+ Azure remains the primary growth driver. In 3Q23, Azure cloud revenue grew by 31% YoY on a constant currency basis, in line with the company’s guidance. Growth continues to be driven by rising cloud adoption as enterprises look to lower operating expenses and digitize their operations. Management highlighted that Azure OpenAI Service customers spiked by 10x QoQ to more than 2,500 (Coursera, Grammarly, and Mercedes-Benz) indicating early traction for its next generation AI services.
+ Demand for Office 365 remains strong. Office 365 commercial revenue (under productivity and business processes) grew 18% YoY in constant currency driven by strong renewal trends and continued E5 momentum. Microsoft reported paid Office 365 commercial user growth of 11% YoY to 382mn led by small-to-medium business and frontline worker offerings. Management also highlighted that Teams surpassed 300mn monthly active users (vs. 280mn in 2Q23) with nearly 60% of Teams customers purchasing Teams Phone, Rooms or Premium.
- Deteriorating PC consumer market hurt Windows OEM revenue. Windows OEM revenue, which includes the sales of Windows software to PC makers, declined by 28% YoY. This is mainly due to weakening consumer demand for PCs, high inventory levels and macro economic uncertainty.
+ Azure cloud unit remains resilient. In 2Q23, cloud remained Microsoft’s fastest growing segment with Azure revenue growth of 38% YoY in constant currency slightly above the company’s guidance of 37%. Growth continues to be driven by increasing cloud adoption and cybersecurity solutions, as companies look to reduce IT costs and digitalize.
+ Continued momentum in Office 365. Office 365 commercial revenue (under productivity and business processes) grew 18% YoY in constant currency driven by solid renewal trends and average revenue per user growth as customers upgrade to the E5 license for its advanced security, voice, and analytics functionality. Additionally, Microsoft reported paid subscriber growth of 12% YoY led by small and medium business and frontline worker offerings.
- Deteriorating PC market. Microsoft posted revenue of US$52.7bn for the quarter, equating to a 2% YoY increase, its slowest revenue growth since 2016. Revenue was hurt by a 5% FX headwind and soft PC environment. In 2Q23, Windows OEM revenue fell by 39% YoY driven by sharp drop in demand for PCs. Microsoft earns this revenue when PC manufacturers put windows on their devices.
+ Continued momentum in cloud business Azure. In 1Q23, Azure and other cloud services revenue grew 42% YoY in constant currency slightly below the company’s guidance of 43%. The growth was mainly due to strong renewal execution and surge in the number of large and long-term Azure contracts driven by continued demand for cloud computing services.
+ Demand for Office 365 remains strong. Office 365 commercial revenue grew 17% YoY in constant currency driven by paid user growth of 14% YoY. The subscriber growth was mainly due to strong momentum in small and medium businesses and frontline worker offerings. Additionally, average revenue per user (ARPU) continued to increase due to the strong adoption of the E5 license. Upsell to this higher tier was largely due to robust demand for advanced security and Teams voice capabilities in Office 365.
- Slowdown in the PC market hurt Windows. Windows OEM revenue, which includes the sales of Windows software to PC makers, declined by 15% YoY. This is mainly due to a slump in the sales of PCs and deteriorating demand as the spike in inflation forced customers to pull back on spending.
+ Demand for Azure remains strong. In 4Q22, Azure and other cloud services revenue grew 46% YoY in constant currency vs 45% in 4Q21. Growth came from a record number of contracts worth more than US$100mn and US$1bn as customers made larger and longer-term Azure commitments. The strength in Azure and the continued shift to the cloud offerings helped drive solid growth in the Intelligent Cloud segment revenue, which grew 20% YoY to US$20.9bn in 4Q22.
+ Office 365 is another solid growth area. Office commercial products and cloud services revenue increased 9% YoY, driven by strong Office 365 commercial growth of 15% YoY (19% YoY in constant currency), which continues to be a key driver of success for the Productivity and Business Processes segment. Microsoft reported Office 365 Commercial user growth of 14% YoY, led by ongoing momentum in small and medium businesses, frontline worker offerings and expansion of average revenue per user (ARPU) due to strong adoption of E5 license. Dynamics 365 revenue grew 31% YoY while LinkedIn revenue grew 26% YoY.
+ Strong demand for cybersecurity drives E5 momentum. In 4Q22, the number of E5 users increased by 60% YoY and now accounts for 12% of the Office 365 commercial installed base. The upgrade to this higher-end tier was because of the robust demand for advanced security capabilities amid rising cybersecurity attacks.
- FX headwinds impacting revenue growth. Microsoft’s total revenue growth of 12% YoY in 4Q22 was the slowest since 2020. In 4Q22, the unfavorable foreign exchange rate movement negatively impacted revenue by US$595mn (or 4% of 4Q22 PATMI) and EPS by US$0.04 (or 2%). The FX impact was guided to decrease revenue growth in 1Q23 by 5%, while lowering the total cost of goods sold and operating expenses growth by 3%.
- Russia/Ukraine war and production shutdowns in China. With the ongoing Russia/Ukraine war, Microsoft has significantly reduced its business operations in Russia. As a result, the company’s operating expenses in 4Q22 increased by US$126mn related to bad debt expenses and asset impairments. Microsoft also witnessed a US$300mn in negative impact to Windows OEM revenue due to production shutdowns in China and slowing sales of PCs.
For FY23e, Microsoft expects double-digit revenue and operating income growth in both USD and constant currency despite a worsening macroeconomic environment. Operating margins are estimated to be roughly flat as the benefit from extending the depreciable useful life for cloud infrastructure will be offset by FX headwinds. In 1Q23, Azure revenue is expected to be sequentially lower by just 3% on a constant currency basis, driven by continued strength in consumption of cloud computing services. Reopening of the economy will continue to drive user growth for Office 365 Commercial. We expect Microsoft to manage costs efficiently and invest aggressively to grow the business.
Results at a glance
Source: Company, PSR. *Note – Azure revenue amount is not disclosed.
+ All segments beat revenue estimates. In Productivity and Business Processes, commercial Office 365 and LinkedIn performed better-than-expected. Paid Office 365 Commercial users grew 16% to 345mn, exceeding our FY22e end target of 341mn, due to demand from small and medium business and frontline worker offerings. More Personal Computing benefited from continued strength for Microsoft 365 and commercial PCs, as well as a surge in search advertising on LinkedIn, up 33%, from a sharp demand uptick that started three quarters ago as the economy reopened amid a tight labour market. In Intelligent Cloud, Azure grew 49% YoY vs estimates of 47%, with continued consumption of cloud services.
+ Another quarter of margin beats. 3Q22 operating margins from Productivity and Business Processes, Intelligent Cloud and More Personal Computing were 46%, 44% and 34%, all higher than estimates of 44%, 40% and 33% respectively. ARPU was higher from continued momentum for Microsoft’s higher-end E5 licenses. Azure cloud services margins continued to improve. The faster growing higher margin LinkedIn services that reached a record high of 13% of total revenue this quarter also helped to boost margins.
- Revenue impact from stronger USD. FX decreased revenue growth by 3%, 1% more than expected. The stronger USD is guided to decrease revenue by 2% in 4Q22 while decreasing COGS and operating expenses by 1%, a net negative to operating margins.
4Q22 was guided to be another strong quarter. Reopening of the economy will drive Office Commercial user growth from small and medium sized businesses, while cybersecurity needs will drive ARPU growth through upgrades to premium E5 licenses. Azure will continue to benefit from businesses’ shift to the cloud. MSFT stated that large (>US$100mn) long-term contracts for Azure saw better-than-expected growth even against a very strong prior-year comparable. Customers are not looking at cutting IT budgets despite slowing economic growth.
Maintain BUY and unchanged TP of US$410.00
Our valuation remains unchanged based on DCF with a WACC of 6.2% and terminal growth of 4.0%. Our FY22e PATMI is raised by 3.5% on stronger revenue guidance and a lower tax rate. Microsoft is at the forefront of digitalisation, benefiting from secular growth in cloud computing, cybersecurity and artificial intelligence. Microsoft’s productivity software is also crucial and the most economically viable solution amid the tight US labour market.
+ Azure growth exceeded expectations. Azure and other cloud services revenue grew 46% YoY vs the consensus growth forecast for 2Q22 of 44% and our FY22e forecast of 41%. The growth was due to continued strong demand for consumption-based cloud computing services. Microsoft now has six industry specific cloud solutions, up from one last year. These solutions include helping customers cope with supply chain constraints and the tight labor market. Cloud adoption has been strong across every sector.
+ Commercial bookings an overwhelming beat. Commercial bookings (customer spending commitments) were up 37% YoY vs consensus estimates of 11%. Growth came from an increase in the number of larger, long-term Azure contracts and strong execution across the sales force. Historically, commercial bookings have been a leading indicator of revenue growth next quarter for Microsoft’s Commercial Office segment (Figure 1).
+ Margin expansion across the board. All segments expanded operating margins in 2Q22. The productivity and business processes margin was 48%, up from 46% YoY, driven by higher average revenue per user (ARPU) from demand for premium licenses offering advanced cybersecurity, compliance and voice services. The intelligent cloud margin was 45%, up from 44% YoY, driven by improvements across cloud services. And the more personal computing margin was 36%, up from 34% YoY, driven by growth in the higher margin Windows and search advertising segments. Operating margins are on track to beat our FY22e forecast of 41%.
- Slight headwinds from stronger USD. Revenue growth impact from the stronger USD was 1% higher than expected. The FX impact was guided to decrease revenue growth in 3Q22 by 2%, while lowering the total cost of goods sold and operating expenses growth by 1%.
Microsoft (MSFT) offers software and cloud-based solutions to enterprises and consumers, as well as hardware comprising laptops and gaming consoles. Its revenue segments are Productivity and Business Processes (32% of FY21 revenue), Intelligent Cloud (36%) and More Personal Computing (32%). The US contributes 50% of MSFT’s revenue.
We initiate coverage with a BUY rating. Our target price is US$405 based on a DCF valuation with a WACC of 6.2% and terminal growth of 4.0%
Microsoft has three revenue segments: Productivity and Business Processes (32% of FY21 revenue) comprising revenue from commercial Office products and LinkedIn; Intelligent Cloud (36%) including revenue from Azure, server and cloud services and other enterprise services; and More Personal Computing (32%) consisting of revenue from the Windows operating system, search advertising, device sales and gaming. The US contributed 50% of FY21 revenue, with the remainder coming from other countries.
Total revenue expanded at 13% CAGR in the past five years (Figure 1). Growth was driven by commercial Office products and Azure which grew at 59% and 12% CAGR respectively in the past three years (Figure 2). We expect these two segments to continue strong growth as MSFT’s vast installed base moves to the cloud, and cybersecurity, economic recovery and price increases provide tailwinds for MSFT’s software licenses.
Cost of sales and total operating expenses grew 10% and 7% CAGR respectively in the past five years. Cost of sales was 31% of FY21 revenue, while Sales and Marketing (12%), General Administrative (3%) and Research and Development (12%) made up operating expenses. All expenses have grown at a slower rate than revenue over the past five years, leading to improved operating and gross margins.
Operating margins improved from 30% to 42% in the past five years as revenue growth outpaced expenses. Operating margins from Productivity and Business Processes are at a five-year high of 45%, up from 38% in FY17, driven by growing Office 365 commercial seats at 24% CAGR and rising ARPUs at 4% CAGR. Similarly for Intelligent Cloud, operating margins are up from 33% to 43% over the same period.
Assets: Fixed assets have grown 25% CAGR in the last five years to US$62bn (Figure 3) in FY21 as MSFT expanded its data centre portfolio. Fixed assets have risen from 10% to 19% of total assets in the period. Goodwill has also grown 23% CAGR to US$50bn following acquistions in LinkedIn and others in areas of cybersecurity, cloud and artificial intelligence.
Liabilities: MSFT has a net debt of US$44bn. Net debt has fallen over the years even as fixed assets have grown (Figure 3).
Cash-flow from operations has steadily grown at 18% CAGR to US$77bn (Figure 4) from FY16 to FY21. Capex stood at US$21bn in FY21, growing at 20% CAGR.
As of FY21, we estimate 70% of MSFT’s revenue is recurring and derived from subscription models.
Productivity and Business Processes (32% FY21 revenue). Products in this segment fall under three categories:
1) Commercial and consumer Office 365 – subscriptions and on-premise licenses comprising software for Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, Skype for business and consumer, Outlook.com, and OneDrive;
2) LinkedIn – Talent Solutions, Marketing Solutions, Premium Subscriptions, Sales Solutions, and Learning Solutions; and
3) Dynamics 365 – a set of intelligent, cloud-based and on-premises applications such as Customer Insights, Power Apps, and Power Automate that encompass enterprise resource planning (ERP), customer relationship management (CRM) activities.
Office commercial products were 24% of FY21 revenue. They grew at 12% CAGR from US$24bn to US$40bn between FY17 and FY21, driven by a 24% CAGR rise in Office 365 commercial seats to 300mn and a 4% CAGR in ARPU to US$100. ARPU spiked 7% in FY21 (Figure 9), the fastest in three years, driven by higher demand for premium licenses. This has been attributed to cyberattacks in 2021 driving demand for MSFT’s higher-end security offerings, and increasing need for General Data Protection Regulation (GDPR) compliance in the European Union driving demand for MSFT’s higher-end compliance offerings. The major cyberattacks in 2021 included SolarWinds (US$18mn ransom), Microsoft Exchange, the Colonial pipeline (US$5mn), and the JBS meat processing plant (US$11mn) hacks. In FY21, MSFT’s highest-end E5 license user base as a percentage of MSFT’s total commercial Office 365 user base rose from 5% to 8%. Commercial Office 365 seat growth (Figure 9) is also being supported by continued economic recovery driving demand from small and medium businesses. We expect productivity and business processes revenue to grow 17% in FY22e, slightly higher than the five-year historical average of 16%.
In addition to the secular tailwinds in cybersecurity and compliance, MSFT announced maiden price increases for its 365 SKU licenses kicking in on 1 March 2022. Many customers may not experience the price increase until FY24/25 as enterprise agreements for the licenses are typically three years. However, we note that higher price increases for lower-end licenses could incentivise new customers to purchase higher-end SKUs. We do not expect much churn due to ongoing innovation and services that come with the licenses and there being no prior price increases historically.
Intelligent Cloud (36%). Microsoft is a provider of public, private, and hybrid server products and cloud services. These include Azure (MSFT’s cloud product), SQL Server, Windows Server, Visual Studio, System Center, related Client Access Licenses (CALs), and GitHub. This segment also includes Enterprise Services, including Premier Support Services and Microsoft Consulting Services.
Azure’s revenue, estimated to be 18% of FY21 revenue, is mainly derived through infrastructure-as-a-service (IaaS) and platform-as-a-service (PaaS) consumption-based services charged on a pay-as-you-go basis, and per user-based services through the Enterprise Mobility + Security licenses (Figure 10) which allow users to access MSFT applications via multiple devices securely. Azure is MSFT’s fastest growing business with revenue growing at 66% CAGR in the last five years. It is expected to grow 41% in FY22e as it remains a popular choice among global enterprises adopting cloud computing who are already clients of MSFT servers and software. Operating margins have also steadily improved from 33% to 43% from FY17 to FY21.
Azure’s strength also lies in its hybrid cloud focus. According to the RightScale State of the Cloud report 2019, hybrid cloud is the dominant enterprise strategy, with 58% of respondents stating that they prefer using private/on-premise cloud together with public cloud and not rely on the public cloud in totality. They need the private cloud for data sovereignty/regulatory challenges, and network challenges where they may not have enough bandwidth or don't want to rely on internet connectivity for workloads to run. Microsoft Azure’s capability in hybrid cloud is superior to AWS and Google Cloud Platform and therefore captures this market more.
More Personal Computing (32%). The products include: 1) Windows operating system (commercial and consumer), Windows Internet of Things, and MSN advertising; 2) Devices including Surface and PC accessories; 3) Gaming, including Xbox hardware and Xbox content and services, comprising digital transactions, Xbox Game Pass and other subscriptions, video games, third-party video game royalties, cloud services, and advertising; and 4) Search advertising - Bing and Microsoft Advertising. MSFT’s devices are primarily manufactured by third-party contract manufacturers.
Revenue from More Personal Computing grew at a modest 6% CAGR in the last five years, however operating margins have markedly improved from 15% to 36%. We believe this is due to stronger growth in the higher margin Windows, Search Advertising and Gaming segments, which grew 6%, 10% and 11% CAGR respectively compared to a decline in revenue from Devices of 3% CAGR.
Cloud computing. Gartner forecasts end-user spending on public cloud services to reach US$396bn in 2021, and grow 22% to reach US$482bn in 2022. Additionally, Gartner predicts public cloud spending by 2026 will exceed 45% of all enterprise IT spending, up from less than 17% in 2021. AWS currently holds a 33% share of the cloud infrastructure services market. It is followed by Microsoft Azure at 20%, and Google Cloud Platform at 10%. Azure’s market share has increased from 10% to 20% between 2017 and 2021 as an installed base of enterprises have chosen Azure as their primary cloud vendor.
Productivity software. The global productivity management software market size was valued at US$43bn in 2020 and is expected to grow at a CAGR of 14% from 2021 to 2028, according to Grand View Research. The rising need to manage tasks and workflow among the business and swiftly growing advancements in the areas of Machine Learning and Artificial Intelligence are the key factors driving market growth. Microsoft’s Office 365 is the clear leader with 89% market share in 2020 according to Gartner, with Google’s Workspace in second place with a 10% share. Other competitors for Office include software and global application vendors, such as Apple, Cisco Systems, Facebook, IBM, Okta, Proofpoint, Slack, Symantec, Zoom.
Higher-than-expected supply chain impact on Surface laptop and Xbox. Ongoing supply chain and chip shortages have led to MSFT being unable to meet demand for its laptop and gaming console hardware. Shortages have resulted in significant lead times and supply volatility and could come in worse than expected. Despite this, management has kept a strong forecast of between US$16.35bn and US$16.75bn for its More Personal Computing segment.
We initiate coverage on Microsoft Corp with a BUY recommendation. We have a DCF valuation of US$405.00 based on a WACC of 6.2% and a terminal growth rate of 4.0%, compared to the long-term average US GDP growth of 3.2%.
Rule of 40
The Rule of 40 is a benchmark that measures the balance between growth and profitability for Software-as-a-Service companies. It takes into account revenue growth and EBITDA margin, the sum of which needs to exceed 40% to fulfil the rule.
The sum of MSFT’s three-year average revenue growth of 15% and EBITDA margin of 48% equals 63%, which fulfils the Rule of 40 criteria.