Microsoft (MSFT) reported a top- and bottom-line miss with its fiscal fourth quarter of 2022 earnings release after the closing bell Tuesday. Revenue of $51.87 billion rose 17% year-over-year on a constant currency basis but missed the consensus estimate on FactSet of $52.36 billion. Gross margins of 68.3% were slightly below the 68.4% expectation and operating margins of 39.5% were marginally below of the 40.1% estimate. Per-share earnings was $2.23, an increase of 9% year over year, missed estimates of $2.29.

Note: Constant currency growth rates, which is what we will cite in this report, help strip out fluctuations in foreign currency, namely a strong U.S. dollar, to provide a clearer financial picture.

Bottom line

All in, this wasn’t the cleanest quarter from Microsoft, but we believe it speaks to relatively strong demand when accounting for the global economic slowdown that’s underway.

While budgets are being reprioritized across industries in anticipation of slower growth ahead, one thing is clear, information technology (IT) spending — specifically as it relates to cloud computing — remains a top priority. As management reiterated on the call, they believe that IT spending will only continue to grow as a percentage of gross domestic product (GDP) going forward. “Every business is trying to fortify itself with digital tech to, in some sense, navigate this macro environment,” the team said.

Investments in technology remain the best way to enhance efficiencies — in fact, we saw this with the release as software investments and increased efficiencies allowed management to extend the useful life of servers and as a result, meaningfully increase reported profits going forward.

Companywide highlights

Productivity and Business Processes revenue in the second-quarter of $16.6 billion, up 17% year over year in constant currency, was a hair short of the $16.62 billion expected while operating income of $7.23 billion, a gain of 19%, missed estimates of $7.31 billion. Partially contributing to the profit miss was a 14% increase in operating expenses driven by investments in LinkedIn and cloud engineering. 

• Office Commercial Products and Cloud Services revenue increased 13% year over year in constant currency. 

• Office Consumer Products and Cloud Services revenue grew 12% year over year in constant currency and the number of Microsoft 365 consumer subscribers increased by roughly 1.3 million quarter over quarter to 59.7 million.

• Dynamics Products and Cloud Services revenue grew 24% year over year in constant currency. 

• LinkedIn saw its revenue increase 29% year over year constant currency with sessions up 22% as the platform once again realized record engagement.

Intelligent Cloud revenue of $20.91 billion, a 25% year over year increase, exceeded estimates of $21.09 billion, and operating income of $8.68 billion, up 18% year over year, was less than expectations of $9.31 billion. Operating expenses here were up 22% versus the year-ago period as the company increased investments in Azure and Nuance, a previously acquired conversational AI company.

• As we’ve repeatedly noted, the single most important line item for the entire company right now is revenue growth for Azure and other cloud services. Investors were hoping to see a growth rate of about 43% with currency factored or about 46.8% in constant currency. While we got close on a constant currency basis, with Microsoft reporting 46% annual growth, the currency headwind appears to have been greater than expected as growth came in at 40% when factoring in the currency dynamic. While both calculations missed the mark, we suspect investors will focus more on the constant currency result versus expectations as it speaks to the sustained demand for the world’s best-in-class hybrid cloud offering. On the call, CEO Satya Nadella called out “larger and longer-term commitments and a record number of $100 million and $1 billion-plus deals this quarter.”

More Personal Computing revenue was $14.36 billion, a rise of 5% year over year, missing estimates of about $14.68 billion, while operating income of $4.62 billion, flat year over year, edged out estimates of $4.6 billion. 

• Windows OEM (original equipment manufacturer) revenue growth fell 2% year over year due to production shutdowns and a weakening PC market. That said, on the call management said that “despite a changing market for PCs during the quarter, we continue to see more PCs shipped than pre-pandemic and are taking share.”

• Windows Commercial Products and Cloud Services revenue grew 12% year over year on the back of Microsoft 365 demand.

• In Gaming, overall revenue decreased 5% in constant currency. Xbox Content and Services revenue declined 4%, while Xbox hardware sales fell 8% in constant currency. 

• Search and News Advertising revenue, excluding traffic acquisition costs (TAC), increased 21% year over year in constant currency. While the increase was driven by higher search volume and revenue per search, this was partially offset by a reduction in customer advertising spend, which speaks to a dynamic we have seen across the advertising space.

Guidance

• Productivity and Business Processes revenue was guided to $15.95 billion to $16.25 billion, which at a midpoint of $16.1 billion was below estimates of $16.94 billion.

• Intelligent Cloud revenue was guided to $20.3 billion to $20.6 billion, representing a slight miss versus the consensus estimates of $20.63 billion. Management expects Azure revenue growth to be lower sequentially by roughly three percentage points on a constant currency basis.

• More Personal Computing was guided to $13 billion to $13.4 billion, also a miss against estimates of $13.82 billion.

Adding that all up, we get a total revenue guide of $49.15 billion to $50.25 billion, which even at the high end was below estimates of $51.6 billion.

Capital allocation and cash flow

• Microsoft returned $12.4 billion to shareholders in the quarter via dividends and buybacks, a 19% annual increase that brings the total full fiscal year cash return to shareholders to $46 billion. 

• Quarterly free cash flow of $17.8 billion, up 9% year over year, came in below expectations of $18.8 billion, while operating cash flow of $24.6 billion, up 8%, missed estimates of $25.23 billion. Despite coming up a bit short versus estimates, Microsoft is still generating a ton of cash. Speaking to the quality of Microsoft’s earnings, that free cash flow figure was still above the $16.7 billion Microsoft reported as net income.

• Capital expenditures (capex), including assets acquired under finance leases, were $8.7 billion, more than the $6.5 billion expected but acceptable in our view. The spending is necessary to support Microsoft’s growth in its cloud offerings.