Microsoft Results Reflect AI Growth and Challenges

Microsoft (Nasdaq: MSFT) reported strong quarterly earnings last night, but investors appear unimpressed with predictions for AI-driven solutions. In particular, they seem put off by guidance toward flat Azure growth next quarter, given management’s claim that OpenAI is driving Azure revenue growth.

In late trading today, Microsoft shares were selling for $400.45, down $8.14 (2%).

For its fiscal second quarter 2024 (which ended December 31, 2023), Microsoft reported $62 billion in revenue, up 18% year-over-year. Adjusted net income was $21.9 billion, up 26%, with diluted earnings per share of $2.93. Both top- and bottom-line growth exceeded Wall Street expectations.

During the earnings call, the emphasis was on AI. Revenues for Microsoft Cloud, the company segment that contains Azure along with Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365, and other cloud offerings, was $33.7 billion, up 24%. The segment's overall growth was driven by Azure, which in turn was driven in part by company interest in AI.

Indeed, breaking the Microsoft Cloud segment down even further, CFO Amy Hood said: “Azure and other cloud services revenue grew 30% and 28% in constant currency, including 6 points of growth from AI services.”

What AI services? asked an analyst during the earnings call Q&A. To which CEO Nadella answered: “Azure OpenAI and then OpenAI on APIs, on top of Azure would be sort of the major drivers…. But it’s predominantly Azure OpenAI today.”

Developer Tool GitHub Outperforms

Notably, revenue from Microsoft’s GitHub developer platform grew over 40%, Nadella said, thanks in no small part to the AI-based tool GitHub Copilot.

“We now have over 1.3 million paid GitHub Copilot subscribers, up 30% quarter-over-quarter,” the CEO said. He said over 50,000 organizations use GitHub Copilot Business today.

“It’s like if you take away spellcheck from Word, I’ll be unemployable. And similarly, it’ll be like I think GitHub Copilot becomes core to anybody who is doing software development,” Nadella said.

But AI Alone Is Not Enough

If AI was a key driver of earnings this quarter, it was also a bone of contention for investors. For one thing, it wasn’t the only cause of good results, despite management’s emphasis. “Both AI and non-AI Azure services drove our outperformance,” said CFO Hood on the call.

Also, AI is not predicted to boost Azure sales next quarter, which are anticipated to be sequentially flat. “In Azure, we expect Q3 revenue growth in constant currency to remain stable to our stronger than expected Q2 result. Growth will be driven by our Azure consumption business with continued strong contribution from AI,” said CFO Hood on the call.

Further, AI requires its own infrastructure, which means more capital expenditure (capex). The need to grow compute and networking capacity to meet AI demand had a mildly negative effect on Microsoft Cloud gross margin, which was 72%. And that’s expected to continue: “Q3 cloud gross margin percentage will be relatively flat as improvement in Office 365 and Azure will be offset by sales mix shift to Azure as well as the impact of scaling our AI infrastructure to meet growing demand,” Hood said. She noted that capex will “increase materially on a sequential basis driven by investments in our cloud and AI infrastructure.” She also expects the upward trend in capex to continue for the forseeable future, “given what we see in terms of pipeline.”

Breaking Down AI by Type

Interestingly, Microsoft management pointed to AI inferencing, or querying a model with live data, as opposed to training of large language models (LLMs) as the main driver of growth in Azure’s AI sales. “Most of what you see in the Azure number is broadly inferencing,” said CEO Nadella.

The CEO also referred to small language models (SLMs), which can run on laptops and mobile devices to help develop applications, as opposed to LLMs, which require supercomputer-scale resources. According to a recent article in The Information, Microsoft has formed a special business unit dedicated to SLMs, a trend that points to its determination to exceed the limits of its dependence on OpenAI.

Futuriom Take: All told, Microsoft’s quarterly gains were substantial, but it still needs to prove that AI can sustain growth in Azure and other products. The next few quarters will be the test of the company’s strength in this direction.