Analysis: Microsoft’s F23Q2 (Premium)

Yesterday, Microsoft reported a mixed financial quarter in which revenues were up only 2 percent, thanks to its cloud business. Here’s a deeper dive into the quarter, with a focus on the client-side technologies that we care about the most.

First, the results: a net income of $16.4 billion on revenues of $52.7 billion for the quarter ending December 31. Net income decreased by 12 percent year-over-year (YOY) in the time period while revenue was up just 2 percent.

Microsoft has three primary business units, and after years in which they were all roughly even from a revenues perspective, it’s clear that Microsoft’s cloud-based businesses are starting to edge ahead of its legacy, on-premises, and client businesses. (Some temporary pandemic-era changes messed with that otherwise consistent behavior, but I feel like the post-pandemic hangover is working to put things back on track. Maybe even overcompensating in the short term.)

In the previous quarter, Microsoft’s biggest business was once again Intelligent Cloud, which consists of Microsoft Azure and the firm’s legacy server products. Intelligent Cloud delivered $21.5 billion in revenues in the quarter, up 18 percent YOY.

Productivity and Business Processes was Microsoft’s second-biggest business in the quarter, with $17 billion in revenues, up 7 percent. This business contains most of Microsoft/Office 365 (minus the Windows bits), LinkedIn, and Dynamics.

And then we have the horribly-named More Personal Computing, which was again the laggard with $14.2 billion in revenues, down an astonishing 19 percent YOY. This business includes Windows, Xbox, and devices (most Surface, but also HoloLens and peripherals). And given how the economy and the PC market went in late 2022, it’s perhaps not surprising that this is where most of the problems were.

It’s also worth mentioning a made-up business that Microsoft likes to promote called Microsoft Cloud, which is a moving target of cherry-picked cloud businesses that changes from quarter to quarter (or can). Microsoft Cloud is there to remind Wall Street how effectively Microsoft’s cloud businesses compete against Amazon AWS, and it delivered $27.1 billion in the quarter, up 22 percent! Literally incredible.

I’m not super-interested in Microsoft’s cloud businesses and I’m no fan of its use of a Microsoft Cloud metric. But it is fair to point out that Microsoft’s cloud businesses saved the day in the previous quarter: had those products not done so well, Microsoft would have experienced a YOY revenue drop. But thanks to its cloud pivot, the quarter instead delivered Microsoft’s slowest growth in over 6 years. In these trying times, that’s what success looks like. Or at least diversification.

This brings me to the Microsoft products and services that I—and, I think, you—care about the most: the client-side products and services that are used by individuals, often consumers, and not the business products. And you don’t have to be a financial expert to see that the previous quarter was a bloodbath.

Let’s start with Windows.

We already knew that PC sales fell off a cliff in 2022: sales fell overall by 16 percent for the calendar year, which doesn’t seem too bad until you look at each quarter in succession, where we see falls of 6 percent, 14 percent, 17 percent, and then 28.3 percent. That 28.3 percent drop was the fourth calendar quarter, and Microsoft’s fiscal second quarter. And the results for Windows reflect not just the problem we saw in that quarter, but the problems we will see in the current (and, I bet, the next) quarter, to: Revenues from Windows OEMs—that is, PC makers—was down an astonishing 39 percent YOY.

But here’s where it gets interesting. While the analysts at Gartner and IDC are quick to point out each quarter that PC sales are “still above pre-pandemic levels,” Microsoft’s revenues from PC makers come from Windows license sales for PCs that will be sold in the future. And Microsoft is not describing those revenues as being “above pre-pandemic levels.” Instead, PC sales have “returned to pre-pandemic levels,” Microsoft says. The question is how low they go in the future.

Worse, one of the few bright spots that Microsoft could find for Windows was that—and, seriously, read this one carefully—“usage intensity of Windows continues to be higher than pre-pandemic, with time spent per PC up nearly 10 percent.” I’m not sure what “usage intensity” means, but let’s assume it’s just “usage.” And people using their current PCs more is bad, not good. It means that they aren’t buying new PCs because they don’t need to. And that Microsoft’s strategy of eking out more subscription revenues from its existing user base—which I literally just wrote about yesterday—is sound.

That said, monthly active Windows PCs also reached an all-time high this quarter, Microsoft said. Windows 11 adoption is vaguely “growing” with its business customers. As is “cloud-delivered Windows.” I will argue that both are low bars and that we will never see hard numbers for either regardless. (“Usage of Windows 365 and Azure Virtual Desktop [is] up by over two-thirds year-over-year,” Microsoft notes, without telling us what usage was last year.)

But that’s it for the good news: the results for More Personal Computing were below Microsoft’s expectations, thanks in large part to weak Windows commercial (and Surface and Search) revenues. And the Windows 11 revenues deferral from last year barely helped the business: had Microsoft not deferred those revenues, More Personal Computing would have suffered a 36 percent drop in revenues YOY instead of 39 percent. What’s 3 percent of $14.2 billion, you wonder? $426 million. That was the impact of the Windows 11 revenue deferral.

Looking to the future, things aren’t getting any better: Microsoft expects Windows OEM revenues to see “continued declines as the PC market returns to pre-pandemic levels.” And not just declines, but massive declines: “Windows OEM revenue should decline in the mid-to-high 30s in line with the PC market [in the current quarter]. We expect Q3 PC units to be similar to pre-pandemic levels.” And Windows commercial revenues will be flat.

Not bad enough? Let’s talk Surface.

When I saw Microsoft’s comments about device revenue declines, I assumed that a big chunk of that was related to HoloLens and the recent bad news about the Army contract. Nope. Devices revenues were down 39 percent in the quarter “driven by continued PC market weakness and execution challenges on new product launches,” Microsoft admitted. In the post-earnings conference call, Surface barely came up explicitly, but one of the few times it did, the firm once again mentioned that “execution challenges impacted our Surface business.”

Devices overall—-read: Surface—was also a key contributor to the woes experienced by the More Personal Computing business unit. As with Windows overall, Microsoft expects its devices business—again, read: Surface—to “see continued declines as the PC market returns to pre-pandemic levels.” But the current quarter will be even worse for Surface: Microsoft expects to see revenue declines in the mid-40s as it “works through the execution challenges noted earlier.” I am fascinated to know what those challenges are.

Here’s a weird fact: the word “HoloLens” didn’t come up once in Microsoft’s post-earnings conference call, nor was it called out in its documentation for the financial results. I expected someone to at least ask about this.

Moving on, Microsoft said it was “energized” by its upcoming lineup of AAA game launches, but Xbox did little to energize revenues during the holiday quarter: overall gaming revenue declined 13 percent YOY, Xbox content and services revenue declined 12 percent YOY, and Xbox hardware revenue declined by 13 percent YOY. Did I mention this was a holiday quarter? Should I remind you that Sony just announced that it has sold over 30 million PlayStation 5 consoles and said its component shortage problems were over? No? Sorry.

Microsoft’s revenue declines in gaming and Xbox were “in line with expectations,” Microsoft said, and it expects low-single-digit revenue declines for Xbox and high-single-digit declines for gaming overall in the current quarter.  Unspecified growth in Xbox Game Pass subscriptions—another low bar—will be “more than offset by lower monetization per hour in third-party and first-party content,” it added. In the good news department, Microsoft does expect “increased console supply” as well.

Microsoft Teams surpassed 280 million monthly active users in the quarter, the first time we’ve seen a new figure since early 2022. A few other Teams numbers, some soft, some hard: “the number of third-party apps with more than 10,000 users increased nearly 40 percent year-over-year,” there are over 500,000 active Teams Rooms devices (up 70 percent YOY), the number of customers with more than 1,000 rooms doubled YOY, Microsoft added over 5 million PSTN seats to Teams Phone in the past year, and there is “strong interest” in Teams Premium. Hah!

Looking at Microsoft 365 more broadly, we see the quote I was waiting for: “Microsoft 365 is rapidly evolving into an AI-first platform.” It sure is. As for numbers, we got one tidbit: 80 percent of Microsoft’s enterprise customers are using 5 or more Microsoft 365 apps.

Office consumer revenue declined 2 percent in the quarter, but Microsoft 365 consumer subscriptions grew 12 percent to 63.2 million. Revenue growth in the current quarter should be up in the low-single digits, driven by subscriptions, Microsoft says.

Office commercial revenue grew 7 percent in the quarter, with Office 365 commercial revenue up 11 percent. Paid Office 365 commercial seats grew 12 percent YOY, but we didn’t get a hard number. Interestingly, Office commercial products revenue—i.e. sales of standalone Office products—was down an incredible 30 percent, “reflecting our continued customer shift to cloud offerings.” Looking to the future, Microsoft expects Office 365 revenue growth to be “sequentially lower by roughly one point,” and its on-premises business to experience revenue declines in the mid-20s.

So there you go. It’s hard to find bright spots in Microsoft’s client-side offerings, though the Microsoft 365/Office product lines seem to have held their own for the most part. The Xbox results were bad, but the Windows and Surface numbers are particularly disheartening because there doesn’t seem to be any end in sight.