Jean-Luc Ichard/iStock Editorial via Getty Images
Jean-Luc Ichard/iStock Editorial via Getty Images
Microsoft's (NASDAQ:MSFT ) operational transparency demonstrated through its downward adjusted guidance in early June on growing FX headwinds had largely moderated investors' expectations coming into the fiscal fourth quarter earnings call. In fact, investors headed into Microsoft's latest earnings call with heightened focus on the company's forward guidance instead, as we had pointed out in a previous coverage - particularly with expectations for continued double-digit growth in Azure in the 40% range, resilience amid weakening consumer sentiment, and clues supporting the company's sustained Long-term growth and margin expansion trajectory. And as Microsoft always does, the company delivered and checked all the boxes.
This is further corroborated by the stock's positive post-earnings performance in late trading despite a slight miss in both fiscal fourth quarter revenues and earnings, suggesting investors' satisfaction with the robust forward guidance of double-digit growth in both the top- and bottom-line for full-year fiscal 2023. Strong take rates on Microsoft's critical enterprise software such as Office 365, Dynamics, and Power Platform apps during the fiscal fourth quarter also suggests that the segment continues to benefit from inelastic demand, providing partial insulation from near-term macro headwinds as corporate budgets shrink amid the impact of rising inflation and heightened recession risks.
Considering Microsoft's resilient long-term growth profile, and robust balance sheet, the stock remains investors' preferred choice as a "haven" investment amid a generally risk-off environment in equities. This is further corroborated by its outperformance against the broader SaaS peer group, which has traded down by more than 30% on average this year (vs. MSFT YTD: -23%). Yet, Microsoft's shares have continued to trade at levels near the pandemic-era low as it has yet to recover from broad-based valuation multiple compression across the equity market in the first half 2022.
While the Microsoft stock has outperformed its broader peer group this year, with the company's underlying fundamentals demonstrating continued strength and resilience ahead of a potential economic slowdown, we expect further volatility in the near-term. This is because the stock has largely moved in tandem with the broader market this year. As mounting macroeconomic uncertainties spanning inflation, Federal rate hikes, and looming recessions risks remain unresolved, markets will remain turbulent in coming months. This suggests there could be better entry opportunities ahead, though the stock still makes a compelling long-term investment with a favorable risk-reward trade-off at current levels.
Microsoft's fiscal fourth quarter revenues grew 12% y/y and 5% sequentially to $51.9 billion, slightly missing both consensus estimates and its previously provided guidance of $52.4 billion and $52.3 billion (mid-range guidance), respectively, due to pronounced FX headwinds. The company reported fiscal fourth quarter earnings per share at $2.23, also falling short of consensus estimates of $2.29 and its previously provided guidance of $2.28 (mid-range).
As mentioned in our previous coverage, Microsoft has largely defied the law of large numbers, as it continues to maintain strong double-digit revenue growth in recent years. In addition to sticky demand for its cloud-based suite of productivity software, Azure remains a key component in ensuring sustainability of Microsoft's long-term growth trajectory.
Azure has consistently demonstrated growth in the high-40% range over the past 12 months. And the continuation of this trend during the fiscal fourth quarter, as well as through fiscal 2023 based on the 43% y/y growth guidance provided by management has largely reassured investors that the high-flying segment continues to benefit from a robust demand environment, defying recession fears.
In addition to favorable secular trends buoyed by robust cloud spending in the enterprise sector, Microsoft Azure has also been diligent in bolstering its offerings to better capitalize on the rise of related opportunities ahead. These include Microsoft's recent acquisition of Nuance, a "leader in conversational AI and ambient intelligence", as well as a commitment to improving its industry-specific cloud-computing solutions to better address different end users' needs and expand its addressable market.
The acquisition of Nuance, which closed in early March, has continued to integrate favorably into Microsoft's Intelligent Cloud business segment, complementing the company's continued build-out of its cloud-computing capabilities.
The consolidation of Nuance is expected to further accelerate Microsoft's efforts in enabling customers with "security-focused, cloud-based solutions infused with powerful, vertically optimized AI", which are crucial to improving productivity and delivering better economic outcomes. The integration of Nuance into Microsoft's roster of cloud-based solutions is expected to drive further capitalization of fast-growing digitization opportunities ahead, especially as it enables cross-selling of new and improved solutions to existing customers, while also supporting penetration of new markets ranging from healthcare to smart customer contact centers.
Synergies from the acquisition is further demonstrated through the continued build-out of Microsoft's modular cloud offerings, such as "Microsoft Cloud for Healthcare", which leverages the AI capabilities offered by Nuance. With technology being one of the top three items identified by frontline healthcare workers in the U.S. that can "help reduce their stress and become more effective", the sector's demand for related cloud-computing solutions is expanding rapidly. The addressable market for healthcare-focused cloud-computing solutions is expected to expand at a compounded annual growth rate ("CAGR") of close to 11% from $383 billion in 2020 towards $900 billion by the end of the decade. And the continued integration of Nuance across Microsoft is expected to further its Intelligent Cloud business' share gains across the healthcare.
In addition to healthcare, Nuance is also bolstering Microsoft's presence in the provision of cloud-based customer relationship management tools. As mentioned in the fiscal fourth quarter earnings call, enterprise AI capabilities offered by Nuance is now integrated with Dynamics 365 and Microsoft Teams to drive greater value for customers of "Microsoft Digital Contact Center Platform". The company has also launched "Viva Sales" this year, a tool that leverages AI to "scan calls and interactions with clients, analyzing customer sentiment" to help sales representatives close deals. We view this as another area in which Microsoft could create synergies through continued integration of Nuance, and improve the company's overall competition against rivals in related areas such as Salesforce (CRM) and Zoom (ZM).
Beyond Nuance, Azure is estimated to have organically grown 44% y/y (derived using ~2 point impact in F3Q as proxy), performing ahead of expectations with stronger-than-expected inflow of long-term Tier 1 workload deal wins valued at more than $100 million and $1 billion. The results are consistent with industry observations that show "workload migration to the Azure cloud platform" remain strong, with "no signs of customers pulling back from purchase plans" despite near-term economic uncertainties.
These results are also reflective of the effectiveness in Azure's increased strategic focus on modularization of industry-specific cloud-computing solutions. The strategy has allowed the segment to better capitalize on opportunities stemming from a rapid wave of workload migrations across all industries from legacy IT infrastructures to the cloud.
For instance, Microsoft Azure has recently partnered with CommScope (COMM), a network infrastructure provider in the U.S., to co-develop a "converged private wireless network solution" that rounds up access to a range of cloud-based tools aimed at improving efficiency in industrial manufacturing. With industrial manufacturing becoming an increasingly connected sector, illustrated by the accelerated adoption of cloud-based tools spanning digital twins, big data analytics, and AI-equipped robotics, Microsoft Azure's recent collaboration with CommScope comes at an opportune time. The collaboration opens Azure up to growth opportunities stemming from an increased demand for industrial cloud-computing solutions, an addressable market valued at $150 billion to $200 billion today that is fast expanding towards a projected value of $3.7 trillion by mid-decade.
The strategic modularization of industry-specific cloud-based solutions offered by Azure also improves its competitiveness against peers who are also implementing a similar approach. For instance, cloud-based data software provider Palantir (PLTR) has recently turned to modularizing industry-specific solutions to improve take-rates on its Foundry operating system designed specifically for commercial application. Google Cloud (GOOG / GOOGL), a key rival to Microsoft Azure and the world's third largest public cloud-computing service provider, has also recently jumped on the modularization bandwagon, introducing its newest "Manufacturing Data Engine" and "Manufacturing Connect" cloud-based solution aimed at better addressing data processing and analytics requirements on the factory floor.
As the second largest public cloud-computing service provider in the world, commanding 21% of market share (vs. AMZN's AWS: 33), Azure's continued differentiation of its services through strategies like modularization, as well as cross-selling by leveraging its massive SaaS client base reinforces its prospects of long-term market share gains. Resilient cloud infrastructure investments this year across the enterprise sector despite mounting economic uncertainties also make strong tailwinds for Azure, supporting its trajectory of continued double-digit growth over the near- to mid-term. The IDC forecasts global cloud infrastructure investments to exceed $90 billion by the end of the year, representing a y/y increase of more than 20%. Related spending is also on track to surpassing investments in legacy non-cloud IT infrastructure for the first time (estimated at $61 billion for 2022), marking an inflection point in the global migration to cloud, and underscoring favorable growth prospects for Azure through the longer-term.
Microsoft is putting its right foot forward and set off on a strong start to fiscal 2023 in the face of looming economic uncertainties. The Microsoft stock's post-market performance immediately after the release of the company's fiscal fourth quarter results was largely positive, which is consistent with the solid forward guidance provided by management. Despite warnings of broad-based demand softening in consumer end markets, which could potentially impact MPC sales, the segment - which hosts Microsoft's Windows, Surface devices, search and advertising, and gaming revenues - is expected to maintain growth in the current fiscal year. Azure and productivity software is also expected maintain double-digit growth, squashing concerns of slowed corporate spending amid near-term economic uncertainties.
Specifically, Productivity and Business Processes segment sales are expected to grow 13% in fiscal 2023 to $71.7 billion, underscoring continued resilience supported by the critical nature of Microsoft's suite of cloud-based productivity software (e.g. Office consumer/commercial, Dynamics, etc.).
Meanwhile, fiscal 2023 sales at Microsoft's recession-prone MPC business are expected to be comparatively muted, with expectations leaning towards the conservative side in consideration of weakening consumer confidence in the near-term economic outlook (i.e. rising inflation, tightening monetary policies, recession risks, etc.). Specifically, MPC growth is expected to decelerate to 7% and achieve revenues of $64.0 billion by the fiscal year-end, supported primarily by strong Windows commercial demand.
And based on the foregoing analysis, Microsoft's Intelligent Cloud segment is expected to be the lead growth driver in fiscal 2023. Our base case forecast projects y/y growth of 24% to $93.1 billion in total Intelligent Cloud sales by year-end. This is consistent with expectations for robust multi-year share gains at Azure, demonstrated through high-visibility revenues backed by the increased volume of commercial bookings.
As Microsoft's corporate strategy continues to encourage greater migration towards higher-margin software and service sales, the company's cost structure is expected to show continued improvements over the longer-term, especially as cloud-computing programs continue to scale. Net income is expected to expand from $80.2 billion by the end of fiscal 2023 towards $139.0 billion by fiscal 2027.
Microsoft_-_Forecasted_Financial_Information.pdf
We are maintaining our price target for Microsoft at $340 despite the near-term macroeconomic overhang. This accordingly represents upside potential of 30% based on the stock's post-earnings price of $262 in late-trading July 26th.
The price target is derived using the discounted cash flows ("DCF") valuation approach, drawing on the projected cash flow streams in accordance with our fundamental forecast analyzed in the above section. Key valuation assumptions applied in the DCF analysis remains largely consistent with our previous forecast (i.e. 17.5x exit multiple; 9% WACC) to reflect Microsoft's continued revenue growth above GDP from CY/2026 and beyond, as well as its robust capital structure characterized by a net cash position of about $55 billion as of the latest period-end.
Microsoft Valuation Analysis (Author) Microsoft Sensitivity Analysis (Author)
Despite near-term downside risks like continued FX headwinds and softening in consumer end markets, the company continues to demonstrate sustained growth and a strong balance sheet - two critical factors to supporting a favorable long-term investment that can overcome the bad times and outperform the good times.
The stock is now trading near low levels last observed during the pandemic crash in early 2020 - about 23x forward P/E and 9x forward EV/sales. This, in our view, is not reflective of the premium that Microsoft deserves with its resilient growth profile and digital moat in the provision of critical cloud-based productivity software and cloud-computing solutions. While we believe market valuations are not expected to show a structural rebound until there is greater clarity on mounting macro uncertainties ahead, the Microsoft stock makes an attractive long-term investment at current levels, nonetheless.
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Disclosure: I/we have a beneficial long position in the shares of GOOG, PLTR 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.