anticipated expansion of commercial demand for Office and Dynamics solutions, are expected to advance at a CAGR of 8.9% from $63.5 billion by the end of fiscal 2022 towards $109.5 billion by fiscal 2027. Meanwhile, More Personal Compute sales are expected to remain on a trajectory of modest growth at a 4.3% CAGR through the forecast period to reflect a softening Windows and device upgrade cycle.

Microsoft Projected Revenues (Author)

As Microsoft's corporate strategy continues to encourage greater migration towards higher-margin software and service sales, the company's cost structure is expected to benefit from continued mild improvements over the longer-term, especially as cloud-computing programs continue to scale. Related income is expected to expand from $73.5 billion by the end of fiscal 2022 towards $142.1 billion by fiscal 2027.

Microsoft Financial Forecast (Author)

Microsoft Financial Forecast (Author)

Is Microsoft Stock a Fair Valuation?

Our price target for Microsoft remains in the mid-$300 level (~$350) despite the near-term macroeconomic overhang on growth tech stocks and equities in general. We expect upside potential of more than 20%, with the bulk of anticipated momentum returning in the second half of the year and through early 2023, based on the stock's last traded share price of $283.22 on April 27th.

Microsoft Valuation Analysis (Author)

The price target is derived using the discounted cash flows ("DCF") valuation approach, drawing on the projected cash flow streams in accordance with our fundamental forecast analyzed in earlier sections. An exit multiple of 18.6x (EV/EBITDA) is applied, which compares to the +20x that Microsoft is currently trading at, to reflect Microsoft's continued revenue growth above GDP from CY/2026 and beyond. A WACC of 9% is also applied to discount the projected cash flows, which reflects Microsoft's current capital structure, as well as its low risk profile considering the consolidated business' ability to generate robust liquidity from day-to-day operations.

Microsoft Valuation Analysis (Author)

Microsoft Valuation Analysis (Author)

Is Microsoft Stock a Buy, Sell or Hold?

Microsoft's stock remains an attractive long-term investment pick, especially under the current market climate, considering its strong balance sheet and robust growth profile still. The solid fiscal third quarter results, paired with a fiscal fourth quarter guidance beat across the board have also "put investors' macroeconomic worries to bed" when it comes to Microsoft.

The bullish environment surrounding cloud-based software - a market in which Microsoft continues to dominate - also makes strong tailwinds for the company's fast-expanding Azure and internet subscription-based Office solutions. The accelerating digitization cycle in coming years highlight Microsoft's massive growth trajectory as it continues to expand and improve its product roadmap, while also maintaining supreme customer satisfaction to ensure success of its recurring revenue SaaS business model. The critical role of Microsoft's offerings in both the corporate and consumer digital fabric will continue to underscore solid, sustained growth over the longer-term, providing for robust valuation prospects ahead.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.