💻 Microsoft: Capacity Constrained
First look at the new segmentation
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In case you missed it:
Microsoft (MSFT) just reported its Q1 FY25 (ending in September).
The stock dropped 6%, signaling it wasn’t quite the home run investors hoped for. Trading at over 30 times next year’s earnings, Microsoft faced high expectations.
CEO Satya Nadella shared:
“Our AI business is on track to surpass an annual revenue run rate of $10 billion next quarter, which will make it the fastest business in our history to reach this milestone.”
That puts AI at roughly 4% of Microsoft’s overall revenue after less than three years—a striking achievement for one of the largest companies on the planet.
If you’re short on time, here are three key takeaways:
☁️ Azure is decelerating. As Microsoft’s most critical segment in the AI arms race, Azure grew 34%, down slightly from 35% in the prior quarter (adjusted after a recast). There are many moving pieces, but Google Cloud set a challenging benchmark, accelerating from 29% to 35% in the same quarter.
🤖 AI growth is supply-constrained, with hardware capacity not keeping up with demand. Data centers don’t get built overnight, and Microsoft is investing billions in infrastructure to catch up, with reacceleration expected in 2025.
👨👩👧👦 Consumer products are not doing so great, notably Gaming and Devices. While these segments are not as critical to the core business, they have underperformed, dragging down the overall trend.
Let’s break down what we learned and visualize the quarter.
Today at a glance:
New segmentation.
Microsoft’s Q1 FY25.
Earnings call takeaways.
What to watch moving forward.
1. New Segmentation
New Business Segments
In August, Microsoft announced a restructuring of its business segments, officially taking effect this quarter. The goal? To better align reporting with Microsoft’s current operations and management approach.
Here's a summary of the key changes:
Consolidation of Microsoft 365 Commercial revenue: All commercial revenue related to M365, including mobility and security services, is now grouped under the Productivity and Business Processes segment.
Shifting of Copilot Pro revenue: The Copilot Pro productivity tool moved from Productivity and Business Processes to More Personal Computing within the Search and news advertising category.
Nuance Enterprise relocation: Revenue from Nuance, previously part of the Intelligent Cloud segment, was shifted to Productivity and Business Processes.
Combined Windows and Devices reporting: Microsoft has begun reporting Windows and Devices revenue together.
Impact of the Changes:
Core Segments:
The short version of all these adjustments is:
Productivity and Business Processes became significantly larger.
Intelligent Cloud shrank due to Nuance and other revenue shifts.
Products and Services:
M365 Commercial has expanded with the addition of Nuance (moved from Server products) and the consolidation of other mobility and security services.
Windows & Devices now combines two slower-growing segments into one.
But wait, there’s more!
Azure—Microsoft’s cloud computing platform and infrastructure—is included in ‘Server products and cloud services.’ Management shares Azure's growth rate but doesn’t disclose the exact revenue number.
Microsoft recast Azure’s growth for the past five quarters, allowing for a more consistent comparison. After the recast, Azure growth was 35% in constant currency last quarter—a significant upside from the 30% previously reported. It’s hard to track these KPIs, especially with management not disclosing total revenue attributed to Azure. Still, this recast has raised the bar for Azure’s growth.
And that brings us to the new quarter.
2. Microsoft’s Q1 FY25
Income Statement:
Revenue grew 16% year-over-year to $65.6 billion ($1.0 billion beat). Microsoft completed its purchase of Activision Blizzard in October 2023. Excluding the acquisition, overall revenue grew by 13%.
Product and Services Breakdown (new segmentation):
☁️ Server products and cloud services $22.2 billion (+23% Y/Y).
📊 M365 Commercial products and cloud services $20.4 billion (+13% Y/Y).
🎮 Gaming $5.6 billion (+43% Y/Y), including the Activision impact.
🪟 Windows and Devices $4.3 billion (flat Y/Y).
👔 LinkedIn $4.3 billion (+10% Y/Y).
🔎 Search and news advertising $3.2 billion (+7% Y/Y).
🔒 Enterprise and partner services $1.9 billion (flat Y/Y).
📈 Dynamics $1.8 billion (+14% Y/Y).
💻 M365 Consumer products and cloud services $1.7 billion (+5% Y/Y).
Let’s turn to the three core business segments.
Core Business Segments:
📊 Productivity and Business Processes grew 12% Y/Y to $28.3 billion (ahead of forecast), driven by M365 Commercial, notably Copilot adoption.
☁️ Intelligent Cloud grew 20% Y/Y to $24.1 billion (in-line), driven by Azure AI services (more on this in a second).
🎮 More Personal Computing grew 17% Y/Y to $13.2 billion (ahead of forecast), including 15 points from the Activision acquisition. Devices declined, but the search and advertising rebound continued, boosted by the new segmentation.
Key Trends:
The table below compares growth year-over-year in constant currency in the last seven quarters. Many of the products and services overlap.
Microsoft Cloud represents all of Microsoft's cloud offerings across multiple segments. It grew 22% year-over-year to $39 billion (in-line), representing 59% of overall revenue (+3pp Y/Y).
Azure is running the show and driving the growth of ‘Server products and cloud services’ and Microsoft Cloud.
Xbox growth has been inflated by the Activision acquisition since Q2 FY24, but it will normalize in Q2 FY25.
Windows OEM and devices are now consolidated (down 2% in Q1 FY25), so I will retire these lines, but I wanted to share them here one last time.
Office was officially renamed Microsoft 365 in the earnings report. I kept the old name in the table below for comparison but will update it starting next quarter.
Gross margin was 69% (-2pp Y/Y and -1pp Q/Q).
Operating margin was 47% (-1pp Y/Y and +4pp Q/Q).
EPS grew 10% to $3.30 ($0.19 beat).
Cash flow:
Operating cash flow was $34 billion (52% margin, -2pp Y/Y).
Balance sheet:
Cash and cash equivalent: $78 billion.
Long-term debt: $43 billion.
Q2 FY25 Guidance (ending in December 2024):
📊 Productivity and Business Processes: +10%-11% Y/Y (stable), driven by M365, which includes Copilot. LinkedIn is expected to grow by roughly 10%. Dynamics to accelerate in the mid-to-high-teens.
☁️ Intelligent Cloud: +18%-20% Y/Y (a slight deceleration). Azure will be the main driver, slowing down to 28%-29% Y/Y in constant currency.
🎮 More Personal Computing: roughly $14 billion in revenue. Declines are expected in Windows and Devices and Gaming (due to the hardware cycle), partially offset by the addition of Copilot Pro to this segment.
So what to make of all this?
Azure's growth decelerated, with a 34% Y/Y increase in constant currency, primarily driven by a 12pp contribution from AI services (compared to 11pp in the previous quarter after recast). While strong, this was softer than the recast 35% from the prior quarter and partially boosted by an accounting adjustment.
Azure remained capacity-constrained as AI demand outpaces hardware availability. Management anticipates further deceleration in Q2 FY25, with Azure growing between 31% and 32% Y/Y, but expects reacceleration in H2 FY25 as infrastructure investments meet demand.
Commercial remaining performance obligation grew 21% to $259 billion, accelerating from 20% in Q4, driven by large contracts.
Margins compressed slightly due to the AI infrastructure investments, with Activision also impacting the operating margin by 2 points.
Capital expenditures rose 50% to $15 billion (excluding finance leases), compared to nearly $14 billion in the previous quarter. Roughly half is for infrastructure. Capex will increase sequentially in Q2.
Management returned $9.0 billion to shareholders through share repurchases and dividends. They bought back $2.8 billion of MSFT shares during the quarter (matching Q4).
The Q2 FY25 revenue outlook came short, at $68.6 billion in the mid-range, versus $69.9 billion expected by analysts. This shortfall—combined with Azure’s slowdown—drove the negative market reaction.
3. Earnings call takeaways
Satya Nadella shared critical milestones across Microsoft’s portfolio.
On Azure AI:
“With Azure AI, we are building an end-to-end app platform to help customers build their own Copilots and agents. Azure OpenAI usage more than doubled over the past six months.”
Nadella emphasized how Azure AI is increasingly becoming an entry point for data and analytics services like Azure Cosmos DB and Azure SQL DB. Microsoft Fabric now has over 16,000 paid subscribers, growing 14% sequentially—a signal of the platform’s rapid adoption.
On AI adoption:
“(Github) Copilot enterprise customers increased 55% quarter-over-quarter. […] nearly 600,000 organizations have used AI-powered capabilities in Power Platform, up 4x year-over-year.”
AI adoption across Microsoft’s software ecosystem saw significant growth this quarter, mirroring trends across other Big Tech companies.
On Microsoft 365 Copilot:
“We launched the next wave of Microsoft 365 Copilot innovation last month, bringing together Web, Work, and Pages as the new design system for knowledge work. […] Nearly 70% of the Fortune 500 now use Microsoft 365 Copilot, and customers continue to adopt it at a faster rate than any other new Microsoft 365 suite. […] Copilot is the UI for AI and with Microsoft 365 Copilot, Copilot Studio and Agents and now Autonomous Agents, we have built an end-to-end system for AI business transformation.”
Microsoft is doubling down on productivity with autonomous agents. It’s still early days, but it could boost M365 Commercial growth in the quarters ahead.
On LinkedIn:
“Member growth continues to accelerate with markets in India and Brazil both growing at double digits. We are also seeing record engagement as we introduce new ways for our more than 1 billion members to connect. […] Our investments in rich formats like video strengthened our leadership in B2B advertising and amplified the value we deliver to our customers. Weekly immersive video views increased 6x quarter-over-quarter, and total video viewership on LinkedIn is up 36% year-over-year.”
LinkedIn’s emphasis on video content is a natural step, aligning with trends across other social platforms. Microsoft’s investment in AI-powered tools for hiring, learning, and sales is also fueling LinkedIn’s revenue growth.
Microsoft’s $26 billion LinkedIn acquisition in 2016 has paid off, especially compared to Elon Musk’s $44 billion purchase of Twitter in 2022 (X’s annual revenue is well below $5 billion today based on market intelligence estimates).
On Search:
“Bing ex-TAC revenue growth outpaced the search market.”
Although Bing and Edge are still starting from a relatively low base, their outpacing of the search market means progress. But they are far from making anyone dance.
On Gaming:
“Game Pass set a new Q1 record for total revenue and average revenue per subscriber. And as we look ahead, our IP across our studios has never been stronger. Last week's launch of Black Ops 6 was the biggest Call of Duty release ever, setting a record for day one players as well as Game Pass subscriber ads on launch day. And unit sales on PlayStation and Steam were also up over 60% year-over-year. This speaks to our strategy of meeting gamers where they are by enabling them to play more games across the screens, they spend their time on.”
Nadella emphasized Black Ops 6’s success on PlayStation, likely aiming to maintain a collaborative tone with Sony. As expected, Activision Blizzard titles are helping boost Game Pass subscriber numbers.
CFO Amy Hood on Capex:
“Capital expenditures, including finance leases, were $20 billion, in line with expectations. […] Roughly half of our cloud and AI-related spend continues to be for long-lived assets that will support monetization over the next 15 years and beyond. The remaining cloud and AI spend is primarily for servers, both CPUs and GPUs, to serve customers based on demand signals.”
Hood highlighted that a significant portion of Microsoft’s AI investments, which will impact operating expenses soon, are geared toward long-term monetization. This investment strategy aims to generate sustained revenue growth well into the future. In short, management is reminding investors to be patient.
4. What to watch looking forward
☢️ Capacity constrained, but what about energy?
Microsoft is addressing its data centers' increasing power demands by turning to nuclear energy. Partnering with Constellation Energy, Microsoft aims to revive a reactor at the historic Three Mile Island nuclear plant. The company plans to use the power generated to support its AI-intensive data centers.
Timeline: Constellation is set to invest $1.6 billion to restart the reactor, expected to be operational by 2028.
Why nuclear? Nuclear power offers a reliable, carbon-free energy source crucial for the energy-intensive needs of AI workloads. Microsoft joins other tech giants like Google and Amazon in exploring nuclear power as a sustainable solution for data centers.
AI will increase our energy needs, and the tech industry must find reliable, carbon-free energy sources. While reviving a reactor at the site of a past nuclear accident may raise concerns, it also underscores the growing importance of nuclear power in a world increasingly reliant on AI.
🤖 The Agent Economy
Microsoft is launching autonomous AI agents in November, introducing tools that enable businesses to automate routine tasks, boosting efficiency.
Here’s what’s coming:
AI agents: Operating with minimal human input, these agents go beyond traditional chatbots, managing tasks like customer inquiries, lead identification, and inventory.
Copilot Studio: Microsoft’s Copilot Studio lets businesses create their own AI agents with minimal coding knowledge.
Pre-built agents: Microsoft will offer 10 ready-to-use agents covering everyday business needs like supply chain management and expense tracking.
Public preview: These AI agents will be available in Copilot Studio for public preview starting next month.
This push into the agent economy highlights Microsoft’s commitment to delivering practical solutions for businesses to accelerate AI adoption across industries.
Salesforce has also entered this space with its Agentforce initiative, sparking competition. Salesforce CEO Mark Benioff recently likened Microsoft’s Copilot to the infamous Clippy assistant from the 90s, playfully fanning the flames of rivalry. We’ll dig deeper into this topic when we cover Salesforce’s earnings—stay tuned!
That’s it for today!
Stay healthy and invest on.
Author's Note (Bertrand here 👋🏼): The views and opinions expressed in this newsletter are solely my own and should not be considered financial advice or any other organization's views.
Disclosure: I am long AMZN, CRM, and GOOG in the App Economy Portfolio. I share my ratings (BUY, SELL, or HOLD) with App Economy Portfolio members.
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"Microsoft’s $26 billion LinkedIn acquisition in 2016 has paid off, especially compared to Elon Musk’s $44 billion purchase of Twitter in 2022" - That's maybe not a fully valid comparison. Microsoft's purchase of LinkedIn was a totally commercial acquisition but Musk had some non-commercial motives for buying Twitter.