Microsoft Earnings Analysis: FY25 Q1 (Premium)

This admittedly unusual look at Microsoft’s earnings is skewed by my focus on the consumer side of the software giant, so I’m mostly ignoring the business segments that are driving its growth. That’s fine, but I do have to peek under the AI kimono to see what’s happening there, of course.

Microsoft’s fiscal 2025 begins with an accounting change, of all things: Back in August, the software giant explained that it was shuffling several business segments into different parts of the company. It claimed it was doing so to be more transparent to investors–a good thing–but as I noted, this was more likely yet another example of Microsoft being less transparent–a bad thing–by hiding poorly performing businesses within ever more inscrutable groups of businesses with no hard numbers and no real understanding of how the sausage is made.

This worry was realized with its most recent earnings announcement, in which Microsoft earned a net income of $24.7 billion on revenues of $65.6 billion, with double-digit growth in both figures. It’s getting harder and harder to know where the money is coming from.

At a high level, Microsoft has three business segments. And thanks to that shuffling, there’s a new winner from a revenue perspective. They are:

• Productivity and Business Processes (Microsoft 365): $28.3 billion in revenues, up 12 percent YOY.

• Intelligent Cloud (Azure): $24.1 billion in revenues, up 20 percent YOY.

• More Personal Computing (Windows, Xbox, Surface): $13.2 billion in revenues, up 17 percent YOY.

So that’s curious. Compounding the changes, Microsoft is eager to prove to investors that its massive and unsustainable investments in AI are paying off. So let’s start there. These days, Microsoft is all about AI.

AI

The obfuscation was immediate in yesterday’s post-earnings conference call with investors.

“All-up, our AI business is on track to surpass an annual revenue run rate of $10 billion next quarter, which will make it the fastest business in our history to reach this milestone,” CEO Satya Nadella said at the start of his prepared comments. Mission accomplished: Using this fuzzy metric–revenues are not profits, we have no idea how it calculated this figure or what it included, and it ignores the elephant in the room, which is the cost of those revenues–it looks like Microsoft’s AI investors are somehow already paying off. So What am I worried about?

Looking at infrastructure, which these days is mostly AI infrastructure, Nadella glossed over a lot of spending. Datacenters in over 60 regions around the world. And new cloud and AI infrastructure investments in Brazil, Italy, Mexico, and Sweden in just that one quarter. He explained away Microsoft’s massive investments in OpenAI by noting how much the company was worth, so that investment is sound (on paper). And then went on to explain, subtly, how Microsoft is reducing its reliance on OpenAI at almost every level. (Microsoft’s “losses on investments” were “as expected.”)

CFO Amy Hood noted that Microsoft Cloud gross margins declined 2 percent in part because of the cost of Microsoft’s AI infrastructure investments. But here’s the big number: Capital expenditures in the quarter were $20 billion, the true cost of those AI infrastructure investments. That figure was $19 billion last quarter, so it hasn’t gone up much, I guess. But here’s the problem: Where Microsoft’s free cash flow last quarter was more than enough to pay for the capital expenditures, that wasn’t the case this quarter: Free cash flow fell 7 percent to $19.3 billion. Interesting. As interesting: Those expenditures will keep going up, she admitted.

“Roughly half of our cloud and AI related spend continues to be for long-lived assets that will support monetization over the next 15 years and beyond,” she noted. “The remaining cloud and AI spend is primarily for servers, both CPUs and GPUs, to serve customers based on demand signals.”

Not surprisingly, the cost of Microsoft’s AI investments came up in the Q&A at the end of the call. As did the constraints around powering the data centers. Repeatedly. In fact, all the questions were about AI. Of course they were.

Apropos of nothing, agentic is the Microsoft word of the year.

Windows, Surface, Copilot+ PC

Windows is a big chunk of that accounting change I mentioned up top. First, Microsoft merged Surface (Devices) into a single business segment called Windows and Devices, and Surface (Devices) revenues now call into the Windows OEM (PC maker) bucket. Perhaps more dramatically from a financial perspective, Windows Commercial products and cloud services revenues were moved under Microsoft 365, which is part of Microsoft’s Productivity and Business Processes segment.

I noted the net result from that second bit in my earnings post: Productivity and Business Processes is, for the first time ever, Microsoft’s biggest segment by revenue, because most Windows revenues come from business licensing. But that also means that More Personal Computing, the segment that used to account for all Windows revenues, is smaller.

How much smaller?

In the previous quarter, More Personal Computing represented 25 percent of Microsoft’s revenues. In this quarter, it was 20 percent. But it’s worse than that 5 percent drop: More Personal Computing also contains Xbox, which includes Activision, and that part of the business experienced a 61 percent revenue boost YOY. Put another way, 88 percent of More Personal Computing’s revenues gains this quarter came from Activision. Not Xbox, Activision. So that revenue shortfall was huge, and it’s being hidden, so to speak, by Activision’s revenues. Put yet another way, Microsoft could never have shuffled Windows commercial revenue around before. But now it can do so without raising any eyebrows.

Anyway. Revenues from PC makers were up 2 percent in the quarter, which isn’t great, but it was dragged down a bit by Surface. (Which Microsoft said faced “execution challenges in the commercial segment,” meaning the products aren’t selling well.) Microsoft expects more of the same in the current quarter: Revenues from PC makers up a bit, but offset by Surface declines. Not that Microsoft uttered the term “Surface” even once.

As for Copilot+ PC, it’s all theory at this point. Microsoft is happy that AMD, Intel, and Qualcomm all “support” Copilot+ PC. There is “momentum” in the form of new Copilot+ PC AI experiences, none of which are broadly available. And it’s exciting from some sort of future possibility perspective. But it hasn’t moved the needle on anything, let alone revenues.

Xbox

There are many questions about Microsoft’s gaming business now that we’re a year into the Activision Blizzard era, and many theories. (Including my own.) Nadella said that Microsoft is “focused on building a business positioned for long-term growth, driven by higher-margin content and services,” which is yet another way of saying that the future of this business is not hardware, but rather subscription services. And there were some soft numbers.

Microsoft set a record for monthly active users on Xbox services. Game Pass set a record for the first fiscal quarter (so, not a record overall) for revenue and average revenue per subscriber, tied to people signing up to play the new Call of Duty. That new Call of Duty was “the biggest Call of Duty release ever” as measured by “day one players.” But here’s an unexpected figure: Unit sales on PlayStation and Steam were up over 60 percent YOY. So much for all that nonsense about COD and PlayStation.

Activision continues to be a mixed bag for Microsoft, however. A big part of the negative news this year involved layoffs and studio closures, but you can see quarter to quarter why this was so: Activision is a big, expensive business to operate and Microsoft is trying to fix that. Activision delivered $1.69 billion in revenues, but thanks to various costs, which include accounting adjustments, business integration costs, and basic operating expenses, the business swung to a loss of $440 million in the quarter.

The forecast for the current (holiday) quarter is interesting.

Microsoft expects overall gaming revenue to decline in the high single digits because of continued console sales issues. And it expects Xbox content and services revenue growth to be flat because of COD: Because so many gamers are signing up for Game Pass to play the game, the short-term revenue will be lower. But longer term, it should work out: Game Pass revenue is realized over time. We’re in uncharted territory here.

Final thoughts

For all the change we see at Microsoft’s there’s a good argument to be made that the most significant changes are happening in the smallest, consumer-focused part of the company, More Personal Computing. Most of the revenues in the business come from licensing, whether its PC makers paying for Windows or gamers, now, buying games and subscribing to Game Pass. Most of the losses are hardware-based, whether its Surface or Xbox hardware, though ongoing costs associated with the Activision acquisition are a drag too. It’s painfully clear that this business would be more profitable and successful if it just stopped making hardware. And just writing that is painful. But that’s the reality here. It’s why I believe Microsoft should consider farming out future generation console hardware to third parties, and why Surface really doesn’t make sense as a business despite my love of the remaining products it makes.

The good news? For now, all eyes–investors, customers, whatever–are on AI, and not on the consumer side of the house. But I feel like the hammer is going to fall on hardware. It’s just a matter of time.