Microsoft beat on both the top and bottom lines with margins above guided levels, with Azure growth accelerating sequentially once more. Revenue growth of 17.7% reached the highest level in two years, driven by the cloud. Microsoft continues to demonstrate increased operating leverage even as it works to quickly build and scale its AI infrastructure to capture growth across the stack.
Fiscal Q2 revenue beat estimates by $890M, with the beat primarily coming from Intelligent Cloud. Microsoft reported 20% growth in Intelligent Cloud to $25.9 billion, ahead of its guide for 17-18% growth to $25.1 billion to $25.4 billion. Azure growth was 30%, a 200 bp QoQ acceleration on strong demand for consumption-based services.
AI’s impact on Azure was notable: Microsoft said that Azure’s 30% growth stemmed from “strong demand for our consumption-based services including 6 points from our AI services.” This 6 point contribution is impressive, given that AI services contributed 3 points to growth last quarter and 1 point in fiscal Q4. While that may seem small, it is significant considering the scale that this growth is attached to, with Azure’s revenue at a $74 billion run rate.
While Microsoft was optimistic about its Copilot AI subscription offerings, it did not divulge any material numbers about adoption rates. Microsoft said it has more than 400 million 365 Commercial customer seats and 78.4 million 365 Consumer subscribers, giving a nearly ~480 million customer base to target. Assuming just a 2% adoption rate across both Commercial and Consumer by the end of the fiscal year, Copilot would already be surpassing a $3 billion annual run rate.
CEO Satya Nadella said that Microsoft now has moved from “talking about AI to applying AI at scale by infusing AI across every layer of our tech stack.” Azure has been one of the first growth outlets, in part due to its tie in with OpenAI, with Copilot subscriptions for enterprises and consumers one of the next outlets. It’s this wide-ranging suite of AI services and ability to capture AI growth at multiple parts of the stack that sets Microsoft apart from the rest of Big Tech.
Revenue and EPS:
- Microsoft reported a fiscal Q2 growth rate of 17.7% YoY for revenue of $62.02 billion, versus expectations for 15.9% growth on revenue of $61.1 billion. This was Microsoft’s highest growth rate since fiscal Q3 2022.
- This beat flowed through to the bottom line, with EPS of $2.93 versus expectations for $2.77. This represented 33% YoY growth, the highest growth rate in more than 2 years.
- Microsoft guided for $60 billion to $61 billion in revenue, for YoY growth of 13.4% to 15.3%.
Segment Revenue:
- Productivity and Business revenue was $19.2 billion, up 13% YoY, driven by 17% growth in Office 365 Commercial. Growth came in 150 bp ahead of the midpoint of the guided range for 11-12% growth.
- Intelligent Cloud revenue was $25.9B, up 20% YoY, driven by strong demand for consumption based services and Azure. This was a 100 bp acceleration from last quarter and a 500 bp acceleration from 15% two quarters ago.
- More Personal Computing revenue was $16.9 billion, up 19% YoY. Windows revenue increased 9% with OEM revenue growth of 11%, while devices revenue decreased (9%).
Guidance on Segment Revenue:
- Productivity and Business revenue guided to decelerate ~185 bp QoQ at midpoint for growth of 10.3% to 12% YoY.
- Intelligent Cloud revenue guided to decelerate ~185 bp QoQ at midpoint for growth of 17.3% to 19% YoY.
- More Personal Computing revenue guided to decelerate 700 bp QoQ at midpoint for growth of 10.5% to 13.5% YoY.
Margins:
Margins were ahead of expectations across the board, with Intelligent Cloud continuing to show improvement in operating margin. We previously discussed after fiscal Q1’s earnings in October that Microsoft can drive operating leverage from AI, and Q2’s results further confirm this thesis – Microsoft boosted its operating margin forecast, saying operating margins would increase 100 to 200 bp YoY after calling for flat margins last quarter.
Operating margin for Q2 was 43.6%, 120 bp ahead of guidance for 42.4% and up 490 bp YoY. For the first half of fiscal 2024, operating margin was 45.4%. Microsoft’s guide of 100 to 200 bp expansion implies full-year operating margin between 42.8% to 43.8%, with next quarter’s guide for 42.9%.
We previously discussed how there may be more room for operating margin expansion in Intelligent Cloud as Microsoft continues to stay disciplined with OpEx with implementing the AI transition with Azure. Intelligent Cloud’s operating margin was 48.1% in fiscal Q2, up from 41.4% in the year ago quarter but down from 48.4% in fiscal Q1. Microsoft’s increased operating margin forecast suggests that Microsoft may capitalize on AI growth in the cloud and drive higher margins for both Azure and 365 over the next two quarters.
- Gross margin of 68.4% was up from 66.9% in the year ago quarter. The guide for next quarter is approximately 69%.
- Operating margin was 43.6%, up from 38.7% in the year ago quarter. Operating margin is guided for 42.9% next quarter, based on the midpoint of provided ranges, implying a slight sequential decrease.
- Net margin was 35.3%, up from 31.1% in the year ago quarter.
- Productivity and Business operating margin was 53.4%, down 20 bp QoQ but expanding 520 bp YoY.
- Intelligent Cloud operating margin was 48.1%, down 30 bp QoQ but expanding 670 bp YoY due to strength in Azure. IC operating income rose 40% YoY to $12.46 billion.
- More Personal Computing operating margin was 25.4%, down 1250 bp QoQ due to a 38% increase in operating expenses primarily from the Activision acquisition.
Cash Flows:
Operating cash flow was $18.9 billion, up 69% YoY on strong cloud billings and collections, versus a lower comparable quarter last year.
Free cash flow was $9.1 billion, up 86% YoY, with the high growth rate again coming against a weak comparable quarter.
Key Metrics:
Bookings increased 17% YoY and 9% on a constant currency basis, up from 14% in Q1. This was driven by strength in long-term Azure contracts and “strong execution across our core annuity sales motions, including healthy renewals.”
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. In addition, more than half of the Fortune 500 are using Azure OpenAI Services, highlighting the strength of Microsoft’s AI offerings.
GitHub Copilot’s paying subscribers surpassed 1.3 million, meaning the offering has surpassed $150 million ARR at a $10/month price. Paid subscribers rose ~30% QoQ from 1 million last quarter, and are up nearly 90% in just two quarters.
Earnings Call:
Microsoft’s earnings call reflected the optimism the company has for its AI offerings as well as the strong momentum and adoption of said offerings, though Microsoft offered little concrete statistics around its newest Copilot subscriptions for 365 customers.
We have said previously that Copilot 365 is one of the more crucial growth trajectories to watch as we move into calendar year 2024. Microsoft explained that its internal research and external studies have shown “as much as 70% improvement in productivity, using generative AI for specific work tasks. And overall early Copilot for Microsoft 365 users were 29% faster in a series of tasks like searching, writing, and summarizing.” These productivity gains are leading to strong adoption of Copilot: Microsoft said that “two months in, we have seen faster adoption than either our E3 or E5 suites.”
Cloud and Azure’s strength was evident throughout the call. CFO Amy Hood noted that “demand for our Microsoft cloud offerings, including AI services drove better-than-expected growth and large long-term Azure contracts.” In addition, “Microsoft 365 suite strength contributed to ARPU expansion for our office commercial business.”
For Azure specifically, management said that “customers continue to choose Azure to simplify and accelerate their cloud migrations. Overall, we are seeing larger and more strategic Azure deals with an increase in the number of $1 billion-plus Azure commitments.”
One of the most important comments of the call was in regards to Azure’s 30% growth. Management said that both “AI and non-AI Azure services drove our outperformance” in the quarter. For Q3, Azure’s growth is expected to remain stable QoQ, driven by consumption-based services “with continued strong contribution from AI.” Reading between the lines here suggests that cloud optimization trends are ending, with comments of stable growth leaning more towards possible acceleration rather than deceleration.
Nadella further hammered that point home in the Q&A, saying that he believes that the “period of massive optimization only and no new workloads start, that I think has ended at this point. So what you're seeing is much more of that continuous cycles by customers, both whether it comes to AI or whether it comes to the traditional workloads.”
Elevated demand for AI services was a common theme, from Azure’s 6 point growth to GitHub to Power Platform. Management said that “GitHub revenue accelerated to over 40% year-over-year, driven by all-up platform growth and adoption of GitHub Copilot, the world's most widely deployed AI developer tool.” GitHub Copilot subscribers rose 30% QoQ and nearly 90% from ~700,000 in fiscal Q4. For Power Platform, Microsoft said that “more than 230,000 organizations have already used AI capabilities in Power Platform, up over 80% quarter-over-quarter.”
Microsoft’s earnings call reflected growing AI optimism, with strong key metrics for its AI offerings across its product suite. Microsoft is hinting at cloud optimization trends fading away, with high demand for AI services in Azure adding 6 points to growth while non-AI services contributed to outperformance.
Conclusion
Microsoft is at the front of Big Tech’s AI revolution on the software side, and this is unlikely to change given the company’s key advantage in targeting 400 million enterprise seats. Revenue growth has accelerated significantly over the past four quarters, from 2% growth to 17.7% growth, driving 33% EPS growth this quarter. Microsoft is proving that its substantial investments in AI infrastructure and its wide-ranging AI suite is paying off on growth for both the top and bottom line.
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