Microsoft Earnings Preview: AI and Cyber Security will be Performance Highlights

Microsoft is expected to release its FY23Q4 earnings report after hours on July 25, ET. Microsoft's stock price has risen by 44.64% since the beginning of 2023. Can the stock price continue to rise? Let's take a look at what concerns Microsoft before the earnings release.

Azure continues to attack the leading position. As of Q1 of FY2023, Amazon's AWS continued to occupy the leading global market share, accounting for 32% of the global cloud market; Microsoft's Azure followed closely, ranking second with 23%. And Statista's March survey results show that more users tend to use Azure products in the future, and Azure is expected to continue to catch up with AWS 'leading position.

Figure 1: Cloud Market User Survey Results March 2023

Figure 2: Global Cloud Market Share Distribution in Q1, 2023

Compared with the industry leader AWS, the greater growth potential of Microsoft Cloud as a Service comes in part from the technical advantages of AI empowerment. On May 23, Microsoft launched Azure AI Studio, where developers can build exclusive conversational AI models based on their own data with just a few clicks, attracting many developers in the field of natural language processing. The company plans to build artificial intelligence into every cloud solution in the future. It is expected that in terms of artificial intelligence, Microsoft can earn more than $10 billion a year from developers of its Azure cloud or OpenAI model. After getting the technical help of OpenAI, Microsoft is very active in the layout of AI embedded in various industries. Although the plan is still in the layout, Azure with built-in AI will be more attractive to users in the future.Although Azure's revenue growth has slowed down significantly in the past year, it is expected to gradually stabilize. Since Q2 in FY2022, Azure's year-on-year growth rate has been on a downward trend, from 50% in Q2 in FY2022 to 27% in Q3 in FY2023, and the month-on-month growth rate in FY2023Q3 is only 0.48%. The gradual saturation of the global cloud market and macro headwinds are the main reasons for the decline in Azure's growth rate in the past year. However, as Azure's AI empowering advantages gradually become prominent, the revenue growth rate is expected to gradually stabilize in this quarter, and it is expected to achieve a growth rate of 26% -27%.

Figure 3: Azure business revenue and year-over-year growth rate by quarter from Q1 2019 to Q3 2023 (USD million;%)

Microsoft's security-related revenue has exceeded $20 billion in the past 12 months, and new products are expected to boost the company's revenue in high-growth areas such as cyber security. On the FY2023Q2 earnings call, Microsoft announced security-related revenue of over $20 billion. The cyber security market has broad prospects. According to IDC data, the total global cyber security investment scale will be $195.51 billion in 2022, and it is expected to increase to $297.91 billion in 2026, with a five-year compound growth rate of about 11.9%. Recently, Microsoft once again launched new products in the field of security services edge, Microsoft Entra Internet Access and Entra Private Access, completing the full layout of the cyber security field. Compared with existing cloud cyber security providers such as Zscaler and Cloudflare, Microsoft's integration advantages in computing, networking and security services are unmatched by these companies. According to market analysis by GlobeNewswire, the global security services edge market is expected to grow from $1.90 billion in 2023 to $5.90 billion in 2028, with an estimated CAGR of 25.0%. Microsoft is expected to further increase its revenue by pioneering in this high-growth area.

Figure 4: Overview of the Security Services Edge Market

The pricing of Office 365 Copilot at $30 per user per month has exceeded market expectations. The company has embedded AI models into its Office suite, greatly improving the auto-generation and analytical capabilities of Word, Copilot, PowerPoint, Excel, OneNote, and Outlook, resulting in a significant increase in productivity. After a period of testing, at least 100 out of over 600 enterprise customers have purchased an additional 10,000 subscription accounts at a cost of $100,000 annually ($100 per account per year). On July 18, Microsoft announced that it would price Office 365 Copilot at $30 per user per month at its global partner conference, a 260% increase from what was expected. This suggests that Microsoft believes businesses are willing to pay more for AI features. The pricing of Office 365 Copilot is at least double that of current Office 365 packages, which range from $6 per month to $38 per month per account, and will help increase Office business revenue.

As of FY2023Q3, the company has 384 million paid commercial seats for Office 365, up 11% YoY, and is expected to maintain high single-digit growth rates as penetration increases. Office 365 Copilot can be applied to Microsoft 365 E3, E5, Business Standard, and Business Premium, among other relatively high-paying enterprise users. Its high pricing of $360 per account per year means that the initial target customer base will mainly be large companies. According to enlyft research, among the enterprise subscription users of Microsoft Office 365, 67% have fewer than 50 employees, while only 9% have more than 1,000 employees. Furthermore, 87% of enterprise subscribers have an annual income of less than $10 million.

Bing Chat Enterprise has attracted enterprise users to upgrade their plans. Bing Chat Enterprise has already released a preview version and is now included free of charge in Microsoft 365 E3, E5, Business Standard, and Business Premium, enhancing product value and pushing for upgrades of Office enterprise plans. Additionally, Bing Chat Enterprise will be launched as a standalone product in the future, priced at $5 per account per month, making it convenient to integrate, extract, and analyze internal company data, improve work efficiency, and generate incremental revenue for the company.

Figure 5: FY19Q3-FY23Q3 Office 365 paid commercial seats

LinkedIn's revenue growth rate has gradually declined since Q1 in FY2022, showing a saturation trend, and revenue may continue to decline month-on-month this quarter. Since Q1 in FY2022, LinkedIn's revenue growth rate has begun to decline sharply, falling below 10% in Q2 in FY2023. According to data disclosed by KEPIOS in April, LinkedIn has about 360 million registered members in the United States, India, and Brazil; while China has at least 60 million registered members. In May 2023, LinkedIn announced layoffs and the closure of its app in China, a move that reflects the difficulty of continuing to achieve high growth, and the loss of about 60 million registered members may also lead to a continued decline in revenue in the quarter.

Figure 6: LinkedIn revenue and year-over-year growth rate by quarter from Q1 2019 to Q3 2023 (USD million;%)

4、Windows business enters a cold winter, Blizzard's acquisition brings more possibilitiesThe year-on-year growth rate of Microsoft's Windows system has continued to decline to a negative value since FY2022 Q2, and has entered a bottleneck period. As the operating system with the largest market share in the world, Windows' revenue has shown a clear downward trend. According to GlobalStats data, Windows' share of the US desktop operating system market in February 2023 has fallen to a record low of 57.37%, a far cry from the record high of 92.37% in January 2009. Judging from the data in the past year, the sluggish PC market is the main reason for the weak Windows system revenue. Considering that the PC market has not yet recovered, revenue is expected to decline year-on-year this quarter.

Figure 7: Windows revenue and year-over-year growth by quarter from Q1 2019 to Q3 2023

Figure 8: Quarterly equipment revenue and year-on-year growth rate from Q1 2019 to Q3 2023

Microsoft's acquisition of Activision Blizzard for $69 billion won the approval of the US court, which is expected to achieve a monopoly in the game industry. On July 12, 2023, Microsoft's acquisition of Activision Blizzard was approved by the US court and is expected to become the third largest game group in the world. Up to now, Microsoft's development in the game industry is still relatively difficult. Except for the Xbox game system, which is not as good as Sony's PlayStation and Nintendo, there has been no obvious breakthrough in mobile games, and the post-epidemic travel repair has led to a relative downturn in the game industry. If the acquisition is completed, Microsoft is expected to achieve business upgrades with Blizzard's excellent game quality and brand IP, improve the game ecology, and improve the competitiveness of game subscriptions and Xbox game hardware. Since the acquisition has not yet been implemented, it has little impact on the performance of this quarter. It is expected that the game revenue in Q4 in FY23 will be roughly the same as that in Q4 in FY22.

Figure 9: Game business revenue and year-on-year growth rate by quarter from Q1 2019 to Q3 2023 (USD million;%)

With the continuous implementation of Microsoft's cost reduction and efficiency increase, the marketing rate has continued to fluctuate and decline in the past three years, from the highest point of 15% to about 11%. However, judging from the data of the past three years, Microsoft tends to invest more marketing expenses in FY23Q4. And with the intensification of competition in the cloud market and Microsoft's AI empowerment on Office products, the company still has high promotion needs in these core businesses. Therefore, I expect Microsoft's marketing rate in Q4 of 23 years to continue to remain at around 11%.

Figure 10: Marketing, management, and R & D expense rates by quarter from Q1 2019 to Q3 2023 (%)

Microsoft has carried out a large number of layoffs and salary cuts in 2023, and it is expected that R & D expenses will shrink significantly. In the past year, Microsoft's quarterly R & D expenses have continued to exceed 6 billion, mainly for the development of Cloud as a Service and the game industry. However, since 2023, Microsoft has cut about 10,000 jobs at the beginning of the year in order to reduce costs and increase efficiency, and also announced in May that it will suspend employee salary increases this year. It is expected that the company's reduction in R & D expenses this quarter is expected to further release the company's net profit.

However, due to limited realization of AI commercialization this quarter, we expect limited impact on company performance. Furthermore, traditional businesses such as Windows continue to face challenges due to a sluggish PC market. We predict that revenue growth will remain flat compared to the previous quarter, while cost control remains key to driving Microsoft's profit growth.

Bloomberg's consensus forecast for Microsoft's FY23Q4 predicts operating revenue of $55.45 billion, a YoY increase of 6.92%; adjusted diluted EPS of 2.6, a YoY increase of 14.59%; and net profit of $19.1 billion, a YoY increase of 14.12%.

We expect Microsoft's actual performance in FY23Q4 to be consistent with Bloomberg's consensus forecast. Azure is expected to continue to attract new business based on its new AI development platform, and the company's cost control measures provide stable support for its performance.