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Microsoft - cloud growth drives earnings

Revenue rose 10% to $52.9bn in the third quarter, ignoring the effect of exchange rates.

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Revenue rose 10% to $52.9bn in the third quarter, ignoring the effect of exchange rates. Growth was driven by double digit increases in Microsoft Cloud. This offset a 28% fall in OEM revenue, which is the price PC manufacturers pay to put Windows on their products. Devices revenue also fell 30%, partly reflecting tough comparisons during the pandemic.

CEO Satya Nadella said Microsoft is the preferred platform for customers to gain exposure to next generation AI.

Operating profit rose 15% to $22.4bn, thanks to the higher revenue which was partially offset by a $678m increase in research and development spending. Microsoft generated free cash flow of $17.8bn in the quarter. Net cash was $56.2bn as at the end of the period.

Microsoft shares rose 7.4% in pre-market trading.

View the latest Microsoft share price and how to deal

Our view

Microsoft's dealing with a marked slowdown in personal computing revenues, which reflects the incredibly challenging consumer environment. Buying a new laptop and the software that comes with it is simply not a priority for many people right now. Luckily for Microsoft, Cloud is picking up the slack, driven by accelerated demand thanks to Artificial Intelligence developments.

After purchasing a major stake in OpenAI, Microsoft is top of the pack when it comes to potential monetisation of Artificial Intelligence (AI). AI can be integrated into the majority of Microsoft's existing products, significantly raising revenue and margin ceilings in these areas. By doing this, the appeal of Microsoft's products should increase, which will help culminate in better pricing dynamics. This doesn't just apply to the ChatGPT side of things, Microsoft's own cloud security offerings should stand to benefit as businesses seek to up their defences against AI attacks.

The potential scale of the AI market is very exciting. But that doesn't mean it's a guaranteed cash cow. Huge advances like this often come with ups and downs and unpredictable competition dynamics. Regulatory risk is also a hurdle. The lack of intricate understanding in regulatory bodies increases the risk of impractical or damaging regulation coming into force, which is something that will need to be monitored closely.

So, while AI sparks into life in the background, it's important to keep an eye on the core business.

There are challenges, especially in Personal Computing. A broader decline in demand for hardware means devices aren't flying off the shelves, and manufacturers aren't paying as much to install Window on their own kit. But overall, we still think Microsoft is an enviable mashup of great businesses. It makes products none of us can live without and owns an increasingly valuable stable of subscription-based products like LinkedIn and Office 365 Commercial.

And let's not forget the traditional cloud business which has strong prospects. The brave new world includes updated versions of old classics, like Office 365, as well as newer business management software like Dynamics. Increasingly those are being delivered as cloud-based services rather than desktop software programs. Through Azure, Microsoft provides customers with the necessary computing power on a pay-as-you-go basis, eliminating the need for companies to pay up front for the storage and upkeep of servers, giving corporate customers more freedom to scale up their tech offerings quickly.

Microsoft's sitting on a net cash pile worth over $50bn. This has left plenty of space to return cash to shareholders through share buybacks and dividends. It's also left the group with plenty of firepower to make strategic acquisitions, including game-maker Activision Blizzard. If approved, this acquisition would dent the balance sheet, but would likely also stoke growth for its languishing personal computing arm. Approval has been knocked back a peg by the UK competition authority, so it'll be important to monitor the outcome of any appeals.

The price/earnings is above the long-term average, and the chances of ups and downs in today's market are heightened.

Microsoft key facts

All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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Written by
Sophie Lund-Yates
Sophie Lund-Yates
Lead Equity Analyst

Sophie is a lead on our Equity Research team, providing research and regular articles on a selection of individual companies and wider sectors. Sophie's specialities are Retail, Fast Moving Consumer Goods (FMCG), Aerospace & Defence as well as a few of the big tech names including Facebook and Apple.

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Article history
Published: 26th April 2023