There’s no such thing as a perfect investment. Buying a stock always involves a trade-off between risk and reward, but also the certainty that at least a few things won’t go according to plan. Companies are forever reacting to changing consumer preferences, new competitive threats, and emerging economic pressures.
Microsoft‘s (MSFT 3.50%) latest earnings announcement was a good example of these countervailing forces at work. While the software giant strengthened its hold on its massive enterprise cloud-services segment, cracks are starting to show in other areas of the business.
Let’s take a look at the biggest green flag for Microsoft right now and the main drawback to owning the stock heading into a potentially rocky 2023.
The green flag
The best news about the business is that Microsoft is still dominating in a massive and growing industry that’s likely to expand for many more years. Its enterprise cloud services segment, anchored by Azure, is still a huge draw among large and small businesses.
The Azure segment grew by a blistering 26% in the fiscal first quarter, which was enough to keep Microsoft’s overall expansion pace stable compared to the prior quarter. The company is still growing at a 16% rate overall after accounting for currency exchange rate shifts. It has gained market share steadily since 2017, with share rising to 21% of the cloud infrastructure market from 13%
Sure, Azure is losing some of its earnings power. Gross profit margin declined by 1 percentage point to 69% of sales. This drop mainly came from higher energy costs associated with running busy data centers. But it is a great sign for the business that more demand is shifting toward its cloud services.
In fact, Microsoft happily spent over $6 billion to build up its digital infrastructure in Q1. “Our data center investments continue to be based on strong customer demand and usage signals,” CFO Amy Hood said in a call with Wall Street analysts.
The red flag
There are weaker demand and usage signals in other areas, though. People aren’t buying PCs at nearly the same pace they were a year ago. Pandemic-related work-from home demand has shrunk, and it is now clear that some demand growth in 2021 was simply borrowing sales gains from 2022 and beyond. Microsoft’s video game segment is struggling with a similar growth hangover.
The outlook for the PC division, which supports sales of operating systems and productivity software, isn’t bright over the short term. Microsoft might even face some profitability pressure as it cuts prices to boost sales in its device niche.
Worse yet, these pressures haven’t shown signs of stabilizing yet. Executives said the PC market worsened through the quarter and was especially weak in September. Similarly, demand trends decelerated in the advertising business late in the quarter. These factors imply a bigger drag from Microsoft’s non-cloud services products through the holiday shopping season and into 2023.
Still a great stock
Investors shouldn’t let these temporary challenges keep them away from an attractive stock. Microsoft is winning in core growth markets like cloud infrastructure services and managing through tough times in other areas. And through it all, it continues to generate plenty of cash that management can direct toward future growth initiatives like the metaverse and augmented reality.
The company’s recent 10% dividend hike also demonstrates a commitment to returning cash to shareholders. Though the stock isn’t perfect, Microsoft still represents one of the best options investors have to gain exposure to the digital transformation trends that will be the defining forces for tech stocks over the next decade.