Is Microsoft Stock A Sell After Earnings? The Key Lies In Azure

Summary:

• Azure’s deceleration in revenue growth was the main disappointment for the market as management guided a further deceleration of 4 to 5 percentage points.
• As a result of a weaker macro backdrop, Microsoft’s FY2023 revenue growth target of 10% is not achievable, which removes another overhang for the stock.
• Management has showed strong operating expense and margin control to limit the downside in EPS.
• OpenAI is not expected to have a material impact on Microsoft on the revenue and capital expenditures front.
• My one-year target price for Microsoft is $305, implying 23% upside from current levels.

Microsoft (NASDAQ:MSFT) recently reported its results and the market went from “It’s over” to a “Conservative Guidance” thesis. This article goes deeper into the recent earnings to determine if there is an opportunity at hand for investors.

Investment thesis

Microsoft has sold off almost 30% from its highs.

This sell off was inevitably due to weakness in the overall business, but more so due to weakness in its most exciting Azure segment. However, I still see Microsoft as a solid investment for the long-term. This is due to their strong competitive advantage with its full, comprehensive suite of products and offerings, as well as its durable growth profile.

In their recent earnings, we also see that the company is able to leverage on costs as a tool to manage earnings per share growth. While Azure may undoubtedly remain under pressure in the near-term, the long-term potential for Azure remains strong. Furthermore, the company’s forward guidance is de-risked, in my view, as management has communicated, and the market has incorporated most of the negative views for the company.

I have written earlier articles on Microsoft.

A disappointment from Azure

For the second quarter, Microsoft reported that Azure grew 38% on a constant currency basis. This was a positive surprise for the market as investors were estimating Azure growth to come in around 35%.

In addition, there was positive commentary from Microsoft as management mentioned a number of large multi-year Azure deal commitments.

That positive sentiment was short-lived as management then commented that Azure exited the second quarter at 35% growth rate, which is implied from its mid-30s comment. Furthermore, they expect that the growth rate for Azure will decelerate further by 4 to 5 percentage points.

This would imply a further weakening of Azure’s growth between 30% to 31% for the third quarter ending March.

This was likely the most material statement in the earnings call that resulted in further bearish sentiment in the near-term. The reason for the deceleration? Management commented it was due to an accelerated trend of optimization of cloud spend as well as a slowdown in new workload migration activity.

Weaker FY2023 revenue growth to be expected

The initial guidance that Microsoft gave for the FY2023 revenue growth target was 10%+. This was a debate amongst investors in the bull and bear camp as the market was undecided whether this revenue target was achievable or not.

In the second quarter call, I think that we can safely say that Microsoft is unlikely to achieve this initial 10% target as a result of uncertainty from the weak PC market.

With the weakness in demand from Azure as cited earlier, as well as management’s comment on persistent weakness in the PC market, weak advertising demand and an overall tough demand backdrop for stand-alone sales. As a result, commercial bookings growth came in at 4% and is expected to be flat for next quarter.

Furthermore, there was a weaker macro commentary from Microsoft, which should support the more cautious view that broader IT spending trends have not stabilized and in fact got worse through the close of 4Q.

To be conservative, I expect FY2023 constant currency revenue growth to come in at 9%, 1% lower than initial guidance from management.

Good operating expense and margin control

Adjusted operating margins for the second quarter came in at 40.9%, which was above my expectations for the quarter. In addition, overall operating expenses were about $500 million below guidance, showing continued good operating expense discipline.

In the last earnings quarter, Microsoft lowered expectations for operating margins, reducing the FY2023 target from roughly flat to down 100 basis points year on year.

In this earnings call, they lowered the FY2023 margin guidance target again, to down 200 basis points year on year, although they expect a $300 million improvement in the energy cost headwind. The fact that margins are only down 200 basis points is a good outcome, in my view, as the company is facing a massive $2 billion incremental headwind from the weakness in Windows.

With weakening of Azure, the Windows PC segment and slowdown in new businesses, it is crucial that Microsoft shows tight operating expense control to protect EPS.

With the reduction in headcount and tight operating expense control, Microsoft managed to beat its EPS guidance for the second quarter and operating expense growth is projected to slow to low single digits by the fourth quarter.

Impact of OpenAI on Azure

As Microsoft stated that they are not commenting on the revenue recognition associated with OpenAI’s consumption of Azure. They also stated that they would have called it out if this was a material driver of Azure growth. In other words, this implies that OpenAI’s consumption of Azure is not a material driver for Azure’s growth.

In terms of the costs of building out GPU capacity for OpenAI, Microsoft is more transparent on this. It stated that these costs have already been included in the reported capital expenditures.

That means that there is no evidence of an AI-related capital expenditures bump, with Microsoft saying that they’ve been investing “for years” to build out AI-based Azure capacity.

Microsoft Stock Valuation

To value Microsoft, I used both the P/E multiple method and the DCF method. I assumed a forward P/E of 25x for Microsoft. This implies a 25% premium to its peer group due to Microsoft’s strong competitive positioning and resilient growth profile.

For my DCF assumptions, I used a cost of equity of 9% to discount Microsoft’s free cash flow to equity. Furthermore, I used a terminal multiple of 16x.

On a relative valuation perspective, Microsoft is currently trading at a P/E of 26x for FY2023 and 23x FY2024. I think that despite the near-term headwinds we see Microsoft facing today as well as the negative sentiment around the stock, I remain positive on Microsoft and I think that it is time to buy, and not sell Microsoft after its recent earnings report. Investors buying at current levels have the opportunity to accumulate a company with strong structural tailwinds and an attractive risk/reward perspective. My one-year target price for Microsoft is $305, implying 23% upside from current levels.

Risks

Weakening macro backdrop

As the macro backdrop worsens, this will likely mean a more difficult operating environment for Microsoft. As business and consumer sentiment worsens, this could stall growth in its newer businesses, and see worsening deceleration of growth for Azure. As Microsoft depends on companies and their willingness to spend on IT. As IT budgets get reduced, the growth profile for Microsoft will also be affected negatively.

Slowdown in cloud migration

The current deceleration of Azure’s revenue has resulted in downward pressure for Microsoft’s stock. There is a risk that companies may delay or put a stop to their cloud migration process. As a result, Azure may see decelerating growth and weaker growth for longer if this persists.

Competition in the cloud

If competition in the hyperscale cloud market intensifies, this may require Microsoft to aggressively invest in Azure. Amazon’s (AMZN) AWS and Alphabet’s (GOOGL) Google Cloud are the main competitors in the market with strong financial resources and a solid commitment to the business.

Conclusion

After its recent earnings results, I think that investors should be buying and not selling MSFT stock The current valuation and risk reward skew is positive for the company as its FY2023 forward guidance has been de-risked. Put simply, this means that Microsoft is able to more easily beat its expectations.

As elaborated earlier, the company has shown strict cost control which will help limit downside on the earnings front, while its guidance for Azure has been de-risked. This is because the company has communicated the reasons for the deceleration of growth, as a result of a slowdown in migration activity and optimization of cloud spend, which is a cloud industry wide issue. Investors buying at current levels have the opportunity to accumulate a company with strong structural tailwinds and an attractive risk/reward perspective. My one-year target price for Microsoft is $305, implying 23% upside from current levels.

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Disclosure: I/we have a beneficial long position in the shares of MSFT either through stock ownership, options, or other derivatives. 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.

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