Justin Sullivan/Getty Images News
Justin Sullivan/Getty Images News
Earlier this month, I wrote an article in collaboration with Envision Research to preview the CY Q4 earnings for Microsoft (NASDAQ:MSFT ). The title of the article, Don't Pull The Trigger Before FY Q4 Earnings , pretty much summed up the whole thesis already. The stock price showed some volatilities since then. Despite a strong rally of nearly 5% after its Q4 earnings report ("ER"), the stock is lagging the overall market by a little bit since then, as you can see from the following chart.
In the preview article, we cautioned readers about a range of uncertainties and urged readers to pay special attention to the following updates during the earnings report: recession risks, global PC shipment decline, global supply chain disruptions, and the uncertainties associated with its Activision Blizzard acquisition. And in this article, we wanted to review its ER with a particular focus on the above issues. We want to elaborate on what conformed to our expectations, what deviated from our expectations, and in which direction so that we can form an outlook for the business ahead.
Overall, the ER yesterday has indeed provided clarity into many of these issues. As you will see, we feel more comfortable about the business now. The PC shipment decline was not as bad as we expected. There are signs of easing of the supplier chain. And management is seeing robust growth in Azure and is committed to keeping strong CAPEX investment to fuel its further growth. Valuation is still on the lofty end. But we see most of the fundamental and valuation risks cleared already.
As detailed in our preview, a key issue to pay attention to during the Q4 earnings is the PC shipment data. As mentioned in our preview article:
The PC shipment directly impacts several MSFT products such as its Windows and Office software installations. Worldwide PC shipments have declined 15.3% year-over-year to 71.3M units in Q2 2022. The decline was worse than expected as supply and logistics further deteriorated due to the lockdowns in China and persistent macroeconomic headwinds.
Indeed, its Q4 ER reported a deteriorated PC market, which contributed to a negative impact on Windows OEM revenue. The deterioration was further exacerbated by the extent production shut down in China. All told, these issues created a headwind of over $300 million. These issues also impacted its other segments such as advising, search, and LinkedIn (the total impacts were around $100 million).
The business had to lower its guidance also due to these issues. To wit, for its productivity and business processes segment, the initial guidance range for revenues was between $16.65B to $16.9B, and the newly adjusted guidance range was $16.49B to $16.74B, lower by about 1%. In terms of the bottom line, the adjustment was a bit larger due to cost, currency exchanges, and margin considerations. The initial guidance range for operating income was between $20.9B to $21.6B, and the newly adjusted guidance range was $20.5B to $21.2B, lower by about 2%.
Overall, the impact was quite mild (milder than I thought). And more importantly, the adjusted guidance provided the clarity that I was looking for.
For our second concern regarding supply chain interruption, unfortunately, we didn't get too much clarity from the earnings report. Management talked in length about how Microsoft products are helping its clients to navigate the supply chain challenges. But they didn't talk too much about how the supply chain challenges are impacting Microsoft itself. The closest comment we can find on this topic is in the following Q&A exchange. It is abridged and with emphasis added by me.
Questions from Philip Winslow (Credit Suisse): … I just wanted to focus in on your comments about capital spending but also just utilization within Azure, and obviously, some of the supply chain issues you mentioned before. Wanted to get a sense… about sort of demand trends relative to supply chain, how are you feeling about sort of where capacity stands right now?
Answers from Amy Hood (CFO of MSFT): … So hence, we've guided to another strong spending quarter in Q1 in terms of capital (on data centers). Although it's a sequential decline, I would think about that more as being timing … We do feel that we've gotten in a good place on capacity on a global basis and are focused on making sure our customers can drive the new units they need, the new usage they need in those data centers…. Satya, if you wanted to add on anything to that.
Answer from Satya Nadella (CEO of MSFT): … I think that you captured it right. And it is also right that customers are using more reserved instances. And so that's like essentially a price discount, right? So that's the kind of optimization that you see.
As you can see, it's kind of a dance-around and does not tell much. In an earlier pressure release, Sherief Ibrahim, MSFT Canada General Manager, acknowledged the Global Supply Chain Disruption on MSFT. The encouraging news is that MSFT has been leveraging its own prowess in digitization since about 5 years ago, so it can move products around between factories easily and swiftly. And the release mentioned that MSFT's "on-time delivery performance has stayed in the mid-90s even amidst the global chip shortage". Furthermore, there are signs that global supply chain disruptions are clearing up. As you can see from Drewry's data below, the global shipping cost has been in steady decline since the beginning of 2022. And the Drewry's composite World Container Index just decreased by another 2.6% to $6,820 per 40ft container this week.
Overall, I feel more comfortable about the business now. The ER has provided clarity to many of our concerns. Valuation is still a bit on the lofty end, but we see most of the valuation risks cleared already due to recent corrections, both compared to the overall market and also to some of its close peers (shown in the chart below). As a particular example, readers familiar with our writing know that we have been consistently arguing for the mispricing between MSFT and AAPL in the past. In our view, AAPL has superior profitability but has been trading at a substantial discount relative to MSFT in the past. But recent price corrections and development have narrowed that gap considerably. As you can see, MSFT now trades essentially at identical multiples as AAPL. Potential investors, especially long-term-oriented investors, may consider building a position gradually from there. Existing investors should feel comfortable holding onto their shares.
Finally, the pending acquisition of Activision Blizzard remains an uncertainty. The ER does not mention too many specifics about the acquisition. But CFO Amy Hood commented that MSFT still expects the acquisition to close by the end of the fiscal year. Furthermore, its current guidance has excluded the impact of the Activision acquisition.
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This article was written by
** Disclosure** I am associated with Envision Research
I am an economist by training, with a focus on financial economics. After I completed my PhD, I have been professionally working as a quantitative modeler, with a focus on the mortgage market, commercial market, and the banking industry for more than a decade. And at the same time, I have been managing several investment accounts for my family for the past 15 years, going through two market crashes and an incredible long bull market in between.
My writing interests are mostly asset allocation and ETFs, particularly those related to the overall market, bonds, banking and financial sectors, and housing markets. I have been a long time SA reader, and am excited to become a more active participator in this wonderful community!
Disclosure: I/we have a beneficial long position in the shares of AAPL 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.