FABRICE COFFRINI/AFP via Getty Images
The fiscal second quarter just ended continued to exhibit resilient results at Microsoft Corporation (NASDAQ:MSFT) despite persistent macroeconomic challenges, including major FX headwinds. This comes as no surprise, and was largely expected and consistent with previous management warnings of persistent fiscal first quarter cyclical and macro trends heading into the seasonally strong December quarter:
Our outlook has many of the trends we saw at the end of Q1, continue into Q2.
This also included continued weakness in the More Personal Computing (“MPC”) segment, given persistent softening in PC demand, which had, inadvertently, further slowed sales of its higher-margin Windows software – the dominant operating system for personal workstations. But relative strength observed in Intelligent Cloud and Productivity and Business Processes (“PBP”) – though not fully immune to macro challenges like FX headwinds – were able to cushion some of the blow, with Microsoft ending the December quarter with a slight earnings beat despite missing consolidated revenue expectations.
Specifically, Intelligent Cloud revenues, which were up 18% y/y (+24% y/y cc) to $21.5 billion, was in line with management’s guided range of $21.25 billion to $21.55 billion; PBP sales increased 7% y/y (+13% y/y cc) to $17 billion, outperforming management’s guided range of $16.6 billion to $16.9 billion; MPC revenue decreased 19% y/y (-16% y/y cc) to $14.2 billion, underperforming the previously guided range of $14.5 billion to $14.9 billion with Windows OEM sales decrease of 39% y/y and weakness in device sales being primary drags, which was consistent with management’s previous expectations.
Looking ahead, calendar 2023 looks to be a “tale of two halves” for Microsoft – the coming March and June quarters are expected to experience similar cyclical / macro trends observed in the first half of fiscal 2023, blighted by ongoing FX uncertainties and near-term demand weakness as persistent inflation, surging interest rates, and looming recession risks continue to weigh on consumer spending and enterprise IT budgets. The recently announced job cuts, “changes to hardware portfolio, and lease consolidation” efforts are not expected to translate into material improvements to margins within the immediate-term, given extended timing of execution.
However, the second half of calendar 2023 – or Microsoft’s first half of fiscal 2024 – is likely to mark a starker shift in focus back towards the company’s core competitive advantages – namely, its market leadership in the provision of “mission critical” consumer and enterprise software, robust organic double-digit growth, and sustained margin expansion, all of which we have discussed in detail in a previous coverage. Specifically, improvements to margin preservation and expansion amid the looming economic downturn will be a key driver of potential upside recovery for Microsoft in the second half of calendar 2023. That is when the impact of recent job cuts, hardware portfolio restructuring, and lease consolidation efforts implemented are expected to place a more evident impact on P&L through the year.
Taken together with the benefit of weaker PY comps from fiscal 1H23, when margins were blighted by higher energy costs, severance / restructuring costs, new acquisition (i.e., Nuance and Xandr) integration costs, and adverse FX headwinds, Microsoft is ripe for a turnaround in the second half of calendar 2023. Although mounting macroeconomic uncertainties – spanning inflation, rate hikes, and a potential global economic downturn – continue to skew markets towards a risk-off stance, Microsoft’s trajectory towards improving margin preservation within the foreseeable future, likely in the second half of calendar 2023, will play favorably to growing investors’ preference for profitability, and support a structural recovery from current levels toward further sustained upside potential over the longer-term.
Breaking Down the External Macro Headwinds
We view these as temporary factors beyond Microsoft’s control that will continue to challenge its near-term fundamental performance. They include persistent FX headwinds, PC weakness, as well as growing uncertainty in enterprise IT spending, which are consistent trends observed in F1H23 that will likely become more prevalent over the coming months.
1. FX Risks
Specifically, the dollar continues to be strong despite the recent retreat, alongside moderating benchmark Treasury yield, from its peak in late September on the back of improving inflation data that has traders dialing back on expectations for more aggressive Fed rate hikes as the year progresses. It remains “too soon to aggressively sell the dollar,” though, as policymakers at the Federal Reserve continue to reaffirm their hawkish stance on keeping rates higher for longer to stem runaway inflation for good. And the timing pertaining to when the dollar’s strength will unwind remains a question of great uncertainty, given it would “require more confidence that inflation is falling back quickly and speculation that the Fed may need to start cutting rates due to recession risks” to slow demand and stem yield for Treasury that has been boosting the dollar.
But such an economic downturn would also incentivize a demand for haven assets like Treasury and refresh “demand for the greenback” – thus, creating a contradicting situation that continues to breed uncertainty over the dollar’s trajectory. The dollar’s persistent strength will likely continue to weigh on Microsoft’s near-term operating results, which has already been thwarted by violent FX headwinds in recent quarters given approximately half of its consolidated revenues are currently generated from operations outside of the U.S.
2. Consumer Weakness
The cyclical nature of PC demand will also remain a drag on Microsoft’s MPC results within the foreseeable future. Specifically, global PC shipments accelerated a decline to -28.5% in the fourth quarter from -19.5% in the third quarter, -12.6% in the second quarter, and -6.8% in the first quarter; full year 2022 PC shipments dropped 16.2% y/y, the steepest level from data dating back to the mid-1990s due to worsening consumer weakness. Although Surface device sales account for only a nominal mix of the company’s consolidated results, Microsoft’s flagship Windows operating system remains the “dominant operating system” for personal workstations, underscoring the MPC segment’s vulnerability to near-term deterioration in economic conditions.
This is further corroborated by the accelerated y/y decline of 39% in Windows OEM revenue in the fourth quarter, and 19% decline in the broader MPC segment’s revenue over the same period, in line with management’s previous expectations for continued weakness in businesses with high exposure to consumer end-markets.
And the challenge remains prevalent, as PC demand continues on an accelerating slowdown in response to worsening consumer weakness. American household savings have come down significantly from the pandemic era, when bank accounts were filled with unspent stimulus cheques due to COVID-related mobility restrictions, hovering near record-low levels in the low 2% range. Meanwhile, credit card debt has steadily racked up beyond pre-pandemic levels, with accumulated revolving credit outstanding climbing $17 billion between November and December to $1.2 trillion. underscoring the growing burden of inflation and surging interest rates. Consumers had also “increased their credit spending by nearly 11% from the previous year over the peak holiday shopping days between December 19 and December 26,” underscoring the growing pinch of persistent inflation and surging borrowing costs on Americans, and inadvertently, the broader economy. With the Fed likely laying its eyes on slowing the relatively resilient labor market next – unemployment remains at a historical low rate of 3.5% – to impede a wage-induced price spiral, despite early signs of a cooldown in wage growth, related uncertainty is likely to persuade consumers to tighten their belts further within the near-term.
Still, a persistently tight labor market with unemployment at a five-decade low means policymakers aren’t ready to declare victory…“Even with the recent moderation, inflation remains high, and policy will need to be sufficiently restrictive for some time to make sure inflation returns to 2% on a sustained basis,” Fed Vice Chair Lael Brainard said Thursday in Chicago.
Source: Bloomberg News
This is likely to translate into continued reluctance in consumer purchases of discretionary big-ticket items like PCs, causing an ensuing slowdown in demand for Windows, and potentially other consumer productivity software offered by Microsoft as well as the temporary macro headwinds persist.
3. Commercial Weakness
In addition to macro-driven consumer weakness, growing uncertainty in enterprise IT budgets will likely remain a near-term overhang on Microsoft’s more resilient PBP and Intelligent Cloud segments as well.
On the PBP front, continued deceleration observed in the fourth quarter is consistent with the increasingly conservative spending approach implemented across enterprise procurement in preparation for the looming cooldown. As discussed in a previous coverage, subscription-based business models – which is implemented by Microsoft for the most part of its PBP segment revenues generated from cloud-based productivity software subscriptions – are generally more recession resistant at first, given the arrangement locks in business for a predetermined period, but become more sensitive as the downturn progresses as renewals decline. And this is consistent with the current situation, where the rising volume of job cuts across the tech industry, which has inadvertently driven down seat subscription volumes, will likely continue to weigh on PBP segment revenue growth within the near-term.
Even when macro headwinds subside, re-acceleration will likely take longer to return given subscription-based business models typically recover last, considering the time-lag in re-ramping up revenue (e.g., wait time for customers to rebuild their workforces and reinstate subscriptions).
Meanwhile, growing uncertainty over corporate IT budgets are also likely to reduce cloud spending, which would likely further deceleration in its Intelligent Cloud segment over coming months. Boardroom executives are already taking a “more measured approach to their purchasing decisions” based on commentary across the tech industry, with many decision makers now “talking pennies, [and] not millions” ahead of the looming economic downturn. This is consistent with Microsoft CEO Satya Nadella’s recent call to “do more with less,” as budgets consolidate in preparation for a “prolonged slump.”
The near-term theme of “cautious spending” underscores a protracted moderation in cloud-computing demand within the near-term as corporate digitization and cloud-migration projects slow:
Slower cloud spending by inflation-hit businesses is expected to stall the sales momentum at Amazon (AMZN) and Microsoft, and add to the troubles of the sector that laid off thousands this month. After years of blistering growth, most recently fueled by remote working and studying during the pandemic, cloud demand has cooled over the past nine months and sales growth may slow further…End-user cloud spending for services including those from the world’s largest providers – AWS and Microsoft’s Azure – are expected to grow 20.7% this year after 18.8% growth in 2022 and 52.8% in 2021, according to research firm Gartner. A lot of companies have been slowing their migration to the cloud or asking for a lower price on their existing plans…
Source: Reuters.
Based on this consideration, while Azure revenues outperformed in the fiscal second quarter with 35% y/y growth (+42% y/y cc), beating consensus estimates for an all-time high deceleration to the low-30% range, the cloud-computing segment remains vulnerable to fluctuations in the enterprise IT spending environment. While longer-term secular growth trends in cloud-computing persist due to the mission critical nature of related solutions for ongoing global digitization efforts – which we view to be beneficial for Azure, especially given growing adoption of a multi-cloud strategy to improve reliability and cost-efficiencies – accelerating “cloud spend optimization” implemented by customers to essentially “do more with less” as Nadella has preached, taken together with persistent input cost fluctuations (e.g., energy), will likely eat further into the business’ profit margins in the near-term as well.
But Microsoft’s growing shift into monetizing the AI paradigm will likely be key to offsetting both macro-driven near-term moderation and longer-term normalization across existing PBP and Intelligent Cloud businesses, while also complementing its broader competitive advantage in sustaining longer-term double-digit growth and margin expansion, which has largely defied the law of large numbers. Specifically, Microsoft’s latest incremental investment into OpenAI, which totals $10 billion over multiple years, will be key to furthering its “AI breakthroughs.” The extended partnership, which entails contribution of significant supercomputing capacity out of Azure to facilitate OpenAI’s “ground-breaking independent AI research,” will only further both parties’ longer-term capitalization of growth in advanced AI technologies.
As discussed in our previous coverage on the stock, Microsoft has already incorporated OpenAI’s AI-enabled text-to-image tool, DALL-E, into its new “Designer” app, as well as other “Image Creator features for Bing and Microsoft Edge”. Further implementation of large language models (“LLM”) like GPT-3.5 used in ChatGPT – the latest internet sensation – as discussed in our recent coverage on the stock will also bolster Microsoft’s competitiveness against rivals counting Amazon’s AWS and Google Search (GOOG / GOOGL). This is already well underway, with Azure’s recent rollout of “Azure OpenAI Service” for all customers after limited availability that began in November 2021. The newly introduced solution will provide Azure customers with access to “the most advanced AI models in the world,” including LLMs, created by OpenAI.
With close to a third of recently surveyed American professionals indicating they have used “ChatGPT or another artificial intelligence program in their work,” Microsoft’s extended partnership with OpenAI will likely grow into a key competitive advantage over the longer-term, and further narrow the market share gap between Azure and industry leader AWS. This is further corroborated with increasing workplace demand for low-code solutions to create value in the data-driven era – more than 40% of corporate employees across the U.S. have highlighted the availability of low-code techniques as critical to improving productivity.
Understanding Internal Job Cuts, Hardware Portfolio Changes, and Lease Consolidation Efforts
Now, on to what Microsoft has internal control over under the currently macro-dominant market climate and operating environment, the company has recently announced plans to slash 10,000 jobs. In addition to joining in on the talent bloodbath that has currently taken the tech industry by the storm, Microsoft has also disclosed plans to engage in changes to its hardware portfolio and embark on lease consolidation efforts “in response to macroeconomic conditions and changing customer priorities.”
Taking into consideration an assumed average annual salary rate of $200,000 across all functions and levels within Microsoft, the latest reduction in force (“RIF”) enforced could result in annualized savings of as much as $2 billion, and bolster consolidated operating margins by 100 to 200 bps with an added $0.20 range boost to EPS. Despite the $1.2 billion one-time charge pertaining to the efforts, which likely includes severance pay, hardware portfolio restructure costs, and other expenses related to consolidating its physical workspace footprint, the resulting annualized savings is expected to bolster Microsoft’s free cash flow margins and further reinforce its longer-term upside potential.
And moving on to hardware portfolio changes, although Microsoft has yet to provide further details on related plans, the recent RIFs enforced at its HoloLens group after “Congress rejected the U.S. Army’s request for $400 million to buy as many as 6,900 of [the goggles] this fiscal year” underscore that the company’s AR ambitions is one dealt with a likely near-term setback. Surface could make another potential hardware unit for further restructuring, in our opinion, considering the near-term slowdown in device sales due to macro-driven consumer weakness. The business’ nominal share in consolidated revenues and unprofitable nature also leaves room for changes that could further help Microsoft preserve its margins ahead of mounting macroeconomic uncertainties. This would mimic peers like Amazon and Google, which have recently been suspending projects that are not expected to yield immediate / substantial returns.
The impact of related cost-savings initiatives are expected to become more evident in the second half of calendar 2023, given the extended timeline of execution. Ensuing improvements to the bottom line, and inadvertently, EPS expansion will likely “strengthen the bull case” for a more sustained recovery in Microsoft Corporation stock later in the calendar year, and offset any persistent top line deceleration coming off of the temporary macroeconomic headwinds.
The Bottom Line
While broader macro themes will likely continue to dictate Microsoft Corporation’s near-term fundamental outlook, its internal efforts implemented to bolster efficiency within the company, paired with its market leadership across key longer-term secular growth trends, remain key supporting factors for a ripe turnaround towards sustained upside potential by the end of calendar 2023. With the stock now trading at under 25x estimated earnings on consensus estimates for 32% free cash flow margins in fiscal 2023 – a discount to its mega cap software peer group (mean 26x estimated earnings; mean 27% CY/2023 free cash flow margin) – we believe the list of negatives facing the underlying business have been reasonably reflected in its market value.
The anticipated improvements to margin preservation resulting from ongoing job cuts, hardware portfolio restructuring, and lease consolidation efforts, alongside a deeper dive into the AI paradigm shift also reinforces confidence in Microsoft’s competitive advantage in sustaining both longer-term growth and profitability, bolstering its longer-term valuation prospects from current levels.
Be the first to comment