MSFT — Q2 2026 Financial Report Analysis

Net income rose 60% on a $10 billion accounting gain — the operating business grew 21%, and capital spending nearly doubled

Microsoft's fiscal 2026 second quarter covers the three months to 31 December 2025. The 10-Q was filed on 28 January 2026.

Revenue was $81.3 billion, up 17% from $69.6 billion. Reported net income was $38.5 billion, up 60%, and reported diluted earnings per share $5.16, up 60%. Those headline figures should not be used to judge the quarter.

The reason is a single below-the-operating-line item. In October 2025 OpenAI converted into a public benefit corporation and completed a recapitalisation. Microsoft's proportionate ownership fell as a result — it now holds roughly 27% of OpenAI on an as-converted basis — and under the equity method of accounting a reduction in ownership stake in an entity whose value has risen produces a dilution gain: a one-off, non-cash accounting profit recognised because the smaller remaining stake is carried at a higher value than the larger old one. Microsoft recorded $10.0 billion of net gains from its OpenAI investments in the quarter, against $1.2 billion of losses a year earlier. The filing puts the effect at $7.6 billion of net income and $1.02 of EPS this quarter versus a $939 million / $0.12 drag last year.

Strip it out and Microsoft's own adjusted EPS was $4.14, up 24%. That is the number that describes the business.

The numbers

Half-year figures (six months to 31 December 2025) for context: revenue $158.9 billion (+18%), operating income $76.2 billion (+23%), reported EPS $8.87 (+36%), adjusted EPS $8.27 (+23%).

Azure and other cloud services — the consumption-based cloud and AI business — grew 39%, effectively flat against the prior quarter's 40%. Commercial remaining performance obligation (RPO) is contracted revenue not yet recognised, in effect the order backlog; it more than doubled to $625 billion.

The backlog number changed character, not just size

The 110% jump in commercial RPO is the most consequential disclosure in this filing, and it needs reading carefully rather than celebrating. Three months earlier the backlog was $392 billion and Microsoft expected roughly 40% of its total-company RPO to convert to revenue within twelve months. This quarter the backlog is $625 billion commercial ($631 billion total) — and the expected twelve-month conversion drops to 25%, with a stated weighted average contract duration of about 2.5 years.

In plain terms: the backlog grew by more than $230 billion in a single quarter, but the newly added contracts are much longer-dated than what was already there. A dollar of this backlog now converts to revenue more slowly than a dollar of last quarter's did. That makes RPO growth a genuine demand signal for multi-year AI-infrastructure commitments, and a much weaker predictor of next year's revenue than the raw percentage implies. The two quarters' RPO figures are not directly comparable as a near-term indicator.

Segments: the cloud pulled, consumer hardware pushed back

Intelligent Cloud grew 29%, with server products and cloud services up $7.2 billion or 31% on Azure. The cost side again outran it: segment cost of revenue rose 44%. Gross margin percentage fell on "continued investments in AI infrastructure and sales mix shift to Azure" — meaning both that AI capacity costs more, and that Azure is a lower-margin line than the on-premises server software it is displacing in the mix. Microsoft Cloud gross margin overall slipped to 67%, from 68% the prior quarter.

Productivity and Business Processes grew 16%, again driven by revenue per user (Microsoft 365 E5 and Copilot) rather than seats, which grew 6%. This is the one segment where gross margin percentage went up, "driven by efficiency gains in Microsoft 365 Commercial cloud."

More Personal Computing turned negative, down 3%, and its operating income fell 3%. Gaming revenue dropped $623 million or 9%: Xbox hardware fell 32% on lower console volume, and Xbox content and services fell 5% against a prior-year quarter "that benefited from strong first-party content performance." The segment also absorbed unquantified impairment charges in the Gaming business, which the filing names as a driver of the 6% rise in segment operating expenses and of the 7% rise in company-wide R&D expense. Windows OEM grew only 5%, down sharply from 18% the prior quarter — the Windows 10 end-of-support pull-forward is fading, as expected, though the filing says inventory levels "remained elevated."

Capital spending is now consuming the cash flow

This is where the quarter is most clearly inflecting. Capital spending was $29,876 million, up 89% year on year and equal to 37% of revenue (it was 23% a year ago). Operating cash flow was $35,758 million.

Subtracting one from the other leaves $5.9 billion of cash after capital spending, down from $6.5 billion in the same quarter last year — a decline, in a quarter when operating income grew 21%. Across the half year, capital spending was $49.3 billion against $30.7 billion a year earlier. Microsoft still returned $14.2 billion to shareholders in the quarter ($7.4 billion of buybacks, $6.8 billion of dividends) and repaid $3.0 billion of debt, but the cushion between what the business generates and what it is spending on datacentres has narrowed to a few billion dollars a quarter.

Note also that Microsoft has committed $13 billion of funding to OpenAI, of which $11.7 billion had been funded as of 31 December 2025.

Two other distortions worth naming

• Currency flattered everything by about two points. Revenue, gross margin and operating income each "included a favorable foreign currency impact of 2%." On a constant-currency basis — that is, holding exchange rates fixed so only underlying volume and price show through — revenue growth was closer to 15% than 17%.
• The tax rate rose from 18% to 20%, and the filing attributes the increase primarily to "deferred tax expense attributable to the dilution gain from the OpenAI Recapitalization." So the OpenAI gain did not merely inflate pre-tax profit; it also raised the tax rate applied to everything else, which slightly understates the underlying business's after-tax performance.

Takeaway: The 60% net income growth is an artefact of a non-cash accounting gain on a shrinking ownership percentage of OpenAI, and reverses nothing about the underlying trend: adjusted EPS grew 24%, Azure decelerated marginally to 39%, and cloud gross margin fell again. The number that actually changed this quarter is capital spending — $29.9 billion, 89% higher, 37% of revenue — which left barely $6 billion of cash after capex despite a 21% rise in operating income. Microsoft is converting an increasing share of its profit into datacentre assets whose depreciation has not yet fully hit the income statement.

What to watch next

The 10-Q contains no numeric revenue guidance. What it does contain is a stated direction of travel: "the investments we are making in cloud and AI infrastructure and devices will continue to increase our operating costs and may decrease our operating margins."

Three specific things to track from here:

1. Whether cash after capital spending goes negative. It has fallen from $6.5 billion to $5.9 billion year on year in this quarter alone, while capital spending nearly doubled. If the spend rate holds and operating cash flow follows its usual seasonality, the gap is the constraint on buybacks, not on the business.
2. Microsoft Cloud gross margin. It has gone 68% → 67% across two quarters and management names the same cause each time. This is the cleanest single measure of whether AI revenue is arriving at acceptable economics.
3. How much of the $625 billion backlog is genuinely incremental third-party demand. The 2.5-year weighted duration and the drop in twelve-month conversion from 40% to 25% both point to a small number of very large, very long contracts. Concentration matters more than the headline.

Our own read: the operating story is intact but narrowing. Growth is coming from one segment (Intelligent Cloud) and one pricing mechanism (revenue per user in Microsoft 365), while consumer hardware shrinks and Windows normalises. The offsetting cost — infrastructure — is being capitalised now and expensed later. Expect the reported margin pressure to build over the next several quarters as this quarter's $29.9 billion of assets starts depreciating, regardless of what OpenAI's carrying value does next.

Source: Microsoft Corporation Form 10-Q for the quarterly period ended 31 December 2025, filed with the US Securities and Exchange Commission on 28 January 2026 (accession number 0001193125-26-027207). All figures are as reported by the company; percentage changes, margin percentages and cash-after-capex figures are calculated from those figures.