Microsoft Q1 earnings: CEO Nadella says ‘fungible’ asset strategy key in AI race

‘We have to fund our own R&D and model capability because in the long run that’s what’s going to differentiate us,’ Microsoft CEO Satya Nadella said.

Microsoft executives assured analysts worried about an artificial intelligence bubble that the vendor is avoiding too much spending, with AI demand still exceeding supply and Microsoft prioritizing “fungible” data center assets applicable to multiple geographies, first-party products, third-party products and research.

Answering questions Wednesday during the Redmond, Wash.-based technology giant’s latest quarterly earnings call, Microsoft CEO Satya Nadella said the vendor is willing to walk away from business that is too concentrated, Nadella said.

“There’s compute, there’s storage–and so if all of the demand just comes for just one meter, that’s really not a long-term business we want to be in,” he said. “We have to fund our own R&D and model capability because in the long run that’s what’s going to differentiate us. … We feel very, very good about the decisions. In some sense, I feel even, each time we say no to (some business), the day after, I feel better.”

Microsoft Q1 earnings

Microsoft reported results Wednesday for the first quarter of its 2026 fiscal year. The quarter ended Sept. 30.

The vendor revealed to analysts that AI demand helped fuel an eye-popping commercial remaining performance obligation (RPO) business backlog of $392 billion, up 51 percent year on year.

That backlog covers “numerous products” and “covers customers of all sizes,” Microsoft Chief Financial Officer Amy Hood said on the call in response to a question about the concentration of customers contributing to the backlog. Microsoft’s RPO has a weighted average duration of about two years, Hood said, meaning “that these are contracts being signed by customers who intend to use it in relatively short order.”

“At that type of scale, I think that’s a pretty remarkable execution,” she said.

The customer concentration question might bring to mind one of the criticisms around Microsoft cloud rival Oracle’s $500 billion-plus backlog of business, which some analysts said had a relatively small number of companies contributing to the business–including Microsoft-backed OpenAI.

Speaking of OpenAI, Nadella told analysts that he is happy with the new contract Microsoft signed with ChatGPT maker OpenAI, saying that the agreement “creates more certainty” around the companies’ intellectual property relationship.

AI demand still exceeds supply

Nadella described Microsoft’s infrastructure investments as “building a planet-scale cloud and an AI factory, maximizing tokens per dollar per watt while supporting the sovereignty needs of customers and countries.”

The vendor plans to increase our total AI capacity by more than 80 percent this year and roughly double its total data center footprint over the next two years. Microsoft’s Fairwater, “the world’s most powerful AI data center,” will go online next year and scale to 2 gigawatts, he said.

Hood told analysts on the call that Microsoft continues to need to invest in building data centers for AI customers because it is still constrained, with demand exceeding supply, saying that her confidence is “very high” that Microsoft needs to use all of the infrastructure.

Microsoft has invested in graphics processing units (GPUs), central processing units (CPUs) and other “short-lived assets” just to meet the duration of a customer contract, which cuts down on risk of overinvesting, she said.

“We’ve spent the past few years not actually being short GPUs and CPUs, per se, we were short the space or the power–is the language we use–to put them in,” she said.

Microsoft has been embracing more leases to meet demand–Oracle co-founder and Chief Technology Officer Larry Ellison has previously pointed to his company’s embrace of leases instead of owning buildings as a way it has quickly expanded capacity to meet demand.

Those Microsoft leases can last up to 20 years as “long-lived assets,” Hood said. Microsoft has a high confidence in the signals from usage patterns and bookings to justify its infrastructure spending.

“We’ve been short (of infrastructure) now for many quarters,” she said. “I thought we were going to catch up. We are not. Demand is increasing. It is not increasing in just one place. It is increasing across many places. We’re seeing usage increases in products. We are seeing new products launch that are getting increasing usage–and increasing usage very quickly.”

Nadella added that the vendor is “building out a very fungible fleet” where data centers are built across the world for pre-training, post-training, reinforcement learning and other use cases.

Microsoft also continually modernizes its fleet of semiconductors and leverages software across different types of semiconductors. For better efficiency over time, the CEO said.

New OpenAI deal

Per Microsoft’s new OpenAI agreement, the upstart stays Microsoft’s frontier model partner and Microsoft continues to have exclusive IP rights and Azure application programming interface (API) exclusivity until OpenAI achieves artificial general intelligence as verified by an independent expert panel. AGI is usually defined as AI that is as good as human intelligence.

Nadella told analysts on Wednesday’s call that he feels “pretty good” about AI’s progress and that he doesn’t think AGI “as defined, at least by us in our contract, is ever going to be achieved anytime soon.”

The new agreement allows Microsoft to independently pursue AGI alone or in partnership with third parties and extends Microsoft’s IP right for models and products through 2032 and includes models post-AGI. Microsoft also has IP rights to research until AGI or through 2030, whichever happens first.

The new agreement marks “the next chapter in what is one of the most successful partnerships and investments our industry has ever seen,” the CEO said. Microsoft has seen 10 times the return on its OpenAI investment, and OpenAI has contracted an incremental $250 billion of Azure services.

“This is a great milestone for both companies,” Nadella said. “We continue to benefit mutually from each other’s growth across multiple dimensions.”

AI systems

Nadella and his team are focused on how users will deploy AI systems in the real world and create a return on the investment by the customer and the provider, the CEO said on the call.

A problem with the AI era is jagged intelligence, where an AI tool performs well at a particular task but fails at tasks just outside of its proficiency even as model versions improve, Nadella said.

Nadella told analysts on the call to look to Microsoft’s GitHub, security stack, Microsoft 365 Copilot and Azure AI Foundry as not just products, but systems that give AI models guardrails. A system like those acts as an organizing layer for multi-agent systems “smooths out those jagged edges and really helps the capability,” Nadella said.

“That’s the type of construction that will be needed, even when the model is magical–all powerful,” Nadella said. “We will be in this jagged intelligence space for a long time.”

Even without AGI in the short term, “I do believe we can drive a lot of value for customers with advances in AI models by building these systems,” Nadella said.

Microsoft agent systems are aimed at high-value domains including information work and coding, he said. Copilot expands the M365 average revenue per user (ARPU), similar to how cloud proved more expansive to server sales despite initial zero-sum fears.

The “coding business is going to be one of the most expansive AI systems,” Nadella said. “We feel very good about being in that category. Same thing with security, same thing with health.”

Consumer AI products by Microsoft will monetize through ads and subscriptions, Nadella added. The revenue opportunities helps give Microsoft executives “the confidence to invest both the capital and the R&D talent to go after this opportunity.”

“The enterprise adoption cycle is just starting,” he said.

Product updates

Per usual, Nadella shared a host of new user milestones on the call to illustrate the growth of Microsoft’s AI and cloud products.

Some of the highlights that might interest solution providers include:

Milestones in the GitHub, coding and security space include:

Among Microsoft’s data, analytics and health care products:

During the quarter, Microsoft also increased the token throughput for GPT-4.1 and GP-5 by more than 30 percent per GPU, Nadella said.

Q1 in depth

Microsoft reported $77.7 billion for the quarter, up 17 percent year on year ignoring foreign exchange. The vendor saw operating income of $38 billion, up 22 percent.

Net income using Generally Accepted Accounting Principles (GAAP) was $27.7 billion, up 12 percent year on year. Non-GAAP net income came in at $30.8 billion, up 21 percent ignoring foreign exchange. The non-GAAP results ignore the effects of investments in ChatGPT maker OpenAI, according to Microsoft.

The vendor lost $3.1 billion in net income from its investment losses in OpenAI in the first quarter. In the first quarter of fiscal year 2025, Microsoft lost $523 million in net income from the investments. Microsoft’s new OpenAI agreement did not affect first quarter numbers, Hood said on the call.

Microsoft cloud revenue came in at $49.1 billion, up 25 percent year on year. Microsoft’s productivity and business processes (PBP) segment brought in $33 billion for the quarter, up 14 percent year on year.

Within this segment, Microsoft 365 commercial cloud revenue grew 15 percent year on year. M365 consumer grew 25 percent. Dynamics 365 grew 16 percent. This segment also includes revenue from social media network LinkedIn.

The intelligent cloud (IC) segment saw $30.9 billion in revenue for the quarter, up 27 percent ignoring foreign exchange. Azure and other cloud services saw a 39 percent increase in revenue year on year.

Microsoft’s more personal computing (MPC) segment brought in $13.8 billion for the quarter, up 4 percent year on year.

Within this segment, Windows original equipment manufacturer (OEM) and devices revenue grew 6 percent. This segment also includes revenue from gaming console Xbox, search and news advertising.

Microsoft’s stock traded at $520 a share after market close Wednesday, down about 4 percent.