Portfolio holding Microsoft (MSFT) reported a flawless beat-and-raise print with its fiscal first quarter 2022 earnings release.

On the top line, revenue of $45.4 billion (+22%) breezed past expectations of $44 billion. Meanwhile stronger than expected profitability with gross margin of 70% versus a 69% consensus and operating margin of 45% versus 42.4% consensus led to earnings of $2.27 per share, outpacing the $2.08 per share consensus.

CEO Satya Nadella commented on the release: “Digital technology is a deflationary force in an inflationary economy. Businesses – small and large – can improve productivity and the affordability of their products and services by building tech intensity. The Microsoft Cloud delivers the end-to-end platforms and tools organizations need to navigate this time of transition and change.”

Microsoft helping companies manage inflation?

Keeping with the theme of deflation, when asked on the call to elaborate on how the shift to cloud computing can help offset inflation, Nadella added: “in an inflationary environment, the first place any business should go to is how to really ensure that they're able to get productivity gains. And even dealing with constraints. For example, if you have supply chain constraints, one of the things you want to do is run your factories at the efficient frontier. That means things like digital-twin simulation are the ones where you're going to make sure that every production run has the least amount of wastage. So I think any which way you look whether it's in the knowledge worker, first-time worker, whether it's actually digital twins and simulation, all of those things are going to be the best way for any company to deal with inflationary pressure so that they can, in fact, have the best productivity and thereby the best ability to be able to meet aggregate demand out there. So that's why we are very, very excited about making sure our software products are available to our business customers all around to be able to manage through this inflationary environment.”

Capital Allocation:

On the capital allocation front, Microsoft returned a whopping $10.9 (+14% YoY) billion to shareholders in the quarter, with $6.2 billion coming via buybacks and the remaining $4.7 billion from dividends.

Operating Segments:

• Moving on to the various operating segments, starting with Productivity and Business Processes, revenue of $15.04 billion (+20% YoY at constant currency - CC) outpaced the $14.7 billion consensus while operating income of $7.58 billion (+29% YoY CC) outpaced expectations of $7.05 billion.

  • Within the segment, Office Commercial products and cloud services revenue increased 16% YoY CC as Office 365 Commercial seats grew 17% YoY. Office consumer products and cloud services revenue grew 8% YoY CC with Microsoft 365 Consumer subscribers increasing to 54.1 million, up from 51.9 million in the prior quarter and 45.3 million in the year ago period. Dynamics products and cloud services revenue advanced 29% YoY CC while Dynamics 365 revenue surged 45% YoY CC with the help of Power Apps, which skyrocketed 197% YoY CC. Finally, LinkedIn revenue, a clear beneficiary of the imbalance between labor supply and job market demand, increased 39% YoY CC as LinkedIn sessions grew 19% “with record engagement.”

• On the Intelligent Cloud front, revenue of $16.96 billion (+29% YoY CC) outpaced the $16.57 billion while operating income of $7.56 billion (+37% YoY CC) surpassed expectations of $7.286 billion.

  • Digging into the segment, server products and cloud services revenue grew 33% YoY CC, a notable acceleration from the 29% rate seen in the prior quarter, while Enterprise Services revenue increased 8% YoY CC. Additionally, server products increased 13% YoY CC “driven by hybrid solutions” and “an increase in multi-year agreements that carry higher in-quarter revenue recognition.” The enterprise installed base also increased 30% to 196 million seats.

  • All that, in mind the one key metric that arguably matters more than any other single metric in the eyes of Wall Street is Azure and other cloud services growth. While FactSet only recently added this metric and only has one estimate contributed, making it far from a consensus number, analysts at Goldman Sachs were modeling 48% coming into the print while analysts at UBS were modeling 46% and called out that they thought the “buy-side bogey” stood at 47%. As a result, we think the 48% YoY CC result to be in line-to- better-than-expected. Notably, that represents an acceleration from the 45% rate seen in the prior quarter and even an acceleration from the 47% seen in the year ago period, when we were still very much in the depths of the pandemic!

• Lastly, in More Personal Computing, revenue of $13.31 billion (+11% YoY CC) outpaced the $12.68 billion while operating income of $5.1 billion (+5% YoY CC) surpassed expectations of $4.61 billion.

  • Driving the segment, Windows OEM revenue grew 10% YoY while Windows commercial products and cloud services revenue advanced 10% YoY CC. Surface revenue declined 19% YoY CC, impacted by a difficult prior year comparable as we are lapping the height of the pandemic (and remote work dynamics). Search and news advertising excluding traffic acquisition costs (TAC) increased 39% YoY CC benefiting from an easy prior year comparable, “with improved customer advertising spend.”

  • Finally, on the gaming front, Xbox content and services revenue was flat YoY CC as growth in Xbox Game Pass subscriptions and first-party titles was partially offset by declines in third-party titles. Given the difficult prior year comparable (remember, everyone was tuck at home playing video games instead of leaving the house for entertainment) we think the flat result is pretty solid. Xbox hardware (which leverages AMD graphics chips) revenue surged 162% thanks to strong demand for the Xbox Series X|S. While that growth is impressive and benefited from better-than-expected console supply, it appears to have been held back as management did note on the call that demand continues to exceed supply.

Guidance:

Finally, a look at guidance, which management doesn’t provide until the conference call, at the end of their prepared remarks. Segment guidance was as follows (spoiler, it was clean sweep):

• Productivity and Business Processes: $15.7 to $15.95 billion a beat versus the $15.399 billion expected

• Intelligent Cloud: $18.1 to $18.35 billion a beat versus the $17.845 billion expected

• More Personal Computing: $16.35 to $16.75 a beat versus the $15.38 billion expected

Adding that all up, we get a total revenue guide of $50.15 billion to $51.05, which at a midpoint of $50.6 billion is a monster guide versus expectations of $48.97 billion coming into the print.

Takeaway: 

All in, this was nothing short of an incredible quarter from Microsoft. Similar to the case of AMD, MSFT shares have been making all time high prior to the print. The relatively muted price action in response is thus understandable because as we often say, exceptions are what matter, and when the market expects perfection, perfection is sometimes only good enough to hold on to the gains made ahead of the print.

That said, we think that Microsoft remains one of the strongest secular growth companies on the planet and as a result expect to see analysts to raise price targets for the stock to continue its steady grind higher as the economy comes back online and companies increase investments in digital infrastructure. To that point, we think the biggest takeaway for subscribers this quarter is to truly absorb Nadella’s commentary on the deflationary aspects of digitization. While pricing power is perhaps the most direct factor a company can leverage to offset rising input costs, the ability to increase a customer’s productivity and efficiency – and therefore lessen the need for that customer to in turn raise prices on their own customers – is an attribute that makes a company invaluable to its customers. So, as the market attempts to price in inflation with every macroeconomic report, investors must screen their holdings for pricing power and the ability of a company to make its customers more productive and efficient. In the case of Microsoft, we get both.