💻 Microsoft: AI everywhere all at once
OpenAI will bolster apps and search, but Azure is slowing down
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Microsoft (MSFT) reported its Q2 FY23 earnings report (ending December 2022).
Today, we’ll cover the following:
Microsoft Q2 FY23.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
Microsoft is a 3-legged business with Office, Cloud, and Personal Computing.
But when it comes to growth, it’s all about the cloud.
The first half of FY23 can be summarized this way:
~70% of revenue came from the Commercial Business.
~70% of that came from Microsoft Cloud (so about half of overall revenue).
Microsoft posted solid results for Q2 FY23. While Personal Computing was a disaster (as expected), Azure’s slowdown was not as bad as feared.
But, as is often the case with Wall Street, guidance was the primary concern.
So let’s dive in!
1. Microsoft Q2 FY23
Here is a bird’s-eye view of the income statement.
Data source: Earnings release.
Revenue grew +2% Y/Y to $52.7 billion ($450 million miss), or +7% fx neutral.
📊 Productivity and Business Processes grew +7% Y/Y to $17.0 billion (+13% Y/Y fx neutral).
☁️ Intelligent Cloud grew +18% Y/Y to $21.5 billion (+24% Y/Y fx neutral).
🎮 More Personal Computing declined -19% to $14.2 billion (-16% Y/Y fx neutral.
Management provides a table with revenue growth for selected products and services. For example, Azure and other cloud services grew +38% Y/Y fx neutral, compared to 42% fx neutral in Q1 FY23.
To add some context, below is a table comparing growth Y/Y fx neutral in Q2 FY23 and Q1 FY23. Azure remains the fastest-growing segment.
Office Commercial remained healthy, but the growth declined sharply on the Consumer side.
Personal computing was expected to be the weakest segment. Windows OEM revenue decreased by 39% (in line with expectations), and devices collapsed by 34% Y/Y (below expectation on challenging product launches).
Ad-based segments like Search and LinkedIn saw headwinds comparable to the rest of the industry.
Azure was expected to slow down but remained impressive at +38% Y/Y.
Gross margin was 67% (-10pp Y/Y and -2pp Q/Q).
Operating margin was 39% (-10pp Y/Y and -4pp Q/Q).
EPS was $2.32 ($0.01 beat).
Operating cash flow was $11.2 billion (21% margin, -7pp Y/Y).
Cash and cash equivalent: $100 billion.
Long-term debt and leases: $71 billion.
Q3 FY23 Guidance:
Q3 FY23 revenue guidance is +1%-4% Y/Y. Wall Street expected +9% Y/Y.
📊 Productivity and Business Processes: +11%-13% Y/Y fx neutral, driven by Office 365. LinkedIn is expected to slow in the mid-single-digit due to a slowdown in hiring and advertising trends.
☁️ Intelligent Cloud: +17%-19% Y/Y fx neutral. That compares to +24% fx neutral in Q2 FY23. Azure exited Q2 with a growth in the mid-30s (compared to 38% for the entire quarter). Management expects further deceleration by 4 to 5 percentage points. So Azure's growth would end in the low 30s in Q3.
🎮 More Personal Computing: (18%)-(15%). Windows OEM should decline in the mid-to-high 30s like the rest of the PC market. Advertising should grow in the single digit with the inclusion of Xandr (the technology behind the ad-supported plan on Netflix). Gaming is expected to decline in the high single digits due to tough comps.
Even with headwinds for lower OEM revenue, the FY23 operating margin is expected to be down only 1 percentage point Y/Y fx neutral (excluding the Q2 restructuring charge). There was no update to the full-year revenue outlook.
For now, management does not include any impact from Activision in its outlook, though they still expect to close the acquisition by June 2023.
So what to make of all this?
Productivity and Intelligent Cloud were in line with the high end of guidance. It was driven by the strong growth of Microsft Cloud, up +29% Y/Y fx neutral.
“Azure and other cloud services” is the focal point for Wall Street. While Q2 was 1 percentage point ahead of expectation, the Q3 guidance in the low 30s was below the consensus of ~34%.
Personal computing was a complete disaster (as expected, sort of). It collapsed by 19% Y/Y (compared to a 16% decline expected). Not only the PC market declined, but Microsoft faced challenges with its Surface business. IDC said global PC sales plunged 28% to 67 million in Q4 2022. Microsoft Devices underperformed, declining by 34% Y/Y.
The strong dollar muted the growth Y/Y across all segments. Therefore, looking at the revenue growth fx neutral is crucial.
Gaming is facing headwinds in line with the rest of the industry. For example, Xbox content and services were down 8% Y/Y fx neutral., which was slightly worse than the trend tracked by NPD in the US for Q4 2022.
The operating margin was down 4 percentage points sequentially, partially explained by the restructuring and the revenue mix.
The company returned $9.7 billion to shareholders through share repurchases and dividends.
The softer-than-expected Q3 FY23 guidance is the main story. Management forecasted ~$51.0 billion in the mid-range compared to the $52.4 billion expected.
Is the business sustainable?
Microsoft has a significant net cash position and has been printing money, with $84 billion in cash from operations in the past 12 months.
2. Recent business highlights.
Investment in Open AI
Chances are you've come across OpenAI by now.
The company specializes in developing artificial intelligence (AI) and machine learning (ML) technologies. They are the creator of GPT-3, a language model that can generate human-like text, and DALL-E, an image-generation tool.
Earlier this week, Microsoft officially extended its OpenAI partnership with a multiyear, multibillion-dollar investment.
Semafor says it’s a $10 billion investment, including venture firms. It values OpenAI at $29 billion. As part of the deal, Microsoft would get 75% of OpenAI's profits until it recoups its investment. After reaching that threshold, Microsoft would have a 49% stake in OpenAI, while other investors would have 49%, and OpenAI's nonprofit parent would have 2%.
Tech CEOs have blamed themselves for over-hiring since the beginning of the pandemic. Now they must “right-size” their ship to adapt to a new environment. They are bracing for a challenging time ahead.
Satya Nadella was no exception:
“We saw customers accelerate their digital spend during the pandemic. We’re now seeing them optimize their digital spend to do more with less.”
Microsoft announced it would lay off 10,000 employees. That’s almost 5% of its 221,000 workforce. But, of course, it needs a bit of context. In 2022 alone, the company’s headcount increased by 40,000.
There are unspecified changes to the company’s hardware portfolio, which could be related to the challenging launches in Q4.
The restructuring charge negatively impacted the gross margin by $152 million and the operating income by $1.2 billion (about 2 points of operating margin).
Headcount grew +19% Y/Y in Q2 FY23, including 6 points from the Nuance and Xandr acquisitions.
3. Key quotes from the earnings call
CEO Satya Nadella on the changing environment (short and long-term):
“Just as we saw customers accelerate their digital spend during the pandemic, we are now seeing them optimize that spend. […] Digital spend as a percentage of GDP is only going to increase. ”
While Wall Street is obsessed with the short-term, the secular trend is intact.
On Microsoft Cloud:
“Microsoft Cloud exceeded $27 billion in quarterly revenue, up 22% and 29% in constant currency.”
That puts Microsoft Cloud at just over half of the overall revenue. And, of course, it will become even more over time.
On Azure Arc (hybrid and multi-cloud management):
“We now have more than 12,000 Arc customers, double the number a year ago, including companies like Citrix, Northern Trust and PayPal.”
On the age of AI:
“The age of AI is upon us and Microsoft is powering it. We are witnessing non-linear improvements in capability of foundation models, which we are making available as platforms. And as customers select their cloud providers and invest in new workloads, we are well positioned to capture that opportunity as a leader in AI. We have the most powerful AI supercomputing infrastructure in the cloud. It’s being used by customers and partners like OpenAI to train state-of-the-art models and services, including ChatGPT. Azure ML revenue alone has increased more than 100% for five quarters in a row. […] Azure ML revenue alone has increased more than 100% for five quarters in a row.”
“GitHub is now home to 100 million developers and GitHub Copilot is the first at-scale AI product built for this era, fundamentally transforming developer productivity. More than 1 million people have used Copilot to-date.”
On Power Platform:
“Power Automate has more than 45,000 customers from AT&T to Rabobank, up over 50% year-over-year.”
On Microsoft 365 (consumer):
“We have more than 63 million consumer subscribers, up 12% year-over-year and we introduced Microsoft 365 Basic, bringing our premium offerings to more people.”
“Teams surpassed 280 million monthly active users this quarter […] Apps from Adobe, Atlassian, Poly, ServiceNow and Workday have each surpassed 0.5 million active users and the number of third-party apps with more than 10,000 users increased nearly 40% year-over-year. There are more than 500,000 active Teams Rooms devices, up 70% year-over-year.”
“While the number of PCs shipped declined during the quarter, returning to pre-pandemic levels, usage intensity of Windows continues to be higher than pre-pandemic with time spent per PC up nearly 10%. […] We are also seeing growth in cloud-delivered Windows with usage of Windows 365 and Azure Virtual Desktop up by over two-thirds year-over-year.”
“Over the past 12 months, our security business surpassed $20 billion in revenue as we help customers protect their digital estate across clouds and endpoint platforms.”
It’s a nice nugget that puts security at more than 10% of overall revenue.
“We once again saw record engagement among our more than 900 million members. Three members are signing up every second. Over 80% of these members are from outside the United States.”
900 million is a 25 million increase compared to last quarter (+3% Q/Q).
“We saw new highs for Game Pass subscriptions, game streaming hours and monthly active devices, and monthly active users surpassed a record 120 million during the quarter.”
There was no update on Game Pass subscribers.
4. What to watch looking forward
Azure market share and revenue growth
Take a look at Azure's growth Y/Y (fx neutral) in the past six quarters:
48% → 46% → 49% → 46% → 42% → 38%.
The recent normalization is not specific to Azure. We’ve observed the same thing in our review of AWS. Azure has been growing faster than AWS (from a lower base).
In Q3 FY22, Azure maintained its 21% market share. Next week, we must keep our eyes peeled for Google and Amazon’s earnings to understand the competitive dynamics.
As anticipated in our article about Activision Blizzard in December, the FTC sued to block the $69 billion acquisition. Microsoft will also likely receive an EU antitrust warning (statement of objections). For now, this is still a developing story. The EU antitrust watchdog has set an April 11 deadline.
AI to power all categories
Microsoft is going to great lengths to secure its position as the top AI player among its Big Tech rivals. The expanding partnership with OpenAI should fuel new functionalities in Microsoft’s productivity apps and cloud services.
OpenAI’s ChatGPT is on everyone’s mind right now. It was called an “iPhone moment for AI” by an analyst at Forrester Research. Erik Brynjolfsson, professor of economics and information technology at Stanford University, suggested ChatGPT will be the calculator for writing, augmenting our writing ability. But can it make Bing (3% market share) a worthy competitor to Google (93% market share) in search?
The jury is still out.
There is little doubt that the technology will be commoditized, and more splashy AI announcements from competitors are coming. But Microsoft has excelled at adding functionalities to its tools for its subscription model to thrive. Offering AI-enabled tools across all products and services is a requirement to succeed in cloud infrastructure. OpenAI is getting all the buzz and attention, and maybe that’s all it takes to gain market share in a highly competitive environment.
Microsoft is well-positioned to put powerful AI models in the hands of consumers and developers. From low-code to Azure ML, integrating easy-to-use, AI-enabled tools will be critical to Microsoft's success in the coming years.
The global collapse in PC demand and the likely slowdown of Azure in a challenging environment will continue to be a drag in the near term. The Activision deal remains a long shot. But it’s fascinating to find Microsoft — long thought to be a victim of disruption from smaller competitors — in a position to challenge the status quo with OpenAI on its side.
The company could continue to thrive in the Office and Cloud segment.
With AI everywhere, all at once.
That’s it for today!
Stay healthy and invest on!
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Great rundown. I could not believe...Microsoft didn't make ANY economic profit from ALL of its personal computing & Xbox division?! No wonder the quality of games has visibly declined..they're not putting the necessary investments into Xbox or personal computing that would be necessary to retake any market share from Nintendo, Sony, or Apple.
The other thing that stood out to me is that Microsoft is extremely dependent upon its Azure division. Much like Amazon, Microsoft's legacy business doesn't appear to be growing like it once could and had, and therefore, Big Tech does not have a very positive way forward, especially as corporate clients continue cutting back on spending on cloud computing.
In the event of a full-blown economic depression, Microsoft will get hit HARD. The investment in OpenAI isn't a sure-thing, either, in my view. The AI is clearly biased in its output, and is still only able to access data up through the end of 2021, which is now going on 2 years. ChatGPT will have big competition from Google and Baidu, going forward.