• 2Q24 revenue was in line with our expectation, while earnings exceeded. 1H24 revenue/PATMI was at 49%/53% of our FY24e forecasts. 2Q24 revenue grew 18% YoY driven by a robust 28% YoY growth in Azure cloud revenue. PATMI rose by 33% YoY to US$21.9bn due to higher operating leverage.
• For 3Q24e, Microsoft expects total revenue to grow by 15% YoY to US$60.5bn fueled by Azure revenue growth of 28% YoY and Office 365 Commercial revenue growth of 15% YoY. Microsoft’s implied operating margin for 3Q24e is ~43%.
• We maintain our ACCUMULATE recommendation with an increased DCF target price of US$450.00 (prev. US$375.00), with an unchanged WACC of 7.2%, and an increased terminal growth rate of 4.5% (prev. 4%). We believe that the growing demand for large AI models could help attract customers to Microsoft’s Azure platform for storage and computing solutions. Also, strong adoption of Office 365 AI tools could provide incremental revenue growth opportunities. Our FY24e revenue/PATMI has been increased by 1%/3% to account for the continuation of AI tailwinds and lower OPEX.

The Positives

+ Azure maintained solid growth. In 2Q24, Intelligent Cloud segment revenue grew 20% YoY to US$25.9bn led by Azure and other cloud services. Azure revenue grew 28% YoY in constant currency, beating the company’s guidance range of 26% to 27% YoY growth. Management highlighted that the generative AI applications built by enterprises on Azure’s infrastructure started scaling up leading to higher usage and revenue growth. AI provided a 6% uplift to Azure’s growth in 2Q24 vs 3% in 1Q24 and was largely made up of inference workloads instead of training. Also, the number of Azure AI customers increased to 53,000 (vs 18,000 in 1Q24) and one-third of that number represents customers new to the Azure platform within the past year suggesting early traction.

+ Strong demand for Office 365 continues. Office 365 Commercial revenue (under productivity and business processes) grew by 16% YoY, in line with the company guidance. Consistent with previous quarters, user growth and higher average revenue per user due to E5 upsell at renewals continued to drive this business segment. Paid Office 365 Commercial users grew by 9% YoY to more than 400mn driven by demand from small and medium businesses and frontline worker offerings.

+ Margins continue to improve. In 2Q24, Microsoft reported an operating margin of 44% (vs 39% in 2Q23) despite elevated AI investments and the impact of the Activision acquisition. The margin improvement was mainly due to top-line upside and continued focus on higher operating leverage through disciplined cost controls (headcount down 2% YoY).

The Negatives

- Nil.

• 1Q24 revenue/PATMI was in line with expectation at 24%/26% of our FY24e forecasts. Total revenue grew 13% YoY as Azure growth re-accelerated to 29% YoY. PATMI rose by 27% YoY due to higher operating leverage.
• For 2Q24e, Microsoft expects total revenue to grow 15% YoY to US$60.9bn driven by corporate cloud-computing demand and increase in gaming revenue. Management reiterated its expectation of flat operating margins for FY24e (~42%) despite absorbing Activision Blizzard. Office 365 Copilot AI tools (US$30 per user per month) to commercially launch on Nov. 1.
• We maintain ACCUMULATE recommendation and nudge our DCF target price to US$375.00 (prev. US$372.00) using a WACC of 7.2% and terminal growth rate of 4%. Our FY24e revenue/PATMI is increased by 2%/0.4% to account for Activision acquisition and continuation of AI tailwinds. Microsoft is well-positioned to benefit from shifting workloads to the cloud, demand for its AI-enabled products, and cybersecurity upgrades.

The Positives

+ Azure revenue growth re-accelerates. Microsoft showed signs of recovery in its cloud-computing unit, with Azure revenue expanding 29% YoY. The growth came ahead of the company's guidance of 26% YoY growth as more enterprises move to the cloud and growing contributions from AI-enabled services (3 percentage points). Management highlighted that Azure OpenAI service now has 18,000 customers compared with 11,000 last quarter (up 60% QoQ) indicating early traction for its AI services.

+ Office 365 momentum continues. Office 365 commercial revenue grew by 18% YoY led by strong growth in its users and higher average revenue per user as customers upsell to E5 license for its advanced functionalities. Paid Office 365 commercial users grew by 10% YoY to approximately 400mn driven by continued demand from small and medium businesses and frontline worker offerings. We believe that the commercial launch of Office 365 AI tools  (US$30 per user per month) on Nov. 1 should enable Microsoft to maintain double-digit Office 365 growth rates.

+ Improvement in margins. In 1Q24, Microsoft reported operating margin of 48% compared with 43% in 1Q23. This was the highest over the last decade despite AI investments. The margin improvement was mainly due to top-line upside and continued focus on operational discipline (headcount down 7% YoY).

The Negatives

- Nil.

• FY23 revenue/PATMI was in line with expectations at 100%/101% of our forecasts. In 4Q23, total revenue grew by 8% YoY driven by a 15% YoY rise in intelligent cloud business. PATMI rose by 20% YoY due to higher operating leverage.
• For 1Q24e, Microsoft expects total revenue to grow by 8% YoY to US$54.3bn driven by corporate cloud-computing demand. The company’s implied operating margin for 1Q24e is 44%. Microsoft plans to charge US$30 per user per month for its Office 365 Copilot AI tools.
• We upgrade to ACCUMULATE with a raised DCF target price of US$372.00 (prev. US$328.00) using a WACC of 7.2% and terminal growth rate of 4%. We are raising our target price as we increased our growth rate assumptions. Microsoft enjoys long-term tailwinds from shifting workloads to the cloud, demand for its AI-enabled products, and cybersecurity upgrades.

The Positives

+ Azure continued to be a bright spot. In 4Q23, Azure cloud revenue grew by 27% YoY on a constant currency basis, at the high end of management’s guidance range, with about a 1 percentage point benefit from AI services. Growth continues to be fueled by corporate cloud-computing demand as enterprises look to lower OPEX and digitize their operations. Management highlighted that Azure OpenAI service now has 11,000 customers (IKEA and Volvo Group) compared with 4,500 in mid-May indicating early traction for its next-generation AI services.

+ Strength in Office 365 commercial revenue. Office 365 commercial revenue (under productivity and business processes) grew 17% YoY in constant currency driven by subscriber growth and ongoing ARPU increases as customers upgrade to the E5 license for its advanced security and analytics functionality. Microsoft reported paid Office 365 commercial user growth of 11% YoY again led by small-to-medium business and frontline worker offerings. While it is early days, we believe the adoption of Office 365 Copiplot AI tools can lead to an uplift in revenue (US$30 per user per month) and should enable Microsoft to maintain double-digit Office 365 growth rates.

The Negatives

- Deteriorating PC market hurt Windows and Devices. In 4Q23, more personal computing revenue fell by 4% YoY to US$13.9bn mainly due to Windows and Devices businesses. Windows OEM revenue, which includes the sales of Windows software to PC makers, declined by 12% YoY. Additionally, Devices revenue, including Microsoft Surface tablets and computers, HoloLens, and PC accessories, fell by 18% YoY. This is mainly due to weakening consumer demand for PCs and macro economic uncertainty.

• 9M23 revenue/PATMI was in line with expectations at 75%/73% of our FY23e forecasts. In 3Q23, total revenue grew by 7% YoY driven by a 16% YoY rise in cloud business. PATMI was hurt by US$704mn (or 4% of 3Q23 PATMI) foreign exchange headwinds.
• Azure revenue grew 31% YoY in constant currency fueled by resilient corporate cloud-computing demand. Expects to deliver 26-27% YoY Azure revenue growth in 4Q23e.
• We downgrade to ACCUMULATE from BUY recommendation after the recent jump in its stock price. We raise our DCF target price to US$328.00 (prev. US$298.00). Our FY24e PATMI is raised by 3%. We expect growth to re-accelerate in FY24e, particularly for Azure as its client base expands and enterprises shift their workloads to the cloud.

The Positives

+ 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.

The Negatives

- 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.

• 1H23 revenue/PATMI was within expectation at 48%/46% of our FY23e forecasts. In 2Q23, total revenue grew just 2% YoY as it witnessed weakness in its PC software.
• Cloud momentum continuing with Azure revenue growth of 38% YoY in constant currency. Office 365 Commercial revenue grew 18% YoY due to subscriber growth of 12% YoY and higher average revenue per user as E5 momentum remained strong.
• PATMI fell by 12% YoY (7% YoY drop normalized) due to higher OPEX and tax rate. The company recorded a charge of US$1.2bn, including US$800mn related to the job cuts.
• We maintain a BUY recommendation with a lower DCF target price of US$298 (WACC 7.2%, g 4%), down from US$319. Our FY23e revenue/PATMI is lowered by 4% to account for PC market weakness and customers seeking to increase the efficiency of their cloud spending. Overall, Microsoft enjoys long-term tailwinds from digital transformation spending, shifting of workloads to the cloud, and cybersecurity upgrades.

The Positives

+ 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.

The Negatives

- 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.

• 1Q23 revenue/PATMI was within expectation at 23% of our FY23e forecasts. Total revenue grew 11% YoY to US$50.1bn driven by a 20% YoY rise in cloud business. PATMI fell by 14% YoY (2% YoY growth normalised) as margins contracted due to investments in Azure as well as US$3.3bn tax benefit in 1Q22.
• Azure revenue grew 42% YoY in constant currency driven by increasing cloud adoption. Office 365 Commercial revenue grew 17% YoY due to subscriber growth of 14% YoY and higher average revenue per user due to strong adoption of E5 license.
• We maintain a BUY recommendation with a lower DCF target price of US$319 (WACC 7.2%, g 4%), down from US$332. Our FY23e revenue/PATMI is lowered by 2%/3% to account for forex headwinds and PC market weakness. Overall, we believe that Microsoft will be a long-term beneficiary of continued strong digital transformation spending, shifting of workloads to the cloud, and cybersecurity upgrades.

The Positives

+ 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.

The Negatives

- 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.

• 4Q22 results were in line with expectations. FY22 revenue/PATMI was at 99% of our forecasts. Total revenue grew 12% YoY to US$51.9bn in 4Q22, mainly due to Productivity and Business Processes and Intelligent Cloud revenues. PATMI was only up 2% YoY as margins contracted due to investments in cloud engineering and FX headwinds (4% of 4Q22 PATMI).
• Azure revenue grew 46% YoY in constant currency in 4Q22 driven by continued demand for cloud computing. Office 365 Commercial revenue grew 19% YoY due to higher volumes and prices.
• We maintain a BUY recommendation with a lower DCF target price of US$332 (WACC 7.1%, g 4%), down from US$338. This is mainly because we reduced our FY23e revenue/PATMI by 3%/4% to account for headwinds from a stronger USD and slowing sales of PCs. Overall, we believe that Microsoft will be a long-term beneficiary of continued shift to the cloud, businesses reopening, cybersecurity upgrades, and price increases at renewals.

The Positives

+ 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.

The Negatives

- 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.

Outlook

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.

• 9M22 revenue was in line at 74% of FY22e forecasts, while PATMI outperformed at 79%.
• Virtually all segments beat on margins driven by higher volumes and prices for MS Office 365 licenses, and unabated corporate adoption of cloud services.
• Our FY22e PATMI is raised by 3.5% on stronger revenue guidance and a lower tax rate. We maintain BUY with an unchanged target price of US$410.00. Valuations are based on DCF with a WACC of 6.2% and terminal growth of 4.0%. MSFT enjoys tailwinds from businesses reopening, cybersecurity and cloud computing secular trends.

Results at a glance

Source: Company, PSR. *Note – Azure revenue amount is not disclosed.

The Positives

+ 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.

The Negatives

- 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.

Outlook

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.

• 1H22 revenue was in line at 50% of our FY22e forecasts, while PATMI exceeded expectations at 58% of FY22e.
• Azure revenue growth and commercial bookings exceeded expectations on continued demand for cloud computing.
• Operating margins elevated in every segment, driven by demand for premium licenses, improvements in cloud services and high-margin services.
• Maintain BUY with a higher target price of US$410.00 as we raise our FY22e PATMI forecast by 4%. Valuations based on DCF with a WACC of 6.2% and terminal growth of 4.0%. We expect another strong quarter in 3Q22 from continued strength in all segments despite slight headwinds from a stronger USD.

The Positives

+ 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%.

The Negatives

- 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 Corp (MSFT) proposed a US$95.00 per share all-cash takeover of leading game developer Activision Blizzard Inc. (ATVI). The transaction is valued at US$68.7bn, more than double MSFT’s previous largest acquisition of US$26.2bn for LinkedIn.
• The acquisition aims to boost MSFT’s console and subscription gaming business and help it expand into the metaverse.
• The deal is expected to be completed by July 2023 pending regulatory and shareholder approval. Activision’s trailing 12-months revenue of US$9bn represents 5% of MSFT’s revenue and is expected to increase MSFT’s gaming segment revenue by 50%. MSFT’s gaming segment contributed 9% of FY21 revenue. We maintain BUY with an unchanged DCF (WACC 6.2%) TP of US$405.00.

Event

1. The deal. MSFT proposed a US$95.00 per share or US$68.7bn all-cash takeover of Activision Blizzard Inc. It represents a 45% premium to the price per share before the deal was announced. MSFT has US$130bn in cash. The transaction is expected to close by July 2023 pending regulatory and shareholder approval. The transaction has been approved by each company’s respective board of directors.
2. About ATVI. Activision is a leading game developer and interactive entertainment content publisher. Its iconic franchises including Candy Crush™, Call of Duty®, World of Warcraft®, Overwatch®, Hearthstone®, Diablo®, and its lucrative eSports events company, Major League Gaming. Activision has about 400mn monthly active players globally, with games widely available on mobile platforms.

Comment

1. The acquisition aims to boost MSFT's console and subscription gaming business and help it expand into the metaverse. MSFT’s gaming segment contributed 9% of FY21 revenue and is derived from Xbox console sales and the Xbox Game Pass monthly subscription service which boasts over 25mn monthly subscribers. We believe MSFT will seek to grow the number of monthly paying subscribers through engaging ATVI’s 400mn monthly active players.
2. MSFT will become the world's third-largest gaming company ranked by revenue, behind only Tencent and Sony. Activision’s trailing 12-months revenue of US$9bn represents 5% of MSFT’s revenue and is expected to increase MSFT’s gaming segment revenue by 50%.
3. The gaming industry, which generates more than US$200bn revenue annually, is the largest and most rapidly growing sector in the entertainment industry. Worldwide over 3bn people play interactive electronic games and that number is forecasted to increase by 50% to 4.5bn by 2030.