Highlights this quarter include Azure’s growth of 31% up from 30% and 28% on CC basis last quarter. Of this, 7 points was from AI compared to 6 points from AI last quarter. The reason that Azure did not see more QoQ growth from AI is due to capacity constraints. In other words, Microsoft has higher demand than they have GPU supply. This is leading Microsoft to grow its capex 80% YoY from $7.8 billion in the year ago quarter to $14 billion this quarter. On a fiscal year basis, capex will grow 50% this year, and what this quarter proves, is that this high growth rate on already high capex spend is only accelerating.
Beyond Azure, management’s focus was on Copilot, which are tools that are not capacity constrained. There were many impressive statistics on Copilot that we share with you below. In addition to Copilot, Microsoft emphasized that security is their number one priority – “over anything else” – which was a good reminder for investors given AI takes up the majority of the time on the call. There were also some initial AI-powered PC stats from this ER that we share below, as well.
Microsoft has a knack for in-line reports. However, bookings and RPO were exceptionally strong this quarter. We detail this and more below.
Microsoft Fiscal Q3 Financials:
Revenue and EPS:
Fiscal Q3 revenue of $61.85 billion beat expectations by $960 million, driven by a 21% increase in Intelligent Cloud revenue and a 17% increase in More Personal Computing revenue. Azure growth was 31%, marking a continuation of the acceleration we’ve seen since the June quarter. Of this, AI drove 7 points. Per the CFO: “Azure and other cloud services revenue grew 31% ahead of expectations, while our AI services contributed 7 points of growth as expected.”
The company guided for Azure growth of 30% to 31% percent next quarter, which represents a management guide of flat growth QoQ.
Revenue and EPS:
- Revenue of $61.85 billion beat estimates by 1.7%, representing YoY growth of 17% but a QoQ decrease of 0.3%.
- For next quarter, management guided to $64 billion, which is under analyst estimates of $64.6 billion and lower mainly due to the rising US dollar.
- GAAP EPS of $2.94 beat estimates by $0.11, representing YoY growth of 20%. Non-GAAP EPS of $2.94 beat estimates by $0.10.
Segment Revenue:
- Productivity and Business revenue was $19.6 billion, up 12% YoY, driven by 15% growth in Office 365 Commercial. Growth came in 100 bp ahead of the midpoint of the guided range.
- Intelligent Cloud revenue was $26.7B, up 21% YoY, driven by strong demand for server products and cloud services revenue from Azure and other cloud services revenue growth of 31%. This was a 260 bp acceleration from last quarter.
- More Personal Computing revenue was $15.6 billion, up 17% YoY. Windows revenue increased 11% with OEM revenue growth of 11%, while devices revenue decreased (17%).
Guidance on Segment Revenue:
- Productivity and Business revenue guided to $20.05 billion at midpoint for growth of 8.7% to 10.4% YoY. This would be a deceleration of 145 bps in growth rate, at the midpoint.
- Intelligent Cloud revenue was guided to $28.55 billion at midpoint for growth of 18.3% to 19.6% YoY. This is a deceleration of 205 bps in growth rate, at the midpoint.
- More Personal Computing revenue was guided to $15.4 billion at midpoint for growth of 9.4% to 12.2% YoY. This would be a deceleration from 17% growth on CC basis this quarter.
Margins:
Margins were strong across the board, topping management’s guide in gross margin, operating margin and net margin. Operating margin for Q3 was 45%, 210 bp above guidance, and a 270 bp increase YoY.
We’ve previously discussed how there may be room for continued operating margin expansion in Intelligent Cloud, but in this report, it was Microsoft’s More Personal Computing segment that experienced strong operating margin expansion, up 610 bp QoQ to 31.6% as the company shifted the sales mix to higher margin businesses.
One of the more bullish comments on the call was the CFO guiding full year operating margin to be up 2 points for FY2024. There was a note it would be down 1 point for FY2025 due to higher capex. Overall, Microsoft has done an excellent job maintaining margin strength.
- Gross margin of 70.1% was up from 69.5% in the year ago quarter. The guide for next quarter is approximately 69.2%.
- Operating margin was 45%, up from 42.3% in the year-ago quarter. Operating margin is guided for 42.3% next quarter.
- Net margin was 35.5%, up from 34.6% in the year-ago quarter. Net margin is guided to decelerate to 33.6%, implying a decrease QoQ.
- Productivity and Business operating margin was 51.8%, down 160 bp QoQ but expanding 250 bp YoY.
- Intelligent Cloud operating margin was 46.9%, down 120 bp QoQ but expanding 400 bp YoY due to strength in Azure.
- More Personal Computing operating margin was 31.6%, up 610 bp QoQ due to a sales mix shift to higher margin businesses.
Cash and Debt:
Operating cash flow was $31.9 billion, up 31% YoY driven by strong cloud billings and collections.
Free cash flow was $21 billion, up 18% YoY reflecting higher capital expenditures to support cloud and AI offerings.
Microsoft returned $8.4 billion to shareholders with $5.6 billion in dividends and $2.8B in share repurchases.
For Q3 2024, the company has $65.44 billion total debt, with $80.02 billion in cash and short-term investments.
Key Metrics:
Bookings increased 29% YoY and 31% on a constant currency basis. This was driven by strength in large, long-term Azure contracts and “strong execution across our core annuity sales motions.” This compares to 17% growth (9% on CC basis) in Bookings last quarter and compares to 11% growth (12% on CC basis) in Bookings in the year ago quarter. This is the highest quarter for bookings since fiscal year 2022.
Commercial RPO grew by 20% YoY to $235 billion. This compares to 17.5% growth last quarter and 26% YoY growth in the year ago quarter.
Last quarter, it was stated that “more than half of the Fortune 500 are using Azure OpenAI Services” and this was updated to “more than 65% of the Fortune 500 now use Azure OpenAI services.” Last quarter, it was stated that “Azure AI customers totaled more than 53,000, with one-third of these being new customers over the past twelve months. This implies customer growth rate of approximately 50% YoY.” This quarter, it was updated to: “The number of $100 million-plus Azure deals increased over 80% year-over-year, while the number of $10 million-plus deals more than doubled.” These aren’t exactly apples-to-apples but seems to imply the trend is up.
According to the opening remarks, over half of Azure AI customers use their data and analytics tools. The next-gen analytics platform, Microsoft Fabric, has over 11,000 paid customers.
Beyond AI, Microsoft stated cloud migrations contributed to Azure growth, as well. Azure Arc has 33,000 customer up 200% YoY as legacy workloads from Oracle and SAP are migrated to Azure.
GitHub commentary certainly showed impressive growth with paying subscribers at 1.8 million, up from 1.3 million last quarter for growth of 35% QoQ up from 30% QoQ. Revenue accelerated 45% YoY and it was stated that “more than 90% of the Fortune 100 are now GitHub customers.”
Copilot for Microsoft 365 was available for its first full quarter with 30,000 organization using Copilot Studio. The low code, no-code Power Platform is being used by “over 330,000 organizations, including over half of Fortune 100 have used AI-powered capabilities in Power Platform, and Power Apps now has over 25 million monthly active users, up over 40% year-over-year.”
There was an important update on CoPilot for Windows provided, which is that it’s now available in 225 million Windows 10 and Windows 11 PCs and is “up 2X quarter-over-quarter.” The company also teased an upcoming event: “And there's much more to come in just a few weeks, we'll hold a special event to talk about our AI vision across Windows and devices.”
Earnings Call:
Well, I won’t be shy about the fact that our firm has been particularly keen to hear capex commentary from this week’s earnings reports. Microsoft’s report was as bullish as it could be on that point.
Capex:
Microsoft stated capex was $14 billion this quarter compared to $7.8 billion in the year ago quarter, up 80% YoY. This compares to $11 billion in the previous quarter, up a whopping 27.2% sequentially.
The way analysts are thinking of this is up 50% YoY on a run rate for this current fiscal year ending in June with whispers this could get to $100 billion.
Keith Weiss (Analysts)
congratulations on the fantastic quarter. a lot of excitement in the marketplace around generative AI and the potential of these technologies. But there's also a lot of investment going on behind them. It looks like Microsoft is on track to ramp CapEx over 50% year-on-year this year to over $50 billion. And there's media speculation of more spending ahead with some reports talking about like $100 billion data center. So obviously, investments are coming well ahead of the revenue contribution. It looks like Microsoft is on track to ramp CapEx over 50% year-on-year this year to over $50 billion. And there's media speculation of more spending ahead with some reports talking about like $100 billion data center. So obviously, investments are coming well ahead of the revenue contribution.
But what I was hoping for is that you could give us some color on how use as the management team, try to quantify the potential opportunities that underlie these investments because they are getting very big. And maybe if you could give us some hint on whether there's any truth to the potential of like $100 billion data center out there.And maybe if you could give us some hint on whether there's any truth to the potential of like $100 billion data center out there.
There was not a direct answer other than the following tone – but the overall message is key to the I/O Fund’s portfolio allocation, and thus, the question in this case reveals more than the answer in terms of what institutions are expecting: “So this is not the quarter. I realize in the news, it's a lot more in the quarter nowadays. But if you look at it, we have been doing what is essentially capital allocation to be a leader in AI for multiple years now, and we plan to sort of essentially keep taking that forward.”
AI Demand Exceeds Capacity
According to the CFO’s opening remarks: “We expect capital expenditures to increase materially on a sequential basis driven by cloud and AI infrastructure investments. As a reminder, there can be normal quarterly spend variability in the timing of our cloud infrastructure build-outs and the timing of finance leases. We continue to bring capacity online as we scale our AI investments with growing demand. Currently, near-term AI demand is a bit higher than our available capacity.” Currently, near-term AI demand is a bit higher than our available capacity.” It was also stated that growth in Azure next quarter “will be driven by our Azure consumption business and continued contribution from AI with some impact from the AI capacity availability noted earlierwith some impact from the AI capacity availability noted earlier.
This later led to an important part of the Q&A that helps spell out why Microsoft must increase capex, and how they expect it to flow-through to Azure. Commentary that Azure is hitting capacity due to demand is very bullish for the outlook on GPUs and ASICs this year.
Question
Karl Keirstead (Analysts)
Satya and Amy, congrats on these outstanding Azure results. I'd love to hone in a little bit on the 7-point lift to Azure growth from AI, outstanding number, but it's leveling off a little bit from 6 points in December. I'm wondering if you could unpack that a little bit. To what extent did the capacity issues that you Amy highlighted on the call, impact that number. Is there any seasonality? I wouldn't think so or any other factor that can swing around that number that you'd advise us to keep in mind?
Answer
Amy Hood (Executives)
[…] it is how much capacity we have in play and how much capacity that we have to sell on the inferencing side, in particular. And so that is partially why you see the capital investment in the shape that is, is because right this minute, we do have demand that exceeds our supply by a bit. So it is fair to say that, that could have been an impact on the number for the quarter and it does impact a little bit the number in Q4.it is how much capacity we have in play and how much capacity that we have to sell on the inferencing side, in particular. And so that is partially why you see the capital investment in the shape that is, is because right this minute, we do have demand that exceeds our supply by a bit. So it is fair to say that, that could have been an impact on the number for the quarter and it does impact a little bit the number in Q4.
Security #1 Priority:
I wanted to pull out this quote from the opening remarks as it was a particularly strong statement in terms of how Microsoft thinks of their security products moving forward. It seemed as if this means security is an even bigger priority than AI (although the capex increase communicates otherwise):
“Security underpins every layer of the tech stack and it's our #1 priority. We launched our Secure Future initiative last fall for this reason, bringing together every part of the company to advance cybersecurity protection and we are doubling down on this very important work, putting security about all else before all other features and investmentsSecurity underpins every layer of the tech stack and it's our #1 priority. We launched our Secure Future initiative last fall for this reason, bringing together every part of the company to advance cybersecurity protection and we are doubling down on this very important work, putting security about all else before all other features and investments.”
Conclusion:
For our purposes, Microsoft’s report confirms we are on the right track for 2024 in terms of how we have structured our portfolio for the AI data center (reference the webinar highlights here). Microsoft’s report signals the trend is clearly up for AI in the years to come – both for Microsoft and the many other AI data center stocks we own. We are pleased to have this stock in our portfolio and our goal is to continue to add at key levels. There is no question in my mind that Microsoft will remain in the Mag 7 over the next decade, alongside Nvidia. The only remaining questions are when do we buy and how much. If we are lucky, we will get it lower in the near-term to hold for the long-term.
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