Microsoft Fiscal Year 2016 Third Quarter Earnings Conference Call

MSFT Earnings Conference Call

Chris Suh, Satya Nadella, Amy Hood

Thursday, April 21, 2016

(Operator Direction.)

CHRIS SUH:  Thank you.

Good afternoon and thank you for joining us today.

On the call with me today are Satya Nadella, Chief Executive Officer; Amy Hood, Chief Financial Officer; Frank Brod, Chief Accounting Officer; and John Seethoff, Deputy General Counsel and Corporate Secretary.

On our website, Microsoft.com/investor, you can find our earnings press release and financial summary slide deck, which is intended to supplement our prepared remarks during today’s call and provide the reconciliation of differences between GAAP and non-GAAP financial measures.

Unless otherwise specified, we will refer to non-GAAP metrics on the call.  The non-GAAP measures exclude the net impact from revenue deferrals and the impact of integration and restructuring charges.  The non-GAAP financial measures provided should not be considered as a substitute for or superior to the measure of financial performance prepared in accordance with GAAP.  They are included as additional clarifying items to aid investors in further understanding the company’s third quarter performance in addition to the impact these items and events had on the financial results.

All growth comparisons we make on the call relate to the corresponding period of last year unless otherwise noted.  We also provide growth rates in constant currency when available as a framework for assessing how our underlying businesses performed excluding the effect of foreign currency rate fluctuation.

At the segment level, we provide constant currency growth for both revenue and gross margin.  However, due to the recent change to our external reporting segments, we aren’t able to provide segment level constant currency operating expense growth and consequently cannot derive constant currency segment operating income either.  We do provide constant currency operating expense and operating income growth at the company-wide level.

Please note that in the third quarter of Fiscal 2016, we adopted a new standard issued by the FASB that made certain changes to accounting for stock-based compensation.  One of the most significant changes require that excess tax benefits and deficiencies be recorded as part of income tax expense rather than as part of additional paid and capital.  Adoption of the new guidance requires us to reflect adjustments as of July 1st, 2015, and hence impacts are previously reported quarterly results for Fiscal 2016.  You can find additional information in the financial summary slide deck and in our 10-Q filing.

We will post our prepared remarks to our website immediately following the call until the complete transcript is available.  Today’s call is being webcast live and recorded.  If you ask a question, it will be included in our live transmission, in the transcript, and in any future use of the recording.  You can replay the call and view the transcript on the Microsoft Investor Relations website until April 21st, 2017.

SATYA NADELLA:  Thank you, Chris.

And thanks to everyone on the phone for joining.

Overall we had a solid quarter.  Amy and I look forward to sharing more about the results and what’s ahead.  We delivered $22.1 billion in revenue with an operating income of $6.8 billion.  We exceeded $10 billion in commercial cloud annualized revenue run rate.  We are halfway to our FY ’18 goal of $20 billion.

This quarter we surpassed 270 million monthly active devices running Windows 10.  We are proud of our progress and look forward to making more as enterprise deployments accelerate.  Now let’s get to the specifics of each of our three segments starting with productivity and business process.

We set out to reinvent productivity and business process because we believe that people should get more out of every moment and organizations should be able to reach new levels of effectiveness.  This approach is opening up new growth opportunity for Microsoft in three ways.  We can reach more users, enter new markets and build a developer platform.  Let me talk through each.

First, we’re reaching new users and strengthening our productivity platform.  Consumer subscriptions of Office grew to more than 22 million.  Devices with our mobile app grew approximately four times year over year.  Commercial Office 365 customers surpassed 70 million monthly active users and we grew seats by 57 percent.

Second, we are expanding into new markets, such as security, analytics, and cloud voice, where we see an opportunity and where we can differentiate.  For example, the cyber security market is expanding rapidly and it is a place where we have unique capabilities, like Advanced Threat Protection, Cloud App Security, and Advanced e-Discovery.  This combination drove a 35 percent quarter over quarter growth of monthly active users of our premium information protection services in Office 365.  A key driver of this growth is our new premium Office 365 Suite E5.

Lastly, we are making Office 365 more than a world class productivity and communications service.  It’s becoming a growing platform for developers.  There is an incredible amount of value developers can deliver by harnessing the data in this platform.  It can be as simple as Starbucks enabling somebody to e-mail a cup of coffee, or it can be as sophisticated as DocuSign streamlining processes for digital signatures based on the understanding of people’s availability and organizational hierarchy.

We continue to make advances in our developer platform by expanding Microsoft’s Graph APIs and opening Skype to developers.  This is generating developer momentum.  In fact, Active Apps calling on Microsoft Graph APIs are up month over month.

In business process application, our Dynamics product line is expanding to include new scenarios, such as IoT, field service, customer self-service, and built-in business intelligence and advanced analytics.  For example, Ecolab uses CRM Online with Azure IoT not only to help their customers use water systems more efficiently, but also to predict equipment failure and direct field engineers to respond.  And Just Eat in the UK uses Dynamics AX to make it easy for millions of people to order food for takeouts online.

These scenarios are driving new growth.  Dynamics CRM Online seats more than doubled this quarter with over 80 percent of our new CRM customers deploying in the cloud.  We grew Dynamics AX revenue double digits.

Now let’s move to the Intelligent Cloud segment.  The cloud is being built into every organization’s quest to optimize and grow.  With our results this quarter, it remains clear we’re one of the two leaders in this market.  Azure revenue increased 120 percent in constant currency with revenue from premium services growing triple digits for the seventh consecutive quarter.

We’re innovating in new areas to help organizations digitally transform.  We’re expanding our competitive strength in hybrid computing.  We’re generating opportunity for developers and partners.  To start, we added more differentiated to high value services in Azure this quarter in three areas that are top of mind for our customers, artificial intelligence, IoT and business analytics.

We expanded Cortana Intelligence Suite, our big data and analytics service that transforms data into predictions and intelligent action.  It now includes over 20 cognitive services ranging from object and emotion recognition to text and linguistic analysis.

The IoT market is expanding as companies look to deliver new services and value.  Our new Azure IoT suite streamlines the process of building IoT applications and acts as the hub for managing and monitoring millions of assets.  Each week more than two trillion IoT messages are processed by Azure.

And analytics is another rapidly growing market where Power BI has more than 200,000 customers and five million users.  Companies like Toyota, BMW, Johnson Controls are all using Cortana Intelligence Suite, Azure IoT and Power BI to transform themselves as well as their industry.  Siemens is also using Azure to connect and analyze data from medical imaging systems around the world, helping providers in their effort to transform healthcare.

We are the only cloud provider that helps companies embrace the cloud on their own terms.  And we continue to innovate in areas that make it easier for our customers, including the recently released preview of Azure Stack, and by bringing SQL Server to Linux.

A critical part of this flexibility is giving customers tools to secure their data wherever it is, on premise, in the cloud, and across all their devices.  We continue to grow in this market with Enterprise Mobility Suite customers more than doubling to over 27,000.  This is three consecutive quarters of triple digit customer growth.  This growth is driven by strong adoption across cloud services.  For example, more than one-third of our Office 365 Enterprise Suite install base has also purchased Enterprise Mobility Services.  And as I said earlier, perhaps the biggest impact we can make is to empower developers.

To this end we are making Windows and Azure the very best environment for developers who want to build applications that run across multiple platforms.  Our acquisition of Xamarin and the inclusion of Bash in Windows 10 will make it easier to build intelligent experiences and apps that leverage our cloud and run natively on Windows, iOS, and Android.  We were excited to announce at Build that we are making Xamarin freely available as part of Visual Studio.

Now let’s move to More Personal Computing segment.  We are reinventing personal computers and personal computing for the mobile-first, cloud-first world.  In this world what matters most is the mobility of a person’s experience, not any one single device.  As I shared last quarter we think about our strategy along three lines.  First, we will deliver more value and innovation, particularly for enterprise customers.  Second, we will grow new monetization through services across the unified Windows platform.  Third, we will innovate in new device categories, in partnership with our OEMs.

First let me talk through the innovation we are delivering that brings new levels of ease of use, trust, productivity to Windows and specifically more value to our enterprise customers.  What we hear most frequently from these customers is how much they value the advanced productivity, security, and device management capabilities in Windows 10.  In fact, this is what led to one of the most security-conscious organizations in the world, the United States Department of Defense, to upgrade all of their PCs and mobile devices to Windows 10 this year.

We see this trend across our enterprise customers with 83 percent of them in active pilots today.  We believe enterprise deployments will continue to drive up the over 270 million monthly active devices running Windows 10.  The number of Windows 10 devices is twice that of Windows 7 over the same time period since launch.

At Build we gave people more reasons to upgrade, with the announcement of new features in ink and touch interfaces, as well as Windows Hello biometric security, and deeper integration with Cortana, all coming this summer with the Windows 10 anniversary update.  Second we are seeing new monetization through services across the Windows platform.  Window Store received more than 5 billion visits.  We are excited about compelling new apps coming from Disney, Square Enix, Bank of America, King, Instagram, and many others.  We grew the number of Universal Windows App developers 60 percent this quarter.

In search developers have already built over a thousand apps designed for Cortana.  These new third party experiences and the 6.3 billion questions people have asked are helping make Cortana smarter and driving search engagement.  Over 35 percent of our search revenue last month came from Windows 10 devices.

In gaming monthly active users of Xbox Live grew 26 percent year-over-year, driven by the growth of Xbox One and Windows 10.  Xbox One continues to outpace prior generations in both reach and engagement.  At the same time we continue to create synergies between Xbox One and Windows 10 devices.  Bringing top Xbox One titles to Windows store helped grow gaming hours on Windows 10 by 50 percent over last quarter.  And starting this summer Universal Windows Apps will run on Xbox One making it easy to build applications and games that work across devices.

Third, we continue to innovate in new device categories in partnership with our OEMs.  We are pleased with the results from Surface this quarter.  This is our second billion dollar revenue quarter for Surface in a row.  And it’s the first outside of a holiday period.  Revenue grew 61 percent in constant currency driven by Surface Pro 4 and Surface Book.  Certainly consumers value these devices, but where we see the strongest momentum is through adoption in the commercial space with particular strength in financial services, manufacturing and healthcare.

Our OEM partners are also innovating in new device areas for consumers and business customers.  In particular they too are seeing growth in the two-in-one device category.  As you can see, we think about renewing growth of Windows.  We think broadly about where growth can come from.  We see early signs of success in Windows driving increased engagement and monetization of services like search, store, and gaming, as well as new sources of revenue from Surface.  As we build premium devices in premium categories we are also stimulating demand across our entire ecosystem.

Ultimately the largest potential for Microsoft’s growth will come through reinvention of personal computers and personal computing, as well as the new platforms we create.  This broader mobile-first, cloud-first opportunity cuts across all of our financial segments and technology ambitions.  And this is what we shared with developers at Build and with business leaders at Envision a few weeks ago.  I hope you have had a chance to watch these events, as well.

We are creating entirely new ways for people to interact with technology and also new ways for them to build technology.  HoloLens Developer Kit is one such example, organizations around the world like Volvo and NASA are using HoloLens to redefine what it means to build and explore.  And Case-Western University is redefining how students learn to be world-class surgeons.

Conversational interface is another example.  We envision a world where people will more naturally interact with their devices in the future through conversation.  Imagine simply asking Cortana to book a hotel, or being able to order a pizza through instant message in Skype.  Conversations will be a new platform that every business, every app and every website will begin to embrace.  And we are at the forefront driving this platform shift.

We are building out cloud services and platform to enable every business across every industry to digitally transform themselves and in turn build their own capability to create more digital technology.  Empowering people and organizations to thrive in this digital world is central to Microsoft’s mission.  I’m proud of our execution so far and what we have achieved.  And I’m also grounded in the work ahead of us.  With that I’ll hand over to Amy to go through this quarter’s results in greater detail and share our outlook for the next quarter.  And I look forward to rejoining you after that to answer questions.

AMY HOOD:  Thank you, Satya, and good afternoon, everyone.

This quarter revenue was $22.1 billion, up 2 percent, and up 5 percent in constant currency.  Gross margin declined slightly, but was up 4 percent in constant currency.  We grew operating income this quarter by 1 percent and 10 percent in constant currency.  And earnings per share was 62 cents, flat year-over-year, and up 10 percent in constant currency.  Our effective tax rate was 24 percent, higher than we anticipated, which impacted our EPS.

From a geographic perspective our performance in most markets was as anticipated.  However, Latin America, the Middle East and Africa, were more unfavorable than we expected.  In our commercial business we continue to see healthy fundamentals, which led to a solid quarter of results.  Commercial bookings increased 7 percent, up 9 percent in constant currency.  Our total commercial annuity business had double digit revenue growth in constant currency.  And commercial annuity mix reached 86 percent, up four points year-over-year.

Commercial unearned revenue grew to just under $18.8 billion, up 3 percent and 8 percent in constant currency, slightly below expectations due to a higher mix of contracts with more in-period recognition and some deal weakness in the geographic markets mentioned earlier.  Our contracted not billed balance again exceeded $25 billion.  Most important, as Satya mentioned earlier, our commercial cloud annualized revenue run rate surpassed $10 billion.  This quarter more than 65 percent of customers who signed enterprise agreements attached our commercial cloud offers, up 15 points from last year.  Our customers continue to make long-term commitments based on our compelling roadmap.

Our commercial cloud gross margin was 45 percent this quarter, declining year-over-year.  The decrease was driven by a higher mix of Azure revenue, our ongoing investment in data center capacity and geographic expansion and the small FX headwinds.

As I mentioned last quarter, even as we are focused on gross margin improvement within each of our key cloud services, our total commercial cloud gross margin will reflect the dynamics of the changing revenue mix and the targeted investment.

In Q3 the FX impact of three points on year over year revenue growth was generally in line with the guidance.  As the recent weakening in the U.S. dollar created less than 1 point of impact overall and across segments.  As Chris explained earlier, we’re not able to provide constant currency impact at the segment level for operating expenses, and therefore segment operating income.  In general, FX had a favorable impact of one point on operating expenses at the total company level.

As expected, our company gross margin percentage declined this quarter driven by our accelerating mix of cloud services in our Intelligent Cloud and Productivity and Business Processes segment offset by higher gross margin percentage performance from products within More Personal Computing.

Segment gross margin increased 2 percent or 6 percent in constant currency driven primarily by gross margin percentage improvements in devices and gaming.  Operating expenses decreased 14 percent primarily through our actions in phone and the transition of our display business to AOL.  As a result, segment operating income grew 57 percent.

Second, our commercial business.  Our commercial business will be on pace for continued strong annuity growth as both new and existing enterprise customers adopt and use our growing portfolio of cloud services, even with projections of tightening global IT spend and currency headwinds, we expect commercial unearned revenue to be $24.3 to $24.5 billion, in line with historic seasonality.

We remain on track toward our $20 billion commercial cloud revenue run rate goal as we  grow revenue, drive consumption and focus on gross margin improvement and Office 365, Azure and Dynamics Online.

Finally, we will continue our investment in data centers and capital equipment to address customer demand for our cloud services.

With that, let me share our view by segment.

In Productivity and Business Processes, we expect revenue to be $6.5 to $6.7 billion with continued annuity shift to the cloud offsetting the impact of a weaker PC market on our transactional business in our consumer and commercial segment.

In Intelligent Cloud, we expect revenue between $6.5 and $6.7 billion driven by annuity growth offset by continued transactional weakness.

In More Personal Computing, we expect revenue between $8.7 and $9 billion.  Here’s a bit more detail on its individual components.  In Windows, we expect our OEM Pro revenue to be largely in line with the commercial PC market.  Our non-Pro revenue is expected to be above the consumer PC market similar to what we saw in Q3 primarily due to the continued benefit from a strong mix of premium devices.

In devices, we anticipate continued momentum and growth for Surface Pro 4 and Surface Book, particularly with business customers.  For phone we expect year over year revenue declines to deepen in Q4 as we work through our Lumia channel position.  In search we will continue to show healthy revenue growth with full year profitability.

Finally, in gaming, we expect to see continued healthy user engagement on our Xbox platform and we look forward to E3, where we will announce new titles for the upcoming fiscal year.  We expect COGS to be $7.8 to $7.9 billion.  We expect operating expenses between $8.2 and $8.3 billion.  Our full year guidance is now down to $31 to $31.1 billion, as we concentrate our investments in engineering and technical sales to accelerate our cloud growth heading into the next fiscal year.

We expect other income and expenses to be negative $200 million in Q4.  This includes the net cost of hedging and interest expense, offset by dividend and interest income.  For tax, based on trends reflected in this quarter’s full year catch up adjustment we expect our Q4 effective tax rate to be 21 and 23 percent.  We expect our full year effective tax rate to be between 20 and 21 percent.

Before I wrap up I’d like to share a few directional comments on Fiscal ’17.  This year we saw strong growth in our commercial cloud portfolio.  And we grew our annuity penetration across our commercial business.  We anticipate those trends will continue next fiscal year, driving our revenue growth and impacting our gross margin percentages.

As we continue to unify and modernize our Windows install base across our consumer and business customers, we will advance our progress and our post-sale monetization scenarios and execute on the Windows 10 enterprise deployment opportunity.  Throughout Fiscal ’16 our significant investment in engineering, sales, and marketing has positioned us to support our customers’ digital transformation and to innovate in device form factors, like Surface and HoloLens.  In Fiscal ’17 we expect to continue that investment and reallocation process.  Therefore, total operating expenses should be flat to up slightly. I look forward to sharing more on our FY ’17 plans in July.

With that, Chris, let’s go to Q&A.