Microsoft (MSFT) reported strong Q3 2023 earnings on Tuesday after the markets closed. Revenues, profits, and Q4 guidance were all better than analyst expectations. As a result, its shares traded nearly 9% higher after-hours.
Turn the page to Wednesday.
It didn’t look like its momentum would carry over after a competition regulator in the U.K. blocked Microsoft’s $69 billion deal to buy Activision Blizzard (ATVI). The regulator said no “over concerns the deal would alter the future of the fast-growing cloud gaming market, leading to reduced innovation and less choice for U.K. gamers over the years to come,” Barron’s reported.
Activision responded by suggesting it would work with Microsoft to reverse the decision on appeal. Activision stock dropped More than 11% Wednesday on the news.
Amazingly, investors were so happy with Microsoft’s earnings that they looked past the rejection. As a result, MSFT finished trading Wednesday up 7% on volume more than 2x its 30-day average.
Microsoft, despite this temporary setback, remains a buy.
The Bad News First
Before looking at all the good news in Q3, it makes sense to consider what the UK rejection means for Microsoft’s gaming business in the near and long term.
In the near term, Microsoft will have to pay lawyers a lot to continue the battle. However, it has plenty of that. MSFT generated $17.8 billion in free cash flow in the third quarter.
However, in the long-term, if it has to go to Plan B, Microsoft Gaming CEO Phil Spencer, isn’t overly worried about the company’s ability to compete in the gaming space.
“This is an important acquisition for us. It’s not some linchpin to the long term — Xbox will exist if this deal doesn’t go through,” Spencer told The Times in February.
However, many gaming experts believe Microsoft will sell Xbox if the Activision deal is ultimately blocked and can't proceed.
“Microsoft selling Xbox would be one of the largest stories in the gaming industry. The Xbox brand is about more than gaming at this point. Microsoft has integrated Xbox with Azure and the company uses the gaming platform to drive people to the Microsoft Store,” stated WindowsCentral.com contributor Sean Endicott in February. “The tech giant has invested billions of dollars into the Xbox brand, including making games playable on the cloud and non-Xbox hardware.”
While it seems crazy for Microsoft to unload the gaming business, it generated approximately $3.19 billion in Q3 2023, $133 millon less than a year earlier. On the other hand, its search and news advertising business generated $3.43 billion in the third quarter, approximately $240 million higher.
There are many other fish to fry if Xbox is no longer part of the Microsoft ecosystem. And it would likely get a pretty penny were it to sell.It’s not the end of the world if the deal falls apart, except maybe for Warren Buffett, who paid an average of $73.28 for the 52.7 million shares of ATVI he still holds. He’s still making money off his 2021 bet, but not nearly as much as he would if the deal goes through at $95.
The Good News Is Very Good
Microsoft reported Q3 2023 revenue of $52.86 billion, $1.84 billion more than the analyst expectation, according to Refinitiv. On the bottom line, its earnings per share were $2.45, 22 cents better than the consensus.
As for Q4 2023, the midpoint of its guidance calls for $55.35 billion in revenue, 6.7% higher than a year earlier and $470 million clear of the analyst estimate.
“As with any significant platform shift, it starts with innovation, and we’re excited about the early feedback and demand signals from the AI capabilities we’ve announced to date,” CNBC reported CFO Amy Hood’s comments from Microsoft’s conference call. “We will continue to invest in our cloud infrastructure, particularly AI-related spend, as we scale to the growing demand driven by customer transformation. And we expect the resulting revenue to grow over time.”
Everybody and their dog is into AI at the moment. So combining AI with Microsoft's Cloud business is a potent one-two punch. The company’s Intelligent Cloud business generated $22.08 billion in the third quarter, 16% higher than a year ago.
What stands out is the difference between Product and Service revenue in the quarter. The former’s revenue decreased by 10.2% in the quarter to $15.59 billion, accounting for less than 30% overall. The latter jumped more than 16% to $37.27 billion. Its gross margins are about 750 basis points less but still very high at 67.2%.
I’ll take slightly lower gross margins and double-digit growth than slowing revenues and slightly higher margins.
The Bottom Line
Analysts really like MSFT. What’s not to like? Of the 49 covering it, 40 rate it a Buy or Overweight, with a median target price of $320.
“We believe Microsoft is one of the most compelling investment opportunities in the technology industry and across sectors,” CNBC reported Goldman Sachs analyst Kash Rangan’s comment from his Tuesday note to clients.
While MSFT stock isn’t cheap at 9.93x sales, it is still slightly less than its five-year average of 10.05x.
Microsoft remains a buy despite the U.K. downer.
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