Microsoft Corporation (MSFT) — Q2 2019 Earnings Call Transcript

Good afternoon, and thank you for joining us today. On the call with me are Satya Nadella, Chief Executive Officer; Amy Hood, Chief Financial Officer; Frank Brod, Chief Accounting Officer; and Carolyn Frantz, Deputy General Counsel and Corporate Secretary. On the Microsoft Investor Relations website, you can find our earnings press release and financial summary slide deck, which is intended to supplement our prepared remarks during today's call and provides a reconciliation of differences between GAAP and non-GAAP financial measures. Unless otherwise specified, we will refer to non-GAAP metrics on the call. The non-GAAP financial measures provided should not be considered as a substitute for or superior to the measures of financial performance prepared in accordance with GAAP. They are included as additional clarifying items to aid investors in further understanding the company's second quarter performance in addition to the impact these items and events have on the financial results. All growth comparisons we make on the call today relate to the corresponding period of last year unless otherwise noted. We will also provide growth rates in constant currency, when available, as a framework for assessing how our underlying businesses performed, excluding the effect of foreign currency rate fluctuations. Where growth rates are the same in constant currency, we will refer to the growth rate only. We will post our prepared remarks to our website immediately following the call until the complete transcript is available. Today's call is being webcast live and recorded. If you ask a question, it will be included in our live transmission, in the transcript, and in any future use of the recording. You can replay the call and view the transcript on the Microsoft Investor Relations website. 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 earnings press release, in the comments made during this conference call and in the Risk Factors section of our Form 10-K, Forms 10-Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. And with that, I'll turn the call over to Satya.

Thank you, Mike, and thanks to everyone for joining us today. We delivered $32.5 billion in revenue this quarter with double-digit top line and bottom line growth driven by strength across all of our commercial cloud. Our commercial cloud revenue grew 48%, anchored by Azure revenue growth of 76%. These results demonstrate our ability to identify the right secular trends in large and growing markets, many of which are still in their infancy, as well as our focused innovation and execution. Leading companies in every industry are partnering with us to build their digital capabilities to compete and grow. This creates a broad opportunity for everyone in our ecosystem. As an example, the co-sell program we introduced 18 months ago has already generated $8 billion in contracted partner revenue. Now, I'll briefly highlight our momentum and innovation across our businesses. Microsoft 365 empowers everyone, from enterprises to small businesses and over 2 billion first-line workers, with an integrated, secure experience that transcends any one device. We are helping every business build out their communication and collaboration systems to drive productivity and business transformation. Microsoft Teams is the hub for teamwork and a powerful on-ramp for Microsoft 365, and we're seeing increased usage of OneDrive, SharePoint, Yammer, and the entire Office Suite of applications. Teams is the only enterprise-grade solution that combines messaging, meetings, video conferencing, and document collaboration. This quarter, we've introduced enhanced voice capabilities like group call forwarding, delegation, and location-based routing into Teams. We are seeing rapid adoption of Teams with more than 420,000 organizations of all sizes, including 89 of the Fortune 100, using Teams. For instance, Pfizer chose Teams as their collaboration platform for 115,000 employees, and we are expanding into new and underpenetrated markets. We introduced new capabilities this quarter to empower first-line workers in service and task-oriented roles to communicate and collaborate more effectively while on the go, including mobile schedule management, location sharing, and easy recording and sharing of secure audio messages. We are expanding our opportunity in education with Microsoft 365, innovating in hardware and software to improve learning outcomes from collaborative classrooms with Teams to personalized learning tools in OneNote and social learning with Flipgrid, as well as affordable, easy-to-manage Windows 10 devices. Cybersecurity is a central challenge, and Microsoft is leading the way, helping all organizations operate in what is known in the industry as a zero-trust environment. This begins with Azure Active Directory and the extensive work we're doing with Microsoft Threat Protection to provide an integrated solution for our customers across identities, device endpoints, email, information, cloud applications, and infrastructure. This quarter, we introduced advanced capabilities for identity and threat protection, as well as information protection and compliance. A comprehensive approach to security and compliance is another reason why customers are adopting Microsoft 365. Customers from Neiman Marcus to Brooks Running to the global biopharmaceutical leader Sanofi all chose our solutions. Surface had its biggest quarter ever this holiday, delivering strong double-digit growth in both consumer and commercial. We continue to innovate and expand our family of devices, setting the bar for the industry with the latest Surface Pro, Surface Laptop, and Surface Go. More broadly, Windows 10 continues to gain traction in the enterprise as the most secure and productive operating system. At CES, our OEM partners showcased always-connected Windows 10 PCs that deliver breakthrough levels of performance to enable powerful new scenarios like immersive gaming. Moving on to business applications and LinkedIn. Dynamics 365 grew 51% this quarter as we win customers with our differentiated approach to systems of record and engagement, making them more modular, extensible, and AI-driven. Increasingly, business process automation includes digitizing physical spaces, activities, and interactions. Dynamics 365, along with advances in Azure IoT, AI, and Mixed Reality, are leading the way for organizations to create new systems of observation and intelligence that drive end-to-end business processes and bridge online and offline worlds. For instance, we now have the capability for customers to manage inventory in real-time from shelves to warehouses to farms. Our Power Platform, including Power BI, Power Apps, and Flow, enables anyone in an organization to start building intelligent applications or workflows where none exists. It is the only solution in the industry that brings together no-code or low-code app development, robotic process automation, and self-service analytics into a single comprehensive application platform. With the Power Platform, Microsoft is fundamentally demarketizing business processes, empowering everyone to make smarter and faster decisions, and I am energized about the tremendous opportunity in this space. Already, Centrica relies on Power BI, Power Apps, and Flow along with Dynamics 365 to transform scheduling and dispatching of its first-line workforce in the United Kingdom. Virgin Group uses Power Apps and Dynamics 365 to gain a single view of its passengers, surfacing insights to improve customer service and increase operational efficiency. In Italy, the postal service uses Dynamics 365 to jumpstart the digital transformation of thousands of post offices nationwide. Moving to LinkedIn, we continue to see strong revenue growth across all businesses, with sessions growing 30% year-over-year, fueled by record engagement levels in the feed and content shared across the platform. We saw record job postings again this quarter. We introduced brand and community-building tools for marketers with LinkedIn pages, making it easier for organizations of all sizes to foster strong connections with LinkedIn's 610 million members. Finally, Glint broadens our market opportunity with its industry-leading employee engagement platform. At a time when competing for talent and skill development is a priority for every leader, the combination of LinkedIn Talent Solutions, Talent Insights, LinkedIn Learning, and now Glint helps every business attract, retain, and develop the best talent in an increasingly competitive job market. Now, turning to Azure. Azure is the only hyperscale cloud with a consistent computing stack that extends from the data center to the edge, and customers across every industry recognize this architectural advantage. In retail, Azure was front and center at the NRF. Kroger is partnering with us to redefine the customer experience in stores and provide employees with AI-driven insights while the Gap chose our cloud to accelerate their digital transformation. Just this week, Albertsons selected Azure as its preferred cloud. In financial services, MasterCard is partnering with us on a more secure way to verify digital identities, while BlackRock utilizes the power of the Microsoft Cloud to reimagine retirement planning, and UBS is using Azure to increase agility while meeting high compliance and security standards. In healthcare, Walgreens Boots Alliance chose Azure to put people at the center of their health and wellness with digital solutions that improve outcomes and lower costs. Additionally, they will roll out Microsoft 365 to over 380,000 employees in stores globally. We're accelerating our innovation in emerging workloads like IoT and edge AI. At CES, our partners showcased how Azure IoT and Azure AI enable them to build new connected devices and experiences that span the cloud and the edge, from connected homes to cars to smart cities. Just this month, Starbucks opted for Azure Sphere to secure its business-critical edge devices in the stores. Developers will increasingly drive influence on business processes and functions across every organization, and we are committed to providing developers with the tools they need to be productive on any platform. More than 12 million developers around the world use Visual Studio to build applications, and new features enable them to collaborate in real-time and focus on driving innovation. We closed our acquisition of GitHub this quarter, allowing us to bring our tools and services to new audiences while helping GitHub to maintain its developer-first ethos. GitHub has over 31 million developer accounts and recently surpassed 100 million code repositories, a significant milestone. Development teams at more than half of the Fortune 50 do their work in GitHub Enterprise. This month, we announced significant updates to broaden GitHub's accessibility to even more developers, introducing unlimited private repositories and a new, simpler, and unified enterprise offering, already available through the Microsoft global sales force. We're not stopping there. Just last week, we announced our acquisition of Citus Data, the leading provider of PostgreSQL, enhancing our overall data platform differentiation and building on our investments in Azure, making it the most comprehensive cloud for open-source and proprietary workloads at any scale. Now I'll turn to gaming. We continue to pursue our expansive opportunity to transform how games are distributed, played, and viewed. Our investments in content, community, and cloud services across every endpoint drove record user engagement, record average revenue per user, and contributed to our largest gaming revenue quarter ever, driven by software and services. We acquired two new studios this quarter, bringing the total to 13, more than doubling our first-party content capacity in the past six months. Xbox Live monthly active users reached a record 64 million, with the highest number of mobile and PC users to date. Xbox Game Pass subscribers and Mixer engagement also hit new all-time highs. Minecraft, one of the most popular and enduring gaming franchises in the industry, delivered record revenue as we expanded into new platforms, geographies, and segments such as education. PlayFab surpassed 1 billion player accounts this quarter, and xCloud will be trialed to the public later this year as we make progress on our ambition to build a world-class gaming platform across mobile, PC, and console. In closing, our accelerating customer momentum is driven by our deep and growing partnerships with leading companies and differentiated innovation across our portfolio. Every company is becoming a digital company, and they are looking for a trusted partner to help them build tech intensity. Microsoft is that partner. With that, I will hand over to Amy, who will cover our financial results in detail and share our outlook. I look forward to rejoining you for questions.

Thank you, Satya, and good afternoon, everyone. First, as a reminder, my comments on our results and outlook include the impact from GitHub, inclusive of purchase accounting, integration, and transaction-related expenses. This quarter, revenue was $32.5 billion, up 12% and 13% in constant currency. Gross margin dollars increased by 12%. Operating income increased by 18%, and earnings per share was $1.10, increasing 15% and 14% in constant currency when adjusting for net charges related to TCJA. Strong execution and continued customer demand for our hybrid cloud offerings drove another quarter of double-digit top and bottom line growth. We continued to benefit from favorable secular trends and IT spending conditions. From a geographic perspective, our performance was in line with macroeconomic trends, with strength across the U.S., Western Europe, and the U.K., partially offset by weaker performance in Central and Eastern Europe and the Middle East and Africa. In our commercial business, annuity mix grew by three points year-over-year to 89%. Commercial unearned revenue was $25.3 billion, growing 20%, slightly above our expectations. Commercial bookings were strong, growing 18% and 22% in constant currency, driven by solid renewal execution and an increase in the number of larger, longer-term Azure contracts. As a reminder, strong performance in larger long-term Azure contracts, Azure consumption overages, and pay-as-you-go contracts will drive bookings growth and in-period revenue but will have a limited impact on unearned revenue. Commercial cloud revenue was $9 billion, growing 48% and 47% in constant currency. Commercial cloud gross margin percentage increased by five points year-over-year to 62%, driven by significant improvement in Azure gross margin. Our company gross margin percentage was 62%, flat year-over-year, as improving cloud margins were offset by sales mix shifts to the commercial cloud and Surface hardware. The U.S. dollar was a bit stronger than anticipated, which resulted in a slightly greater impact on our results. FX reduced revenue, COGS, and operating expense growth by less than one point. Operating expenses grew by 7%, slightly lower than anticipated as some marketing spend shifted to Q3. We again expanded operating margins due to focused investment, solid execution, and improving gross margins in key product areas. Now, to segment results. Revenue from Productivity and Business Processes was $10.1 billion, increasing 13% driven by Office 365 Commercial, LinkedIn, and Dynamics 365. Office Commercial revenue grew by 11%. Office 365 Commercial revenue increased by 34%, driven by seat growth of 27% and ARPU expansion from continued migration to higher value E3 and E5 offerings. We saw installed base growth across all workloads and customer segments. Office Consumer revenue grew by 1% and 2% in constant currency, below our expectations. As discussed on our last earnings call, Q2 revenue growth was impacted by channel inventories normalizing after the pre-launch builds in Q1 and was further negatively impacted by a smaller-than-expected consumer PC market and execution challenges throughout the quarter. Office 365 Consumer subscribers grew to 33.3 million, a sequential slowdown primarily due to changes made in how Office 365 is sold in Japan. Our Dynamics business grew by 17% driven by Dynamics 365 revenue growth of 51% and 50% in constant currency. This quarter, more than 9 out of every 10 new Dynamics CRM customers chose our cloud offering. LinkedIn revenue increased by 29% and 30% in constant currency with continued strong execution across all businesses. LinkedIn sessions grew by 30% as engagement reached record levels. Segment gross margin dollars increased by 11%, and gross margin percentage declined slightly year-over-year as increased cloud mix offset the benefits from improvements in LinkedIn and Office 365 margins. Operating expenses increased by 3% and 4% in constant currency as we continued to invest in LinkedIn and cloud engineering. Operating income increased by 20% and 19% in constant currency. Next, the Intelligent Cloud segment, which now includes GitHub. Revenue was $9.4 billion, increasing 20% and 21% in constant currency, ahead of expectations, driven by continued strength in our hybrid solutions. Server products and cloud services revenue increased by 24%. Azure revenue increased by 76%, with strong growth from both the consumption and per user base businesses. In our on-premises server business, continued customer demand for flexible hybrid solutions and our premium offerings drove growth of 3% and 4% in constant currency. Enterprise Services revenue increased by 6% and 7% in constant currency, driven by growth in premier support services and Microsoft Consulting Services. Segment gross margin dollars increased by 20%. Gross margin percentage was relatively unchanged as revenue mix to Azure IaaS and PaaS was offset by material improvement in Azure gross margin percentage. Operating expenses increased by 26% with continued investment in cloud and AI engineering as well as commercial sales capacity and the addition of GitHub. Operating income grew by 16% and 15% in constant currency. Now, to the results for the More Personal Computing segment. Revenue was $13 billion, increasing by 7%. Results in our Windows OEM business were lower than expected, partially offset by strong Surface results. In Windows, the overall PC market was smaller than we expected primarily due to the timing of chip supply to our OEM partners, which constrained an otherwise healthy PC ecosystem and negatively impacted both OEM Pro and non-Pro revenue growth. Windows OEM Pro revenue declined by 2%, roughly in line with the commercial PC market. OEM non-Pro revenue declined by 11%, below the market with continued pressure in the entry-level category. Inventory levels ended the quarter below the normal range. Windows Commercial products and cloud services grew by 13% and 14% in constant currency with continued customer adoption of our premium offerings. Windows 10 deployments across new and existing devices remained strong. Gaming revenue grew by 8% and 9% in constant currency. Xbox software and services revenue increased by 31% and 32% in constant currency, primarily driven by continued strength from a third-party title. Additionally, strong subscriber growth across Xbox Live and Game Pass helped offset lower-than-expected performance from other third-party titles on the platform. Xbox hardware performed better than expected but declined year-over-year given the holiday launch of the Xbox One X a year ago. In Surface, revenue increased by 39% and 41% in constant currency to nearly $1.9 billion, ahead of our expectations, driven by strong growth across both our consumer and commercial segments. Search revenue ex TAC increased by 14%, driven by Bing rate growth and increased volume in the U.S. and international markets. Segment gross margin dollars increased by 6% and 7% in constant currency, and gross margin percentage decreased due to sales mix shifting to our lower-margin Surface and gaming businesses. Operating expenses declined by 4%. As a result, operating income increased by 18% and 19% in constant currency. Now back to total company results. Capital expenditures, including finance leases, were down sequentially to $3.9 billion, lower than originally planned mainly due to quarter-to-quarter variability and the timing of cloud infrastructure build-out. Cash paid for plant, property, and equipment was $3.7 billion. Cash flow from operations increased by 13% year-over-year, driven by strong cloud billings and collections. Free cash flow was $5.2 billion and decreased by 2% year-over-year, reflecting the timing of higher cash payments for plant, property, and equipment. Other income was $127 million, higher than anticipated, driven by interest income and investment gains, partially offset by interest expense and net losses on foreign currency remeasurement. Our non-GAAP effective tax rate was slightly above 17%, in line with expectations. We returned $9.6 billion to shareholders through share repurchases and dividends, an increase of 91%. Our Q2 share repurchase was $6.1 billion, higher than our normal quarterly pace, aligned with our commitment to fully offset stock consideration issued in the GitHub transaction by the end of the fiscal year. Now let's move to the outlook. For Q3, first, FX. With the stronger U.S. dollar and assuming the current rates remain stable, we now expect FX to decrease revenue and operating expense growth by approximately 2 points and decrease COGS growth by approximately 1 point. With the segments, we anticipate about 2 points of negative FX impact on revenue growth for Productivity and Business Processes and Intelligent Cloud and 1 point in More Personal Computing. Second, continued strong customer demand, healthy bookings growth, and increasing revenue annuity mix should drive another solid quarter in our commercial business. Commercial unearned revenue is expected to decline approximately 2% to 3%, consistent sequentially with historical trends. We expect commercial cloud gross margin percentage to continue to improve year-over-year, as significant improvement in Azure gross margin will again be partially offset by the mix of revenue toward Azure consumption-based services. Third, CapEx. We expect a sequential dollar increase in capital expenditures as we continue to invest to support increasing demand. Now, to segment guidance. In Productivity and Business Processes, we expect revenue between $9.9 billion and $10.1 billion, driven by double-digit growth in Office Commercial and Dynamics, as well as healthy LinkedIn growth on a strong prior year comparable. We expect Office Consumer revenue growth to continue to be in the low single digits, as growth in Office 365 will be partially offset by continuation of consumer PC market headwinds. For Intelligent Cloud, we expect revenue between $9.15 billion and $9.35 billion, with our hybrid demand continuing to drive strong growth in server products and cloud services. Azure growth will reflect the balance between strong growth in our consumption-based businesses and moderating growth in our per-user business. In More Personal Computing, we expect revenue between $10.35 billion and $10.65 billion, with a shift in revenue mix towards our Surface and gaming businesses. In Windows overall, OEM revenue growth should be in the low single digits, as we anticipate continued market impact from constrained chip supply in Q3. In Surface, continued momentum from Surface Pro 6, Surface Laptop 2, and Surface Go will drive another strong quarter of over 20% growth for Surface. In search ex TAC, we expect revenue growth similar to Q2. In gaming, we expect revenue growth to be slightly higher than last quarter, with a sales mix shifting to software and services where we expect healthy growth. Now back to overall company guidance. We expect COGS of $10.35 billion to $10.55 billion and operating expenses of $10.1 billion to $10.2 billion, inclusive of marketing spend that shifted from Q2 to Q3. Other income and expense should be approximately $50 million as interest income is partially offset by interest expense. We expect our Q3 effective tax rate to be in line with the full year rate of 17%. A few comments on our outlook for Q4 and the full fiscal year, which are unchanged from October. First on FX. In Q4, assuming rates remain stable, we expect FX to decrease revenue growth by approximately 2 points and COGS and operating expense growth by approximately 1 point. Second, in Q4, we expect continued strong performance in our commercial cloud business; but as a reminder, we also have several challenging comparisons from the prior year, specifically in on-premise server, LinkedIn, Windows OEM, and the strength of a third-party title in gaming. In terms of operating expenses, we expect full year growth of roughly 8%. We will continue to invest in strategic growth areas like Azure, GitHub, Dynamics, the Power Platform, LinkedIn, Teams, and gaming content given our significant growth opportunities, competitive advantage, and growing momentum. We expect full-year operating margin to be up slightly year-over-year, inclusive of the full GAAP impact of GitHub. For CapEx, we expect the growth rate for the year to moderate, even as we meet high demand for our cloud services. We remain committed to an incremental share buyback beyond the normal quarterly pace that will fully offset stock consideration issued in the GitHub transaction by the end of the fiscal year. We expect the full-year effective tax rate to be roughly 17% with quarterly variability. With that, Mike, let's move to Q&A.

Thanks, Amy. We'll now move over to Q&A. Operator, can you please repeat your instructions?

Nice quarter. A question on Azure, and it's a two-parter, one part for Satya and one for Amy. Satya, there's been a lot of press releases of you up on the stage with CEOs from companies like Albertson and Walgreens talking about these large strategic deals that you're executing with these firms. Can you help us understand how these large strategic deals translate into the services being used on Azure changing? Is there a mix shift in the type of services that are supporting these large digital transformations that we should be aware of on a going-forward basis? And to Amy, one of the significant investor debates is that many suppliers into the major cloud vendors, including yourself, are talking about weaker shipments to the suppliers. But you have sustained very stable growth. Azure growth remained solid from Q1 to Q2. Can you help us understand how the capital intensity of some of these cloud businesses have been evolving over time?

Sure. First of all, thank you, Keith, for the question. It is very true that at this point, we have seen these very large digital transformative efforts and projects that we are partnered with, spanning all industries. I think in the last quarter, you saw it in healthcare, retail, and financial services. I view these partnerships internally as being as critical as our relationships with our traditional OEM partners in the PC ecosystem. At this point, some of the partnerships we have with customers are of comparable magnitude. This reflects what's happening in the economy: every company is becoming a digital company, and essentially, what used to be COGS and operating expense is now going digital. Regarding service mix, it always starts with infrastructure, the edge and cloud, where infrastructure is used primarily as compute. The measure of a company transitioning to digital is the compute they use. So that's the base. On top of that, this compute also utilizes data, which leads to one of the largest changes: consolidating data so it can be evaluated. This is where AI services come into play. We definitely see customers adopting various Azure layers, but it doesn't stop there. For example, Walgreens Boots Alliance utilized both Microsoft 365 and Azure. Additionally, in many instances, IoT projects on Azure lead to Dynamics field service projects. This shows the breadth and depth of our cloud offering providing real synergy within our customers' goals, which is exactly what we aim for. One final comment is regarding our demand; we don't see any change. In fact, it is very healthy, and we expect it to remain robust. At our scale, we are becoming increasingly efficient in how we utilize software to manage our capacity, leading to significant utilization gains across our cloud resources. So with that, I'll turn it over to Amy.

And Keith, the thing I would add in addition to Satya's comments about the investment is that it significantly enhances our performance and utilization. What we've experienced is that it can be a little lumpy quarter-to-quarter, and so we expect sequential growth into Q3. This is typically a movement that occurs intermittently. Our guidance in terms of overall capital expenditure has remained unchanged from 90 days ago, despite timing moving month-to-month.

Amy, I just wanted to ask you a question about your March quarter guidance. The total looks terrific. The only area that might decelerate appears to be the Intelligent Cloud segment, where 17%, I think at the midpoint, implies still amazing but down from 20-plus percent the last three quarters. Could you help us understand some of the variables impacting next quarter's growth in the Intelligent Cloud business?

Thanks, Karl. The first place to start is obviously FX. We've got a 2-point headwind on that range of 16% to 18%, so if you think about that, consider moving your midpoint up to 19%. Additionally, within that guidance, there's a reasonable level of confidence that the server products and services KPI will remain quite healthy.

I have a question for Satya and then one for Amy if you don't mind. Satya, in the different documents related to the earnings this quarter, there is a discussion on the Microsoft launch of the Quantum Development Kit. Can you share a bit about how you're approaching quantum computing today, where it is in terms of maturation, and potential opportunities?

Sure. Thanks, Mark. We think of our overall investment in Quantum as a systems investment. At the scale we operate, the Intelligent Cloud and intelligent edge infrastructure that you track as Azure is our core platform, powering every aspect of Microsoft, from gaming ambitions to Dynamics 365 and even our third-party Azure business. Considering the scale, it is essential for us to stay at the forefront of breakthroughs in system architecture that can improve efficiency in distributed computing. This is why we have a long-term view on quantum, and the progress we've made in this last quarter includes bringing quantum simulator technologies to Azure. We're seeing solid adoption among scientific labs, universities, and some pharmaceutical companies who are preparing to build their quantum algorithmic promise long before the quantum computer cloud is a reality, ensuring they can take advantage of that computing capacity when it becomes available. However, keep in mind that before quantum becomes widely adopted, there are many byproducts of quantum efforts that can significantly improve efficiency and competitiveness in the broader computing landscape. This is why we emphasize the long-term goal of quantum, but you can expect us to bring many advancements and learnings to market sooner.

I really appreciate it. Amy, you provided great insights this quarter, but overall, there was transactional weak performance. Could you provide a bit more clarity? Is this driven by structural issues, such as U.S. government or China weakness, fewer renewal contracts, or is it simply technology-related?

Thanks, Mark, for the question. The only transactional weakness I noticed in the quarter was related to the OEM impact from chip supply, which accounted for about 1.5 points of growth on the More Personal Computing segment, and the Office Consumer impact was affected by the PC environment along with some execution challenges that we've identified and plan to resolve in H2. Apart from that, our transactional execution met our expectations. Office Commercial had a solid quarter despite some impacts we encountered in Q1, contributing a couple of points of growth. Similarly, the product and service KPIs in on-premises and server demonstrated strong performance amidst hybrid demand. Given the evolution in data center modernization, we continue to see solid demand for our premium SKUs.

Congrats on the great quarter. Focusing on Windows, Amy, you guided to low single-digit growth in Windows OEM revenue for Q3. Can you help us reconcile this with your comments about inventory levels being low for OEMs and issues with the mix?

Thank you! On the OEM side, we anticipate inventory levels to remain low as we exit the next quarter too. Given that we've seen constrained chip supply, we don't expect to foresee any impact from shifting inventory levels for the upcoming quarter. However, I do think we will observe improved performance in the Pro side of the market, which should help a bit. Regarding Windows Commercial, I acknowledge your point; we are starting to reach some tougher comparables, but much of those comparables stem from licensing changes that cause revenue recognition variations. This will continue to produce lumpiness in revenue. The actual billings have been consistent with double-digit growth, resembling the pattern of Office 365 growth which includes these SKUs.

I appreciate the visibility you have into transactional businesses. It suggests that you're stable or at least optimistic about the PC outlook for the rest of the year. Given that Windows significantly drives Microsoft’s overall profitability, if we see a prolonged decline in PC unit sales, can you share whether operating cost adjustments are possible to protect margins, or should we expect investments to align with longer-term strategies for commercial cloud and other lower-margin but high-opportunity businesses?

Let me start, and then Amy can add her perspective. First of all, the opportunity for our shareholders has never been better. When I look at every business transitioning to digital, our broad platform capabilities position us as the best technology partner for our customers globally as they embark on their digital journeys. Our business model aligns closely with their interests, enabling us to invest in commercial cloud segments, gaming, and support our aspirations for Microsoft 365, which extends beyond Windows and Office on Windows. We focus on the relevance of our products across all devices, including security, identity management, and information protection to create holistic customer value. Thus, I feel encouraged by the product and market investments that we make to ensure our shareholders will see their growth potential realized in an increasingly digital landscape.

To add a bit more context, Jennifer, around OEM, the signals from our commercial customers suggest a steady demand for the value Windows 10 provides. We've seen this reflected in deployments across new and existing devices, highlighting security and manageability, which enterprises value for their employees. Additionally, we know some end-of-support deadlines also provide ongoing opportunities for us in the marketplace, and I remain positive about our execution plans.

I wanted to focus on the data and database side of your business. We saw the recent acquisition of Citus Data. Could you discuss your perspective on Cosmos DB and the broader database ecosystem in terms of client adoption?

Yes, we feel very positive about our data platform and the portfolio we offer, whether it's on the relational side with SQL and PostgreSQL support or our Cosmos DB becoming the leading multi-model, multi-region database. I believe our data platform growth and competitiveness are solid and increasing. We are still the only provider capable of executing these solutions in a hybrid manner. The consistency of data handling from the edge to the cloud is crucial as edge scenarios continue to grow in significance. As a result, I am very confident in our data strategy, especially with the acquisition of Citus bolstering our PostgreSQL capabilities.

A question on Azure: growth numbers this quarter are very robust. Can you speak to your insights regarding growth visibility? A lot of that comes from enterprise agreements and customer commitments, and I wonder if you're comfortable providing a growth trajectory moving forward, given recent investor interest in that regard.

Regarding Azure growth, it is predominantly driven by consumption. This means we need to initiate projects successfully, allowing customers to realize the anticipated value from their investments. Hence, that's why we've been reiterating how we've seen larger commitments being made that contribute to bookings but not necessarily to unearned revenue on the balance sheet. It's a slightly different mechanism compared to what our standard enterprise agreements would look like. For IaaS and PaaS layers, the momentum builds on our execution each quarter, which is crucial for driving value. Another point is that Azure Hybrid Benefits reflect in on-prem revenue, even if it's ultimately utilized on the Azure side.

Satya, recently, you've announced several large, multi-year Azure wins with companies like Walmart and Albertsons. Are you sensing an amplified tailwind from Amazon's ambitions to compete with retailers and healthcare providers, like on the cloud side? Amy, I assume these wins are included in the robustness we see in commercial bookings growth, which is up 22%. But do we capture the entirety of those contracts in that metric? Or are we only seeing part of those bookings given the consumption structure?

Absolutely, the core focus is on establishing product truth and capabilities, which enable us to thrive in the competitive cloud environment. We have a compelling platform across our commercial cloud offerings and a strong alignment between our business model and our customers' objectives. Our primary goal is to empower every company striving to become digital enterprises by delivering comprehensive digital solutions. This has imparted competitive advantages over our competitors with more complex business models. Our commitment remains on ensuring that our product offerings uphold real synergies with what our customers aim to accomplish. We're actively leveraging our flexible business model to foster trust and loyalty, which is essential for our sustainable growth.

Most of these larger contracts are reflected in the commercial bookings number, and we referenced that these larger, long-term contracts showcase strong growth. Very little is recorded as unearned revenue, and that's the distinction driving many of these Azure contracts. It will show up in Azure revenue growth on the P&L as they get utilized.

Satya, you talked about Microsoft 365 being the new operating system, and you've emphasized your efforts to engage front-line workers, a demographic you previously couldn’t reach. What insights can you share about the total addressable market (TAM) expansion from that perspective?

A prime example of our front-line opportunity was displayed at NRF this January where we launched Teams for front-line workers, incorporating features for shift workers and secure messaging. One of the challenges in retail and other sectors is identifying a secure messaging tool that has the requisite enterprise-level security rather than relying on consumer messaging apps that exert liability on enterprises. This represents the opportunity we see across various domains including manufacturing and healthcare. These enhancements signify a significant TAM expansion across Microsoft 365.

Satya, about a year and a half ago, you reorganized the sales and customer service organization significantly. Are you observing any changes in sales cycles due to increasing deal complexity, and is there an observable impact on sales cycles from the macro volatility we've seen recently?

The transformation we conducted across engineering, marketing, and sales has been driven by the opportunity presented by the comprehensive capabilities of our commercial cloud services. It is true that larger contracts often result in more comprehensive engagements with deeper product stacks. Nevertheless, we have substantial experience dealing with various business areas with our customers, from refreshing on-premises infrastructures to executing high-ambition digital transformation projects. Hence, we are well-positioned to navigate the complexity and variability of our customers' demands, supported by the internal transformation that enhances our Cloud business.

We've observed that our sales organization experiences longer cycles similar to Dynamics or Power platform transactions that entail thorough understanding of business processes and necessary changes. These often come with longer sales cycles. Azure embodies many of these traits in terms of complexity and the digital transformation projects Satya describes. The considerable variability might be more noticeable in bookings, but we’re focused on maintaining growth.

Okay. Thank you, Alex. That wraps up the Q&A portion of today's earnings call. Thank you for joining us, and we look forward to speaking with all of you soon.

Thank you all.

Thank you.