Microsoft (MSFT, Financial) is a global technology titan which is primarily known for its Windows operating system and Microsoft Office applications. Even though its business has already reached juggernaut status with a market cap of over $2 trillion, I still think it has strong growth potential due to artificial intelligence (AI), gaming headwinds and more. The growth potential of these factors could be enough to move the needle even on $2 trillion; let's take a look at why.
Mixed financials
Microsoft recently announced mixed financial results for its second quarter of fiscal year 2023. Its revenue and earnings missed analyst expectations, which may seem negative at first glance. However, this result was mainly driven by lower demand in the PC and gaming markets, which are currently gong through a cyclical downturn. Therefore, I don't deem this to be a major issue in the long term. Microsoft's Cloud business is still growing at a rapid rate. The company also has a huge opportunity in the Artificial Intelligence (AI) industry with its investments in Open AI; this is a market expected to be worth $1.7 trillion by 2029 according to estimates from Fortune Business Insights.
For the quarter, revenue was $52.7 billion which increased by 2% year over year, despite missing analyst estimates by $409.46 million. Microsoft's international revenue was impacted by foreign exchange rate headwinds due to the stronger U.S. dollar. On a constant currency basis, revenue actually increased by 7% year over year, which is slightly better.
Breaking revenue down by segment, the true health of Microsoft's business is apparent. Its Intelligent Cloud segment has now become its largest segment by revenue, contributing to 40.8% of the total. Its Cloud revenue was $21.51 billion in the quarter and increased by 18% year over year, or 24% on a constant currency basis. This is also the most profitable segment of the company, generating $8.90 billion in operating income, up 7% year over year, or 15% on a constant currency basis.
Microsoft Azure is regarded as the second largest Cloud infrastructure provider in the world, just behind Amazon (AMZN, Financial) with AWS. Amazon had a first mover advantage in the Cloud market, but Azure has caught up rapidly. According to a study by Statista, AWS has a 33% market share as of this writing, and Azure had 21% of total market share.
The worldwide Cloud computing industry was valued at $480 billion in 2022 and is forecast to grow at a rapid 19.9% compounded annual growth rate, reaching $1.7 trillion by 2029 according to Fortune Business Insights.
The AI opportunity
The AI industry was valued at $387.45 billion in 2022 and is forecast to grow at a 20.1% CAGR, reaching $1.394 trillion by 2029 according to Fortune Business Insights. Microsoft is poised to benefit from this trend as the company has the backbone infrastructure via its AI-ready supercomputing infrastructure at Azure. In addition, the company has made a series of investments into the space. In 2022, Microsoft acquired Nuance, a leader in conversational AI solutions for the health care market primarily.
In an early stage investment, Microsoft also invested into Open AI and has recently invested another $10 billion into the company. Open AI’s GPT has now been integrated into Microsoft’s Bing search engine and could signal a renaissance in the legacy browser.
According to the recent quarter's earnings call, Microsoft Edge, which is Microsoft's web browser, has gained market share for the seventh consecutive quarter, and Bing continues to gain market share in the U.S. Daily users of its "personalized content feed" have increased by 30% year over year.
Productivity challenges
Back to the second-quarter earnings, Microsoft's Productivity and Business Processes segment reported $17 billion in revenue for the period, which increased by 7% year over year, or 13% on a constant currency basis.
Breaking down this segment by product, Microsoft reported a 2% decline in Office Consumer products, which was expected due to the cyclical downturn in the PC market as well as increasing competition from players such as Alphabet's (GOOG, Financial)(GOOGL, Financial) Google, which offers a free alternative (Google Sheets, Slides etc). The good news is, on a constant currency basis, this product increased its revenue by 3% year over year.
LinkedIn has also continued to grow revenue by 10% year over year, or 14% on a constant currency basis. I believe LinkedIn has a huge amount of potential for future growth and is a great platform that could unlock opportunities for B2B marketing and sales.
More PC headwinds
Microsoft's More Personal Computing segment reported revenue of $14.24 billion, which declined by an eye watering 19% year over year, down 16% on a constant currency basis. Operating income also plummeted by 47% year over year, or 40% on a constant currency basis. Some context needs to be highlighted here. In the calendar year of 2020, we saw a boom in digital products such as PCs and gaming due to the pandemic. However, since the global reopening of economies in 2021 and 2022, we saw an adjustment in demand and a cyclical downturn in the PC and gaming markets.
Advanced valuation
In order to value Microsoft, I have plugged its latest financials into my discounted cash flow model. I have forecast just 6% revenue growth for next year, which in my model also includes the next quarters coming up for the rest of fiscal 2023. I believe this is a fairly conservative estimate that is aligned with the prior growth and continued expected headwinds in the PC and gaming market. In years two through five, I have forecast 15% revenue growth per year, which is based upon a rebound in the PC and gaming markets, as well as continued growth in the Cloud segment.
To increase the accuracy of my valuation model, I have capitalized R&D expenses, which has lifted net income. I have forecast a pre-tax operating margin of 48% over the next seven years. This is optimistic, but I think it is possible if we see a rebound in profitability for the More Personal Computing and gaming segments. In addition, I believe the huge investments into AI could offer upsell opportunities to Microsoft's existing business customers.
Given these estimates, I get a fair value projection of $284 per share. The stock is currently trading at a similar level and is thus fairly valued according to my model and forecasts. Prudent investors may wish to wait for the AI hype to die down and the stock to pull back in order to find an entry point with a margin of safety.
Final thoughts
Microsoft is a technology powerhouse that has continued to grow its business despite a tough economic backdrop. Its Cloud business is a tremendous growth engine and has strong digital transformation tailwinds. Its PC and gaming segments are currently experiencing headwinds from lower demand, but I don't deem this to be a major issue long term.
