VMW - The AI Revolution: Microsoft's Unbeatable Tech Journey Unveiled

2023-07-25 10:15:52 ET

Summary

• This Tuesday, after the bells, Microsoft Corporation, one of the leaders in the technology sector, will publish its financial report for the fourth quarter of fiscal year 2023.
• According to StatCounter, Bing has surpassed Google's share of the U.S. console search engine market.
• Driven by year-on-year growth in net income and an active R&D program, Microsoft is rapidly developing AI technologies being implemented in cloud services and Office products.
• We initiate our coverage of Microsoft stock with an "outperform" rating for the next 12 months.

On July 25, 2023 , Microsoft Corporation ( MSFT ), one of the leaders in the technology sector, will publish its financial report for the fourth quarter of fiscal year 2023.

In addition to the world-famous Windows operating system, which changed the world with widespread adoption on laptops, personal computers, and servers, the company's product portfolio consists of software applications such as Microsoft 365, SQL, Office, and more. Sales revenue of these products showed mixed dynamics in recent quarters due to weakness in consumer spending caused by the Fed's high-interest rate.

However, the situation began to improve in recent months, and Satya Nadella, CEO of Microsoft, continued to please investors with the news. The first is the news of the company's victory in the U.S. Federal Trade Commission battle and the information that the UK Competition and Markets Authority ((CMA)) has begun a second review process on acquiring Activision Blizzard, Inc. (ATVI). Moreover, on July 21, Reuters reported that the CMA would likely be able to reach a new preliminary view on the deal in the second week of August. We believe that the likelihood of Microsoft closing this acquisition is high, which will not only return the company's Gaming segment to a growth path but also reduce the impact of short sellers on its share price.

Furthermore, the company has made massive progress in cloud computing thanks to Microsoft Azure, which has become the main competitor to Amazon Web Services ( AMZN ) and the Alphabet (GOOG) Google Cloud Platform. Microsoft Inspire kicked off on July 18, 2023, where the technology mastodon spoke about Bing Chat Enterprise and provided more information about the Microsoft 365 Copilot artificial intelligence assistant technology. For example, Microsoft 365 Copilot will cost $30 per user per month. We believe that this price is attractive to customers since, taking into account its functionality, the productivity of employees is significantly increased. As a result, demand for Microsoft 365 Copilot will snowball after its commercial release.

On the other hand, thanks to the AI hype and the increase in the number of users of the Azure OpenAI service, since the beginning of 2023, Microsoft's share price has shown growth of more than 44%, outperforming such major competitors in the technology sector as Oracle ( ORCL ), VMware ( VMW ), and Alphabet.

We initiate our coverage of Microsoft with an "outperform" rating for the next 12 months.

The financial position of Microsoft and its prospects

Microsoft's revenue for the first three months of 2023 was $52.86 billion, up 0.21% from the previous quarter and 7.1% from the third quarter of fiscal year 2022. Besides that, the company's actual revenue has beaten analysts' consensus estimates in seven of the last nine quarters, suggesting that Wall Street is underestimating Microsoft.

We believe that thanks to the innovative strategies implemented by Satya Nadella, the company is effectively coping with tougher competition in the industry and the slow pace of recovery in consumer spending in China.

In recent months, the company does not stop at the progress made and develops and sells tablets, game consoles, and other popular devices worldwide. The company's key operating segment is Intelligent Cloud, contributing about 41.8% of Microsoft's total revenue for Q3 FY 2023.

According to Seeking Alpha , Microsoft's revenue for Q4 FY 2023 is expected to be $54.71-$56.2 billion, up 8.6% from analysts' expectations for Q3 FY23. At the same time, under our model, the total revenue of Microsoft will be within this range and amount to $55.7 billion.

The sharp increase in revenue relative to the previous year will be provided by two of its sources - Server Products and Cloud Services and Office Products and Cloud Services. Microsoft management continues to invest hundreds of millions of dollars in developing AI technology and its subsequent implementation in various company services. So on the earnings call , the company's CEO stated the following.

We're also bringing next-generation AI to Power Platform so anyone can automate workflows, create apps or web pages, build virtual agents and analyze data using only natural language.

More than 36,000 organizations have already used existing AI-powered capabilities in Power Platform. And with our new Copilot in Power Apps, we are extending these capabilities to end users who can interact with any app through conversation instead of clicks. All up, we now have nearly 33 million monthly active users of Power Platform, up nearly 50% year-over-year.

After gradually adding AI functionality and making further improvements to the once-fading Bing, we have seen an increase in user satisfaction in recent weeks. As a result, the number of downloads of the Bing mobile app is growing at a high rate, ultimately positively impacting advertising revenue and beyond. According to StatCounter , Bing has surpassed Google's share of the U.S. console search engine market.

One of the main factors behind Microsoft's industry leadership and revenue growth is its active R&D policy. Thanks to it, there is an increase in devices, corporate products, and services that not only increase the efficiency of business processes but also improve interaction with customers. As a result, the company can attract more users and advertisers to its platforms. Microsoft's R&D spending continued to rise and was $6.99 billion in Q3 FY 2023, or 13.2% of total revenue, one of the largest in the sector.

Microsoft's Q3 FY 2023 operating income margin was 42.29%, up from the previous quarter and above its median of 41.8% between January 1, 2021, and the end of March 2023. At the same time, we expect that by 2023 the operating income margin of the company will remain stable and reach 43.5%, and by 2024 this value will increase to 45.1% due to the launch of new products, lower inflation, and increased demand for Azure and other cloud services.

The company's earnings per share for the first three months of 2023 was $2.45, up 5.2% quarter-on-quarter, and just as notably, it beat analyst consensus estimates in eight of the last nine quarters.

According to Seeking Alpha, Microsoft's FY23 Q4 EPS is expected to be $2.45-$2.62, up 14.8% from the Q3 FY23 consensus estimate. While we believe these are low expectations, our model puts Microsoft's EPS at $2.58.

At the same time, Microsoft's Non-GAAP P/E [TTM] is 36.77x, 91.5% more than the average for the sector and 15.98% more than the average over the past five years.

On the other hand, the Non-GAAP P/E [FWD] of 35.09x is one of the factors indicating that Microsoft Corporation is slightly overvalued amid the AI euphoria reigning on Wall Street and the sharp slowdown in consumer prices in the U.S. and the Eurozone.

A key reason for Microsoft's beating consensus EPS in recent quarters is also the active use of the share repurchase program. For the third quarter of fiscal year 2023, Microsoft bought back about $5.51 billion of its shares. At the same time, at the end of March 2023, the remaining authorization to buy back Microsoft's shares amounted to $26.9 billion , allowing its management to minimize the impact of short sellers on the company's share price.

Conclusion

This Tuesday, July 25, after the bell, Microsoft Corporation, one of the leaders in the technology sector, will publish its financial report for the fourth quarter of fiscal year 2023.

In recent weeks, Satya Nadella continued to delight investors with news of the successful promotion of the deal to acquire Activision Blizzard. Microsoft wins the legal fight against the U.S. Federal Trade Commission. In addition, on July 21, Reuters reported that the Competition and Markets Authority would likely be able to reach a new preliminary view on the deal in the second week of August. We believe that the likelihood of Microsoft closing this acquisition is high, eventually leading to faster development of the company's Gaming segment.

We believe that gaming communities with millions of users will continue to grow and develop, creating substantial commercial opportunities for the company. In today's fast-paced world, games are one of the most essential assets to drive the evolution of the Metaverse platforms. Ultimately, the deal to acquire Activision Blizzard will allow Microsoft Corporation to expand significantly in fast-growing markets such as China and India and gain access to various gaming technologies.

Driven by year-on-year growth in net income and an active R&D program, Microsoft Corporation is rapidly developing AI technologies being implemented in cloud services and Office products. Microsoft's dividend yield of 0.79%, a drop in total debt/EBITDA ratio to a record low of 0.79x, and a remaining $26.9 billion buyback authorization for the company's shares are just some of the many investment theses that make this tech mastodon an attractive asset for long-term investors.

We initiate our coverage of Microsoft with an "outperform" rating for the next 12 months.

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