Analysis: Microsoft’s FY24 Q1 is All About AI, Activision, and the Future (Premium)

Yesterday, Microsoft reported its financial results for the first quarter of its fiscal 2024. Here’s a closer look at the quarter, with an emphasis on the consumer businesses we care about the most here at Thurrott.com.

This is the second momentous Microsoft earnings announcement in a row. In the previous quarter, Microsoft finally address how the costs of its AI advances would impact its business going forward. And in this quarter, it revealed how the long-overdue Activision Blizzard acquisition would impact its earnings.

Activision Blizzard

So let’s start there before moving on to the numbers and the other details that Microsoft’s executives revealed in the post-earnings conference call.

“The net impact of the Activision acquisition includes purchase accounting impact, integration, and transaction-related expenses, based on our current understanding of the purchase price allocation and related deal accounting,” Microsoft CFO Amy Hood said during the call. “The net impact includes adjusting for the movement of Activision content from our prior relationship as a third-party partner to first-party.”

As you probably know, Xbox and gaming revenues are reported as part of Microsoft’s More Personal Computing business unit, and so the addition of Activision will obviously impact that part of the company from a revenue perspective going forward. Hood said that Microsoft’s expectation for the current quarter is revenues of $16.5 billion to $16.9 billion for all of More Personal Computing, with the Activision acquisition responsible for “35 points of net impact” overall and “50 points of net impact to Xbox content and services revenues.”

So what does that mean?

Well, you may recall that I previously examined how the addition of Activision Blizzard would impact Microsoft’s revenues in Microsoft + Activision Blizzard: Show Me the Money! (Premium). And in looking at the previous four quarters (at that time), I saw that Activision would have increased More Personal Computing’s quarterly revenues by an average of 12.83 percent. (Its average impact on Microsoft overall would have been just 3.85 percent.)

More specifically, More Personal Computing delivered revenues of $14.2 billion in FY23 Q2 one year ago, a decline of 19 percent year-over-year (YOY). And I had calculated that had Activision been part of Microsoft at that time, this business unit would have delivered revenues of $16.53 billion, a gain of 16.4 percent. And that figure is right below Hood’s estimate for the current quarter, which is kind of interesting. (And random: Windows, Surface, and Search are part of this business unit too, and none of these businesses, including Activision, will see flat growth.) So that’s kind of fun.

Separately, Hood expects the Activision acquisition to trigger $400 million in operating expenses from purchase accounting adjustments, integration, and other transaction-related costs, and a $500 million income decline related to the reduction of Microsoft’s investment portfolio balance and some short-term debt in each of the next three quarters. Or approximately $900 million in expenses “in each quarter in H2.” What’s a couple of billion extra dollars?

More Personal Computing

OK, let’s look at the quarter in question.

As noted yesterday, Microsoft announced that it earned a net income of $22.3 billion on revenues of $56.5 billion in the quarter, with net income up 27 percent and revenues up 13 percent. And More Personal Computing was its smallest business unit, with $13.7 billion in revenues and growth of just 3 percent.

Put another way, the part of Microsoft I care about the most continues its downward slide, accounting for just 24.2 percent of revenues overall. In the year-ago quarter, More Personal Computing contributed 27 percent of Microsoft’s revenues. Two years ago, it was 29 percent. (In FY16 Q1, the first year that More Personal Computing existed, it represented an astonishing 46 percent of Microsoft’s revenues! My, how the mighty have fallen.)

Windows

This part of the call got off to a bad start. Microsoft claimed that it “rolled out the biggest update to Windows 11 ever” in the quarter but neglected to tell investors that this update was available in preview form only (and still is) and that the key features it bragged about, like Copilot, are still not available to the subset of the user base that bothered to install it.

So that was nonsense, but here’s some real news: Windows revenues from PC makers actually rose by 4 percent in the quarter YOY, and as I speculated in my news report about the earnings, this was “significantly ahead expectations” and could indicate that the PC market is starting its slow trip back to growth: PC makers buy Windows licenses ahead of selling them, and if those sales are up, the current quarter might be a better than expected for PCs. Or, as Microsoft put it, the growth was “driven by stronger-than-expected consumer channel inventory builds and the stabilizing PC market demand, particularly in commercial.” Nice.

And here’s some more data for that PC industry growth spurt to-be. “PC market unit volumes” were at roughly pre-pandemic levels in the quarter, which is the metric everyone loves using these days. But looking ahead, Microsoft expects Windows revenues from PC makers to grow even further in the current quarter, by “mid-to-high single digits.” This isn’t spectacular, of course. But it’s still growth and an improvement over the previous quarter. (Which makes sense: The current quarter is a holiday quarter.)

And that was literally it for Windows. Moving on.

Surface

Devices revenues—meaning Surface revenues—declined by 22 percent, which Microsoft said was “ahead of expectations.” And here’s a gut punch: That means “better than expectations,” because “the commercial segment” had “stronger execution” than expected. In other words, Microsoft expected Surface revenues to decline even worse and was surprised when they did not. (Microsoft didn’t utter the term “Surface” even once on the call.)

Xbox and gaming

Moving to Xbox and gaming, Microsoft was of course “delighted” to flush nearly $70 billion down the toilet, er ah, close its acquisition of “Activision Blizzard King” earlier this month. Which brings up an interesting point: What the hell was the name of the company? Its executives referred to it as “Activision” 10 times, “Activision Blizzard” once, and “Activision Blizzard King” twice. I guess even they don’t know.

Anyway, Gaming revenue overall was up 9 percent in the quarter, ahead of expectations, and Microsoft credited “better-than-expected subscriber growth in Xbox Game Pass as well as first-party content,” especially Starfield, for that growth. And there was a bit of data for both of those things. A bit of intertwined data, in fact.

On the Game Pass front, Microsoft noted that the service had “set a record for hours played per subscriber [in the] quarter.” And Starfield has surpassed over 11 million players since its launch, with nearly half of the hours played on PC. Microsoft even set a record for the most Game Pass subscriptions added on a single day ever on the day Starfield launched.

Of course, Minecraft has now surpassed 300 million copies sold making it the number one or two best-selling game of all time, depending on which numbers you believe. But the biggest gaming title-related news was this: Microsoft now has 13 game franchises—“from Candy Crush, Diablo, and Halo, to Warcraft, Elder Scrolls, and Gears of War”—that have generated over $1 billion in revenues. This is a deep stable of popular content. They should make some of them exclusives. (Kidding.)

Xbox content and services revenue increased 13 percent in the quarter, but Xbox hardware continued its ongoing slide despite the new Xbox Series S model, with revenues down 7 percent. Microsoft never uttered the word “console” even once on the call, let alone the name of a specific model. Perhaps we’ll see some movement there in the current (holiday) quarter.

Or not: Looking ahead, Microsoft spoke glowingly about Xbox content and services revenue growth in the current quarter, due to the “net impact from the Activision acquisition.” But nothing on hardware.

Office and Microsoft 365

Finally, let’s move on to Office, which is hidden inside Microsoft’s Productivity and Business Processes business unit, which delivered $18.6 billion in revenues, up 13 percent YOY.

Most of the credit went to the “slightly better than expected results from Office 365 commercial,” and revenues from that part of the business did jump 18 percent, compared to 15 percent for Office commercial overall. Microsoft said growth was driven by “healthy renewal execution” and an unidentified increase in average revenue per user (ARPU), with more customers choosing more expensive SKUs like E5.

Meanwhile, seats—actual license/user numbers—in Office 365 commercial grew 10 percent YOY, driven by its “small and medium business and frontline worker offerings.” And tied to all this growth in subscription-based offerings, revenues from Microsoft’s old-school on-prem Office offerings continued to decline, naturally, by 17 percent this past quarter. Microsoft’s customers continue to “shift to cloud offerings,” it says.

On the consumer end, Office consumer products and services revenue overall increased 3 percent while the Microsoft 365 consumer installed base grew 18 percent to 76.7 million. We had learned both numbers from the original announcement, but Microsoft offered no additional commentary during the call.

Looking forward, Microsoft expects Productivity and Business Processes revenues to grow between 11 and 12 percent in the current quarter to about $18.9 billion dollars. Office commercial will continue on its positive trajectory thanks to the same factor as before. But Microsoft says it is “excited for Microsoft 365 Copilot general availability on November 1,” and it expects the related revenue to grow gradually over time, which suggests there won’t be a huge jump at first. The revenue decline in its on-premises business will continue in “the mid to high teens.” And Office consumer will see “mid-single digit” revenue growth.  So nothing dramatic overall despite the excitement around Microsoft 365 Copilot.

The impact of AI

Speaking of which, perhaps we should examine what Microsoft said about AI before signing off. Most of this is tied to the commercial cloud space, which I don’t care about all that much, but since it’s such an important component of Microsoft’s future, it’s worth looking at.

Microsoft executives uttered the term “AI” over 35 times on its post-earnings conference call, more than Azure (21 times), Office (17), Windows (12), or Microsoft Cloud (6). And it said “Copilot” another 29 times. So, yeah. There’s your proof that this is the primary message the firm is trying to communicate now that the explosive growth from the cloud has slowed.

“With copilots, we are making the age of AI real for people and businesses everywhere,” CEO Satay Nadella said at the top of the call. “We are rapidly infusing AI across every layer of the tech stack and for every role and business process to drive productivity gains for our customers.”

From there, he discussed “progress,” but what’s most important, perhaps, is how Microsoft is handling the crushing costs of AI. This came up a lot in the previous quarter’s call, of course, but what I was looking for was a bit of new information or detail.

On the positive side of the equation, Azure revenue growth was up thanks to “higher than expected AI consumption” by its customers. Roughly three percentage points of Azure and other cloud services revenue growth came from AI services and was “ahead of expectations primarily driven by increased GPU capacity and better-than-expected GPU utilization of [its] AI services.”

On the negative side, Microsoft Cloud (an invented term for a non-business that is an aggregate of select businesses) gross margins were impacted “by the impact of scaling [its] AI infrastructure to meet growing demand.” And operating expenses for Azure and other cloud services were up 2 percent.

But the real meat came very late in the call when Hood finally admitted that capital expenditures in the quarter “to support cloud demand, including investments to scale [the] AI infrastructure” were $9.9 billion. In the previous quarter, this figure was $10.7 billion.

But here’s the thing: Microsoft earns such a huge profit that most of that cost isn’t applied to whatever business units, it simply comes out of profit. In the previous quarter, for example, $8.9 billion of that $10.7 cost was simply paid in cash. This quarter, however, Hood didn’t make this distinction. One wonders if the payment for Activision Blizzard factors into a cash flow scenario, or if that money was put aside many months ago. All I know for sure is that “cash” was never mentioned.

Well, that and the fact that Microsoft expects this quarterly expense to escalate.

“Expect capital expenditures to increase sequentially on a dollar basis driven by investments in our cloud and AI infrastructure,” Hood said, referring to the current quarter. “As a reminder, there can be normal quarterly spend variability in the timing of our cloud infrastructure buildout.”

And then she went further out in time.

“For our full FY24 [which ends June 30, 2024], we remain committed to investing for the cloud and AI opportunity while also maintaining our disciplined focus on operating leverage,” she continued. “Therefore, as we add the net impact of Activision, inclusive of purchase accounting adjustments as well as integration and transaction-related expenses, we continue to expect full-year operating margins to remain flat year-over-year.”

So it’s fair to assume that the cost of AI to Microsoft right now is roughly $10 billion per quarter and that this cost will only rise over time. Until it doesn’t: Somewhere down the road, Microsoft is counting on advances in lower-cost AI chipsets and an evening off in infrastructure demand to lower costs. But until then, Microsoft is going to pay big bucks for this investment with the hope of an even bigger payoff down the line.