Recently, in the Top 15 AI Stocks analysis it was stated “If Nvidia holds the crown in the AI hardware arena, then Microsoft holds the crown in the AI enterprise arena.” Tonight, Microsoft proved why the AI Enterprise crown is rightfully theirs. 

Management came out swinging this evening on multiple fronts. First off, the acceleration in Azure and Other Services to 39% up from 35% last quarter was significantly higher than expected, with the Street calling for growth of 33.7%. To grow nearly 40% at this scale is impressive.  

Microsoft also revealed its Azure revenue number for the first time of $75 billion for FY2025 (although not entirely surprising as we were modeling for Azure to be hitting $80 billion very soon). From there, the CFO guided for 37% growth in Azure for next quarter – indicating continuing a high growth rate at scale will not be a problem in the near-term (note, H2 is expected to see lower growth than H1). 

However, if we look at Commercial RPO, it’s clear something big is going on. Last quarter, we pointed out that Commercial RPO was the one key metric we were watching, stating: “Commercial RPO growth above 30% suggests that Microsoft’s stock could (finally) resume strength again.” At the time, RPO was at $315 billion, up 34% and 33% on a constant currency (CC) basis.  

This quarter, Commercial RPO has accelerated to $368 billion, up 37% and 35% on CC basis. Microsoft’s Commercial RPO was in the mid-$100 range in 2022-2023 period to help illustrate how quickly contracted revenue has grown. Wow. We do not typically see such large growth rates on such a large RPO base. It’s almost inconceivable.  

A few years back, I described in detail why AI is first and foremost an enterprise technology, specifically calling out Microsoft’s path to $100 billion in AI revenue by 2027. We are seeing this materialize now. Microsoft is putting formidable distance between itself and best-of-breed cloud players. To illustrate, stocks like Confluent are down 27% after hours following the loss of a large customer.  

In addition to the key metrics stated above, management carries a sense of confidence  when analysts question the ROI on capex. And when Mark Zuckerburg boasted about building a gigawatt-plus cluster called Prometheus next year, Satya made sure to lead his introduction by saying “We stood up more than 2 gigawatts of new capacity over the past 12 months alone.” You’ll find more commentary on this below. 

Revenue – Azure reported as standalone segment for first time 

Revenue was up $76.4 billion for growth of 18% or 17% in constant currency. This is up from last quarter with growth of 13% or 15% in constant currency and beat consensus of $73.83 billion. For the fiscal year ending in June, the company reported revenue of $281.7 billion, up 15%.  

Azure revenue was reported as a standalone metric for the first time, being stripped out of “Azure and Other Services.” The company stated Azure saw $75 billion in revenue or growth of 34%. For comp purposes, the original segment grew 39% up from 33% / 35% on CC basis last quarter.  

Below, you can see the visible acceleration in overall revenue 

Below you can see that 39% is the highest growth rate we’ve seen in some time for Azure and Other Services: 

Looking forward, management guided for revenue of $75.25B at the midpoint, beating consensus of $74.15B. This would represent growth of 14.7%. 

According to the CEO, Microsoft is ahead of other hyperscalers in speed of data center buildouts: “We continue to lead the AI infrastructure wave and took share every quarter this year. We opened new DCs across 6 continents and now have over 400 data centers across 70 regions, more than any other cloud provider. There is a lot of talk in the industry about building the first gigawatt and multi-gigawatt data centers. We stood up more than 2 gigawatts of new capacity over the past 12 months alone. And we continue to scale our own data center capacity faster than any other competitor.” 

Revenue segments – Cloud has highest growth rates since 2022 

Cloud reported some of its highest growth in three years. The CEO stated: “Through software optimizations alone, we are delivering 90% more tokens for the same GPU compared to a year ago” as well as “ 

• Microsoft Cloud was up 27% and up 25% on CC basis for revenue of $46.7B. This marks the highest quarterly growth rate since CY2022 
• Gross margin was 70% up 100 basis points from 69% last quarter 
• Productivity and other Businesses was $33.1 billion, up 16% and 14% on CC basis.  
• Intelligent Cloud was up 26% and up 25% on CC basis for revenue of $29.9 billion. This was the highest growth rate since CY2022 
• More Personal Computing was up $13.5B for growth of 9% 

Commercial Bookings Surpasses $100 Billion for the first time 

To help support the case for future growth, both commercial bookings and commercial RPO came in surprisingly strong.  

The CFO stated that for the first time commercial bookings surpassed the $100 billion mark, increasing 30% on CC basis. Commercial RPO increased to $368 billion, up 35% on CC basis with 35% recognized in revenue in the next 12 months. 

Additional key metrics: 500 trillion tokens processed last year; 800M AI Product Users 

Azure is always the main metric looked at, yet we should pause and share a few more important key metrics in this banner report. 

• Copilot apps have surpassed 100 million monthly active users across commercial and consumer.  
• Across broader AI features, there are over 800 million monthly active users. 
• Foundry Agent Service is now being used by 14,000 customers to build agents.  
• 80% of Fortune 500 use Foundry, processing 500 trillion tokens, up 7X YoY.  
• Microsoft Fabric is a data and analytics platform for AI workloads, with revenue up 55% year-over-year and over 25,000 customers. According to management: “It's the fastest-growing database product in our history.” 
• There are 20 million GitHub Copilot users. GitHub Copilot enterprise customers increased 75% quarter-over-quarter and 90% of the Fortune 100 use GitHub Copilot.

Margins & Earnings 

EPS of $3.65 beat consensus estimates of $3.38.  

• Gross margin was 68.5% up from 68.1% last quarter for gross profit of $52.4B. 
• Operating margin of 44.9% was up from 44% for operating profits of $34.3B. 
• Net margin was 35.6% up from 34.9% last quarter for net profits of $27.2B. 

Cash flows & capex raised to eye-watering $30B per quarter  

• Operating cash flow of $42.6B was up 15% YoY 
• Free cash flow of $25.6B was up 10% YoY 
• Capex of $24.2 billion was up 27% YoY with management guiding for capex of $30 billion next quarter.

Earnings Call Q&A: 

Capex Spend Correlates to $368B in RPO: 

Every Big Tech company will be asked about ROI on capex spending, and the CFO handled the question quite well, stating: “when you think about the full year comments I've made on CapEx as well as the Q1 guidance of over $30 billion, you first have to ground yourself in the fact that we have $368 billion of contracted backlog we need to deliver, not just across Azure but across the breadth of the Microsoft Cloud. 

So in terms of feeling good about the ROI and the growth rates and the correlation, I feel very good that the spend that we're making is correlated to basically contracted on the books business that we need to deliver and we need the teams to execute at their very best to get the capacity in place as quickly and effectively as they can. 

And so when you look, and we've talked about the growth rate [of capex] will decline year-over-year, but at its core, our investments, particularly in short-lived assets like servers, GPUs, CPUs, networking storage, is just really correlated to the backlog we see and the curve of demand. And I talked about, my gosh, in January and said I thought we'd be in better supply demand shape by June. And now I'm saying I hope I'm in better shape by December.”

Conclusion: 

This was an earnings report for the ages – simply because the Commercial RPO is massive, and Microsoft is proving they can grow at a scale we haven't seen yet in AI software. Earlier today, I had stated on Bloomberg that Microsoft could see $40 billion in AI revenuesometime in 2026 – which is a massive number, but what's most important is the rapid ascent in reaching that number.  

If you zoom-out, a few years back I've made the case that Microsoft could see as much as $100 billion in AI revenue by 2027 and then I upped it to $200 billion by 2028.  Should we see this ballpark figure, it would mark a rapid ascent hard to fathom a few years back. This earnings report is a step in the right direction to meet that mark.

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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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.

Notably, Microsoft’s report, Tesla report with 130% increase in H100 equivalents, and Meta’s earnings report supports what we discussed in our recent Quarterly Kickoff webinar on capex and AI spend. To understand critical points on how we have structured our AI portfolio, view the Quarterly Kickoff webinar here. Per the webinar, Microsoft’s report was a vote of confidence we are positioned well.

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 below 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 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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Microsoft kicks off Big Tech’s earnings alongside AMD and Alphabet, with AI in the spotlight as the company posted a sizable beat last quarter while seeing “higher-than-expected AI consumption.” Revenue and EPS estimates have inched higher, with the current revenue estimate of $61.1 billion slightly above management’s guide for $60.9 billion, highlighting the optimism the Street has on AI-related tailwinds.

Azure and Copilot will be closely watched, as Intelligent Cloud drove $850M of Microsoft’s ~$2 billion beat in fiscal Q1 due to AI tailwinds, while analysts are optimistic on Copilot creating a new stream of revenue over the next few fiscal years. Microsoft has been a big investor in scaling its data center and AI capabilities, and the Street is looking for these investments to bear fruits in Q2.

Notably, as stated in our AMD write-up, keep an eye out for a PC super cycle which could occur in H2 2024. Microsoft will be a clear beneficiary of this given Windows is expected to get its most important upgrade in many years (decades?) with many AI features.

Revenue and EPS:

Microsoft is currently expected to report $2.77 EPS on $61.13 billion in revenue, representing 19.3% and 15.9% YoY growth respectively. This would mark a significant acceleration in revenue growth, from 8.3% in fiscal Q4 to 12.8% in fiscal Q1. To put this in perspective, revenue growth estimates for fiscal Q2 were just 10.6% in October, with Q1’s beat and guide leading to a 530 bp acceleration.

Revenue growth rates are expected to hover around 15% through fiscal Q1 2025 as Microsoft captures AI related growth in Azure and Copilot. However, Microsoft’s guide for operating margins look to be weighing on EPS estimates, which are pointing to growth decelerating to the low single-digit range in fiscal Q4.

Margins:

Fiscal Q1 saw Microsoft post strong operating margin expansion, rising 440 bp from 43.2% to 47.6%, driven by a 450 bp margin expansion in Intelligent Cloud. However, Microsoft guided for operating margin of 42.4% in fiscal Q2 and flat for the full year.

The concern here is that margins continue to deteriorate through the end of the fiscal year. Last quarter’s guide for flat YoY operating margin suggests FY24’s margin will hover around 41.8%, or a ~320 bp decline over the next two quarters. Management explained that the flat guide “speaks to the pace at which we're delivering AI revenue with the increasing cost expense and capital investment ahead with the demand we see.”

There may be some room for margin expansion in Intelligent Cloud should Microsoft remain disciplined within its spending as it progresses with Azure’s AI transition. There is potential upside to operating margins on better-than-expected integration of the Activision acquisition and Microsoft’s continued efforts to improve Azure and Microsoft 365 gross margins, given recent Copilot subscription launches.

What to Watch: Azure and Copilot

Microsoft will give the first insight into Copilot’s revenue this quarter, after launching commercial subscriptions on November 1 for its AI assistant. We highlighted previously that Copilot was among one of six levers that could drive an additional $100 billion in revenue for Microsoft by 2027.

Microsoft has ~160 million users on 365 Enterprise plans, meaning that it needs just 18% adoption of Copilot to reach a $10 billion annual revenue run rate. For the consumer Copilot, priced at $20/month compared to $30/month for enterprises, just over 5% adoption from its ~77 million user base is needed to reach a $1 billion revenue run rate.

Analysts are similarly bullish on Copilot, with Citi highlighting how “a 5% adoption rate by its 77M customers using Microsoft 365 could add $925 million in revenue by fiscal year 2025. An adoption rate of 15% could add $2.7 billion in sales.”

The immediate impact of Copilot is likely to be minimal to start given the timing of the launch, while any clues as to the initial adoption rate among enterprises will be watched closely.

Microsoft’s predominant stream of AI-related revenues at the moment stems from Azure, as it is powering a handful of the largest LLMs and AI assistants on the market, from OpenAI’s ChatGPT to Meta’s Llama and Llama 2 to Microsoft’s own Bing Copilot.

A consumption pricing model offers tailwinds to Azure, as a majority of OpenAI’s APIs for ChatGPT were all new workloads for Azure over the last twelve months. In addition, Azure Open AI Services has been adopted by 18,000 organizations, which allows companies to use OpenAI’s APIs for new development purposes. Essentially, OpenAI is helping drive growth for Azure even if startups or companies are not direct Azure customers.

Q3 saw Azure’s growth inflect whereas Google Cloud’s growth decelerated, reflecting the benefits of this consumption pricing model. Microsoft’s CFO Amy Hood explained last quarter that Azure’s “growth was ahead of expectations, primarily driven by increased GPU capacity and better-than-expected GPU utilization of our AI services as well as slightly higher-than-expected growth in our per-user business.”

What will be key for Microsoft is a sequential acceleration in Azure in fiscal Q2 – this confirms the bull thesis that AI is driving stronger revenue growth in the early innings of monetization while rivals AWS and Google falter, and the long-term thesis that AI will drive tens of billions in additional revenue. However, if Azure decelerates even slightly, such as by 1 percentage point QoQ, Microsoft’s stretched valuation leaves it vulnerable to the downside with no room for error.

Capex:

Capex commentary will be watched closely as well, given that Microsoft is estimated to have devoted 13% of Capex to AI in 2023, the most among the top cloud service providers. CFO Amy Hood said last quarter that “Capital expenditures, including finance leases were $11.2 billion to support cloud demand, including investments to scale our AI infrastructure. … We expect capital expenditures to increase sequentially on a dollar basis, driven by investments in our cloud and AI infrastructure. As a reminder, there can be normal quarterly spend variability in the timing of our cloud infrastructure buildout.”

Capex here is important as it not only allows Microsoft to rapidly deploy and scale its AI infrastructure, but it opens the door for further leverage in the future. Management explained that for “every capital dollar we spend, if we optimize revenue against it, we will have great leverage. Because wherever demand shows up in the layers, whether it's at the SaaS layer, whether it's at the infrastructure lower, whether it's for training workloads, we're able to quickly put our infrastructure to work generating revenue.”

Being able to meet high consumption and demand for AI regardless of where it is in the stack serves as a crucial tailwind in that it should allow Microsoft to fare better than its peers whenever budgets are optimized, for short or extended periods of time. To do so, Microsoft has to spend quite aggressively – its Capex to revenue ratio is nearing the highest level in 33 years, at 0.145 compared to a peak at 0.148 in March 1991.

Management may not provide a concrete capex number this quarter, given the commentary last quarter was fairly vague in terms of sequential increases. What’s critical for the company will be showing how this elevated capex spend can flow directly through to the cloud and Azure.

Valuation:

The primary risk here is that Microsoft’s valuation is back at peak levels, opening up downside risk should it show any hint of weakness, whether that surfaces in margins, EPS forecasts, Azure growth, or overall cloud revenue.

Microsoft is trading at all-time highs just below $410 after rallying more than 11% since January 5. Shares are trading at a PE of 39.7x and a forward PE of 36.5x, levels that it has historically failed to hold, with the most notable being 2021’s top. Shares are also trading at a large premium to its 5-year median PE of 31.6x.

A look at sales-based valuation metrics shows a similar trend. Microsoft is trading at 14x sales and 12.5x forward sales, both far above the 5-year median of 10.9x. Microsoft historically has struggled to hold a forward PS above 12.9x, suggesting that shares are closing in on a top if the report is nothing less than stellar.

Conclusion:

Microsoft kicks off a jam-packed week for Big Tech and AI, with the focus likely to be primarily on initial revenue generation for Copilot and any outlook provided (if any) as well as Azure’s growth and if AI can drive a meaningful sequential increase in growth. Microsoft is demonstrating that it has multiple levers within its product suite to capture AI growth and multiple outlets to capture AI growth via Azure. Fiscal Q2 is expected to start a multiple quarter streak with revenue growth near the 15% range, but EPS estimates raise concerns that margins may weigh on the bottom line. Microsoft’s valuation leaves little room for error, with shares at peak valuations and hard-to-hold levels historically. Yet, AI has been a powerful trend – let’s see if Microsoft’s AI commentary can push the stock higher, or perhaps Microsoft will instead be a reminder of just how far the Mag 7 has come in price in a brief period of time.

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Let’s be real, the Nasdaq has rallied more than it has in its 52-year history off fairly unimpressive top line growth in the tech industry and minimal to no earnings growth.

Although fellow growth investors have greatly benefited, we shouldn’t be surprised if the buying is exhausted at the moment. The reaction to Microsoft’s earnings is a clue that this could be the case.

Microsoft was in line for this quarter. However, the guide was a tad weak at $52.3 billion compared to $54.5 billion. It’s also important to note that estimates had been coming down going into the ER. We had consensus of $54.9 billion a month ago.

The operating margin of 43.3% is expected to be flat moving forward, which is good news for AI chip investors such as ourselves, because some of the capex is going toward data center buildouts and outsized AI demand. Also, Microsoft has a strong margin right now so flat is certainly acceptable. Part of Microsoft’s strong margins comes from extending the useful life of their servers and equipment, which we’ve covered in the past. 

Psychologically, Azure dipping below Google Cloud revenue growth rate for the first time is not ideal. The reality is that Azure is growing at a similar growth rate on a much higher revenue base, but headlines will take hold of these oversimplified percentages. Within Azure, AI contributed 2% and management stated this is the number to watch moving forward. Regardless, if optimizations end and we see recurring software from AI kick-in, we should see Azure bottom and accelerate in growth in calendar year H1 2024. This is key for MSFT investors. Reference more notes below.

Copilot 365 is among the top reasons to remain invested in Microsoft. For $30/per user per month, enterprises can increase developer productivity by 40% to 50%. It sounded like this will be in general availability by FYH1 with results showing in FYH2 (which is calendar year H1 2024). Having deep pockets to acquire GitHub, and then rolling-out CoPilot 365 is an example of AI being a winner-takes-all market; which is that these acquisitions were carefully placed years ago.

Similar to our note on Google last night, Microsoft’s capex comments spell good things for our particular holdings in the semi-industry. With this level of exposure, these comments are arguably more important for IOF Members than Microsoft’s individual results. The market will go up (and down), but as long as capex increases, we should be in good shape with our current holdings.

There are additional questions from analysts noted below about when optimization will potentially end, when Azure will increase its growth rate, and when AI will start to affect revenue. All of these are important to note, and the pertinent Q&A is highlighted for you below.

Scorecard:

Figures are for FYQ4 ending in June and year-over-year, unless otherwise stated:

Revenue and EPS:

• Consensus earnings of $2.54 versus $2.70 EPS Reported
• Midpoint guidance of $55.35B (+7 y/y) and Consensus of $55.42B versus $56.2B Reported
• FY24 Q1 consensus of $54.53B versus FY24 Q1 Guidance of $54.250B

Microsoft sales guidance by division 

• Azure & other cloud – +26-27% y/y in constant currency, includes about 1% from AI services versus 26% Reported and 2% from AI Services
• Productivity & Business Processes – $17.8B to $18.28B, +8.7% midpoint. CC guidance is 10% to 12% versus $18.3B up 10% and 12% on CC Basis
• Intelligent Cloud – $23.6B to $23.9B up 13.6% midpoint, CC guidance is 15-16% versus $24 billion, up 15% and 17% on CC Basis
• Personal Computing – $13.35B to 13.75B, (-5.6%) y/y at midpoint versus $13.9 billion (-4%) and (-3%) on CC Basis.

Margins

• Q4FY23 MSFT gross margin of guidance of 69.5% vs Q323 of 69.5% actual vs Q223 of 67% actual versus 70.1% Reported
• Q4FY23 MSFT operating margin of guidance of 42.1% vs Q323 of 42.3% actual vs Q223 of 41% actual versus 43.3% reported 

Cash flow + Cash 

• Q3FY23 operating and free cash flow was $24.5B and $17.8B respectively versus $28.7B and $19.8B
• Q3FY23 cash stood at $104B and $48B in debt versus $111.3B in cash

Earnings Call:

The number 1 question is this — when will Microsoft begin to realize strong growth from AI? Given AI has been the primary driver in this historic Nasdaq rally, we want to make darn sure there is AI revenue on the way (and soonish). I think some investors are going to get burned by piling AI stocks far too early, for example. But for Microsoft, we are a mere 9-12 months out. I’m including the quote below because this analyst is unfiltered in terms of how exciting the modeling can become:

Karl Keirstead

Okay, great. Amy, if I could double-click a little bit on the exciting news around M365 Copilot as everybody on the line looks to layer that opportunity into our models, I just wanted to get your views. Are there any guardrails you'd offer us to sort of keep us in line? Is there a degree of gross margin pressure in the Office segment? In other words, is it a fairly cost-intensive new product that we should keep in mind? And also, could it pull along Azure in the sense that you need Azure AD and perhaps some of the other cybersecurity products? So a little color there might help everybody with their modeling exercise tonight and in the coming weeks.

Amy Hood

Thanks, Karl. I think maybe I'll first start with the process we have when we release new products. And I absolutely understand we are excited, too, by the demand signal, the customer reaction, really the requests we're getting to be in the paid preview. It's all encouraging. As you know, we've — last week, we announced pricing, then we'll continue to work through the paid preview process get good feedback. Then we'll announce the general availability date, then we'll get to the GA date. Then we'll, of course, be able to sell it and then recognize revenue.

And that is why I continue to say that I am just as excited as everyone else about this, and it should be more H2 weighted. And we've, I think, given you some sizing opportunities. And I think I would use all that. But I do think this is really about pacing. And of course, we've still got to get our Security Copilot and some of the Dynamics workloads priced and released. And we'll continue to work toward that.

My note: this is calendar H2, so within 9-12 months, we should have a decent start on what AI can do for Microsoft on recurring software.

This is a brief comment on when cloud optimizations will end—which should be the perfect storm if we can get cloud to resume growth and then AI layered on top: “I think, in the next couple of quarters, what is the last catch-up optimization.” My note: I imagine this also means 9-12 months out.

Similar to Google, the comments on capex were bullish:

“To support our Microsoft Cloud growth and demand for our AI platform, we will accelerate investment in our cloud infrastructure. We expect capital expenditures to increase sequentially each quarter through the year as we scale to meet demand signals.”

Later, it was also stated: 

“And we do expect, as you asked and Satya talked about, the pace of this adoption curve, we do expect to be faster. So you're seeing the CapEx spend accelerate in Q4 and then again in Q1, and we've talked about what it should look like the rest of the year” and then also: “So it's why I do comment quite often that it's both overall Commercial Cloud demand and building out capacity for AI. It's both.” My note: That’s bullish for AMD, as well, in terms of CPUs.

The CEO also stated this, which I think is interesting for our particular holdings, which is that the rate of investment is higher than the Cloud growth rate right now. “Yes. And I think just for perspective, I think it's sort of always good to think about it, right, where we have, what, 111 [billion] commercial cloud business growing at, what, 22% year-over-year. And then you had a CapEx growth, which is around the same number, 23%, 24%. So in some sense, it's sort of replacement capital plus some new capital that is going to drive new growth.” My note: keep it coming on the capex! ☺

Lastly, Microsoft expressed they believe they are the best data platform on the market. Of course, this is biased but I want to earmark this for as we go along because the argument the CEO is making is important:

“I mean to give you a flavor for it, right, so you have your data in an Azure data lake. You can bring SQL Compute to it. You can bring Spark to it. You can bring Azure AI or Azure OpenAI to it, right? So the fact is you have storage separated from all these compute meters, and they're all interchangeable, right? So you don't have to buy each of these separately. That's the disruptive business model.”

Conclusion:

I chose to cover Google quickly last night because Microsoft (as always) came in as-expected. This is not a dramatic stock to own, rather is a good choice for those who prefer their drama comes elsewhere, and outside of their pocketbook. 

The Nasdaq is due for a breather and I’m kinda hoping for a selloff so we can load up at lower prices in the Fall and Winter. Amy Hood has archery-like skills when she provides guidance – she hits the bullseye on her numbers frequently. Because it’s coming from her, I have it written in ink to expect AI revenue to appear in calendar H1 of 2024. The remaining question of how to best position (and when) will be answered through Knox’s notes and trade alerts on Advanced Market Signals. 

  Recommended Readings:

• Alphabet Q2 Earnings: More on the Year of Execution
• Microsoft Q4FY23 Pre-ER: Looking to build AI momentum into FY24
• I/O Fund Portfolio & Must-Read Theses
• Microsoft: Premium Update on AI and Buy Plan
• Microsoft Q3 FY23: Strong earnings report