Microsoft earnings: Solid performance, with Azure strength offset by margin pressure in 2024

Microsoft stock at a glance

  • Fair Value Estimate: Increased to $360 from $325
  • Morningstar Rating: 3 stars
  • Morningstar Uncertainty Rating: Medium
  • Morningstar Economic Moat Rating: Wide

Wide-moat Microsoft (NAS: MSFT) reported solid fourth-quarter results, including upside on both the top and bottom lines.

We see continued signs of encouragement in important areas like Azure, which did slightly better than our model; and Microsoft 365, which was solid, based on better-than-expected upsells and renewals. However, the outlook overall was slightly shy of our model. Further, capacity investments in front of artificial intelligence-driven demand will limit near-term margin expansion, which we think is an easy trade given the opportunity.

AI demand building for Microsoft

The upshot of this is that AI demand is already materializing. Lastly, macroeconomic pressures remain but don’t seem to be worsening. We think results are solid overall, and after advancing our model to account for the firm’s year-end, we lift our fair value estimate to $360 per share, from $325, and continue to view shares as attractive.

We see results as reinforcing our long-term thesis centering on the proliferation of hybrid cloud environments and Azure, as the firm continues to use its on-premises dominance to allow clients to move to the cloud at their own pace. We center our growth assumptions around Azure, Microsoft 365 E5 migration, and traction with the Power Platform for long-term value creation. We also see a new growth avenue emerging in the form of AI, where

Microsoft is positioned as a clear leader

Microsoft Cloud continued to grow nicely, driven by Azure strength, and was up 21% year over year in constant currency to $33.3 billion. Growth here was consistent, with the 22% achieved in each of the last two quarters, which, taken together, we view as continued signs of stabilization. Azure grew 27% year over year in constant currency, versus guidance of 26%-27%. Importantly, management noted that more than 50% of the $110 billion commercial cloud revenue was from Azure, which is consistent with our long-running estimate that now reads $58 billion. AI added about 100 basis points of growth to Azure performance and is expected to add 200 basis points of growth in the first quarter.

Management continues to point to lapping challenging comparisons for Azure as elevated workload optimization trends ease beginning in the first quarter, carrying on throughout fiscal 2024. Commentary from Amazon is consistent with this. Management also noted good deal activity for Azure, which we think bodes well for the next couple of years.

For the June quarter, revenue grew 8% year over year as reported, or 10% in constant currency, to $56.19 billion, compared with the midpoint of guidance of $55.35 billion.

Relative to the year-ago period (as reported), productivity and business processes grew 10%, intelligent cloud grew 15%, and more personal computing, or MPC, declined 4%. Compared with guidance, all three segments were slightly ahead of the top end of the guidance ranges. Good sales execution helped drive solid renewals once again. Additionally, AI is already helping drive overall demand, which we expect to accelerate over the next couple of years.

Alphabet earnings: Google search and YouTube growth doubts are subsiding; Stock remains attractive

Alphabet stock at a glance

  • Fair Value Estimate: $161
  • Morningstar Rating: 4 stars
  • Morningstar Uncertainty Rating: High
  • Morningstar Economic Moat Rating: Wide

We maintain our $161 fair value estimate on wide-moat Alphabet (NAS: GOOG) and continue to view it as attractive. Growth in search and cloud, plus a turnaround in YouTube, drove the firm’s impressive second-quarter revenue growth.

Accelerating growth in Google’s core search business demonstrated that the segment’s network effect moat source is intact, despite threats from Microsoft and OpenAI. Also, as we expected, YouTube ad revenue returned to growth due to a more balanced mix of broad-based and direct response ad demand, improvement in YouTube Shorts monetization, and increasing demand for ads on connected TVs. We were surprised by another revenue decline in Google’s advertising technology offerings but expect that segment to improve as economic uncertainty lessens and ad spending across the internet picks up.

Google’s cloud momentum continues

Google’s cloud momentum continued with impressive top-line growth and margin expansion. While management remained cautious about future cloud growth, we look for revenue acceleration, driven mainly by increasing demand for artificial intelligence tools and features.

Total second-quarter revenue came in at $74.6 billion, up 7% from last year. Advertising revenue returned to growth (up more than 3%) after two consecutive quarters of a decline, with improvements in both search (up 5.6%), which was driven by strength in retail, and YouTube (up 4.4%), partially offset by the ongoing weakness in advertising technology revenue (down 5%). Cloud revenue increased 28%, and other services, which includes hardware and Google Play, was up 10%.

Operating income of $21.8 billion (29% margin) was higher than last year’s $19.5 billion (28% margin) helped by a slight decline in traffic acquisition cost as a percentage of advertising revenue and the longer useful lives assumed for servers and other hardware, which resulted in lower depreciation expense. Lower sales, marketing, general, and administrative expenses as a percentage of revenue also contributed to the higher operating margin.

Ad spending improving

We expect ad spending will continue to pick up given the resilient economic backdrop. While ad-holding firms such as Omnicom and IPG disappointed the market recently, we think investors have misperceived their second-quarter results as an indication of lower ad spending. In fact, the media buying segments of those firms posted strong revenue, which indicate that advertising spending by large brands may be picking up. This was supported further by the strong growth in broad-based ad demand on YouTube in the quarter. On the other hand, we continue to think that the firm could be forced to pay higher traffic acquisition fees not only to Apple but also possibly to Samsung.

Regarding search, Google’s second-quarter numbers show no evidence of lost market share to Microsoft Bing. While it is still too early and search revenue deceleration and some market share loss may happen, we think Google will maintain its search dominance. Also, on the earnings call, Google management mentioned that it is receiving positive feedback regarding its generative AI-capable Bard search chatbot and search generative experience, or SGE, the firm’s latest search platform to combine generative AI and traditional listing search.