ORCL - Microsoft: Reset In Expectations For 2023

Summary

• Using multiple levers to drive revenue, Microsoft is demonstrating its ability to drive growth in revenue through pricing actions.
• The partnership with a leading financial services firm shows continued strength in cloud in the current macro backdrop.
• Azure expectations have been reset, in my view, after the recent miss and weak results from AWS.
• My 1-year target price for Microsoft is $305, implying 27% upside from current levels.

With the stock price of Microsoft (MSFT) down 30% in 2022, 2023 could be a year of redemption for the company.

Investment thesis

I think the recent sell off was due to weakness in its Azure segment as well as operating margins. That said, I continue to see Microsoft as a solid investment for the long-term given their strong competitive advantage with its full, comprehensive suite of products and offerings, as well as its durable growth profile. Recently, Microsoft announced its strategic partnership with a major financial services player that demonstrated strength in the sector for Microsoft, while the company continues to use different levers for growth, including price hikes. Lastly, expectations for Microsoft seems to have been de-risked following last quarter and the risk reward looks attractive at current levels.

I have written an earlier article on why I think Microsoft's previous quarter was misinterpreted, which brings an opportunity to investors.

Pricing as a revenue driver

Microsoft seems to be tilting more towards selling price increases as a main driver for revenue growth, at least more so than it has in the recent past.

The first big change came in 2022, when Microsoft announced big Office 365 and Microsoft 365 price increases. This was the first substantive pricing update since Office 365 was launched a decade ago. This pricing update was communicated as a reflection of the increased innovation that Microsoft has brought to customers in the last 10 years, in the aspect of communications, security and artificial intelligence. I think that the pricing update, though it was the biggest one in recent years, was still accepted by customers. This is more so due to the pricing power and strong competitive positioning that Microsoft enjoys today. For Microsoft to be able to leverage on price as a mechanism for revenue growth shows the strong competitive advantage in the Office and Microsoft 365 suite of products.

On top of that price change, there were three other pricing changes that I noticed. The first is a material price increase for all Microsoft SQL Server on-premise database licenses of 10%. This price hike will start on January 1, 2023, and represents a material price increase on Microsoft's largest component of the large Server Product segment. In FY2022, this segment contributed $23.5 billion in revenues, with on-premise SQL Server database revenues estimated to contribute slightly more than 40% of this. This could encourage Microsoft's customers to buy ahead of the price increase and, in particular, the strength in Server Product growth in the September and December quarter could be explained by the material price increase. Furthermore, this price increase helps the company to meet its commercial revenue growth target for FY2023. For the Azure-hosted SQL Server database services, there were no price changes announced. I would also add that Oracle ( ORCL ), one of Microsoft's database rivals also recently increased its database support fees by 8%. Secondly, Microsoft will also be moving to USD-based pricing for all Microsoft Cloud services starting January 1. This includes Azure and will replace existing local currency price lists. This pricing will be adjusted twice a year according to local foreign exchange rates. This does not affect customers that have existing subscriptions until the end of the subscription and there will be no price changes for them until then. The current pricing does align Microsoft more with AWS and helps to reduce the impact of foreign exchange rates. Lastly, there was also a new Azure pricing plan called Azure Savings Plans, where customers can lower their per-unit price point by making at least a one-year commitment but offering more flexibility than Reserved Instances.

Strength in financial services cloud

Microsoft's partnership with London Stock Exchange Group ("LSEG") brings with it increasing financial services cloud strength. This is a 10-year strategic partnership with LSEG and along with this partnership Microsoft will be purchasing 4% of LSEG equity and brings a sizeable $2.8 billion cloud contract to Microsoft. This brings strong signals that there is increasing strength in financials for Microsoft and how it is able to be a strong value proposition to financial customers looking to migrate to the cloud. Microsoft sees this strategic investment in LSEG as part of its broader verticalization strategy as LSEG has data and analytics assets that can be used to realize $2.2 billion in incremental revenues beyond 2025.

The goal of this partnership between the two companies is to migrate LSEG's data platform to Azure, utilize Azure Machine Learning to co-develop new data analytics and modeling tools for the industry, as well as to enhance the Refinitiv Workspace by incorporating Teams, Microsoft 365, and built-in compliance features.

The $2.8 billion in Azure cloud spend will likely be back-end loaded, in my view, considering the typical ramp up period. LSEG expects that it will have £250-£300M in incremental cash costs, which will be paid from 2023 to 2025. This translates to about 12% of the committed cloud spend and will add about 0.15% lift in additional Azure revenue over the period from 2023 to 2025. As a result, most of the cloud revenue contribution from the partnership will come in from 2026 onwards.

I think that the significance for the announcement of partnership with LSEG comes in that financial services and exchanges continue to see strong cloud demand. This current deal between Microsoft and LSEG is quite similar to Google ( GOOG ) Cloud's $1 billion equity investment in and 10-year cloud partnership with CME Group ( CME ) and Amazon ( AMZN )'s multi-year partnership with Nasdaq ( NDAQ ), both of which were announced in 2021.

Other key Microsoft updates

For Azure, Microsoft continues to see optimizations continue as a result of the increased prioritization of workloads. The key risk and opportunities for Azure's growth relative to guidance in October will thus be largely affected by broad changes to the macro environment, like cloud consumption, amongst others.

In addition, Microsoft recently told its partner network that any Commercial Cloud products in local currency will be potentially reassessed at the start of 2023. This comes as many geographies have not seen pricing adjusted for historical currency changes. As a result, customers could potentially face higher prices when they renew their contracts. This is another price action that Microsoft looks to take to improve revenue growth in the near-term.

Azure expectations reset

After speaking to several sell-side analysts on their forecast and forward assumptions for Azure in the next few quarters, they have modeled a far more pessimistic view of Azure growth in the next three quarters (December 2022, March 2023 and June 2023). The general consensus is a steeper 4% deceleration in each of March 2023 and June 203 quarters. Given the current macro backdrop, I think that the caution in these sell-side analysts forecasts is warranted given that there continues to be pressure coming from continued slower new workload as optimization efforts persist, lower than expected Azure growth, AWS results and outlook disappointing market. At the end of the day this would leave Azure with 29% constant currency growth.

The bottom line is Azure remains an attractive asset and growth driver in the long-term, and the recent fears and weakness in macro has resulted in a more de-risked forecast for the segment that allows for easier beats on lower expectations for Azure.

Valuation

I used both the P/E multiple method and the DCF method to value Microsoft. Firstly, I made the assumption of 25x for the company's forward P/E, implying a premium of about 25% to its peer group due to strong competitive positioning and a resilient growth profile. For my DCF assumptions, I discounted the cash flows at 9% and used a terminal multiple of 16x. On a relative valuation perspective, Microsoft is currently trading at a P/E of 25x for FY2023 and 21x FY2024. While near-term headwinds remain as well as a weaker macro backdrop, I think that this allows investors to accumulate a company with strong structural tailwinds and attractive risk reward perspective. My one-year target price for Microsoft is $305, implying 27% upside from current levels.

Risks

Weaker spending in IT

If the macro backdrop continues to worsen, this will result in more sour business sentiment and result in a reduced willingness to spend. Microsoft depends on companies and small businesses to spend on IT and a smaller proportion of IT budgets and spending will certainly lead to a slower growth profile for a company like Microsoft.

Weaker cloud migration

The risk is that the cloud migration pace may be slowing in the current environment as we have seen a deceleration in Azure's growth rate. While this was said to be due to the optimization of the current workloads of its customers, if customers start to slow down their pace of cloud migration, this could lead to more worrying trends for Azure.

Competition

The key for Microsoft to compete is its strong suite of products and offerings. That said, there are software companies that specialize in each offering that may provide better depth, coverage and have better technology in a particular aspect of Microsoft's offerings. As a result, the company needs to continue to innovate to be able to fend off against these threats.

Conclusion

Microsoft continues to be a core holding, in my view, due to strong structural tailwinds for its business. The near-term headwinds that the company is currently facing will prove to be a great buying opportunity for patient investors and the company continues to have a solid and durable growth profile in my view. My one-year target price for Microsoft is $305, implying 27% upside from current levels.

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