In the world of investing, a share price can be punished even when it puts in an otherwise decent result. It all comes down to performance vs. expectations, as those expectations are the basis for the share price heading into earnings season.
In the latest quarter, Microsoft missed expectations for both revenue and earnings. Does that make it a bad company? Even more confusingly, why is the share price up 7.5% in the past week despite the miss?
Investors seem to be looking through this cycle and with good reason.
The macroeconomic challenges facing US tech companies can’t be ignored, so let’s start there.
Firstly, the US dollar has been on a rampage (ironically due to recessionary fears in the US – it’s a long story) and this impacts international revenue. Pricing needs to be adapted for each market and this lowers the average revenue per user (ARPU) in international markets. With a cost base that is primarily in the US and packed to the rafters with highly paid developers, this squeezes margins for US tech firms.
The second issue is inflation. Those highly paid developers are demanding increases and so is everyone else, which puts an even tighter squeeze on margins unless product pricing can be increased by a similar percentage. Increases aren’t always possible, creating a structural drop in margins. Sometimes it’s just a timing issue, as pricing increases aren’t as immediate as inflationary pressure on staff costs. In these scenarios, margins take a knock for a couple of quarters before bouncing back in a big way.
Microsoft isn’t immune to these issues. In the quarter ended June 2022 (the final quarter of the 2022 financial year), revenue increased 12% as reported and 16% in constant currency, so there’s the impact of the strong dollar coming through. The constant currency percentage gives a better idea of the true underlying growth in the business.
Margin pressure is visible further down, with operating income up 8% as reported and 14% in constant currency. Both of those percentages are lower than revenue growth, which immediately tells you that margins are lower.
It gets worse the further down you look, with diluted earnings per share just 3% higher as reported and 8% in constant currency.
In a low inflation environment, you typically see operating leverage come through – the benefit of growing revenue off a relatively fixed cost base. The percentage growth in revenue is usually lower than the percentage growth in profits. In a high inflation environment, the opposite effect comes through and profit growth lags revenue growth as margins compress.
These margin pressures are temporary. Either staff costs will normalise or pricing will be increased to compensate for it, as the world has no choice but to run on Microsoft products. This is the benefit of being the fabric of the world’s computing systems.
A highlight in this result was Microsoft Cloud, which grew revenue by 28% year-on-year. Azure and other cloud services grew by 40%. Office 365 Commercial revenue grew by 15% and the number of Microsoft 365 Consumer subscribers grew to 59.7 million, so the core businesses that have defined Satya Nadella’s tenure as CEO are looking alive and well.
Despite their substantial scale, they are still growing quickly. This is a key focus area for investors.
Bucking the trend at many other social platforms, LinkedIn grew revenue by 26%. It helps to appeal to professionals rather than teenagers who are always ready to move on to the next fad.
It’s not all good news, obviously. Xbox content and services revenue fell 6%, admittedly after a couple of years of incredible growth as people Stayed Home and Stayed Safe with a gaming console working overtime to entertain them.
Another issue was the extended production shutdown in China and a deteriorating PC market, which drove a decrease in Windows OEM revenue of $300 million. Revenue growth would’ve been 65 basis points higher were it not for this issue. Of course, every company loves the “were it not” argument – the reality is that “it was” and shareholders must live with it.
This quarter clearly wasn’t what Microsoft investors are accustomed to seeing. When looking at the full financial year though, the power of Microsoft is clear.
Revenue was up 18%, operating income increased 19% and diluted earnings per share was 20% higher. Even with such a tough fourth quarter, the correct “shape” of the income statement (higher profit growth than revenue growth) was achieved.
As a final observation, Microsoft’s full year R&D spend increased by 18%. For context, sales and marketing expenses only increased by 8.5%.
Accelerating spend on R&D is a trend we are observing in many tech companies at the moment. They are all competing with one other and fighting over the same talent. That’s ok provided the return on investment is appealing (like in Microsoft) but becomes problematic for companies that have a questionable business model (like Twitter and Snap Inc).
In good times and in bad, one thing I am confident of is Microsoft’s position at the forefront of the tech industry. Based on the share price growth in response to this nasty quarter, the market seems to feel the same way.