Analysis: Microsoft’s FY24 Q4 (Premium)

Microsoft just completed the first full fiscal year of the AI era, and while the real-world impact of AI remains elusive, most of the company is firing on all cylinders. There are, of course, two exceptions, and both are tied to consumer hardware: Surface and Xbox continue to hemorrhage revenues at an alarming and unsustainable rate.

So let’s dive in. Here’s a more detailed look at the quarter, focusing as always on the consumer businesses that we care about the most here on Thurrott.com.

The raw numbers

Overall earnings: A net income of $22 billion (up 10 percent year-over-year) on revenues of $64.7 billion (up 15 percent) for the quarter, and a net income of $88.1 billion (up 22 percent) on revenues of $245.1 billion (up 16 percent)

Intelligent Cloud:

• Key businesses: Azure, Windows Server
• $28.5 billion in revenues, up 19 percent YOY

Productivity and Business Processes:

• Key businesses: Microsoft 365 commercial
• $20.3 billion in revenues, up 11 percent YOY

More Personal Computing:

• Key businesses: Windows, Xbox/Gaming
• $15.9 billion in revenues, up 14 percent YOY

Windows

Windows has been the focus of my professional life for 30 years, so it’s been troubling watching over time as Microsoft shifted from being Windows-centric to almost completely sidelining the product. Today, Windows is important, of course, it generates over $10 billion in revenues every quarter, fairly consistently. But it’s also not the focus, which you can see clearly in the shabby ways in which Microsoft enshittifies Windows 11 today.

More relevant to this analysis, Windows is yesterday from a financial perspective, a legacy product that is best mentioned only infrequently, lest Wall Street by reminded how much it still contributes. But it’s the foundation of Microsoft’s More Personal Computing business, the smallest of Microsoft’s three top-level businesses. And we did get some numbers, and a bit of context.

Windows barely factored into Microsoft’s post-earnings conference call: It was mentioned only 8 times, with the company’s executives noting that the PC market was “as expected,” with revenue growth from PC makers (OEMs) up just 4 percent in the quarter.

Microsoft has never provided hard Windows 11 usage or market share numbers, as it did in the early years of Windows 10. But it did claim that “Windows 11 active devices”—usage share—was up 50 percent YOY, suggesting that it’s finally making some inroads on its predecessor. We don’t have a great third-party source for this, but StatCounter claims that Windows 11 represents 29.75 percent of the installed base today, compared to 66 percent for Windows 10. A year ago, Windows 11 was 24 percent, while Windows 10 was 71 percent. Is that a 50 percent YOY gain? No: If you assume the market size hasn’t changed, that’s a gain of less than 17 percent. But Windows 10 usage only dropped by 7 percent and … I don’t know. These numbers aren’t accurate, so it’s impossible to verify Microsoft’s assertion.

Windows commercial products and services revenue was up 11 percent, which Microsoft noted was “ahead of expectations due to higher in-period revenue recognition from the mix of contracts.” This refers to Microsoft’s commercial licensing, which isn’t Windows 11-specific but is rather just all supported Windows versions, meaning Windows 10 and 11. And as this quote suggests, this type of growth isn’t cyclic or predictable. Sometimes it’s higher, sometimes it’s lower. So it’s impossible to attribute this to anything.

Looking ahead, Microsoft doesn’t see much in the way of improvements. Revenue from PC makers is expected to be flat in the current quarter, which is unfortunate, and suggests that the Copilot+ PC launch hasn’t upended the market doldrums. But Microsoft expects “mid-single digit growth in Windows commercial products and cloud services thanks to continued demand for Microsoft 365.” Which impacts Windows financially, but isn’t “because” of Windows, if that makes sense.

Well, that was depressing.

Office

Microsoft Office long ago surpassed Windows as Microsoft’s biggest earner, and as the firm shifted to a cloud strategy over a decade ago, it made a natural shift to what we now called Microsoft 365 (thought Microsoft still refers to its as Office 365 repeatedly in its financial statements).

There’s not much to say here.

Not surprisingly, this business is still doing great, especially on the commercial (business) side: Office commercial products and services revenues were up 12 percent in the quarter, Office 365 commercial revenue was up 13 percent, with a seat (user base) growth of 7 percent, which it said was “driven by small and medium business and frontline worker offerings” and a growth in revenue-per-user.

That latter bit is somewhat interesting. In the post-earnings call, Microsoft noted that the more expensive Microsoft 365 E5 and Copilot for Microsoft 365 subscriptions played major roles in overall Office commercial revenue growth. But this was partially offset by the cost of scaling the AI infrastructure, with margins down slightly YOY.

Consumers continue to be a relatively small part of this business. Microsoft 365 consumer grew revenue by 3 percent in the quarter, and the user base grew 10 percent to 82.5 million.

Looking ahead, expect clear sailing: Office commercial revenue growth will be about 14 percent this quarter, while Microsoft expects low to mid-single-digit revenue growth on the consumer side.

Surface

The Devices business inside More Personal Computing consists of two product lines, Surface and HoloLens, only one of which, Surface, that’s an active concern with financial impact. Unfortunately, that impact is nothing but negative, and it has been for a long time.

How long, you ask? By one measure, forever: Surface has never been profitable. But looking just at revenues, which is all Microsoft ever reports, the last time Surface saw YOY revenue growth was the fourth quarter of its fiscal year 2022. Right. Surface has now experienced two straight years—8 consecutive quarters—of revenue decline. And most of those were double-digit YOY revenue declines.

Here are the numbers. In the first quarter of FY23—July to September 2022–Microsoft reported that its Devices business experienced a 2 percent revenue increase YOY after three consecutive quarters of revenue gains. In each quarter since then, it’s suffered declines of 39, 30, 20, 22, 9, 17, and now 11 percent.

Two straight years of failing and flailing explains the strategy shift that resulted in Surface focusing on higher-margin premium PCs, a shift that we believe contributed to the departure of controversial product lead Panos Panay. But this past quarter presented a curious problem for Microsoft: It launched the Copilot+ PC platform with hardware partner Qualcomm in the quarter—late in the quarter—and it went all-in by making its two core products, Surface Pro and Surface Laptop, available in Copilot+ PC versions. And Microsoft, like other companies, loves to discuss important milestones in its earnings announcements. So it could not ignore Copilot+ PC and, thus, Surface, though it is notable that the term Surface doesn’t appear once in its earnings report or slide deck. And Microsoft’s executives never once uttered this term in its post-earnings conference call.

“When it comes to devices, we introduced our new category of Copilot+ PCs this quarter,” Microsoft CEO Satya Nadella said late in his opening remarks on the call. “They are the fastest, most intelligent Windows PCs ever, and they include a new system architecture designed to deliver best-in-class performance and breakthrough AI experiences. We are delighted by early reviews. And we are looking forward to the introduction of more Copilot+ PCs powered by all of our silicon and OEM partners in the coming months.”

To be fair, Copilot+ PC launched so late in the quarter—less than two weeks before it ended—that this platform’s impact would always be minimal. Microsoft and PC makers would have registered the bulk of new Copilot+ PC sales in June, and PC makers would have acquired Windows licenses for those PCs earlier in the quarter. So it’s likely that Copilot+ PC, at least the first generation Qualcomm Snapdragon-based models, will not turn things around for Windows in 2024.

More specifically, it didn’t help Surface: Microsoft may be “delighted” by early Copilot+ PC reviews, but its own offerings—the new Surface Pro and Surface Laptop—didn’t get a bump. Revenues from devices—Surface—were down 11 percent in the quarter. Which Microsoft said was “roughly in line with expectations, as we remain focused on our higher margin premium products.”

Here’s one glimmer of good news: The revenue growth drought might end this quarter, as Microsoft said it expects to see growth (!) in the low to mid-single digits. Perhaps this is related to strong sales of new Copilot+ PC-based Surface PCs, perhaps not. But if it is, Microsoft will surely note that in its next earnings release.

Xbox

Xbox is … problematic.

As a videogame console, Xbox has never been profitable and would never be profitable, and so Phil Spencer convinced Satya Nadella to pivot the business to online services that would work across platforms and be backed by game studio acquisitions. This strategy reached an obvious apex with the successful conclusion of Microsoft’s blockbuster $68 billion acquisition of Activision Blizzard in October (FY24 Q2), which should have marked a turning point for the platform.

Instead, it’s been downhill ever since and 2024 has been horrifically bad for the brand, for Xbox, and for Microsoft’s investment in this space. There’s no reason to repeat what I’ve written at length, and repeatedly, over the past two quarters. But Xbox today is in more trouble than it’s ever been. There’s no path to console profitability. And its Activision Blizzard acquisition triggered multiple rounds of layoffs and studio closures, while only two Activision Blizzard titles have appeared on Game Pass, Microsoft’s services offering. In short, the financial reality of Activision Blizzard, which comes with great costs, has led to the enshittification of Game Pass, not the phoenix-like rebirth fans expected.

This past quarter was an awkward time for Xbox financially, and I get the feeling that we’re waiting on a series of separate but interrelated advances–more efficient and Arm-based console hardware, the introduction of more Activision Blizzard titles to Game Pass, and the paying down of the acquisition costs—before the positive impacts of Activision Blizzard will occur. So we’re in a holding pattern.

The console business is in trouble. Xbox hardware revenue declined an incredible 42 percent YOY, and it wasn’t like the year-ago quarter was particularly positive. If you look at the previous two years (8 quarters), you’ll see a Surface-like pattern emerging in which Xbox hardware revenues declined in all but two quarters, and usually by double digits. In three of those quarters (including the previous quarter), those losses were over 30 percent. That’s nuts.

(The numbers, from Q1 FY2023 to Q4 FY2024, are, in order, up 13 percent, down 13 percent, down 30 percent, down 13 percent, down 7 percent, up 3 percent, down 31 percent, and down 42 percent.)

But Xbox isn’t just the console, of course, and its impact on financials is now largely driven by Activision Blizzard. Gaming revenue overall was up 44 percent in the quarter, but that’s all Activision Blizzard: Excluding this business, Gaming revenue would have fallen by 4 percent. Xbox content and services saw a similar Activision Blizzard-based revenues gain of 61 percent, 58 points of which came from the acquisition. (So it would have seen a gain of 3 percent otherwise.) This last metric was, Microsoft said, “slightly ahead of expectations,” and “stronger-than-expected performance in first-party content was partially offset by third-party content performance.”

As such, Microsoft executives mentioned “Xbox” just three times in the post-earnings conference call. But they noted “games,” “gaming,” or similar at least 7 times. And “Activision” or similar 14 times. Perhaps Xbox should be renamed to Activision Blizzard.

Microsoft now claims that it has over 500 million active users across platforms and devices, a purposefully vague commingling of console users and Activision gamers. Finding an exact number for pre-Microsoft Activision active users isn’t difficult: In a July 2023 financial filing, its last before the acquisition, Activision claimed 356 million active users. Note that roughly 200 million of that is/was on mobile, thanks to King, a little-discussed part of that acquisition. By comparison, the hotly debated Call of Duty has “just” 90 million or so users. But … that’s over. Now that Microsoft owns these businesses, we won’t see this kind of transparency ever again.

Instead, Microsoft talked up all the games it announced in the quarter and other pointless milestones, like getting Xbox Cloud Gaming on Fire TV Stick. Oh, and this bit of happenstance that Microsoft played no role in. “We are bringing our IP to new audiences,” Mr. Nadella noted. “Fallout, for example, made its debut as a TV show on Amazon Prime this quarter. It was the second most watched title on the platform ever, and hours played on Game Pass for the Fallout franchise increased nearly 5 times quarter-over-quarter.”

Nadella claims he is “energized about the opportunities ahead,” and he says that Microsoft is investing in gaming for the long term, “in our fundamentals, in our innovation, and in our people.” But you can’t see that in the numbers. Not yet anyway.

So what’s the real impact of Activision Blizzard on Microsoft as a business?

Short term, it’s all negative: “Activision contributed a net impact of approximately 3 points to revenue growth, was a 2 point drag on operating income growth, and had a negative 6 cent impact to earnings per share” in the quarter. Some of this impact is temporary, as the shift from a third-party partner to a first-party business will impact the YOY comparables. And Microsoft registered a $938 million loss “from purchase accounting adjustments, integration, and transaction-related costs” in the quarter.

Worse, overall operating expenses at Microsoft were up 13 percent YOY and 9 points of that came directly from the Activision acquisition. (I assume the other 4 percent is largely AI-related.)

It’s not clear when this ends, or at least eases. But looking ahead to the current quarter, Microsoft expects Gaming revenue growth in the mid-30s, but that includes approximately 40 points of net impact from the Activision acquisition. Xbox content and services revenues will likewise be up in the mid-50s. And hardware revenue “will again decline year-over-year.” Note that even Surface expects a turnaround in the current quarter, temporary or not.

Finally, the negative impacts from the Activision acquisition will continue, with operating costs of over $15 billion “from purchase accounting, integration, and transaction-related costs from the Activision acquisition.”

AI

We’ve been debating the merits of Microsoft’s all-in AI strategy since its inception, and the past few quarters have given us some insight into the costs of this historic investment and how Microsoft pays the bills. The short answer is, “with cash”: Microsoft is so profitable as a business that it can easily absorb the roughly $10 billion to 15 billion it’s spending each quarter on infrastructure tied to AI. That said, the costs have to come down sometime.

You won’t see much mention of AI in Microsoft’s financial report: The products and services offered by its Intelligent Cloud, Productivity and Business Processes, and More Personal Computing are all offering heavily-promoted AI features throughout, but none of this appears in the numbers. Instead, Microsoft vaguely reported that capital expenditures were $19 billion in the quarter due to “support demand in [its] cloud and AI offerings.” (More on this below.) But on the flip side, Microsoft’s free cash flow is now $23.3 billion, up 18 percent YOY “reflecting higher capital expenditures to support [its] cloud and AI offerings.” We’re meant to assume that AI is, for lack of a better term, paying for itself.

That’s unlikely, of course: Aside from platform offerings to customers through Azure, most AI features that Microsoft offers are part of other things, like Microsoft 365 and Windows, and it’s not breaking out the financials because it never does.

Microsoft executives mentioned AI almost 40 times in the post-earnings conference call, about three times as much as it mentioned security, despite its alleged pivot to focus on that. Indeed, Satya Nadella opened the call with a monologue explaining Microsoft’s real focus and why he has chosen this expensive new path.

“I want to offer some broader perspective on the AI platform shift,” he said. “Similar to the cloud, this transition involves both knowledge and capital intensive investments. As we go through this shift, we are focused on two fundamental things: First, driving innovation across a product portfolio that spans infrastructure and applications so as to ensure we are maximizing our opportunity, while in parallel continuing to scale our cloud business and prioritizing fundamentals, starting with security. Second, using customer demand signal and time to value to manage our cost structure dynamically and generate durable, long-term operating leverage.”

This speaks to the cost/benefit calculation Microsoft is making, and he provided a few examples of where this investment in AI has or will pay off: Its massive infrastructure expansion (“datacenter footprint”), sustained revenue growth as it migrates to more powerful AMD, Nvidia, and in-house silicon, Azure AI, Azure OpenAI Service, and even smaller models like Phi-3. Azure’s growth included 8 points of growth tied to AI services (though infrastructure scaling costs countered that with a 5 percent increase in operating costs). He cited GitHub Copilot as “by far” the most widely adopted AI-powered developer tool, thought the financial impact of that is tiny (and is allegedly negative). AI was mentioned alongside virtually every product or service that Nadella and Amy Hood discussed on the call, as it turns out. (Except, oddly, Xbox and gaming.)

Speaking of Ms. Hood, Microsoft’s CFO provided a bit more detail on the cost of AI.

“Capital expenditures were $19 billion, in line with expectations,” she said. “Cloud and AI related spend represents nearly all of [our] total capital expenditures. Within that, roughly half is for infrastructure needs where we continue to build and lease datacenters that will support monetization over the next 15 years and beyond. The remaining cloud and AI related spend is primarily for servers, both CPUs and GPUs, to serve customers based on demand signals.”

$19 billion. Almost all of it tied to AI. Yikes.

In the good news department, free cash flow in the quarter was $23.3 billion, as noted, and it was $119 billion for the full fiscal year. That’s the first time Microsoft ended a year with over $100 billion in free cash flow. So it can “afford” AI, just as it could afford to absorb Activision Blizzard. But the goal with both, of course, is for them to turn into profit centers.

When that happens is unclear in both cases. Looking ahead, Microsoft expects its capital expenditures in the current fiscal year—what we might read as “the cost of AI”—as being higher than was the case in the just-concluded year. It also expects to lower its operating margins by just 1 percent over this entire year.

But again, Microsoft can afford this. And that is, perhaps, the central point.

“We delivered operating margin growth of nearly three points year over year even as we accelerated our AI investments, completed the Activision acquisition, and had a headwind from the change in useful lives last year,” Ms. Hood noted. “So, as we begin FY25, we will continue to invest in the cloud and AI opportunity ahead aligned, and, if needed, adjust to the demand signals we see. We are committed to growing our leadership across our commercial cloud and within that, the AI platform, and we feel well positioned as we start FY25.”

Indeed.