Fourth Quarter Highlights and Thesis
Earlier this month, I wrote an article in conjunction with Envision Research to preview CY Q4 revenue for Microsoft (NASDAQ: MSFT). The title of the article, Don’t shoot Triggering before fiscal year 4 results, already summed up almost the entire thesis. The stock price has shown some volatility since then. Despite a strong rally of almost 5% after its fourth quarter (“ER”) earnings report, the stock has lagged the overall market somewhat since then, as you can see in the following chart.
In the preview article, we warned readers of a range of uncertainties and urged them to pay close attention to the following updates when reporting the results: recession risks, global drop in shipments PC, global supply chain disruptions and uncertainties associated with its Activision Blizzard. acquisition. And in this article, we wanted to review his ER with a particular focus on the above issues. We want to elaborate on what is in line with our expectations, what has deviated from our expectations and in which direction so that we can form an outlook for the business ahead.
Overall, yesterday’s ER did indeed shed some light on many of these issues. As you will see, we feel more comfortable with the company now. The decline in PC shipments was not as severe as expected. There are signs of a loosening supply chain. And management sees robust growth in Azure and is committed to maintaining strong CAPEX investments to fuel future growth. Valuation is still high. But we believe that most fundamental and valuation risks have already been eliminated.
Decline in PC shipments and logistics digestion
As detailed in our preview, a key issue to pay attention to during the fourth quarter results is PC shipment data. As mentioned in our preview article:
PC shipping has a direct impact on several MSFT products such as its Windows and Office software installations. Global PC shipments fell 15.3% year-over-year to 71.3 million units in the second quarter of 2022. The decline was worse than expected as supply and logistics tightened. deteriorated further due to lockdowns in China and continued macroeconomic headwinds.
Indeed, its Q4 ER reported a deteriorating PC market, which contributed to a negative impact on Windows OEM revenue. The deterioration was further exacerbated by the scale of the production shutdown in China. In total, these issues created a headwind of more than $300 million. These issues also impacted its other segments such as consulting, research and LinkedIn (total impacts were around $100 million).
The company also had to lower its forecast due to these issues. Namely, for its productivity and business process segment, the initial revenue guidance range was between $16.65 billion and $16.9 billion, and the newly adjusted guidance range was from $16.49 billion to $16.74 billion, a decrease of approximately 1%. In terms of results, the adjustment was a bit larger due to cost, currency and margin considerations. The initial guidance range for operating profit was between $20.9 billion and $21.6 billion, and the newly adjusted guidance range was $20.5 billion to $21.2 billion. dollars, a decrease of approximately 2%.
Overall the impact was pretty light (softer than I thought). And more importantly, the adjusted guidance provided the clarity I was looking for.
Supply chain disruptions
For our second concern about supply chain disruption, unfortunately, we didn’t get too much clarity in the results report. Management spoke at length about how Microsoft products help customers solve supply chain challenges. But they didn’t talk too much about the impact of supply chain challenges on Microsoft itself. The closest comment we can find on this topic is in the following Q&A. It is abbreviated and highlighted by me.
Questions from Philip Winslow (Credit Suisse): …I just wanted to focus on your comments on capital expenditure, but also on usage within Azure, and obviously some of the supply chain issues you have mentioned previously. I wanted to get an idea… of the types of demand trends in relation to the supply chain, how do you feel about the current capacity?
Responses from Amy Hood (MSFT CFO): …So we guided to another quarter of heavy spending in the first quarter in terms of capital (on data centers). Although this is a sequential decline, I would view it more as a matter of timing… We believe we are well placed in terms of capability globally and are working to ensure that our customers can drive the new units they need, the new use what they need in these data centers…. Satya, if you wanted to add something to that.
Response from Satya Nadella (CEO of MSFT): … I think you have understood correctly. And it’s also normal for customers to use more Reserved Instances. And so it’s basically a price reduction, right? So that’s the kind of optimization you see.
As you can see it’s kind of a dance and doesn’t say much. In an earlier press release, Sharif Ibrahim, Managing Director of MSFT Canada, acknowledged the global supply chain disruption on MSFT. The encouraging news is that MSFT has been leveraging its own digitization prowess for about 5 years, so it can easily and quickly move products between factories. And the statement mentioned that “MSFT’s on-time delivery performance remained in the mid-90s, even amidst the global chip shortage.” Additionally, there are signs that global supply chain disruptions are dissipating. As you can see from Drewry’s data below, the cost of global shipping has been steadily falling since the start of 2022. And Drewry’s Global Container Composite Index just fell another 2.6% to $6,820 per 40ft container this week.
Final thoughts and other risks
Overall, I feel more comfortable with the company now. The urgency clarified many of our concerns. Valuation is still a bit elevated, but we believe most valuation risks have already been eliminated due to recent corrections, both relative to the broader market and also to some of its close peers (shown in the graph below). As a particular example, readers familiar with our writings will know that we have consistently argued for poor pricing between MSFT and AAPL in the past. In our view, AAPL has superior profitability, but has traded at a substantial discount to MSFT in the past. But recent corrections and price developments have significantly reduced this gap. As you can see, MSFT now essentially trades at identical multiples to AAPL. Prospective investors, especially long-term oriented investors, may consider building a position gradually from there. Existing investors should feel comfortable holding their shares.
Finally, the ongoing acquisition of ActivisionBlizzard remains an uncertainty. The ER doesn’t mention too many details about the acquisition. But Chief Financial Officer Amy Hood said MSFT still expects the acquisition to close by the end of the fiscal year. Additionally, its current forecast has excluded the impact of the Activision acquisition.