The beginning of 2023 saw a new wave of mass interest in AI, and it has been a key driver of growth for Microsoft stock. The company’s technological leadership is also projected onto the stock market, allowing the stock to outperform the market. In the 4 months since the last review, Microsoft shares have shown impressive gains of more than 30%. We upgrade our target price on the stock given that the company’s toughest period is behind it and new technology opens up new opportunities for business expansion.
We reiterate a “Hold” rating on Microsoft stock and raise our target price from $286 to $341 for the next 12 months. The upside potential from the current level is 2.2%.
Microsoft Corporation is an American high-tech company, a business and personal software conglomerate and provider of the Microsoft Cloud platform.
The cloud segment remains the main driver of Microsoft’s revenue growth. The cloud computing industry has so far been relatively resilient to the worsening global economy. In 3Q 2023, Microsoft Cloud platform revenue reached a record $28.5 billion, up 22% YoY. Cloud revenue now accounts for 54% of the company’s total revenue.
Microsoft’s leadership in AI presents a huge opportunity for Microsoft. Embedding AI into all products and services is one of Microsoft’s long-term strategic goals. Distribution of products based on AI will help the company to increase revenues from cloud services and enterprise software.
According to Microsoft’s CEO, the creation of an AI-enabled search engine is “the most important thing that has happened to his company in the last 9 years”. Thanks to the addition of AI functionality to the Bing search engine and Edge browser, their share of the search market in the US continues to grow gradually. Microsoft hopes that AI will help it push Alphabet out of the search market.
In 3Q 2023, Microsoft’s total revenue reached a record $52.9 billion (+7% YoY) and significantly exceeded market expectations. The company also reported record revenue and operating profit in two segments – Productivity & Business Processes and Intelligent Cloud. The Personal Computing segment, on the other hand, is stagnating and looks weak due to the unfavourable conditions in the global PC industry.
In 3Q 2023 Microsoft showed a significant improvement in operating and net profit dynamics. Like other companies, Microsoft has to adapt to high inflation and high interest rates. But compared to many tech corporations, Microsoft is doing so without sacrificing operational efficiency. In 3Q 2023 the company’s gross margin increased by 1p to 69%, the operating margin similarly increased by 1p to 42%.
In our valuation of Microsoft shares we used forecasted P/E and EV/EBITDA multiples of U.S. peers. This methodology assumes a 2.2% upside on the stock.
The main risks for Microsoft are high interest rates and increased volatility in the US stock market. There are also risks associated with a slowdown in cloud revenue, tighter AI regulation and the cancellation of the Activision Blizzard acquisition.
Issuer Description
Microsoft Corporation is an American high-tech company, a conglomerate in business and consumer software. Founded in 1976 by Bill Gates and his associates, Microsoft has been publicly traded since 1986. In 2019, the company’s market capitalisation exceeded $1 trillion for the first time, rising above $2 trillion in 2021 for the first time.
Microsoft operates in three main segments: Intelligent Cloud (software products, platforms, devices, services and business solutions in cloud storage), Productivity & Business Processes (development of operating systems, server applications and various business applications) and Personal Computing (manufacture of PCs, tablets, game consoles, smart devices and related accessories, gaming business).
A key area of investment for Microsoft is in AI technology. You could say that artificial intelligence is the starting point for the development of new applications and software products. The beginning of 2023 saw a new wave of mass interest in artificial intelligence. The news that Microsoft had invested $10 billion in OpenAI, the developer of the ChatGPT chatbot, was the occasion. Microsoft is increasingly establishing itself as a leader in the development of AI technology. Leading economists estimate that Microsoft invests about 30% of its total R&D investment in AI, twice as much as Alphabet and Amazon.
Against this backdrop, Microsoft shares have been significantly outperforming indices since the beginning of 2023. The company has a current market capitalisation of around $2.5 trillion.
Outlook and risks
The cloud segment remains the main driver of Microsoft’s revenue growth. The cloud computing industry has so far been resilient to the worsening global economy. Gartner predicts that end-user spending on public clouds will grow 21-22% y/y in 2023-2024, while global ICT spending might only grow 5% y/y over that period. Thus, Microsoft can be confident that its cloud services will be in good demand. In 3Q 2023, Microsoft Cloud platform revenue reached a record $28.5 billion, up 22% YoY. Cloud revenue now accounts for 54% of the company’s total revenue. The cloud platform’s gross margin for the quarter was 72%, up 2 percentage points from last year. Yet cloud revenue growth has been slowing over the past few quarters due to weakness in the global economy and high-base effects, despite a favourable industry environment. In 3Q 2023, revenue for its key product, the Microsoft Azure platform, grew 27% y/y, although just a year ago growth was 46% y/y. The company forecasts Azure growth to slow further to 23-24% YoY in 4Q 2023.
The leadership in AI is an enormous opportunity for Microsoft. Statista estimates the global AI market will grow from $142 billion in 2022 to $1.8 trillion by 2030, at a CAGR of 38%. IDC predicts global AI spending (including hardware, software, IT services) will double from $154 billion to $300 billion by 2026 at a CAGR of 27%. Embedding AI into all products and services is one of Microsoft’s long-term strategic goals. OpenAI’s ChatGPT exists as a standalone product and is also being rolled out gradually to others – Microsoft 365 Copilot, Business Chat, Dynamics 365 Copilot, GitHub Copilot, Viva Sales, Microsoft Azure and others. On the conference call, the CEO said that 36,000 organizations have already tried AI tools on the Power Platform, and the number of Azure OpenAI service users increased 10-fold over the quarter to 2,500. Microsoft also plans to build an AI assistant into the Windows operating system, plans to allow paid advertising in Bing AI chatbot and release technology to help large companies launch their own chatbots using OpenAI ChatGPT technology.
Microsoft CEO Satya Nadella believes the creation of an AI-powered search engine is “the most important thing that has happened to his company in the last nine years”. The company has already announced a new version of the Bing search engine, including a Bing app for iPhone and Android, based on the new big language model Prometheus, which is more powerful than ChatGPT. Bing will be built into new versions of the Edge browser. The Edge browser also features an AI tool for creating images from text descriptions – Bing Image Creator, which is a modified version of the DALL-E 2 neural network. The addition of AI functionality to the Bing search engine has brought the number of its daily active users to 100 million and the number of downloads of the Bing mobile app has increased fourfold. Bing and Edge’s share of the US search market continues to grow gradually, and Microsoft is hoping that AI will help it to challenge Alphabet.
Microsoft has done well in the cybersecurity space, although it has had to compete with industry peers. Microsoft’s cybersecurity services generate more than $20 billion in annual revenues, making it a very big player in the industry – it has a global market share of about 3% in cybersecurity solutions. The cybersecurity industry has outpaced the global IT market by twice the rate of growth over the last 5 years. Fortune Business Insights estimates the long-term growth rate of the industry at an average of 15% annually through 2029.
The Personal Computing segment looks the most problematic, with 3Q 2023 revenue down 9% YoY. In the previous quarter, revenue declined by 19% YoY. The situation remains difficult, but appears to be levelling out. Within this segment, revenue from preinstalled Windows operating systems at 3Q fell by 28% y/y, following a 39% y/y decline in 2Q due to the continued decline in global PC shipments. The global PC market has yet to improve. Canalys estimates that global shipments collapsed by 29% y/y in 4Q 2022 and the decline intensified to 33% y/y in 1Q 2023. PC demand is not expected to start recovering until early 2024. Microsoft’s revenue from other devices declined by 30% YoY in the last reported quarter and Xbox console revenue declined similarly. Microsoft predicts that Personal Computing segment will continue to stagnate in 4Q 2023, showing a 5-8% YoY decline in revenues, with Windows pre-installed operating system revenues likely to decline by 20-25% YoY.
Microsoft is not giving up hope of closing the deal to buy Activision Blizzard. The European Commission has approved this $69bn deal, the biggest in the gaming industry. Microsoft has responded by confirming that it will comply with antitrust authorities’ requirement to license popular Activision Blizzard games (Warcraft, Diablo, Call of Duty, Overwatch, Candy Crush and others) to competing services. That is, Activision Blizzard’s games will not be exclusive to Xbox for 10 years, and other game companies will be able to retain access to them. The deal has also been approved by Japanese and South Korean regulators, but Microsoft has yet to wait for approval from US and UK antitrust authorities. The UK antitrust regulator initially blocked the deal, but the company has appealed, which will be heard by a London court.
Like other companies, Microsoft has to adapt to high inflation and high interest rates. That said, compared to many tech corporations, Microsoft has managed to grow, evolve and invest in innovation without sacrificing operational efficiency. In 3Q 2023 the company’s gross margin increased by 1pc to 69% and operating margin similarly increased by 1pc to 42%. At the beginning of the year, Microsoft cut about 5% of its workforce (10,000-11,000 people), and before that even allowed employees to take indefinite unpaid leave at any time. Microsoft has focused as much as possible on controlling operating costs. Costs and operating costs are not expected to rise more than a few per cent in 4Q 2023.
Return on capital
For the full year 2022 the company paid a dividend of $18.6bn ($2.48 per share), up 10.2% from 2021. In early 2023, as we expected, Microsoft raised its dividend payout to $2.72 per share on an annualised basis. At the start of 2024, which starts in July, there is likely to be another payout increase. We estimate NTM’s dividend yield at 0.9%.
On the buyback side, Microsoft bought back $28bn worth of shares in 2022, up 22% from 2021. However, the buy-back has been drastically reduced from $7.8bn to $4.6bn per quarter since the start of FY2023. Harsh times and optimisation require the company to make such decisions. The last buyback program was in September 2021, when the board authorized a $60bn buyback. We estimate the available buyback volume under the current program to be around $24.4bn (less than 1% of capitalization).
Financial performance and outlook
Based on 3Q 2023 results Microsoft’s total revenue reached a record level of $ 52.9 billion (+7% YoY) and significantly exceeded the forecast range of $ 50.5-51.5 billion and the Refinitiv consensus forecast of $ 51 billion. Microsoft Cloud remains the main driver of revenue growth, with revenues up 22% YoY to a record $28.5bn. However, for two quarters in a row, total revenue growth has been below 10% YoY, a trend seen previously in 2017.
The company reported record revenue and operating profit in two segments – Productivity & Business Processes and Intelligent Cloud. The Productivity & Business Processes segment added 11% YoY in revenue to $17.5bn, while operating profit increased 20% YoY to $8.6bn. In Intelligent Cloud, revenue expanded 16% YoY to $22.1bn, while operating profit rose 13% YoY to $9.5bn.
The Personal Computing segment remained weak due to unfavorable conditions in the global PC industry, but its results were still better than expected. Segment revenues fell 9% YoY to $13.3 billion, Windows PC pre-installation revenues decreased 28% YoY, and device sales, including Xbox gaming consoles, decreased 30% YoY, down from 39% YoY in the prior year quarter in each of these segments. Segment operating profit declined by 12% YoY.
Returning to the overall results, for the reporting quarter, Microsoft’s operating profit exceeded the forecast of $20.6bn to $22.4bn (+10% YoY). The operating margin rose to 42.3% from 41.3% a year earlier. Net income was $18.3bn (+9% YoY) and diluted EPS was $2.45 (+10% YoY), beating Refinitiv’s consensus estimate of $2.24. Compared to the previous quarter, we note a significant improvement in the dynamics of operating and net income, as both indicators recorded a decline in the previous quarter and returned to growth in the reporting quarter.
In 4Q 2023, Microsoft forecasts revenues in the range of $54.8-55.8 billion, which implies growth of 6-8% YoY. Analysts’ consensus is in the middle of this range at $55.5 billion. The Productivity & Business Processes segment is forecast to grow at 8-10% y/y and the Intelligent Cloud segment at around 13-15% y/y. The Personal Computing segment will remain negative, at minus 5-8% YoY. It is interesting to note that Microsoft also gave its forecasts for revenue dynamics for each product line, which it has not done before.
Against the backdrop of a good 1Q report, the forecasts for key metrics for fiscal 2023-2025 were raised slightly. For that period, revenue CAGR is 10%, EBITDA CAGR 12% and net profit CAGR 10%. For FY2023, ending June 30, the consensus is revenues of $211.4bn (previously $209bn), the consensus is EBITDA of $101.9bn (previously $99.6bn), the consensus is net profit of $71.9bn (previously $69.6bn).
