Below is transcript of the Microsoft Corporation (NASDAQ:MSFT)’s Fiscal Year 2015 Second Quarter Earnings Conference Call, held on Monday, January 26, 2015, at 5:30 pm EST. Valueact Capital, Route One Investment Company and Edinburgh Partners was among Microsoft Corporation (NASDAQ:MSFT) shareholders at the end of the first quarter.
Microsoft Corporation (NASDAQ:MSFT) is engaged in developing, licensing and supporting a range of software products and services. The Company also designs and sells hardware, and delivers online advertising to the customers. The Company operates in five segments: Devices and Consumer (D&C) Licensing, D&C Hardware, D&C Other, Commercial Licensing, and Commercial Other.
Company Representatives:
Chris Suh – General Manager of Investor Relations, Microsoft Inc.
Satya Nadella – Chief Executive officer, Microsoft Inc.
Amy Hood – Chief Financial Officer, Microsoft Inc.
Analysts:
Mark Moerdler – Bernstein
Brent Thill – UBS
Walter Pritchard – Citigroup
Keith Weiss – Morgan Stanley
Rick Sherlund – Nomura
Philip Winslow – Credit Suisse
Heather Bellini – Goldman Sachs
Raimo Lenschow – Barclays
Brendon Barnicle – Pacific Crest Securities
Ed McGuire – CLSA
Operator: Welcome to the second quarter fiscal year 2015 Microsoft corporation earnings conference call. At this time all participants are in listen-only mode, question and answer session will follow on from presentation. When you require operators assistance during the conference please press *0 on your telephone keypad. As a reminder this conference is being recorded, I would now turn the call over to Chris Suh, General Manager of Investor Relations. Chris, please proceed.
Chris Suh: Thank you. Good after noon and thank you for joining us today. On 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. On our website microsoft.com/investor we have posted our press release and a file that provides a summary of our results this quarter. Unless otherwise specified all growth comparisons we make on call today relate to the corresponding period of last year. Additionally any mention of operating expense refers to segments operating expenses as defined in the foot notes of our 10Q and includes research & development, sales & marketing and general and administrative but excludes integration and restructuring charges. We will post the preparatory remarks for 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 January 26, 2016. During this call we will be making forward-looking statements which are predictions, projections or other statements about future events, these statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ because of factors discussed in today’s earning press release, in the comments made during this conference call and then the risk factor section of our form 10-K, form 10-Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statements and with that I will turn the call over to Satya.
Satya Nadella: Thank you Chris. Good after noon everyone. Today I will focus my top line talks on our progress this quarter and the progress we are making in transforming our business. This quarter we reached 26.5 billion in revenue with an operating income of 7.8 billion. This quarter results shows the product and business transformation under way at Microsoft. We saw success in a number of our strategic areas including cloud adoption, redefining and revitalizing the Windows Eco System and improving economics in our hardware portfolio. We also saw some challenges this quarter, as expected the one-time benefit of Windows XP end-of-life PC refresh cycle has now tailed off, additionally we ran into unexpected issues in select geographies. Where there are execution issues, we will address them where there are macroeconomic challenges we will weather them. With that in mind I’ll walk you through the quarter. Let’s start with our cloud business, an area where we are extending our leadership position and accelerating our innovation. In commercial cloud, we saw continued customer and revenue growth across the growing footprints of cloud services, Office 365, Azure, Enterprise Mobility Suite and Dynamic CRM online.
In fact this quarter is the 6th consecutive quarter of triple digit revenue growth in commercial cloud and we are now at a run rate of $5.5 billion. Azure services continue to grow in appeal to enterprise IT and developers with rapid improvements across hybrid services, premium cloud storage and virtual machine offerings, enhance data and data analytics offerings. Microsoft enterprise mobility suite is one key area of product innovation that I would like to highlight given the growth in the uniqueness of this offering. Microsoft offers a comprehensive solution for all devices that brings together mobile device management, mobile application management, hybrid identity management and data protection into one unified offering through EMS. Office 365 now includes new application experiences on all phones and tablets for mobile productivity, further we have released completely new scenarios. This includes Office Sway for visualizing and sharing ideas, Delve to help search and discover content, Office 365 groups to make it easier to collaborate, Office 365 video for secure media streaming for businesses. Finally we continue to invest in enterprise value by integrating MDM and enterprise mobility suite into office 365, new encryption technologies, compliance certification and new E-discovery capabilities in exchange.
In dynamics CRM online, we added 53 markets this quarter bringing us 130 markets around the world. We are bringing together CRM with Cortana, Yammer, Power BI and Skype to add unique value to customers. We are expanding our capabilities in the cloud through 5 new acquisitions, last week we announced an agreement to purchase revolution analytics, the leading provider of statistical computing and predictive analytics which will enable our customers to unlock big data in sites. We bought Hockey App, a leading mobile app testing and development service to enhance azure services for mobile developers. Our acquisition of Arvato accelerates our ability to give customers unique security capabilities by tapping into behavioral intelligence on our identity and access spending on premise and the cloud. We are bringing on new capabilities in machine learning as applied to e-discovery and other enterprise compliance processes with the acquisition of Equivio and we also welcomed Acompli, a provider of innovative mobile e-mail applications for IOS and Andriod. The common theme across all these acquisitions is advanced data analytics and machine learning driven capabilities that improve with more customer adoption and usage of the cloud. We are also making progress in our consumer cloud services. Office 365 home and personal revenue grew nearly 150% year-over-year as we added 2.1 million net new subscribers since last quarter. Bing US-search share continues to grow as the search revenue with 23% growth this quarter.
I will talk about our progress in Xbox live later in my comments. Now let’s turn to Windows, to start the overall Windows ecosystem is driving more innovation over the holiday season at CES. Our partner showcased the diverse lineup of Windows devices including more premium device choices than ever. Last spring we made a strategic decision to introduce new Windows pricing program to drive unit growth and opening price point PCs as well as tablet and in this quarter we saw year-over-year growth.
Also businesses continued to value Windows, we have seen healthy demand for Windows Pro even though we face challenging prior comparable in Q2 as well as in the second half of the year following the Windows XP end of support related PC refresh. Now let’s talk about Windows 10, last week was an important milestone on our path to release Windows 10 and usher in an era of more personal computing. The heritage of Windows was about enabling one single device the PC, with Windows 10 we are rebuilding a device platform for the mobile first cloud first world. It’s a world where the mobility a person’s experience is paramount, requiring a platform that spans devices from small screens to large-screens to no screens at all. It’s a world where interacting with technology that’s natural as interacting with other people and it’s a world that demands trust and security, it is also world with rich opportunity for developers and window 10 will be the most attractive Windows development platform ever with our free upgrade offer and with universal application and unified store for developers, we will have a large unified up-to-date user-base to target.
We want people to love Windows and have made this almost collaborative project yet, with more than 2 million insiders giving us feedback every day, I’m very optimistic about Windows 10. We are making progress with our own devices for those in the market today and also the one that we’ve recently announced. This quarter we surpassed the 1 billion revenue mark with surface for the first time. The value proposition of being the most productive tablet is resonating, further the sales for Lumia phone’s top 10 million units growing 30% year-over-year this quarter with strength in devices such as the Lumia 500 and 600 series, are affordable smartphones. In this segment of the market the combination of our brand and value standout and we plan to continue to build a beachhead year. We are also creating new device types that open up new markets and opportunities for Microsoft.
In October we launched our first wearable the Microsoft band and just last week we revealed two new hardware with Windows 10, with Microsoft surface Hub, and Microsoft HoloLens. Microsoft Surface Hub will revolutionize group collaboration and meetings, HoloLens and Windows holographic computing will make mixed reality applications part of everyday life across work and home. I want to talk briefly about Xbox, Xbox One console adoption accelerated this holiday and was the top-selling console in the US and fans on Xbox live were engaged with the service more than ever before, however it’s our strategies coming together with window 10 that give me the greatest optimism. The vibrant social gaming community on Xbox live will span Xbox, Windows PCs, Tablets and phones With window 10, gamers on a PC, Tablet or Xbox console can play together and games on Xbox One can easily stream to a window 10 PC or tablet.
It’s also getting clear how games people love today will evolve to mind blowing experiences in the future when designed for mixed reality that window 10 and HoloLens create. Just imagine what’s possible with Minecraft, gaming truly is a valuable part of millions of people’s lives and Microsoft will excel and increase our lead. Before closing I want to share few thoughts on capital allocation. Over the past several quarters and certainly with last week’s Windows 10 announcement, you’ve seen us unleash new innovation in our cloud services with Windows and our hardware. We did all of this without materially growing our cost-base, this required clarity in purpose and value proposition realignment of talent and disciplined execution. Our increasing innovation and competitiveness in today’s growth markets and the creation of new categories is how we would most positively impact the returns for our investors. Earlier today we announced our intention to complete the existing $40 billion share repurchase authorization by December 31, 2016. This is another step in our ongoing commitment to increase capital return for our shareholders while investing in the growth of our business. It too shows our optimism for the future growth of Microsoft. As we move forward, we will certainly continue to be thoughtful in our capital return decisions, balance across dividends and share repurchase.
In closing I’m encouraged by the progress we’re making in our transformation to become the productivity and platform company for the mobile first cloud first world. I’m proud of how our teams are stepping up to both change and execute to make this transformation happen. I’m confident of the decisions and choices we’re making to drive our business and products forward to serve our customers and partners in the future, with that I will hand over to Amy to go through the quarter’s results in further detail and share our outlook for the next quarter. I look forward to rejoining you after that to answer your questions, thank you.
Amy Hood: Thanks and Good After noon everyone. I start to share and [inaudible] we again made solid progress on our business transformation. We had strong growth in our cloud and subscription businesses, our annuity renewals were healthy as customers remain committed to our enterprise portfolio and our hardware products performed well during the holiday season. As we expected our year-over-year growth rates were impacted by the prior year benefits that we realized in our OEM and Office transactional businesses following the Window XP end of support refresh cycle. Beyond that our results in China and Japan fell short of our expectations. In Japan the PC market lagged due to their [inaudible] economic environment along with the combined impact of XP end of support and the VIT increase last year. Our Office attached right to PCs is very high there so the weak PC market also impacted Office revenue.
With that said let me take you through the financial highlights of our 2nd quarter. Revenue was $26.5 billion up 8% and would have been 1 point better without the impact of foreign exchange, gross margin grew slightly this quarter even when comparing against the year ago that benefited from the XP refresh cycle. Our commitments to ongoing execution improvement and thoughtful portfolio management help improve the gross margin percentage in each of our operating segment. Operating income declined 2% which included $243 million of immigration and restructuring expenses, excluding that operating income grew 1%. A reporting gap earnings-per-share was 71cents was including a 2 cent negative impact from immigration and restructuring expense and a 4 cent income tax charge for an IRS audit adjustments. Foreign exchange had a 1 cent negative impact on EPS.
As we discussed last quarter FX movement first impact our bookings growth and unearned revenue on our balance sheet are contracted but not build balanced was adjusted down to reflect current FX rates, therefore our booking were flat this quarter. On our revenue we got 9% year-over-year to $21.2 billion but the sequential decline was slightly larger slightly higher than we expected due to the larger than anticipated impact from FX. Adjusting for that FX impact, our commercial unearned balance was in line with historical trends and our expectations. From the geographic perspective relative to our expectations, the US outperformed and Europe was generally in line. As I mentioned earlier China and Japan were below our expectations…with that backdrop I will now move to detailed discussion of our results.
Last year we added support for Windows XP that stimulated a PC refresh cycle, in particular in developed market and with business customers. During the period from Q2 through the end of our fiscal year, Windows Pro revenue growth was over 10% and meaningfully outpaced business PC growth. As expected in Q2 PCs have reverted to a more normalized mix between developed and emerging markets and Pro attached to business PCs has returned to levels we saw prior to FY 14. Also to drive revenue growth in academic institutions we lower the price of Windows Pro for that customer segment, this pricing change along with the impact of XP caused Windows revenue growth to be lower than a relatively stable Business PC market we’ve seen since the end of FY 13.
We again grew Windows non-Pro licenses and saw year-over-year growth in activations, this was driven by particularly strong demand for opening price point PCs related to the strategic decisions that just spoke of earlier. The hybrid mix shift to opening price point PCs impact the license mix and therefore aggregate revenue per license in the quarter. The mix shift was the main driver of our Windows non- pro revenue decline. Inventory in the channel is a bit higher than normal which we expect to work through in Q3. Office consumer products and services revenue declined 12% and was impacted by the ongoing transition to Office 365 and by the dynamics in Japan. Our PC growth was lower than we expected in a geography where the paid attach to Office is high. Adoption of Office 365 Home and Personal remained strong and we now have over 9.2 million subscribers.
In our computing in gaming segment we are proud of the continued progress we’re making in our Surface portfolio. Strong interest in Surface Pro 3 helped to drive record revenue as well as improved gross margin, Surface Pro 3 volumes are pacing over three times the rate of what we saw for Surface Pro 2. In gaming, Xbox One was the console sales leader in the US, Xbox live users grew and those users increase their purchases as third party publisher content and consumable. Sales of the Xbox platform exclusive Halo, The Master Chief Collection and Forza Horizon 2 were strong and this quarter we welcome Minecraft.
We articulated our plan for the phone business back in July and we are executing to plan. With our Lumia portfolio as phone we are driving volumes in the low priced device category, we sold 10.5 million Lumia phones this quarter, an all-time high. We also sold over 39 million non-Lumia phones even while we make changes to the product portfolio and manage this business for profitability. We are looking forward to bring new products to market that will showcase the features that we presented at our Windows 10 event last week. Revenue on our devices and consumer other segment grew 30%, as those of earlier Xbox Live transactions and first party games performed well and contributed to this growth, additionally search revenue growth were strong with improvements in both rate and volume. Within display, revenue declined on MSN portal tough we saw revenue growth across other Microsoft properties.
We are also pleased by our growth margin expansion in this segment. Transitioning now to our consumer results, our revenue grew 5%, our annuity revenue remained strong growing double-digits and renewal rates remained high, customers are continuing to move from transactional purchasing to long-term annuity contracts as they show an increased commitment to our product roadmap. Our transactional revenue declined over 15% slightly more than we expected primarily in office and mostly due to our performance in China and Japan which I detailed earlier. Additionally FX had a greater negative impact on commercial revenue than we had anticipated. Our commercial cloud services delivered triple digit revenue growth for the sixth consecutive quarter, Office 365 continues to be priority for CIOs as both existing and new customers move to the cloud. This transition accelerated with 45% of our renewal season office moving to cloud this quarter.
We are seeing great growth in revenue from premium azure services driven by both the increasing customer base and an expansion in the number of services that those customers deploy. Within [inaudible] online customer growth accelerated and revenue nearly doubled. For our product perspective, commercial office product and services revenue declined 1% slightly below our expectations. Annuity revenue remained strong with higher renewal rate and continued adoption of Office 365. Within our Office transactional business year on year comparable are difficult given the benefits from last year’s XP refresh where customers chose to update their desktop productivity solutions along their PC. Additionally the shift off to Office 355 continues to impact transactional revenue. While these dynamics were consistent with our expectations revenue in China and Japan both fell short given the factors that I noted earlier.
Server products and services revenue grew 9% again outpacing the broader IT market. Growth in premium mix helped to drive double-digit revenue growth in SQL Server and system center. Windows server annuity revenue grew double-digit again this quarter, the transactional revenue was down primarily due a declining traditional server market. Additionally we are pleased with the performance in our dynamics business which grew revenues 13% driven by growth in both on premise and cloud offerings. Operating expense grew 1% to $8.3 billion and was favorable to our expectations. These results are inclusive of investments that we made in our strategic growth areas, a few of which were showcased last week at Windows 10 event. Excluding approximately $750 million from the addition of NDS, operating expense would have declined 8%. Relative to the guidance that we provided for the quarter roughly half of the favorability resulted from FX changes with the balance driven by our continued prioritization [inaudible] . Our integration and restructuring efforts have been focused on optimizing resources across the company which includes reducing the expense base in our phone business.
To date we have integrated the manufacturing and supply-chain teams across Microsoft while also rationalizing our phone manufacturing capacity. In operating expense we committed to reducing $1 billion from the phone cost base which we have done to continue to look for opportunities to try further efficiencies. Our effective tax rate was 25% and higher-than-expected due to previously mentioned income tax charge per IRS audit adjustment, beyond that the increase was driven by the inclusion of phone result in our changing geographic mix. Capital expenditures were $1.5 billion driven primarily by investments to increase our capacity as we expanded existing and added new data centers as well as main server purchases in support of our fast growing cloud business. This quarter we increased our capital return by 5% to $4.5 billion return to shareholders through buybacks and dividends, and in fact to reinforce these comments we will continue to take thoughtful steps to increase capital returns to shareholders with a focus on value.
With that overview of the current quarter let me now turn to our outlook. Our guidance is based on our current view of the FX rates. Should the US dollar strengthened beyond those assumptions as it did this quarter we would see additional negative impact to earnings, revenue, our balance sheet and our contracted but not billed balanced.
As a reminder in our annuity businesses the FX impact is first reflected on our revenue which is recorded at a rate when the contract is build, then revenue comes on to the P&L at that same rate as it is recognized generally over the next year, therefore in Q3 we will start to recognize a higher percentage of revenue from periods with a stronger US Dollar than the prior year comparison in total we expect that FX from negatively impact revenue growth by approximately 4 points in Q3. The majority of this impact is in our commercial business. In FY 14 it was our Q2 to Q4 results that most benefited from Windows XP and it’s support. As such our growth rates across Windows Pro and transactional office will be impacted if our business moves back to pre-XP levels. On a geographic basis we expect a year on year revenue declines in China, Russia and Japan.
In Japan Q3 represents an even tougher comparison with the anniversary of the VHA which again will create different comparable, difficult comparable in Windows and Office. We currently expect the geographic dynamics challenging comparable from XP and FX had once would be in placed throughout the remainder of our fiscal year. With that overall background let me move to our specific Q3 guidance. Starting with devices and consumer, revenue guidance includes approximately 4 point drag from FX, in licensing we expect revenue to be $3.4-$3.6 billion this range seems to more challenging comparable I mentioned earlier. The range also includes the reduction channel inventory for Windows non Pro opening price point PCs.
Within consumer office we expect to see similar trends to Q2 and within our IP licensing business, we expect lower per unit royalties with the changing mix of devices sold by our licensees.In computing and gaming we expect the revenue to be $1.5 to $1.7 billion, this range reflects normal seasonality coming out of the holidays for Xbox and Surface businesses.
In phone hardware we expect revenue to be $1.4 to $1.5 billion, this range anticipates accelerating year-over-year growth in Lumia units driven by our affordable smartphone devices. We also expect both volumes and ASP’s of non Lumia devices to continue to decline in Q3, with this lower aggregate revenue base we expect gross margins which include non-cash amortization to be lower for the next couple of quarters.
In devices and consumer other we expect revenue to be about $2 billion reflecting continued progress in key areas like Office 365 home and personal, Xbox live and search. In our commercial business we expect our significant momentum in annuity and commercial cloud services to continue. Within our commercial licensing segment we expect revenue to be $9.7 to $9.9 billion. In addition to the factors that I discussed which impact our year over year comparability we anticipate a 4 point drag from FX. In commercial other we expect revenue to be $2.6 to $2.7 billion even after considering the impact of FX, growth will remain robust with expected momentum across our commercial cloud portfolio, Office 355, Azure and CRM online. And in corporate we don’t expect any revenue impact.
As we continue to work towards the launch of Windows 10 we will share additional detailed information regarding any accounting impacts from the Windows 10 free upgrade offer and Windows as a service. I would like to reiterate our OEM royalty model which is paid upfront will remain in place. We expect COGS to be $7.1 to $7.4 billion with variability driven by both hardware segments, we expects third-quarter operating expense to be $8.2 to $8.4 billion, we are lowering our full year guidance to $33.2 to $33.6 billion which reduces full year growth including NDS to 4 to 5%. Our Q3 plans include investment in advertising and customer facing role to continue to accelerate our momentum with commercial products such as SQL and the cloud, these investments are a direct result of our prioritization decisions made during H1.
Over the remainder of the fiscal year we expect incur an additional $200 million of restructuring expense, this results in total charges of roughly $1.4 billion which is lower than our previous guidance. Separately we still expect integration expense of a hundred million dollars per quarter for the remainder of the fiscal year. As a reminder other income and expense includes dividend and interest income, offset by interest expense and the net cost of hedging. Given the current FX environment we expect other income and expense to be negative $100 million in Q3, we now expect our full year tax rate to be between 22% and 24%, this includes the Q2 income tax charge for an IRS audit adjustment as well as the changing geographic mix of our business. In Q3 we expect CAPEX to sequentially increase in support of our growing cloud business. Unearned revenue will continue to benefit from customers moving towards our subscription services and high contract renewal rates. We expect to see low single-digit sequential decline in our unearned for Q3 which includes 1 point drag from FX as new billing will reflect the impact of the strengthening US dollar. Our commercial unearned balance will follow recent historical seasonality when adjusted for FX.
In closing, this quarter was another example of the progress that we are making across this company, our execution continues to improve and we are making data-driven decisions to inform more investments of shorter-term as you have seen in our marketing and sales adjustments as well for the longer-term as we adjust our product portfolio. There are certainly short-term comparability challenges as we anniversary last year’s XP refresh cycle and see the impact of strengthening US dollar, but we are confident in the underlying health of our business, proud of the significant innovation we are funding within our prioritized operating budget and excited to continue gaining share in key strategic markets. Before I hand it back over to Chris I would like to announce that we will be webcasting a briefing for the investor community on April 29th in conjunction with our build developer conference in San Francisco. We will share more details as we get closer to the date. With that I turn it back over to Chris and we can move to Q&A.
Chris: Thanks Amy. With that we will now move to the Q&A. Operator can you please repeat your instructions?
Operator: Thank you. We will now be conducting a question and answer session. If you would like to ask a question please press *1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. Press *2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please as we poll for questions, thank you. Our first question comes from the line of Mark Moerdler of Bernstein. Please proceed with your question.
Mark: Thank you very much, I appreciate it. Amy can you give us a bit more details on what is driving the increase in cloud margins within the commercial office segment as well as any sense of how creative the cloud is becoming? Then I have a follow up question.
Amy: Sure, why don’t I talk a little bit about that from a math perspective and I’ll let Satya add from some of our engineering improvements which I think is important. Mark, as I talked a bit about, we’ve seen some mix shift as we have moved Office 365 and Azure to our premium service and to our premium queues within our cloud environment. That is one of the drivers that helps improve margin growth. In addition, we have done a lot of hard engineering work I believe over the past 6 quarters to be able to take advantage of more utilization and capacity over time and I’ll let Satya add a little bit technically.
Satya : Overall, the shift to the higher layer services on is the real driver here which is…obviously Office 365 and its various levels is one factor. The other one is what I talked about in the Enterprise Mobility Suite. That’s really got fantastic momentum in the marketplace because the solution has really come together and it’s fairly unique, as well as dynamic CRN. So these are all got a different profile in terms of margin and they’re all pretty high growth businesses for us so when you think about our cloud you’ve got to think about the low level infrastructure. Even there, we now have premium offerings and then we have higher level services so that aggregate portfolio is what helps us move up the margin curve.
Mark: One quick follow up. How should we think about monetization with Windows devices sub 9”?
Satya : One of the comments I had made in my remarks was some momentum we are seeing is in our consumer cloud services so for example the store modernization, Bing modernization, Xbox Live modernization as it is now going to span devices, are all things that drive modernization for bellow 9”. I think of device growth margin in some cases because we are building devices such as the phones, as well as post sale monetization using our consumer cloud services as the two additional levers that we have in order to be able to monetize Windows devices.
Mark: Thanks, I appreciate it.
Operator: Our next question comes from Brent Thill from UBS. Please proceed.
Brent: Thanks. Just on the XP tailoff, are there other commercial products seen being impacted? I just want to be clear, there were a lot of questions that is there some sort of Halo impact from the XP taking growth down on the other solutions.
Amy: Sure Brent, thanks for the questions. I think it’s the exact product portfolio that we talked about last year when the impact was happening so let me take this opportunity to walk you through those components again. Obviously there’s a very direct impact which we talked the most about in terms of Windows Pro and its mixed when attached to Business PCs. The other important component of that is when people bought a PC, as we talked through the year, they often took the chance whether generally in the business segment which impacts in our world commercial licensing as a reporting unit to buy Office and generally on a non-annuity basis. So if you think about that being the next major transactional type purchase that was driven a year ago as the first externality. The second was that in Windows VL we also saw non-annuity purchases in Windows VL which again is in our commercial licensing segment. If you think about it from a product portfolio it really is Windows and Office, if you think about it from our reporting segments, it’s the DNC licensing segment as well as our commercial licensing segment and specifically our transactional revenue growth year over year.
Brent: Okay and quick follow up, just on the reduction and operating expenses for the full year, is this across the board Amy or is there a particular area that you’re finding more opportunity to cut?
Amy: Brent, thanks again. I actually think of it as a general concept. We are trying to invest behind opportunities where we see them and some of those are more public like we talked about as we see it in marketing adjustments or ad campaigns that we run such as the commercial clouds, others you don’t have the opportunity to see until we launch products like we did last week where we were able to reassert our product portfolio and really move our talent to invest in… I guess mind-blowing is the word Satya used…in terms of product portfolio in that way so I’m not sure that all of it Brent I would say is across a line in that way. They are sort of short term optimization and longer term portfolio optimization that, I think we’ve talked about this before, I think the entire senior leadership team views it as an opportunity to see where we can best innovate and drive the highest value of every dollar that we invest and I think that we’ve made great progress as a team. I think you’re seeing that both in the long term guidance and frankly our day to day execution through the quarter.
Satya: I’ll ad that we’re also making pretty significant changes in the very workflow of our engineering teams and that also leads to us getting more out of our current investments so there are significant combinations of culture change as well as how we work change that drives more innovation for the same dollar.
Brent: Thank you.
Operator: Our next question comes from Walter Pritchard of Citigroup. Please proceed.
Walter: Thanks, two questions. One on execution it sounded like you listed some issues in Japan and heard about VET from other companies, can you just talk about what you’re doing to address some of the issues and is there any concern about if that may spread beyond what you see in Japan and China?
Amy: Thanks Walter. Is that both your questions? I just want ot make sure I get them.
Walter: No but I just wanted to understand generally. I had one other but it’s the same.
Satya: I’ll just start with talking about China. We have in China currently a set of geopolitical issues that we are working through. We are very committed to china as a market, we have in fact pockets of good growth in china with our cloud doing fairly well but at the same time we’re grounded that in the fact that we need more work to do and we are working through them and as in when that will work out we’ll let you know.
Amy: And I’ll talk a little bit about Japan and Walter to answer your question, I don’t have any concerns that that will expand especially since this is a unique issue beyond Japan. With the Windows end of XP plus the bad VAT increase, I do think as well as some of the macroeconomic environments that it tightens far faster than we had anticipated and Japan in particular, because it’s a model for us, it is an annuity geography for us so impacts in Japan more directly come to the P&L as opposed to our under CND balances and that’s why this quarter you saw some weakness in commercial licensing but when adjusted for FX and unearned balance and booking felt quite good from a commercial perspective.
Walter: Quick question about the Office 365 commercial, can you talk about the deployment rate there? I know you’ve done a good job of getting them into contracts but how many customers are actually running their email and SharePoint and other products in the cloud versus just having the rights to it?
Amy: Thanks Walter. I think with all products I think about the complete sales cycle and I’m really encouraged by the fact that we’re doing a good job of moving from the initial sales through deployment, through adding on services and back to renewals and I think the importance of that customer life cycle is reshaping how we think about our workloads and our workload health in the cloud. The workload that we’re furthest along on is obviously Exchange and it happens to come also with directory implementation. We generally think of a fast deployment and adding on workflows and premium work cycles and then, as you might imagine, that provides an interesting environment for us to add on some of the products that Satya mentioned directly in his comments such as EMS or enterprise mobility suite. So I think that there’s always a lag, the actual goal is the commitment that the customer shows to the cloud and them moving them as quickly as we can but also at their own pace through deployment.
Walter: Thank you.
Operator: Thank you, our next question comes from the line of Keith Weiss of Morgan Stanley. Please proceed.
Keith: Thank you guys for taking our question. I just want to dig into Windows OEM ASPs a little bit and try to understand the dynamics between what we see in the marketplace when we look at the industry analysts that we’re looking at, basically sort of flat, slightly down unit growth and the down 13% OEM that revenue growth that you guys are seeing. Some of this makes [inaudible] and some of ASP, I wonder if you can help us on with a little bit color on in terms of exactly what that ASP dynamic that’s going on in terms of lower entry level additions, what’s that doing to overall ASP and what you’re able to extract from the market ?
Amy: Thanks Keith. I’ll take the opportunity to do it for both Pro as well as non Pro because I wasn’t sure what category you were talking about. Let me start at the highest level which is. . . if I look at industry analysts as well as many of our peers in the ecosystem I actually think that we agree with most of the benchmarks in terms of PC unit health across business which has been stable since FY13 and across consumer where we see meaningful progress made in unit growth both last quarter and especially this one. Then I’ll take a second and talk about the distinction between the revenue growth versus the unit growth and let me start first in Pro. There are really two dynamics. The first is the return to the XP levels that we saw prior to the XP refresh. They’re consistent, the dynamic mixes in terms of emerging and developed as well as enterprise sizing and it’s not an ASP problem in Pro. It is a return to the attach level we saw before. The component that actually is impact, the second component in Pro that is a “ASP/mix comment” is the academic licenses that I referred to earlier where we did lower the price and saw an increased unit number so that was a second component of the revenue piece but the larger component was XP reversion and again that’s not an ASP comment.
When it comes to non-Pro I think this really refers back to Satya’s comment which is we saw device grow in low price devices opening price points, we actually made, I believe, a strategic decision to increase our ability to put devices on the shelf, especially at retail at prices under $200 to $249, is what I think about the price points that were most impacted. We do have the Windows with being skew there, it is a lower RPL than our traditional non Pro OEM license but I do believe that growing meaningful ecosystems helps as well and throws good competitive dynamics in the channel and so overall while it did have an RPL impact which does explain along with mix shift the minus 13% in non Pro OEM versus the PC license growth that we saw, I think Satya covered the actual logic to that in terms of overall ecosystem health which we feel quite good about.
Keith: If I could squeeze in one follow up, have you guys done any assessment in terms of the success that you’ve seen in Surface Pro 3, definitely is a real productivity device…to what extent is that cannibalistic from what would’ve been Windows PC sales and to what extent do you think you’re expanding the market opportunity with that device?
Satya: I think it’s definitely expanding the market opportunity. One of the things I feel very good about is the risk we took to introduce the two-in-one category and I feel now that it in fact inspired even a lot of activity in our own OEM ecosystem and we see many good designs coming because it’s viewed as a category that drives growth and so. From that perspective, I feel good about leading because that’s one of our strategic goals, we want to create new categories faster and with more demand for the entire ecosystem.
Keith: Thank you very much guys.
Operator: Thank you. Our next question comes from Rick Sherlund with Nomura. Please proceed.
Rick: Thanks. Could you talk about the implications of Windows 10 for a moment? I’m thinking in terms of the new platform for innovation and maybe you can talk about post sale monetization…what do you think the impact is on the demand in the industry and the opportunity for Microsoft around the new platform?
Satya: Thanks Rick for the question. As I said in my remarks, I’m very optimistic about what Windows 10 means for our customers, partners and Microsoft. The core idea of Windows 10 is to build a device operating system that spans the gamut from no screens to small screens to PCs and even large screens. In fact if you look at our innovation, we are perhaps unique in the large screen innovation that we’re doing with Surface, Hub, HoloLens, as well as some of the two-in-one form factors. Overall I think the most strategic objective for us is to get developer momentum with Windows 10 and that’s where we’re focused on with a lot of different actions. One is the one unified developer platform which is what I think is the most strategic piece of Windows 10 along with the unified store and now couple that with the call we made to provide an upgrade offer.
We’re creating a great opportunity for every developer to write these universal Windows applications that will run on the desktop as well as on our phone and tablets and as well as on Surface Hub and in fact HoloLens runs universal applications. No one else provides that sort of a unified marketplace for developers and especially the changes we’ve made to the desktop user interface means these universal applications are in fact very naturally discoverable right where we have high usage which is the desktop. So that’s the combination of things that we think are going to play out effectively and of course we’re in beta right now or previews right now and getting daily feedback across all the length and breadth of Windows 10 but overall I’m very optimistic with what it means both as a platform as well as a set of end-user features.
Chris: Thanks, we’ll take the next question please.
Operator: Thank you. Our next question comes from the line of Philip Winslow of Credit Suisse. Please proceed.
Phil: Thanks guys. I just have a question on the commercial other line. Obviously that continues to show strong growth, even high up where the cloud seems to be with Azure and Office 365 but I just want to double click on the Azure side. Wondering if you can help us parse through sort of the infrastructure service and the platform server side and the trends there and any sort of joint benefit of being able to operate both those two. Also, as the business does scale how did you think of the growth margin and operating margin characteristics as the revenue continues to grow here?
Satya: Thanks Phil, let me start. Overall what we’re seeing is clearly there is increased usage of infrastructure as a service because a lot of people will move an existing workload into the cloud. The interesting thing that happens once you move your initial workload is that you build around it, especially, for example, if you move a VM with some data into the cloud you may want to use the same data to build a mobile front end and that’s when you’re starting to use some of our platform as a service component like our Azure mobile services, Azure media services. We see the combination– that they’re not all happening coincidentally and there’s time lag in it but that’s one of the reasons why we want to be very aggressive in getting the workloads onto Azure, both storage and compute, and even in the storage and compute we now have premium offerings for higher SLA, for higher performance and higher VM sizes and then on top of that we have these manage services which have a different margin profile so media services, mobile services, web which is another place where ewe have a lot of traction and then that’s all just on Azure.
Once you get beyond Azure you have things such as CRM online, you have Enterprise Mobility Suite and of course the Office 365 lineup and when you think about our capital and the core infrastructure, we don’t have different infrastructure for these different services. It’s one common infrastructure and one common data center footprint between all 365, Azure, CRM, Xbox Live, everything. That’s why utilization of that entire infrastructure is how we think about even total return on invested capital for our cloud business.
Chris: Thanks Phil. We’ll move on to the next question please.
Operator: Thank you. Our next question is from Heather Bellini with Goldman Sachs. Please proceed.
Heather: Great, thanks for taking the question. I just wanted to follow up Amy, your commercial other business continues to have fantastic growth and I’m just wondering when you juxtapose that with the growth in the commercial licensing business, I heard you in terms of the headwinds that you face but when you think about it more than one quarter out and you think about the revenue transition as you guys continue to build market share in the cloud, how do we think about the trends in the commercial licensing business in the next year or so?
Amy: I think in general, let me start by saying all up. In our commercial business we have done a very good job of continuing to outpace IT spend on an overall basis and continuing to push customers to our annuity business whether they are on premise or the cloud. That is our strategic goal as well as our impacts in both segments. Let me talk about some unique commercial licensing and how to think about it but I won’t give specific guidance. I will talk about how to think about the impact in particular from XP. Our transactional revenue will have a headwind from XP. That doesn’t and shouldn’t’ be interpreted as customers not continuing to be committed or not continuing to move to annuity over the longer term which is exactly the question that you’re asking. While we have a comparability issue that will show itself, mot directly as weakness in commercial licensing and most specifically as weakness in office transactional licensing which will be a headwind, the overall goal of continuing to have more customers every quarter move to the cloud or whether or not they move, adding cloud services even if they have on prem because they believe in a hybrid model is actually the structural sort of guide post we have of a mutli-year journey.
Chris: Thanks Heather. Operator we will move to the next question please.
Operator: Thank you. Our next question comes from Raimo Lenschow with Barclays. Please proceed.
Raimo : Thanks for taking my questions, two quick questions. I wanted to follow up on Phil Winslow’s question earlier on Azure and the use cases there. I mean in theory you have a huge opportunity given your install based on the server side. Can you talk a little about what you think the SMB customer base doing there? Are people trying out bursting or where is that huge customer base in terms of adoption on Azure?
Satya: One of the other elements that I actually did not talk about in response to Phil’s question is the hybrid offering. One of the products that’s doing very, very well for us is the store simple product which is essentially a storage product that cloud tiers virtualization storage from on premise to the cloud. We also have built now into the Windows servers backup and disaster recovery and the same thing with SQL server so that’s the first thing that we’re seeing is increased usage of our servers with a cloud component. Bursting is something for sure, a lot of people do but that’s more on the high end because in the SMB segment the real movement there is more to Office 365. In fact, one of the things in Office 365 is that we’re getting people to effectively use servers which just happens to be in cloud who never bought servers form us ever before because they didn’t have Exchange, they didn’t have Linked, they didn’t have any of the core capabilities of Office 365 so those are the 2 trends we’re seeing.
Raimo: Perfect and quick follow up for Amy. If you look at the changes on the operating side that you’re talking about, it obviously seems that the cultural shift it it’s more dynamic budgeting. It is very much a return based culture that you seem to be introducing here but it’s something that needs to feed through the organization and it’s more cultural change. Where are you in terms of having that fully through the organization?
Amy: Thanks for that question. I think we talked about this in prior quarters. While many people want to see it as a finesse concept, it’s not. It’s a senior leadership team concept and a leadership environment that I think we’re making collective decisions faster, I think we’re applying our recourses to opportunities when we see them, I think we have the freedom to make those choices quickly and I feel very good both about the decisiveness that comes with it but also the empowerment that we give people in our organization to make those calls to increase our performance without waiting to an annual budget process. I think some people call it dynamic budgeting. For us, I think it’s more about thinking about the opportunities we have and stack ranking those every day to improve our execution and our returns.
Chris: Thanks. We’ll move to the next question please.
Operator: Thank you. Our next question comes from the line of Brendon Barnicle with Pacific Crest Securities. Please Proceed.
Brendon: Thanks so much. Amy, when we first started talking about Office 365, I think at that time that you were suggesting that the move from an office cal to an office 365 license would increase growth profit by about 50%. Now that you’ve had a couple quarters with Office 365 do you think that the changes to the model still make sense. More importantly, are there other changes that you’re seeing that are more accurate?
Amy: Thanks for the question. In general, I think we’re still on the early ends of seeing the opportunity that we have in that segment. As you point out, there are a couple components that make gross profit dollars per seat or the lifetime value of a customer depending on the terms you want to use improve and increase over the life cycle. The very first think, and I think Satya even mentioned it, and its most direct in SNB, is moving to buying a copy of Office, which was a very static concept, to the idea where you can buy Office and frankly get all the benefit that those used to deploy servers used to get only with IT departments of their own. When you move Office, it’s simply the first step so even though it comes with a lower growth margin percentage, our abilities to add workloads, to add premium services and to increase our overall footprint inside a customer is really where the lifetime value goes up and frankly over time in watching the creativity and the pace of innovation we’ve seen coming out of our engineering teams particularly in Azure and Office 365 and our CRM Team online, I actually even have more confidence in our ability to attach and grow that growth profit over time. We mentioned simply one that didn’t exist. I think Brendon when we first started having this conversation, which was our EMS suite, and I look and say those opportunities as well as the creativity of our people I think gives me more confidence, not less, in the structural integrity of the lifetime value of a customer argument.
Chris: Thanks. Operator we’ll have time for one last question please.
Operator: Our last question comes from the line of Ed McGuire from CLSA. Please proceed.
Ed: Thank you. I was in the last several quarters. Particularly Satya you’ve opened up a number of products to the different platforms of Office and android and with Minecraft and Skype you’ve got a number of multi platform products and services. Could you quantity so far to what extent you’ve seen benefit and if this plays in to the free upgrade for Windows 10 at least for a limited period, how you expect this to play out benefitting the business case of your products across the portfolio?
Satya: Overall at the higher levels our strategy here is to make sure that the Microsoft services i.e cloud services, the Azure, Office 365, CRM online and Enterprise Mobility Suite are covering all the devices out there in the marketplace so that that way we maximize the opportunity we have for each of these subscription and capacity based services so that’s the core rationale for why we’re doing cross-platform. The next question is, what’s the uniqueness of Windows? The uniqueness of Windows comes because we don’t think of these services and their application end points as apps but fundamentally pour into the Windows experience so we’re building them natively into Windows.
For example, when you log into Windows you’re logging in with a Microsoft account or Azure. When you have files, they’re syncing with One Drive, Outlook is the email client for Windows, so that’s how Windows will differentiate and not to mention our gaming and Xbox Live experience so overall we will build a differentiated windows because our application experiences for our cloud end points will be native in Windows and at the same time we will make sure that our services are available on all end points driving more usage and driving more subscription growth so the best way to measure up progress is the Office 365 subscription growth, Azure growth and EMS growth.
Chris: That wraps up the Q&A portion of our call. We look forward to seeing you in the coming months at various investor conferences and for those unable to attend in person, these events will generally be webcast and you can follow our comments on Microsoft.com/investor. Please contact us if you need any additional details and thank you for joining us today.
