We raise our fair value estimate for wide-moat Microsoft (MSFT) to $490 per share, from $435 after the company delivered another good quarter overall, even if it was in line with our expectations on headline numbers.
Key Morningstar Metrics for Microsoft
• Fair Value Estimate: $490
• Morningstar Rating: 3 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium
Microsoft Profitability Forecasts Tweaked
In an earnings call packed with new data points around artificial intelligence-related demand, which were impressive, in our view, the single most important item was guidance that calls for Azure revenue to accelerate in the second half of the year as the current surging investment in data center capacity comes online. Therefore, we raised our revenue growth estimates for the medium term, and we also tweaked our profitability assumptions higher based on consistently good performance and a solid outlook. Revenue was again governed by data center capacity constraints and several pockets of slight weakness arising in Europe. With shares down slightly afterhours following a recent pullback, we see the stock as attractive.
We see results reinforcing our long-term thesis, which centers on the proliferation of hybrid cloud environments and Azure. The firm continues to use its on-premises dominance to allow clients to move to the cloud at their own pace. We center our growth assumptions around Azure, Microsoft 365 E5 migration, and traction with the Power Platform for long-term value creation. AI is also quickly supplementing growth, which we see as another secular driver.
For the June quarter, revenue increased 15% year over year to $64.73 billion, compared with the midpoint of guidance of $64.00 billion. Activision added about $1.68 billion, or 3 points of growth, to revenue. Relative to the year-ago period, productivity and business processes rose 11%, intelligent cloud increased 19%, and more personal computing expanded 14%. Compared with guidance, both PBP and MPC came in above the high end, while IC was just below the midpoint. Good sales execution and sales mix toward software, away from hardware, supported margins.
Microsoft Builds on AI Leadership
We see near-term demand as good, based on stout forward-looking metrics. Commercial bookings grew 19% year over year in constant currency based on strength in large Azure deals, while remaining performance obligations increased 20% year over year to $269 billion. Renewals also remain strong, which we think is partly driven by high interest in AI and consistently good execution.
Intelligent cloud performance was critical in solid results this quarter, as Microsoft continues to distance itself from the pack in terms of AI leadership. Microsoft cloud revenue increased 21% to $36.8 billion. Azure remains the key driver, growing 30% in constant currency, compared with guidance of 30%-31%. We think this trivial hiccup is to blame for a minor after-hours selloff — Azure revenue did not come in at the top end of guidance.
As management has been saying for several quarters, the company is capacity-constrained within Azure. Said another way, despite the book of business being $22 billion quarter and despite capacity issues, Azure still grew 30% year over year, which is impressive and signifies a thirst for AI services on the part of customers. After contributing 300 basis points to Azure growth in the September quarter, 600 basis points in the December quarter, and 700 basis points of growth in the June quarter, AI workloads drove 800 basis points of Azure growth this quarter. Management noted that Copilot customers grew more than 60% sequentially, while Azure AI customers grew nearly 60% year over year to more than 60,000, and customers are already coming back for more seats.
In PBP, office and dynamics continue to power performance and drove solid results. Overall, the segment revenue was up 11% year over year. Dynamics increased 16% in constant currency, Dynamics 365 grew 20% in constant currency, and Office commercial products and cloud services rose 13% in constant currency. Overall small and medium business performed reasonably well, but continued to show signs of moderation, while Copilot add-ons helped per-seat pricing. Lastly, management disclosed that Teams now has more than 3 million premium seats.
Activision Deal Bearing Fruit
MPC drove the most upside relative to the company’s guidance for the second consecutive quarter, with the year-over-year comparison distorted by the Activision acquisition. Windows, Activision, and search and advertising all performed well during the quarter, which supported revenue outperformance. We see early signs of success for the Activision deal, with Diablo 4 added to Game Pass, resulting in strong user adds and engagement.
Due to several pressure points, including the Activision headwinds and accounting changes for server depreciation, margins were largely in line with our expectations. Margins have been a source of strength for most of our coverage in recent quarters. Further, Microsoft continues to make heavy data center capacity investments that will pressure gross margin in fiscal 2025. GAAP operating margin was 43.1%, compared with 43.1% last year and the midpoint of guidance at 42.3%, with relative strength driven by continued careful cost management and favorable product mix. Regarding mix, Xbox and Surface revenue was diminished, while Server, Windows, Azure, and other software solutions were strong.
Guidance was approximately in line overall for the first quarter relative to our estimates, with revenue being slightly shy and EPS slightly better. Management maintained its outlook from last quarter for the full year, which included double-digit revenue growth and a 1-percentage-point decline in operating margin. The outlook for the September quarter calls for revenue of $63.8 billion-$64.8 billion and an implied operating margin of approximately 45.1% at the midpoint. Microsoft expects Azure to grow 29%-30% year over year in the first quarter, which, in a vacuum, is impressive. However, management noted that heavy capital expenditure investment would lead to capacity coming online in the second half of the year, allowing Azure growth to accelerate from already high levels.
Capex is expected to be up again in fiscal 2025. On this point, management indicated that capex was overwhelmingly related to Azure this quarter, and approximately 50% of capex was for long-term assets, such as land and buildings, while 50% was for equipment, including servers and network gear. Microsoft is building to demand signals and can pull back on the equipment side of the equation in relatively short order should demand materialize more slowly than expected. Given early demand signals and the massive success of similar Azure investments more than a decade ago, we believe these investments will pay off for the company and investors.
