3 = =j Equity Research Goldman Sachs Microsoft Corp. ism 23 January 2022 | 7:14PM PST Expecting continued Microsoft Cloud momentum as demand remains robust — F2022 preview MSFT 127 Price Targot $400.00 Price: $296.03 Upside: 35.1% F2022 Results on 1/25. Building on strong momentum in 10, we expect another strong quarter in F2Q as our conversations point to healthy demand environment including sustained momentum in public cloud adoption and continued traction in upseliing E5 into the installed base; while we anticipate some volatility in reported ‘growth with FX likely to represent an incremental headwind relative ‘to when the company guided in October, we nonetheless expect a solid quarter driven by continued Microsoft Cloud momentum, with ‘commercial bookings lapping a 7pp easier ce compare, although ‘comps do become more difficult into 2H. Moreover, upcoming price increases for Office 365 (more below) in March will likely present tailwind to growth and margins in CY22 and beyond. We continue to believe investor focus will remain on the sustainability of Microsoft Cloud growth (namely Azure} alongside operating margins into FY22, particularly as the company laps 450bps of yoy op margin expansion in FY21. With Microsoft Cloud continuing to mix higher, we remain constructive on the long-term growth outlook, particularly as Microsoft remains well positioned to capitalize on DX initiatives and rising public cloud adoption. We reiterate our Buy rating (on CL) and 12-month price target of $400. Our price target is based on equal-weighted OCF; EV/FCF, and P/E. At ~$296, MSFT trades at ~30x and ~25x our CY22 and CY23 EPS estimates of $9.93 and $11.97 (consensus $9.68 and $11.21), Since reporting F102 earnings on 10/26, MSFT is down 5% ‘compared to a 10% decline for the NASDAQ and an average 27% decline across our software coverage. Despite recent relative outperformance, with the stock trading roughly incline with its pre-COVID peak of 31x, we continue to view risk/reward as favorable, as the overall demand environment remains strong and FCF support should continue to mitigate volatility relative to the rest Kash Rangen soz oh oom ban sh 4 oh ete Nikolay Bolioy Andrew Eisenson SESE be tersntye con key Market cap 6226 Entre ae: $2 tr "gm ADTN" $9.60 Unites States mess Sot 68S Factor Profile ——————o a os Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, ar go to \www.gs.com/research/hedge. html. Analysts employed by non-US affiliates are not registered/qualified as researchGoldman Sachs Microsoft Corp. (MSFT) rosoft Corp. (MsFT) Balance Sheet ($mn) SE ating size Jn 21,2021 contcaheanalots weno arm Tews wean Ser Se ees) cee ae or Sees onc) ama | ra Rats & Valuation Charen os ao) ees) od se Sos bums Seon lat Ever o0 2200 zh mB Totes amymo miss aes st2770 = ao me oe Soe nner oye te te amt mms oes = BEBE etait A ee ocooe cs a eae a Growth & Margins (8 Coster tate ao ue Sm? emo eee gees ee eee ee) ee ae oe. Seo Sar See Su moe es totem aa ee Gros rege ots a? Tot ah aguy samo sass 00571 ies Pethormance cash Flow $m) “ eo Nota tes es) me cae _ al [Nes inclec working crit wan Genr3 aR ES 00 Ones smea asco | km 380 200 200 Ca on tam apertns vena mem wraue tans oo lees maemo cae Gao ERS 10 segeitere . “ * 2 Ore fass0 200 war om soe Ch ow tom even wasn) come isms (aise So . tay Duster rasa qaaon fay Bhan a — os gia Surtananaepuctcl moma ota feana —eama sour Fatt Press 2 Jn 222 cose, OP fo) bal 7 5 — : aon tom Baansng vase Gams (707 (mss Income Statement mn} ‘oud ow eo “sso sa s7303 Taste woaieo sams zene asiam2 Pecan ow stot yao tia tam Gane emets mma jeune mien eo Soon Conny ta Gots Sue asec sees Netrtstnedont seo muy Preteortt nwo ame meus ses Provsenttmse nasa yaase case eas ‘xine pon como eso oes Ps bie pre-e so a8 ‘ast 5s, ret (8 mm 39 ae us mm 30 aeGoldman Sachs Microsoft Corp. (MSFT) of our coverage group. We see @ continued path towards outperformance driven by accelerating demand for digital transformation and rising public cloud adoption catalyzed by structural changes in enterprise and consumer behaviors in the wake of the COVID-19 pandemic, and we see a path towards durable double-digit topline growth alongside margin expansion driven by Microsoft Cloud (Azure, Office 365, Dynamics, and Linkedin Commercial) momentum which we believe has the potential to grow from 2 ~$80bn business to a $120bn to $140bn business longer term, Our conversations this quarter: our conversations with partners in the quarter point to continued momentum in cloud migrations and app modernization projects alongside solid E5 momentum as security and voice help drive SKU migration with customers able to bundle more functionality onto the Office 366 platform. While cloud adoption intentions in our December CIO survey moderated slightly relative to their December 2019 peak, we note the long-term outlook for cloud adoption remains strong and we expect continued strength in digital transformation related spending, which we expect to outpace overall IT spend for the foreseeable future (see our initiation for more details), and believe MSFT remains well positioned to capitalize on DX strength with a strong positioning across the cloud stack. For F2022 we are modeling revenue and EPS of $50.9bn (+18% yoy] and $2.32 compared to consensus (FactSet) of $50.6bn (+18% yoy) and 2.31 respectively. While FX will ikely drive some volatility in reported growth (more below), based on our conversations, we expect upside in the quarter on a ce basis, as demand remains robust and the company laps @ 7op easier yoy co compare for commercial bookings. We continue to see upside to Azure growth into 2H as public cloud momentum, continues and comps become easier: Recall, in F1Q Azure cc revenue growth of 48% marked a Sp acceleration relative to F4Q (albeit against a Spp easier yoy compare) While changes in FX rates since the company last reported in October will ikely drive volatility in reported Azure revenue growth (we estimate an incremental ~2pp headwind to total reported revenue relative to guidance for a ~1pp tailwind!, on a cc basis we see room for sustained momentum over the course of FY22. Our conversations point to a robust demand environment in the quarter with Azure becoming an increasingly strategic cloud partner and continuing to gain share. We note Azure cc comps get easier into F2H22 and we see potential for sustained momentum over the course of the year. Longer term, as public cloud adoption continues, we believe the installed base of Windows Servers (25:30mn GSe} alone represents an $80-$90bn opportunity for Azure and note Azure continues to gain market share with growth coming from new workloads and cloud migrations. For F222, we model reported Azure revenue growth of 46% (compared to 50% reported yoy in F122 and 48% constant currency) and forecast Server products and Cloud services revenue growth of 28% versus 35% (33% in constant currency) in F102. Commercial Office 365 pricing increases provide tailwinds to CY22 growth and margins: we see continued runway for Office 365 growth, with potential for the company roughly double its installed base of ~300mn users to 500mn, given the massive number of knowledge workers worldwide and the company continues to gain traction with its F1 SKU aimed at frontline workers. As noted above, our conversationsGoldman Sachs Microsoft Corp. (MSFT) point to continued traction with premium £3 and E5 SKUs as driving sustained growth over the medium-term, with recently announced pricing increases (see our takeaways note for more details) kely simed at driving further premium SKU adoption; recall, the ‘company’s E5 SKU accounts for only ~8% of the 300mn+ paid user installed base. While pricing increases for Commercial Office 365 will not take effect until the end of 3022 (March 2022), at ~18% of FY21 revenue and mixing higher, we see tailwinds to ‘growth and margins in F2H22 and into FY23. While it will ikely take time for price increases to flow through the model based on the cadence of customer renewals, increases of 25%/15%/9% for E1/E3/E5 respectively should provide tailwinds to revenue growth in CY22 and beyond. For F2022 we are modeling Commercial Office 365 growth of 20% yoy compared to 21% yoy cc growth in F122 against a similar compare. We expect total Office Commercial growth of 14% yoy in F2022, with growth in Commercial 365 partially offset by a decline of 18% in the on-prem Commercial Office business. Despite near-term gross margin headwinds, we see longer-term potential for ‘margin improvement: Following changes in useful life accounting assumptions for server and network equipment, an incremental ~$2.7bn in depreciation expense shifted from FY21 into future periods, with the company now lapping a ~400bps benefit to Microsoft Cloud gross margins. Consequently, management noted an expected 4pp headwind to Microsoft Cloud gross margins in F2022. Guidance for F2Q Microsoft Cloud gross margins to be down ~2pp yoy despite an anticipated ~4pp headwind highlights continued improvement in the gross margin profile despite increasing mix shift to Azure, and the Azure consumption business (laaS and PaaS) in particular Longerterm we see further potential improvement in gross margins, particularly as near-term headwinds from changes in accounting estimates fade alongside continued efficiencies and scale in the Microsoft Cloud business. Recall on the company’s 4020 earnings call, management announced changes to the useful life accounting ‘assumptions for server equipment and network equipment for the company’s cloud infrastructure effective the beginning of FY21. Server equipment useful life assumptions, will move to 4 years (3 prior), while network useful life assumptions will move to 4 years (from 2 prior) due to advances in technology and efficiencies in how the company operates their server and network equipment. Longerterm, as Azure continues to scale, we see further potential for margin expansion as continuous improvements in hardware, software and data center design drive more efficient Capex. FY22 EPS growth now lapping more difficult comps following ~450bps of operating margin expansion in FY21. Heading into FY22, we see potential for OpEX to accelerate, particularly as the pace of hiring increases and COVID related savings (~$1.2bn} potentially come back into the model to some degree. Longerterm, we continue to expect some runway for continued margin expansion ahead, however we expect EPS growth to moderate from a peak 34% ce yoy in F4Q21. That said, we remain bullish on the long-term outlook for revenue and EPS growth and are modeling EPS to grow at an 18% CAGR from FY21 through FY24. PC market declined in 40 following 6 consecutive quarters of growth: in C4021, the global PC market declined 5% yoy including Chromebooks according to Gartner asGoldman Sachs Microsoft Corp. (MSFT) global supply chain issues and a sharp deciine in Chromebook shipments weighed on ‘market growth. While Windows OEM compares are easier in 1H22, particularly for Windows OEM pro, with the October release of Windows 11, a portion of Windows OEM revenue was deferred from F102 into F2Q with anticipated 6pp ($210mn) impact to Windows OEM revenue growth in the quarter. Given high contribution margins, we estimate that all else being equal, every $100mn change (~3pp of growth) in OEM revenue would translate to ~$0.01 impact to EPS in the quarter, FX: On the company’s F1022 (September) conference call, management guided to a ~1pt FX tailwind (~$430mn) to revenue and no impact to COGS and operating expense (growth. Based on the current FX environment, we estimate an incremental ~225bps headwind from FX since the company last reported on 10/26, and we expect a ~125bps (~8$540mn} headwind to revenue growth in the quarter; we note that Microsoft hedges a portion of its FX exposure. Our estimates heading into the quarter: For F2022 we are modeling revenue and EPS of $50.9bn (+18% yoy) and $2.32 compared to consensus of $50.6bn (+18% yoy) and $2.31 respectively, As noted above, we see potential upside to our Microsoft Cloud estimate of $22.4bn (+34% yoy). For FY22, we are modeling revenue and EPS of $197bn (+17% yoy) and $9.17 compared to consensus of $196bn (+17% yoy) and $9.19. ‘As noted above, we believe OpEx growth in FY22 will be a focal point for investors as the company laps a strong operating margin compare and COVID related savings; for FY22 we are forecasting OpEx growth of 13% yoy compared to consensus of 14% yoy. For more details regarding our estimates relative to consensus and guidance, see Exhibit 1. (Our thesis on Microsoft: With a strong presence across all ayers of the cloud stack, including applications, platforms, and infrastructure, Microsoft is well positioned to capitalize on a number of long-term secular trends, including public cloud and SaaS adoption, digital transformation, AVML, B/analytics, and DevOps (amongst others). We see a pathway for sustained double-digit topline growth alongside continued margin expansion, particularly as the Microsoft Cloud business continues to grow as a percentage of the overall mix. Our conversations point to Microsoft Azure increasingly shortlisted as a strategic cloud vendor within large enterprise customers where we believe Microsoft is well positioned to continue to take market share. We continue to see upside to Azure growth, particularly as the company begins to lap negative consumption impact fram highly affected verticals during the pandemic (ie. travel, transportation, and hospitality) in the June quarter. Longerterm, as public cloud adoption continues, we believe the installed base of Windows Servers (25-30mn GSe) alone represents an $80-890bn opportunity for Azure, and note Azure continues to gain market share, with growth coming from both new workloads and data center migrations. Similarly, we see runway for continued growth in Office 365, with the potential for the company to double its installed base of ~300mn users to 500mn, given the massive number of knowledge workers worldwide. We continue to see sustainable double-digit top line growth for Microsoft for several years to come alongside margin expansion and are modeling revenue and earnings to grow at an 14% and 18% CAGR from FY21 through FY24 respectively.Goldman Sachs Microsoft Corp. (MSFT) Exhibit GS vs, consensus Sinn, except per share items Src: Ft Caran a, Glan Sts Gb esta ash MSFT through the lens of the GS Framework for Investing in Software: With 2 broad portfolio and strong presence across all layers of the cloud stack, we note MSFT screens well across our framework, with an expansive TAM and a number of secular tailwinds underpinning sustainable long-term growth, including cloud adoption and digital transformation. While MSFT competes with a number of best of breed and platform providers across various layers of the tach stack, we believe the company's breadth of offerings and large installed base position the company to expand its share of wallet within customers’ IT budgets, with MSFT exhibiting the greatest net strength in our DX Survey. As Microsoft Cloud continues to grow as a percentage of the overall mix, we see the potential for sustained long-term growth,Goldman Sachs Microsoft Corp. (MSFT) Exhibit 2: Mapping Microsoft tothe GS Framework for Investing ——EEEE ee) ae ad gong TAT [rosie pore acoss al ayers of oud sack ath athe oval pandng anianmant [ne pace of ous and SaaS adoption [Bud asepton, cata vanetoraton AUNT, buenas [ncigence an sate, and Devs lamcngst ter) poston a core cplain on cloud migrations acess [seo tas8, ons Pas. [a tare CEE ae aa of sponding ad Wa paca ot Gaal vnslonnaon pos] PRS oar BT nT Tr marg expansion win Conmnreal Ocud paris fn respet 1g Aawe gross margins a5iPans micros [See aby bund and consonance [storia which shoul ay hgh emer mars ake oF oral arin ean He Tk Connon TO SA lroodportoto of ofan oss varcus ar ft ch stack | (Pampative postonng scons proaie oFanras [Abn io Buses and compete agaist point prosucs [Bead patorm actos aatare wih a ge tad base of lessor gba. Lage ard growing share gubie cous postoned across pubne ad Wy dao [Sat new ece TE wi a Gal Ba cTbOn PEWS [zo an SOC Eo OO a ITT FARE FO SOE lrescnas Sry: Compr Glan Sas Gla neste ese Microsoft Cloud snapshot (Commercial Office 365 + Azure + Dynamics Online + Linkedin Commercial). We are modeling F222 Microsoft Cloud revenue of $22.4bn (434% yoy vs. +34% cic last quarter) off a ~-100bps more difficult ec compare. For F2022, we model Microsoft Cloud gross margins of 69%, or down 200bps qoq and yoy. Recall, on the company’s F122 eamings call management pointed to a ~400bps negative impact to Microsoft Cloud gross margins from the change in server and network useful life assumptions noted above, Excluding the associated negative 4pp impact, would imply roughly 200bps of yoy Microsoft Cloud gross margin expansion despite mix shifting more towards Azure and Azure consumption revenue (laaS and PaaS). For FY22, we are modeling Microsoft Cloud gross margins of 69% (down ~100bps yoy) vs. 70% in FY21, 68% in FY20, and 63% in FY19. For FY23, we are modeling 72% (+300bps). We are forecasting gross profit dollars for Microsoft Cloud to increase ~$15.0bn in FY22 (+31% yoy) vs. an increase of $14.4bn in FY21 (+42% yoy)Goldman Sachs Microsoft Corp. (MSFT) Exhibit: Microsoft Cloud revenue and gross profit trends J mom “t | am ae E 8 = cy |= mI a cons Soa Compan Glan Sse il nse esac) (Our 12-month price target of $400 is derived from an equal weighting of a DCF {~2% perpetuity growth rate), 37x Q5-O8 EV/FCF, and 36x Q5-8 P/E. Key risks include slowerthar-anticipated public cloud adoption, an overall slowdown in IT spending, a slower pace of margin expansion and an adverse change in the competitive landscape.Goldman Sachs Microsoft Corp. (MSFT) Disclosure Appendix Reg AC | Kash Rangan, herby cetty that al ofthe views expressed inthis report accurately ratlect my persona views about the subject company or ‘Companies ands or ther seourites. | aS0 cert that no prt of my compensation was, aril be, rect or insrecty, related To The spec ‘ecommendations or vows expressed in his repre. Unies otherwise stated, the individuals listed on the cover page ofthis report te ansyst in Goan Sache! Global investment Research division GS Factor Profile ‘The Goldman Sachs Factor Profile provides investment context fora stock by comparing key atbutes to the mart (our coverage universe and its sector pours, The four key atibutes dopeted ae: Growth, Financ Return, Multpe leg, valuation] and Integrated la composite of Growth Finan Returns and utile. Growth, Franca etums and Multiple ae calculated by using normalized rake for specie mets foreach stork The normalized ranks forthe metrics are then averagod and converted to percents forthe relvantatibute. The precise ealcustion of eath metric may ‘ary depending onthe fiscal year, industry and region, but he standard spproach i 3 folows Growth s based ona stock's forwardlooking sales growth, EBITDA growth and EPS growth or franca stocks, only EPS and sales growth), witha higher percent inating a higher grovah company. Fnanlal Returns is based ona stock’ forwardookig ROE, ROCE and CROC! (or nancial! stock, only AOB, with higher percentile iaicatng acompary with higher fnancal etuns. Multiple is based ona stock's forvataiookng IE. PB, Dicaldwdond (PD), EVIESITOA, EVIFCF and EV/Debt Adjusted Cash Flow [DACA fr financial stots only PI, P/B and PD), with ahiher percentio Idesting 8 stock vacing st higher mulipe. The Integrated percentiles calulated as the average ofthe Growth percetle, Financia Returns ereansie and 1003 - Mulspo pereantih Financial Returns and Multiple use the Goidman Sachs analyst forecasts at the fiscal yearend at last thoe quarters inthe future, Growth uses inputs forthe fiscal yar at least seven quarersin the flue compared wih the year at east twee quarors the future on a pershare bass fra maths). 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No 96,2014 of te European Patlament and of she Counl Including as that Delogated Ragultion is Implemented nto Unted Kingdom domeste lw and regulation foving the United Kingdom departure fom te European Union snd the European onan Aral wth regard to requatorytechrical standard or the tecnica arrangements for objective prsantaton of investment ‘ecommendatons father information recommending of suggesting an investment svetegy and Tor ascloaue of paricuar interests or indeations of confts of interests aval at hipsdlvarm.gscomilsclosures/evopesnpolahiml wich states the Eurcpesn Polity for Managing Conficis of Interest n Connection with Investment Research Japan: Goliman Sachs Jepen Co Lids @ Financial Instrument Dealer registered with the Kanto Finacil Bureau under registration number Kinsho {av and s member of Jasan Secures Dealers Aesociaon, Fnancal Futures Assocation ot Japan and Type Il nancial struments ms Assocation, Sei and purchase ol equities ste subject to commission pre-determined with cients pus consumption tax, See company spacti dclosures 9 10 any appeabe closures required by Japanese stock exchanges, he Japanese Securtos Daslrs Association or the -apanese Securitas France Company. Ratings, coverage universe and related definitions ‘Buy (B}, Neutral (N}, Sel (5) Analysts recommend stocks 3s Buys or Soll for inlsion on vatous regional Ivestmant Lists. Being assigned 2 Buy of Sollon an Investment List detrmined bya stock’ ot retun potental relative to ts coverage universe, Any stack not assigned as 2 Buy ora Sellon an Investmont List wath an scve rath (Le, stack thts not ating Suspended, Not Rated, Coverage Suspended or Not Covered, s deemed Neutal Each region's Inestment Revew Commitee manages Regional Conviction lists, which represent nvestment recommendations focused on ‘the 826 othe total retum potential andor he keine ofthe realzation of he ret seo tel respective areas of average. The adsivon or removal of stocks fom such Corwiction fst donot represent a change the analysts westment rating for such stocks. ‘Total rtum potential represents the upside or downside diferent betwen the cutent share ce and the pie target inluding al paid or anticipated dvdends, expected duing the tene horizon assocated with the pic target. Pie targets are required fe al covered stocks. Te total ‘etm potential, pice target and associated tme havin ata stated in each report adding of retering an Investment List mombership Coverage Universe: lst of al stocks in each coverage universe is able by primary ana, stock nd coverage universe st sags cm im Not Rated (NR, The investment atin, target pric and earnings estimates (where relevant have boon suspended pursuant o Goldman Sachs policy ‘when Goldman Sacts fs acting n an aBulsory expacty ina merger ofa statogicWasacton involving tis company, when thre are lal. regulatory ‘rpaicy constraints due to Galdman Sachs invelvement na transaction, and i cerlan ther cicumstancos. Rating Suspended (RS) Golan Soths Research has suspended the investment rating and pice target for ths stock, because there isnot suffcent fundamental basis for termining an investment rating or farget price. The previous investment retin and trget price, any, are no longer in elect fr this stock and should not beled upon. Coverage Suspended (CS). Galdran Sachs ha suspered coverage o ths company. Not Govered (NC). Goldman Sachs dows ‘ot cover ths company. Not Avalable oF Not Applicable (NA. Th nformaton snot aasle for disply of fot sppecable. Not Mesningtal {NM The intrmation isnot meaningful ands therefore excluce. Global product; distributing entities The Global investment Research Divison of Goldman Sachs produces and distributes research products for cents of Goémen Sachs ona global bass. [Analysts baced Goldman Sechs offces sound the world preduce seach on Industnes and compaties, an research on mactooconamies, teurencies, commodities and posto svategy This research dlssominated in Auta by Goldman Sacks Astros Py Lk (ABN 21 008 787 897: 9 Bran by Goldman Sachs do Bas Coretora de lulose Vaores Moblaios SA; Pubic Communicaton Channel Golan Sachs Bran: 0800 727 5764 and [ot contatogoldmantrasis com. 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Other than cisclosues eating to Goldman Sachs, his research is based on curont pubic information that we conalde elabie, but we do not reson it acuta or compet, nd shoud not be ole on as such, The information, opinions, estimates and {orecssis contained herin aro a of tho dato hereo! and ao subject e change without prior notfcatin. We Seok to update cur rasaaith 3s appropriate, but various regultions may preven us rom doing 3. Other than certain industyrenets publshed ona period basis, the loge malonty ‘Of reports ae pubshed at egulrintervas as spproprate n the analysts jalgment. 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