Hi YXI friends,

Microsoft earnings comes in the same week as DeepSeek triggered an upheaval in the market. One cannot time it more perfectly.

Interestingly, on the latest earning call, Satya Nadella has embraced DeepSeek rather than dismissed it. Instead of getting sued, DeepSeek R1 is now available on Azure AI Foundry and GitHub. What a turnaround!

Nadella comments that DeepSeek represents Moore’s Law “working in hyperdrive” (Moore’s Law states that the number of transistors in a chip doubles roughly every two years). This acceleration is driven by AI-specific hardware optimisations and cloud-scale efficiencies, which allow massive AI workloads to be processed more efficiently than ever before.

There are two key aspects of AI compute: 1) Pre-training Compute - the computational effort required to train foundational AI models like GPT-4 or DeepSeek R1, and 2) Inference Compute - the computing power needed to use (or “run”) AI models after they are trained.

While pre-training costs are already declining, the bigger breakthrough is in inference efficiency. Microsoft has observed a 10x improvement in inference compute efficiency per cycle. Every iteration of AI model deployment becomes significantly cheaper to run. As AI inference costs fall, more companies and developers will integrate AI to real-world applications, a big positive for mass adoption.

Moreover, AI models are becoming efficient enough to run directly on PCs and edge devices (e.g. smartphones, IoT devices). This may be why Apple’s shares went up while the rest of the market cratered.

Now, let’s dive into Microsoft’s earnings.

Table of Contents

• 1. Revenue Growth has slowed

  • Quarterly Revenue

  • Business Segment Revenue

  • Revenue by Product and Service Offerings

• 2. Profitability Margins

• 3. Valuation With “AI Premium”

• 4. Technical analysis

• 6. Rating: Equal Weight

DISCLAIMER: This newsletter is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.

1. Revenue Growth has slowed

Quarterly Revenue

Microsoft’s Quarter ending December 31, 2024 beat the prior management guidance (a low ball of +10% YoY), but still marks a slowdown compared with the past four quarters.

Things are not going to look better in Q3 FY25 either, as the management guides a mid point of $68.5 billion, or 10.7% growth YoY. It is certainly a low-teens phase for Microsoft right now.

TTM Revenue

The TTM Revenue adds to $262 billion, a deceleration from 16.5% to 15% YoY. This should correspond to a lower revenue multiple for valuation.

Business Segment Revenue

In Q2, Productivity and Business Processes continue being the largest revenue driver, contributing $29.4 billion, equivalent to 42% of the overall revenue. P&BP includes Microsoft 365 Commercial and Consumer, LinkedIn, Dynamics products & cloud services, and Dynamics 365.

Meanwhile, Intelligent Cloud is closely behind at $25.5 billion in revenue. This segment is the fastest growing, including Azure and Server products & cloud services.

More Personal Computing’s revenue is the smallest at $14.7 billion. This segments includes Windows OEM & Devices, Xbox content & services, and Search & news advertising.

Intelligent Cloud grew the fastest in Q2, at 19%, thanks to Azure (31% YoY) and Server products (21% YoY).

P&BP grew by 14%, mainly driven by Microsoft 365 Commercial (15% YoY), Dynamics products & cloud services (15% YoY) and Dynamics 365 (19% YoY).

In contrast, More Personal Computing is flat year on year, although Search & news advertising grew by double digit.

For Q3, the management guides 11-12% YoY for Productivity & Business Processes, 19-20% YoY for Intelligent Cloud, and flat growth for More Personal Computing again.

Revenue by Product and Service Offerings

A more detailed examination of Microsoft’s products and services shows that Server products and Cloud services are the fastest growing area, at 21% YoY. The main driver comes from the enterprise demand for AI-powered cloud solutions.

Microsoft 365 Commercial products and cloud services accelerated vs last quarter, up 15% YoY (vs. 13%). This is on the back of Microsoft pushing AI-powered Copilot features to customers, with increased adoption among SMBs and large enterprises. Copilot usage was up 60% QoQ.

One interesting growth are is Search and News Advertising, which is up 12% thanks to higher ad spend on Bing and Microsoft Ad. While Alphabet is dominant in this area, we do begin to see Microsoft having a real go at Search by integrating ChatGPT.

Microsoft Cloud

Microsoft Cloud continues to be the dominant revenue driver for Microsoft, accounting for nearly 59% of the quarterly revenue.

Microsoft Cloud revenue continues to decelerate at 21% growth YoY, although breaking the $40 billion mark for the quarter.

Azure Slowed Down Again

This is the area that investors are most unhappy about, driving a selloff post-earnings.

Apps using Azure OpenAI more than doubled YoY. Even DeepSeek R1 launched on Azure AI Foundry & GitHub. Microsoft wants to turn DeepSeek’s impressive performance into an advantage, with the management commenting that “(Users) will soon be able to run DeepSeek's R1 distilled models locally on Copilot+ PCs as well as the vast ecosystem of GPUs available on Windows.”

Azure AI services grew 157%, but non-AI Azure growth is now slowing significantly in SMBs & partner channels. Overall, Azure’s revenue is in a decelerating trend, from 33% growth a year ago to 31% in the latest quarter. For Q3, the management guides a similar 31-32% growth YoY.

2. Profitability Margins

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