When you read Microsoft's 10-K, you will see its FY26 revenue is $331.8bn. But don't stop there. You want to ask: where did the revenue come from? Then we can see Azure's revenue breaks $100bn. Then we want to look at cost of revenue. Microsoft's revenue grows 18%. But its gross margin drops from 69% to 67%. This is margin compression. It means cost of revenue grows faster than revenue.
Gross margin drop isn't necessary a bad thing. If gross margin drops is due to lower pricing, then it is bad. But if it is due to massive infrasturcture development for a new business then it is good. It means the company sacrifices short term margin to trade for long term absolute profit. So a good finance analysis doesn't stop at margin reduction. It sees margin reduction and asks why and is the reduction temporary or structural.
It is important to know the movement is temporary or structural. For example, Microsoft is currently building massive data centers. This causes depreciation grows fast. However, this is temporary. In a few years' time when the data centers are fully utilized, revenue will grow much faster than cost. Then the margin will recover. When we look at AI business, each response needs to consume expensive GPU computation. So the AI service's marginal cost is naturally higher than traditional software. This is structual instead of temporary.
When you analyze the financial reports, don't just ask how much revenue does Azure grow. You also need to ask:
- How fast does Azure revenue grow?
- How much money is spent to gain that growth?
- How much gross profit does the increased revenue generate?
- How much CapEx is needed?
- When matured, can the gross margin recover or grow?
- When matured, how much free cash flow can be generated?