Microsoft Corporation (MSFT) Comm Stk US$ 0.0000125 (Crest Depository Interest)

Microsoft’s third quarter revenue rose 17% to $61.9bn which was better than expected. Within that, Cloud revenue rose 23% to $35.1bn, with performance boosted by AI demand. Operating profit was $27.6bn, compared to $22.4bn last year.

Some elements of AI growth were held back by capacity constraints. Chief Financial Officer Amy Hood said that near-term AI demand is higher than available capacity.

The group generated free cash flow of $21.0bn and had net cash of $14.6bn as at the end of the quarter.

Microsoft’s revenue guidance of $65bn for the fourth quarter was slightly lower than expected.

The shares rose 4.3% in pre-market trading.

Our view

Microsoft is now far more about cloud computing and AI than it is Excel and Word. So few companies can afford a seat at the cloud table that Microsoft's able to dig in. We're especially excited about Azure. AI services contributed a big whack of Azure's growth last quarter, and that's a trend we expect to continue. For now, demand is outstripping capacity, which is holding growth back a touch – but we’re not overly concerned – it’s a nice problem to have.

Put simply, Microsoft is top of the pack when it comes to the potential monetisation of 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, analytics, productivity and storage offerings should stand to benefit as businesses seek to up their defences and workplace efficiency.

With that said. technology budgets could still face some pressure. End customers are likely going to trim spending while they ride out the economic storm. The potential for Microsoft to do exceptionally well from generative AI remains, but the exact moment in time that this tech will be adopted at large will depend on if and when corporate spending picks up the pace and there are no guarantees.

There are more strings to Microsoft's bow too. More Personal Computing is the benefits of the acquisition of Call of Duty maker, Activision Blizzard. This is offsetting declines in physical hardware sales, reflective of the challenging consumer environment. While this trend plays out it's important to consider the growth levers available to Microsoft.

There's a lot to like. But huge advances like cloud and AI often come with ups and downs and unpredictable competition dynamics – which are getting tougher. 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.

Overall, we still think Microsoft is an enviable mashup of great businesses. It makes products we can't live without and owns an increasingly valuable stable of subscription-based products like LinkedIn and Office 365 Commercial. The inclusion of Activision Blizzard opens up a new frontier for gaming revenue potential, but we'd like a bit more detail on the growth strategy.

Despite taking on a hefty chunk of new debt, Microsoft's balance sheet is in rude health which helps it stomach ups and downs.

Ultimately, Microsoft is top dog, reflected in a valuation above the long-term average. The market’s still at the very early stages of the AI race in the grand scheme of things, and it’s important to remember that defining the overall winner is a very difficult ask, so the pressure to deliver strong growth is acute, meaning there’s likely to be ups and downs ahead.

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