Second Quarter Results for the Magnificent Seven

How have the Magnificent Seven performed in the second quarter of 2023?

Amazon Stock at a Glance

• Fair Value Estimate: $150

• Morningstar Rating: 3 stars

• Morningstar Uncertainty Rating: High

• Morningstar Economic Moat Rating: Wide

Amazon Earnings: Strong Q2 and Better-Than-Expected Outlook

Wide-moat Amazon AMZN reported strong second-quarter results and provided better-than-expected guidance for the third quarter.

E-commerce and advertising drove most of the upside, but AWS revenue stabilized and came in better than feared with a more upbeat outlook. Operational improvements continue apace and propelled the firm to its strongest operating margin in the last two years.

We still envision healthy long-term growth driven by e-commerce proliferation, AWS, and advertising and believe the biggest near-term issue is evolving to be the health of the consumer rather than business spending on the cloud. After increasing our growth and profitability assumptions based on results and guidance, we are increasing our fair value estimate to $150 per share, from $137 previously, and see modest upside for the stock.

We see plenty of green shoots within segment performance. Second-quarter revenue grew 11% year over year both as reported and in constant currency, to $134.4 billion, compared with the high end of guidance at $133 billion. The two most critical segments, AWS and advertising, grew 12% and 22% as reported, respectively, over the year-ago period. Amazon’s growth in this category continues to outpace that of its large internet peers.

Relative to our model, online stores, third-party seller services, or 3P, and advertising drove the vast majority of upside. Physical stores were in line while all other segments were slightly ahead. From a retail perspective (all year over year, as reported), revenue from online stores grew 4%, physical stores grew 6%, 3P grew 18%, and subscription services increased 14%. Paid unit growth accelerated modestly to 9% year-over-year growth.

Operating profit came in at $7.7 billion, compared with the high end of guidance at $5.5 billion, resulting in an operating margin of 5.7%, compared with 2.7% a year ago. Both North American and AWS margins expanded sequentially, while international continues to narrow its losses.

AWS Stabilizing

AWS was our biggest concern from last quarter, and we were pleased to hear about stabilization during the quarter and through July, as optimization efforts are easing, and new workloads are taking hold. This is consistent with commentary from Microsoft regarding recent Azure performance. Management remains optimistic on AWS and is continuing to invest heavily in the segment. We continue to believe that the migration to the public cloud is an enormous opportunity and remains in the early stages of evolution, with AWS being the clear leader.

We think the company has entered a second phase of margin improvement after the massive expansion during COVID-19 and the resulting issues that followed as the lockdowns subsided. Now the company has moved to a regional fulfilment model, which has helped speed delivery times and lowered costs. Amazon continues to make progress on margins on a variety of fronts and we expect including improvements to the productivity of the fulfillment network and transportation, but also throughout the entire business as well.

Like nearly all of our coverage, management discussed its artificial intelligence initiatives, noting it has been in the AI and machine learning business for years already—a point we regularly reinforce with clients.

Amazon noted its prowess in AI, including more than 25 AWS services; two internally designed chips; Bedrock, its own managed AI service; and Titan, its own family of large language models. AI is clearly embedded in much of what Amazon has built over time, so we fully expect the company to be a leader in AI, especially given the cost and compute capacity required to build, train, and run these models. Management is rightfully optimistic the company will be a leader in this category, a point with which we agree.

Apple Stock at a Glance

• Fair Value Estimate: $150

• Morningstar Rating: 2 stars

• Morningstar Uncertainty Rating: High

• Morningstar Economic Moat Rating: Wide

Apple Earnings: Solid Results As Next Wave of iPhones Are on Deck

Wide-moat Apple AAPL reported solid results for its fiscal third quarter and provided investors with a flattish outlook for the September quarter. We continue to take Apple’s results in both the June and September quarters with a grain of salt, as results are composed of the older iPhone series and we would instead keep our eyes on the next wave of Apple devices and whether Apple can entice a larger portion of its customer base to buy the latest and greatest iPhone.

We maintain our fair value estimate of $150 per share and view shares as overvalued. We’re encouraged by Apple’s success in reaching 1 billion paid subscribers for its services businesses, but still struggle to foresee the company as being more than a mid- to high-single-digit revenue grower in the long term.

Encouraging Shifts to iPhones From Android

Revenue in the June quarter was $81.8 billion, down 1% year over year as reported, but up on a constant-currency basis. The iPhone revenue performance was similar, down 2% year over year as reported but up in constant-currency terms. We’re encouraged that Apple saw a June-quarter record in switchers to iPhone and away from Android.

Services revenue was the bright spot, up 8% year over year and ahead of expectations, with June-quarter records in several subsegments like video and payment services. The iPad and Mac revenue continue to struggle after a natural slowdown in these markets post-COVID-19 lockdowns, as revenue was down 20% and 7% year over year, respectively. Apple remained highly profitable with a record high gross margin of 44.5%, up 20 basis points sequentially.

In the September quarter, Apple expects revenue to be flattish on a year-over-year reported basis. On the upside, iPhone and services year-over-year growth should accelerate and currency headwinds should dissipate. However, Apple expects iPad and Mac revenue to be down at least 10% year over year because of tough comparisons to a strong September 2022 quarter.

Apple’s AI Investments

We see virtually all tech companies being asked about artificial intelligence. On this front, we heard Apple discuss its investments in AI and machine learning and how it is integrated into many of its products already.

Generative AI, such as ChatGPT where the AI generates new content rather than surfaces patterns within existing data, is also an area where Apple is investing, albeit secretly. Ultimately, we foresee a host of niche or customized generative AI models being infused into software and platforms over time, and Apple’s work here is no exception.

We would speculate that any sort of co-pilot functionality would make sense to us within Apple’s suite of products, given all of the services Apple layers within its devices and its integration across various form factors.

Meta Stock at a Glance

• Fair Value Estimate: $311
• Morningstar Rating: 3 stars
• Morningstar Uncertainty Rating: High
• Morningstar Economic Moat Rating: Wide

Meta Earnings Update

META again displayed its strong network effect moat source as its user base across all apps increased, engagement remained healthy, and monetization improved further during the second quarter. Advertisers are gaining confidence in Meta’s enhanced and artificial intelligence-powered campaign planning and measurement capabilities, and spending more.

Unsurprisingly, Reels monetization keeps improving. We also applaud the firm’s continuing focus on cost control and overall efficiency, which resulted in year-over-year margin expansion for the first time since second-quarter 2021. We think margin expansion likely will continue through 2027, albeit with continuing losses at its Reality Labs.

Raising Fair Value Estimate on Meta Stock

We have increased our fair value estimate of wide-moat Meta to $311, from $278. With the stock more than tripling its 52-week lows, we now believe it is now fairly valued, with much faster revenue growth than initially anticipated this year and higher long-term margins now priced into the shares.

Total revenue of $32 billion is up 11% from last year and 12% on a constant-currency basis. Meta’s user count increased in all regions. Engagement across Meta’s family of apps increased as average monthly and average daily users jumped 6.3% and 6.6% from last year, respectively. The Facebook app also experienced higher engagement, with growth in both monthly (up 3.3%) and daily (up 4.9%) users. Advertising revenue grew 12% from last year to $31.5 billion as more impressions were sold (up 34%), more than offsetting Reels-driven lower prices (down 16%).

AI Investments Showing Immediate Returns

The increase in engagement displays immediate returns on Meta’s AI investments, as content recommendations from nonfollowers and overall easier content search are keeping users on the platforms longer.

Operating margin improved 35 basis points to 29.4%. Excluding restructuring charges, operating margin was 31.8%. We expect significant operating leverage from accelerated revenue growth because of the firm’s success in streamlining its operations.

We commend Meta’s AI investments, which are mainly focused on increasing user engagement, easing ad placement, and improving ad returns on investment, all at lower costs for the firm. Meta’s content discovery and recommendation enhancements have led to more than 200 billion Reels played per day, which has tripled Reels’ annual revenue run rate to around $10 billion from last year, according to management. In addition, Meta has begun to apply its large language model LLaMA internally to its platforms where it can help users create more content. Plus, the firm’s Advantage+ AI-based product is now helping advertisers better automate the creation, placement, and targeting of ads.

Regarding Threads, while we are pleased with the early user count of the app, uncertainties regarding user retention in the long run and monetization remain. According to estimated data from Quiver Quantitative, more than two weeks after the apps’ user count hit 100 million (in only four days), it has added only around 18 million users. As mentioned in our July 11 note, we still think that if monetized successfully, revenue from Threads would add only another 3%-6% to our fair value estimate of Meta.

We have also increased our margin assumptions as we think Meta’s AI investments may strengthen the firm’s network effect and reduce needed sales and marketing spending to retain users and attract advertisers. Regarding the advertising side, AI-powered tools like Advantage+ should not only attract more ad spending but would also increase efficiency for Meta’s ad placement capabilities. We now expect operating margin to improve to 37% by 2027, from our projection of 31% this year.

Alphabet Stock at a Glance

Fair Value Estimate: $161

Morningstar Rating: 4 stars

Morningstar Uncertainty Rating: High

Morningstar Economic Moat Rating: Wide

Alphabet Earnings: Google Search and YouTube Growth Doubts Are Subsiding; Stock Remains Attractive

We maintain our $161 fair value estimate on wide-moat Alphabet GOOG, GOOGL and continue to view it as attractive. Growth in search and cloud, plus a turnaround in YouTube, drove the firm’s impressive second-quarter revenue growth. 

Accelerating growth in Google’s core search business demonstrated that the segment’s network effect moat source is intact, despite threats from Microsoft and OpenAI. Also, as we expected, YouTube ad revenue returned to growth due to a more balanced mix of broad-based and direct response ad demand, improvement in YouTube Shorts monetization, and increasing demand for ads on connected TVs. We were surprised by another revenue decline in Google’s advertising technology offerings but expect that segment to improve as economic uncertainty lessens and ad spending across the internet picks up. 

Google’s Cloud Momentum Continues

Google’s cloud momentum continued with impressive top-line growth and margin expansion. While management remained cautious about future cloud growth, we look for revenue acceleration, driven mainly by increasing demand for artificial intelligence tools and features.

Total second-quarter revenue came in at $74.6 billion, up 7% from last year. Advertising revenue returned to growth (up more than 3%) after two consecutive quarters of a decline, with improvements in both search (up 5.6%), which was driven by strength in retail, and YouTube (up 4.4%), partially offset by the ongoing weakness in advertising technology revenue (down 5%). Cloud revenue increased 28%, and other services, which includes hardware and Google Play, was up 10%.

Operating income of $21.8 billion (29% margin) was higher than last year’s $19.5 billion (28% margin) helped by a slight decline in traffic acquisition cost as a percentage of advertising revenue and the longer useful lives assumed for servers and other hardware, which resulted in lower depreciation expense. Lower sales, marketing, general, and administrative expenses as a percentage of revenue also contributed to the higher operating margin.

Ad Spending Improving

We expect ad spending will continue to pick up given the resilient economic backdrop. While ad-holding firms such as Omnicom and IPG disappointed the market recently, we think investors have misperceived their second-quarter results as an indication of lower ad spending. In fact, the media buying segments of those firms posted strong revenue, which indicate that advertising spending by large brands may be picking up. This was supported further by the strong growth in broad-based ad demand on YouTube in the quarter. On the other hand, we continue to think that the firm could be forced to pay higher traffic acquisition fees not only to Apple but also possibly to Samsung.

Regarding search, Google’s second-quarter numbers show no evidence of lost market share to Microsoft Bing. While it is still too early and search revenue deceleration and some market share loss may happen, we think Google will maintain its search dominance. Also, on the earnings call, Google management mentioned that it is receiving positive feedback regarding its generative AI-capable Bard search chatbot and search generative experience, or SGE, the firm’s latest search platform to combine generative AI and traditional listing search.

Ali Moghrabi, Morningstar Analyst

Microsoft Stock at a Glance

Fair Value Estimate: $360.00

Morningstar Rating: 3 stars

Morningstar Uncertainty Rating: Medium

Morningstar Economic Moat Rating: Wide

Microsoft Earnings: Solid Performance, With Azure Strength Offset by Margin Pressure in 2024

Wide-moat Microsoft MSFT reported solid fourth-quarter results, including upside on both the top and bottom lines.

We see continued signs of encouragement in important areas like Azure, which did slightly better than our model; and Microsoft 365, which was solid, based on better-than-expected upsells and renewals. However, the outlook overall was slightly shy of our model. Further, capacity investments in front of artificial intelligence-driven demand will limit near-term margin expansion, which we think is an easy trade given the opportunity. 

AI Demand Building for Microsoft

The upshot of this is that AI demand is already materializing. Lastly, macroeconomic pressures remain but don’t seem to be worsening. We think results are solid overall, and after advancing our model to account for the firm’s year-end, we lift our fair value estimate to $360 per share, from $325, and continue to view shares as attractive.

We see results as reinforcing our long-term thesis centering on the proliferation of hybrid cloud environments and Azure, as the firm continues to use its on-premises dominance to allow clients to move to the cloud at their own pace. We center our growth assumptions around Azure, Microsoft 365 E5 migration, and traction with the Power Platform for long-term value creation. We also see a new growth avenue emerging in the form of AI, where Microsoft is positioned as a clear leader.

Microsoft Cloud continued to grow nicely, driven by Azure strength, and was up 21% year over year in constant currency to $33.3 billion. Growth here was consistent, with the 22% achieved in each of the last two quarters, which, taken together, we view as continued signs of stabilization. Azure grew 27% year over year in constant currency, versus guidance of 26%-27%. Importantly, management noted that more than 50% of the $110 billion commercial cloud revenue was from Azure, which is consistent with our long-running estimate that now reads $58 billion. AI added about 100 basis points of growth to Azure performance and is expected to add 200 basis points of growth in the first quarter. Management continues to point to lapping challenging comparisons for Azure as elevated workload optimization trends ease beginning in the first quarter, carrying on throughout fiscal 2024. Commentary from Amazon is consistent with this. Management also noted good deal activity for Azure, which we think bodes well for the next couple of years.

For the June quarter, revenue grew 8% year over year as reported, or 10% in constant currency, to $56.19 billion, compared with the midpoint of guidance of $55.35 billion. Relative to the year-ago period (as reported), productivity and business processes grew 10%, intelligent cloud grew 15%, and more personal computing, or MPC, declined 4%. Compared with guidance, all three segments were slightly ahead of the top end of the guidance ranges. Good sales execution helped drive solid renewals once again. Additionally, AI is already helping drive overall demand, which we expect to accelerate over the next couple of years.

Dan Romanoff, Morningstar Analyst

Tesla Stock at a Glance

• Fair Value Estimate: $215
• Morningstar Rating: 2 stars
• Morningstar Uncertainty Rating: Very High
• Morningstar Economic Moat Rating: Narrow

Tesla Earnings: Profit Margins Contract for Third Straight Time, Driven by Price Cuts

We maintain our $215 per share fair value estimate and narrow moat rating for Tesla TSLA following the company’s second-quarter earnings. Tesla shares fell immediately after the company’s results the market responded to management’s commentary that further price cuts could be coming later this year. At current prices, we view Tesla shares as overvalued, with the stock trading in 2-star territory.

In response to slowing demand, Tesla began cutting prices in the fourth quarter of 2022 and has continued through the first half of this year, leading to three straight quarters of lower average selling prices and lower automotive gross profit margins. 

More Tesla Price Cuts Likely

We think the company is likely to cut prices in the second half of the year in response to other automakers also cutting prices, which would result in further margin declines. Accordingly, we reduced our 2023 automotive gross profit assumption.

However, we think prices will begin to stabilize by the end of the year as economic conditions improve, leading to 2023 being the cyclical low for margins.

During the earnings call, management highlighted the launch of the company’s first pickup truck, aptly named Cybertruck. Over the long term, we see this vehicle as having a relatively modest contribution to total deliveries, as we forecast a peak of around 100,000 vehicles per year, well short of management’s 250,000 target. However, the truck aims to show off Tesla’s new technology, which we view as crucial to Tesla’s brand, which is producing vehicles with the best technology.

Additionally, Tesla began production of its Dojo supercomputer. This aims to train Tesla’s autonomous driving software, which should allow the company to develop faster improvements and accelerate the timeline for the full launch. The full self-driving software should allow Tesla’s vehicles to have a third ancillary revenue stream, in addition to charging and insurance, which boosts the value of each car sold to Tesla over the long-run.

Seth Goldstein, Morningstar Analyst