Microsoft: Q1 Shows AI Investments Are Worth It As Azure And Copilot Deliver
Contributor since 2021 / 737 Followers
Summary:
- Microsoft had a strong start to FY25, beating both the top- and bottom-line estimates, with Azure rebounding and AI investments driving growth.
- Despite Azure’s Q1 success, Q2 guidance predicts slower growth due to supply constraints, not demand issues, suggesting future growth potential.
- AI investments, particularly in Copilot, are paying off, with significant adoption among Fortune 500 companies.
- At a forward P/E of 30x, MSFT’s stock is expensive, justifying a Hold rating; I would add to my position if there’s a market pullback.
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Investment Thesis
The last time I wrote about Microsoft (NASDAQ:MSFT), in August 2024, I initiated coverage of the company and analysed the key takeaways from the company’s fourth quarter report. I had a HOLD rating on the stock.
Since the article was published, the company’s shares are up 0.84%, significantly underperforming the S&P 500, which gained 8.8% during the same period.
In this article, I dissect the company’s first quarter results and investigate the progress made by the company with respect to its AI investments. More specifically, I analyse the Azure growth and explore whether the investment in OpenAI is starting to significantly pay off.
A Snapshot of Q1 Earnings Report
Microsoft, in my opinion, had a strong start to the fiscal year, with a beat on both the top- and bottom-lines. More specifically, Q1 revenues came in at $65.59 billion, up 16% y/y and beating analyst estimates by $1.03 billion. Diluted EPS of $3.30 was up 10.4% y/y and comfortably beat analyst estimates by $0.20. Operating margins, while down 1% y/y, still came in strong at 47%, and when the net impact from the Activision acquisition was excluded, they were up 1% y/y, demonstrating the company’s ability to drive efficiencies even as the AI-driven capex spending shows no signs of abating. It is also worth noting that the actual revenues came well ahead of the high-end of the company’s own guidance of $64.8 billion, and it even beat analysts’ previous expectations of $65.1 billion.
For the second quarter, the company expects revenues to come in the range between $68.1 billion and $69.1 billion, below analysts’ expectations of $69.9 billion. Revenue growth in Azure is expected to be 31% to 32% in constant currency. COGS for the second quarter is expected to be between $21.9 billion and $22.1 billion, operating expenses are expected to be between $16.4 and $16.5 billion, and other income and expenses are expected to be approximately negative $1.5 billion. The effective tax rate is expected to stay at around 19%.
Azure Makes a Comeback and AI Contribution Jumps
In my last article on MSFT, I did mention that there were enough signs that the growth in Azure would be coming back, after what looked like a slowdown in the fourth quarter of FY24. This is exactly what happened in the first quarter, as evidenced by the 34% y/y revenue growth (in constant currency), which sailed past both the company’s own expectations as well as the analyst estimate. What is even more important is that AI contributed 12% to Azure’s growth, a significant improvement from the 8-point contribution made in the previous quarter. The contribution of AI towards Azure’s growth has been on an upward trend, which suggests that the demand remains strong, and which further justifies the company’s AI spend.
Despite this positive development, the company’s AI spend was called into question during the quarter as well, especially after the company offered Q2 guidance, which projected that growth in Azure would fall to the low 30s. This lower guidance for Azure growth was one of the primary reasons why the stock fell post earnings, after initially jumping prior to the earnings call.
I simply don’t understand the market’s logic. First, CFO Amy Hood clearly indicated, during the earnings call, that the rationale behind the low 30s growth projection for Azure is due to supply push outs. Put simply, the company was expecting more of AI supply to come online in the second quarter, but that has now been pushed to the second half of the year. Nowhere in the earnings call or in the press release was there any evidence of demand slipping. If it’s a supply constraint problem, and one that is expected to normalize after a short delay, then I don’t understand why there needs to be a reason to panic. It’s a classic case of “invest now, bring it to scale, and then enjoy the future growth” cycle, as articulated by the CFO during the earnings call. And as mentioned earlier, the investments are already paying dividends for the company, as observed by the significant contribution that AI is making towards Azure’s growth.
Furthermore, during the earnings call, management also announced that the company’s overall AI business is on track to exceed the annual revenue run rate of $10 billion next quarter, making it the fastest business in the company’s history to achieve this milestone. And there is rationale behind these numbers, based on the developments from this quarter. For instance, Azure gained market share in Q1, the number of copilot enterprise customers saw a sequential jump of 55%, and Microsoft 365 Copilot has led to daily usage of M365 doubling q/q. Finally, the company announced that nearly 70% of the Fortune 500 companies now use M365 Copilot and the monthly active users of Copilot across the company’s CRM and ERP network jumped 60% q/q. This is by no means an exclusive list, but it just goes to show how the investments in AI are already starting to pay off for MSFT.
Lastly, I also believe that the management’s guidance of Azure growth is conservative. In the last fiscal year, for instance, only once did the actual Azure growth fail to exceed the management’s guidance (Q4, when it only matched the company’s low-end of the guidance). In all the other quarters, Azure growth exceeded the guidance. I am not saying that Azure will, with complete certainty, beat the company’s guidance in Q2. However, even if it hits low 30s in Q2 as predicted, the fact that the company expects Azure growth to accelerate in the second half of FY25 as more of AI capacity comes online, does suggest that the growth story of Azure remains intact.
In a nutshell, the Azure growth story is dependent on how fast the capacity constraints can be removed, which is manageable and actually a positive for the company’s long-term growth. Demand is not the problem, and as long as that remains the case, there is no rationale, in my opinion, behind punishing the company on account of a 1-to-2-point projected deceleration in Azure for one single quarter.
An Impressive Performance by Productive & Business Processes Segment Courtesy of AI
The other key takeaway from MSFT’s first quarter was the consistent growth seen in the company’s Productivity & Business Processes division. This segment has been growing at a consistent pace for the last few quarters, and each quarter is seeing incremental y/y growth compared to the previous quarter. More specifically, the revenue growth this quarter was 13% in constant currency, up from 12% growth in Q4 and 11% in the third quarter of FY24.
Once again, AI has been at the forefront of this incremental growth, given that the primary driver of the segment’s growth was the Office Commercial products and cloud services segment, which consists of the likes of Office 365 E5 and the M365 Copilot. This is hardly surprising, in my opinion, given the host of AI-related products, which the company has been releasing for both the M365 Consumer and Commercial segment. For instance, during the first quarter, the company has enhanced the functionality of Copilot in Excel, with added support for complex formulae like XLOOKUP & SUMIF. The company also introduced the Narrative builder functionality in Microsoft PowerPoint, which helps to enhance the productivity when it comes to making presentations. These products and enhancements are certainly boosting demand for the segment, as mentioned in the previous section.
In addition to Azure, one of the key questions hanging over investors’ minds when it comes to the company’s AI spending has been Copilot and whether there have been enough enterprises adapting it to justify the spend. The incremental growth seen in every quarter of the Productivity & Business Processes division, being driven by Copilot, along with the fact that majority of the Fortune 500 businesses have now adopted Copilot, suggests that the investments in AI along with the company’s investment in OpenAI are paying off in my opinion.
Valuation
|
Forward P/E Multiple Approach |
|
|
Price Target |
$423 |
|
Projected Forward P/E Multiple |
30x |
|
Projected FY25 EPS |
$12.48 |
|
Projected Earnings Growth |
13.04% |
|
Projected FY25 EPS |
$14.11 |
Source: LSEG Data (formerly Refinitiv), Author’s Calculations, Seeking Alpha, and Microsoft Q1FY25 Earnings Transcript
In my last article on MSFT, I had projected FY25 revenues to grow at the company’s trailing 5-year CAGR, which was 14.3% according to LSEG Data, which translated to FY25 revenues of $280.1 billion. Assuming the company hits the high-end of the revenue guidance for Q2 ($69.1 billion), a reasonable estimate in my opinion given the company’s track record and given the growth seen across its segments, combined revenues for H1 of FY25 would be $134.7 billion. At the high-end of the company’s guidance, Q2 revenue growth would be 11.4%. During the earnings call, management mentioned that they see the revenue growth during the second half of FY25 to be relatively stable compared to Q2. Therefore, assuming the company maintains the same revenue growth for Q3 and Q4 as Q2 (11.4%), then the total revenues for H2 of FY25 would be $141 billion. Total revenues for FY25 would then be $275.7 billion, lower than my previous estimate of $280.1 billion, and translates to a y/y growth of 12.5%.
I have maintained my FY25 operating margins estimate at 43.6%, given that the company is expecting a sequential increase in AI-related investments. There was nothing in the earnings call that suggested that the spend would be coming down in FY25, which further justifies my estimate. Operating income for FY25 would then be $120.2 billion, slightly lower than my previous estimate of $122.1 billion. The company expects other income and expense to be negative $1.5 billion for Q2, primarily driven by the expected loss from OpenAI and as a result of accounting this transaction under the equity method. I am maintaining the same figure for Q3 and Q4, as a conservative estimate, which would take the total other income and expense for FY25 to be negative $5.18 billion, significantly higher than my previous estimate of negative $1.32 billion. This results in FY25 net income of $115.02 billion. I have assumed the effective tax rate for FY25 to be 19%, which results in FY25 net income (after taxes) to come in at $93.2 billion, lower than my previous estimate of $97.85 billion.
According to the Q1 press release, the diluted weighted average number of shares outstanding stands at 7.47 billion, which results in a projected FY25 EPS of $12.48, which shows a y/y growth of 5.8%, significantly lower than the company’s long-term earnings growth rate of 14.6%.
According to LSEG data, the company currently trades at a forward P/E of 30x, in line with its historical multiples. I have assumed its historical forward P/E of 30x for my calculations, the same as my previous estimate.
The company, according to Seeking Alpha, currently trades at a forward PEG ratio of 2.4, slightly higher than its 5-year average of 2.33x. I am firmly of the opinion that the earnings growth would pick up from FY26 since I believe that the AI-related spend should come down, which should subsequently boost its margins. This is also because AI-related investments are already translating into revenue growth and the issue for the company is not demand but capacity. As such, I have maintained my forward PEG ratio from last time, which is 2.3. This results in a projected earnings growth of 13.04%. At the projected earnings growth, FY26 EPS would come in at $14.11.
At a forward P/E of 30x and a projected EPS of $14.11 results in a price target of $423, which suggests an upside of about 3.6% from current levels. The new price target is also lower than my previous target of $444. Despite lowering the price target, I am maintaining my HOLD rating on the stock. I am also maintaining my opinion that one should not initiate a new position at these levels. However, should there be any market meltdown on account of election-related volatility or other macro factors, I would look to add to my existing position.
Risk Factors
My risk factor remains the same as the ones I mentioned in my last article, which is whether the investments in AI would translate to meaningful earnings growth, especially from an Azure perspective. The entire premise of my thesis is that earnings growth picks up in FY26, as capacity finally catches up to demand and the company can then stop spending significantly on AI infrastructure. Whether the economies of scale would be achieved by then is an area that investors need to consider.
Concluding Thoughts
Microsoft had a solid start to the year, with a beat on both the top- and bottom-lines. After disappointing in the previous quarter, Azure bounced back, with revenues surpassing both the company’s and the analysts’ expectations. The management also provided some colour on the adoption of Copilot, and the product enhancements made by the company seems to be paying off, as Copilot played an integral role in driving the revenue growth of the Productivity & Business Processes division. The company has no plans to stop their AI-driven spend, which for the long term, I continue to believe is the right thing to do.
My only concern is the valuation. There is a reason why Microsoft shares have not performed as well as the other hyperscalers. At 30x forward P/E, the stock is expensive, and as a result of a dip in operating margins as well as the expected losses from OpenAI, I do expect the company’s earnings growth to suffer in the short term. While I do expect the company to bounce back in the coming years, from a valuation perspective, now is not the time to enter the name in my opinion.
There is nothing wrong with the company inherently, and if there is any meaningful pullback, I would add to my existing position. For now, it’s a matter of being patient with these Magnificent Seven members.
Analyst’s 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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