Microsoft Corporation (MSFT) — Q2 2015 Earnings Call Transcript

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. On our website, microsoft.com/investor, we have posted our press release and a slide deck to provide a summary of our results for the quarter. Unless otherwise specified, all growth comparisons we make on the call today relate to the corresponding period of last year. Additionally, any mention of operating expenses refers to segment operating expenses as defined in the footnote of our 10-Q and includes research and development, sales and marketing, and general and administrative, but excludes integration and restructuring charges. We’ll post the 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 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 due to factors discussed in today’s earnings press release, in the comments made during this conference call, and in 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’ll turn the call over to Satya.

Thank you, Chris. Good afternoon everyone. Today I'll focus my topline thoughts on our progress this quarter and the transformation of our business. This quarter we reached $26.5 billion in revenue, with an operating income of $7.8 billion. This quarter's results show the product and business transformation underway at Microsoft. We saw success in a number of our strategic areas including cloud adoption, redefining and revitalizing the Windows Ecosystem, and improving economics in our hardware portfolio. We also faced some challenges this quarter. As expected, the one-time benefit of the Windows XP end-of-life PC refresh cycle has now tailed off. Additionally, we encountered 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're extending our leadership position and accelerating our innovation. In commercial cloud, we saw continued customer and revenue growth across a growing footprint of cloud services, Office 365, Azure, Enterprise Mobility Suite, and Dynamic CRM Online. In fact, this quarter marks the sixth consecutive quarter of triple-digit revenue growth in commercial cloud and we're 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, virtual machine offerings, and enhanced 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 and 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 has now introduced new application experiences on all phones and tablets for mobile productivity. Further, we released completely new scenarios, including Office Sway for visualizing and sharing ideas, Delve to help search and discover content, Office 365 Groups to make collaboration easier, and Office 365 Video for secure media streaming for businesses. We are also continuing to invest in enterprise value by integrating MDM and Enterprise Mobility Suite into Office 365, with new encryption technologies, compliance certifications, and new e-discovery capabilities in Exchange. In Dynamic CRM Online, we added 53 markets this quarter, bringing us to 130 markets around the world. We're combining CRM with Cortana, Yammer, Power BI, and Skype to provide unique value to our customers. We're expanding our capabilities in the Cloud through five 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. We acquired HockeyApp, a leading mobile app testing and development service to enhance Azure services for mobile developers. Our acquisition of Orato accelerates our ability to give customers unique security capabilities through behavioral intelligence on identity and access spanning on-premise and cloud. We're adding new capabilities in machine learning as applied to e-Discovery and other enterprise compliance processes through the acquisition of Equivio, and we also welcomed Acompli, a provider of innovative mobile email applications for iOS and Android. 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're 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 U.S. search share continues to grow, as does search revenue with 23% growth this quarter. I will discuss 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 SCES, our partners showcased a diverse lineup of Windows devices, including more premium device choices than ever. Last spring, we made a strategic decision to introduce new Windows pricing programs to drive unit growth in opening price point PCs as well as tablets, and this quarter, we saw year-over-year growth. Businesses continue to value Windows and we are seeing healthy demand for Windows Pro, despite facing challenging prior year comparables in Q2 and in the second half of the year, following the XP end of support related PC refresh. Now, let's discuss 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 a single device, the PC. With Windows 10, we're building a device platform for the mobile-first, cloud-first world. It's a world where the mobility of a person's experience is paramount, and requires a platform that spans devices from small screens to large screens, to no screens at all. It's a world where interacting with technology is as natural as interacting with other people, and it's a world that demands trust and security. It represents a rich opportunity for developers, and Windows 10 will be the most attractive Windows development platform ever. With our free upgrade offer and universal applications with a unified store for developers, we'll have a large, unified, up-to-date user base to target. We want people to love Windows and have made this our most collaborative project yet, with more than two million insiders providing us feedback every day. I am very optimistic about Windows 10. We're making progress with our own devices, both those on the market today and those that we have 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. Additionally, sales of Lumia phones topped 10 million units, growing 30% year-over-year this quarter, with strength in devices like the Lumia 500 and 600 series, our affordable smartphones. In this segment of the market, the combination of our brand and value stands out, and we plan to continue to build a beachhead here. 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 products with Windows 10: 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 a part of everyday life across work and home. I want to briefly mention Xbox. Xbox One console adoption accelerated this holiday and was the top-selling console in the U.S. Fans on Xbox Live engaged with the service more than ever before. However, it's our strategies coming together with Windows 10 that give me the greatest optimism. The vibrant social gaming community on Xbox Live will span Xbox, Windows PC, tablets, and phones. With Windows 10, gamers on a PC, tablet, or Xbox console can play together, and games on Xbox One can easily stream through a Windows 10 PC or tablet. It's also becoming clear how games that people love today will evolve into mind-blowing experiences in the future when designed for mixed reality that Windows 10 and HoloLens create. Imagine what's possible with Minecraft. Gaming is truly a valuable part of millions of people's lives, and Microsoft will excel and increase our lead. Before closing, I wanted to share a few thoughts on capital allocation. Over the past several quarters, and certainly with last week's Windows 10 announcements, 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, purpose, and a realignment of talent, alongside disciplined execution. Our increasing innovation and competitiveness in today's growth markets and the creation of new categories is how we will positively impact 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 also demonstrates our optimism for the future growth of Microsoft. As we move forward, we will continue to be thoughtful in our capital return decisions, balancing dividends and share repurchases. In closing, I am encouraged by the progress we are making in our transformation into the productivity and platform company for a 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 in the decisions we're making to drive our business and products forward to serve our customers and partners in the future. With that, I'll 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.

Thanks, and good afternoon, everyone. As Satya shared, in Q2 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 remained 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 Windows 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 the macroeconomic environment, along with the combined impact of XP end-of-support and the VAT increase last year. Our Office attach rate 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 second quarter. Revenue was $26.5 billion, up 8%, and would have been one point better without the impact of foreign exchange. Gross margin grew slightly this quarter, even when comparing against a year ago that benefited from the XP Refresh cycle. Our commitment to ongoing execution improvement and thoughtful portfolio management helped improve the gross margin percentage in each of our operating segments. Operating income declined 2%, which included $243 million of integration and restructuring expenses. Excluding that, operating income grew 1%. Our reported GAAP earnings per share were $0.71, which included a $0.02 negative impact from integration and restructuring expense and a $0.04 income tax charge for an IRS audit adjustment. Foreign exchange had a $0.01 negative impact on EPS. As we discussed last quarter, FX movements first impacted bookings growth and unearned revenue on our balance sheet as our contracted but not billed balance was adjusted down to reflect current FX rates. Therefore, our bookings were flat this quarter. Unearned revenue was up 9% year-over-year to $21.2 billion, but the sequential decline was slightly larger than we expected due to the greater-than-anticipated impact from FX. Adjusting for that FX impact, our commercial unearned balance is in line with historical trends and our expectations. From a geographic perspective, relative to our expectations, the U.S. outperformed while Europe was generally in line. As I mentioned earlier, China and Japan were below our expectations. With that backdrop, I will now move to a detailed discussion of our results. Last year, we ended support for Windows XP. That simulated a PC Refresh cycle, particularly in developed markets 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 normal mix between developed and emerging markets, and Pro attached business PCs have returned to the levels we saw prior to FY '14. To drive revenue growth in academic institutions, we lowered 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 the relatively stable business PC market we've seen at 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 Satya just spoke about earlier. The harbor mix shift to opening price point PCs impacted license mix and therefore aggregate revenue per license in the quarter. The mixed 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 where PC growth was lower than we expected in a geography where the paid attach rate for Office is high. Adoption of Office 365 home and personal remained strong, and we now have over 9.2 million subscribers. In our computing and gaming segment, we are proud of the continued progress we are making in our service portfolio. Strong interest in Surface Pro 3 helped drive record revenue as well as improved gross margins. 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 U.S. Xbox Live users grew, and those users increased their purchases of third-party publisher content and consumables. Sales of the Xbox platform-exclusive Halo: The Master Chief Collection and Forza Horizon 2 were strong, and this quarter we welcomed Minecraft. We articulated our plan for the phone business back in July, and we are executing to plan. With our Lumia portfolio of phones, we drove 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 made changes to the product portfolio and managed this business for profitability. We are looking forward to bringing new products to market that will showcase the features that we presented at our Windows 10 event last week. Revenue in our devices and consumer other segment grew 30%. As noted earlier, Xbox Live transactions and first-party games performed well and contributed to this growth. Additionally, search revenue growth was strong with improvements in both rate and volumes. Within display, revenue declined in our MSN portal, though we saw revenue growth across other Microsoft properties. We are also pleased with our gross margin expansion in this segment. Transitioning now to our consumer results, where 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 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 a 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 the cloud this quarter. We are experiencing 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 Dynamic CRM Online, customer growth accelerated and revenue nearly doubled. From a product perspective, commercial Office product and services revenue declined 1%, slightly below our expectations. Annuity revenue remained strong with high renewal rates and continued adoption of Office 365. Within our Office transactional business, year-on-year comparables are difficult given the benefits from last year's XP Refresh, where customers chose to update their desktop productivity solutions along with their PCs. Additionally, the shift to Office 365 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 markets. Growth in premium mix helped drive double-digit revenue growth in SQL Server and System Center. Windows Server annuity revenue grew double-digits again this quarter. We are pleased with the performance in our Dynamics business which grew revenues 13%, driven by growth in both on-premises and cloud offerings. Operating expenses grew 1% to $8.3 billion and were favorable to our expectations. These results include investments that we made in our strategic growth areas, a few of which were showcased last week at our Windows 10 event. Excluding approximately $750 million from the addition of NDS, operating expenses 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 of spend. Our integration and restructuring efforts have 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 expenses, we committed to reducing $1 billion from the phone cost base, which we have accomplished. We continue to seek opportunities to drive further efficiencies. Our effective tax rate was 25% and higher than expected due to the previously mentioned income tax charge for an IRS audit adjustment. Beyond that, the increase was driven by the inclusion of phone results and 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 made server purchases in support of our fast-growing cloud business. This quarter, we increased our capital return by 5%, with $4.5 billion returned to shareholders through buybacks and dividends, and as Satya reinforced in his comments, we will continue to take thoughtful steps to increase capital return 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 FX rates. Should the U.S. dollar strengthen beyond those assumptions as it did this quarter, we would see additional negative impacts on earnings, revenue, our balance sheet, and our contracted but not billed balance. As a reminder, in our annuity businesses, the FX impact is first reflected on our revenue, which is recorded at the rate when the contract is billed, then revenue comes onto 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 U.S. dollar than the prior-year comparison. In total, we expect that FX will negatively impact revenue growth by approximately four points in Q3. The majority of this impact is in our commercial business. In FY '14, it was our Q2 through Q4 results that most benefited from the Windows XP end of support. As such, our growth rates across Windows Pro and transactional Office will be impacted as our business moves back to pre-XP levels. On a geographic basis, we expect year-on-year revenue declines in China, Russia, and Japan. In Japan, Q3 represents an even tougher comparison with the anniversary of the VAT, which again will create difficult comparables in Windows and Office. We currently expect that these geographic dynamics, challenging comparables from XP, and FX headwinds will be present throughout the remainder of our fiscal year. With that overall background, let me move to our specific Q3 guidance starting with devices and consumer. Our revenue guidance includes approximately four points of drag from FX. In licensing, we expect revenue to be $3.4 billion to $3.6 billion. This range reflects the more challenging comparables I mentioned earlier. The range also includes a reduction in channel inventory for Windows non-Pro opening price point PCs. Within consumer Office, we expect to see similar trends to Q2, and in our IP licensing business, we expect lower per-unit royalties with the changing mix of devices filled by our licensees. In computing and gaming, we expect revenue to be $1.5 billion to $1.7 billion. This range reflects normal seasonality coming out of the holidays for our Xbox and Surface businesses. In phone hardware, we expect revenue to be $1.4 billion 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 ASPs 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 billion to $9.9 billion. In addition to the factors I discussed, which impact our year-over-year comparability, we anticipate a four-point drag from FX. In Commercial Other, we expect revenue to be $2.6 billion to $2.7 billion. Even after considering the impact of FX, growth will remain robust with expected momentum across our commercial cloud portfolio, Office 365, 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 that our OEM royalty model, which is paid upfront, will remain in place. We expect COGS to be $7.1 billion to $7.4 billion with variability driven by both hardware segments. We expect third-quarter operating expenses to be $8.2 billion to $8.4 billion. We are lowering our full-year guidance to $33.2 billion to $33.6 billion, which reduces full-year growth including NDS to 4% to 5%. Our Q3 plans include investments in advertising and customer-facing roles to continue to accelerate our momentum with commercial products, such as SQL and the cloud. These investments are a direct response to prioritization decisions made during the first half. Over the remainder of the fiscal year, we expect to 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 expenses of $100 million 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%, which 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 to our subscription services and high contract renewal rates. We expect to see a low single-digit sequential decline in our unearned for Q3, which includes a one-point drag from FX as new billings will reflect the impact of the strengthening U.S. 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 enhance investments both shorter-term as you have seen in our marketing and sales adjustments, as well as 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 the strengthening U.S. dollar, but we are confident in the underlying health of our business from the significant innovation we are funding within our prioritized operating budgets 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 29, 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 will turn it back over to Chris, and we can move to Q&A.

Thank you very much. I appreciate it. Amy, can you give us a bit more details on what's driving the increase in cloud margins within the commercial other segment as well as any sense for how accretive the cloud is becoming? And then I have a follow-up question.

Sure, why don’t I talk a little bit about that from a math perspective and I'll let Satya add from some more engineering improvements, which I think are important. Mark, as I talked a bit about, we've seen a mix shift as we have moved Office 365 and Azure to our premium service and to premium SKUs within our cloud environment, which is one of the drivers that helps improve margin growth. In addition, we've done a lot of hard engineering work over the past six quarters to be able to take advantage of more utilization and capacity over time and I'll let Satya maybe add a little bit technically.

Overall, the shift to the higher layer services 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, which has fantastic momentum in the marketplace because the solution has come together and is fairly unique, as well as Dynamic CRM. So these all have different profiles in terms of margin and they are all high-growth businesses for us. So when you think about our cloud, you have 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.

Excellent and one quick follow-up, how should we think about monetization, Satya, for the Windows devices below 9 inches?

One of the comments I made in my remarks was some momentum we're seeing in our consumer cloud services. The monetization for stores, Bing monetization, and Xbox Live monetization are all things that drive monetization for devices below 9 inches. I think of device gross margin in some cases because we are building devices like the phones as well as post-sale monetization using our consumer cloud services as the two additional levers that we have to be able to monetize Windows devices.

Excellent, thank you. I appreciate Mark.

Thanks. Amy, just on the XP tail-off, are there other commercial products that you're seeing being impacted? I just wanted to be clear; there are a lot of questions about whether there is some type of halo impact from the XP taking drop-down on the other solutions.

Sure Brent, thanks for the question. 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've talked the most about in terms of Windows Pro and its mix attached to business PCs. The other important component of that was when people bought a PC as we talked through the year, they often took the chance whether generally in the business segment, which impacts our world commercial licensing as a reporting unit to buy Office 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 in Windows DL. We also saw non-annuity purchases in Windows DL, which again is in our commercial licensing segment. Therefore, from a product portfolio perspective, it really is Windows and Office. From our reporting segments, it’s the D&C licensing segment and our commercial licensing segment, specifically our transactional revenue growth year-over-year.

Okay. And just a quick follow-up, just on the reduction in operating expenses for the full year, is this across the board, Amy? Is there a particular area where you're finding more opportunity to cut?

Brent, thanks again. I actually think of it as a general concept where we’re trying to invest behind opportunities where we see them. Some of those are more public as we talk about in terms of our sales and marketing adjustments or ad campaigns that we run by the commercial cloud. Others, I think, you don't get 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 innovate, in ways that might be labeled as mind-blowing, as Satya used the phrase. I'm not sure that all of it, Brent, is across the board in that way. They are short-term optimizations and longer-term portfolio optimizations that I think we've talked about before. I think the entire Senior Leadership Team sees it as an opportunity to consider where we can best innovate and drive the highest value of every dollar we invest, and I think we've made great progress as a team, which you’re seeing in both long-term guidance and our day-to-day execution through the quarter.

Thank you.

I will just add that we're also making pretty significant changes in just the workflow of our engineering teams and that also leads us to get more out of our current investments. So there is a significant combination of culture change as well as how we work that drives more innovation for the same dollar.

Thank you.

Thank you, Brent. We will move to the next question please.

Hi, thanks. Two questions: just one on execution. It sounds like you highlighted some issues in Japan, and we've heard about VAT from companies. Can you just talk about what you're doing to address some of those issues? And is there any concern that that might spread beyond what you've seen in Japan and China?

Thanks, Walter. Is that both your questions? I just want to make sure I get them?

I'll just start by talking about China. We have a set of geopolitical issues that we are currently working through. We're very committed to China as a market. We have, in fact, pockets of good growth in China with our cloud doing fairly well, but we recognize that we still have work to do, and as we navigate those issues, we’ll keep you updated.

In Japan, to address your question, I don't have concerns about the issue spreading beyond Japan. With the Windows XP end of support plus the VAT increase, it tightened far faster than we had anticipated, particularly given that Japan is a non-annuity geography for us. Impacts in Japan more directly come to the P&L as opposed to on our unearned and contract balances. We experienced some weakness in commercial licensing, but when adjusted for FX, our unearned balance and bookings felt quite good from our commercial perspective.

And then just a question on Office 365 commercial: can you talk about deployment rates? I know you've done a good job of getting those into contracts; how many customers are actually running it and running their email and SharePoint and other products in the cloud versus just having the rights to it?

Thanks, Walter. I think with all products, I think about the complete sales cycle and I am really encouraged by the fact that we're doing a good job of moving from initial sales through deployment, through adding on services, and back to renewals. The workload that we're furthest along on is obviously Exchange. It also requires directory implementation, so we generally think of a fast deployment and then adding on workloads. That provides an environment for us to add products like EMS or Enterprise Mobility Suite. While there may always be a lag, the commitment from customers to move to the cloud and their pace through deployment is critical.

Great. Thank you.

Thanks, Walter.

We'll move to the next question please.

Excellent. Thank you, guys, for taking our question. I just wanted to dig into Windows OEM ASPs a little bit and just understand the dynamic of what we see in the marketplace. When we look at industry analysts, it seems that industry is seeing flat to slightly down unit growth, and we’re seeing a down 13% OEM revenue growth. I was wondering if you could help us with a bit more color in terms of what exactly is happening with that ASP dynamic given these lower entry-level editions?

Thanks, Keith. I would actually like to address both Pro and non-Pro. At the highest level, based on industry analyst views and those of many peers in the ecosystem, I believe we agree with most of the benchmarks regarding PC unit health across business, which has stabilized since FY '13, and across consumer, where we made meaningful progress in unit growth in both last quarter and especially this one. Then I'll talk about why revenue growth contrasts with unit growth. In Pro, there are really two key dynamics. First, we’ve returned to the XP levels we saw before the XP refresh, so the dynamic mix between emerging and developed markets is not an ASP problem in Pro; it's a return to normal attach levels. The second component impacting revenue growth in Pro are academic licenses, where we lowered the price and saw increased unit numbers. So that was a second contributor to the revenue decline, while the larger component was the XP reversion. In non-Pro, we experienced growth in low-price devices at opening price points, as we've strategically decided to increase our ability to place devices on the shelf at prices under $200 to $249. That has skewed the RPL there, but it did drive meaningful ecosystem health and competitive dynamics in the channel. Overall, while there has been an RPL impact, which has contributed to the minus 13% in non-Pro OEM, the PC license growth we saw demonstrates the ecosystem health we feel positive about.

If I could squeeze in one follow-up, have you guys done any assessment on Surface Pro 3 being a real productivity device? To what extent is that cannibalizing what would have been Windows PC sales, and to what extent do you think you're expanding the market opportunity with that device?

I think it's definitely expanding the market opportunity. One of the things that I feel good about is the risk we took to introduce the two-in-one category. In fact, we're seeing a lot of activity in our OEM ecosystem, and we see many good designs emerging because it’s viewed as a category that drives growth. From that perspective, I feel good about leading because it aligns with one of our strategic goals: we want to create new categories and foster more demand for the entire ecosystem.

Thank you.

We'll take the next question please.

Thanks for Satya; 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 demand in the industry and the opportunities for Microsoft around the new platform?

Thanks, Rick, for the question. As I stated in my remarks, I am 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. One unique aspect of our innovation includes our attempts to leverage the large-screen market through Surface Hub, HoloLens, and other two-in-one form factors. Our strategic objective is to create developer momentum with Windows 10 and that’s where we’re focusing on with a variety of actions. One is the unified developer platform, which I think is the most strategic piece of Windows 10 along with the unified store. By providing a free upgrade offer, we're creating great opportunities for every developer to write these universal Windows applications that will run on the desktop, tablets, and smartphones, as well as on Surface Hub and HoloLens. We are thus building a differentiated Windows experience, as our application experiences for cloud endpoints will be native in Windows and integrated appropriately across our offering. Overall, we want to ensure that Office 365 subscription growth, Azure growth, and EMS growth remain key metrics for measuring our progress.

Thanks, Rick. Operator, we'll take the next question please.

Thanks guys. Just got a question on the commercial other line. Obviously, that continues to show strong growth and has been climbing up in the cloud business. Whether it be Azure or Office 365, but I wanted to double click on Azure side, wondering if you could help us parse through the infrastructure as a service and the platform as server side and the trends there and any sort of joint benefit, I guess, that you’re seeing and being able to offer both as those businesses scale. And then Amy, I would love you to chime in here too; how do you think about the gross margin and just operating margin characteristics as the revenue continues to grow here?

Thanks, Phil. Overall, what we're seeing is that there is clearly increased usage of infrastructure as a service because a lot of people are moving existing workloads into the cloud. The interesting thing that happens once you move your initial workload is you build around it. For example, if you move a VM with data into the cloud, you may want to use that same data to build a mobile front end which is when you're beginning to use some of our platform as a service components. We recognize this combination isn't happening all at once, but there is a time lag. Therefore, that's one of the key areas we’re focusing on getting workloads onto Azure, including storage, computing, and the recent introduction of premium offerings for higher SLA and performance. Those premium services have a different margin profile. This approach also accommodates our CRM Online, enterprise mobility suite, and Office 365 lines. When we consider our capital, that core infrastructure doesn't vary between the different services as it supports all - O365, Azure, CRM, Xbox Live, and everything else. This explains how scaling the entire infrastructure translates into positive operational capital returns for our cloud business.

Thanks, Phil. We'll move to the next question please.

Great. Thank you for taking my question. I just wanted to follow up, Amy; your commercial other business continues to experience fantastic growth and I am just wondering when you juxtapose that with the growth in the commercial licensing business. I heard you in terms of the headwinds that you faced, but when we think about it more than one quarter out and consider the revenue transition as you 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?

Let me start by saying all up right now; in our commercial business, I think we’ve done an excellent job of continuing to outpace IT spending on an overall basis by pushing customers to our annuity business, whether on-prem or in the cloud. That is our strategic goal. Now, in terms of commercial licensing, while I won’t offer specific guidance, I will discuss the expected impact from XP. Our transactional revenue will see a headwind from XP, which shouldn’t be interpreted as customers not continuing to commit to move to annuity over the long term. Consequently, while we have comparability issues that will show up as weakness in commercial licensing - particularly in Office transactional licensing - the overall goal of attracting more customers to the cloud or adding cloud services is a multi-year journey that remains on track.

Thanks Heather. Operator, we'll move to the next question please.

Okay. Thanks for taking my question. Two quick questions: Satya, I wanted to follow up on Phil Winslow’s question about Azure and use cases. The opportunity is significant, given your install base on the server side. Can you talk a little bit about what you're seeing from the SMB customer base? Are we seeing people trying bursting, or where is that large customer base in terms of adoption on Azure?

On Azure itself, one of the components I didn’t address earlier is our hybrid offering. One successful product is Store Simple, which essentially optimizes storage virtualization from on-premise to the cloud. We’ve seamlessly integrated Windows Server backup and disaster recovery, as well as SQL Server offerings. Increased usage from servers with cloud components suggests strong growth. Bursting, which is more common at the higher end, is significant, but in the SMB segment, the predominant movement is more to Office 365. In fact, one aspect of Office 365 is the use of servers in the cloud, which attracts clients who have never purchased servers due to their previous lack of core capabilities.

Perfect. And a quick follow-up for Amy; considering the changes on the operating side you've mentioned, it seems that you're transitioning to an increasingly dynamic budgeting mechanism. However, this is also a cultural change that should be instilled throughout the organization. Where do you feel you are in that journey?

Thanks for that question. I think we've discussed this in prior quarters; while many view it as a finance concept, it’s actually a core senior leadership team principle. Our leadership environment encourages collective decision-making. The result is that we're applying resources to opportunities more rapidly as they arise and facilitating our people’s decision-making autonomy without having to wait for an annual budget process. I know some people refer to it as dynamic budgeting. For us, it's about identifying cash flow opportunities and ranking those every day to improve both our execution and returns.

Thank you, Raimo. We'll move to the next question, please.

Thanks so much. Amy, when we first began discussing Office 365, I think at that time, you suggested that the shift from an Office CAL to an Office 365 license would increase gross profit by about 50%. Now that you've had a couple of quarters with Office 365, do you think those changes to the model still make sense? More importantly, are there potentially other changes you’re seeing that may offer a more accurate picture?

Thanks for the question. Overall, I believe we're still at the early stages of exploring the opportunities in that segment. As you pointed out, there are a few factors that drive gross profit per seat or lifetime value from a customer perspective, which increase over time. The first element is moving from a single purchase of Office to an ongoing subscription model that provides the same benefits as traditional IT departments with all solutions unlocked. As a result, although it generates slightly lower gross margin percentages, it allows for more powerful customer engagement, increased offerings, and a deeper customer lifecycle. I’m more optimistic, given the pace of creativity and innovation from our engineering teams, especially in Azure. We currently see the ability to attach and augment gross profit over time, highlighting the complexity of the product offering we presented last week. Therefore, I am confident in the structural integrity of this model.

Great. Thank you so much.

At a high level, our strategy is to ensure that Microsoft Services, namely our cloud services, reach all devices in the marketplace for maximum opportunity. That's why we are pursuing cross-platform availability. On the other hand, Windows offers unique advantages—we don’t treat these services solely as apps but as a core element of the Windows experience. Our applications are deeply integrated into Windows, so when you log into Windows, you’re doing so with your Microsoft account or Azure ID. When files are available, they’re synchronized with OneDrive; Outlook acts as the email client for Windows. Alongside our gaming and Xbox Live experiences, we aim to build a differentiated Windows environment, driven by native applications across all endpoints that will ultimately lead to a greater usage and subscription growth.

Great. Thank you.

That wraps up the Q&A portion of today’s earnings call. We look forward to seeing many of you in the coming months at various investor conferences. For those unable to attend in person, these events will generally be webcast and you can follow our comments at microsoft.com/investor. Please contact us if you need any additional details, and thank you for joining us today.

Thank you.

Thank you.