Microsoft Earnings Preview: Increased Spending May Erode Profit Growth

Microsoft is a globally leading technology company with operations spanning worldwide and applications in various fields. Benefiting from the momentum driven by AI concepts and applications, the company’s stock price has increased by 11.67% so far in 2024. However, recently, due to factors such as expectations of interest rate cuts and investor panic, the stock prices of major tech companies, including Microsoft, have seen some declines.

Microsoft primarily profits from three business segments: Intelligent Cloud; Productivity & Business Processes; and More Personal Computing.

The Intelligent Cloud segment includes services related to Microsoft Azure, Windows Server, and data centers. The Productivity & Business Processes segment encompasses content under the Office brand, such as Microsoft Office 2016 to the Microsoft Office 365 cloud suite. The More Personal Computing segment refers to personal products and services such as the Windows operating system, Bing search, personal hardware, and Xbox video games.

According to Microsoft's last quarterly earnings report, the Intelligent Cloud business accounted for approximately 43.18% of total revenue, Productivity & Business Processes accounted for about 31.64%, and More Personal Computing accounted for around 25.19%.

Within the scope of the three business segments, several key areas are worth focusing on in the earnings report: Azure, Office 365, and the gaming business. The continuous growth of AI applications within Azure, stable Office revenue, and the sustained positive impact from the acquisition of Activision are driving significant growth in the revenue of Microsoft's three business segments. Consensus expectations indicate that the company's revenue for Q2 2024 is projected to be $64.477 billion, representing a 4.2% increase from the previous quarter and a 14.75% increase from the same period last year.

Microsoft Azure is a cloud computing platform developed by Microsoft. It offers a range of services, including Software as a Service (SaaS), Platform as a Service (PaaS), and Infrastructure as a Service (IaaS). Microsoft Azure supports numerous programming languages, tools, and frameworks, including both Microsoft-specific and third-party software and systems.

By business segment, Azure falls under Intelligent Cloud, which currently accounts for more than 40% of total revenue. This means that nearly half of Microsoft's revenue is contributed by Intelligent Cloud-related income. Data from Q1 2024 shows that Azure nearly accounted for two-thirds of Intelligent Cloud's revenue. This indicates that Azure is the core component of the Intelligent Cloud business. Additionally, Azure holds a significant share in the overall cloud computing market: according to last quarter's data, Azure captured about 25% of the cloud computing market share, second only to Amazon's 31%.

Azure has distinct advantages over other cloud computing platforms: in terms of software ecosystem, its compatibility with Windows and Microsoft Office provides a highly integrated working environment for users; in terms of AI capabilities, Azure benefits directly from OpenAI's support, allowing it to leverage cutting-edge technological advancements; in terms of infrastructure, multiple data centers and related facilities worldwide support Azure's operations, ensuring high stability and a service range that is not limited by geographical constraints; in terms of business scope, Azure offers a comprehensive range of services covering SaaS, PaaS, and IaaS, capable of performing a wide array of tasks.

Moreover, driven by technological advancement and the generally bullish sentiment of investors towards AI and tech-related developments this year, the U.S. cloud computing services market is gradually expanding. In this environment, the cloud computing platforms of major companies associated with technological trends are expected to see performance improvements in Q2 2024. For instance, Alphabet's recently released Q2 2024 earnings report showed a significant 28.83% year-over-year increase in Google Cloud's revenue and an 8.07% quarter-over-quarter growth. Therefore, Azure's revenue in Q2 2024 is also expected to achieve considerable growth.

As an early shareholder holding 49% of OpenAI, Microsoft is entitled to benefit from OpenAI's technological advancements. This advantage is expected to further bolster Azure's competitive edge in the cloud computing market. With the integration of AI-related technologies, Azure's revenue and related income are likely to increase further: it is estimated that AI contributed approximately $1.3 billion to Azure's revenue in Microsoft's fourth fiscal quarter.

Combining the above analysis, we can make a positive estimate of Azure’s business development prospects: according to Bloomberg consensus estimates, the Intelligent Cloud segment's revenue for Q2 2024 is projected to be $28.716 billion, representing a 7.51% increase from the previous quarter and a 19.69% increase year-over-year; Azure's revenue for Q2 2024 is expected to be $20.448 billion, accounting for 71.20% of the Intelligent Cloud segment's $28.716 billion revenue; the growth rate of Azure's revenue is projected to be 30.46%, slightly lower than last quarter's 31.00%.

Office 365 is a cloud-based service suite offered by Microsoft, combining traditional Microsoft Office software with various online services, enabling users to access their office applications and services from anywhere via the internet. Currently, Office 365 commercial revenue constitutes a major portion of the Productivity & Business Processes segment's revenue. Therefore, the performance of Office 365 significantly impacts the Productivity & Business Processes division.

As Office 365 operates on a subscription model, the number of subscribers is a crucial metric for assessing its performance. In recent years, the number of Office 365 subscribers has steadily increased. As of Q1 2024, the subscriber count reached 80.8 million, representing an approximate 3% growth from Q4 2023. According to Bloomberg consensus estimates, the subscriber count for Q2 2024 is expected to reach 82.76 million, reflecting a 2.42% increase from Q1 2024.

The introduction of Copilot has significantly boosted the sales of productivity tools like Office 365. The Copilot service was initially publicly tested with GitHub in June 2021, and Microsoft 365 Copilot, compatible with Office 365, was announced in March 2023, with a subscription fee of $30 per person per month starting in July 2023. Additionally, Copilot Pro, launched in January this year, allows subscribers to access Copilot within certain Office 365 applications, with a subscription fee of $20 per person per month. This tool provides real-time intelligent assistance, enhancing users' creativity, productivity, and skills. This has considerably increased the efficiency of using office-related productivity tools. Also, since the tool requires a separate subscription fee, the overall Average Revenue Per User (ARPU) for Office suite-related products is expected to continue rising.

Considering that consumers are still in the adoption phase for the Copilot service within Office 365, it will take some time before Office 365 subscribers widely use Copilot services. Additionally, the operational costs in terms of computing power and economics are relatively high, so the true breakout period for this business is expected to take some time (e.g., 1-2 years). As a reference, Piper Sandler previously estimated that the conversion rate for Copilot products would reach 18% by 2026.

Although the revenue growth rate for Office 365 has been slowly declining in recent years, it remains stable at around 15%, indicating that the associated revenue from this office suite is still growing. According to Bloomberg consensus estimates, the Productivity & Business Processes segment's revenue for Q2 2024 is projected to be $20.216 billion, representing a 3.3% increase from the previous quarter and a 10.52% increase year-over-year. Office 365's revenue for Q2 2024 is expected to be $12.076 billion, accounting for 71.20% of the cloud computing revenue of $28.716 billion. The revenue growth rate is projected to be 13.85%, slightly slowing from the previous quarter's 15%.

The gaming business falls under the "More Personal Computing" segment. Following Microsoft's acquisition of Activision Blizzard, gaming has become the largest contributor to the More Personal Computing segment's revenue. In Q1 2024, the gaming industry accounted for 34.99% of More Personal Computing's total revenue, surpassing the contributions from Windows OEM and Windows Commercial Products & Cloud Services.

Microsoft initiated the acquisition of Activision Blizzard in January 2022, and it was completed in October 2023. This acquisition continues to yield benefits for the company. In Q1 2024 (Microsoft's fiscal Q3 2024), the acquisition-related impact led to a 41% increase in operating expenses for More Personal Computing. Conversely, Xbox content and services revenue, influenced by the acquisition, increased by 62%. Overall, the gross margin for More Personal Computing rose by 27% due to the incremental impact of the gaming segment brought by the acquisition. Overall, the acquisition has generated significant revenue for the company.

Microsoft's acquisition of Activision Blizzard will significantly enhance its market share and competitiveness in the gaming industry. Activision Blizzard's well-known games, such as the annual Call of Duty series, will substantially increase the appeal of Xbox subscription services to users. The high revenue and stable profit margins from these gaming franchises will significantly boost Microsoft's financial performance.

The positive impact of the Activision Blizzard acquisition is expected to continue through the end of this year. According to Bloomberg consensus estimates, the More Personal Computing segment’s revenue for Q2 2024 is projected to be $15.551 billion, representing a 0.19% decline from the previous quarter but an 11.84% increase year-over-year. The gaming business's revenue for Q2 2024 is expected to be $4.832 billion, accounting for 31.07% of the More Personal Computing segment's $15.551 billion revenue. The revenue growth rate is projected to be 41.60%, compared to 51.00% in the previous quarter, indicating that the growth impact from the acquisition is gradually being absorbed.

Since Q1 2023, Microsoft has been significantly increasing its capital expenditures at a high growth rate. In 2022, the year-over-year growth rate of capital expenditures was below 10% each quarter. However, starting from Q1 2023, the annual year-over-year growth rate of capital expenditures exceeded 20%, with Q1 2024 reaching an astonishing 65.76%. Data centers constitute a significant portion of Microsoft's capital expenditures. With the rapid growth of its cloud computing business, Microsoft continues to invest in the construction and expansion of global data centers. Additionally, to support its various cloud services and online platforms, Microsoft requires a substantial amount of servers and network equipment infrastructure. These necessary expenditures are aimed at supporting the development of AI and cloud businesses, but the rapidly increasing costs seem to suggest that Microsoft's profitability is under pressure. As a reference, consensus estimates indicate that the company's capital expenditures for Q2 2024 are expected to be $13.273 billion, representing a 21.20% increase from the previous quarter and a 48.43% increase year-over-year.

Furthermore, the acquisition of Activision Blizzard has also contributed to higher operating expenses. Integrating and restructuring human resources and business operations requires time and funds, and the addition of Activision Blizzard's employees will increase Microsoft's operating expenses. The company's operating expenses have been accelerating since 2022 and are expected to continue rising until the costs associated with the acquisition are fully absorbed. Once the impact of the acquisition subsides, the growth rate of the gaming business is also expected to slow down. Consensus estimates indicate that the company's operating expenses for Q2 2024 are projected to be $17.236 billion, representing a 9.28% increase from the previous quarter and a 13.85% increase year-over-year.

Therefore, due to various factors, it is anticipated that the gross margin for Q2 2024 will experience a slight decline. Consensus estimates forecast the company's gross profit for Q2 2024 to be $44.753 billion, representing a 3.22% increase from the previous quarter. The gross margin is expected to be 69.40%, down by 0.7 percentage points from the previous quarter.

Microsoft's increased cost and expenditure investments in Q2 2024 have resulted in business growth that cannot fully cover the rise in costs and expenses. Although there is an overall increase in net profit, the gross margin is likely to see a slight decline. Considering that the AI industry is expected to continue significant growth in the coming years, Microsoft's long-term performance remains promising. As a reference, consensus estimates suggest that Microsoft's EPS for Q2 2024 is projected to be $2.94, unchanged from the previous quarter, but reflecting a 9.18% increase year-over-year. It is noteworthy that in the previous four quarters, the year-over-year EPS growth was 20% or higher, while the expected year-over-year EPS growth for Q2 2024 is less than 10%, which may indicate a slowdown in Microsoft's growth rate.

Overall, the likelihood of Microsoft exceeding investor expectations in Q2 2024 is low. The revenue growth across various business segments is overshadowed by the increase in costs and expenses, suggesting a potential slowdown in the company's growth. Consensus estimates indicate that Microsoft's revenue for Q2 2024 is projected to be $64.477 billion, a 4.2% increase from the previous quarter. However, total costs and expenses are expected to reach $36.955 billion, a 7.81% increase from the previous quarter, exceeding the revenue growth rate. Additionally, Microsoft's EPS for Q2 2024 is estimated to be $2.94, with the year-over-year growth rate falling from over 20% in the past to below 10%.

Shareholder Returns: While the company does distribute dividends at the end of each quarter, Microsoft's current dividend yield is relatively low. As of July 25, the company's trailing twelve-month (TTM) dividend yield was only 0.67%. The company regularly conducts stock buybacks; from May 31, 2023, to May 31, 2024, Microsoft repurchased shares worth a total of $18.36 billion. However, given the company's current market capitalization of $3.19 trillion, the repurchase value constitutes only a small portion of the market cap. Therefore, the primary driver for Microsoft's stock price appreciation remains business growth.

Valuation: Microsoft's forward P/E ratio for the next 12 months is projected to be 33.73, which is relatively high among the top seven tech stocks, indicating the valuation is still on the higher side.

Recent cooling of the AI hype, coupled with strengthened expectations of Federal Reserve rate cuts, has led some profit-taking investors to shift gains from tech stocks to safe-haven assets. Additionally, companies like Tesla and Google, which have already reported earnings, did not meet the high growth expectations of investors, resulting in a decline in their stock prices. Moreover, other tech stocks, including Microsoft, have also experienced declines due to the broader market environment.

For investors holding the stock: It is recommended to adopt a covered call strategy.

For investors not holding the stock: Consider buying puts to profit from a potential decline in the stock price. Alternatively, wait for a price correction and then buy the stock at a lower cost for long-term investment.