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Microsoft (MSFT) recently reported its Q1 FY23 earnings report (ending September 2022). I covered all other big tech earnings in the past few weeks, and many readers have asked about Microsoft, so here it is!

Today, we’ll cover the following:

Microsoft is a giant that needs no introduction.

The business has evolved in recent years through many high-profile acquisitions worth mentioning.

2011: Skype (communication) $8.5 billion.
2013: Nokia (smartphones) $7.2 billion.
2014: Mojang (Minecraft) $2.5 billion.
2016: LinkedIn (social network) $26.2 billion.
2018: GitHub (software development) $7.5 billion.
2020: Zenimax (video games) $8.1 billion.
2021: Nuance (speech synthesis) $19.7 billion.
2022: Activision Blizzard (video games) $68.7 billion (pending approval).
And so many others I could mention here.

I’m a gaming industry veteran, so I can’t help but highlight the incredible work done by Phil Spencer and his teams to integrate an avalanche of studios and technologies under the Xbox umbrella.

Let’s discuss how Microsoft makes money.

Revenue has three main components:
- 📊 Productivity and Business Processes (~33% of overall revenue).
  - Office Commercial (Office 365 subscriptions)
  - Office Consumer (Microsoft 365 subscriptions).
  - LinkedIn (Talent, Marketing, Sales solutions, and premium subscriptions).
  - Dynamics business solutions (Dynamics 365, ERP, and CRM apps).
- ☁️ Intelligent Cloud (~40% of overall revenue).
  - Azure and other cloud services (Server products, Nuance, and GitHub).
  - Enterprise Services (Enterprise Support, Microsoft Consulting).
- 🎮 More Personal Computing (~27% of overall revenue).
  - Windows (licensing, cloud services, Internet of Things).
  - Devices (Surface, HoloLens, and PC accessories).
  - Gaming (Xbox hardware, content, and services).
  - Search and news advertising (including Xandr).

The graph below from GeekWire breaks down the major product lines by revenue over time. The rise of server and cloud services has been the main story in the past five years.

Costs and expenses include:
- Cost of revenue: Manufacturing and distribution costs for products sold and programs licensed, traffic acquisition costs, support (such as data centers), and amortization of capitalized software development costs.
- Research & development: Product development headcounts, programming, and localization costs.
- Sales & marketing: Marketing personnel, advertising, promotions, and more.
Margins:
- The operating margin has been above 30% of revenue in the past five years and improving steadily. The continued rise of Microsoft Cloud has improved the company's margin profile. All segments broken by management show operating margins north of 30%.

Let’s look at the most recent quarter!

1. Microsoft Q1 FY23

Income statement:

Here is a bird’s-eye view of the income statement.

Data source: 10-Q.

Main highlights:

Revenue grew +11% Y/Y to $50.1 billion ($0.4 billion beat).
- 📊 Productivity and Business Processes grew +9% Y/Y to $16.5 billion.
- ☁️ Intelligent Cloud grew +20% Y/Y to $20.3 billion.
- 🎮 More Personal Computing decreased slightly to $13.3 billion.
Management provides a table with revenue growth for selected products and services. Azure and other cloud services grew +35% Y/Y (and +42% Y/Y fx neutral).
Gross margin was 69% (-1pp Y/Y).
Operating margin was 43% (-2pp Y/Y).
EPS was $2.35 ($0.04 beat).

Cash flow:

Operating cash flow was $23.2 billion (46% margin, -8pp Y/Y).

Balance sheet:

Cash and cash equivalent: $107 billion.
Long-term debt: $77 billion.

Guidance:

CFO Amy Hood said the company expects"double-digit" revenue growth Y/Y in FY23 (ending June 2023). However, she also pointed to potential challenges in the months ahead.
Q2 FY23 revenue guidance is +1%-4% Y/Y. Wall Street expected +9% Y/Y.
- Productivity and Business Processes: +11%-13% Y/Y fx neutral
- Intelligent Cloud: +22%-24% Y/Y fx neutral.
- More Personal Computing: (15%)-(17%).
There will be some margin compression with a 5pp currency headwind on revenue but only a 3pp headwind on expenses (since most of them are denominated in dollars).
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?

Revenue came ahead of expectations. The Productivity and Business Processes segment was the main driver of the overperformance. Azure was 1 point lower than expected due to moderation in consumption growth (like AWS).
The strong dollar muted the growth Y/Y across all segments. Revenue was up +16% Y/Y fx neutral.
Gaming is facing headwinds in line with the rest of the industry. Xbox content and services were down 3% Y/Y. According to NPD, US consumer spending on video game products decreased by 5% Y/Y in Q3 2022.
More Personal Computing will be a drag in the near term. Management expects a significant slowdown with weak PC demand and tough comparisons Y/Y.
Q2 FY23 guidance came in well below expectations. Revenue growth is softer, and the profitability trend will be ugly with an unfavorable fx impact. On the positive side, the outlook for the full year FY23 remained somewhat in line with the consensus.

Is the business sustainable?

Microsoft has a significant net cash position and has been printing money, with $88 billion in cash from operations in the past 12 months.

2. Recent business highlights.

Some numbers caught my attention across business and productivity apps:

Power Apps (market leader in Low-Code/No-Code tools) has nearly 15 million monthly active users (up more than 50% Y/Y).
Power Automate has more than seven million monthly active users.
More than 400,000 organizations now use Dynamics 365 (business applications).
Users interact with Microsoft Teams 1,500 times per month on average.
Enterprise users running third-party and custom applications within Teams increased nearly 60% Y/Y.
55% of customers who use Teams also buy Teams Rooms or Teams Phone.
Microsoft announced Teams Premium, offering advanced meeting features like additional security options and intelligent meeting recaps.
Microsoft Places (new category) helps organizations evolve and manage the space for hybrid and in-person work.
Microsoft Viva (employee experience and engagement) now has more than 20 million monthly active users.

3. Key quotes from the earnings call

CEO Satya Nadella on Microsoft Cloud:

“This quarter, the Microsoft Cloud again exceeded $25 billion in quarterly revenue, up 24% and 31% in constant currency. And based on current trends continuing, we expect our broader commercial business to grow at around 20% in constant currency this fiscal year.”

On Azure Arc (hybrid and multi-cloud management):

We now have more than 8,500 Arc customers, more than double the number a year ago. We are the platform of choice for customers' SAP workloads in the cloud.

On AI:

We are turning the world's most advanced models into platforms for customers. Earlier this month, we brought the power of DALL-E to Azure OpenAI service. […] Azure ML revenue has increased more than 100% for four quarters in a row.

On GitHub:

“GitHub is now at $1 billion in annual recurring revenue. [...] More than 90 million people now use the service to build software for any cloud on any platform up three times.”

On LinkedIn:

“Now on to LinkedIn. We once again saw record engagement among our more than 875 million members, with international growth increasing at nearly 2x the pace as in the United States. There are now more than 150 million subscriptions to newsletters on LinkedIn, up 4x year-over-year. […] LinkedIn Marketing Solution continues to provide leading innovation and ROI in B2B digital advertising.”

About gaming:

“PC Game Pass subscriptions increased 159% year-over-year. And with cloud gaming, we're transforming how games are distributed, played and viewed. More than 20 million people have used the service to stream games to date.”

4. What to watch looking forward

Azure market share and revenue growth

Azure delivered another strong quarter, maintaining its position with a 21% market share in a fast-growing industry.

Azure has been a model of consistency, growing north of 40% (fx neutral). However, investors should brace for a challenging quarter ahead (as explained in my Amazon article). Management expects Azure to be “sequentially lower by roughly 5 points on a constant currency basis.”

App Economy Insights @EconomyApp

Cloud Infrastructure Services Market. $57 billion in spending in Q3 2022. → +24% Y/Y. → +30% Y/Y fx neutral. Q3 2022 market share: 🟧 $AMZN AWS 34% (unchanged). 🟦 $MSFT Azure 21% (unchanged). 🟩 $GOOG GCP 11% (+1pp Q/Q). Estimates by Synergy Research Group.

AI to power all categories

I discussed the importance of AI in my review of Google’s recent quarter.

Microsoft is well-positioned to put powerful AI models in the hands of consumers and developers. This week, the company announced a partnership with NVIDIA (NVDA) to build one of the most powerful AI supercomputers.

App Economy Insights @EconomyApp

NVIDIA partners with Microsoft. They plan to build one of the most powerful AI supercomputers in the world. It will be powered by: • Microsoft Azure's infrastructure. • NVIDIA GPUs and full stack of AI software. The goal is to help train, deploy and scale AI. $NVDA $MSFT

From low-code to Azure ML, integrating easy-to-use, AI-enabled tools will be critical to Microsoft's success in the coming years.

While the global slowdown in PC demand will continue to be a drag in the near term, the forecast for the future of Microsoft remains the same.

Cloudy, with a chance of AI.

That’s it for today!

Stay healthy and invest on!

Disclosure: I am long NFLX and NVDA in the App Economy Portfolio. I share my ratings (BUY, SELL or HOLD) with App Economy Portfolio members here.

💻 Microsoft: Cloudy with a chance of AI