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No one can stay immune forever, even Microsoft is struggling to hold up.

Microsoft (NASDAQ: MSFT) released its Q1 FY2023 financial report on October 26, after the US stock market closed. Overall, revenue growth continued to slow down under the influence of exchange rate fluctuations, but excluding exchange rate effects, revenue growth remained strong. Gross profit did not improve as expected, but was offset by good cost control. This quarter's performance was satisfactory, but the slower growth in "stored grain" that confirms revenue, significantly lower than expected guidance for the next quarter, and the uncertainty of future performance has made the overall impression less than satisfactory. The main points are as follows:

  1. This quarter's overall performance was still good, with significant impact from exchange rates: Microsoft achieved a total revenue of 50.1 billion US dollars this quarter, slightly higher than the market expectation of 49.7 billion, with a year-on-year growth rate slightly slowing down to 10.6%. This quarter, the operating profit reached 21.5 billion US dollars, slightly higher than the expected 21.1 billion. However, in an environment of slowing demand and high inflation, the quarter-on-quarter operating profit margin has declined by nearly 1.7 percentage points, which has caused the operating profit to only increase by 6% year-on-year, entering a vicious circle of increasing revenue but not increasing profit.

However, as the US dollar has appreciated by more than 10% year-on-year, and Microsoft's overseas revenue accounts for nearly 50%, exchange rate factors have a significant adverse impact on Microsoft's revenue. If exchange rate factors are excluded, the actual revenue growth rate of the company is 16%, which is basically the same as the previous quarter. From this perspective, Microsoft's overall performance this quarter is still good.

  1. Although exchange rates are to blame, the fact is that growth is slowing down: However, excluding exchange rate factors and only looking at the revenue growth rate in the United States, it still slowed down this quarter from 15.1% in the previous quarter to 13.3%, showing that the slowdown in demand is also a fact. At the same time, Microsoft's most important business, Azure cloud services, also saw a sharp decline in revenue growth rate this quarter by 5 percentage points to 35%, and even if exchange rate effects are excluded, the growth rate has also dropped by 4 percentage points. The intelligent cloud sector contributes nearly 60% of Microsoft's valuation, and Azure accounts for almost all of the incremental space in this sector. Therefore, the sustained slowdown in the growth of the core business has to worry the market.

According to the company's conference call, assuming stable exchange rates, Azure's revenue growth rate will further decline by 5% quarter-on-quarter, or about 30%. The main reasons for the slowdown in growth are: 1) for users who are charged based on usage, they are optimizing their usage to save costs, 2) growth of monthly-paying users with higher revenue certainty is significantly slowing down.

  1. The slower growth of "stored grain" has slightly weakened Microsoft's short-term certainty: In addition to the slowdown in revenue growth this quarter, the "stored grain" of the company's core 2B cloud business--the contract balance of unconfirmed revenue--also slowed down from 34% in the previous quarter to 31%.

However, the slowdown in quarter-on-quarter growth in Q1 of this fiscal year is a seasonal rule. With the remaining grain of over 100 billion US dollars still growing by more than 30%, it is still considerable. Therefore, Microsoft's long-term stored grain is still worry-free, but its short-term stored grain is slightly risky.

According to Dolphin Analyst's calculations, the absolute value of new signed 2B contracts this quarter is only about 28 billion US dollars, a year-on-year shrinkage of 3%. This reflects that companies' new investment in cloud services is weakening. In the short term, deferred revenue, which represents "leftover food", was $43.9 billion at the end of the quarter (more than 90% of which is expected to be recognized as revenue within a year), with a growth rate of only 7% in single digits, continuing to slow from the previous quarter's 10%. It can be said that the long-term certainty of enterprise cloud services remains strong, but in the context of a weak macro economy, short- and medium-term certainty is still dim.

4. Gross profit improvement did not meet expectations, companies began to "consume downgrade": As the company announced the extension of the depreciation period for servers, the market originally expected the overall gross margin of the company to increase by nearly 4pct to 72.3% on a month-on-month basis, but the actual figure was only 69.2%. If the favorable impact of depreciation extension is excluded, the gross margin of the company's smart cloud and productivity sectors actually decreased compared with the previous month, and the gross margin performance was significantly lower than expected. Behind this, the reason is that the product structure used by users is inclined towards lower-priced products, or that users are "downgrading consumption".

As verification, the company's average customer unit price for corporate Office 365 in the quarter shrank by 3% year-on-year. The company explained that many of the current new users are small and micro enterprises, and they subscribe to lower-priced services, which dragged down both the customer unit price and gross profit. This is also the main reason why the company's profit growth rate this quarter did not keep up with revenue. If users continue to downgrade consumption and the customer unit price is difficult to increase, the company may continue to be in the vicious circle of increasing revenue but not profit in the medium term.

5. Next quarter's revenue guidance will further slow down: If Microsoft's performance this quarter is still acceptable, the company's guidance for next quarter's performance has made the market feel even more "chill". The company's median guidance revenue is $52.9 billion, implying a year-on-year growth rate of only 2.2%, far below the market expectation of $56.1 billion, and the guidance for the three major sectors is also lower than expected. Even if the exchange rate impact is excluded, the actual revenue growth rate next quarter is only about 8%, which is still half the revenue growth rate this quarter of 16%. It provides the market with a more sluggish and gloomy outlook.

Dolphin Analyst's Viewpoint:

Overall, although Microsoft's financial report for this quarter is still acceptable, and the exchange rate losses caused by the appreciation of the US dollar are mainly responsible, the company's actual operating trend revealed by this quarter's financial report is as follows: 1) the growth rate of core cloud services has slowed significantly even after excluding the exchange rate. Although cloud business users can give the company high long-term business certainty after signing contracts, when the economy is not good, they can still reduce their expenses by reducing usage. Therefore, the short- and medium-term revenue growth rate of cloud business will also have higher uncertainty; 2) Small and micro enterprise users will face more pressure in the near future inflation or possible recession environment. Although these users cannot completely stop using Microsoft's office products, they will also reduce the level or price of using products, thereby reducing their expenses.

Both of these points mean that in the downward economic cycle, Microsoft's short- and medium-term performance may face considerable pressure and fluctuations. The company's contracted balances with growth slowed down, and the conservative guidance given for next quarter also reflects the expected poor performance. Therefore, although Microsoft's long-term logic remains unshaken and the advantages of industrial Internet and cloudification are still reflected in this earnings report, in the medium and short term, Microsoft cannot escape the current economic downturn in Europe and America. Moreover, the poor performance of Microsoft's cloud business also implies a potential risk to the third quarter report of Amazon, which is mainly supported by AWS. Investors need to be vigilant.

Therefore, when the company is oversold, for a company like Microsoft that has no worries in the long run, buying the dip will be a good investment logic.

Dolphin Analyst will later share the telephone conference summary with Longbridge App users and dolphin user groups. Interested users are welcome to add WeChat ID "dolphinR123" to join the Dolphin Investment Research Group and obtain the telephone conference summary for the first time.

Introduction to Microsoft's business structure:

Microsoft's business includes B-end cloud services, productivity software, advertising services, and C-end personal computers, games, search and other services, and the business is relatively complex. Readers can briefly understand Microsoft's business structure and current situation through the following figure, in order to better understand the analysis in the following text.

Among the above-mentioned assets:

  1. The "productivity and business processes" business dominated by Office has gradually revitalized with the cloudification of traditional software and the transformation of business models to subscription-based SaaS models. This is one of the highlights of the company's performance evolution in the cloud era.

  2. The smart cloud business with Azure as the core is the biggest fulcrum for Microsoft to regenerate growth in the era of industrial Internet and is still growing rapidly. These two businesses constitute the two core supports for Microsoft's foray into the cloud era, and are the core focus of every quarterly report.

  3. More personal computer-related businesses, such as C-end products such as Surface, Xbox, game business, Bing search, including Windows business, are more of Microsoft's legacy assets in the mobile era, and have the lowest strategic position among the three businesses.

Detailed review of the earnings report:

2.1 Excluding the impact of exchange rates, Azure's growth has indeed slowed down

First, let's take a look at Azure, the core, and the most revenue-contributing product in Microsoft's smart cloud business. This quarter, it achieved revenue of $13 billion, with a year-on-year growth rate of 35%, significantly down from 40% in the previous quarter. However, according to Dolphin's observation, international banks have a relatively higher growth rate expectation for Azure, between 35% and 38%. Therefore, Azure's growth performance this quarter is still somewhat disappointing and did not show the resilience that the market expected. Although the US dollar has risen sharply recently, which has had a negative impact on Microsoft's overseas revenue from exchange rate losses, even if excluding exchange rate losses, the actual revenue growth rate of Azure on the operational level has fallen from 46% to 42% last quarter, so the reason for the slowdown in Azure growth is more due to weak demand, and exchange rate effects are not the main cause.

However, while Azure's performance is not satisfactory, other non-Azure businesses in the intelligent cloud segment (including SQL Server and Visual Studio) have unexpectedly improved, and revenue growth rate has narrowed from last quarter's sharp decline of 8% to basically unchanged compared to the same period last year this quarter. According to the company, the resilience of non-Azure businesses is mainly due to increased demand from customers for Nuance and hybrid cloud products, and consulting enterprise service revenue growth rate this quarter is also relatively resilient, basically unchanged from last quarter at 5%.

Therefore, although Azure's growth has slowed significantly, with the help of the strong performance of non-Azure businesses, the overall revenue of the intelligent cloud business this quarter reached USD 20.3 billion, and the growth rate remained at 20%, which is basically consistent with market expectations.

2.2 Office Business Volume and Price Decrease, Corporate Office Expenditure also Decreases?

In Q1 FY2023, Microsoft's enterprise office SaaS product, Office 365, achieved revenue of USD 9.3 billion, and the year-on-year growth rate continued to decline from last quarter's 15% to 11%. Since the end of 2021, revenue growth rate has slowed for five consecutive quarters. After the basic completion of the enterprise office cloud process, the office business urgently needs new growth drivers.

From the perspective of volume and price: 1) the growth of Office 365 enterprise subscription users, 2) the average revenue ASP generated by single enterprise users, the reasons for the slowdown in revenue can be analyzed as follows:

  1. This quarter, the number of enterprise monthly subscription customers for Office continues to grow by 14% year-on-year, and there is no slowdown compared to last quarter. However, according to the company, the growth this quarter is mainly due to small and micro enterprises and freelancers, and the growth of medium-sized and large enterprise users may slow down.

  2. If the number of users has stickiness and is still growing year-on-year, then from the price perspective, users will be more sensitive. After the growth in unit price per customer continued to slow down in the previous quarters (due to the strong USD, which offset the increase in Office product prices), the unit price per customer this quarter has fallen to the contraction range, with a year-on-year decrease of around 3%, which is the first time since FY2017 that the unit price for enterprise Office 365 has decreased year-on-year. Although the appreciation of the US dollar has had an adverse effect, the negative growth in unit price also reflects that users are reducing their usage of office services, or subscribing to cheaper products. Moreover, the addition of mostly small and micro-enterprises this quarter is one of the reasons for the decline in unit price.

Looking at the percentage of Office365's share of total Enterprise Office business revenue, there was a small increase of 1% to 92% this quarter. Since entering the 2022 fiscal year, the pace of cloudization has significantly slowed down, and the remaining room for improvement is only in the single digits.

Therefore, when the Office cloudization dividend is basically over, subsequent growth is expected to be driven more by the increase in unit price (product price increase or increase in single user usage). However, in the current economic environment, users have a tendency to "consume downgrading", which results in a decrease in unit price instead of an increase, making it difficult to achieve further growth in Office in the short to medium term.

In addition to the core Enterprise Office business, most of the other businesses in the Productivity and Business Processes segment also showed a similar slowing trend in revenue growth.

Revenue growth rates for Personal Office, Dynamics, and LinkedIn for this quarter are down to 7%, 15%, and 17%, respectively, and growth rates have continued to decline since the 2022 fiscal year (2nd half of 2021).

However, revenue growth rates for cloud-based product Dynamics 365 and Commercial LinkedIn business aimed at enterprise marketing are both above 20%. This indicates that cloud-based or enterprise-based businesses still have stronger growth resilience and space compared to the non-cloud or personal end businesses.

Overall, due to the slowing growth rates of each segment, the total revenue of the Microsoft Productivity and Business Processes segment this quarter was 16.5 billion yuan, with a year-on-year growth rate of only 9.5%, which is slightly higher than the median market expectation of 16.1 billion yuan, but it cannot change the clear and critical issue of revenue growth rates falling in a straight line.

The cloud penetration rate of the To B business is still increasing, but there is no hiding the issue of slowing down.

To better evaluate the performance of enterprise cloudization, Microsoft combined cloud revenue in the Intelligent Cloud and Productivity segments (including Enterprise Office 365, Dynamics 365, Enterprise LinkedIn, and Azure) to independently calculate the revenue for enterprise cloud business, which reached 25.7 billion yuan, a year-on-year increase of 24%, but the growth rate has continued to decline. In addition, according to the disclosure, the gross margin of Microsoft's enterprise cloud services significantly increased by 4pct to 73% this quarter. The main reason is that the company will extend the depreciation period of server equipment from 4 years to 6 years from fiscal year 2023, which significantly reduces depreciation expenses. However, excluding the impact of changing the depreciation period, the gross profit of the company's enterprise cloud business actually decreased by 1pct, due to the migration of product structure towards lower-priced products. In addition, according to the company's conference call disclosure, the cost increase of electricity for the server center also resulted in a decline in gross profit.

However, according to Dolphin Analyst's calculations, the proportion of 2B cloud services in overall 2B business revenue and company revenue continues to increase steadily. Compared to the previous quarter, they have both increased by 3pct to 71% and 51%, respectively. This once again reflects that even in a difficult macro environment, cloud business still has a relative growth advantage. However, this advantage is not enough to reverse the downward trend of the overall environment. The final trend of revenue growth for cloud business is still downward.

3. The worst PC business in history is not as bad as expected

Compared with cloud and productivity business oriented towards the B-end, Microsoft's personal computing business oriented towards the C-end is relatively less valued by the market and belongs to Microsoft's "legacy" business in the PC Internet era. Overall, after going through the peak period of over-consumption purchasing of electronic products such as PCs and mobile phones during the "stay-at-home economy" period of the pandemic, PC shipments have begun to plummet in recent quarters. According to IDC data, PC shipments in the third quarter of this year, excluding Apple Mac, fell sharply by 18.8% year-on-year, marking the largest-ever decline in history. Therefore, the market generally has low expectations for Microsoft's personal business.

The actual situation is basically in line with expectations. Microsoft's personal computing division achieved revenue of $13.3 billion this quarter, with little year-on-year growth. However, in the context of a sharp decline in PC shipments, the performance of flat year-on-year is slightly better than the market's expected decline of 1.4% year-on-year.

Looking at the breakdown,

  1. The revenue of Windows business most related to PC shipments fell by 6% year-on-year, and OEM revenue decreased significantly by 15%.

  2. Despite the global gaming industry downturn, Xbox software and content revenue also declined by 3% YoY, but improved compared to the previous quarter's 6% decline. Xbox hardware sales increased by a whopping 25% YoY.

  3. Search and advertising services, which reflect US macro advertising demand, continued to decline this quarter, with revenue growth slowing to 16% after removing purchase costs, 2pct slower than the previous quarter. Even Microsoft's advertising business, which still has growth potential and a low base, finds it difficult to maintain high growth in an extremely weak advertising market.

4. Continued Slowing Revenue Growth, With Exchange Rates and Falling Demand to Blame

4.1 Overall Revenue Performance: Quantity Is Decent, but the Structure Is Worsening

Microsoft achieved $50.1 billion in overall revenue this quarter, falling in the upper range of the company's guidance of $49.3-50.3 billion and slightly higher than the market's median expectation of $49.7 billion. From this perspective, Microsoft's overall revenue performance seems good. However, in terms of structure, the productivity and personal computing segments outperformed the guidance, while the critical intelligent cloud segment was close to the lower limit of its guidance.

Looking at the absolute growth rates of each segment, the intelligent cloud, which has the highest and market's highest growth expectations, did not perform as well as expected, while the productivity and personal computing segments, with lower growth potential and lower market expectations, did not perform as poorly as expected. Poor performance in key businesses, combined with good performance in peripheral businesses, still leaves a relatively negative impression on the market.

4.2 Exchange Rates and Falling Demand to Blame

However, due to the consecutive interest rate hikes in the US and the sharp rise in US bond yields, global funds are flowing back to the US, causing the US dollar to appreciate significantly against major global currencies. As of mid-October, the US dollar index has risen more than 12% compared to the same period last year. The sharp appreciation of the US dollar also means that overseas income is devalued after conversion to US dollars, which is reflected in the decrease in revenue in the financial report. For Microsoft, whose overseas revenue accounts for nearly 50%, the negative impact of exchange rate losses will be quite significant. So, how much of Microsoft's poor performance this time is due to exchange rates? And how much is actually due to falling demand?

According to the company, after removing the impact of exchange rates, the company's total revenue actually grew by 16% this quarter, consistent with the growth rate of the previous quarter. The negative impact of exchange rates on revenue growth this quarter reached -5.4pct, which is slightly larger than the previous few quarters. It can be seen that exchange rate factors have a significant responsibility for the continued slowing of Microsoft's revenue growth. Combining the revenue growth rate by region (measured in USD), the US still has a growth rate of 13.3% for this quarter, while the growth rate in other overseas regions (measured in USD) is only 7.8%. According to Dolphin Analyst's estimate, the actual growth rate overseas for this quarter exceeds that of the domestic US, but due to exchange rate factors, overseas regions have become a drag on the growth rate.

However, it is worth noting that the domestic US growth rate without exchange rate impacts has also shown a continuous slowdown trend in recent quarters. Therefore, exchange rate factors may have compounded the issue, and the fact that demands for IT services have declined for US domestic companies is also a reality.

Fifth, is Microsoft going to start benefiting from "crumbs" due to sluggish new demand?

Although revenue growth for both cloud and Office businesses has slowed down this quarter, the market is more concerned about the prospects and certainty of future revenue growth in addition to the performance for this quarter.

First, take a look at the contract balance of the long-term "crumbs":

This quarter, the amount of contract balance (deferred income that has already been received but not yet recognized as income + contract balance that has not yet been paid but not unrecognized as income ) for enterprise clients was 180 billion US dollars (of which 81 billion is expected to be recognized as revenue in 12 months), with a year-on-year growth rate of 31%, down from last quarter's 34%. However, from a historical perspective, the seasonal feature of a decrease in contract balance from the fourth quarter of the previous year to the first quarter of the current year is quite normal. The company's long-term "crumbs" are still secure, despite signs of a slight slowdown.

However, while the long-term prospects are secure, they may not be enough to avoid trouble in the short term. Corresponding to the decrease in contract balance ratio, Dolphin Analyst estimates that Microsoft's new 2B contracts for this quarter are worth about 28 billion US dollars, while the official website states that new contract amounts fell by 3% year-on-year. This shows that new demand for IT services is still relatively weak this quarter. If the impact of exchange rates is excluded, the growth rate of new contract amounts disclosed by the company is still 16%, but this is still a significant slowdown compared to last quarter's 35% growth rate.

The company has received higher certainty, short-term "crumbs" -- deferred income at the end of this quarter was 43.9 billion US dollars (over 90% will be recognized as revenue within a year), with a year-on-year growth rate of 7%, which is also a slight decrease from last quarter's 10% growth rate. From a structural point of view, the growth rate of deferred revenue of various businesses has fallen back, among which the most miserable personal computing business's deferred revenue has shrunk by 3% year-on-year. Specifically, the deferred revenue of personal computing business mainly comes from the game business, and the general miserable revenue in the post-epidemic era of games should be the main reason for the year-on-year shrinkage of deferred revenue. The growth rates of deferred revenue of productivity business and intelligent cloud business have also dropped to below 10%.

Therefore, unlike the "leftovers" of confirmed income that accelerated growth despite the slowdown in revenue growth rate in the previous quarter, this quarter not only saw further slowdown in the growth of confirmed income for the quarter, but also in the speed of accumulation of "leftovers". Therefore, the certainty of Microsoft's performance growth in the short and medium term future is somewhat dim, and it may not be able to pass through the possible economic recession in the United States unscathed.

VI. Improvement in gross margin falls short of expectations, but cost control is effective

1) On gross margin performance: In this quarter, the gross profit was USD 34.7 billion, and the gross profit margin was 69.2%. Although it improved compared to the gross profit margin of 68.3% in the previous quarter, it was significantly lower than the market's expected gross profit margin of 72.3%. Dolphin Analyst believes that the shortfall in gross margin from expectations is mainly due to the extended depreciation period offset by the structural downward trend in average product prices used by users. If the depreciation impact is excluded, the gross margins of the intelligent cloud and productivity sectors have actually decreased.

  1. Although the improvement in gross margin falls short of expectations, the company's expenses are still continuously decreasing. The company originally guided the operating expenses for this quarter to be between USD 13.3 to 13.4 billion, and the actual expense spending was USD 13.15 billion, below the lower limit of the guidance. Specifically, only the R&D investment for future investment is relatively rigid, while the subjective and controllable sales and administrative expenses as a proportion of revenue have decreased significantly compared to the previous quarter. Recently, news reports have also emerged that Microsoft will have minor layoffs and suspend recruitment, and it can be expected to have more effective cost control in the future.

Overall, in the case of gross margin below market expectations, the company achieved an operating profit of USD 21.5 billion, which was higher than the market's expected USD 21.1 billion, and the operating profit increased by 3 percentage points to 43% compared to the previous quarter. However, due to the stronger demand and lower inflation environment in the same period last year, the company's operating profit margin year-on-year still decreased. Therefore, the company's operating profit only increased by 6% year-on-year, which is lower than the growth rate of 11% in revenue.

Looking at it by business segment, the operating profits of the Productivity and Intelligent Cloud segments both increased in absolute value this quarter (regardless of MoM or YoY). At the same time, due to the favorable depreciation of servers, the operating profit margins also improved significantly on a MoM basis (but remained basically the same YoY).

However, the operating profit of the Personal Computing segment has declined for 4 consecutive quarters on a MoM basis, and the operating profit margin has also continued to decline, which has clearly dragged down the overall profit of the company.

Microsoft's Past Research:

Financial Report Review

Conference Call on July 27, 2022: "How Microsoft Views Its 23rd Fiscal Year Performance (Conference Call Summary)"

July 27, 2022 Financial report review: "Microsoft: Harder Confidence Under Soft Paralysis"

Conference Call on April 27, 2022: "Microsoft's Journey Is The Real Starry Sea (Q3 Conference Call Summary)"

April 27, 2022 Financial report review: "Microsoft's resilience is the strongest support for the US stock market"

Conference Call on January 26, 2022: "Nadella: "Microsoft is strong because it can see trends before consensus""

January 26, 2022 Financial report review: "No need to worry, Microsoft is still "reliable""

Conference Call on October 27, 2021: "Is Digital Technology the Deflating Force in the Inflationary Era? Take a Look at Nadella's Explanation (Conference Call Summary)"

In-depth Research

May 30, 2022, "Microsoft is Perfect After Killing the Price"

February 15, 2022 "Microsoft: Don't just focus on the poor expectations, having orders and surplus food is the hard truth"

November 22, 2021 "Why is Microsoft even stronger while Ali and Tencent have aged before their time?"

Risk disclosure and statement of this article: [Dolphin Analyst Disclaimer and General Disclosure] (https://support.longbridge.global/topics/misc/dolphin-disclaimer)

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