Morning Note: Market news and updates from Microsoft and Shell.

Market News

The UK 10-year gilt yield moved up to 4.4% in response to the Budget, a five-month high, as traders scaled back expectations of Bank of England rate cuts. Chancellor Rachel Reeves introduced £40bn in tax increases to boost public services and address a £22bn fiscal hole inherited from the previous government. Key measures include a 1.2 percentage point rise in employers’ national insurance and a rise in capital gains tax. The Office for Budget Responsibility estimates the new measures will increase inflation by 0.4 percentage points at their peak effect in 2026. Sterling trades at $1.2983 and €1.1957, while the FTSE 100 is currently trading 0.5% lower at 8,116.

US equities fell last night – S&P 500 (-0.3%); Nasdaq (-0.6%) – and are currently trading lower in the futures market. Microsoft (see below) dropped almost 4% post-market after it gave disappointing forecasts, while Meta also fell 4% on concerns over rising investment on AI. Pharma giant Eli Lilly fell 6% on weak earnings. The 10-year Treasury yields 4.28%, while gold trades at $2,777 an ounce.

In Asia this morning, the yen strengthened after Kazuo Ueda reiterated that the Bank of Japan will continue to increase the policy rate if it meets its inflation target. The central bank earlier raised its growth forecast and kept the rate unchanged at 0.25% as Japan’s political instability stoked uncertainty. China’s official manufacturing PMI unexpectedly expanded to 50.1 in October after five months of contraction, suggesting recent stimulus efforts may have begun to boost growth momentum. Equity markets were mixed: Nikkei 225 (-0.5%); Hang Seng (-0.3%); Shanghai Composite (+0.4%).

Source: Bloomberg

Company News

Last night, Microsoft released results for the three months to 30 September 2024, the first quarter of its financial year to June 2025, which were ahead of market expectations. However, the guidance for the current quarter disappointed the market, in particular the forecast for slower cloud revenue growth, reflecting the struggle to bring data centres online fast enough, and a higher level of capital investment. In response, the shares 4% in after-hours trading.

Microsoft is a global leader in consumer and enterprise software, services, devices, and solutions, leaving it well placed to benefit from the ongoing shift to digital technology and several other secular trends including AI. In an inflationary world, digital technology provides a deflationary force to help business offset cost pressures elsewhere. The group’s competitive edge lies in the strength and breadth of its portfolio of resilient and trusted technology which provides unique integration of its cloud-based products and services, covering productivity apps, infrastructure services, security, and communications. The group’s offering includes Windows, Microsoft 365 (formerly Office), Skype, Hotmail, LinkedIn, Bing, GitHub, Surface, Xbox, and OpenAI ChatGPT. Not only are the group’s products designed to work together but, for the customer, it is also more economical to bundle multiple products.

Its portfolio is being continuously enhanced through in-house product development and acquisitions, allowing the company to push through price increases and sell new products and services to a growing base of consumers. In addition, as one of the world’s three largest cloud companies, Microsoft Azure is benefitting from the migration of workloads from on-premise to public cloud platforms, a transition that we believe has further to go. With its stake in OpenAI and its agreement to be their exclusive cloud provider, Microsoft is well placed in the world of AI. Earlier in the year, the group has released the Microsoft Windows Copilot, the AI assistant tool.

The group operates a user subscription model which generates a visible, long-term annuity revenue stream with high margins and strong cash flow. In FY2024, the company generated revenue of $245bn (up 15%), gross margins of 70%, and operating margins of 43%. Microsoft has a very strong balance sheet and in addition to reinvesting cash back into high growth opportunities and M&A, the company has consistently increased its dividend and is repurchasing its own shares.

During the latest quarter, revenue grew 16% at constant current (CC) to $65.6bn, slightly above the consensus forecast of $64.5bn.

·       Productivity & Business Processes generated revenue of $28.3bn, up 13% at CC, versus company guidance of 10%-11%. Growth was driven by Microsoft 365 Commercial Cloud (+16%) and Dynamics 365 (+19%). 

·       Intelligent Cloud generated revenue of $24.1bn, up 21% at CC, versus the company guidance of 18%-20%. Growth was driven by Azure (+34%). Microsoft Azure’s is outperforming the other cloud providers due to its greater exposure to enterprise and hence, potentially more resilience, and its better positioning around AI workloads.

·       More Personal Computing generated revenue of $13.2bn, up 17% at CC, versus the company guidance of 9%-12%. Growth was driven by Xbox content and services (+61% due to the Activision acquisition).

Other commercial highlights included 23% growth in commercial bookings and a 98% commercial revenue annuity mix. All cloud revenue growth by 22% to $38.9bn, with a gross margin of 71%.

The gross margin slipped by two percentage points to 69%. Operating expenses grew by 12%, mainly due to the Activision acquisition and investments in cloud engineering. As a result, the operating margin fell to 46.6%. EPS grew by 10% at CC to $3.30, well above the market forecast of $3.10.

Microsoft spent heavily on capex, $20bn in the quarter, mostly on new AI chips and high-performance networking for its datacentres. However, the group still generated strong free cash flow of $19.3bn, albeit down 7% in the quarter, and ended the period with net cash of $33bn. The company is authorised to repurchase up to $60bn in shares, with $2.8bn bought back in the latest quarter. The company also paid out $6.2bn in dividends.

On the analysts’ call, the group reiterated its guidance for the financial year to June 2025: double-digit revenue growth and operating margins down by 1%. However, guidance for capex has been pushed up, with the group now expected to spend $80 billion over the year, up some $30bn on last year. Divisional revenue guidance was also provided for the current quarter: Productivity and Business Processes is expected to grow by 10%-11%, Intelligent Cloud by 18%-20%, and More Personal Computing by 5%-8%.

We believe in the current environment the company faces a relatively lower level of political risk and should prove more defensive during the current economic uncertainty.

Source: Bloomberg

Shell has this morning released Q3 results which were better market estimates, driven by higher LNG sales. The balance sheet remains strong, and the group announced another $3.5bn share buyback. In response, the shares are up 1% in early trading against a weak overall market backdrop.

Shell is a global integrated energy company with expertise in the exploration, production, refining, and marketing of oil and natural gas, and the manufacturing and marketing of chemicals. The group is also allocating capital to low and zero carbon products and services including wind, solar, advanced biofuels, EV charging, hydrogen, and carbon capture & storage. According to Brand Finance Global 500, Shell is the most valuable brand in the industry, valued at around $50bn.

The business is divided into five segments:

·       Upstream (i.e. E&P) explores for and extracts crude oil, natural gas and natural gas liquids. Shell has best-in-class deepwater assets complemented by resilient conventional assets in the Gulf of Mexico, Brazil, Nigeria, UK, Kazakhstan, Oman, Brunei, and Malaysia.

·       Integrated Gas includes liquefied natural gas (LNG), conversion of natural gas into gas-to-liquids (GTL) fuels, and other products. Shell is the global leader in LNG (achieved through the 2016 acquisition of BG), a critical fuel for the energy transition, with a business that spans upstream, liquefaction, shipping, marketing, optimising, and trading.

·       Chemicals & Products is made up of a focused set of assets – there are currently five energy and chemicals parks (i.e. integrated refining and chemicals sites) and seven chemicals-only sites.

·       Marketing includes mobility, lubricants, and decarbonisation. In addition to the service stations with their EV charging footprint, Shell is the global number one lubricants supplier and operator of assets is renewable natural gas, sugar cane ethanol, and biofuels.

·       Renewables & Energy Solutions includes Shell’s production and marketing of hydrogen, integrated power activities (solar and wind), carbon capture & storage, and nature-based projects. The assets are helping to reduce the carbon intensity of the group’s hydrocarbon product sites.

The group’s strategy (Powering Progress) is to invest in providing secure supplies of energy, while actively working to reduce carbon emissions at a time of macroeconomic and geopolitical uncertainty.

The focus is on ‘value over volume’ – the group will take advantage of opportunities where it has competitive strengths, existing adjacencies, a track record, strong customer demand, and clear regulatory support from governments.

In the period to the end of 2025 (known as the First Sprint), the company is seeking to:

·       Improve performance and increase efficiency, with annual operating costs reducing by $2bn-$3bn by the end 2025, of which $1bn was achieved in 2023. We believe this could prove to be prudent.

·       Increase investment discipline – capital investment (organic spend and M&A) will reduce to $22bn-$25bn p.a. over 2024 and 2025, with around a quarter for low carbon solutions.

·       Simplify the portfolio through the sale of high-cost and lower-return businesses.

·       Generate free cash flow per share growth of 10% p.a. through to 2025 and free cash flow growth on an absolute basis more than 6% p.a. between now and 2030.

In the three months to 30 September, adjusted earnings fell by 3% to $6,028m, albeit they were well above the market forecast of $5,360m. Compared to the previous quarter, earnings fell 4%, reflecting lower refining margins, lower realised oil prices and higher operating expenses partly offset by favourable tax movements and higher Integrated Gas volumes.

Adjusted earnings by division were: Upstream (+9% to $2.4bn); Integrated Gas (+13% to $2.9bn); Chemicals & Products (down 68% to $0.5bn); Marketing (+84% to $1.2bn); Renewables & Energy Solutions (a loss of $0.2bn). Oil and gas production was up 4% to 2.8m boe/d, while underlying operating expenses fell by 5%.

The group spent $5.0bn on capital expenditure and is now guiding to the lower end of the $22bn-$25bn range for the full year. Free cash flow was $10.8bn. The balance sheet is strong and the company targets AA credit metrics through the cycle. At the end of the September quarter, net debt stood at $35.2bn (down from $40.5bn last year), with gearing at a comfortable 15.7%.

Shell’s current policy is to return 30%-40% of cash flow from operations (CFFO) to shareholders through the cycle through a combination of dividends and share buybacks. The group’s dividend breakeven is around $40 per barrel (vs. $72 currently) and the group is targetting 4% growth annually.

With today’s results, a Q3 dividend of 34.4c a share was declared, 4% above the same quarter last year. At that rate, the full-year yield would be 4.2%.

At $50 a barrel, share buybacks will be undertaken as a priority to debt reduction as management believe the shares are undervalued. The latest $3.5bn programme was recently completed and a new $3.5bn programme has been announced today which will run to the end of January. Total shareholder returns are expected to amount to more than 10% of the current market cap.

We believe decarbonisation can’t happen at the flick of a switch – oil and gas will remain part of the global energy mix for decades, with demand driven by population growth and higher incomes, particularly in developing countries where the desire for energy intensive goods and services like cars, international travel, and air conditioning is rising. We also believe the production of the materials needed to transition to net zero can’t happen without using hydrocarbons. At the same time, reduced investment in new production, partly because of environmental concerns, and natural decline rates, are increasingly leading to constrained supply.

In common with all the oil majors, Shell is looking to reduce emissions in a way that delivers attractive returns for shareholders at a time of macroeconomic and geopolitical uncertainty. The shares remain on an undemanding valuation (PE 8x), both in absolute terms and relative to its US majors, which fails to discount the potential for free cash flow generation and shareholder returns. We believe they also provide something of a hedge against inflation.

Source: Bloomberg