Microsoft Corporation (MSFT) Comm Stk US$ 0.0000125 (Crest Depository Interest)

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Microsoft’s second quarter revenue grew by 12% to $69.6bn, compared to market expectations of 10.9%.

The company saw strong growth in all divisions including 31% in Azure and other cloud services which was at the bottom of the narrow guidance range.

Operating profit also came in better than expected increasing 17% to $31.7bn, with costs growing a little slower than revenues.

Free cash flow fell 29% to $6.5bn reflecting higher investment expenditure to support Microsoft’s cloud and AI business. Net cash was $2.6bn higher at $26.6bn. The company returned $9.7bn in cash to shareholders over the quarter.

The company issued third quarter revenue guidance of $67.7bn-$68.7bn which was lower than the $69.8bn forecast by analysts.

The shares fell 1.1% in after-hours trading.

Our view

Microsoft’s weaker than expected immediate outlook was greeted with a little disappointment. We take some comfort that operational rather than demand issues appear to be the main obstacle to accelerating cloud growth. But these too will need to be addressed if investors are to be reassured.

Microsoft's future is now far more about cloud computing and Artificial Intelligence (AI) than it is Excel and Word – not to say the latter aren’t important. AI services contributed a big, and growing, chunk of Azure's growth in the last two quarters, and that's a trend we expect to continue. For now, demand is outstripping capacity, which is holding growth back a touch – but we're not overly concerned – it's a nice problem to have.

Investment in new infrastructure is ramping up to service that demand. It's a hefty weight, but Microsoft is such an efficient beast that it's still managing to generate healthy levels of free cash. There are genuine concerns that AI isn't delivering the end products and services needed to support all the buildout. The emergence of some impressive competition has also caught the market’s attention. But we think that misses the bigger picture. Megatrends like AI take time, rarely track in a perfect line, and bumps in the road are part of the journey.

Aside from enabling other businesses to build AI products, Microsoft's own software stack can also be a major beneficiary. Copilot, an AI chatbot integrated into apps like Word, is a great example of a new tool showing impressive growth. But there are question marks around how and when it’ll drive meaningful additional revenue.

There are more strings to Microsoft's bow, too. The Personal Computing division is reaping the benefits of the acquisition of Call of Duty maker Activision Blizzard. This is offsetting softness in physical hardware sales, reflective of the challenging consumer environment. Then, of course, there's the stack of products we can't live without, with an increasingly valuable stream of subscription-based revenue from the likes of LinkedIn and Office.

When you have the size and reach of Microsoft, regulation is always a key risk. We don't know how the new AI world will be regulated or whether it'll hurt or hinder the largest kids on the block. For now, it's something to watch and be mindful of.

Ultimately, Microsoft is a top dog, reflected in a valuation above the long-term average. We continue to view its mix of infrastructure and software services as essential components and anticipated benefactors of the coming AI transition. Key risks lie around competition in the cloud space, question marks on the effectiveness of its copilot tools, and the valuation adds pressure to deliver.

Environmental, social and governance risk

The technology sector is generally medium/low risk in terms of ESG, though some segments are more exposed, like Electronic Components (environmental risks) and data monetisers (social risks). Business ethics tend to be a material risk within the tech sector, ranging from anti-competitive practices to intellectual property rights. Other key risks include labour relations, data privacy, product governance and resource use.

According to Sustainalytics, Microsoft’s overall management of material ESG issues is strong.

Microsoft’s deep pockets mean it’s able to spend $20bn in the coming few years to help combat the threat of cybersecurity attacks. At the same time, the group already has relatively robust analytics and oversight structures in place to help reduce this risk. That said, Microsoft’s handling of data has come under scrutiny in the past, and its huge scale means this risk remains material.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

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