Microsoft earnings: Shares fall but we raise our fair value estimate

Key Morningstar metrics for Microsoft

Fair Value Estimate: $490
Morningstar Rating: 3 stars
Morningstar Economic Moat Rating: Wide
Morningstar Uncertainty Rating: Medium

What we thought of Microsoft’s earnings

We raise our fair value estimate for wide-moat Microsoft (NAS: MSFT) to $490 per share, from $435 after the company delivered another good quarter overall, even if it was in line with our expectations on headline numbers. In an earnings call packed with new data points around artificial intelligence-related demand, which were impressive, in our view, the single most important item was guidance that calls for Azure revenue to accelerate in the second half of the year as the current surging investment in data center capacity comes online.

Therefore, we raised our revenue growth estimates for the medium term, and we also tweaked our profitability assumptions higher based on consistently good performance and a solid outlook. Revenue was again governed by data center capacity constraints and several pockets of slight weakness arising in Europe. With shares down slightly afterhours following a recent pullback, we see the stock as attractive.

We see results reinforcing our long-term thesis, which centers on the proliferation of hybrid cloud environments and Azure. 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. AI is also quickly supplementing growth, which we see as another secular driver.

For the June quarter, revenue increased 15% year over year to $64.73 billion, compared with the midpoint of guidance of $64.00 billion. Activision added about $1.68 billion, or 3 points of growth, to revenue. Relative to the year-ago period, productivity and business processes rose 11%, intelligent cloud increased 19%, and more personal computing expanded 14%. Compared with guidance, both PBP and MPC came in above the high end, while IC was just below the midpoint. Good sales execution and sales mix toward software, away from hardware, supported margins.

Microsoft builds on AI leadership

We see near-term demand as good, based on stout forward-looking metrics. Commercial bookings grew 19% year over year in constant currency based on strength in large Azure deals, while remaining performance obligations increased 20% year over year to $269 billion. Renewals also remain strong, which we think is partly driven by high interest in AI and consistently good execution.

Intelligent cloud performance was critical in solid results this quarter, as Microsoft continues to distance itself from the pack in terms of AI leadership. Microsoft cloud revenue increased 21% to $36.8 billion. Azure remains the key driver, growing 30% in constant currency, compared with guidance of 30%-31%. We think this trivial hiccup is to blame for a minor after-hours selloff — Azure revenue did not come in at the top end of guidance.

As management has been saying for several quarters, the company is capacity-constrained within Azure. Said another way, despite the book of business being $22 billion quarter and despite capacity issues, Azure still grew 30% year over year, which is impressive and signifies a thirst for AI services on the part of customers. After contributing 300 basis points to Azure growth in the September quarter, 600 basis points in the December quarter, and 700 basis points of growth in the June quarter, AI workloads drove 800 basis points of Azure growth this quarter. Management noted that Copilot customers grew more than 60% sequentially, while Azure AI customers grew nearly 60% year over year to more than 60,000, and customers are already coming back for more seats.

In PBP, office and dynamics continue to power performance and drove solid results. Overall, the segment revenue was up 11% year over year. Dynamics increased 16% in constant currency, Dynamics 365 grew 20% in constant currency, and Office commercial products and cloud services rose 13% in constant currency. Overall small and medium business performed reasonably well, but continued to show signs of moderation, while Copilot add-ons helped per-seat pricing. Lastly, management disclosed that Teams now has more than 3 million premium seats.

Activision deal bearing fruit

MPC drove the most upside relative to the company’s guidance for the second consecutive quarter, with the year-over-year comparison distorted by the Activision acquisition. Windows, Activision, and search and advertising all performed well during the quarter, which supported revenue outperformance. We see early signs of success for the Activision deal, with Diablo 4 added to Game Pass, resulting in strong user adds and engagement.

Due to several pressure points, including the Activision headwinds and accounting changes for server depreciation, margins were largely in line with our expectations. Margins have been a source of strength for most of our coverage in recent quarters. Further, Microsoft continues to make heavy data center capacity investments that will pressure gross margin in fiscal 2025. GAAP operating margin was 43.1%, compared with 43.1% last year and the midpoint of guidance at 42.3%, with relative strength driven by continued careful cost management and favorable product mix. Regarding mix, Xbox and Surface revenue was diminished, while Server, Windows, Azure, and other software solutions were strong.

Guidance was approximately in line overall for the first quarter relative to our estimates, with revenue being slightly shy and EPS slightly better. Management maintained its outlook from last quarter for the full year, which included double-digit revenue growth and a 1-percentage-point decline in operating margin. The outlook for the September quarter calls for revenue of $63.8 billion-$64.8 billion and an implied operating margin of approximately 45.1% at the midpoint. Microsoft expects Azure to grow 29%-30% year over year in the first quarter, which, in a vacuum, is impressive. However, management noted that heavy capital expenditure investment would lead to capacity coming online in the second half of the year, allowing Azure growth to accelerate from already high levels.

Capex is expected to be up again in fiscal 2025. On this point, management indicated that capex was overwhelmingly related to Azure this quarter, and approximately 50% of capex was for long-term assets, such as land and buildings, while 50% was for equipment, including servers and network gear. Microsoft is building to demand signals and can pull back on the equipment side of the equation in relatively short order should demand materialize more slowly than expected. Given early demand signals and the massive success of similar Azure investments more than a decade ago, we believe these investments will pay off for the company and investors.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.