"Dislocated" Microsoft: Lean Reality vs Ambitious Future, it's time to test faith again!

$Microsoft(MSFT.US) On January 30th, after-hours trading in the U.S. stock market announced the financial report for the second quarter of fiscal year 2025 ending in December. At first glance, both revenue and operating profit for this quarter exceeded market expectations, but the core issue is that the growth of Azure, which is central to the core, and the guidance for the next quarter fell short of expectations, which is the biggest "defect." The key points are as follows:

1. Azure's acceleration expectations dashed: Under the new criteria, the year-on-year and constant currency growth rate for Azure this quarter is 31% . This is a decrease of 2 percentage points compared to the previous quarter. Although it is at the lower limit of the company's previous guidance range of 31% to 32%, it seems barely acceptable. However, the market generally believed before the earnings report that Azure would end the continuous slowdown in growth over three quarters in the second half of fiscal year 2025 and accelerate again. Buyers actually expected Azure's growth rate for this quarter to be at least 32%, and hoped for further acceleration to 33% to 34% next quarter.

In reality, not only did the quarterly growth fall short of buyer expectations, but the company's guidance for Azure's growth rate next quarter remains at 31% to 32%, in other words, management does not expect Azure's growth to accelerate next quarter. Both the current quarter and the guidance for the next quarter missing expectations have basically dashed the beautiful vision that "Azure will accelerate growth in the second half of the fiscal year" (for example, Deutsche Bank had expected Azure's growth rates for Q3 and Q4 to be 33% and 34%, respectively, gradually increasing), which will prompt the market to lower its growth expectations for Azure for the entire FY25 and even for the longer term.

Of the 31% growth in Azure this quarter, about 13 percentage points came from AI-related businesses, and the contribution ratio continued to rise slightly by 1 percentage point compared to the previous quarter, which aligns with market expectations. However, the growth contribution from traditional non-AI businesses significantly decreased by 3 percentage points, marking a continuous decline for three quarters with an expanding magnitude, indicating that the weakness in non-AI businesses is the culprit for Azure's overall poor performance.

Dolphin Investment Research learned from a recent survey by a foreign investment bank regarding overall IT spending by enterprises that enterprises are currently relatively cautious about their total IT investment in 2025 (with expected year-on-year growth in spending only in the low single digits). Due to budget constraints, the increase in spending on AI-related areas may likely lead to a reduction in traditional expenditures. The company also stated in the conference call that the balance between customers' AI workloads and traditional workloads is one of the reasons for the growth falling short of expectations, and this impact is expected to continue in the second half of the fiscal year.

2. Productivity business accelerates overall, initial results of AI applications visible: The Microsoft 365 commercial business, which is closely tied to AI, saw revenue growth of 16% this quarter (15% growth at constant currency), showing a slight acceleration of 1 percentage point compared to the previous quarter Compared to the company's previous guidance, the 14% growth rate under unchanged exchange rates is also 1 percentage point higher. From the perspective of price and volume driving structure, the number of enterprise M365 subscription seats increased by 7% year-on-year this quarter, down 1 percentage point from the previous quarter, still at a historical low; while the average customer unit price increased by 8.4% year-on-year, significantly higher than the 6% to 7% in the previous two quarters.** The acceleration in growth mainly relies on price increases, and we believe that high-priced products like E5, as well as various Copilot features that require additional payment, should perform well. Management also confirmed this speculation during the conference call. According to Dolphin Investment Research's reference to foreign banks' research, the current number of seats using Copilot may have reached 3 to 5 million. Enterprises' adoption rate of Copilot has seen a certain increase.

In addition, the growth rate of personal 365 business and Dynamics business has also significantly accelerated this quarter. From the productivity process sector, the growth of other application-related businesses, except for LinkedIn (advertising-related), has shown improvement. We believe that after more than two years of development, AI functions have begun to drive demand at the application level (such as software or SaaS) or improve the payment effect per customer. The benefits of AI are gradually shifting from upstream hardware and cloud computing services to downstream terminals.

4. Leading indicators are "explosively" strong? Unlike the poor performance of Azure in the current period and the similarly poor guidance revealing negative signals, the leading indicators of performance reflect quite optimistic signals. First, the growth rate of newly signed enterprise contract amounts surged by 67% year-on-year this quarter, the highest value since Dolphin Investment Research began tracking historical data. Similarly, the balance of contracts to be fulfilled also increased significantly by about $39 billion this quarter, reaching $298 billion, a year-on-year increase of 34%, also the highest since the pandemic. According to the company's disclosure, the surge in new order amounts is mainly contributed by large and long-term pre-orders from OpenAI and other users.

The not-so-good performance in the current period vs. very strong leading indicators like newly signed contracts may be explained by the fact that enterprises are still relatively cautious about total IT spending, leading to AI spending largely substituting traditional spending rather than being purely incremental, thus limiting the performance of current revenue.

However, looking at the long term, enterprises remain optimistic about the vast prospects of AI, especially as expectations for the implementation of AI applications are increasingly high. Therefore, some enterprises are willing to sign framework agreements or contracts in advance to prepare capacity for the subsequent growth in AI application demand. However, whether AI applications will truly lead to significant usage, thereby converting contracts into actual revenue, still depends on the product strength of AI applications and the benefits they can bring to enterprises or users.

5. Efficiency increase or proactive cost control? From a profitability perspective, Microsoft's performance seems quite good at first glance. First, the gross margin is 68.7%, a slight increase of 0.3 percentage points year-on-year. The actual COGS expenditure was $21.8 billion, less than the lower limit of the previous guidance range of $21.9 to $22.1 billion However, from a segment perspective, the gross margins of the productivity and intelligent cloud segments have slightly declined year-on-year due to investments in AI infrastructure. The overall improvement in gross margin is entirely due to the impact of the consolidation of Activision Blizzard on the personal computing segment, which has alleviated the drag on gross margin compared to the same period last year.

From an expense perspective, apart from R&D expenses generally growing in line with revenue, which is not considered stingy, marketing expenses and administrative expenses grew by only 3% and -8% year-on-year, significantly lower than the revenue growth rate. Whether due to the efficiency gains brought by AI or the company's proactive choice to cut jobs and control costs in response to the need to hedge against significant AI capital expenditures, the result is that through control over marketing and administrative expenses, approximately 1.6 percentage points of additional operating profit margin has been squeezed out, resulting in Microsoft's overall operating profit of $31.7 billion this quarter, about 5% higher than the expected $30.1 billion.

6. Is the guidance for the next quarter good or bad? Regarding the guidance for Q3 of fiscal year 2025, due to the recent rise of the US dollar, the company expects exchange rates to have a negative impact of 2 percentage points on revenue, but since there is a similar negative impact on costs and expenses, the effect on profit is minimal.

In terms of guidance for other key businesses, due to the underperformance of Azure, the expected median growth for the intelligent cloud segment in the next quarter is 17.7%, continuing to slow down and about 3% lower than market expectations. The core enterprise M365 Cloud business in the productivity segment is expected to grow by 14% to 15% at constant exchange rates, roughly in line with this quarter. The entire segment is expected to have revenue about 3% higher than expected, and the performance in the next quarter is still expected to be good. The guidance for the next quarter's operating profit margin is about 44%, an increase of 1.1 percentage points year-on-year, continuing from the previous quarter, and generally in line with market expectations.

7. Other noteworthy points: This quarter, Microsoft's Capex expenditure increased from $20 billion in the previous quarter to $22.6 billion, a year-on-year increase of 97%. The intensity of investment continues to rise, and based on the current trend, the company's previous expectation of a total capex budget of $80 billion for fiscal year 2025 is likely to be exceeded.

Additionally, this quarter, the company confirmed over $2.2 billion in other operating losses, which is higher than the losses expected from OpenAI by Dolphin Investment Research. However, this quarter saw the announcement of the dissolution of the Cruise business, and Microsoft confirmed the impact of investment impairment. The company's expectation for other operating losses in the next quarter is about $1 billion, which should be seen as a baseline for the short-term profit drag from OpenAI on Microsoft.

Dolphin Investment Research's View:

In summary, it can be seen that Microsoft's performance this quarter is a mix of good and bad, with different businesses and indicators reflecting conflicting signals. So how should we understand Microsoft's performance this time?

Dolphin Investment Research believes that the current market's main focus on Microsoft is: 1) Can Azure's growth accelerate again under the demand for AI, and when will the turning point appear? This reflects the extent to which Microsoft benefits from enterprise AI and overall IT investments at the upstream IaaS + PaaS level; 2) Represented by various Copilots, when will AI in SaaS and software reach a tipping point for large-scale user adoption? This reflects Microsoft's ability to land AI at the application level and directly obtain incremental profits by creating value for end users; 3) From the perspective of capex and profit margins, it measures Microsoft's own investment and output ratio in AI. That is, with an annual investment close to $100 billion, will it ultimately enhance profits or erode them?

From the perspective of question 1), the signals revealed by Microsoft's recent performance are clearly negative. As companies need to balance AI vs. non-AI investments, large players like Microsoft (including AWS) cannot "purely" enjoy the increments brought by AI. Moreover, the current Deepseek model shows a relatively low demand for computing power, which may reduce companies' subsequent demand for hardware and cloud computing infrastructure during the development phase (the inference demand generated after AI applications are widely implemented belongs to another level).

From the perspective that Copilot has slightly improved the growth rate of most businesses in the productivity sector, the landing of AI at the application end seems to have improved compared to the previous "almost no progress." However, according to research conducted by Dolphin Investment Research, the current adoption of AI applications by enterprises and individuals is still in a very early stage. The penetration rate of Copilot among all enterprise M365 users should still be in the low single digits. Therefore, the direct monetization of AI aimed at end users undoubtedly has significant potential, and it is indeed a key development direction in the current industry. However, compared to the thousands of billions of dollars spent annually on hardware, servers, cloud, and other infrastructure, the application and monetization of applications are still more in the conceptual and early landing stage, in the future rather than in the present.

Given the continued rise in Capex spending and the reality that the gross margins of the productivity and intelligent cloud sectors are declining due to increased investment, we believe that at least in the short term (with Azure not showing acceleration and the progress of application landing not being quick), the time mismatch between upfront investment and the incremental revenue that will gradually be released in the future is likely to have a more negative than positive impact on Microsoft's performance.

However, from a long-term perspective, based on the recent user experience of various AI models and applications, Dolphin Investment Research's confidence in the long-term development and growth potential of AI has significantly increased. Personally, I increasingly believe that AI indeed has the potential to revolutionize many industries, and its potential market space is indeed vast. Similar to the surge in order amounts for Microsoft this time, although it is particularly uncertain when and whether it can be converted into actual revenue in the short term, in the long run, the probability of "turning the dream into reality" should be significantly higher than that of not happening.

The following is a detailed commentary on the financial report:

1. Changes in Financial Report Disclosure

After the last quarterly financial report, Microsoft announced that it would make significant adjustments to the departmental structure of financial report disclosures starting in fiscal year 25. The adjustment approach is to move all enterprise-facing Microsoft 365 service projects (in addition to the B2B Office 365, also including Windows 365 and Security 365) into the major revenue category of Office 365's productivity and processes (PBP). We have already interpreted this in the last performance commentary, so we will not repeat it to avoid wasting words The following image briefly summarizes the adjustments for your reference.

II. Azure Disillusionment, Application Implementation?

1.1 The "Dream" of Accelerating Azure Shattered?

First, the most concerning Azure business for the market, under the new criteria, the year-on-year and constant currency growth rate for this quarter is 31%. This is a 2 percentage point decrease compared to the previous quarter. Although it seems to meet the lower end of the previously guided growth range of 31% to 32% at constant currency, in reality, the market had generally recognized and believed in the management's guidance before the performance—that Azure would end the three-quarter growth slowdown phase in the second half of fiscal year 2025 and accelerate again. Buyers expected Azure's growth rate to be 32% or even higher, with further acceleration to 33% to 34% next quarter.

However, the reality is that not only did the quarterly performance fail to surprise and underperform buyer expectations, but a bigger issue is that the guidance range for Azure's growth rate next quarter remains the same at 31% to 32%, unchanged from the previous quarter, showing no acceleration. If the growth rate for this quarter were slightly below expectations, the market could still comfort itself with the thought that "next quarter will improve," but the guidance that also falls short of expectations implies that the expectation of "Azure's growth will accelerate in the second half of the fiscal year" is not the "high probability event" it was imagined to be. (For example, Deutsche Bank had expected Azure's growth rates for Q3 and Q4 to be 33% and 34%, respectively, gradually increasing). This has prompted the market to lower its growth expectations for Azure for the entire FY25 and even for the longer term.

According to the company's disclosure, of the 31% growth in Azure this quarter, about 13 percentage points came from AI-related businesses, with the contribution ratio continuing to rise slightly by 1 percentage point compared to the previous quarter, in line with market expectations. However, conversely, the growth contribution from traditional non-AI businesses has significantly decreased by 3 percentage points, marking a decline for three consecutive quarters with an expanding magnitude. Combined with the latest research from Dolphin Investment Research on overall IT investment growth among enterprises, companies expect a 4.4% growth in total IT investment for 2025, down from 5.6% in the May survey. According to this research, amid the AI wave, enterprises do not seem to be "aggressively" increasing IT investments but are still cautiously controlling the growth of total expenditures. Due to the control over the total expenditure budget, the increase in corporate investment in AI-related areas may not fully translate into net growth in cloud computing demand, as a significant portion may be offset by reduced traditional expenditures.

Overall, due to the slowdown in Azure business growth, which slightly fell short of market expectations, the entire intelligent cloud segment reported revenue of $25.5 billion this quarter, slightly below the expected $25.9 billion. This represents a year-on-year growth of 19%, with a quarter-on-quarter slowdown of 1 percentage point.

1.2 Comprehensive Growth in Productivity Business, Initial Results of AI Application?

The Microsoft 365 commercial business, which is closely tied to AI and ranks among the top two in revenue after adjustments, saw a 16% revenue growth this quarter (15% growth at constant exchange rates), slightly accelerating by 1 percentage point compared to the previous quarter. This is also 1 percentage point higher than the company's prior guidance of 14% growth at constant exchange rates.

From a volume and price perspective, the increase in average transaction value was the main contributor to this quarter's growth exceeding expectations: 1) According to the company, the number of enterprise M365 subscription seats increased by 7% year-on-year this quarter, a decline of 1 percentage point compared to the previous quarter, still at a historical low; 2) Correspondingly, the average transaction value increased by 8.4% year-on-year, significantly up from the 6%-7% range in the previous two quarters. Based on this, Dolphin Investment Research believes that the penetration of high-priced products like E5 and the Copilot feature may have contributed. Management also confirmed our speculation during the conference call.

In other major businesses within the productivity segment, the growth rates of personal 365 and Dynamics businesses both showed significant improvement this quarter. In the productivity process segment, most application-related businesses, except for LinkedIn (which is ad-related), showed signs of improvement, a possible explanation being that AI features have begun to drive demand recovery or increase the amount paid by individual customers.

Overall, as mentioned earlier, due to the acceleration in growth of major businesses including Enterprise M365, this quarter the overall revenue of the Productivity Process segment reached $29.4 billion, significantly exceeding the market expectation of $28.5 billion. The revenue growth rate also increased from 12% in the previous quarter to 13.9%. The growth inflection point of this segment may indicate that the benefits of AI have gradually transitioned from upstream hardware to the application layer at the end.

III. After the consolidation benefits, returning to "original form," search and AI PCs are the focus areas

After passing through the impact period of consolidating Activision Blizzard in the second quarter of last fiscal year, the year-on-year revenue growth rate of the personal computing segment this quarter has fallen back to 0%— back to the low growth range before consolidation. However, compared to the lower market expectation growth rate (-1.4%), the actual performance of zero growth is not unexpectedly bad news.

Specifically: 1) The growth rate of the gaming business, after the impact of consolidation has faded, has dropped from over 40% to -7%, and the gaming business still faces significant challenges; 2) The combined revenue of Windows and related hardware devices grew by 3%, showing slight improvement compared to before. However, whether it can substantially break away from low single-digit growth still depends on whether the AI PC concept can significantly boost demand for personal computers.

The growth of the advertising business, which has incorporated Copilot pro, continues to accelerate, with a year-on-year growth of 12% this quarter, rising from -1% growth over four quarters to over 10%. This still proves that search is currently the most effective application direction for AI in the consumer sector.

IV. Leading indicators surge, not-so-good current performance vs. huge future potential?

Microsoft Group's overall revenue this quarter was $69.6 billion, and due to the end of the favorable period from consolidating Activision Blizzard, the year-on-year growth rate has decreased from the range of 15% to 18% in previous quarters to 12%. However, excluding the impact of consolidation, Microsoft's comparable revenue growth rate last quarter was about 13%, so in comparable terms, the actual total revenue growth rate this quarter has slowed by about 1 percentage point. Overall, this is not bad, but the main issue is that the structurally most important Azure business performed poorly.

However, the signals revealed by Azure's recent poor performance and guidance are completely different; the leading indicators of performance reflect quite optimistic signals. First, the growth rate of new enterprise contract amounts surged by 67% year-on-year this quarter, the highest value since Dolphin Investment Research began tracking historical data.

Similarly, the balance of contracts to be fulfilled also increased significantly by about $39 billion this quarter, reaching $298 billion, a year-on-year increase of 34%, also setting a record high since the pandemic. According to the company's disclosures in the report, the explosive growth in new order amounts is mainly attributed to large orders from OpenAI.

The Azure business, which has poor current performance and guidance, contrasts with the "explosive" strength of the new contract leading indicators, presenting a somewhat "twisted" situation—enterprises may still be cautiously optimistic about total IT spending, with new investments in AI leading to reductions in traditional spending, resulting in minimal net increases.

Looking at the long term, companies remain optimistic about the vast prospects of AI, willing to try novel AI features and services, and sign framework agreements or contracts in advance. However, whether these contracts can actually convert into revenue and whether the willingness can ultimately translate into actual usage still depends on how much benefit AI applications can create for enterprises when they are actually implemented.

V. AI investments continue to drag down the profitability of the IC and PBP sectors, with unexpected gains coming entirely from the MPC business

From a growth perspective, it is a mixed picture where current performance is not great, but leading indicators are quite strong. From a profitability perspective, Microsoft's performance this time is relatively good.

First, in terms of gross profit, Microsoft's gross margin this quarter was 68.7%, a slight year-on-year increase of 0.3 percentage points. The actual COGS was $21.8 billion, below the lower limit of the previous guidance range of $21.9 to $22.1 billion. However, looking at the segments, the gross margins of the Productivity and Business Processes and Intelligent Cloud segments have actually declined year-on-year due to investments in AI infrastructure. This is mainly because the Personal Computing segment has passed the base period of the consolidation of Activision Blizzard, eliminating the drag on gross margin from a year-on-year perspective, making the overall gross margin of the group appear improved.

From an expense perspective, Microsoft's marketing, research and development, and administrative expenses grew only 5% year-on-year this quarter, significantly lower than the 12% revenue growth rate, resulting in a year-on-year decrease of 1.6 percentage points in the expense ratio. Specifically, R&D expenses grew by 11% year-on-year, basically in sync with revenue growth, indicating that investment in R&D is not being spared However, marketing expenses and management expenses increased by 3% and decreased by 8% year-on-year, respectively. This may be due to cost reduction and efficiency improvement brought about by AI, or the company proactively controlling expenses in response to the large capital expenditures on AI. In any case, Microsoft has continued to squeeze out some incremental profits through control over marketing and management expenses.

Overall, due to the disappearance of the drag on gross margin from consolidation and control over marketing and management expenses, Microsoft achieved an operating profit of $31.7 billion this quarter, about 5% higher than the expected $30.1 billion, with an operating profit margin increasing by 1.9 percentage points year-on-year.

By segment, the biggest contributor to the improvement in profit margin this quarter was the MPC segment, which was free from the impact of consolidation, with an improvement in operating profit margin of over 6 percentage points year-on-year. The productivity processes segment saw a slight increase in operating profit margin year-on-year due to a year-on-year increase in operating expenses of only 6%. However, the intelligent cloud segment experienced a year-on-year decline of 1.9 percentage points in operating profit margin due to higher investments.

Dolphin Investment Research's past research on [Microsoft]:

Financial Report Commentary

October 31, 2024, conference call summary “ Microsoft: What is restricting Azure's growth? ”

October 31, 2024, commentary “ Microsoft: AI only shows “spending” but not “returns” ”

July 31, 2024, commentary “ Microsoft: No miracles from strong efforts, is the AI dream stalled? ”

July 31, 2024, conference call summary “ Microsoft: How to grasp the rhythm of AI investment ”

April 26, 2024, financial report commentary “Microsoft: Azure carries everything, definitely the “stabilizing force” of U.S. stocks](https://longportapp.com/zh-CN/topics/20753433)” April 26, 2024 Conference Call Summary: Microsoft: How Much to Invest in AI?

October 25, 2023 Conference Call: Microsoft: AI Features Progressing Steadily, Driving Demand Recovery

October 25, 2023 Earnings Report Commentary: “AI” Microsoft is Here, Is the Internet Entering the Microsoft Era Again?

July 26, 2023 Conference Call: Microsoft: All in AI

July 26, 2023 Earnings Report Commentary: The Vision of AI is Beautiful, but Microsoft's Reality is Still Slim

April 26, 2023 Conference Call: What Will Be the Impact of AI on Microsoft's Performance?

April 26, 2023 Earnings Report Commentary: “Giant” Microsoft Comes Out of the Low Point, Can It Soar Again with the Help of ChatGPT?

In-Depth Research

July 5, 2023: Can AI “Recreate” Microsoft? Not So Easy

This article's risk disclosure and statement: Dolphin Investment Research Disclaimer and General Disclosure