• Continued shift in revenue mix towards its Intelligent Cloud component, driven by strong momentum in Azure
• Improving advertising and job market from positive economic outlook may continue to drive its Linkedin and Search businesses
• Segmental guidance by the management for 3Q 2021 displays continued resilience ahead
• Digital transformation trend is underway and Microsoft may be the beneficiary at the forefront of a continued digital transformation

4 Key Takeaways from 2Q2021 Earnings

1. Continued shift in revenue mix towards its Intelligent Cloud component, driven by strong momentum in Azure. In its 2Q2021 results, its ‘Intelligent Cloud’ component accounted for 33.9% of total revenue, largely driven by a 50% y-o-y growth in Azure. That is a positive shift where the segment only accounted for 26.2% of total revenue back in 2017 (Figure 1), which highlighted that Azure is an increasingly important driver of Microsoft’s overall earnings and revenue growth. Operating margin for this segment continues to improve y-o-y, expanding by 2.5% compared to the previous year.

In its outlook earnings call for 3Q2021, the management mentioned that generally, due to increasing mix of large long-term Azure contracts which tends to be more unpredictable in timing of recognition, it may cause volatility in growth rate. They also mentioned a ‘sequential increase’ in capital expenditure as they continue to enhance their cloud services to meet growing global demand. We believe that this signals that we should not expect any strong growth in margin in the near term. However, we remain positive on its cloud business as this segment displays the highest growth momentum with a 3-year CAGR of 23.3%, compared to Productivity and Business Processes (14.4%) and Personal Computing (7.5%). (Figure 2)

2. Improving advertising and job market from positive economic outlook may continue to drive its Linkedin and Search businesses. Due to Covid-19, macroeconomic weakness in the job market and lower spend on advertising has weighed on its LinkedIn and Search revenues, as revenue declined q-o-q by 5.4% in Q3 2020 and 10.4% in Q4 2020 (Figure 3). Both segments account for around 11% of total revenue.

In its 2Q 2021 results, combined revenue for these two segments grew 19.2% q-o-q, exceeding above pre-Covid levels and offsetting the negative impact from Covid-19 (Figure 3). For the quarter, Linkedin’s sessions grew 30% y-o-y to deliver record levels of engagement. We believe this validated the view that the advertising market is improving on the backdrop of positive economic outlook and demonstrated resilience in these two segments of Microsoft to weather the financial impact of the pandemic. With improving economic conditions and gradual recovery in the labour market, the management expects Linkedin revenue to continue its growth at the low 20% range.

3. Segmental guidance for 3Q 2021 displays continued resilience ahead. In its earnings guidance for 3Q 2021, the management expects revenue for its Productivity and Business Processes segment to be between $13.35 to $13.6bn. That translated to a y-o-y growth of between 13.7% to 15.8%, higher than latest 2Q 2021 growth rate of 13.3%. This segment accounts for 13.4% of total revenue.

For Intelligent Cloud segment, the management expects revenue between $14.7 to $14.95bn. This translated to a y-o-y growth of between 19.7% to 21.7%, slightly lower than current quarter’s growth of 23%. We believe that this is due to the high demand for cloud services in Q3 2020 due to Covid-19 which has seen a 27.2% y-o-y jump. Therefore, some demand may have been brought forward in Q3 2020 and the slowdown in growth for upcoming Q3 2021 should not be a cause for concern.

Lastly, for its More Personal Computing segment, the management expects revenue between $12.3 and $12.7bn. This translated to a y-o-y growth of 11.8% to 15.5%, comparable to current quarter’s growth of 14.3%.

4. Digital transformation trend is underway. Microsoft may be the beneficiary at the forefront of a continued digital transformation. For its latest quarter, Office Commercial products and cloud services grew 11% y-o-y for its latest quarter (Figure 4), with management noting a continued customer shift to cloud offerings from on-premises annuity. Office 365 commercial revenue grew 21% y-o-y, driven both by strong seat growth and revenue per user. The management mentioned in its earnings call that they see continued upsell opportunities which will drive growth for its Office commercial revenue. However, they note that they expect revenue for their on-premises business to decline in the ‘mid-to-high teens’ range (estimated 15-19% decline). For Office Consumer products, they expect revenue growth to be similar to last quarter with continued growth in subscribers. Microsoft 365 consumer subscription has been picking up pace over the past one year with q-o-q growth of 6.3% (Figure 5), potentially accelerated by Covid-19, and management seems to suggest that the trend will continue in the near term.

Conclusion

We are positive on MSFT. Current P/E for MSFT stands at 36.8. On first glance, it may appear expensive by trending 1 standard deviation above its 3-year historical average. However, we believe that the valuation is justified, considering that strong growth across all its business segments is expected to continue. Strong growth momentum for its Cloud segment has also been validated in this result and may potentially strengthened Microsoft competitive position in the cloud computing market, currently dominated by Amazon’s AWS.