All figures in US$ unless otherwise specified.

Key Financial Data (YE June 30, $M)
  2022 2023E 2024E
Cash and cash equivalents $104,757 $132,456 $164,520
Working Capital $74,602 $97,324 $128,792
Total Assets $364,840 $416,146 $477,520
Revenue $198,270 $208,188 $233,629
Net Income $72,738 $67,172 $79,398
EPS Diluted ($) $9.70 $8.95 $10.53
MSFT and NASDAQ, YTD and 12M
  YTD 12M
MSFT 4% -17%
NASDAQ 10% -14%

Quarterly Revenue

Q2 revenue was up just 2% YoY (Q1 was up 11%), and 2% lower than our estimate. Management is expecting 2%-4% growth in Q3. The largest revenue segment (server products and cloud services; 37% of total revenue) registered the highest growth (22% YoY), followed by LinkedIn (10%). In contrast, revenue from Windows, Gaming, and Devices declined due to lower global PC and console sales.

Product Revenue Breakdown
($M) Q2-2022 Q3-2022 Q4-2022 Q1-2023 Q2-2023
Server products and cloud services 16,382 17,038 18,861 18,388 19,594
% growth 28.7% 29.0% 22.0% 22.0% 19.6%
as a % of revenue 31.7% 34.5% 36.4% 36.7% 37.1%
Office products and cloud services 11,251 11,164 11,660 11,548 11,837
% growth 13.9% 11.5% 9.0% 6.8% 5.2%
as a % of revenue 21.8% 22.6% 22.5% 23.0% 22.4%
Windows 6,594 6,077 6,946 5,313 4,808
% growth 15.4% 11.2% 0.7% -6.4% -27.1%
as a % of revenue 12.7% 12.3% 13.4% 10.6% 9.1%
Gaming 5,442 3,740 3,455 3,610 4,758
% growth 8.2% 5.9% -7.0% 0.5% -12.6%
as a % of revenue 10.5% 7.6% 6.7% 7.2% 9.0%
Search advertising 3,064 2,945 2,300 2,928 3,223
% growth 40.3% 22.7% 15.0% 10.2% 5.2%
as a % of revenue 5.9% 6.0% 4.4% 5.8% 6.1%
LinkedIn 3,531 3,437 3,712 3,663 3,876
% growth 37.0% 34.2% 26.1% 16.8% 9.8%
as a % of revenue 6.8% 7.0% 7.2% 7.3% 7.3%
Enterprise Services 1,823 1,891 1,902 1,876 1,862
% growth 7.6% 4.9% 5.2% 4.7% 2.1%
as a % of revenue 3.5% 3.8% 3.7% 3.7% 3.5%
Devices 2,357 1,764 1,597 1,448 1,430
% growth 11.2% 10.3% 10.0% 2.4% -39.3%
as a % of revenue 4.6% 3.6% 3.1% 2.9% 2.7%
Other 1,284 1,304 1,432 1,348 1,359
% growth 12.3% 15.9% 21.5% 14.7% 5.8%
as a % of revenue 2.5% 2.6% 2.8% 2.7% 2.6%
Total 51,728 49,360 51,865 50,122 52,747
% growth 20.1% 18.4% 12.4% 10.6% 2.0%

Azure continues to spearhead the Intelligent Cloud segment. Revenue from Personal Computing contracted on weaker Windows and gaming revenue.

Three Months Ended December 31th
  Q2-2022 Q2-2023 Growth
Revenue Segments      
Productivity and Business Processes $15,936 $17,002 7%
Intelligent Cloud $18,262 $21,508 18%
More Personal Computing $17,530 $14,237 -19%
Total $51,728 $52,747 2%
Operating Income      
Productivity and Business Processes $7,688 $8,175 6%
Intelligent Cloud $8,323 $8,904 7%
More Personal Computing $6,236 $3,320 -47%
Total $22,247 $20,399 -8%

EBITDA and Net margins fell due to higher R&D and G&A expenses.

Margins
Margins Q2-2021 Q3-2021 Q4-2021 Q1-2022 Q2-2022 Q3-2022 Q4-2022 Q1-2023 Q2-2023
Gross 67% 69% 70% 70% 67% 68% 68% 69% 67%
EBITDA 48% 48% 49% 52% 50% 49% 47% 48% 46%
EBIT 42% 41% 41% 45% 43% 41% 40% 43% 39%
Net 36% 37% 36% 45% 36% 34% 32% 35% 31%
Expenses as % of Revenues
Expenses as % of Revenues Q2-2021 Q3-2021 Q4-2021 Q1-2022 Q2-2022 Q3-2022 Q4-2022 Q1-2023 Q2-2023
Research and development 11% 12% 12% 12% 11% 13% 13% 13% 13%
Sales and marketing 11% 12% 13% 10% 10% 11% 12% 10% 11%
General and administrative 3% 3% 3% 3% 3% 3% 3% 3% 4%

Adjusted EPS was down 5% YoY, and 2% below our estimate.

($M): Revenue, EBITDA, Net Income, EPS ($)
($M) Q2-2022 Q3-2022 Q4-2022 FY-2022 Q1-2023 Q2-2023
Revenue 51,728 49,360 51,865 198,270 50,122 52,747
EBITDA 25,743 24,137 24,513 97,843 24,308 24,047
Net Income 18,765 16,728 16,740 72,738 17,556 16,425
EPS ($) 2.48 2.22 2.23 9.65 2.35 2.20

FCF was down 43% YoY.

Summary of Cash Flows (YE June 30, $M)
Summary of Cash Flows (YE June 30, $M) FY 2022 Q2-2022 Q2-2023
Cash Flows from Operations 89,035 14,480 11,173
Cash Flows from Investing -30,311 -1,161 -7,150
Cash Flows from Financing -58,876 -11,986 -11,349
Exchange Rate -141 106 88
Net Change -293 1,439 -7,238
Free Cash Flows 65,149 8,615 4,899

Balance sheet remains strong.

Liquidity & Capital Structure (YE June 30, $ million)
Liquidity & Capital Structure (YE June 30, $ million) Q2-2022 Q3-2022 Q4-2022 FY-2022 Q1-2023 Q2-2023
Cash 125,369 104,693 104,757 104,757 107,262 99,508
Working Capital 96,678 76,483 74,602 74,602 73,423 76,105
Current Ratio 2.2 2.0 1.8 1.8 1.8 1.9
LT Debt 48,260 48,177 47,032 47,032 45,374 44,119
Total Debt 53,258 49,926 49,781 49,781 48,622 48,116
Total Debt/Capital 33% 31% 30% 30% 28% 26%
Long Term Debt/Capital 30% 30% 28% 28% 26% 24%

FRC Projections and Valuation

We are lowering our FY2023 and FY2024 EPS forecasts.

Old and New FY-2023E and FY-2024E: Revenue, EBITDA, Net Income, EPS ($)
($M) Old FY-2023E New FY-2023E Old FY-2024E New FY-2024E
Revenue 222,045 208,188 259,099 233,629
EBITDA 105,637 96,922 124,078 114,899
Net Income 73,975 67,172 86,225 79,398
EPS ($) 9.88 8.95 11.46 10.53

FRC Discounted Cash Flow Model

As a result, our DCF valuation declined by 8%, from $298 to $274.

FRC Discounted Cash Flow Model
   
Enterprise Value ($ M) 1,991,314
Add: Cash - Debt 51,392
Equity Value ($M) 2,042,706
Shares Outstanding (M) 7,451
Target Price ($) 274.15
Current Price ($) 248.16
Upside/Downside 10.5%

Relative Valuation

Since our previous report in November 2022, MSFT and the NASDAQ are up 13% and 11%, respectively. Sector multiples are up 11%. MSFT is trading at a 42% premium over its peers (previously 28%).

Comparable Companies
Comparable Companies P/E FY23E P/E FY24E
Microsoft Corp 27.73 23.56
Alphabet Inc 18.03 15.40
Amazon.com Inc 60.01 33.44
Apple Inc 21.84 20.70
Cisco Systems Inc 13.52 12.51
International Business Machines Corp 14.65 13.85
Oracle Corp 18.27 16.07
SAP SE 19.60 16.78
Average Market Multiples (excl. outliers) 19.1x 17.0x
Median Market Multiples 18.9x 16.4x
MSFT's Premium 45% 39%

Our comparables valuation is up 1% due to higher sector multiples, partially offset by lower EPS estimates. Our fair value estimate is down 4%, from $270 to $259.

Relative Valuation - MSFT
Relative Valuation - MSFT  
EPS 2023E ($) $8.95
EPS 2024E ($) $10.53
Target P/E multiple for 2023E (x) - 40% premium to avg 26.7x
Target P/E Multiple for 2024E (x) - 40% premium to avg 23.8x
Fair value per share ($) - P/E Multiple (2023E) $239.19
Fair value per share ($) - P/E Multiple (2024E) $250.39
Valuation Method, Fair Value per share ($) and Weight
Valuation Method Fair Value per share ($) Weight
DCF Valuation $274.15 50.0%
Fair value per share ($) - P/E Multiple (2023E) $239.19 25.0%
Fair value per share ($) - P/E Multiple (2024E) $250.39 25.0%
Fair Value Estimate ($) $259.47  
Current Price ($) $248.16  
Upside/(Downside) 4.6%  
Forward Dividend Yield 1.1%  
Total return including dividends 5.7%  

Although the Fed is likely to slow or pause rate hikes in the near-term, we expect tech stocks to be under pressure, amid slower GDP growth and ad spending.

Risks

Maintaining our risk rating of 2 (Below Average).

  • Intense competition in the software, devices, and cloud services markets.
  • Supply chain issues
  • Technology risks
  • Ongoing innovation is vital
  • Exchange rate risks

Appendix

Income Statement (YE June 30, $ million)
  2022 2023E 2024E
Total Revenue 198,270 208,188 233,629
COGS 62,650 65,784 73,823
Gross Margin 135,620 142,404 159,806
Research and development 24,512 27,271 28,853
Sales and marketing 21,825 22,917 25,717
General and administrative 5,900 9,224 7,009
EBIT 83,383 82,992 98,227
Depreciation and Amortization 14,460 13,930 16,672
EBITDA (calculated) 97,843 96,922 114,899
Other income (expense) 333 711 711
EBT 83,716 83,703 98,938
Provision for income taxes 10,978 16,531 19,540
Net Income 72,738 67,172 79,398
Balance Sheet (YE June 30, $ million)
  2022 2023E 2024E
Assets      
Total cash, cash equivalents, and short-term investments 104,757 132,456 164,520
Accounts receivable, net 44,261 46,731 52,441
Inventories 3,742 3,279 3,680
Other 16,924 16,924 16,924
Total current assets 169,684 199,391 237,566
Property and equipment, net 74,398 85,548 97,022
Operating lease right-of-use assets 13,148 13,148 13,148
Equity and other investments 6,891 6,891 6,891
Goodwill 67,524 67,524 67,524
Intangible assets, net 11,298 21,747 33,472
Other long-term assets 21,897 21,897 21,897
Total assets 364,840 416,146 477,520
Liabilities and stockholders' equity      
Accounts payable 19,000 23,706 24,571
Current portion of long-term debt 2,749 2,749 2,749
Short-term unearned revenue 45,538 47,816 53,659
Other liabilities 27,795 27,795 27,795
Total current liabilities 95,082 102,066 108,774
Long-term debt 47,032 44,282 39,032
Long-term unearned revenue 2,870 3,014 3,382
Other long-term liabilities 148,396 155,380 162,088
Total liabilities 198,298 202,676 204,502
Common stock and paid-in capital 86,939 95,286 104,116
Retained earnings 84,281 122,862 173,580
Total stockholders' equity 166,542 213,470 273,018
Total liabilities and stockholders' equity 364,840 416,146 477,520
Cash Flow (YE June 30, $ million)
  2022 2023E 2024E
Net income 72,738 67,172 79,398
Depreciation, amortization, and other 14,460 13,930 16,672
Stock-based compensation expense 7,502 8,347 8,831
Changes in operating assets and liabilities:      
Accounts receivable -6,834 -2,470 -5,711
Inventories -1,123 463 -401
Accounts payable 2,943 4,706 865
Unearned revenue 5,109 2,422 6,211
Other -5,760 0 0
Net cash from operations 89,035 94,569 105,865
Financing      
Repayments of debt -9,023 -2,750 -5,250
Common stock cash dividends paid -18,135 -20,416 -20,506
Other -31,718 -8,174 -8,174
Net cash from (used in) financing -58,876 -31,340 -33,930
Investing      
Additions to property and equipment -23,886 -25,081 -28,146
Acquisition of companies, net of cash acquired, and purchases of intangible and other assets -22,038 -10,449 -11,726
Other 15,613 0 0
Net cash used in investing -30,311 -35,530 -39,871
Effect of foreign exchange rates on cash and cash equivaler -141 0 0
Net change in cash and cash equivalents -293 27,699 32,064
Cash and cash equivalents, beginning of period 14,224 13,931 41,630
Cash and cash equivalents, end of period 13,931 41,630 73,694

Frequently asked questions

Why did FRC downgrade Microsoft to HOLD?
We expect Q3 and Q4 revenue growth to be impacted by slower global GDP growth and weaker ad spending. MSFT expects Q3 revenue to grow 2%-4% YoY in Q3 vs our previous forecast of 12%. We are lowering our fair value estimate by 4%, and adjusting our rating from BUY to HOLD. Note that 27 of the 34 analysts covering MSFT have a BUY rating.
Why did FRC lower Microsoft's fair value estimate?
We are lowering our FY2023 revenue and EPS forecasts by 6% and 9%, respectively. NASDAQ and MSFT are up 11% and 13%, respectively, since our last report in November 2022. However, we expect tech stocks to be under pressure in the near-term, amid slowing global economic growth.
What drove Microsoft's Q2-2023 revenue?
Q2 revenue growth came primarily from server products and cloud services (20% YoY), and LinkedIn (10% YoY), partially offset by weaker revenue from Windows (down 27% YoY) and gaming (down 13% YoY) amid lower global PC and console sales. Adjusted EPS fell 5% YoY, and was 2% below our forecast as well.
Is Microsoft's OpenAI investment included in FRC's valuation?
MSFT is investing $10B in artificial intelligence (AI) developer OpenAI. Although we believe OpenAI's tools and solutions can be incorporated into MSFT's products, we have not included any upside potential from this deal in our valuation models, for conservatism.

About the analysts

Sid Rajeev, B.Tech, CFA, MBA — Head of Research, Fundamental Research Corp.

Alexis Cabel, BA Econ — Equity Analyst, Fundamental Research Corp.

The full report — the designed PDF with all charts and the complete disclosure — remains available as published, free of charge with a free account. This page is the same analysis in the form a search engine, an AI assistant and a phone screen can read.

Disclosures. No fees were paid by MSFT to FRC. Fundamental Research Corp. "FRC" owns shares of the subject company, but does not make a market or offer shares for sale of the subject company, and does not have any investment banking business with the subject company. The Analyst does not own shares of the subject company. Hold – Annual expected rate of return is between 5% and 12% for micro & small-cap companies, and 5% and 8% for mid & large-cap companies. 2 (Below Average Risk) - The company operates in an industry where the fundamentals and outlook are positive. The industry and company are relatively less sensitive to systematic risk than companies with a Risk Rating of 3. The company has a history of profitability and has demonstrated its ability to generate positive free cash flows (though current free cash flow may be negative due to capital investment). The company's capital structure is conservative with little to modest use of debt. The distribution of FRC's ratings are as follows: BUY (62%), HOLD (3%), SELL / SUSPEND (35%). ALWAYS TALK TO YOUR FINANCIAL ADVISOR BEFORE YOU INVEST.