Tough Azure can't save Microsoft in the cycle

After the U.S. market on January 24, Microsoft (NASDAQ: MSFT) announced its financial results for the second quarter of fiscal 2023 ended at the end of December, with the core points as follows:

1. Overall performance is weak, but the core business is strong: Microsoft achieved total revenue of $52.7 billion in the quarter, slightly below market expectations of $53 billion, and revenue growth continued to decline to just 2%. The operating profit for the quarter was $20.4 billion, which was even more different from the expected $21.1 billion, and the overall performance was not good.

However, the key is that the revenue of the company's core productivity sector and smart cloud segment actually slightly exceeded market expectations, mainly dragged down by the "old" personal business sector. Among them, Pearl's Azure business achieved revenue of 14.7 billion, far exceeding market expectations of 13.8 billion, with a year-on-year growth rate of 31%, only slowing down by 4pct from the previous quarter. Other B-side businesses such as Dynamic 365 and Commercial LinkedIn also grew by more than 20%. Therefore, the overall poor interior is that the core B-side business is tougher than expected.

2. The impact of exchange rates is gradually reduced, and the risk of recession will be key: after excluding the exchange loss caused by the appreciation of the US dollar to Microsoft, the company's overall revenue growth rate was 7%, but the growth rate also decreased by 9pct sequentially, which is similar to the slowdown in revenue growth after including foreign exchange factors. And the drag on revenue in the quarter has eased from 5.4% in the previous quarter to 5% in the quarter. In the future, as the US interest rate hike peaks, the US dollar exchange rate is likely to peak and decline, so the impact of the exchange rate on the company's performance should gradually decrease. In terms of regions, the growth rate of US domestic revenue directly and sharply slowed down from 13% in the previous quarter to only 2%, which shows that the actual demand is weakening significantly. Even if the adverse currency headwinds subside significantly next year, a recession could still seriously hurt corporate growth.

3. Surplus growth bottomed out: The contract balance of the company's core 2B cloud business, the "surplus food" - revenue to be recognized, is 189 billion, although the growth rate continues to slow down as the base becomes larger, but the total balance is still at an all-time high, and the future revenue certainty is worry-free. In addition, according to Dolphin Jun, the amount of new 2B contracts signed this quarter was US$47.1 billion, an increase of 7% year-on-year. This is a clear bottoming rebound from 28.3 billion in the previous quarter. However, after excluding exchange rate factors, the growth rate of new contract value is only 4%, compared with 16% growth in the previous quarter, and more than 30% in previous quarters. In this way, the rebound of new contracts signed this quarter is more due to the increase in the proportion of new contracts signed in the United States, and the actual overseas demand is rapidly weakening.

4. Profit deteriorated across the board: Gross profit for the quarter was $35.3 billion, with a gross margin of 66.8%, which was significantly worse than the previous quarter's gross profit of 69.2% and less than market expectations. In addition, the operating expense ratio in the current quarter is also increasing marginally, and Dolphin Jun believes that in addition to the trend increase in labor costs, the severance pay generated by the company's recent layoffs may also lead to an increase in expenses.

In the end, due to the deterioration of costs and expenses, the company achieved an operating profit of 20.4 billion yuan in the quarter, significantly lower than the market expectation of 21.1 billion yuan, and the operating profit also fell by more than 4pct to 38.7% sequentially. Under the influence of inflation, the company's profit growth has been worse than revenue in recent quarters, and this quarter's operating profit fell by 8% year-on-year, and the performance at the profit level was even worse.

5. Guide the bottom of the next quarter, but the market is not satisfied?

Under the guidance of the company, the quarterly revenue center was 51 billion yuan, and the year-on-year growth rate rebounded from 2% in this quarter to 3.3%; The operating profit for the next quarter was 20.5 billion yuan, and the profit margin also improved to 40.2% from 38.7% in the current quarter. It can be seen that the company expects that the next quarter is about to usher in an inflection point in performance. However, according to the after-hours stock price performance, the market is not satisfied with this guidance, which is actually lower than the market's expectations, and the most critical smart cloud sector guidance for the next quarter growth rate is only 14.7%, which is still significantly slowing down from 17.4% in this quarter, making the market worry about the future growth of Pearl Azure's business.

Longbridge Dolphin Jun Viewpoint:

Overall, the company's overall performance in this quarter was not satisfactory in terms of revenue growth and profit performance, growth slowed down further, profit margin also fell further, and profit growth continued to be lower than revenue growth. However, structurally, the company's smart cloud and productivity sectors actually performed better than expected, and the growth rate of B-side or cloud businesses such as Azure, Dynamics 365, and Commercial LinkedIn was significantly better than pessimistic market expectations. The greater resilience and growth potential of the B-side industrial Internet have been once again proven. This is the brightest point in the company's unattractive earnings report.

At the same time, the earnings report also shows that the impact of foreign exchange losses caused by the appreciation of the US dollar interest rate on the company's performance is gradually decreasing, but the growth of the United States, which is not affected by the exchange rate, has fallen rapidly, and the amount of new contracts can also be seen that overseas demand is weakening. The key factor affecting the company's performance is shifting from interest & exchange rates to real economic growth.

Dolphin Jun believes that the current performance of Microsoft is still in the general trend of decline, in this case, judging the marginal inflection point of poor performance is the optimal investment logic. The guidance for the next quarter in the company's conference call does not seem to satisfy the market, and the extent to which the US and European economies will deteriorate in 2023 is not clear, so Dolphin Jun believes that Microsoft's performance inflection point has not yet arrived.

1. Introduction to Microsoft's business composition

Microsoft's business includes B-side cloud services, productivity tool software, advertising services, and C-side personal computers, games, search and other services, and the business is relatively complex. Readers can briefly understand Microsoft's business composition and current situation through the following figure, so as to better understand the following analysis.

Among the many assets listed above:

1. The "productivity and business process" business based on Office has been reborn with the gradual cloudification of traditional software and the transformation of business model to a subscription-based SaaS model, which is a major attraction of the company's performance evolution in the cloud era.

2. The smart cloud business with Azure as the core is the largest fulcrum for Microsoft's re-growth in the industrial Internet era, and it is still growing rapidly. The above two businesses constitute the two core pillars of Microsoft's comeback in the cloud era, and are the core focus of Microsoft's quarterly financial reports.

3. More personal computing businesses, such as C-end products Surface, Xbox and other hardware, game business, Bing search, including Windows business, are more of Microsoft's legacy assets in the mobile era, and the strategic position is the lowest among the three major businesses.

The following is a detailed review of the earnings report

Second, the growth of the core business is not so bad, and it is also a bitter pleasure

2.1 Far stronger than pessimistic expectations, Azure is a pillar of strength

Looking at Azure, Microsoft's most core and most revenue-contributing smart cloud business, the revenue this quarter reached $14.7 billion, with year-on-year growth continuing to decline from 35% in the previous quarter to 31%, and growth continued to slow down for four consecutive quarters. At the same time, the absolute increase in Azure revenue in this quarter was also lower than the same period last year for the first time in recent years, once again proving that the slowdown is not only due to a larger base, but also a real reduction in demand.

Due to the appreciation of the US dollar, it had an adverse foreign exchange impact on Microsoft's overseas revenue. Excluding foreign exchange losses, the real growth rate on the constant Azure exchange rate was 38%, which also slowed down by 4pct sequentially. Therefore, even after adjusting for the adverse effects of exchange rates, the trend of slowing growth is consistent.

However, although Azure can hardly hide the trend deceleration, Azure's performance is quite tough compared to the market's overly pessimistic expectations. The consensus expectation is that Azure's revenue in this quarter is only $13.8 billion, that is, the absolute revenue will not increase sequentially, and the year-on-year growth rate will only be 23%, so the actual revenue of 14.7 billion will far exceed expectations and is one of the biggest highlights in this quarter's financial report.

In line with the trend shown by Azure, the growth of other server businesses in the smart cloud segment is also slowing down, and the growth rate is 3~4pct month-on-month. Among them, the revenue growth rate of non-Azure server business (including SQL server, Visual Studio, etc.) fell from -1% to -5%. Advisory enterprise services revenue growth slowed to 2% in the quarter from 5% in the previous quarter. According to the company, the slowdown in growth is mainly due to weak demand and customers switching to hybrid cloud services.

Overall, because Azure was much stronger than pessimistic expectations, the smart cloud segment achieved revenue of US$21.5 billion in the quarter, which was at the upper end of the company's previous guidance range of 21.2-21.5 billion, and slightly more than the median market expectation of 21.4 billion. Good performance from the perspective of poor expectations.

2.2 Office needs new impetus due to slow volume and price decline, and cloud penetration peak

In the quarter, Microsoft's enterprise-oriented SaaS product Office 365 achieved revenue of $9.7 billion, the year-on-year growth rate was 11% unchanged from the previous quarter, and finally stabilized at a low level after five consecutive quarters of declining growth, but the problem of cloud dividends basically exhausted remains.

From a volume-price perspective: 1) The number of Office365 enterprise monthly subscription customers still increased 12% year-over-year in the quarter, continuing to decline from 14% in the previous quarter. It can be seen that under the situation that the penetration rate of Office cloud is close to the ceiling and the economy is sluggish, the growth of new Office 365 users has slowed down.

2) From the perspective of price, the unit price of Office 365 customers in this quarter still decreased by 2% year-on-year, which has been declining for two consecutive quarters. Despite the adverse effect of the appreciation of the US dollar, the continued negative growth of customer unit prices still reflects that enterprise users are reducing the use of office services or switching to cheaper products.

3) From a cloud penetration perspective, Office365's share of overall enterprise Office revenue declined 1pct to 91% quarter-over-quarter. It can be seen that the cloud penetration rate has stopped at 91% for several consecutive quarters, which can basically confirm that the enterprise Office cloud has touched the ceiling in the medium term, and the subsequent improvement space is very limited. Subsequent growth is more driven by the increase in customer unit price (product price increase or single-user usage increase), but in the current environment, enterprise users "consumption downgrade", so Office's recent performance is not gratifying.

In addition to the core Enterprise Office business, most of the other businesses in the Productivity and Business Processes segment showed a similar slowdown in revenue growth.

Among them, the revenue of the traditional personal Office business has begun to shrink, and this quarter fell 2% year-over-year. Dynamics and LinkedIn, two relatively new businesses, have maintained year-over-year growth of 13% and 10%, but their growth rates have slowed down by several percentage points compared to last quarter.

More subdivided, Dynamics 365, a cloud-based product, and Commercial LinkedIn, which is marketing for enterprises, still have revenue growth of more than 20%. Cloud and enterprise businesses still have stronger growth resilience and space than on-cloud or personal businesses.

Overall, as the growth rate of various segments continued to slow down, the overall revenue growth rate of Microsoft's productivity and business processes segment further fell to 7% this quarter, achieving a total revenue of 17 billion yuan. However, from the perspective of poor expectations, the revenue of the core business of the sector, enterprise Office services, was actually nearly 5% higher than expected, and the overall revenue of the sector also exceeded the guidance limit of 16.9 billion and market expectations, which is also not as bad as the actual performance is as worried.

2.3 To B business cloud penetration rate is still increasing, but it is difficult to hide the slowdown

In order to better evaluate the performance of enterprise business cloudification, Microsoft summarized the cloud revenue in the smart cloud segment and the productivity segment (including the enterprise version of Office 365, Dynamics 365, enterprise LinkedIn and Azure), and the independently disclosed enterprise cloud business revenue reached 27.1 billion, an absolute high again, and the revenue growth rate only slowed down by 1pct to 23% month-on-month, which is significantly smaller than the overall revenue, and the industrial Internet for enterprises is still more resilient.

At the gross margin level, the gross margin of enterprise cloud services decreased by 1pct sequentially in the quarter, according to the company, although the accounting adjustment to extend the depreciation life of servers improved the gross margin center, but the restructuring of user products and higher energy expenses increased the market cost of cloud services.

According to Dolphin Jun's calculations, the proportion of enterprise cloud services in the overall enterprise revenue and the company's total revenue stagnated this quarter, and the proportion was completely consistent with the previous quarter. It can be seen that the sluggish macro situation still slows down the intensity and rhythm of enterprise cloud migration.

Third, the worst PC business in history is not as bad as expected

Compared with the B-side cloud business and productivity business, Microsoft's C-side personal computing business is relatively less important to the market, which belongs to Microsoft's "heritage" business in the PC Internet era. Overall, after the boom period of the "stay-at-home economy" during the epidemic, the PC-related sector is currently experiencing a post-recession period.

In this context, Microsoft's personal computing segment achieved revenue of $14.2 billion in the quarter, down 18% year-on-year, and even significantly lower than the 14.5 billion at the lower limit of guidance, which shows the poor performance of this sector.

In terms of sub-items, 1) Among them, the revenue of Windows business, which is highly correlated with PC shipments, fell by 27% year-on-year, and OEM revenue plummeted by 39% year-on-year.

2) Hardware sales revenue dominated by the Surface product line also decreased by 37% year-on-year

3) Due to last year's high base and the general slump in the overseas game market after the normalization of work, the company's Xbox software and content revenue also shrank by 12% year-on-year, and Xbox hardware sales fell 14% year-on-year.

4) The growth rate of advertising business, which is highly correlated with the macro boom, is also slowing down significantly, from 16% to only 10% this quarter.

Fourth, the key business is strong, and the performance is stronger than the poor

4.1 The total amount is not good, the structure is not bad

Microsoft achieved overall revenue of $52.7 billion in the quarter, basically at the middle of the company's guidance range of 523-533, but slightly below market expectations of $53 billion. While the overall look is below market expectations, the key productivity sectors and smart cloud sectors are both performing better than expected and are at the upper limit of guidance. Azure's pearl business is also significantly stronger than expected. Therefore, although the total amount is not good, the quality of the revenue structure is actually good, mainly dragged down by the hardware-related personal business segment.

4.2 Exchange rate impacts are reduced and recession risks are more problematic

Due to the appreciation of the US dollar and the company's overseas revenue accounting for nearly 50%, foreign exchange losses have had a significant impact on the company's performance in recent quarters. The company's revenue for the quarter increased only 2% year-on-year, and if currency effects are excluded, the actual increase is 7%, but it is also a significant decline from 16% in the previous quarter. Under the floating exchange rate and constant exchange rate, Microsoft's revenue growth rate fell by the same amount, and the drag of exchange rate on revenue in the quarter has been reduced from 5.4% in the previous quarter to 5% in the current quarter. In the future, as the US interest rate hike peaks, the US dollar exchange rate is likely to peak and decline, so the impact of the exchange rate on the company's performance should gradually decrease.

Combined with Microsoft's revenue growth in the U.S. and overseas regions (in US dollars), the growth rate in the US region this quarter directly slowed down sharply from 13% in the previous quarter to only 2%, while the growth rate in overseas regions (in US dollars) was only 1.9%. As can be seen from the growth rate in the US region, which is not affected by exchange rates, the real growth of the company as a whole is indeed weak (mainly dragged down by the personal computing business). At the same time, it is worth noting that the revenue growth rate of overseas regions after excluding the impact of exchange rates is actually higher than that of the United States.

Fifth, the performance of the quarter is difficult to say good, the balance of new signatures has bottomed out in advance?

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

Let's first look at the contract balance of the to B business as a long-term "surplus food": this quarter, the balance of the contract amount for the enterprise side (that is, deferred revenue of unrecognized revenue received for payment + contract amount of unrecognized revenue without payment received) is 189 billion, although the growth rate continues to slow down as the base becomes larger, but the total balance is still at a historical high, and the growth of future revenue is temporarily ignored, and the certainty is basically worry-free.

From a more critical incremental perspective, Dolphin Jun estimated that Microsoft's new 2B contracts this quarter were about $47.1 billion, and the company's disclosed new contract amounts also increased by 7% year-on-year. This is a clear bottoming rebound from 28.3 billion in the previous quarter. However, according to the company's disclosure, after excluding exchange rate factors, the growth rate of new contract value is only 4%, and even in the previous quarter, there was still a 16% increase, and in the past few quarters, it was as high as more than 30%.

In this way, the amount of new contracts signed by Microsoft in overseas regions this quarter should have decreased significantly, while the amount of new contracts signed in the United States was more. This is not good news and may indicate that overseas demand is weakening rapidly in the future.

The company has received cash and is more certain of its short-term "surplus" – deferred revenue at the end of the quarter was $43.9 billion (more than 90% will be recognized as revenue within a year), an increase of 8% year-over-year and also bottoming out from the previous quarter's 7% growth. However, referring to the new contract amount, Dolphin Jun believes that the bottoming rebound of deferred revenue may also be due to the decrease in the proportion of overseas and the increase in the proportion of the United States. From a structural point of view, the deferred revenue growth rate of all businesses is bottoming out.

Sixth, gross profit continued to deteriorate, and the revenue & profit growth rate scissors difference reversed

1) Gross profit for the quarter was US$35.3 billion, with a gross margin of 66.8%, a significant decrease from the previous quarter's gross profit of 69.2% and lower than the market expectation of 67%. Dolphin Jun believes that the main reason for the decline in gross profit is that the impact of the user's use of products to low-priced products, the rise in energy costs for server operations, and the rise in employee labor costs are gradually released.

2) In addition to the deterioration in gross profit, the company's operating expense ratio also increased marginally during the quarter. Sales expenses and administrative expense ratios have increased both month-on-month and year-on-year, and Dolphin Jun believes that in addition to the trend increase in labor costs, the additional expenses generated by the company's recent layoffs may also be one of the reasons, and you can pay attention to how the company's conference call is explained.

Overall, due to the deterioration of costs and expenses, the company achieved an operating profit of 20.4 billion yuan in the quarter, significantly lower than the market expectation of 21.1 billion yuan, and the operating profit also fell by more than 4pct to 38.7% sequentially. Under the influence of inflation and other factors, Microsoft's profit growth rate in the 2020-2022 fiscal year continued to exceed the law of revenue, and in recent quarters, profit growth has been inferior to revenue, and this quarter's operating profit fell by 8% year-on-year. Compared to the slowdown in revenue growth, the performance at the profit level is actually worse.

3) In terms of business segments, except for a brief rebound in profit margins caused by extended server depreciation last quarter, the experience profit margins of all sectors fell again in the inflationary environment. Among them, the personal computing sector deteriorated the most, falling by more than 8pct month-on-month. The absolute amount of operating profit of the other two major sectors also decreased from the previous quarter, and the same increase in revenue was reduced.