Analysis: Microsoft’s F23Q3 (Premium)

Yesterday, Microsoft reported its financial results for the third quarter of its fiscal 2023. Here’s a closer look at that quarter, with an emphasis on the Microsoft businesses we care about the most here at Thurrott.com: Windows, Xbox, Surface, and Microsoft 365.

As you may have seen, earned a net income of $18.3 billion (up 9 percent) on revenues of $52.9 billion (up 7 percent) for the quarter ending March 31. What you may not have seen is that these figures topped expectations, and that, as a result, Microsoft’s stock price is currently racing towards its highest price in over a year. Wall Street liked what it saw.

But then, of course it would: Microsoft’s financial successes of the past decade are all based on speculation about its cloud computing advances, speculation that has sent its stock price—and market capitalization—soaring. Thanks to this bit of marketing, Microsoft is now the second biggest company in the world, after only Apple, by market cap.

The downside to this success, to me, is that Microsoft talks a lot less about its legacy, non-cloud businesses because it emphasizing what Wall Street sees as the past would have a negative impact on its stock price and market cap: this is all about the future. And in my never-ending quest to figure out why Microsoft, the most conservative of Big Tech companies, would ever unleash unreliable and unsafe AI technology on the world, as it did this past March, I’ve come upon yet another theory, and it’s tied to its marketing of cloud.

And it goes like this: Microsoft for years was able to tout 70 percent-ish growth in Azure revenues, a major contributor not just to its bottom line but to its ongoing success in the future. But Azure revenues eventually slowed, as they must. And with Wall Street getting increasingly edgy about ever-lower Azure growth, given that it’s now a mature business, Microsoft needed to make a move that would excite Wall Street. And maybe that was part of the calculation behind unleashing its AI earlier than its AI ethics rules would have normally allowed. To that point, Azure (and other services) revenues grew only by only 27 percent in the quarter. That figure was 31 percent one quarter ago and 46 percent one year ago.

Granted, Intelligent Cloud, the Microsoft business that owns Azure, was still Microsoft’s biggest. It contributed $22.1 billion in revenues in the quarter, up 16 percent year over year (YOY). Almost 42 percent of Microsoft’s revenues overall came from this business.

Microsoft’s other cloud-focused business unit, Productivity and Business Processes, delivered another $17.5 billion in revenues, up 11 percent YOY. This business, which includes most of Microsoft 365 (and all of Office), LinkedIn, and Dynamics, accounted for 33 percent of Microsoft’s revenues. And while it’s not fair to claim that all of Productivity and Business Processes’ revenues come from the cloud, most do. Even a conservative estimate suggests that over 50 percent of Microsoft’s overall revenues now come from the cloud. Microsoft, in short, has finally caught up with the marketing of the past decade.

But let’s turn to what we all really care about here: Windows and the other client-side products and services that you, me, and other actual human beings use and interact with every day. And as has been the case for the past four or five quarters, there is very little positive news to report. Most of what we care about is contained in Microsoft’s third business unit, More Personal Computing, which once again brought up the rear, with $13.3 billion in revenues, a decline of 9 percent YOY. More Personal Computing accounted for just 25 percent of Microsoft’s overall revenues. In the previous quarter, which I described as a bloodbath, this business accounted for 27 percent of Microsoft’s overall revenues.

Let’s dive in.

You may recall that PC sales fell 16 percent in 2022, but got worse in each quarter, with the market seeing a whopping 28.3 percent decline in the fourth quarter. We don’t yet have a full picture of Q1, but IDC reported that PC sales in the quarter fell about 29 percent in that time period as well.

And Microsoft’s numbers confirm that: Windows revenues from PC makers fell 28 percent in the quarter, and Devices revenues (which is mostly Surface, Microsoft’s PC line) likewise fell by 30 percent. Incredibly, Microsoft CFO Amy Hood stated that PC demand was “better than expected,” and that “channel inventory levels remained elevated” in the quarter, “negatively impacting results.”

Here’s where that comes from: in the previous quarter, Microsoft’s revenues from PC makers fell an astonishing 39 percent (and in a holiday quarter, no less), as did Devices (Surface) revenues. So PC sales did improve, according to Microsoft (though that’s not what IDC reported), the issue was only that customers were largely buying PCs that had been sitting unsold in the channel, so its own revenues didn’t follow as the licenses for those PCs were sold in the past.

And … I’m not buying it. If PC sales were improving, PC makers would be buying more Windows licenses now. The more telling number there, so to speak, is Devices (Surface) revenue growth, as this comes from actual sales of devices to actual customers. And PCs did not sell well in the quarter, and there was a decline.

Of course, most Windows revenues don’t come from PC makers, they come from enterprises that license Windows directly from Microsoft. And that business somehow landed upright: revenues from Windows Commercial products and cloud services increased 14 percent YOY, “driven by strong renewal execution and an increase in agreements that carried higher in-period revenue recognition.” Ms. Hood noted during the call that a lot of that came via Microsoft 365, and that “growth trends in Microsoft Enterprise Mobility + Security (EMS and Windows Commercial standalone products remained consistent” with the year-ago quarter.

I guess the way to look at this is that Windows is doing very poorly and that the few positive signs that Microsoft reported have little or nothing to do with anything the Windows organization is doing. To be clear, I’m not sure what the business could do to drive revenues further. If anything, they’ve pushed too hard to monetize Windows in ways that increasingly alienate the user base. Not really a topic for today, but there it is.

Surface barely came up during Microsoft’s post-earnings conference call. As noted, the Device business that houses Surface and HoloLens—it’s like the island of misfit toys inside of More Personal Computing—saw a 30 percent revenue decline in the quarter, thanks to “elevated channel inventory levels” that drove “additional weakness beyond declining PC demand.” So where Microsoft said earlier that PC sales were better than expected, that wasn’t true of Surface. Interesting.

And that’s it. There was no other discussion around Surface. I keep wondering why Microsoft keeps this business afloat, but I’ve heard about new generation Surface PCs with integrated neural processing units (NPUs) from multiple sources, so it clearly plans to keep this loss leader in the market for the foreseeable future. (And no, HoloLens never came up, not even once.)

Turning to Xbox, we see the same kind of word soup noted above. Xbox console sales and other hardware revenues fell 30 percent in the quarter while gaming revenue, overall, declined 4 percent and Xbox content and services revenue grew 3 percent.

So what’s the key takeaway there? Well, that hardware sales tanked. And here, we get an explanation: in the year-ago quarter, Microsoft was somehow able to improve the supply of its consoles, leading to higher-than-usual sales in an age of supply constraints. So it’s sort of an unfair comparable, I guess. But the company also issued no guidance on future hardware sales, so we can assume this isn’t going to improve anytime soon.

That said, there was some good news: Microsoft set records for monthly active users and monthly active devices, without specifying either figure. It has seen a collected 500 million unique users play its first-party games. And we got a hard number, too: its revenue from Xbox subscriptions reached nearly $1 billion in the quarter, the first time I can recall Microsoft discussing such a thing. So Xbox Game Pass and Xbox Live combined are about to become the firm’s next billion-dollar business. Nice.

The picture gets a little rosier once we look outside More Personal Computing.

Microsoft Teams now has over 300 million monthly active users, up from 280 million in the previous quarter. It’s nice to see Microsoft providing these figures again, as it took several months off last year, leading to speculation that user growth had stalled. But it also provided a bit of protein, noting that Teams “once again took share across every category, from collaboration, to chat, to meetings, to calling.” Teams is a force of nature, and though I often discuss it as a platform, it’s worth noting that it’s an ecosystem too.

And on that note, Teams is also expanding its “total addressable market,” or TAM, meaning that it is adding revenues beyond direct sales, in this case via a growing market for Teams software, services, and hardware add-ons. Nearly 60 percent of Teams customers are also buying Teams phones, Teams Rooms, or Teams Premium. Each of these side hustles experienced tremendous growth if you like soft numbers: Teams Phone “is the undisputed market leader in cloud calling,” Teams Rooms revenue more than doubled year-over-year, and Teams Premium is “one of Microsoft’s fastest-growing Modern Work products ever, with thousands of paid customers just two months in.” (I’ve been told by a source that Teams Premium is performing horribly, so I guess that’s another way to look at it.)

Looking at the broader Microsoft 365, I noted above how Microsoft 365 commercial license growth benefitted Windows commercial, but there’s a lot more going on there. Office commercial revenue grew 13 percent in the quarter, with “strong renewal execution and E5 [a high-end and expensive SKU] momentum.” Paid Office 365 commercial seats were up 11 percent YOY to 382 million, a nice hard number, with “growth driven by small and medium business and frontline worker offerings.” And even Office consumer revenues were up, sort of, by 1 percent, while the Microsoft 365 consumer user base grew 12 percent to 65.4 million.

Microsoft indicated that the Office revenue party would continue in the future, though it said that the size of the user base somewhat tempered what was possible. This led to a question in the post-earnings conference call about how Microsoft could possibly keep growing this business.

“The Office 365 suite, but broadly, the Microsoft 365 suite adds a ton of value for users,” Ms. Hood replied. “And so, if you think about the users and on the global base, we’ve been able to add users, which you continue to see, we still have in the frontline scenario and a [small business] opportunity to continue to grow. And in the enterprise, where we are a basic productivity tool, the labor market is still tight in those places. And we continue to see customers committed to the value they’re getting. And so, this is not something that I think our focus has really been on continuing to get healthy renewals, continuing to add new products, and renewal where it makes sense to save customers money and increase value. And so, I think that’s the story of the resilience you’re seeing. And, of course, we did have a good E5 quarter, which you’re starting to see, and it helps on RPU [revenue per use].”

“Fundamentally, what we’re focused on is making sure that the customers are able to derive the value out of our offerings, whether it’s the Microsoft 365 suite value, which is significant, whether it’s E3 or E5,” Microsoft CEO Satya Nadella said later in the call. “And we want to make sure that they’re getting deployed, they’re getting used. And that’s obviously going to lead to our share gains in many cases.”

So there it is. As with the previous quarter—OK, the previous several quarters—it’s hard to find much in the way of good news in Microsoft’s and most of Microsoft’s client offerings. Office is obviously solid, and it will be interesting to see how the introduction of Loop impacts things. But Windows, Surface, and Xbox are all struggling in their own ways, and the issue, as always, is that it’s impossible to see a light at the end of the tunnel. Of the three, Xbox has been most to gain should it be able to realize its cloud future dreams. But Windows and Surface are, by nature, old-school legacy businesses, and they are very much at the whim of whatever is happening out in the world. I would very much like to see some improvements to both businesses.