Microsoft (MSFT) announced its financial report for the fourth quarter of the 2024 fiscal year ending June 30th after the US stock market on July 30th. Although a 15% growth in revenue and operating profit from an absolute perspective is not bad, under high expectations and high valuations, the lack of significant highlights in performance can lead to downward pressure. Meanwhile, the continuous increase in AI investment without a significant growth in incremental revenue contribution poses the biggest challenge for Microsoft and the entire AI gaming industry, with specific points as follows:

1. Disappointing Performance of the "Pillar" Azure: Azure, as the business most closely related to AI and contributing the most incremental revenue, is the key focus of the market. Compared to the previously optimistic market expectations and even the expected acceleration, Azure's actual year-on-year growth rate this quarter was 29% and 30% at constant exchange rates, a decrease of 2 percentage points and 1 percentage point quarter-on-quarter. Although the absolute growth rate is not low, it is still disappointing under high expectations. According to management disclosures, AI-related revenue accounted for 8% this quarter, up 1 percentage point from the previous quarter, but the increase was not significant. There is still no clear sign of acceleration in revenue contribution from AI.

2. Office Business Growth is Flat, Slow Promotion of Copilot: The Office 365 business, closely related to AI, saw a 13% increase in revenue this quarter, with a decrease of about 2 percentage points quarter-on-quarter. As the industry consensus is that the promotion of AI features like Copilot has not seen explosive growth yet, the growth in enterprise users is becoming increasingly challenging. Without a significant improvement in revenue growth for enterprise Office without price increases through additional features like Copilot.

3. Still Waiting for the Moment of "AI PC": Excluding the impact of Blizzard in the personal computing segment this quarter, the comparable revenue growth rate was 2%, still at a low level. Windows OEM business revenue grew by 4% year-on-year, with PC shipments close to the same quarter, showing no significant acceleration. Although Microsoft has previously launched AI PC products, without a blockbuster AI application, it has not yet been able to truly stimulate the replacement cycle.

4. Significant Fluctuations in Leading Revenue Indicators: The growth rate of new enterprise cloud contract amounts dropped significantly from 29% in the previous quarter to 17%. At constant exchange rates, the growth rate also decreased by 12 percentage points quarter-on-quarter. Although it is still unclear whether this quarter's fluctuation reflects a weakening in incremental demand or is simply a seasonal fluctuation, with the revenue growth slowing down this quarter, the weakening of leading indicators is a worrying signal.

5. Revenue Growth Slowing Down, Increased Investment, End of Profit Acceleration Cycle? Due to the general slowdown in growth across the three major segments, Microsoft's overall revenue grew by 15% year-on-year this quarter, a 2 percentage point slowdown from the previous quarter. At the same time, operating profit also increased by 15% year-on-year, with a more pronounced slowdown compared to the previous two quarters, now completely in line with revenue growth. The operating profit margin also saw a year-on-year decline for the first time since the 24 fiscal year (-0.1 percentage points)

The main reason for the decline in operating profit margin is that the gross profit margin decreased by 0.5 percentage points, while the research and development expense ratio increased by 0.4 percentage points year-on-year. Despite the fact that sales and administrative expenses are still contracting year-on-year, this ultimately led to a 0.1 percentage point decrease in the operating profit margin. It can be seen that although Microsoft remains quite frugal in other expense categories, the depreciation and investment in research personnel and equipment related to AI have put considerable pressure on the profit margin.

Moreover, this quarter's Capex investment increased by 36% to $19 billion compared to the previous quarter, which is already equivalent to 70-80% of the expected operating profit for the 25th fiscal year on an annualized basis. With such a huge investment, there may be even greater pressure on future profit margins.

6. Is the guidance for the next quarter too conservative or really poor? Regarding the guidance for the first quarter of the 25th fiscal year, the revenue of the three major segments, as well as the median gross profit and operating profit guidance for the company as a whole, are generally slightly lower than the market's original expectations by a few billion. Although the difference is not significant, Microsoft tends to have a conservative guidance habit, and the actual delivery situation mostly exceeds the upper limit of the guidance. However, having all guidance indicators lower than expected is undoubtedly somewhat negative. The most crucial point is that the constant currency growth rate of Azure, which the company expects to be between 28% and 29%, is lower than expected compared to this quarter. There is still no sign of a significant increase in revenue driven by AI demand.

Dolphin Research's Viewpoint:

As mentioned earlier, with revenue and operating profit both increasing by 15%, and Azure achieving a 29% revenue growth rate, from an absolute perspective, it is not bad at all, and can even be said to have quite impressive growth. However, the issue lies in the fact that Microsoft is currently trading at a PE valuation of around 30 times its 25-year profit, and a profit growth expectation of around 15% is clearly unsustainable.

The reason the market is willing to give Microsoft a significant valuation premium is due to investors' imagination of substantial incremental revenue from AI in the future, and Microsoft's relatively high visibility in the mid-to-lower stream of the AI race. Therefore, whether in this quarter or in the guidance for the next quarter, neither Azure nor Office copilot, which are closely related to AI, have clearly demonstrated the incremental revenue potential brought by AI, while the significantly increased Capex investment has already begun to, and will continue to, drag down the company's profitability. This will inevitably make the market consider whether AI can really bring in revenue that exceeds the required investment, and whether the ROI is attractive.

However, the lack of a significant acceleration in revenue in the past 1-2 quarters also does not disprove the imagination space for AI in the medium to long term (possibly as early as the second half of the 25th fiscal year). Therefore, we believe that after this performance, Microsoft will likely experience a brief period of correction, but it will not lead to a significant downward revision of the valuation logic in the medium term.

Below is a detailed review of the financial report:

I. Neither Azure nor Copilot Validates the "AI" Moment

1.1 Azure's Growth Rate Slightly Declines

With the continuous rise in the value of Microsoft (including other major tech stocks), and the situation where traditional business growth and macro experiences are not optimistic, whether it is performance or valuation support, it can be said that everything depends on Azure. Foreign institutions had generally optimistic expectations for Azure's performance, but the actual year-on-year growth rate of Azure this quarter was 29% and 30% at constant exchange rates, which, although not bad in absolute terms, saw a decrease of 2 percentage points and 1 percentage point respectively compared to the previous quarter, which is somewhat disappointing from the perspective of many overly optimistic investors who originally expected accelerated growth.

However, according to our calculations, the non-Azure business within the Intelligent Cloud segment saw a year-on-year revenue growth turning negative to about -6% this quarter. Dolphin Research, through surveys conducted by outsiders in China, also noted that although enterprise IT budgets have returned to a growth trend, a considerable portion of it is allocated to AI-related investments, leading to a relatively tight budget for traditional demand.

Overall, due to the high-end growth slowdown of Azure and the contraction of other businesses year-on-year, the overall revenue growth of the Intelligent Cloud segment decreased by about 2 percentage points to 19% this quarter compared to the previous quarter, with actual revenue slightly below the expected $2 billion.

1.2 Office growth remains flat, Copilot lacks highlights

In the Office business, which has the second highest AI density, the largest segment, 1) Enterprise Office 365, saw a 13% revenue growth this quarter, with a decrease of about 2 percentage points compared to the previous quarter. However, the progress of Office Copilot and other AI features being adopted by users has been poor, which is already an industry consensus, and the market did not expect much from the Office business, which has proven to be in line with expectations.

Looking at it from a quantity and price perspective: 1) this quarter, the number of Enterprise Office 365 subscription customers grew at a slower pace to 7% year-on-year, as market saturation and not-so-good macroeconomic expectations have led to a slowdown in user growth being one of the anticipated issues in the market.

2) Since user growth is difficult to significantly accelerate, pricing is the main driver of revenue growth. According to our calculations, the average revenue per user of Office 365 increased by 5% year-on-year this quarter, with a slight slowdown of 1 percentage point. It is evident that the increase in average revenue per user driven by enterprises adopting high-priced products like E5 is still ongoing. However, the space and speed for further price increases are narrowing due to the poor progress of additional paid features like Copilot**

In other businesses in the productivity sector: ① Personal Office growth continued to decline at a low single-digit rate, ② Dynamics growth also slowed by 3 percentage points, but the 16% growth is still the fastest-growing business in the PBP sector; ③ LinkedIn maintained a 10% growth rate.

Overall, due to the AI functionality not advancing the acceleration of the core business of Commercial Office, most other businesses also stabilized and slowed down. This quarter, revenue in the productivity flow sector increased by 11%, continuing to slow down by 1 percentage point from the previous quarter, which is within expectations without any highlights.

II. Personal PC sector remains weak, advertising business unexpectedly accelerates

Revenue growth in the personal computing sector this quarter increased by 17% year-on-year, excluding the impact of acquisitions, comparable growth was 2%, basically flat compared to the previous quarter, and the personal computing sector is still growing at a low rate. Actual revenue slightly exceeded market expectations by 400 million, but it is not significant in the overall picture.

In terms of specific businesses: ① Windows OEM business revenue increased by 4% year-on-year, which is roughly consistent with PC shipment growth. Although Microsoft has launched the first batch of "AI PC" products, it cannot immediately drive the PC replacement cycle until popular AI applications emerge in the 2C end;

② After the acquisition of Blizzard, gaming business revenue increased by 44% year-on-year, but 48% of this is from the consolidation of Blizzard's impact, while the original business revenue continues to decline, with no sign of a turnaround;

4) This quarter, advertising business revenue increased by 5% year-on-year, although the absolute growth rate is not high, the quarter-on-quarter growth rate increased by 2 percentage points , after excluding buying costs, advertising revenue growth reached 19%, an increase of 7 percentage points from the previous quarter, which is one of the few segments that showed a significant acceleration this quarter. This may indicate that AI functionality has indeed brought more user time to Bing Search, along with the accompanying advertising. Stay tuned for explanations during the conference call.

III. Is the slowdown in leading revenue indicators more worrying?

Summarizing the performance of revenue growth in the three major sectors in the previous quarter, there were no significant highlights that exceeded expectations, absolute growth did not show a significant decline, and it generally met market expectations

However, the leading indicators reflecting the subsequent revenue growth trend have shown more significant fluctuations. Among them, the growth rate of new enterprise cloud contract amount dropped significantly from 29% in the previous quarter to 17%. Even at a constant exchange rate, the growth rate decreased by 12 percentage points compared to the previous quarter. Although it is still difficult to determine whether this reflects a decrease in incremental demand or just seasonal fluctuations based on a single quarter, it is somewhat a worrying signal.

In terms of the indicator of unconfirmed revenue (deferred revenue), the P&BP segment's year-on-year growth remains roughly stable, but both the Intelligent Cloud and Personal Computing segments have shown significant declines, leading to a further 1 percentage point decrease in overall deferred revenue growth to 12%. This also includes the impact of a surge in game deferred revenue due to mergers and acquisitions.

However, the balance of outstanding performance obligations (deferred revenue received but not recognized + contract amount signed but payment not received) for this quarter is 235 billion, with a year-on-year growth rate holding steady at 20%. Although the growth of new contracts slowed down during the quarter, there are no apparent issues from the perspective of outstanding obligations.

IV. Overall Performance: Revenue did not accelerate, investment increased, and the profit acceleration cycle ended?

1) Due to a slight decrease in growth across the three major segments, overall revenue grew by 15% year-on-year this quarter, slowing down by 2 percentage points compared to the previous quarter, with 1 percentage point attributed to the negative impact of exchange rates. Excluding the impact of Blizzard's consolidation, the total revenue growth rate can actually be adjusted to 12.2%. Similarly, it slowed down by approximately 1 percentage point compared to the previous quarter. In other words, Microsoft's revenue growth throughout the 24 fiscal year has been fluctuating within a small range of 12% to 14%, without any particularly significant improvement or deterioration.

2) From a gross profit perspective, Microsoft achieved a gross profit of $45 billion this quarter, a year-on-year increase of 14.3%, with a decrease in growth rate by nearly 4 percentage points compared to the previous quarter. The gross profit margin is 69.6%, both decreasing by 0.5 percentage points year-on-year and quarter-on-quarter. According to the company's explanation, objective reasons include the end of the previous fiscal year's favorable depreciation extension and the costs of acquiring Blizzard. However, the significant increase in Capex leading to a rise in depreciation and other costs may also be one of the reasons.

3) From a cost perspective, compared to last year, Microsoft's marketing and management expense ratios have still contracted by 0.5% and 0.4% year-on-year, indicating that Microsoft's expense spending is still relatively cautious. The recent reports of Microsoft continuing to lay off hundreds to thousands of people also validate this point.

However, the R&D expense ratio has increased by 0.4% year-on-year, most likely due to the growth in AI-related research and development personnel and equipment investment.

4) Overall, due to the growth in R&D expenses and costs outpacing the thriftiness of marketing and management expenses, the company's operating profit margin for this quarter has decreased by 0.1% year-on-year to 43.1%, marking the first year-on-year decline in profit margin since FY24. Operating profit increased by 15% year-on-year, significantly slowing down compared to the previous two quarters, and is now completely in line with revenue growth. This indicates that the profit improvement cycle for Microsoft, where profit growth exceeded revenue growth since 3Q23, may come to an end.

5) Microsoft's Capex spending for this quarter increased by 36% quarter-on-quarter, rising significantly to $19 billion. Even if we assume no further quarter-on-quarter growth in the following quarters, the annualized Capex investment is equivalent to 2.4 times that of FY23. The $76 billion annualized investment is equivalent to nearly 70% to 80% of the 25-year expected operating profit. Such massive investment will inevitably exert significant pressure on profitability.

6) Looking at the segments, even if we ignore the personal PC business that dragged down the operating profit margin due to consolidation, the unaffected Productivity and Business Processes and Intelligent Cloud segments both saw a significant decline of over 1% in operating profit margin quarter-on-quarter.

**Dolphin Research on Microsoft:**

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