Microsoft: A Deflationary Tool for Customers – and a Safe Hedge against Inflation for Investors?

Digital transformation tailwinds continue to drive this sprawling, entrenched enterprise giant

During the Q3 2022 earnings call, CEO Satya Nadella describes Microsoft as a deflationary tool for customers amidst urgent digital transformations:

“…the interesting thing I find from perhaps even past challenges, whether macro or micro, is I don't hear of businesses looking to their IT budgets or digital transformation projects as the place for cuts. If anything, some of these projects are the way they're going to accelerate their transformation or, for that matter, automation, for example. I have not seen this level of demand for automation technology to improve productivity because in an inflationary environment, the only deflationary force is software”

Microsoft (Ticker: MSFT) has so many business units, it can be hard to decipher the numbers. It is a solid quarter, with its all-important cloud story fully intact.

Q3 2022 total revenue was up 18.4%, slightly lower than the 20+% rates reported in the preceding three quarters. But this is to be expected, as it is more due to seasonality and tough comps from last year. Gaming business, for example, grew only 6%, compared to 50% in Q3 2021, as it tapered off with reopening.

Zooming into the collection of future-forward, hypergrowth businesses that drive the bulk of Microsoft’s valuation – Microsoft Cloud. This aggregated “assortment” comprises Azure, Office 365 + Microsoft 365 + Dynamics 365, Linkedin and other cloud services. Though it is only around half of current revenue, growth rate in Q3 2022 hit 32%, consistent with recent quarters. Evidently, there is no slowdown or pull forward seen from Microsoft Cloud. Microsoft continues to lean into the cloud, leveraging on its enterprise sales and distribution channels to bundle, upsell and cross-sell to its installed base of entrenched customer franchises.

Now looking into each of the 3 business segments:

Intelligent Cloud (IC): Strongest segment @26% growth (some inorganic component from Nuance) driven by Azure and steady growth of server sales:

• 46% growth at Azure, which is ~60% of IC segment and continues to outpace everything else

• Azure likely accounts for 50% of Microsoft’s valuation, so its continued hypergrowth rate reinforces the investment thesis on Microsoft

• Intelligent Cloud operating margin @43.5%, an improvement from the 42.5% the year prior

• Ancillary cloud services appear to be growing rapidly: Cosmos DB transactions and data volume increased over 100% year-over-year for the third quarter in a row; number of customers using its security solutions grew nearly 50% year-over-year

More Personal Computing (MPC): +11.4%

• Window grew by 11%; it is still the dominant segment here (>40% of MPC) and a highly profitable (still thriving) cash cow business for Microsoft. Sustained – and growing - commercial demand for PC is a tailwind, as related on the earnings call

• Surface is only about 10% of MPC and grew 13% in Q3

• Gaming and advertising are where the growth initiatives are focused on, with recent Activision and Xandr acquisitions

• Gaming is ~30% of MPC and will grow to ~40% once Activision acquisition is completed

• Search is ~15% of MPC and grew 23% (almost the same as Google and Amazon, which is good)

• More Personal Computing operating margin @33.7%, a slight drop from last year, likely due to slowdown in Gaming business

Productivity and Business Processes (PBP): +16.5%

• The cloud transition to Office 365 (from perpetual) is effectively done – it is now ~90% of total Office revenue

• Office 365 is ~55% of PBP, and though already a mature product, still grew at a high double digit of 17%, driven by seat growth and pricing (since this is no longer a transition from perpetual, growth here is largely organic – impressive)

• Microsoft 365 (consumer segment) is ~10% of PBP – it grew its subscriber base by 16%

• Dynamics – competitor to Salesforce - is ~5% of PBP but grew at 35%

• Linkedin is 20% of PBP and growing fast; Q3 grew 34% due to strong hiring (up 88% year on year) and advertising demand in Marketing Solutions. Also registered record engagement in Q3

• Power Platform surpassed $2 billion in revenue over the past 12 months, up 72% year-over-year, making it one of the fastest growing businesses, at scale

• PBP segment operating margin @45.5%, an improvement from last year

Commercial remaining performance obligation (RPO) increased by 32.5% to $155 billion. RPO continues to accelerate in recent quarters and corroborates with the pace at which Microsoft is winning in the cloud, particularly Azure. However, note that RPO for Microsoft is not immediately comparable to the figures reported by Alphabet and Amazon, because Microsoft’s RPO includes server products, cloud services other than Azure, Office Commercial, Windows Commercial, commercial portion of LinkedIn, Enterprise Services, and Dynamics. Whereas Alphabet’s and Amazon’s RPO figures are primarily GCP and AWS, respectively. Also, Microsoft has a much more mature and larger enterprise customer base, especially compared to GCP – renewals alone likely accounted for the bulk of the $8bn RPO add in Q3 2022.

Taking a step back, it is safe to say that Microsoft continues to execute well, led by Microsoft Cloud. It is an entrenched component of today’s digital fabric, extending across almost every layer, from gaming and ad-tech, to productivity workflows and cloud computing.

Microsoft will remain even more relevant as digital transformations continue to unfold globally.

(Author owns Microsoft shares)

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