Strong Azure can't save Microsoft in the cycle

On January 24th, following the U.S. stock market's closing, Microsoft $Microsoft.US disclosed its second-quarter fiscal 2023 earnings, which ended in December. The key points are as follows:

1. Overall performance was weak, but the core business held strong: Microsoft achieved total revenue of $52.7 billion this quarter, slightly below the market's expected $53 billion, and its revenue growth rate continued to decline, reaching only 2%. This quarter's operating profit was $20.4 billion, well below the expected $21.1 billion, making its overall performance unimpressive.

However, the key is that the company's core productivity and intelligent cloud segments' revenue, in reality, slightly exceed the market's expected values, primarily due to the personal business segment of "legacy" dragging them down. Among them, Azure's business segment achieved $14.7 billion in revenue, far exceeding the expected $13.8 billion, and its year-over-year growth rate remains at 31%, with a quarter-over-quarter slowdown of only 4%. Other B2B businesses, such as Dynamic 365 and Commercial LinkedIn, also grew more than 20%. Therefore, despite the overall poor performance, the core B2B business is more resilient than expected.

1. The impact of foreign exchange rates is gradually declining, and the risk of a recession will be crucial: Excluding the impact of the appreciation of the U.S. dollar on Microsoft's finances, the company's overall revenue growth rate is 7%. However, growth also declined by 9% quarter-over-quarter, which is equivalent to the slowdown rate of revenue growth after accounting for exchange rate factors. This quarter's exchange rate drag on revenue decreased from 5.4% in the previous quarter to 5% this quarter. In the future, as the United States' interest rate peaks, the dollar's exchange rate will probably top out and decline. Thus, the impact of the exchange rate on the company's performance should gradually diminish. In terms of regions, the growth rate of U.S. domestic revenue, which is not affected by exchange rates, plunged from 13% in the previous quarter to only 2%, indicating that actual demand is clearly weakening. Even if the impact of exchange rates on next year's earnings is significantly reduced, an economic recession may still seriously damage the company's growth.

2. Growth in confirmed "residuals" has bottomed out and rebounded: The company's core 2B cloud business's contract backlog, which is awaiting confirmation of revenue, is $189 billion, although its growth rate is continuing to slow down as the base grows larger, the total amount of the backlog is still at a record high, ensuring the future certainty of its income. In addition, according to Dolphin Analyst's calculations,the 2B contracts signed this quarter amounted to $47.1 billion, a 7% increase year-over-year. Compared with the previous quarter's $28.3 billion, this is a significant rebound from a low point. However, excluding the exchange rate factor, the growth rate of the new contract amount rebounded only by 4%, while in the previous quarter, there was still 16% growth, and in the past few quarters, it was over 30%. Therefore, it appears that the rebound in new contract amounts this quarter is due to an increase in their proportion being signed in the United States, while overseas demand, in reality, is quickly weakening.

3. Overall profit deterioration: This quarter's gross profit was $35.3 billion, with a gross profit margin of 66.8%, significantly worse than last quarter's gross profit of 69.2%, and below the market's expectations. In addition, the operating expense ratio increased marginally this quarter; Dolphin thinks that, aside from the trend of labor costs incursion, the costs generated by the company's recent layoffs may also lead to expense growth. Finally, due to the deterioration of costs and expenses, the company achieved an operating profit of 20.4 billion this season, which is significantly lower than the market expected 21.1 billion. The operating profit also decreased by more than 4pct to 38.7% compared to the previous season. Under the influence of inflation, the company's profit growth has been lower than revenue growth in the past few quarters, and this season's operating profit has also decreased by 8% year-on-year, indicating a poor performance in terms of profits.

4. Is the market not satisfied with the guidance for the next quarter's rebound?

The company pointed out that the central revenue of the next quarter is 51 billion yuan, with a year-on-year growth rate rebounding from 2% this season to 3.3%, and the next quarter's operating profit will be 20.5 billion, and the profit margin will also improve from 38.7% this season to 40.2%. It can be seen from the company's expectations that the next quarter will usher in a turning point in performance. However, according to the post-market stock price performance, the market is not satisfied with this guidance, which is actually lower than the market's expectations. The most crucial Wisdom Cloud sector guidance for the next quarter only has a growth rate of 14.7%, which is still significantly slower than this season's 17.4%, making the market concerned about the future growth of the Azure business.

Dolphin Analyst's point of view:

Overall, the company's overall performance this season is not satisfactory in terms of both revenue growth and profit performance. The growth further slowed down, and the profit margin further declined, with profit growth continuing to be lower than revenue growth. However, structurally, the company's Wisdom Cloud and productivity sectors performed better than expected, with B-side or cloud-based businesses such as Azure, Dynamics 365, and Commercial LinkedIn showing growth rates that are significantly better than the market's pessimistic expectations. The stronger resilience and growth potential of the industrial Internet facing B-end have been once again demonstrated. This is the most dazzling point in this not-so-good financial report of the company.

At the same time, the financial report also shows that the impact of exchange rate losses caused by the appreciation of the US dollar and interest rate hikes on the company's performance is gradually easing, but the rapid decline of US domestic growth unaffected by exchange rates, which can also be seen from the amount of new contracts, indicates that overseas demand is weakening. The key factors affecting the company's performance are shifting from interest rates & exchange rates to actual economic growth.

Dolphin Analyst believes that Microsoft's performance is still in a downward trend, and in this situation, judging that the marginal turning point of poor performance is the best investment logic. The guidance for the next quarter in the company's conference call seems to be unsatisfactory to the market, and it is still unclear to what extent the US and European economies will deteriorate in 2023, so Dolphin Analyst believes that the turning point of Microsoft's performance is still unlikely to arrive.

Dolphin Analyst will later share the summary of the conference call with Longbridge's Dolphin users through the Longbridge App. Interested users are welcome to add the WeChat account "dolphinR123" to join the Dolphin investment research group and obtain conference call summaries for the first time.

I. Introduction to Microsoft's Business Structure Microsoft's business includes Azure cloud services, productivity tool software, advertising, personal computers, games, and search services, making its business relatively complex. Readers can gain a brief understanding of Microsoft's business structure and current situation through the following chart, which will help them better understand the analysis in the text.

Of the many assets:

1. The "Productivity and Business Processes" business, mainly based on Office, has flourished in the cloud era as traditional software gradually moves to the cloud and business models shift to subscription-based SaaS models. It is a key point of performance evolution for cloud-era companies.

2. The intelligent cloud business with Azure at its core is Microsoft's biggest growth point in the era of industrial interconnection and is still growing rapidly. These two businesses make up the two core pillars of Microsoft's charge in the cloud era and are the core focus of Microsoft's quarterly financial reports.

3. More personal computing businesses such as C-side products, Surface, Xbox, hardware, gaming, and Bing search, including Windows, are Microsoft's legacy assets in the mobile era and have the lowest strategic position of the three businesses.

The following is a detailed financial report review:

Second, the growth of core business is not so bad, also considered making the most of a bad situation

2.1 Stronger than pessimistic expectations, Azure deserves the top spot

Looking first at the core business of Microsoft's intelligent cloud, which contributes the most revenue, the flagship product, Azure, achieved revenue of $14.7 billion this quarter, a year-on-year growth rate that slowed further from 35% last quarter to 31%, marking continuing deceleration for the fourth consecutive quarter. At the same time, the absolute increase in Azure revenue this quarter was also lower than the same period last year for the first time in recent years, confirming that the slowdown is not just due to a larger base but to a real decrease in demand.

Due to the appreciation of the US dollar, the exchange rate had an adverse effect on Microsoft's overseas revenue. Removing exchange rate losses, the actual growth rate of Azure on a constant-currency basis was 38%, which similarly decreased by 4 percentage points compared to the previous quarter. Therefore, even after excluding the adverse impact of exchange rates, the trend of growth slowing down remains consistent.

However, although Azure's trend of deceleration is difficult to conceal, compared with the market's over-pessimistic expectations, Azure's performance appears quite resilient. The market consensus expected Azure's revenue to be only $13.8 billion this quarter, approximately the same revenue as the previous quarter, with a year-on-year growth rate of only 23%. Therefore, the actual revenue of $14.7 billion greatly exceeded expectations and was one of the brightest spots in this quarter's financial report.

Consistent with the trend presented by Azure, the growth of other server businesses in the Intelligent Cloud segment has also slowed down, with a decrease in growth rate of 3-4pct compared to the previous quarter. Among them, the revenue growth rate of non-Azure server business (including SQL server, Visual Studio, etc.) has decreased from -1% to -5%. The growth rate of consulting enterprise services revenue this quarter has dropped from 5% in the previous quarter to 2%. According to the company's disclosure, the slowdown in growth is mainly due to weak demand and customers turning to hybrid cloud services.

Overall, due to Azure's performance far exceeding bleak expectations, the Intelligent Cloud segment achieved a total revenue of 21.5 billion US dollars this quarter, which is at the upper limit of the company's previous guidance range of 21.2-21.5 billion US dollars, slightly higher than the market's expected median of 21.4 billion US dollars. It performed well from the perspective of expectation difference.

"2.2 Slow Growth and Price Decline - Office, which has reached its cloud penetration ceiling, needs new impetus"

This quarter, Microsoft's SaaS product Office 365 for enterprises achieved revenue of 9.7 billion US dollars, with a year-on-year growth rate that remained flat at 11% compared to the previous quarter. After five consecutive quarters of declining growth, it finally stabilized at a low level, but the problem of the basic consumption of the cloud dividend has basically been exhausted.

From the perspective of quantity and price, 1) the number of enterprise monthly subscription customers for Office365 increased by 12% year-on-year this quarter, which continued to decline from the previous quarter's 14%. It can be seen that with Office's cloud penetration rate nearing its ceiling and the economic downturn, the growth of new Office 365 users has slowed down.

1. From the perspective of price, this quarter's Office 365 customer price has dropped by 2% year-on-year, having declined for two consecutive quarters. Although there is an unfavorable impact from the appreciation of the US dollar, the continuous negative growth in customer price still reflects that enterprise users are reducing the usage of Office services, or turning to cheaper products.

2. From the perspective of cloud penetration rate, the proportion of Office365 in the overall enterprise Office business revenue this quarter has decreased by 1pct to 91% compared to the previous quarter. It can be seen that the cloud penetration rate has stopped at 91% for several consecutive quarters, and it is basically confirmed that enterprise Office has touched the ceiling of the mid-term. Future growth is more dependent on the increase in customer price (product price increase or increase in single user usage), but in the current environment, enterprise users are "consuming down", so Office's recent performance is also difficult to be satisfactory.

Apart from the core enterprise Office business, most of the other businesses in the productivity and business process segment have shown a similar slowdown in revenue growth.

Revenue from traditional personal Office business has started to decline, with a 2% YoY decrease this quarter. Although the relatively new businesses Dynamics and LinkedIn maintain 13% and 10% YoY growth, their growth rates have slowed by several percentage points compared to last quarter.

Looking further into it, cloud product Dynamics 365 and Commercial LinkedIn, which is aimed at enterprise marketing, still maintain a growth rate of over 20%. Cloud and enterprise businesses are still more resilient and have more room for growth compared to on-premises or personal businesses.

Overall, as the growth rates of various segments continue to slow down, the overall revenue growth of Microsoft's productivity and business process segment has further decreased to 7% this quarter, achieving a total revenue of 17 billion RMB. However, from the perspective of lower expectations, the revenue generated by the core business of the segment - enterprise Office service - is actually nearly 5% higher than expected. The overall revenue of the segment also exceeded the upper limit of guidance at 16.9 billion RMB and market expectations, showing that the actual performance was not as bad as expected.

The cloud penetration rate of B2B business is still increasing, but the slowdown problem is hard to conceal.

In order to better evaluate the performance of enterprise cloud services, Microsoft independently disclosed that the revenue from enterprise cloud services (including Enterprise Edition Office 365, Dynamics 365, Enterprise LinkedIn, and Azure) in the Smart Cloud and Productivity segments reached 27.1 billion RMB, a new high in absolute amount, and the revenue growth rate only slowed by 1pct to 23%, which is significantly less than the overall revenue growth rate. Industrial internet facing enterprises are still more resilient.

In terms of gross profit, the gross profit margin of enterprise cloud services decreased by 1pct QoQ this quarter. According to the company's disclosure, although the accounting adjustment of extending server depreciation life has increased the gross profit margin central value, the structural adjustment of user product usage and higher energy costs have increased the market cost of cloud services.

According to Dolphin Analyst’s calculation, the proportion of enterprise cloud services to the overall revenue and total revenue of the company remained unchanged this quarter, indicating that the sluggish macro environment has slowed down the pace and rhythm of corporate cloud adoption.

3. PC Business Underperformed but not as Bad as Expected

Compared with cloud business and productivity business targeting B-side, Microsoft's personal computing business targeting C-side is not highly valued by the market and is a "legacy" business during the PC Internet era of Microsoft. Overall, after the boom period of the "stay-at-home economy" during the pandemic, the PC-related sector is currently experiencing a downturn after the backlash.

Given this background, Microsoft's personal computing business achieved revenue of US$14.2 billion this quarter, a year-on-year drop of 18%, even significantly lower than the lower limit of the guidance of US$14.5 billion, indicating poor performance.

Looking at the details, 1) the revenue of the Windows business closely related to PC shipments dropped by 27% year-on-year, and the revenue of OEMs plummeted by 39% year-on-year.

1. Sales revenue of the hardware product line centered on Surface also decreased by 37% year-on-year.

2. Due to the higher base last year and the general sluggishness of overseas gaming markets after work normalization, the Xbox software and content revenue of the company also shrank by 12% year-on-year, while Xbox hardware sales fell by 14% year-on-year.

3. The growth rate of advertising business highly related to the macroeconomic situation has also slowed down significantly, with the quarterly growth rate dropping from 16% to just 10%.

4. Key Business Strong, Performance Stronger than Poor

4.1. Quantity not Good, But No Fault in Structure

In this quarter, Microsoft achieved overall revenue of US$52.7 billion, which basically falls in the middle of the guidance range of US$52.3 billion to US$53.3 billion, but slightly lower than the market's expectation of US$53 billion. Although the overall performance fell short of the market expectation, the key productivity and intelligent cloud business units exceed expectations and are at the upper limit of the guidance range. The Azure business is also stronger than expected. Thus, while the quantity is not great, the quality of revenue structure is actually good, mainly due to the drag from the personal computing business related to hardware.

4.2 Reduced impact of exchange rate, recession risk becomes a bigger concern

Due to the appreciation of the US dollar and the fact that the company's overseas revenue accounts for nearly 50%, exchange losses have had a significant impact on the company's performance in recent quarters. The company's revenue this quarter only increased by 2% year-on-year, and the actual growth rate was 7% after excluding the exchange rate factor. However, this is still a significant decrease compared to the previous quarter's growth rate of 16%. Under both the floating exchange rate and fixed exchange rate, the decline in Microsoft’s revenue growth rate is essentially the same, and the drag effect of exchange rates on revenue has decreased from 5.4% in the previous quarter to 5% in this quarter. As the US raises interest rates, the dollar exchange rate is likely to peak and decline, and the impact of exchange rates on the company's performance is expected to gradually decrease.

Based on Microsoft's revenue growth rate in the US and overseas (in US dollars), the growth rate in the US this quarter dropped significantly from 13% in the previous quarter to only 2%, while the growth rate in overseas regions (in US dollars) was only 1.9%. From the growth rate in the US region that is not affected by exchange rates, it can be seen that the company's overall actual growth is indeed weak (mainly due to the drag effect of individual computing business). At the same time, it is worth noting that after excluding the impact of exchange rates, the revenue growth rate in overseas regions is actually higher than that in the US region.

Five, difficult current performance, has the newly signed balance bounced back early?

So in addition to the performance achieved this quarter, what are the growth prospects and certainty of the company's future revenue?

First, let's look at the B2B contract balance, which is a long-term "reserve": The amount of contract balance for the enterprise side (deferred income for already received payments + contract balance for unpaid and unconfirmed income) this quarter was 189 billion yuan. Although the growth rate is continuing to slow down as the base gets larger, the total balance is still at a historic high, and regardless of the growth potential of future income, the certainty is basically assured.

More importantly, according to Dolphin Analyst's estimation, Microsoft's newly signed 2B contract amount this quarter is approximately US$47.1 billion, and the company's disclosed new contract amount has also increased by 7% year-on-year. Compared with the previous quarter's $28.3 billion, it has obviously rebounded. However, according to the company's disclosure, after excluding the impact of exchange rates, the growth rate of newly signed contract amount is only 4%, and even in the previous quarter, it was still as high as over 16%, with even higher rates of over 30% in the past few quarters. If viewed this way, Microsoft's new contract amount in overseas regions this season should have decreased significantly, while the new contract amount in the United States is relatively higher. This is not good news and may indicate that overseas demand is rapidly weakening.

The company has received cash with higher certainty in the short term - deferred revenue at the end of this quarter was US$43.9 billion (more than 90% will be confirmed as revenue within one year), an increase of 8% year-on-year, which is also a rebound from the 7% growth in the previous quarter. However, referring to the situation of the new contract amount, Dolphin Analyst believes that the rebound in deferred revenue may also be due to the decrease in the proportion of overseas regions and the increase in the proportion of the United States. Structurally, the deferred revenue growth rate of each business is rebounding.

The continued deterioration of gross profit, the reversal of the growth rate gap between revenue and profit

1. This quarter achieved a gross profit of US$35.3 billion, with a gross profit margin of 66.8%, which is significantly lower than the gross profit of 69.2% in the previous quarter and lower than the market's expected 67%. Dolphin Analyst believes that the main reason for the decline in gross profit is still the impact of users transferring to low-priced products, the increase in energy costs for server operations, and the gradual release of the impact of rising employee labor costs.

2. In addition to deteriorating gross profit, the company's operating expense ratio this season has also marginally increased. The sales expense and administrative expense ratios have increased both sequentially and year-on-year. Dolphin Analyst believes that in addition to the trend of rising labor costs, the additional expenses generated by the company's recent layoffs may also be one of the reasons, and it is worth paying attention to how the company explains it during its conference call.

Overall, due to the deterioration of cost and expense levels, the company achieved an operating profit of 20.4 billion this season, which is significantly lower than the market's expected 21.1 billion. The operating profit also decreased by more than 4pct to 38.7% compared to the previous quarter. Under the influence of various factors such as inflation, Microsoft's rule of profit growth consistently exceeding revenue growth between 2020 and 2022 has been reversed. In recent quarters, profit growth has been worse than revenue growth, and this season's operating profit has decreased by 8% year-on-year. Compared with the slowdown in revenue growth, the performance at the profit level is actually worse. **

Looking at the sectoral performance, all business segments experienced a decline in operating profit margin in a high-inflation environment last quarter, with the exception of a brief rebound stemming from server depreciation. Of all the segments, the personal computing unit experienced the most alarming decline, dropping over 8% QoQ. Both of the other two segments' operating profits also decreased compared to the previous quarter, despite revenue growth accompanied by a decline in income.

Previous Research by Microsoft:

Financial Report Review

October 26, 2022 Conference Call: "Can Microsoft Walk Away Unscathed Amid Economic Downturn? (1Q23 Conference Call Summary)"

October 26, 2022 Financial Report Review: "No One is Immune to Cycles: Even Microsoft is Struggling to Survive"

July 27, 2022 Conference Call: "Microsoft's View on the 23 Fiscal Year Performance (Conference Call Summary)"

July 27, 2022 Financial Report Review: "Under Paralysis, Microsoft Has Greater Resilience"

April 27, 2022 Conference Call: "Microsoft's Journey - The Real Starry Sky and Ocean (3Q Conference Call Summary)"

April 27, 2022 Financial Report Review: "Steadfast Microsoft - The Strongest Pillar of the US Stock Market"

January 26, 2022 Conference Call: "Nadella: 'Microsoft's Strength Lies in Being Able to See Trends Ahead of the Consensus'"

2022 January 26 Financial Report Review "[No need to worry, Microsoft is still "reliable"] (https://longbridgeapp.com/topics/1872521)"

October 27, 2021 Telephone Conference "[Is digital technology a deflationary force in the inflationary era? Please see Nadella's explanation (summary of the telephone conference)] (https://longbridgeapp.com/topics/1257488?invite-code=032064)"

October 27, 2021 Financial Report Review "[Microsoft: the most beautiful giant in the post-epidemic era with unparalleled dominance! | Dolphin Analyst] (https://longbridgeapp.com/topics/1255305?invite-code=032064)"

In-depth research

May 30, 2022 "[Microsoft is flawless, the perfection after killing the price] (https://longbridgeapp.com/topics/2695095)"

February 15, 2022 "[Microsoft: Don't blindly focus on poor expectations, having orders and reserves is the hard truth] (https://longbridgeapp.com/topics/1921121)"

November 22, 2021 "[Why can Microsoft stay strong while Alibaba and Tencent decline prematurely?] (https://longbridgeapp.com/topics/1349677)"

Risk disclosure and statement of this article: [Dolphin Analyst's Disclaimer and General Disclosure] (https://support.longbridge.global/topics/misc/dolphin-disclaimer)