Microsoft will release its Q2 FY2025 (Dec Q) results on Jan 29th. Analysts expect FQ2 revenue to grow 11% YoY to $68.8 billion and EPS to grow 6.3% YoY to $3.12. Revenue is expected to accelerate to 13% growth in FQ3 and 13.6% in FQ4.
The December quarter (fiscal Q2) is expected to be a challenging quarter for Microsoft, as it battles weaker momentum in gaming, device sales, 365 Commercial products and a slight hiccup for Azure’s growth. Wells Fargo analyst Michael Turrin expects balanced December quarter results with continued growth in Microsoft Cloud revenue and bookings due to continued consolidation across software, the company’s leading position in AI (especially Azure AI), and a year-end budget flush.
Morgan Stanley analyst Keith Weiss said that the recent CIO survey suggests that Microsoft will maintain its lead as the number one share gainer of IT wallet due to a shift to the cloud on both a one-year and three-year view. Microsoft Azure was the preferred vendor for CIOs in the AlphaWise survey, handling about 54% of overall workloads and about 41% expected to keep Azure Open AI for the next twelve months.
The company also recently announced plans to invest approximately $80 billion in AI-enabled data centers in FY2025, a significant increase from the $55.7 billion capex in FY2024. Investors will look for clarity during the earnings call on the timeline for the returns on these long-term investments.
Revenue
Management provided a soft FQ2 guide of $68.1 billion to $69.1 billion, representing YoY growth of 10.6% at the midpoint. While acknowledging temporary supply chain constraints, particularly delays in data center infrastructure deliveries, management expects these issues to be resolved in the second half of the fiscal year. This resolution and increased AI capacity resulting from prior investments are anticipated to drive Azure and overall revenue acceleration in the second half of the fiscal year.
- FQ1 revenue grew by 16% YoY to $65.6 billion, driven by continued strong business gains.
- Analysts expect FQ2 revenue to grow 11% YoY to $68.8 billion. Revenue is expected to accelerate to 13% YoY growth to $69.9 billion in FQ3 and 13.6% to $73.5 billion in FQ4.
- Looking further out, analysts expect revenue to grow 13.7% YoY to $278.6 billion for the FY2025 ending June. Revenue is expected to accelerate to 14.4% growth in FY2026 and 15.3% YoY growth in FY2027.
Segment Revenue
The company's Productivity and Business Processes segment delivered stronger-than-expected results in the FQ1. However, the Personal Computing segment encountered challenges due to weaker consumer demand. Revenue within the Intelligent Cloud segment was in line with management expectations. The company is experiencing temporary supply chain constraints impacting Azure AI revenue in FQ2, which are anticipated to be resolved in the second half of the fiscal year.
- FQ1 productivity and business processes revenue grew by 12% YoY and 13% in constant currency to $28.3 billion, driven by better-than-expected revenue across all the businesses. Management expects FQ2 revenue in productivity and business processes to grow between 10% and 11% in constant currency or $28.7 billion to $29 billion.
M365 commercial cloud revenue is expected to grow 14% in constant currency, with moderating seat growth across customer segments and ARPU growth through E5 and M365 Copilot. LinkedIn revenue is expected to grow by about 10% and Dynamics 365 (A suite of business applications like CRM and ERP for improving operational efficiencies) is expected to grow mid to high teens in the December quarter.
- More Personal Computing FQ1 revenue grew by 17% YoY to $13.2 billion, which included the net impact of 15 percentage points from the Activision acquisition. Management expects More Personal Computing revenue to be $13.85 billion to $14.25 billion in FQ2. Windows OEM and devices revenue is expected to decline in the low to mid-single digits. Search and news advertising ex-TAC revenue is expected to grow in the high teens, and gaming is expected to decline in the high single digits due to hardware.
- FQ1 intelligent cloud revenue grew by 20% YoY and 21% in constant currency to $24.1 billion. Azure revenue grew by 33% and 34% in constant currency, with healthy consumption trends that were in line with management’s expectations. Azure growth included roughly 12 percentage points from AI services.
Analyst see Azure accelerating to +35% growth
- Management expects FQ2 Azure growth to be between 31% to 32% in constant currency and expects roughly 12 percentage points contribution from AI services. The soft FQ2 guidance is due to supply constraints, which is expected to improve in the second half of the fiscal year, and Azure growth is expected to accelerate in H2 FY2025. Berstein analyst Mark Moerdler expects Azure growth to accelerate to 35% to 40% YoY growth in the first half of CY2025.
- KeyBanc analyst Jackson Ader said, “Over the December quarter (fiscal 2Q) Azure instances were up 17.3% sequentially and 28.0% year-on-year, each of which are multi-year highs." The analyst believes that non-AI growth from increased CPUs could positively surprise investors, given the supply constraints in FQ2 that will impact Azure revenue.
Margins
Microsoft has maintained strong margins driven by operating efficiencies. However, in the recent quarter’s investor sentiment has come down due to rising capex. Investors will be looking for more clarity during the earnings call on the timeframe of the returns on these long-term investments.
The company is continuing with its cost-cutting initiatives. Microsoft announced recently that they had frozen new hires in U.S. consulting and that minor layoffs were possible. In the second week of January, it revealed it was cutting less than 1% of its employees across multiple departments based on performance.
Microsoft increased the prices of the Consumer version of Microsoft 365 by $3 per month and now bundles with Copilot features, marking a 43% hike. The price increase reflects Microsoft’s plan to capitalize on the growing demand for AI services and enhance its revenue and profitability.
- Management has guided a gross margin of 67.9% for FQ2 compared to 68.4% in the same period last year.
- FQ1 operating margin was 46.6% compared to 47.6% in the same period last year. Excluding the impact of the Activision acquisition, the operating margin would have been up 1 percentage point compared to last year, driven by operational efficiencies.
- Management operating margin guide for FQ2 is 44% compared to 43.6% in the same period last year.
- Net margin FQ2 guide is 33.8% compared to 35.3% in the same period last year.
- The company also expects a $800 million impairment charge in FQ2 over its investment in robotaxi startup Cruise after General Motors announced that they would halt the development of Cruise autonomous vehicles. This charge was not included when the company provided the guidance for FQ2. It is expected to have a negative impact of $0.09 on the FQ2 EPS.
EPS
FQ1 EPS grew by 10.4% YoY to $3.30, beating analysts estimates by 6.3% driven by operational efficiencies.
- Analysts expect FQ2 EPS to grow 6.3% YoY to $3.12 and accelerate to 7.5% growth in FQ3 and 11.5% in FQ4.
- Looking further out, analysts expect better EPS growth in the coming years. Analysts expect FY2025 ending June EPS to grow 10.5% to $13.04, followed by 15.6% and 18.5% growth for the next two years.
Cash Flows and Balance Sheet
The company has strong cash flows. However, due to the strong growth in AI, the company has a higher capital investment plan. The company recently announced plans to invest approximately $80 billion in AI-enabled data centers in FY2025, a significant increase from the $55.7 billion capex in FY2024.
- FQ1 operating cash flow grew by 12% YoY to $34.2 billion or 52.1% of revenue compared to 54.1% in the same period last year. The cash flow growth was driven by strong cloud billings and collections, partially offset by higher supplier payments, and employee and tax payments.
- FQ1 free cash flow was down (-7%) YoY to $19.3 billion, reflecting higher capital expenditures to support the cloud and AI offerings. The free cash flow margin was 29.4% compared to 36.6% in the same period last year. Capex was $20 billion and included roughly 50% towards long-lived assets and the remaining towards servers, including CPUs and GPUs. Management expects capex to increase sequentially in FQ2.
- The company had cash and short-term investments of $78.4 billion and debt of $45.1 billion compared to $75.5 billion and $51.6 billion at the end of the FQ4.
Key Metrics
Key metrics like Commercial RPO are demonstrating positive trends. Wells Fargo analyst Michael Turrin expects continued growth in Microsoft Cloud revenue and bookings in the December quarter driven by consolidation across software, the company’s leading position in AI (especially Azure AI), and a year-end budget flush.
Commercial RPO
Commercial remaining performance obligation grew by 22% and 21% in constant currency to $259 billion in FQ1. Roughly 40% is expected to be recognized in revenue in the next 12 months, up 17% YoY. The remaining portion, recognized beyond 12 months, grew by 27%.
Commercial Bookings
The company witnessed increased demand and long-term commitments to the Microsoft Cloud platform in FQ1. Commercial bookings increased 30% and 23% in constant currency, driven by growth in contracts worth more than $10 million for Azure and Microsoft 365. In addition, the company witnessed a strong increase of over $100 million in contracts for Azure.
Microsoft Cloud
Microsoft Cloud revenue grew by 22% YoY to $38.9 billion in FQ1. Microsoft Cloud’s gross margin was 71% in FQ1 compared to 73% in the same period last year. Management expects gross margin to be around 70% in FQ2, down from 72% in the same period last year due to the increased AI spending.
- Azure Arc, a tool that allows organizations to manage resources not hosted on Azure, had over 39,000 customers in FQ1, which is up 80% YoY and 8% QoQ.
- The next-gen analytics platform, Microsoft Fabric, had over 16,000 customers in FQ1, up 14% QoQ.
- Power Platform, a collection of low-code development tools, has been used by nearly 600,000 organizations, up 4x YoY.
- Monthly active users in Copilot across CRM and ERP portfolio increased by 60% QoQ.
AI Revenue
During the FQ1 earnings call, management announced that its AI business is on track to surpass an annual revenue run rate of $10 billion in the FQ2. This remarkable achievement marks the fastest growth for any business in the company's history, reached within just 2.5 years. Management emphasized that this AI revenue primarily stems from inferencing services, which are known for their greater stability. This milestone also underscores Microsoft's strong relationships with Fortune 500 companies. Analyst Mark Moerdler of Bernstein estimates that Azure AI contributes significantly to this revenue, with approximately $9.7 billion. Moerdler also anticipates that the AI revenue mix will likely deliver healthy profit margins.
Valuation
The company is trading at a P/E ratio of 36.6 and a forward P/E ratio of 34, higher than the 5-year average P/E ratio of 33.1. It is trading at a P/S ratio of 13 and a forward P/S ratio of 11.8.
Conclusion
Microsoft's diverse product portfolio and strong leadership under Satya Nadella position the company for continued success. The company is expected to surpass the $10 billion annual AI revenue run rate in FQ2, showcasing the company's dominance in AI. Investors will be keen to understand the anticipated timeline for returns on AI-related investments. Also, the confirmation of Azure's growth trajectory in the second half of FY2025 are the key catalysts to watch in the upcoming earnings.
Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
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