Key Morningstar Metrics for Microsoft
- Fair Value Estimate: $490
- Morningstar Rating: 4 stars
- Morningstar Economic Moat Rating: Wide
- Morningstar Uncertainty Rating: Medium
What We Thought of Microsoft’s Earnings
We are maintaining our fair value estimate for wide-moat Microsoft MSFT at $490 per share after the firm reported good results with guidance that was somewhere between our expectations and slightly light. The outlook generally offsets quarterly performance, which holds our fair value steady. Results look solid across the board, with good artificial intelligence demand and monetization. With shares down after-hours we continue to view the stock as attractive, and we think accelerating Azure revenue in the fourth quarter will help drive propel it higher over the next year. We see results reinforcing our long-term thesis, which centers on the expansion of hybrid cloud environments, the proliferation of artificial intelligence, 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.
For the December quarter, revenue increased 12% year over year to $69.6 billion, compared with the high end of guidance of $69.1 billion. Relative to the year-ago period, productivity and business processes rose 13% in constant currency, intelligent cloud grew 19%, and more personal computing was flat. Compared with guidance, both PBP and MPC came in above the high end, while IC was at the low end, indicating solid performance relative to our model. Good sales execution and sales mix toward software, away from hardware, supported margins.
In our view, near-term demand indicators are positive. Commercial bookings accelerated sharply from 23% year-over-year growth in constant currency last quarter to 75% growth this quarter based on surging Azure commitments from OpenAI and other large deals. Remaining performance obligations increased 36% year over year to $298 billion. Renewals also remain strong, which we think is partly driven by high interest in AI and consistently good execution.
Microsoft Stock vs. Morningstar Fair Value Estimate
Source: Morningstar Direct.
Azure the Key Driver for Microsoft Cloud
Intelligent cloud performance remains the key pillar of the investment case, in our view, and it performed well this quarter despite the modest shortfall relative to our expectations. Microsoft cloud revenue increased 21% to $40.9 billion. Azure remains the key driver, growing 31% in constant currency, compared with guidance of 31% to 32%. While Azure remains capacity-constrained, AI performed better than internal expectations, while traditional workloads faced some execution issues from a sales standpoint, notably with partners selling to smaller and mid size clients. Effectively there is surging interest in AI and so sales efforts have gone in that direction and away from traditional workloads. This dynamic basically prevented Azure from growing near the top of its guidance range. We think this is addressed within a couple quarters. AI services contributed 13 points of growth within Azure and now represent a $13 billion run rate, up 175% year over year, which supports one of our key AI thesis points, which is that the benefits of generative AI are disproportionately accruing to large public cloud vendors like Microsoft.
In PBP, Office and Dynamics continue to power performance and drove solid results. Segment revenue was up 13% year over year in constant currency. Within PBP Microsoft 365 Commercial Cloud grew 15% year over year in constant currency, while Dynamics 365 was up 18%, and LinkedIn was up 9%. Overall, small and medium businesses, along with front-line workers performed reasonably well but pressured pricing, while Copilot add-ons helped support per-seat pricing. Unfortunately for Microsoft, Dynamics 365 as a standalone company would be a great investment, but it is completely overshadowed by Azure and AI at this point.
While flat year over year, MPC performed well, with continued strength in search and news advertising, which accelerated to 20% year over year in constant currency. The Activision acquisition closed in early October last year, so the year-over-year distortion was minimal. Inventory builds helped Windows, while gaming performed well with strength in Call of Duty, and positive trends with Gamepass and engagement. The mix shift to software away from hardware helped margins as well.
Microsoft’s ability to deliver on margins despite ballooning Azure investments, headwinds from the Activision acquisition, and accounting changes for server depreciation, is impressive. We think this bodes well for margins as Azure capacity starts coming online, which should help ease these pressures and drive a multiyear expansion. GAAP operating margin was 45.5%, compared with 43.6% last year and the midpoint of guidance at 44.0%, with relative strength driven by continued careful cost management and favorable product mix. Regarding mix, Xbox and Surface revenue was de-emphasized, while Windows, Office, Azure, and other software solutions were relatively stronger, which helped margins.
What the Dollar Strength Means for Microsoft Earnings
We think third-quarter guidance explains the pressure on the shares in the aftermarket, as the topline is about $1.6 billion shy of FactSet consensus estimates, with operating margin and EPS both slightly ahead of expectations. However, a strengthening US dollar is expected to be about a $1 billion headwind to revenue, meaning the topline is less than a percent light. The outlook for the March quarter calls for revenue of $67.7 billion to $68.7 billion and an implied operating margin of approximately 44.0% at the midpoint. Microsoft expects Azure to grow 31% to 32% year over year in the third quarter, which is impressive in the context of the size of Azure, but is not obviously the acceleration management was talking about over the last two quarters. Overall we think Azure is fundamentally strong and well positioned so this will likely prove to be noise over the course of a year.
Capital expenditures are expected to be relatively steady on a quarterly basis compared with the second quarter for the rest of 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. We expect this mix to start shifting more toward IT equipment rather than building and land over the next year. 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, good AI revenue traction, 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.
We think Stargate is generally positive for Microsoft as more focus on AI is good for one of the clear AI leaders. We also think that the evolving nature of the relationship with OpenAI does not portend problems, as OpenAI now has more flexibility but the two companies still have the basic framework of their original agreement. OpenAI’s growth and success clearly benefits Microsoft. Regarding DeepSeek, our thesis for the last two years has been that the AI models will become table stakes and this commodification will drive AI pricing down, which will spur adoption, and subsequently increase utilization in Azure data centers. While we are surprised at the rate at which pricing per token is moving down the cost curve, this development wholly supports our view. Microsoft is now publicly offering a similar view on the evolution of AI.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
