Microsoft (NASDAQ:MSFT) did not meet EPS predictions, but the software company presented a solid FQ4'22 earnings sheet nevertheless. Microsoft is seeing continual momentum in its Cloud business, especially regarding Azure which benefits from increasing customer uptake and is driving the entire firm's top line growth. Robust free cash flows and high FCF margins indicate that Microsoft's intrinsic value is growing. While shares dipped after earnings, the market may soon realize Microsoft's deep free cash flow value!
Microsoft's FQ4'22 earnings card
Microsoft missed earnings predictions for its fourth quarter. Microsoft said it had EPS of $2.23 and revenues of $51.87B while the prediction was for Microsoft to reveal EPS of $2.29 and revenues of $52.44B.
Given that Microsoft navigated multiple challenges in its core markets in the last quarter -- including weakness in the PC market and unfavorable foreign exchange rate movement resulting from a strengthening USD -- Microsoft's FQ4'22 earnings card was quite good.
The firm's revenues in FQ4'22 were $51.87B, showing 12% year over year growth. In constant currencies, Microsoft's top line increased 16% year over year. Every segment showed positive year over year growth, with the weakest segment once again being Personal Computing with a growth rate of only 2%.
Intelligent Cloud is (and will remain) Microsoft's top growth driver
With more workloads migrating to the cloud, Microsoft faces favorable long term growth trends in its Intelligent Cloud segment.
Microsoft's Intelligent Cloud business is comprised of server products and cloud services, including Microsoft Azure, for which the company is charging corporate clients lucrative fees.
Intelligent Cloud is not only Microsoft's growth leader but it also compensates for decelerating growth in other business segments, like Personal Computing. Intelligent Cloud generated $20.91B in revenues in FQ4'22 and 20% revenue growth year over year. If it weren't for the strong USD, which appreciated against major currencies in 2022, Intelligent Cloud would have seen 25% top line growth.
Within the Cloud business, Microsoft's growth is driven chiefly by Azure. Azure is Microsoft's public cloud computing platform that allows companies to use analytics, storage, networking and computing services. Microsoft charges customers on a consumption basis, which makes the use of Azure attractive for companies that want to temporarily hire computing power.
Microsoft's Azure business generated 40% year over year revenue growth in FQ4'22 due to strong customer demand. Microsoft Cloud, which includes Azure and other cloud services, generated a gross margin of 69% in the last quarter, a decline of 1 percentage point quarter over quarter. It is by far the company's most profitable business.
Free cash flow
Microsoft generated $65.15B in free cash flow on revenues of $198.27B in the last twelve months, which calculates to a free cash flow margin of 32.9%. In FQ4'22, due chiefly to strong commercial performance in the Cloud business, Microsoft generated $17.76B in free cash flow, implying a 9% year over year growth rate and a FCF margin of 34.2%.
$billions FQ4'22 FQ3'22 FQ2'22 FQ1'22 FQ4'21 Y/Y Growth Revenues $51,865 $49,360 $51,728 $45,317 $46,152 12% Cash Flow From Operating Activities $24,629 $25,386 $14,480 $24,540 $22,710 8% Capital Expenditures ($6,871) ($5,340) ($5,865) ($5,810) ($6,452) 6% Free Cash Flow $17,758 $20,046 $8,615 $18,730 $16,258 9% Free Cash Flow Margin 34.2% 40.6% 16.7% 41.3% 35.2% -
(Source: Author)
Because Microsoft also runs its Cloud platform and sells hardware products like gaming consoles and Surface Laptops, Microsoft has much less exposure to the digital advertising market than other FAANG stocks like Meta Platforms (META) or Alphabet (GOOG) (GOOGL). The digital advertising market is feared to go through a correction as inflation impacts cool consumer spending and advertisers pull back on marketing campaigns. Concerns over a slowdown in the ad market were behind last week's 39% drop in the pricing of Snap (SNAP)'s shares. Microsoft has exposure to the ad market through LinkedIn as well as Search and News advertising.
Because of Meta's and Google's exposure to the advertising market, their shares are trading at low P-FCF ratios of 11.3x and 20.6x. Microsoft's shares trade at a P-FCF ratio of 30.0x but also have much less down-side due to the firm's broader product positioning.
Better-than-expected outlook
Microsoft surprised with its outlook for FY 2023. Despite a continual cooling of the PC market and decelerating growth in Microsoft's non-cloud businesses, the firm said that it sees "double-digit revenue and operating income growth" in FY 2023. Microsoft said that it does not expect the PC market to fundamentally improve and, for that reason, still sees revenue headwinds in Windows OEM, Surface, LinkedIn, Search and news advertising revenue, however. The outlook surprised and indicates that investors have perhaps become too cautious about Microsoft.
Risks with Microsoft
The USD remains a challenge for Microsoft because profits achieved outside of the US are less valuable for the company if the USD keeps appreciating. About half of Microsoft's revenues come from countries other than the US. Besides currency challenges, a slowdown in the Cloud market may impact Microsoft's top line growth rate. With a moderation in growth in key metrics such as free cash flow, investors may see Microsoft's shares revalue lower.
Final thoughts
Microsoft is not as cheap as Meta Platforms or Google, based off of free cash flow, but the stock remains interesting as a growth play on the rapidly expanding cloud market. Companies with strong free cash flow and recession-resistant business models like Microsoft are attractive to own.
Microsoft is less dependent on advertising revenues than other FAANG stocks and has a much more diversified business that includes software, cloud and hardware revenues. Due to its strong free cash flow and weaker reliance on the advertising market, Microsoft's stock is a buy!
The Asian Investor
I look for high-risk, high-reward situations. Five largest portfolio holdings: Bitcoin, SoFi, Alibaba, PayPal, Western Alliance. Early buyer of cryptocurrencies. I live in Thailand :)
Analyst’s Disclosure: I/we have a beneficial long position in the shares of MSFT, GOOG, META either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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