Microsoft Corporation (MSFT) — Q1 2020 Earnings Call Transcript

Good afternoon. 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 Keith Dolliver, Deputy General Counsel. 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. 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 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 Microsoft Investor Relations website. During this call, we will be making forward-looking statements which are predictions, projections, and 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 factor 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 on the phone for joining. We are off to a strong start in fiscal 2020, delivering $33 billion in revenue this quarter. Our Commercial Cloud business continues to grow at scale as we work alongside the world’s leading companies to help them build their own digital capability. Microsoft provides a differentiated technology stack spanning application infrastructure, data and AI, developer tools and services, security and compliance, business process productivity and collaboration. First, each of these areas represents secular, long-term growth opportunities; second, we’re delivering best-in-class innovation and openness in each layer; and third, we offer unparalleled integration and architectural coherence across the entire stack to meet the real-world needs of our customers. Now, I’ll briefly highlight how we’re accelerating our progress in innovation, starting with Azure. Organizations today need a distributed computing fabric to meet their real-world operational sovereignty and regulatory needs. This quarter, we opened new data center regions in Germany and Switzerland. And in India, we’re bringing the power of Microsoft Cloud to millions of small businesses through our partnership with Jio, one of the largest mobile carriers in the country. Every Fortune 500 customer today is on a cloud migration journey, and we are making it faster and easier. Just this week, we announced an extensive go-to-market partnership with SAP, making Azure the preferred destination for every SAP customer. And our partnerships with VMware and Oracle also bring these ecosystems to our cloud. We’re extending beyond the cloud to the edge, enabling customers to get real-time insights where data is generated while ensuring security and privacy. And we’re seeing traction in every industry from Azure Sphere, securely connecting Starbucks coffee machines to Azure Stack, enabling scenarios from smart factories and modern compliant banking to mobile health care in remote areas. We are reimagining customers’ data estates with the cloud era with new limitless capabilities. Azure SQL database brings hyper-scale capabilities to relational databases, and Azure Cosmos DB, the low-latency high-availability database for globally distributed applications of any data type. The quintessential characteristic of every application going forward will be AI. And we have the most comprehensive portfolio of AI tools, infrastructure, and services. Azure AI now has more than 20,000 customers, and more than 85% of the Fortune 100 companies are using Azure AI in the last 12 months. In health care, Novartis chose Azure AI to transform how medicines are discovered, developed, and commercialized. Nuance will rely on our cloud to power the patient exam room of the future where clinical documentation writes itself. And Humana is using Azure AI to build personalized health care solutions for its more than 10 million members. We’re also pushing the bounds of how computers and AI can generalize learning beyond narrow domains, collaborating with OpenAI on a supercomputing platform to train and run AI models. I’m excited about our partnership and our collective pursuit to democratize AI and its benefits for everyone. Now to developer tools. The rise of digital IP creation in every organization means developers will increasingly drive and influence every business process and function, and GitHub is where they go to learn, share, and collaborate. GitHub has grown to more than 40 million developers, up more than 30% since our acquisition a year ago, and more than 2 million organizations use GitHub, including the majority of the Fortune 50. At Ford Motor Company alone, 8,000 employees use GitHub to innovate and collaborate with the vast ecosystem of third-party software developers. Our acquisition of semantic code analysis engine, Semmle, this quarter strengthens our security capabilities, enabling developers to more easily find vulnerabilities in large open-source code bases. Now, let’s turn to our workflow cloud Power Platform. Automating workflows across every function will be key to productivity gains for every organization. We are building Power Platform as the extensibility framework for both, Microsoft 365 inclusive of Microsoft Teams as well as Dynamics 365. It brings together low-code, no-code app development, robotic process automation, and self-service analytics, enabling everyone in an organization to build an intelligent app or workflow where none exists. Power Platform already has more than 2.5 million monthly active citizen developers. PowerApps helps domain experts, those closest to the business problem, to design, build and publish custom apps fast. And 84% of the Fortune 500 have already created power applications. Now, let’s talk about security. Rising cyber threats and increasing regulation mean security and compliance is a strategic priority for every organization. We have a comprehensive offering across identity, security, and compliance spanning people, devices, apps, developer tools, data, and infrastructure to protect customers in today’s zero trust environment. It starts with Azure Active Directory Premium used by more than 100,000 organizations for identity, access management, and SaaS application security across heterogeneous environments. It builds with information protection and cloud security with Microsoft Defender Advanced Threat Protection, and now with risk-based vulnerability management. And it extends to Azure Sentinel, now broadly available. Sentinel is a cloud-first service that analyzes security signals at massive scale across the entire organization using AI to detect, investigate, and automatically remediate threats. We’ll share more about our expanding opportunity in security at our Ignite Conference in the next few weeks. Now, on to business applications. Dynamics 365 is the only AI-powered business cloud that gives customers a 360-degree view of their business, from marketing and sales to finance and operations to unified data and insights. It enables every level of organization to move from reactive silo transaction processes to proactive, repeatable, and predictable business outcomes. This quarter, we introduced Dynamics 365 Commerce, a new omni-channel solution to unify back office, in-store, and digital experiences and deliver personalized content wherever shoppers are. Dynamics 365 AI insights app ingests data from any first-party or third-party source, freeing data from systems of record to power modern systems of engagement and intelligence. New Dynamics 365 Product Insights provides organizations like Ecolab a real-time view of how customers are using their products to maximize customer lifetime value. And Dynamics 365 connected store helps retailers like Marks & Spencer analyze observational data to optimize the in-store shopping experience. We’re enabling our customers to bridge the physical and digital business processes with our mixed reality cloud spanning HoloLens 2, Azure mixed reality services, and Dynamics 365 applications. Pharmaceutical company Patheon, for example, is using Dynamics 365 Guides along with HoloLens 2 to reimagine training for its employees. Now to LinkedIn. We saw record levels of engagement again this quarter across the platform. Marketing Solutions remains our fastest-growing segment, up 44% year-over-year, as marketers leverage our community-based tools to connect with LinkedIn’s nearly 660 million members. We continue to innovate across our talent portfolio, including Talent Solutions, Talent Insights, Glint, LinkedIn Learning to help every organization attract, retain, and develop top talent. LinkedIn Skills Assessment is a new way for members to showcase their proficiency and become more discoverable to recruiters. Now, turning to Microsoft 365 and Surface. Earlier this month, we unveiled our broadest Surface lineup to date, including two new dual-screen devices coming next year. We are reimagining every layer with how we infuse AI from silicon up to device form factors and the role of operating systems to help people be more productive and creative in a multi-sense, multi-device world. We will continue to invest across form and function to create new categories that benefit our entire OEM ecosystem. And our expanded partnership with Samsung builds on a promise to help people be more productive on any device anywhere, bringing OneDrive, Outlook, and more to new Samsung devices. Microsoft 365 is the world’s productivity cloud and the only comprehensive solution that empowers everyone from the C-suite to first-line workers with an integrated secure experience on any device. We’re infusing AI across Microsoft 365 to help make work more intuitive and natural. New Presenter Coach and PowerPoint makes anyone a better public speaker, new capabilities in Word enable professionals to transcribe or record audio files while staying in the flow. Video is more searchable, shareable, and first-class within Microsoft 365 with Stream. And new inking capabilities let users create and reply to comments from anywhere, using pen or voice. Microsoft Teams continues to gain traction, bringing together everything a team needs: chat, voice, meetings, and collaboration with the power of Office and business process workflow into a single integrated user experience, all with the highest security and compliance. Teams keeps all of your work, conversations, and meetings in context, eliminating the need to bounce back and forth between different apps with features like integrated calendaring and one-touch to join meetings from your phone, and we are broadening our opportunity with 2 billion first-line workers worldwide, adding priority notifications, role-specific targeted messages, and the ability to clock in and out of a shift. Our differentiated offering is driving usage making Teams the category leader. More than 350 organizations now have more than 10,000 users of Teams. More broadly, all this innovation is fueling growth. Office 365 commercial monthly active users surpassed 200 million this quarter. Leading organizations like Cerner, Chevron, and the LEGO Group are choosing our premium Microsoft 365 E5 offerings for their advanced security and productivity experiences. Finally, gaming. In gaming, we’re investing in content, community, and cloud services to expand our opportunity with 2 billion gamers worldwide. We saw record Xbox Live monthly active users with strength both on and off console in mobile and PC, and continued growth for Game Pass subscriptions. Gears 5 saw more than 3 million players in its first weekend alone. 10 years in, Minecraft is stronger than ever with record revenue and usage, and we are bringing the franchise to new audiences with Minecraft Earth. Finally, just last week, we started trials of Project xCloud, so gamers can play games wherever and whenever they want on any device. In closing, we are accelerating our innovation across the entire technology stack to deliver new value for customers. We’re investing aggressively in large markets with significant growth potential, and it’s still early days. With that, I’ll hand over to Amy who will call our financial results in detail and share our outlook. And I look forward to rejoining for your questions.

Thank you, Satya, and good afternoon, everyone. This quarter, revenue was $33.1 billion, up 14%, and 15% in constant currency. Gross margin dollars increased 18%, and 20% in constant currency. Operating income increased 27%, and 32% in constant currency, and earnings per share was $1.38, increasing 21%, and 25% in constant currency. Consistent execution and strong demand for our hybrid and cloud offerings drove a solid start to the fiscal year with another quarter of double-digit top and bottom line growth. From a geographic perspective, we saw broad-based strength across all markets. In our Commercial business, we again saw increased customer commitment across our cloud platform. In Azure, we had material growth in the number of $10 million plus contracts. Additionally, Microsoft 365 drove new customer adoption as well as expansion in our existing customer base, given the strong value Office 365, Windows 10, and Enterprise Mobility and Security provide as a secure intelligence solution. As a result, Commercial bookings growth was ahead of expectations, increasing 30%, and 35% in constant currency, with a higher volume of new business and strong renewal execution. Commercial annuity mix increased to 91% and Commercial unearned revenue was ahead of expectations at $31.1 billion, up 14% and 16% in constant currency. Our Commercial remaining performance obligation was $86 billion, up 26% and 27% in constant currency, driven by these long-term customer commitments. As a reminder, going forward, we will disclose the Commercial remaining performance obligations as a KPI, which better reflects commitments our customers are making across all contract types. Commercial Cloud revenue was $11.6 billion, growing 36% and 39% in constant currency. Commercial Cloud gross margin percentage increased 4 points year-over-year to 66%, as significant improvement in Azure gross margin offset a sales mix shift to Azure. Company gross margin percentage was 69%, up 3 points year-over-year and ahead of our expectations, driven by sales mix to higher-margin businesses. The U.S. dollar was a bit weaker than anticipated, which resulted in slightly less impact on our results. FX reduced revenue growth by less than 2 points, and cost of goods sold and operating expenses growth by approximately 1 point. Operating expenses grew 8% to 9% in constant currency, slightly lower than expectations mainly driven by the timing of marketing and project spend. And operating margins expanded this quarter, driven by the combination of higher gross margins and operating leverage through effective resource allocation. Now, to our segment results. Revenue from Productivity and Business Processes was $11.1 billion, increasing 13% and 15% in constant currency, ahead of expectations, primarily driven by the On-Premises Office Commercial business. Office Commercial revenue grew 13% and 15% in constant currency and benefited approximately 2 points from the transactional strength in Japan. Office 365 Commercial revenue growth of 25% and 28% in constant currency was again driven by installed base growth across all workloads and customer segments, as well as higher ARPU. Office 365 Commercial Seats increased 21% with a growing mix from our Microsoft 365 suite. Office Consumer revenue grew 5% and 6% in constant currency with roughly 7 points of benefit from transactional strength in Japan, more than offsetting the strong prior year comparable related to the launch of Office 2019. Office 365 consumer subscribers grew to 35.6 million. Dynamics revenue grew 14% and 16% in constant currency, driven by Dynamics 365 revenue growth of 41% and 44% in constant currency. LinkedIn revenue increased 25% and 26% in constant currency with continued strength across all businesses. LinkedIn sessions increased 22% as engagement again reached record levels. Segment gross margin dollars increased 16% and 19% in constant currency, and gross margin percentage increased 2 points year-over-year as improvements in LinkedIn and Office 365 margins more than offset an increase in cloud revenue mix. Operating expenses increased 8% and 9% in constant currency, driven by continued investment in LinkedIn and Cloud Engineering. Operating income increased 23% and 27% in constant currency. Next, the Intelligent Cloud segment. Revenue was $10.8 billion, increasing 27% and 29% in constant currency, ahead of expectations, driven by our on-premises server business. On a significant base, server products and cloud services revenue increased 30% and 33% in constant currency, driven by continued demand from our hybrid value. Azure revenue increased 59% and 63% in constant currency, with strong growth in our consumption-based business across all customer segments, partially offset by further moderation in our per-user business. Our Enterprise Mobility installed base grew 36% to over 120 million seats, benefiting from the Microsoft 365 suite momentum. And our on-premises server business grew 12% and 14% in constant currency, driven by continued strength across our hybrid and premium offerings, GitHub, and roughly 4 points of benefit from the end of support for SQL and Windows Server 2008. Enterprise Services revenue increased 7% and 8% in constant currency, driven by growth in Premier Support services. Segment gross margin dollars increased 27% and 30% in constant currency. Gross margin percentage was up slightly as another quarter of material improvement in Azure gross margin was partially offset by a growing mix of Azure IaaS and PaaS revenue. Operating expenses increased 22%, driven by ongoing engineering and sales investments in cloud and AI, including GitHub. Operating income grew 33% and 38% in constant currency. Now to More Personal Computing. Revenue was $11.1 billion, increasing 4% and 5% in constant currency, ahead of expectations as better-than-expected performance in our OEM Pro and Windows Commercial businesses more than offset lower than expected monetization across third-party titles within gaming. In Windows, OEM non-Pro revenue declined 7%, below the consumer PC market, with continued pressure in the entry-level category. OEM Pro revenue grew 19%, ahead of the commercial PC market, driven by strong Windows 10 demand and momentum in advance of the Windows 7 end of support. Inventory levels ended the quarter in the normal range. Windows Commercial products and cloud services revenue grew 26% and 29% in constant currency, driven by healthy demand for Microsoft 365, which carries higher in-quarter revenue recognition. Surface revenue declined 4% and 2% in constant currency, driven by the timing of product lifecycle transitions ahead of the recently announced product launches. Search revenue excluding TAC increased 11% and 13% in constant currency, driven by Bing rate growth. In gaming, revenue declined 7% and 6% in constant currency, driven by lower console sales. Xbox content and services revenue was relatively unchanged and increased 1% in constant currency with growth from Minecraft, Gears of War 5, and Game Pass subscriptions offset by a strong third-party title in the prior year. Segment gross margin dollars increased 12% and 13% in constant currency and gross margin percentage increased 4 points due to higher margin sales mix. Operating expenses declined 7% and 6% in constant currency as redeployment of engineering resources to higher growth opportunities was partially offset by investments in gaming. As a result, operating income grew 28% and 31% in constant currency. Now, back to total Company results. Capital expenditures including finance leases were $4.8 billion, up 12% year-over-year, driven by ongoing investment to meet growing demand for our cloud services and slightly below expectations due to normal quarterly spend variability in the timing of our cloud infrastructure build-out. Cash paid for PP&E was $3.4 billion. Cash flow from operations was $13.8 billion and increased 1% year-over-year, as strong cloud billings and collections were partially offset by tax payments related to the Q4 transfer of intangible property. Free cash flow was $10.4 billion and increased 4%. Excluding the impact of these tax payments, cash flow from operations and free cash flow grew 27% and 39%, respectively. As expected, in other income and expense, interest income was offset by interest expense, foreign currency remeasurement, and recognized losses on investments. Our effective tax rate was 16%, in line with expectations. And finally, we returned $7.9 billion to shareholders through share repurchases and dividends, an increase of 28% year-over-year. Now, let’s move to our outlook. Assuming current rates remain stable, we expect FX to decrease Intelligent Cloud revenue growth by approximately 2 points, total Company Productivity and Business Processes and More Personal Computing revenue growth by approximately 1 point, and have no impact on total Company COGS and operating expenses growth. We expect another strong quarter in our commercial business. Demand for our hybrid offerings and cloud services remained strong and capital expenditures will continue to reflect that. Given the normal variability and infrastructure spend timing, we expect Q2 CapEx spend to be down slightly on a sequential basis, but still growing from the prior year. And Commercial Cloud gross margin percentage will continue to improve on a year-over-year basis, even with the continued mix of revenue towards Azure consumption-based services. Now to segment guidance. In Productivity and Business Processes, we expect revenue between $11.3 billion and $11.5 billion, driven by double-digit growth across Office Commercial, Dynamics, and LinkedIn. For Intelligent Cloud, we expect revenue between $11.25 billion and $11.45 billion. In Azure, we expect continued strong growth in our consumption-based business and moderating growth in our per-user business, given the size of the installed base. Our on-premises server business will be driven by demand for our hybrid and premium solutions, as well as the continued benefit from increased demand ahead of the end of support for Windows Server 2008. In More Personal Computing, we expect revenue between $12.6 billion and $13 billion. In Windows, overall OEM revenue growth should again be ahead of the PC market as we balance healthy Windows 10 demand and the benefit from the upcoming end of support for Windows 7 with the supply chain’s ability to meet this demand in Q2. Based on our customer demand signals and prior end of support cycles, we expect some continued momentum past January, end of support deadline. In Windows Commercial products and cloud services, we expect another strong quarter, benefiting from continued Microsoft 365 momentum. In Surface, the launch of the latest Surface Pro and Surface laptop devices should drive low double-digit revenue growth on a strong prior year comparable. In Search excluding TAC, we expect revenue growth similar to Q1. And in gaming, we expect revenue to decline in the mid-20% range driven by lower console sales as we near the end of this generation, as well as the most challenging quarterly comparable and third-party titles from last year. Now, back to overall Company guidance. We expect COGS of $12.45 billion to $12.65 billion and operating expenses of $10.8 billion to $10.9 billion. Other income and expense should be approximately $50 million as interest income is partially offset by interest and finance lease expense. And finally, we expect our Q2 effective tax rate to be slightly above the full-year rate of 17%. Now, let me share some additional comments on the full year. At the Company level, we continue to expect double-digit revenue and operating income growth, driven by continued momentum in our commercial business. Given our strong first-quarter results and the expected sales mix for the remainder of the year, we now expect operating margins to be up slightly year-over-year, even as we continue to invest with significant ambition in high-growth areas. With that, Mike, let’s go to Q&A.

Thanks, Amy. We’ll now move over to Q&A. Out of respect to others on the call, we request the participants please only ask one question. Operator, can you please repeat your instructions?

Thank you for the question and for the positive feedback on the quarter. I would like to focus on the Intelligent Cloud business and your insights on hybrid trends. Satya, could you elaborate on how hybrid engagements are being rolled out with larger customers and how they are contracting? Additionally, how do these customers engage with both on-premise and cloud assets? Many investors have been pleasantly surprised by the performance of Server & Tools. Amy, could you provide clarity on Server & Tools’ growth of 14% in constant currency, which exceeded our expectations? How should we assess the sustainability of this growth considering the demand surge ahead of expirations like SQL Server and Windows Server? What aspects are likely to maintain strength moving forward?

Sure, Keith. Thanks for the question. Overall, our approach has always been about this distributed computing fabric or thinking about hybrid as not as some transitory phase, but as a long-term vision for how computing will meet the real-world needs. Because if you think about the long-term, compute will migrate to wherever data is getting generated, and increasingly there will be data generated in the real world, where just when you think about the cloud, you have to think about the edge of the cloud as a very first-class construct. So, in that context, what we see is a couple of things that you see even in the results today. One is the hybrid benefits. That is increasingly what is getting customers excited about the Azure choice and the fact that they can renew, knowing that they have the flexibility of both the cloud and the edge. That’s definitely driving growth. Second is we’re also gaining share. When you think about what’s happening even with the edge, some of our data center addition products are very competitive in the marketplace. And so, you see both of those effects. But architecturally, we feel well-placed. In fact at our Ignite Conference, you will see us even take the next leap forward even in terms of how we think about the architecture inclusive of the application models and programming models on what distributed computing looks like going forward. So, we feel well-positioned there.

In response to your question about durability, we highlighted four points that were related to the end of support, which accounts for four out of the twelve in USD. If we take a step back, the sustainable trends mentioned by Satya focus on licensing in a manner that acknowledges the long-term necessity of data and computing, which we refer to as the hybrid value proposition. The rights associated with this proposition are reflected in how we present these figures. Therefore, you will notice strong performance, as seen this quarter in both SQL and Windows, driven by the hybrid value proposition and overall strength, as customers appreciate the flexibility that comes with not being limited by licensing when managing their estate.

Excellent. That’s super helpful. Thanks, guys.

Thanks, Keith. Operator, we’ll take the next question, please.

Great. Thank you so much. This is a question for Amy. I was just wondering, you’ve been saying for a while now that you’re seeing material improvements in Azure gross margins, and that’s obviously hugely benefited Commercial Cloud gross margin. I’m just wondering if you could share with us how much of the improvement is related to the need to maybe expand data centers at a lower clip than you have been, and maybe it’s less depreciation and amortization that’s coming that you’re starting to recognize. How much of it is due to just better capacity utilization? And I’m just trying to get a sense of how much longer you’re going to be able to say that for, I guess, and just have you guys been ratcheting up your target gross margins for Azure over the years to where you think they could be, as you look ahead? Thank you.

Thank you, Heather. To begin with, the gross margin in the Commercial Cloud has been experiencing revenue growth that has significantly outpaced our capital expenditure growth over the past nearly two years. Starting from a broad perspective, we are observing an overall improvement in gross margins across our portfolio, which is particularly evident in Azure. This improvement is driven by a reduction in cost per unit and a shift in revenue toward premium services, allowing us to offer more SaaS-like and consumption services, as well as premium data services, which tend to have higher margins and consistent growth. This is reflected in our improving targets. Overall, the team has successfully executed on what we envisioned as a five-year plan to enhance gross margins substantially. As we continue to see a shift toward consumption-based Azure services, the overall cloud gross margin is expected to improve at a similar pace, and we anticipate this trend will continue in the future. Additionally, we expect Azure's gross margins, particularly on the consumption side, to further improve, especially as we roll out and see greater adoption of premium services.

Great. Thank you.

Thanks, Heather. Operator, we’ll take the next question, please.

Thank you. Amy, question for you. When I look at your next quarter guidance by revenue segment, it seems to equate to an overall revenue growth rate, assuming the midpoint of about 9% to 10%. So, when I combine that with the 14% growth you just put up in Q1, it implies that in the second half overall Microsoft revenue growth should remain roughly in the 10% ZIP code to enable you to get to double-digit growth for the full year, despite the fact that you’re moving past some fairly key end of support milestones. I think, some of us were expecting a little bit more of a first half, second half delta. So, I just wanted to ask you what are the maybe one or two or three drivers that enable you to sustain that growth rate in the second half, and if it’s fair to assume that your guidance doesn’t really reflect any deterioration in the overall spending environment? Thanks a lot.

Yes, I think there are several key points to highlight. Overall, the first quarter showed a strong start in terms of bookings, with positive trends across the board. We are seeing significant Azure commitments, consistent consumption growth rates for Azure, and strong commitments to Microsoft 365. Additionally, we have encouraging signs in our Dynamics, Power Platform, workflow cloud, and LinkedIn. It was a robust quarter for bookings and execution with good renewals, recapture rates, and new business. We are confident that these trends will continue throughout the year. While the end of support will present some challenges each quarter, the more sustainable trends show that our Commercial Cloud provides significant value and differentiation, leading to longer-term commitments from customers and continued growth in ARPU. Regarding the seasonality you mentioned, I believe the second quarter poses some challenges primarily related to gaming, which is reflected in improved margins compared to last year. Looking ahead to the second half, I anticipate that Surface will face easier comparisons and benefit from a new portfolio, allowing for a positive trajectory in H2 as well.

Terrific. Thank you, Amy.

Thanks, Karl. Operator, we’ll take the next question, please.

Thank you, and congrats on the quarter. AI is obviously a large focus; it was a large driver of Intelligent Cloud OpEx spending growth this quarter. Satya, can you give us some more color on where you see Microsoft on the AI journey? And, Amy, is this investing way ahead of revenue, or is AI already driving big revenue for Azure, how should we think about it? I appreciate it. Thanks.

Thanks, Mark. It’s a great question, because we look at what’s happening with AI having 2 dimensions to it. One is, I would say just our own use of AI as first-party SaaS applications. There are some phenomenal breakthroughs when you see new transcription features or new computer vision features that come with HoloLens. All of these are being driven by new AI capabilities that are all by the way powered by the same cloud infrastructure. We all build everything at Microsoft with first party equals third party with Azure as the core platform. And so what you see us is in fact using our own SaaS applications and consumer innovation even to drive the high-end AI capability, but then bringing the best-in-class tooling for enterprise customers. For example, like we have innovated even in, what does DevOps look like for the machine learning age? That’s a unique capability that’s there in Azure ML. And those are the types of innovations that are even driving the projects that our enterprise customers have on Azure. So, you will see us leverage our overall spend, whether it’s CapEx or OpEx across all of what Microsoft does and then surface them in I think what is perhaps the best way to get traction in the enterprise market, which is great tooling, compliance, security. And that’s a place where we’re making good progress.

And so, for me Mark, it’s a little bit hard for me to say, gosh, we invest in AI here and you’ll see it specifically here. What I think, you heard through Satya’s commentary is actually AI woven through every layer and component of the entire tech stack, and how important that is, whether you’re participating at the Dynamics 365 layer with Insights or whether you’re using components like some of our customers are for natural interaction work. And so, for me, it is almost fundamental to see that cost and investment because you’ll see it in margin and usage, and frankly product differentiation that we can provide versus our competitors.

Excellent. I really appreciate it. Thank you.

Thanks, Mark. Operator, we’ll take the next question, please.

Thanks. Amy, there’s been a lot of macro concern among tech investors, given some of the peers in your group have seen some weakness. It doesn’t seem that you have seen anything. But, I’m curious if you could just comment on what you’re seeing from a demand perspective.

Thanks, Brent. What I would say is for us, it has been so important to remain focused on where growth and opportunity exist, and to invest in those areas that are large, expansive, and durable. And I think, when you think about where we spend our time both building products, investing in marketing, and investing in sales capability and technical capability, it has been in many, if not all, of those places. So, when I look and say, where is our execution or how do I think about our ability to execute in a macro environment, for me, it is about investing in the right places, executing in a great way, remaining focused on the transition, our customers need us to help them through to create their own opportunity and their own growth. And I think we’ve done a nice job of being invested in the right places. Satya mentioned a few of them on the call, but there are really many. If you think about security, compliance, communication, workflow, business process reinvention, the list can go on and on where I feel like we have set up a multi-year journey to be well-positioned. And I tend to think of every quarter, every year as an opportunity to continue to differentiate, invest in innovation, and execute well to take share. And so, that’s I think how I’ve approached that.

And I think, that’s probably the unifying theme quite frankly of all the questions so far, which is what’s next. What’s next for us is in the apps and infra go from perhaps first innings to second innings; for data and AI to start the first innings. When it comes to security and compliance, we never participated in this. Guess what, we get to participate in a fairly competitive way now. We’ve built something that didn’t even exist a few years ago, which is the workflow cloud. That’s a huge opportunity for us. Biz apps, we are a very competitive and growing footprint. Even when you think about something like Microsoft 365, we never participated, in spite of our past success with all the first-line work, and now we get to participate in it. So, I see long-term secular growth opportunities, and we are going to stay focused on making sure our innovation is competitive in all those layers we talked about.

Thank you.

Thanks, Brent. Operator, we’ll take the next question, please.

Hey, guys. Thanks for taking my question, and congrats on another really impressive quarter. Satya, I want to focus on the strategic announcements you talked about earlier in the call, the Oracle, VMware, and obviously the most recent one with SAP. Wondering if you would just walk us through the sort of the strategic thoughts behind these. And then, also, especially with VMware and Oracle, since those are out there obviously longer, what’s the feedback from customers been? And then, I guess, to Amy, how do you think about sort of these big strategic differences showing up in the numbers?

Sure. Phil, thanks. So, overall, I think this is again one of those things where in the past we participated in the infrastructure business, but we had a fairly narrow footprint, which is we had our own infrastructure that supported primarily our databases and our operating systems. Whereas with the migration to the cloud, customers are looking for us to be a provider of all their infrastructure needs, which is heterogeneous. And that’s what has really led us at the infrastructure layer to have partnerships with VMware and Oracle. We, as you know, have first-class support for Windows and Linux, Java and .NET, Postgres and SQL, VMware, Red Hat as well as obviously the Windows hypervisor. So, I feel that we now have that ability to be able to take the entire infrastructure estate, the entire data estate and really add value with these partnerships. And SAP represents the same because SAP has got both infrastructure, we now are the preferred cloud. So, I think it’s a fairly no-brainer for any customer who is an SAP customer who wants to accelerate their migration to the cloud and innovation from SAP and us that they should move to Azure. And that’s what this announcement was all about. And so, we’re really looking forward to essentially executing on that strategy and that customer need that we see very clearly.

And Phil, to your question on where would we see this. You’d actually see it in a couple of places, not just in Azure, which may in fact be the most logical extension. But, at the heart of this is making it easier, faster, and more reliable for us to help customers move their estate to the cloud and to migrate that with confidence. And so, when we do that, it’s about becoming a committed partner. And you actually see that in broader Microsoft Cloud results whether that’s helping even through these partnerships to be able and get closer to Tier 1 workloads, business process changes. And so, I actually think these are quite important for us to continue to make sure the first goal is customer-centric, which is why we continue to move in this direction.

Thanks, Phil. Operator, we’ll take the next question, please.

Great. Thank you. I think this question is likely for Amy. As I analyze the dynamics within Office 365 and the conversation surrounding the sustainability of double-digit growth in the Commercial segment, I've noticed that the seat count has slowed down, and the increase in pricing may not be as significant as it has been in the past. This leads me to believe that you are experiencing considerable success with the frontline worker aspect, which might be a larger factor driving the seat count moving forward. However, can you elaborate on the remaining opportunities for migrating commercial licenses compared to potentially relying more on frontline worker initiatives to maintain that growth? Also, is there a possibility that the seat growth in frontline roles could negatively impact your ability to increase average revenue per user (ARPU) for your existing customer base?

Thanks, Jen. Let me break this question down because you are actually highlighting important dynamics that I don’t necessarily view as trade-offs. First, regarding seat growth, we still have potential beyond just first-line workers, especially in small and mid-sized businesses globally with mobile-first workers. This presents a broad opportunity for us to engage with people trying to accomplish their tasks and work on devices of any size. There is significant potential for us to make progress in this area. Now, might this lead to some long-term pressure on average revenue per user? It certainly could. However, I don’t consider that to be a negative. Previously, we earned very little from the seats we've just discussed, so every dollar earned from these new seats represents new revenue and new opportunity for us. Let me distinguish that from the next dynamic, which is why an average number might not be the best indicator of our ability to move customers to higher value products, whether through added features in security, compliance, communications, collaboration, knowledge, or learning. We can add value in this area, whether we label it E5 or E3, and I believe we still have room for that transition. I feel very optimistic about Microsoft 365 and our capacity to continue to provide value. Hopefully, that clarifies things, Jen.

Yes. That’s great. Thank you.

Thanks, Jen. Operator, we’ll take our last question now, please.

Hey. Thanks for squeezing me in. Quick question on Azure. If I look at the SAP announcements, but you had some other industry announcements out there that smell like Humana, et cetera. Like, how do I have to think about the progress you guys are making there in terms of getting more into the different industries and to kind of create deeper relationships around Azure evolving and just doing kind of simple infrastructure outsourcing? Thank you.

Yes. It’s a very deliberate strategy that we have. In meeting our customers’ needs, we need to have the partners they already work with and want to work with also on our platform. So, it starts sometimes with the customers, whether it’s Humana or Walgreens or Walmart and others. It also starts with partners like Nuance, which is another one that we announced recently. And so, the idea is for us to be really ensuring that by every industry we have the right marquee customers as well as the partners and have strong go-to-market strategies. One of the things that everyone I think in the marketplace understands is Microsoft, especially from a partner perspective, is a great route to market. We have a platform directly with our sales force, as well as our channel, that is very attractive to third-party developers to get on Azure, and they realize those benefits. And in fact, our customers rely on that as also a benefit because it helps them get the best value from their partners as well.

Thanks, Raimo. That wraps up the Q&A portion of today’s earnings call. Thank you for joining us today. And we look forward to speaking with all of you soon.

Thank you.

Thank you, all.