Microsoft’s Q3 Earnings: Eyes on the Cloud, but Windows Supply Chain Also In Focus

Microsoft plays a significant role in providing technology to work remotely—a necessity in the current environment. When Microsoft releases its Q3 earnings, many investors will be focused especially on the performance of its cloud services since that could provide clues as to future performance of the company.

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5 min read
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Key Takeaways

  • Microsoft set to report Q3 earnings April 29
  • Despite Microsoft’s downward guidance revision due to supply, demand remains constant, according to the company
  • Microsoft’s cloud has been a key driver in growth across all segments

Last quarter, Microsoft’s (MSFT) solid earnings results helped kick off a sharp rally in the stock. Part of this rise had to do with MSFT’s guidance, which was better than many analysts had expected.

Soon after, MSFT, along with the broader market, went through a steep decline as coronavirus fears began reshaping the economic landscape. Fueling the slide, MSFT warned that it wouldn’t meet that positive guidance because of supply chain disruptions. But in mid-March, MSFT shares caught an updraft, helping it gain steam heading into its Q3 reporting season. Shares are actually up slightly year-to-date, an accomplishment that’s hard to find in a market where the S&P 500 Index (SPX) is down more than 15% (see chart below).

We know that COVID-19 has roiled markets overall, creating wicked short-term volatility and longer-term uncertainty. We know that factory shutdowns and transportation disruptions have slowed the supply chain. But some companies are more broadly diversified than others and hold significant cash in reserve. That’s true for MSFT and has served it well in this crisis. MSFT has several main engines that might help it steam through whatever storm may be on the horizon.

The Intelligent Cloud—Microsoft’s Floating Growth Engine

Virtual access to all things social, be it work or play, may be a critical element of the COVID-19 pandemic—at least the economic part, anyway. Generally, it helps to have things virtualized and digitized now.

But are these urgent needs the tip of the iceberg? In a recent conference call, MSFT’s CEO Satya Nadella would argue that it is. “Stepping back from the quarter and reflecting more broadly on the next decade, the defining secular trend will be the increasing rate of digitization of people, places, and things,” he said in the company’s last quarterly earnings call.

MSFT’s Intelligent Cloud, which includes Azure, GitHub, SQL Server, Windows Server and other enterprise services, may be among MSFT’s most formidable segments leaning toward that trend or, what Nadella describes as “innovation momentum.”

Looking ahead, “every customer will need a distributed computing fabric across the cloud and the edge, to power their mission-critical workloads,” said Nadella. And to top it off, according to company reports, MSFT has “more datacenter regions than any other cloud provider”—a strong volley aimed toward the virtuality arena.

Last quarter, MSFT reported Intelligent Cloud revenue at $11.9 billion, up 27%. This figure also beat analyst estimates of $11.40 billion, according to a CNBC report. Azure’s revenue grew by 64% in fiscal Q2, server and other cloud products increasing by 30%, and enterprise services increased by 6%.   

FIGURE 1: HOLDING ON. After falling during the “coronavirus crash” in March 2020, Microsoft (MSFT–candlestick) shares have been holding strong, outperforming the S&P 500 Index (SPX–purple line). The Technology sector has held up relatively well during the pandemic and software companies appear to be the leaders in the sector. Data Sources: NASDAQ, S&P Dow Jones Indices. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. 

Looking to the coming quarter, MSFT’s CFO Amy Hood offered guidance of $11.85 billion to $12.05 billion for Intelligent Cloud revenue.

More Personal Computing Lagging in Supply, Not Demand

On February 26, when MSFT announced that it could miss Q3 earnings guidance on its More Personal Computing (MPC) segment, its shares were already in the midst of a slide, driven in part by the broader “coronavirus crash.”

MPC, a segment that brought in $13.2 billion in revenue last quarter, consists of the Windows operating system, PC line Surface, Xbox video game console, and its Bing search engine.

In a Feb. 26 press release, the company warned that although it saw strong Windows demand in line with expectations, supply chain for the segment was “returning to normal operations at a slower pace” than previously expected when it provided Q3 guidance. Because of these disruptions, MSFT doesn’t expect to meet Hood’s original guidance of between $10.75 billion and $11.15 billion in the segment. Yet, the release noted that “all other components of our Q3 guidance remain unchanged.”

Gleaning insight from MSFT’s press release, the supply chain disruption may be a relatively short-term issue; cloud services, MSFT’s main revenue driver, may not be impacted by the disruption; and perhaps most importantly, the company’s main hurdle in the More Personal Computing segment is a matter of supply, not demand.

Productivity and Business Process Steaming Ahead

Maintaining “business as usual” from a home location is essential to workers who can operate remotely. Alongside the Cloud, there are other tools and processes that can help maintain that “new normal” momentum. MSFT’s Productivity and Business Process segment, consisting of Office, Dynamics, and LinkedIn, arguably helps MSFT be well positioned toward maintaining that functional bridge between work and home.

Last quarter, the segment pulled in $11.83 billion in revenue. For Q3, MSFT is expecting to see double-digit growth in all three components, with the total segment generating between $11.5 billion and $11.7 billion in revenue, according to Hood.

Software: A "Leader Among Leaders"

Looking at the year-to-date picture, Technology is among the leading sectors, though the way things have gone so far it’s kind of like being the best house in a bad neighborhood. Of all the sub-sectors in Technology, Software is the only industry not in the red.

Of course, today’s coronavirus-driven volatility can make playthings of these percentages. But still, Software at the top, whether positive or negative, may tell you something about the strength of the industry at a time when many sectors have gone a bit sour.

MSFT is Software’s biggest player by market cap. CFRA analysts forecast a three-year compound annual growth rate for the MSFT segment of 14% through fiscal-year 2022 driven by the cloud-driven elements of all three segments mentioned above. Though MSFT is not immune to slowdowns in the global economy, analysts noted MSFT’s “strong balance sheet” as a plus that may help it get through murky waters.

Microsoft Earnings and Options Activity

When it shares earnings this Wednesday, MSFT is expected to report adjusted earnings per share of $1.28, up from $1.14 in the prior-year quarter, according to third-party consensus analyst estimates. Revenue is projected at $33.88 billion, up 11% from a year ago.

The options market has priced in an expected share price move of 3.9% in either direction around the earnings release, according to the Market Maker Move™ indicator on the thinkorswim® platform.

Looking at the May 1 options expiration, call activity has been heaviest at the 180 strike while puts have been active at the 162.5 and 165 strikes. The implied volatility sits at the 34th percentile as of Monday morning.

Note: Call options represent the right, but not the obligation, to buy the underlying security at a predetermined price over a set period of time. Put options represent the right, but not the obligation to sell the underlying security at a predetermined price over a set period of time.

Good Trading,
JJ
@TDAJJKinahan

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    Key Takeaways

    • Microsoft set to report Q3 earnings April 29
    • Despite Microsoft’s downward guidance revision due to supply, demand remains constant, according to the company
    • Microsoft’s cloud has been a key driver in growth across all segments

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