Computing giant Microsoft (MSFT -0.32%) recently reported earnings for the fiscal first quarter of 2023, or the period ending Sept. 30, 2022. There was a lot to unpack from this report. Consumer demand in the personal computer sector has been weak for the last several quarters, and management believes this trend will continue due to cyclical trends such as inflation.
Moreover, the company's social networking platform, LinkedIn, is experiencing a decline in advertising revenue, which isn't entirely surprising given the overall waning demand for ad spending.
However, the beauty of a company like Microsoft is that the company has a number of different levers to generate revenue. And despite the macro environment affecting its core hardware and advertising businesses, there is one end market that seems to be resilient even during times of economic volatility. In this article, we are going to analyze Microsoft's cloud business and how its growth should encourage long-term investors.
Unpacking the big picture
For the quarter ended Sept. 30, 2022, Microsoft reported $50.1 billion in total revenue, up 11% year over year. The primary laggards during the current quarter were the company's gaming services and original equipment manufacturer (OEM) segments, which declined 3% and 15%, respectively. Additionally, devices only increased 2% annually due to weakening demand for the company's flagship hardware product, Surface.
At first glance, this can appear alarming for investors. After all, Microsoft made a name for itself with popular products like Xbox and other hardware. However, the company's CEO Satya Nadella did a nice job of explaining the current economic climate by stating, "based on current trends continuing, we expect our broader commercial business to grow at around 20% in constant currency this fiscal year, as we manage through the cyclical trends affecting our consumer business."
Microsoft's CFO, Amy Hood, echoed Nadella when she stated:
The PC market is cyclical. And we had some great benefits for a couple of years during the pandemic, and we chose not to spend against that favorability over the past couple of years, and it fell to the bottom line, and you saw substantially increased margins over that time period. And we did that potentially because it is a cyclical market. And so in the same way I see it now is that PCs are going to be a tough headwind for us for the year.
Nadella and Hood illustrate that while the consumer business battles lingering market conditions, namely from inflation impacting spending habits, the overall picture for the company appears quite strong. Additionally, it should not be entirely surprising that the personal computing market has cooled down as consumers around the globe ratcheted up their hardware needs during the peak days of the COVID-19 pandemic and remote work. While working from home is still common, consumer needs for additional devices such as laptops has plateaued.
Another segment where Microsoft is experiencing headwinds is LinkedIn. It's important to note that LinkedIn's quarterly revenue increased 17% year over year, which was ahead of management's expectations. However, Hood made it clear that investors should temper expectations for LinkedIn when she said, "reductions in customer advertising spend, which also weakened later in the quarter, impacted search and news advertising and LinkedIn Marketing Solutions."
It is important for investors to remember that the above statements and figures all apply to Microsoft's consumer business. The company also has a large commercial business that is thriving. Let's analyze how and why Microsoft's commercial business seems to outmaneuver the current cyclical dynamics of the market.
The power of the cloud
Cloud computing has become a pillar of modern-day enterprise. Companies rely on data to make decisions, demand top-notch security modules to protect devices such as laptops or phones, and need to be able to communicate with team members around the world seamlessly and efficiently. The power of the cloud provides all of these functions.
For this reason, despite tightening corporate budgets in areas such as advertising, companies like Microsoft, and its competition in Amazon and Alphabet, still generate strong demand from commercial cloud needs. Stated differently, lingering inflation and the prospects of recession are not enough to deter a corporation's need to invest in a scaling cloud business.
A cloud instance can help organizations move forward with existing infrastructure in a more efficient and secure way. For example, one of the biggest selling points for Microsoft Cloud is that Azure can integrate with both SAP and Oracle. This means that companies that use SAP for their workloads or Oracle databases can access sensitive information horizontally, across the organization, among different product groups and do so in a secure environment.
Valuation looks attractive
The notion of valuation can be tricky. It can be tempting to buy a stock that appears cheap due to its low price or pass up on a stock because it seems expensive. And while there is a multitude of valuation methodologies, for a mature and consistently profitable business like Microsoft, price to earnings is usually an acceptable multiple to analyze.
As of the time of this writing, Microsoft is trading at 26 times price to earnings. While this is lower than the 35 times it was trading at during this time last year, Microsoft is definitely commanding a premium. For reference, the long-run average of the S&P 500 is between 15 and 16 times price to earnings.
However, when it comes to Microsoft, there certainly is more than meets the eye. As I've written about previously regarding Alphabet and Amazon, big-tech cloud businesses can almost be thought of as high-growth start-ups operating within a mature business.
For the quarter ended Sept. 30, 2022, Microsoft reported $25.7 billion in cloud revenue, up 24% year over year. Given management's bullish outlook on the commercial business, it is not out of the question for Microsoft to generate $100 billion of annualized revenue for the cloud business alone. Microsoft's current market capitalization is $1.8 trillion.
Similar to what hedge fund analyst Daniel Loeb did for Amazon Web Services, in a scenario where Azure represents just 10% of Microsoft's total value, that implies the cloud could become a $200 billion revenue stream. Given the positive momentum the company has in the cloud, coupled with management's outlook, the rate at which the cloud is growing most likely makes Azure worth materially more than 10% of Microsoft. For this reason, even though the company's overall multiple appears a bit expensive, it's key to remember that it has a multi-hundred billion business that is growing and has not yet peaked. Given these robust growth prospects, Microsoft certainly looks like a compelling long-term buy.