The multi-billion dollar business within Microsoft that nobody talks about

computing giant Microsoft (MSFT 0.17%) recently reported earnings for the first quarter of fiscal year 2023 or the period ended September 30, 2022. There was a lot to unpack from this report. Consumer demand in the PC sector has been weak in recent quarters and management expects this trend to continue on the back of cyclical trends such as inflation.

Additionally, the company’s social networking platform, LinkedIn, is seeing a decline in ad revenue, which isn’t entirely surprising given the overall slowdown in demand for ad spend.

An IT worker uses a laptop to connect to a server.

Image source: Getty Images.

However, the beauty of a company like Microsoft is that the company has a number of different levers to generate revenue. And despite the macro environment affecting its core hardware and advertising businesses, there’s one end market that seems resilient even during times of economic volatility. In this article, we analyze Microsoft’s cloud business and how its growth should encourage long-term investors.

Unpack the big picture

For the quarter ended September 30, 2022, Microsoft reported total revenue of $50.1 billion, up 11% year over year. The biggest laggards in the current quarter were the company’s gaming services and original equipment manufacturer (OEM) segments, down 3% and 15%, respectively. Additionally, devices grew just 2% annually due to weaker demand for the company’s flagship hardware product, Surface.

At first glance, this can be unsettling for investors. After all, Microsoft has made a name for itself with popular products like Xbox and other hardware. However, the company’s CEO, Satya Nadella, has explained the current economic climate well, saying: “Based on ongoing current trends, we expect our broader trading business to grow about 20% in constant currencies this fiscal year as we come through.” the cyclical trends affecting our retail banking.”

Microsoft CFO Amy Hood echoed Nadella when she said:

The PC market is cyclical. And we’ve had some great perks for a number of years during the pandemic and we’ve chosen not to spend against that perk in recent years and it’s bottom line has fallen and you’ve seen margins increase significantly over that period. And we may have done that because it’s a cyclical market. And that’s how I see it now that PCs are going to be a tough headwind for us this year.

Nadella and Hood illustrate that while the consumer business is struggling with ongoing market conditions, particularly inflation affecting spending habits, the overall picture for the company looks quite strong. Additionally, it shouldn’t come as a complete surprise that the personal computing market has cooled as consumers around the world increased their hardware needs during the peak days of the COVID-19 pandemic and remote working. While working from home is still common, consumers’ need for additional devices such as laptops has diminished.

Another segment where Microsoft is facing headwinds is LinkedIn. It’s important to note that LinkedIn’s quarterly revenue grew 17% year over year, ahead of management’s expectations. However, Hood made it clear that investors should temper expectations for LinkedIn when she said, “Reduced advertising spend by customers, which also weakened later in the quarter, impacted search and news advertising, as well as LinkedIn marketing solutions.”

It is important for investors to remember that the above statements and figures Everyone apply to Microsoft’s consumer business. The company also has a large commercial business that is thriving. Let’s analyze how and why Microsoft’s commercial business appears to be outsmarting the current market cyclical dynamics.

The power of the cloud

Cloud computing has become a pillar of modern business. Businesses rely on data to make decisions, demand best-in-class security modules to protect devices like laptops or phones, and be able to communicate seamlessly and efficiently with team members around the world. The power of the cloud offers all these functions.

Because of this, despite the tightening of corporate budgets in areas like advertising, companies like Microsoft and its competitors in Amazon and alphabet, continue to generate strong demand from commercial cloud requirements. Put another way, persistent inflation and the prospect of a recession aren’t enough to deter companies from investing in a scaling cloud business.

A cloud instance can help companies move forward more efficiently and securely with the existing infrastructure. For example, one of the biggest selling points for Microsoft Cloud is that Azure integrates with both JUICE and oracle. This means that companies using SAP for their workloads or Oracle databases can access confidential information horizontally, company-wide, across different product groups and in a secure environment.

The valuation looks attractive

The notion of assessment can be tricky. It can be tempting to buy a stock that looks cheap because it’s priced low, or to forego a stock because it looks expensive. And while there are a variety of valuation methods, for a mature and consistently profitable company like Microsoft, the price-to-earnings multiple is usually an acceptable multiple for analysis.

At the time of writing, Microsoft is trading at 26x price-to-earnings. While this is lower than 35 times where it was trading at this time last year, Microsoft definitely has a premium. The long-term average serves as a reference S&P500 is between 15 and 16 times the price-to-earnings ratio.

However, when it comes to Microsoft, there’s certainly more to it than meets the eye. As I’ve already written in relation to Alphabet and Amazon, big tech cloud companies can almost be viewed as high growth startups operating within a mature enterprise.

For the quarter ended September 30, 2022, Microsoft reported cloud revenue of $25.7 billion, up 24% year over year. Given management’s optimistic outlook for the commercial business, it’s not out of the question that Microsoft could generate $100 billion in annual revenue from its cloud business alone. Microsoft’s current market cap is $1.8 trillion.

Much like hedge fund analyst Daniel Loeb did for Amazon Web Services, in a scenario where Azure accounts for just 10% of Microsoft’s overall value, that means the cloud could become a $200 billion revenue stream. Given the positive momentum the company has in the cloud, coupled with management’s prospects, the rate at which the cloud is growing most likely makes Azure worth substantially more than 10% of Microsoft. Because of this, it’s important to remember that the company has a multi-hundred-billion dollar business, even if the company’s overall multiple seems a bit pricey growing and has not yet reached a peak. Given this robust growth outlook, Microsoft certainly looks like a compelling long-term buy.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Adam Spatacco has positions in Alphabet (A shares), Amazon and Microsoft. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Amazon, and Microsoft. The Motley Fool recommends SAP SE. The Motley Fool has a disclosure policy.

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