Microsoft's Strong Earnings Report Struggles Against Pressure from High Valuation

Microsoft announced its Q2 earnings report for fiscal year 2024 after the market closed on January 30th, Eastern Time. The performance exceeded expectations across the board, but shares fell by more than 2% in after-hours trading.

Microsoft's business model has evolved from its early days as a tech giant, initially seizing the PC wave with Windows and Office to dominate the software industry. Now, by capitalizing on the innovative waves of cloud computing and AI, it has once again positioned itself at the forefront of the era. As of the close on Friday, January 12th, Microsoft's market capitalization reached $2.8872 trillion, surpassing Apple's $2.8747 trillion, reclaiming the throne as the world's most valuable company.

So, what exactly is Microsoft's business model, and how has it managed to return to the top after so many years?

Microsoft is a software company that initially gained profit by selling essential office software and Windows operating systems for computers.

However, with the waning of the PC era, Microsoft has developed a more flexible cloud computing business. Leveraging its scale, the company transitioned from a traditional business model of selling consumer electronics products and software services to a long-term paid subscription model.

Overall, Microsoft's products and services are shifting towards a cloud computing pay model, and from one-time sales to rental services, allowing for more sustained and robust growth in profits and cash flow.

Looking at the specific composition of its business, Microsoft's revenue is primarily divided into three segments: Intelligent Cloud, Productivity and Business Processes, and More Personal Computing, which account for 41.48%, 32.69%, and 25.83% of the revenue, respectively. Among these, the Intelligent Cloud business has become the main driver of the company's growth.

Chart: Fiscal Year 2023 Revenue Situation

In FY24 Q2, Microsoft's revenue increased by 17.6% year-over-year to $62 billion, exceeding both company guidance and market consensus expectations. Among its businesses, the Intelligent Cloud segment grew the fastest and was the main driver of the company's revenue growth.

Chart: Microsoft Revenue Performance (in millions of dollars)

The Intelligent Cloud business, which includes Azure, server products, and GitHub, continues to experience high growth driven by the demand for AI. In FY24 Q2, the company's Intelligent Cloud business revenue reached $25.88 billion, a year-over-year increase of 20.4%. Within this, Microsoft Azure and other cloud services revenue grew by 30%, but when adjusted for constant currency, the growth was 28%, which is significantly higher than Google Cloud's 25% growth rate. Driven by AI, Azure's AI services penetration rate has seen a substantial increase, contributing 6% to growth (compared to 1% in the previous quarter).

1) As a traditional provider of enterprise-level software and services, Microsoft has a deep-rooted presence in the enterprise market. Many customers are already using products such as Windows Server, Office 365, and Dynamics 365, and Microsoft's Azure cloud can seamlessly integrate with their existing IT environments.

2) The acceleration of enterprise digital transformation has led to a continuously rising demand for cloud computing. Azure is able to provide comprehensive and advanced Infrastructure as a Service (IaaS), Platform as a Service (PaaS), and Software as a Service (SaaS).

3) Azure has a well-developed development system, emphasizing support for hybrid and multi-cloud, allowing enterprises to flexibly deploy and manage across private clouds, public clouds, and on-premises environments, which is very attractive to customers.

However, in the area of cloud computing, there are also numerous competitors. For example, in certain vertical markets, AWS has a clear advantage due to its early market entry.

Chart: Azure and Other Cloud Services Revenue (in millions of dollars)

Microsoft's Productivity and Business Processes business includes the traditional Office suite of software products, as well as subscription-based products such as Office 365, Microsoft 365, Dynamics 365, LinkedIn, and other SaaS products. In FY24 Q2, Microsoft's Productivity and Business Processes business generated $19.25 billion in revenue, a 13% increase year-over-year, exceeding the expected $19 billion.

Benefiting from Office customers' continued shift to cloud products, the number of subscribers to Microsoft's productivity software and systems has been growing steadily. Additionally, the Average Revenue Per User (ARPU) has been increasing, driven by software and system upgrades resulting from AI enhancements. Revenue from Office commercial products and cloud services grew by 15%, with Office 365 commercial seats increasing by 9%, driven by contributions from small and medium-sized businesses and first-line workers. Office consumer products and cloud services revenue grew by 5% year-over-year, with Microsoft 365 Consumer subscriptions increasing by 16% to 78.4 million. Moreover, revenue from Dynamics products and cloud services for office systems increased by 21%; LinkedIn revenue grew by 9%.

Benefiting from the lightweight asset and scalable business model advantages of software, the operating profit margin for the Productivity and Business Processes business exceeded 53%, and it is expected to maintain this level of profitability in the future.

Microsoft's More Personal Computing segment includes the Windows operating system, Surface hardware, Xbox gaming consoles, and the newly acquired gaming company Activision Blizzard, primarily focused on the traditional PC business.

The acquisition of Activision Blizzard is expected to contribute 15% to growth for the quarter. In FY24 Q2, Microsoft's More Personal Computing business revenue increased by approximately 19% year-over-year to $16.89 billion, slightly exceeding expectations, mainly due to the 15% growth brought about by the completion of the Activision Blizzard acquisition. Furthermore, following the acquisition of Activision Blizzard, substantial growth in gaming and other businesses resulted in Xbox content and services revenue increasing by 61% year-over-year.

Additionally, benefiting from the rebound in the PC market, Windows OEM revenue increased by 11% year-over-year, surpassing expectations, while the decline in device revenue narrowed to 9%.

The operating profit margin for the More Personal Computing business was 25%, which showed a significant decline quarter-over-quarter, primarily due to the increase in operating expenses caused by the acquisition. It is expected that the operating profit margin for this segment will improve once the acquisition-related expenses are gradually absorbed.

The company's profit margin continues to rise, primarily due to capital expenditures being lower than expected and the expansion of operating leverage. In FY24 Q2, the company's gross margin was 68%, a 1 percentage point increase year-over-year. Operating margin was 44%, a 5 percentage point increase year-over-year. Non-GAAP diluted earnings per share (EPS) increased by 26% year-over-year to $2.93, exceeding market consensus expectations.

Microsoft's business model is excellent, with most costs being fixed. As company revenue continues to rise, profit growth becomes more pronounced. The company's costs and expenses mainly come from two areas:

1) Capital Expenditures. Capital expenditures, including finance leases, were $11.5 billion in FY24 Q2, below expectations due to delayed contract deliveries. Cash expenditures for the acquisition of property, plant, and equipment amounted to $9.7 billion.

2) Operating Expenses. Benefiting from the continuous expansion of operating leverage, Microsoft's sales, general and administrative (SG&A) expenses, and research and development (R&D) expenses all saw a year-over-year decline.

Chart: Microsoft's Gross Margin, Operating Margin, and Net Margin Trends

As the company's profitability steadily improves, its free cash flow has seen rapid growth, although the intensity of stock repurchases has declined. In FY24 Q2, the company's free cash flow was $9.1 billion, an increase of 86% year-over-year, indicating abundant cash flow. With the support of ample cash flow, the company returned $8.4 billion to shareholders through dividends and buybacks this quarter, which is lower than in previous quarters. This could be related to the company's currently high valuation and a reduced intensity in buybacks.

Microsoft's performance this fiscal quarter remains very impressive, with both revenue and EPS exceeding expectations. The Intelligent Cloud, Productivity and Business Processes, and More Personal Computing segments all surpassed expectations, and Azure continued to maintain a high growth rate.

For the second half of fiscal year 2024, generative AI is still expected to be the main driving force behind the company's performance growth. It is anticipated that Microsoft Azure cloud and Copilot will become significant drivers of the company's performance growth, for the following main reasons:

1) Microsoft possesses the most comprehensive AI ecosystem, with products and services covering everything from B2B to B2C, and from IaaS to SaaS. By using Copilot to seamlessly integrate products such as Office into its ecosystem, Microsoft holds an irreplaceable competitive advantage in AI products.

2) IT spending across various industries is expected to improve in 2024 compared to 2023. The monetization of AI is expected to drive growth in Microsoft's performance.

3) Microsoft customers continue to have strong demand for Azure AI services, and the contribution of AI to revenue is expected to keep increasing. Additionally, with Copilot opening up from the B2B to the B2C market at the end of 2023, the adoption rate is expected to gradually increase, having a more positive impact on the company's revenue.

Regarding performance guidance, for FY24 Q3, the Productivity and Business Processes segment is expected to have revenues of $19.3 billion to $19.6 billion, representing a year-over-year growth of 10% to 12%. The Intelligent Cloud segment's revenue is projected to reach $26 billion to $26.3 billion, corresponding to a growth of 18% to 19%, with Azure expected to maintain a stable growth rate. More Personal Computing is anticipated to see a revenue increase of 11%-14%, reaching $14.7 billion to $15.1 billion.

In terms of performance, the company is expected to maintain a high double-digit growth in both revenue and EPS for the fiscal years 2024 and 2025. With the expansion of operating leverage, the company's operating profit margin is expected to continue to expand.

Valuation-wise, due to significant increases in the earlier period and high market expectations, Microsoft's current valuation is relatively high, with a PE (TTM) of 39.59x, which is at the upper-mid level historically.

Regarding shareholder returns, the company's free cash flow is expected to continue to grow steadily, providing support for shareholder returns. However, due to the currently high market capitalization, shareholder returns are somewhat diluted, only around 1.2%-1.3%. In the fiscal year 2023, the company spent $38.8 billion on stock repurchases and dividend payments, and $17.5 billion in the first half of fiscal year 2024, with an expected total spend of $35 billion on buybacks and dividends for the full year. With a current market capitalization of $3.04 trillion, the company’s shareholder return rate is approximately 1.2%-1.3%.

From this analysis, it is easier to judge the investment value of Microsoft.