Azure: ‘Microsoft’s the leader in cloud,’ analyst says

Brent Bracelin, Piper Sandler Equity Research Analyst for cloud software and analytics, joins Yahoo Finance Live to discuss Microsoft earnings and cloud growth.

Video transcript

JULIE HYMAN: And here's what you need to know as the clock hits 9:00 AM. Stormy clouds ahead for Microsoft. The company warns there will be more deceleration ahead after reporting its slowest revenue growth in six years.

BRAD SMITH: Plus, a breakup at Google. The Justice Department just sued Google to break up its advertising empire. But what would that look like, and can it even happen? We're going to bring you the details.

BRIAN SOZZI: And trouble in the skies. Shares of Boeing skidding in the premarket after the company missed estimates on the top and bottom lines, blaming labor and supply challenges for the disappointing numbers. But first, let's get a quick check of the futures here as we get, really, a lot of earnings reports out this morning, not many of them quite good. We're seeing futures down across the board. Dow down about 285 points or so.

Let's get to our top story for this morning. Microsoft's earnings initially got a few high fives on Wall Street after the bell yesterday, but it was a different story on the earnings call when CFO Amy Hood emphasized caution ahead as the company issued gloomy guidance for the cloud segment.

AMY HOOD: We are seeing customers exercise caution in this environment. And we saw results weaken through December. We saw moderated consumption growth in Azure and lower than expected growth in new business across the standalone Office 365 EMS and Windows commercial products that are sold outside the Microsoft 365 suite. From a geographic perspective, we saw strong execution in many regions around the world. However, performance in the US was weaker than expected.

BRIAN SOZZI: Well, this was the earnings call, guys. And I think Microsoft was really-- or has been reading its own press clippings. They talked about slowdown in their business. That word of-- note of caution, I have more of this now in a story on the Yahoo Finance homepage.

But played up that theme of caution in what customers are buying and selling, but then also tried to pitch the Street that, hey, we have ChatGPT, and maybe that will change the game fundamentally for us over time. And it might, but the Street is more focused on the now, Brad, and what that caution might mean to the next couple of quarters of sales and profits for Microsoft.

BRAD SMITH: Yeah, AI being the big word and buzzword that we may continue to hear, especially from tech companies over the course of this earnings season. But I think when you have to factor in that next leg of growth and when it actually will come and what kind of expenditure that dollar figure is going to come off of as well, that puts even more pressure on what the operating and profit margins look like to continue to invest in some of those efforts going forward.

So when you hear about for one of their most profitable segments in Azure, the type of deceleration in growth that they're anticipating and already seeing in some instances-- North America, they pointed out here in this most recent earnings call as well that we just played a clip from-- that certainly puts some cold water on how long investors would have to wait for that next leg of growth.

And I'll tell you, there are two instances where we saw not just a downgrade this morning off the back of this report, but one firm that got this right weeks ago was UBS. They had lowered the stock to a neutral from a buy and cited many of the very issues that investors became a little bit more clear about over the course of this earnings call and after the earnings as well.

JULIE HYMAN: So if you're talking about a deceleration here from the 31% growth that Azure saw, they're talking about a four or five percentage point deceleration from that 34-- 30-- low 30s percentage point. But you look at some of their other groups here and what they were seeing, it was sort of a little bit mixed. I mean, Azure, as I mentioned, saw 31%. It's part of Intelligent Cloud, which was up by 18%. But personal computing revenue was down 19%.

As part of that, Windows related revenue was down 39%. And hardware devices that the company makes, down 39%. Gaming revenue was down 12%. So cloud in the form of Azure has really been, to your point, the profitability growth. It has been the driver for Microsoft as of late at a time when other parts of the business are not working as well.

All of that said, you mentioned UBS in its call looking over a lot of the analyst commentary this morning. Many of them are saying these are sort of challenges not unique to Microsoft. And they don't seem that concerned about the company's long-term growth trajectory absent these couple of quarters that are going to be tricky.

BRIAN SOZZI: Yeah, well, now I think you're getting more clarity, of course, on why they laid off 10,000 people last week and why as a lot of these software companies report their earnings, you're probably likely to see that justification for the layoffs they did. One number that caught my attention on the earnings call, guys, 280 million, that was the number of users for Microsoft Teams, which has just turned into a complete juggernaut. And in a few weeks, we'll hear from Zoom.

And I have to wonder if Teams is just starting to absolutely pummel Zoom in a market where a lot of these key small business clients for Zoom and Microsoft just might be consolidating onto Microsoft, instead of Zoom. But wow, that is-- the growth in Teams has just absolutely taken off. And it doesn't really appear to be slowing.

BRAD SMITH: Yeah, and that was really the competitive advantage that Microsoft had over Zoom and that Zoom, for much of the time that it's been publicly traded, has been a one-trick pony. And it continues to be thought of among the portfolio client base that they have as just that. For Microsoft Teams, it's integrated into a broader suite of solutions, collaborative tools that Microsoft has been able to sell into corporations for years, and then acquire specific add-ons to sell further into that portfolio of clients.

And so that was always kind of one of the bear overhangs or one of the headwinds for Zoom is that you're going up against the behemoth in Microsoft that can accelerate based on the install base that they already had when they did roll out that video product in concert there, too.

JULIE HYMAN: Yeah, and talking about competition, getting back to Cloud for just a second, we are seeing the depressive force of the juggernaut that is Microsoft on the other cloud stocks--

BRIAN SOZZI: Dark cloud over the space, Julie.

JULIE HYMAN: --this morning.

BRIAN SOZZI: Dark cloud.

JULIE HYMAN: Exactly. Because as I mentioned earlier, if these are a reflection of caution on the part of clients of Microsoft, as we heard from Satya Nadella, then that's what we're seeing for clients of other cloud companies, too, most likely. And so we're seeing the whole complex that is trading lower in today's session here.

BRAD SMITH: Absolutely. Well--

JULIE HYMAN: Microsoft closely watched Cloud business Azure, as we said, did slow year over year in the latest quarter. The company warning of uncertainty ahead. Let's check in on how Azure could rebound in the coming quarters and get Wall Street's take on the company with Piper Sandler equity research analyst Brent Bracelin. Brent, thanks for being here. So when you look at that cloud deceleration here, how acute do you think it's going to be? Obviously, the stock is being punished for that. Do you think it should be?

BRENT BRACELIN: Actually, I have a little bit of a different take here. Listen, if you look at the cloud industry, this is a market that's gone from an early cycle adoption period to midcycle. When I say early adoption, cloud was a $10 billion industry, going back to 2012. It's a $385 billion industry today. Microsoft's the leader in cloud. Azure is one of the faster growing parts of cloud. But we're going from a very large market with hyper growth to now an industry that's going to have healthy growth.

The overall cloud market will slow to less than 20% growth in 2023 for the first time. And so I think as we think about framing Azure, framing the moderation in Azure, these are just a lot of large numbers. Azure is still going to grow 30% constant currency, 26% this quarter. That's faster than we think the overall cloud industry will grow this year. So they actually still are gaining share in cloud. I actually think the Azure numbers were better than I had feared. I think the bigger concern on Microsoft is their non-cloud business.

The non-cloud business for Microsoft is $100 billion business that declined in aggregate 13%. It's going to decline by double digits again. So I think what's the market's grappling with right now is not necessarily a slowdown in cloud. That's anticipated, and it's probably not as bad as feared. The bigger concern is this $100 billion non-cloud segment that might be more cyclical than people appreciate.

And that's the concern, I think, that people have, institutional investors have. That's our primary fear, is the slowdown in their non-cloud business is happening much worse and is a little bit more cyclical than investors appreciate. So that's, I think, the primary issue we're focused on and what's dragging down earnings here short-term.

BRIAN SOZZI: Brent, in addition to slowing cloud revenue, we saw weakness in the PC business. We saw weakness in gaming. We saw advertising weakness in LinkedIn. Given all of that slowing, do you just sell Microsoft shares on the thesis that all of these trends just worsen from the first quarter to the second quarter, and we don't get a bottom in some of these growth rates until later this year?

BRENT BRACELIN: Yes, we're going to bottom here either this quarter, the current quarter reported, or next quarter. So we're close to basically seeing the worst decline in some of these non-cloud segments like Windows and devices and advertising. So I think we're closer to kind of a growth bottom in Microsoft than maybe people appreciate.

We actually took numbers down this year, fiscal year ending in June, by less than a half-- less than a billion dollars. We were Street low. We took numbers down by about $2 billion for next year. We were Street low. But we actually kept EPS inline. So we actually think with some of the layoffs, with some tight expense management, that EPS could decline here in fiscal '23. But in fiscal '24, we can see actually see a trend back to double digit EPS growth for Microsoft.

So we're in the eye of the storm. I like to call it the darkest before the dawn. We probably have another quarter of some challenging numbers here in the non-cloud business. And then I think it stabilizes from there. So I think these concerns on Microsoft are really short-lived over the next quarter. And we'll start to see stabilization going into fiscal '24.

BRAD SMITH: The darkest before dawn period certainly sounds analogous to what the crypto community would call a winter, if you will. And so even within this kind of darkest before dawn scenario where Microsoft still has to invest in its cloud business, invest in its advertising business, it sounds like I could be kind of a dual component, or at least, an investment for both of those businesses as well. But is AI the savior for Bing? Is AI the savior for-- or the next leg of growth for its cloud business, especially when that's been in some competitive clouds already?

BRENT BRACELIN: Listen, generative AI is super exciting. ChatGPT has caught the attention of the world here and the promise it has. But let's be clear. Microsoft's a $200 billion revenue business. For generative AI to become a material impact on Microsoft, I think that's going to be measured in years, not months. If you're a startup, with the revenue, absolutely. ChatGPT, these generative AI models can absolutely have an impact in 2023 on your growth rates. Microsoft's just too big.

So I think it's going to take years for generative AI to really have a material impact on Microsoft's growth trajectory. I think it absolutely will. We're very bullish around these large AI models and the impact it's going to have on software. These are big platform plays. This feels like the beginning of a new internet-like era going forward, but it is very, very early. I'm cautious getting too excited about a trend. I think Moore's law applies here and do suggest a little caution, even though this technology is really, really promising.

JULIE HYMAN: Brent, on that front, this-- I mean, we've been talking about ChatGPT sort of amongst ourselves. And Brad was joking yesterday he was talking about it at brunch over the weekend. Like, it's become part of the popular consciousness. But we were trying to remember this morning-- I mean, IBM had Watson. We had almost forgotten that existed, right? We've had other waves of these AI developments that promise to be changing in a big way. Is this time different, even if it is early, in this new wave of AI?

BRENT BRACELIN: I think it's different. And I think it's important to frame the pace of change. If I think about, like, software, software is being powered by Moore's law, by the number of transistors doubling every two years for the last 40 years. If you look at the pace of change with some of these large AI models, we're talking not a doubling of transistors every two years. We're talking about a 100-fold increase in intelligence every year.

So it is something to watch closely. Things are changing very fast here. I think it is different because the pace of change is different. But again, we have to go from the lab to production to convincing large enterprises to adopt the technology. Things typically happen first in consumer and then bleed over into the enterprise, where there's security and data governance requirements. But no doubt, very exciting to talk about what the potential is here. It is different, I think, than Watson, but again, very early.

BRIAN SOZZI: Brent, Microsoft really, obviously, of course, played up ChatGPT on the call last night, but also talked about it, putting it in other software applications. My interpretation was it may show up in Teams. It's going to be used to help sell more cloud services. Are Microsoft's cloud rivals, Amazon and Alphabet, working on similar technology to prevent a Microsoft from coming in here and just gaining a lot of market share?

BRENT BRACELIN: If you look at some of the industry folks that are really close in the weeds around generative AI, I think there's a belief that, yes, ChatGPT was based on OpenAI kind of GPT 3, 3 and 1/2 model. That's kind of what we're talking about now. There could be a dozen different large language models by the end of the year.

So there's going to be a lot of other folks leveraging other AI models in different ways. So I don't think it's a singular OpenAI game. I think it's just going to have multiple players who are really, really early. So it's going to be fascinating to watch. It's going to be exciting to watch. But again, I'll stress, we are in the very nascent stages of adoption. But things will happen fast.

BRAD SMITH: Piper Sandler equity research analyst Brent Bracelin joining us this morning. Brent, thanks so much for breaking down the earnings with us.

BRENT BRACELIN: You're welcome.

BRAD SMITH: Microsoft said that it reversed a network change believed to have prompted an outage that happened on Tuesday, which resulted in thousands of customers losing access to its services like Teams and Outlook. The outage lasted for four hours and impacted many across Europe and Asia. This happened just hours after the company reported earnings.