Microsoft Q1 2023 Quick Take: Snooze, You Lose

Summary

• Microsoft delivered a sales and earnings beat Tuesday evening, assuaging investors' concerns over potential weakness ahead of a looming economic downturn.
• More Personal Computing sales were down slightly as expected, given the global slowdown in PC demand, with added pressure from FX headwinds that have impacted consolidated results.
• Yet, consolidated growth underscores the tremendous value of Microsoft's moat in the provision of mission-critical software and public cloud solutions.
• With continued resilience demonstrated across every arm of the business under tough macro conditions over coming months, and a checkbook that keeps growing to sustain favorable shareholder returns over the long run, Microsoft stock makes an attractive investment for both growth and income investors alike at current levels.
• Looking for more investing ideas like this one? Get them exclusively at Livy Investment Research. Learn More »

David Ramos

Microsoft Corporation (NASDAQ:MSFT) stock has lost close to 30% of its value this year, with the steepest declines seen during the three months through June. That is when it became clear that inflation was going to stick around for longer than expected, and Fed rate hikes would only become more aggressive, pointing to further macroeconomic headwinds through the remainder of the year. While the company’s revenue growth has decelerated towards the slowest pace in years in low double-digits over the past two quarters, its latest fiscal first quarter double beat offers some relief, especially given the tough operating and macro environment in the three months through September.

As CEO Satya Nadella has preached repeatedly, Microsoft is not “immune to the economic forces hitting its clients,” but the company’s sprawling portfolio of mission-critical offerings can help “improve overall efficiency.” This is consistent with the increasing momentum observed in demand for Microsoft’s Azure cloud-computing solutions – dubbed a “deflationary force” by Nadella – which will help to offset any near-term weakness in PC demand due to cyclical headwinds.

Meanwhile, the surging dollar remains a key overhang on Microsoft’s near-term fundamental and valuation outlook, given more than half of the company’s consolidated revenues are generated from operations outside of the U.S. Specifically, Treasury yields that are now pushing past 4% in anticipation for more aggressive rate hikes, along with the surging dollar, are two major factors injecting uncertainty over Microsoft’s forward fundamental and valuation outlook. Yet, given the performance of its underlying business remains resilient, with consistent progress on the cloud-computing front amidst a turbulent September-quarter, alongside a significantly discounted valuation relative to peers and its own multi-year average, Microsoft is well-positioned for a strong recovery at current levels.

Mission-Critical Payoff

Microsoft’s Productivity and Business Processes segment revenues topped $16 billion (+9% y/y; -1% q/q) in the fiscal first quarter, highlighting again the strength of its moat in the provision of mission-critical software across all use cases, spanning corporate to day-to-day personal settings. As mentioned in one of our previous coverages on the stock earlier this year, demand for Microsoft’s suite of productivity software offerings has become relatively inelastic to price changes, which plays a critical role in ensuring the company’s overall resilience in a slowing economy and reinforcing the company’s favorable forward growth prospects.

Job postings across America have continued on a steady decline this year. And in corporate America, where Microsoft’s offerings are primarily used, job postings have declined for 30 straight weeks, down more than 6% m/m through October 23. Yet, Microsoft 365 still managed to add seats, which is corroborated by y/y growth of 11% in Office 365 Commercial sales alone during the fiscal first quarter. The segment’s continued delivery of organic growth, albeit at a decelerating pace, is impressive given its maturity – not only does it defy “the law of large numbers,” but also demonstrates resistance against challenges of a looming consumer slowdown that has put investors on edge this year. The segment’s robust fiscal first quarter results continues to support a robust demand environment for Microsoft’s productivity software, assuaging investors' angst over potential adverse impacts from dwindling corporate IT budgets as macroeconomic conditions deteriorate.

We believe the change in working and collaboration patterns following the pandemic has played a significant role in bolstering the mission-critical nature of Microsoft’s cloud-based productivity software. Since the start of the pandemic, the use of online / digital collaboration and productivity platforms has increased by close to 50% to accommodate remote working arrangements, drawing up compensating tailwinds for Microsoft amidst a weakening economy.

The critical nature of Microsoft’s productivity software in corporate America today is further corroborated by CIOs reluctance to cut investments in software and communications solutions “if macro were to deteriorate further” – a recent survey conducted by RBC Capital Markets on a cohort of IT executives indicated “spending intentions were most positive for Microsoft,” among others, with 71% of respondents indicating a need to double-down on the software giant’s productivity solutions. And to better capitalize on this opportunity, Microsoft has also improved the value proposition of its productivity software with the recent roll-out of new features spanning Teams Premium, Microsoft Places, and OpenAI’s Dall-E 2 for Microsoft Designer, among others:

• Teams Premium: Despite rival Zoom Video Communications, Inc. (ZM) being synonymous with video conferencing during the pandemic era, Microsoft Teams has now become the leading all-in-one cloud-based collaboration tool across large-scale commercial settings. Close to 90% of large corporations with annual revenues exceeding $1 billion have indicated Teams as their primary video conferencing tool, while Zoom makes a distant second place with about 33% share and WebEx (CSCO) 13%. Meanwhile, Zoom leads amongst the more recession-prone small- and medium-sized businesses, underscoring its increased exposure to revenue risks in the near-term, while Microsoft reinforces its market leadership. Microsoft’s recent partnership with Cisco, which runs legacy video conferencing system Webex, provides further validation on Teams’ increasing importance within the corporate landscape – beginning 1H23, Cisco will enable Microsoft Teams compatibility across its family of conferencing devices, which implies acknowledgement of Microsoft Teams’ rising leadership in the concentrated corporate video conferencing industry. And to better monetize Microsoft Teams, which is currently offered as part of the Microsoft 365 (formerly, Microsoft Office) subscription, Microsoft has recently introduced Teams Premium. Teams Premium, which is capable of offering more personalized collaboration experiences, such as summarizing meetings with “chapters and personalized highlights” to better inform employees not in attendance, will become available as an add-on at $10 per user per month starting December. The enhanced offering is expected to generate a greater appeal to Microsoft Team’s enterprise-focused customer base, which are urgently looking for ways to become more adaptive to the new normal of “location-agnostic” working arrangements.
• Microsoft Places: In my previous workplace, which adopts an “agile workplace” system with no assigned desks, there used to be a big screen by the elevators in the lobby tracking which floors are the least and most accessed; and the firms’ employees have typically relied on the information displayed on the big screen to infer seat availability during the peak hours between 8:30AM and 9:00AM in the morning (and this was before the pandemic hit, of course). Microsoft Places is essentially that – but at the palm of your hand to address the new normal of remote / hybrid working arrangements. In the post-pandemic era where tradition cubicle working arrangements have been largely upended, with once bustling corporate hubs now facing record-high vacancy rates (or “onerous” leases with increasing employee pushback against return-to-office mandates), Microsoft Places aims to address an $81 billion void on technology solutions that can help minimize the financial impact of transitioning from a physical to connected workplace. Microsoft Places is a new app focused on improving Microsoft customers’ overall efficiency – a core focus for the software giant as discussed in the earlier section, and a key driver of its fundamental resilience amid a looming economic downturn. The app aims at facilitating a “Connected Workplace” by taking critical information about an office’s utilization online – employees can now see when their colleagues “plan to be in the office or attend a meeting in person,” while managers get immediate real-time access to information that can help “decisions about electricity, heating and cooling” to save money. The app essentially helps both employees at the frontline and executives at the decision-making level to optimize both time and cost efficiencies amidst rapidly changing in-office work patterns.
• Dall-E 2 for Microsoft Designer: More than 40% of corporate employees across the U.S. have noted that the use of low-code techniques will be critical in creating value in the data-driven era. And Microsoft’s increasing integration of easy-to-use, AI-enabled tools in its productivity software does just that. Following its $1 billion investment into OpenAI, an “AI research and deployment company,” in 2019, Microsoft has recently introduced its new “Designer” app that will feature the investee’s “Dall-E 2” AI-enabled text-to-image tool to facilitate simple, low-code graphic designing capabilities to users. Microsoft Designer will become available as part of the Microsoft 365 upon roll-out, underscoring the company’s prowess in consolidating numerous high-demand software into an all-in-one bundle, and further enhancing its appeal to users. Microsoft Designer will feature Dall-E 2, an AI-enabled software created by OpenAI that will allow users to convert text into images within seconds – imagine Google Search (GOOG, GOOGL) but for real-time AI-generated images in all sorts of combinations you can think of, not just images available on the internet today. The newly introduced design app is now being punt against industry leaders Canva and Adobe (ADBE) in the provision of online easy-to-use low-code design tools. In a similar story to Microsoft Teams, the roll-out strategy for Microsoft Design through Microsoft 365 is expected to help the company gain share at a rapid pace given the productivity software suite’s sprawling user base. With rising demand for low-code techniques in the increasingly data-driven era, Microsoft Design marks the beginning of further inroads for Microsoft over coming years in the realm of cloud-based low-code solutions following its success with Power Apps.

Increasing Cloud Momentum

Intelligent Cloud is where the spotlight is at for Microsoft. The segment’s revenues grew 20% y/y to $20.3 billion in the fiscal first quarter, underscoring robust hyperscaler demand still despite diminishing IT budgets as part of pre-emptive cost-savings efforts implemented across the board ahead of a looming economic downturn. More importantly, the results demonstrate strong share gains by Azure, narrowing its distance from market leader AWS (AMZN) in the global cloud-computing race.

Azure has gained significant momentum since our last coverage on the stock in July. Deal wins valued at $100+ million and $1+ billion remain on the rise, reinforcing the robust growth trends management had alluded to previously in its FY 2023 outlook. In fact, Azure is putting market leader AWS on notice by becoming an increasingly favored public cloud-computing service provider among large enterprises, given the impressive pace of growth in Tier 1 workload deal volumes secured in recent quarters. More than 71% of IT executives recently surveyed by RBC Capital Markets had indicated strong spending intentions for Microsoft Azure, while Google Cloud garnered a solid 73% and AWS 57%. And over a longer time span, many C-suite decision-makers “see the greatest increase in spend 2022 [and] in 2025 [on] Microsoft” software and cloud-computing solutions, with AWS following closely behind.

Azure is also well-positioned to monetize on growing demand for cybersecurity solutions. Security software is currently the most resilient segments against growing recession risks, representing the “top area of investment still to come in 2022” given the increasing urgency to counter rising cybersecurity threats. With more workloads migrating from legacy IT infrastructures to the cloud, the commercial segment is placing an increasing emphasis on cloud security, in addition to other “security spending priorities” such as “endpoint protection, identity, email, and application security.” Specifically, AI/ML is becoming an increasingly critical consideration when decision-makers think about their respective cybersecurity set-ups.

And these trends continue to reinforce Azure’s growth story; about a quarter of Microsoft’s revenues are generated from security sales after all. Its provision of cybersecurity solutions to address each of the top security spending priorities identified above also makes it well-positioned as a “security spend consolidator”. Critical security services provided include Azure Active Directory, which protects user identity and authentication to “guard against 99.9% of cybersecurity attacks”; Microsoft Sentinel, which is an AI-enabled security information and event manager (“SIEM”) platform, uses AI for quick “threat detection and response” while realizing as much as 48% in cost-savings compared to traditional SIEMs; and Microsoft Defender for Cloud, which builds on Microsoft Defender offered to individuals through Microsoft 365, and protects against cybersecurity “weak spots” across different cloud configurations spanning “multicloud and hybrid environments.”

Near-Term Risks to Consider

• FX: FX remains a near-term headwind on revenues, with more than half of the company’s consolidated sales generated from operations outside of the U.S. With the dollar is still on the rise in response to surging interest rate hikes and rising Treasury yield, we expect FX headwinds to remain an evolving macro-overhang on Microsoft’s near-term fundamental outlook. It remains a challenge beyond Microsoft’s control – even if the business can achieve 100% resiliency against the near-term consumer slowdown, FX impacts will still eat into its fundamentals. However, we believe these risks have already been priced into the stock’s valuation as well as consensus fundamental estimates on Microsoft’s FY’23 performance.
• Consumer Softness: PC shipments continue to decline at a rapid pace as a result of pulled forward demand during the pandemic, waning consumer confidence amid surging inflation, and a broad-based economic slowdown. The latest tally of global PC shipments in the calendar third quarter showed acceleration in declining demand this year – shipments fell 6.8% y/y in 1Q22, 15% y/y in 2Q22, and 20% y/y in 3Q22, with 4Q22 numbers expected to worsen as consumers shun big ticket items due to weakening spending power. As a result, Microsoft’s Windows licensing take-rates and Surface device sales (relatively nominal contribution to consolidated sales mix) will inevitably take a hit over coming quarters as the economy braces for a downturn. This is consistent with expectations for continued weakness in More Personal Computing sales in the near term, as recession-prone businesses spanning Windows, Surface and search ads (namely, Bing) see a macro-driven slowdown over coming months. However, continued strength from Microsoft’s differentiated business portfolio – including impressive resilience demonstrated across its cloud-based productivity software and cloud-computing businesses discussed in the foregoing analysis – is expected to absorb some of the near-term sales pressures on its consumer-centric businesses.
• Activision Blizzard: Microsoft’s proposed $69 billion acquisition of Activision Blizzard (ATVI), which has racked up regulatory scrutiny in recent months, could potentially be another drag on investors’ sentiment on both stocks in the near term. The deal, which Microsoft plans to close by June 2023, is now part of in-depth investigations by regulators across the UK (Competition Markets Authority, or “CMA”) and Europe (European Commission) to ensure no violation of antitrust conditions. The regulatory hurdles have been largely expected, given the consolidation of Activistic Blizzard – which owns some of the best-selling gaming franchises spanning Call of Duty, World of Warcraft and Guitar Hero – would only further complement Microsoft’s Xbox gaming console and Game Pass cloud-based gaming subscription businesses, and boost the software giant’s global market share in the burgeoning gaming arena. While both Microsoft and Wall Street analysts remain optimistic that the deal will close within the next year, increased regulatory scrutiny over the proposed transaction continues to weigh on investors’ sentiment on the stock, especially amid the current risk-off sentiment on growth equities.

Final Thoughts

Balancing revenue growth with sustained margin expansion through disciplined execution of day-to-day operational requirements and investment opportunities remains a priority for Microsoft. And despite near-term macroeconomic weakness, the company has continued to demonstrate its ability to deliver. Not only that, Microsoft’s fiscal first quarter results also highlights a few of its key strengths that bolster its longer-term growth prospects – namely, its ability to ensure a sustained growth trajectory over the longer term via a diversified product portfolio, leverage its existing customer base to enter new growth opportunities and expand its addressable market (e.g. Microsoft Design and Microsoft Teams), and maintain profit margin expansion by gradually and steadily gaining market share in the burgeoning cloud-computing business. These continue to make valuable strengths to help Microsoft overcome its biggest near-term roadblocks, including FX headwinds, broader market weakness, and any regulatory challenges.

In our view, Microsoft remains a favorable long-term investment at current levels for both growth and income investors. With the stock now trading at a significant discount relative to its own multi-year average and to its large-cap peers, despite having its growth prospects intact, further uptrend momentum awaits which seeks to benefit growth investors looking for a compelling risk/reward entry. Meanwhile, Microsoft has also steadily upped its dividends in recent years as a result of its growing checkbook, underscoring favorable shareholder returns for income-focused investors over the longer-term.

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.