Microsoft (MSFT) reported a top- and bottom-line beat in its fiscal first quarter of 2023 after the closing bell Tuesday. Despite strong headline results, shares fell roughly 6.5% in extended trading on lighter Azure cloud growth and weaker forward guidance. We think it best to wait a few days for the sellers to exhaust themselves before deciding on what level may be appropriate to buy more shares in a company we like long-term.

• Revenue of $50.12 billion rose 16% year-over-year on a constant currency basis and was a head of the $49.61 billion consensus estimate.

• Gross margin of 69% was slightly below the 69.7% expectation. However, operating margin of 43% was in line with expectations.

• Per-share earnings of $2.35, a decrease of 7% year over year, outpaced estimates of $2.30 per share.

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.

Companywide highlights

Productivity and Business Processes revenue in the fiscal first-quarter of $16.47 billion, up 15% year over year in constant currency, was better than the $16.13 billion expected while operating income of $8.32 billion, a gain of 19%, exceeded estimates of $7.88 billion.

• Within the segment, Office Commercial Products and Cloud Services revenue increased 13% year over year in constant currency with Office 365 commercial seat growth advancing 14% annually.

• Office Consumer Products and Cloud Services revenue grew 11% year over year in constant currency and the number of Microsoft 365 consumer subscribers increased by roughly 1.6 million quarter over quarter to 61.3 million, and acceleration from the 1.3 million sequential additions seen in the prior quarter.

• Dynamics Products and Cloud Services revenue grew 22% year over year in constant currency. 

• LinkedIn saw its revenue increase 21% year over year constant currency with sessions up 24% as the platform once again realized record engagement.

Intelligent Cloud revenue of $20.33 billion, a 26% year over year increase, was a bit short of estimates of $20.41 billion. However, despite the revenue miss, operating income of $8.98 billion, up 25% year over year, was better than expectations of $8.85 billion. Operating expenses here were up 28% 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 in this segment, and perhaps the entire company, is revenue growth for Azure and other cloud services. Investors were hoping to see a growth rate in the high 30s percent range with currency factored in or about 43% in constant currency. While we got close on a constant currency basis, with Microsoft reporting 42% annual growth, the currency headwind may have been a bit greater than expected as growth came in at 35% when factoring in the currency dynamic.

• On the call, management did note that Azure growth was roughly one percentage point below their own expectations with the miss “driven by the continued moderation in Azure consumption growth [Microsoft] helped customers optimize current workloads while they prioritize new workloads”

More Personal Computing revenue was $13.33 billion, a rise of 3% year over year and ahead of estimates of about $13.16 billion, while operating income of $4.22 billion, down 9% year over year, came up short of estimates of $4.4 billion. 

• Windows OEM (original equipment manufacturer) revenue fell 15% year over year, hit by weakening PC demand that we have become all too familiar with.

• Windows Commercial Products and Cloud Services revenue grew 15% year over year on the back of Microsoft 365 demand.

• In Gaming, overall revenue increased 4% in constant currency. Xbox Content and Services revenue ticked up 1% in constant currency, while Xbox hardware sales jumped 19% in constant currency. 

• Search and News Advertising revenue, excluding traffic acquisition costs (TAC), increased 21% year over year in constant currency. Aiding performance was an increase in Search volumes as Microsoft’s Edge browser once again gained market share during the quarter.

Guidance

Segment revenue guidance was as follows for fiscal Q2.

• Productivity and Business Processes revenue was guided to $16.6 billion to $16.9 billion, below estimates of $17.11 billion.

• Intelligent Cloud revenue was guided to $21.25 billion to $21.55 billion, representing a miss versus the consensus estimates of $21.87 billion. Management expects Azure revenue growth to be lower sequentially by roughly five percentage points on a constant currency basis.

• More Personal Computing was guided to $14.5 billion to $14.9 billion, well below estimates of $16.83 billion.

Adding that all up, we get a total revenue guide of $52.35 billion to $53.35 billion, which even at the high end was below estimates of $56.22 billion.

In addition to the quarterly guidance, management said they continue to expect double-digit revenue and operating income growth for its full fiscal year, driven by 29% constant currency growth in the commercial business.

Though we didn’t get anything more specific and double-digit can mean many things, we take it to be at least in line with expectation coming into the print for 10.2% revenue growth and 10.9% operating income growth for the full fiscal year.

Capital allocation, cash flow

• Microsoft returned $9.7 billion to shareholders in the quarter via dividends and buybacks, an 11% annual decrease, with $4.6 billion coming via share repurchases and $5.1 billion coming in the form of dividends. 

• Quarterly free cash flow of $16.9 billion, down 10% year over year, came in below expectations of $17.51 billion, while operating cash flow of $23.2 billion, down 5%, missed estimates of $24.65 billion. Notably, if adjusted for what the company called “a tax payment related to the transfer of intangible properties” in its first quarter of fiscal 2022, free cash flow was essentially unchanged versus the year ago period and operating cash flow actually increase 2% due to strong cloud billings and collections.

• 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 nearly equivalent to the $17.6 billion Microsoft reported as net income while operating cash flow was nicely above.

• Capital expenditures (capex), including assets acquired under finance leases, were $6.6 billion, a tad more than the $6.5 billion expected but acceptable in our view as the expenditures are to support growth in cloud offerings.

Bottom line

This was not the quarter we were hoping to see from Microsoft. Along with poor results from fellow Club holding Alphabet (GOOGL), Nasdaq futures were sharply lower, which will likely take some of the steam out of the market’s recent rally when Wall Street opens Wednesday. Microsoft shares dropped about 6.5% to $234 in after hours trading.

While Microsoft is clearly a crucial backbone of global productivity, the sheer size of its business means that it’s becoming less able to buck macroeconomic dynamics. We saw that with this release. In addition to weakness in the consumer personal computer market, business customers are taking a closer look at their own budgets leading to slightly lower than expected result at Azure, where profit margins also took a hit on higher energy costs, and a decline in advertising spend.

However, CEO Satya Nadella said on the call that “moving to the cloud is the best way for organizations to do more with less today. It helps them align their spend with demand and mitigate risk around increasing energy costs and supply chain constraints.” As a result, while the platform is being hit due to a Federal Reserve-induced economic slowdown — though to be clear, 42% constant currency for a business this size is incredibly impressive — we fully expect growth to continue in the near, mid and long-term.

Similar to what we noted in our Alphabet earnings commentary, Microsoft’s second quarter guidance will likely lead to downward earnings and price target revisions from analysts. Given the tough environment — and despite our longer-term positive view — we are reducing our Microsoft price target to $300 per share from $375. But that still reflects 28% upside.