MSFT is HedgeyeTech Short.
On today’s morning call (here), we had a conversation with (sector head of macro) Keith McCullough about our expectations for Microsoft’s earnings (Tuesday amc), discussing some of the puts and takes going into the quarter. Summing up the data points (below) we suggested that the Dec-Q was not the problem, nor the implied outlook for FCF, but rather the weak outlook for backlog growth in 1H and its translation to forward Billings and 2H (CY) revenue.
It's tough to guess exactly how the world will react to numbers but if MSFT puts up an in-line backlog growth quarter and gives puts and takes that push Street to raise FCF estimates, the stock may shrug off (for now) the weaker outlook for 1H (CY) growth. We think that likely just pushes the problem out, rather than resolves it, and as the Street approaches considerations for 2H (CY) topline growth, weaker backlog growth will impact.
Here are some of the puts and takes we are thinking through:
- Easy math in Dec-Q, tough setup for 1H23. After last quarter’s much worse than seasonal sequential backlog growth, the math is a much easier setup q/q for backlog growth in the Dec-Q. However, we expect 1H23 quarters to exhibit below average backlog growth against tough RPO growth quarters while exhibiting below seasonal average sequential increments, which also imply a continuation of negative RPO Billings growth y/y...translating to weaker Billings and weaker Revenue, on a lag.
- MSFT had originally planned for its hiring freeze to end in November, and on schedule the company lifted the Azure hiring freeze, unlike some peers which deepened freezes into full headcount reductions. In that sense, the 5% January headcount reduction is an about face. However, it was manifest as a strategic move rather than a back-footed act of desperation in that it combined a reduction in force, the removal of accrual for PTO for all employees (3 week standard PTO), some product removal, and a consolidation of real estate. The result is that FCF estimates will move higher on guidance.
- Lastly, after a large RIF, it is unlikely that MSFT will sound an ebullient tone about demand or outlook that would open themselves up to a lawsuit
We keep the Short on MSFT as part of a Quad4 positioning, seeing as MSFT continues to signal to us as a late cycle corrector, with many investors still hiding out in its shares, which becomes a problem as its results languish while others reach easier comps and potentially re-accelerate. Our original thesis has modified somewhat with time. We are closer to Street forward revenue estimates for Azure now compared to when we launched the short, as Street estimates now nearly reflect our expected deceleration for the unit.
IaaS is a great growth business, still transformative for MSFT, but also facing a tougher stretch wherein a) new lift and shift projects are likely to stall, b) underlying customer enterprise growth will slow towards business growth, c) yet IaaS providers still need to explore new areas of elasticity to promote the next wave of adoption, d) capex battles have to remain top of mind as the newest gear offers best cost structures, and one provider cannot afford to fall a half step behind (especially in light of the tightness in elasticity we previously pointed out).
Much of the rest of MSFT businesses are either languishing in cyclical washout or secular saturation, or the after-effects of taking price and narrowing market demand.
The bull case continues to rely on Satya’s great vision to lead the company through choppy waters and to try to dominate a new product cycle (AI). Embedding AI in an old product would give MSFT a path to a renewal product cycle, making Office the center of gravity in enterprise productivity for another 20 years. We like all of that but…we aren’t biting, not at this stage. There is a long road of execution risk ahead for AI into Office. There is also a risk that the OpenAI ‘moment’ is here…and may pass with rising competition, product limitations, MSFT related objections, or maybe even the FTC/DOJ preferring that a monolith like MSFT not have the control to throttle AI development in the US.
We stay Short. We admit the Dec-Q results & implied outlook for FCF may be enough for a neutral on the stock into EPS, but we think weak backlog growth in the next 180 days will remind investors of the shrinking available growth rate, which should also be accompanied with a shrinking EV/NTM FCF multiple.
Links to our recent MSFT work are below for your reference:
- SHORT MSFT | Seek Shelter Elsewhere (10/13/22) Webcast & Materials: CLICK HERE
- MSFT First Look | Definitely Slower, Bulls May Defend (10/26/22)
- INVITE | SHORT MSFT | Seek Shelter Elsewhere (10/7/22)
