Surprise followed by a red light? AI supports Microsoft with Q3 Azure revenue growth exceeding 30%, but Q4 growth is expected to slow down, and AI spending is ramping up | Earnings report insights

Following Google, Microsoft, regarded as a "leader in artificial intelligence (AI)," has also announced good news about AI applications boosting business growth. After an unexpected slowdown in the second quarter, Microsoft's cloud business revenue accelerated its growth momentum in the third quarter, with the cloud computing platform Azure maintaining a growth rate of over 30%, and the contribution of AI to Azure's revenue growth increasing.

In the third quarter, the cloud and Office software businesses jointly propelled Microsoft's revenue to exceed expectations, which is seen as a sign that Microsoft's significant investments in AI are beginning to pay off. What concerns investors is that Microsoft projected further slowing growth for Azure in the current quarter during its earnings call, and the AI-related expenditures, which had already surged beyond analysts' expectations and suppressed gross margins, will be further increased, effectively delivering a surprise from the previous quarter's performance while signaling a red light for the current quarter's results.

On October 30, Eastern Time, after the U.S. stock market closed, Microsoft announced its financial data for the first fiscal quarter of 2025 (referred to as the third quarter) for the period ending September 30, 2024.

1) Key Financial Data

Revenue: Third quarter operating revenue was $65.585 billion, a year-on-year increase of 16%, compared to analysts' expectations of $64.51 billion, and a year-on-year increase of 15% in the second quarter.

EPS: The diluted earnings per share (EPS) for the third quarter was $3.30, a year-on-year increase of 10%, compared to analysts' expectations of $3.11, and a year-on-year increase of 10% in the second quarter.

Operating Profit: The operating profit for the third quarter was $30.552 billion, a year-on-year increase of 14%, compared to analysts' expectations of $29.21 billion, and a year-on-year increase of 15% in the second quarter.

Net Profit: The net profit for the third quarter was $24.667 billion, a year-on-year increase of 11%, with a year-on-year increase of 10% in the second quarter.

Capital Expenditure: Including assets obtained through finance leases, total capital expenditure in the third quarter was approximately $20 billion, a year-on-year increase of 78.6%, compared to $19 billion in the second quarter; of which, cash expenditures related to real estate and equipment were $14.92 billion, a year-on-year increase of 50.7%, compared to analysts' expectations of $14.55 billion, and $13.87 billion in the second quarter.

2) Segment Business Data

Intelligent Cloud: Including Azure public cloud, Windows Server, voice recognition software Nuance, and GitHub's intelligent cloud business unit, third quarter revenue was $24.092 billion, a year-on-year increase of 20%, compared to analysts' expectations of $26.74 billion, and a year-on-year increase of 19% in the second quarter.

Productivity and Business Processes: Including Microsoft 365 Copilot AI tools and other Office software, the productivity and business processes segment had third quarter revenue of $28.317 billion, a year-on-year increase of 11%, compared to analysts' expectations of $22.88 billion, and a year-on-year increase of 11% in the second quarter.

More Personal Computing: Including Windows operating system, Surface hardware, Xbox gaming consoles, and video game company Activision Blizzard, the more personal computing segment had third quarter revenue of $13.176 billion, a year-on-year increase of 17%, compared to analysts' expectations of $14.23 billion, and a year-on-year increase of 14% in the second quarter

After the earnings report was released, Microsoft's stock price, which rose slightly by over 0.1% on Wednesday, quickly expanded its after-hours gains, at one point rising over 2%. During the earnings call, the stock price gradually retraced its gains and turned negative, at one point dropping over 4%.

In Q3, Microsoft's total cloud revenue grew by 22%, with AI contributing 12 percentage points to Azure's growth

In Q3, Microsoft's revenue and profit maintained double-digit growth, with EPS earnings and net profit both setting a record for the highest single-quarter figures in Microsoft's over fifty-year history. Similar to Alphabet, Google's parent company, which released its earnings report a day earlier, Microsoft's cloud business also saw the most rapid revenue growth among its main businesses.

Alphabet announced its earnings after hours on Tuesday, with Google Cloud's revenue, heavily influenced by AI applications, exceeding expectations with a robust 35% increase in Q3. Subsequent commentary suggested that Google Cloud's sales performance is a positive signal for cloud giants Microsoft and Amazon, indicating that the AI-assisted computing market is likely to continue growing.

This earnings report from Microsoft showed that total cloud revenue, including products like Office and Azure, grew by 22% year-on-year to $38.9 billion in Q3, exceeding analysts' expectations of $38.11 billion by 2%.

In the earnings announcement, Microsoft's Executive Vice President and Chief Financial Officer (CFO) Amy Hood specifically mentioned the 22% growth rate of Microsoft Cloud, stating, "The outstanding execution of our sales team and partners has provided a strong start to our fiscal year."

Even more notably, in the Intelligent Cloud segment, revenue from Azure and other cloud services grew by 33% in Q3, with a 34% increase after excluding the impact of exchange rate fluctuations. This was a slight slowdown from the 35% growth in Q2, but still above analysts' expectations of 30.4%. The degree of slowdown was significantly less than Wall Street's expectations and clearly stronger than the guidance range of 28% to 29% provided by Microsoft during the Q2 earnings call.

Microsoft stated that in Q3, 12 percentage points of Azure's growth came from AI, which is higher than the 11 percentage points contributed by AI in Q2.

Q4 Azure revenue is expected to further slow down

During the earnings call, Microsoft CEO Satya Nadella stated that the company's AI business is expected to achieve an annual revenue of $10 billion in the next quarter. If this becomes a reality, the AI business will become the fastest segment in Microsoft's history to reach the $10 billion revenue milestoneHowever, it was also during the earnings call that Microsoft projected a slowdown in revenue for its Azure cloud computing business in the second fiscal quarter, which is the fourth quarter of this year, excluding the impact of exchange rates. The company expects Azure revenue growth in the fourth quarter to be between 31% and 32%, down from 34% in the third quarter.

This indicates that Microsoft anticipates a further slowdown in Azure revenue growth in the fourth quarter following the third quarter, with the rate of slowdown exceeding one percentage point compared to the third quarter, potentially reaching as much as three percentage points.

However, CFO Amy Hood confirmed the outlook for accelerated Azure growth in the second half of the year. She stated, "We still expect Azure's growth to re-accelerate compared to the first half, as our capital investments bring more available AI (computing) capabilities to meet the growing demand."

Comments pointed out that Microsoft's AI-related revenue mainly comes from two areas: one is cloud services, and the other is AI-enhanced productivity assistants built into Office, which can help users summarize emails, transcribe conference calls, and create slides.

Before the earnings report was released, Daniel Ives, an analyst at Wedbush Securities, mentioned in a report on Tuesday that investors are looking for signs of adoption of Microsoft's AI assistant Copilot.

"Over the past few months, investors' views on Microsoft have become more neutral/cautious, with stock performance lagging behind the Nasdaq 100 index. Investors are concerned about the pace of Copilot adoption and increased competition from other major tech companies in the AI ecosystem."

Ives also stated that this is a "test" quarter for Microsoft, as many on Wall Street have begun to question the pace of Microsoft's AI/cloud computing growth.

Capital Expenditures in Q3 Grew Nearly 79% Year-on-Year, Expected to Increase Sequentially in Q4

Wall Street Insight mentioned that there were two main points of dissatisfaction in the market regarding Microsoft's Q2 earnings report released at the end of July this year: one was that Azure cloud business revenue growth was below expectations, and the other was that after surpassing the $50 billion mark in annual capital expenditures for fiscal year 2024, Microsoft also expects capital expenditures to continue to grow. These two points intensified market concerns that AI investments would take longer to yield returns.

This earnings report shows that Microsoft is still on the path of increasing investment in AI.

In Q3, Microsoft's capital expenditures surged further, with capital expenditures including financing leases growing 78.6% year-on-year, up from 77.6% in Q2. However, the sequential growth significantly slowed, increasing by 5.3% compared to Q2, where the sequential growth rate was 35.7%. In capital expenditures, real estate and equipment-related expenditures in Q3 grew by 50.7% year-on-year, while analysts expected a growth of 47%.

Microsoft stated that overall capital expenditures in Q3 were used to support the company's cloud and AI products. About half of the capital expenditures for cloud and AI were for long-term assets.

Microsoft disclosed that due to the increase in service revenue costs offsetting the decrease in product revenue costs, the gross margin in Q3 fell by nearly 2 percentage points, from 71.2% to 69.4%The gross margins of the productivity and intelligent cloud segments in the third quarter both declined year-on-year due to the expansion of AI infrastructure.

During the earnings call, Microsoft stated that it will continue to increase its investment in AI infrastructure, with no reduction in the budget for this area in the fourth quarter. Microsoft expects that capital expenditures in the fourth quarter will increase quarter-on-quarter, meaning it will exceed $20 billion.

CFO Amy Hood stated, "We will remain consistent and will adjust based on the demand signals we see if necessary. It is important to note that due to the delivery times of cloud infrastructure construction and financing leases, quarterly expenditures may vary."