Microsoft Corporation (MSFT) — Q1 2024 Earnings Call Transcript

Good afternoon, and thank you for joining us today. On the call with me are Satya Nadella, Chairman and Chief Executive Officer; Amy Hood, Chief Financial Officer; Alice Jolla, Chief Accounting Officer; and Keith Dolliver, Corporate Secretary and 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 the reconciliation of differences between GAAP and non-GAAP financial measures. More detailed outlook slides will be available on the Microsoft Investor Relations website when we provide outlook commentary on today's call. Microsoft completed the acquisition of Activision Blizzard on October 13, 2023. We will share more on the expected impact of the Activision acquisition during the outlook commentary portion of today's call. On this call, we will discuss certain non-GAAP items. The non-GAAP financial measures provided should not be considered 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 first-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'll 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'll 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, 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 statement. And with that, I'll turn the call over to Satya.

Thank you, Brett. We are off to a strong start to the fiscal year, driven by the continued strength in Microsoft Cloud, which surpassed $31.8 billion in quarterly revenue, up 24%. With Copilots, we are making the age of AI real for people and businesses everywhere. We are rapidly infusing AI across every layer of the tech stack, and for every role and business process to drive productivity gains for our customers. Now I'll highlight examples of our progress starting with infrastructure. Azure again took share as organizations bring their workloads to our cloud. We have the most comprehensive cloud footprint with more than 60 data center regions worldwide, as well as the best AI infrastructure for both training and inference. We also have our AI services deployed in more regions than any other cloud provider. This quarter, we announced the general availability of our next-generation H100 Virtual Machines. Azure AI provides access to best-in-class frontier models from OpenAI and open-source models, including our own, as well as from Meta and Hugging Face, which customers can use to build their own AI apps while meeting specific cost latency and performance needs. Because of our overall differentiation, more than 18,000 organizations now use Azure OpenAI services, including new Azure customers. We continue to see more cloud migrations with Azure Arc. We're meeting customers where they are, helping them run apps across on-prem edge and multi-cloud environments. We now have 21,000 Arc customers, up 140% year-over-year. We are the only cloud provider to run Oracle's database services, making it simpler for customers to migrate their on-prem Oracle databases to our cloud. Customers like PepsiCo and Vodafone will have access to a seamless fully integrated experience for deploying, managing, and using Oracle database instances on Azure. And we are the cloud of choice for customers' SAP workloads too. Companies like Brother Industries, Hanes, ZEISS, and ZF Group all run SAP on Azure. Now on to data, in the age of Copilots, organizations are looking to consolidate their data estate; that's why with our Microsoft Intelligent Data Platform, we are bringing together operational data stores, analytics, and governance. More than 73% of the Fortune 1000 use three or more of our data solutions today. And with Microsoft Fabric, we are unifying compute, storage, and governance into one end-to-end analytical solution with an all-inclusive business model. More than 16,000 customers are actively using Fabric, including over 50% of the Fortune 500. Now on to developers. With GitHub Copilot, we are increasing developer productivity by up to 55%, while helping them stay in the flow and bringing the joy back to coding. We have over 1 million paid Copilot users and more than 37,000 organizations have subscribed to Copilot for business, up 40% quarter-over-quarter with significant traction outside the United States. This quarter we added new capabilities with GitHub Copilot Chat, which are already being used by both digital natives like Shopify, as well as leading enterprises like Maersk and PwC to supercharge the productivity of their software developers. Overall, the number of developers using GitHub has increased 4x since our acquisition five years ago. We've also brought Copilot to Power Platform, enabling anyone to use natural language to create apps, build virtual agents, and analyze data. More than 126,000 organizations, including 3M, Equinor, Lumen Technologies, Nationwide, PG&E, and Toyota have all used Copilot in Power Platform to date. EY, for example, has enabled Copilot for all 170,000-plus Power Platform users at the company. And this quarter we added new Copilot capabilities to Power Pages, making it possible to build a data-driven website using just a few sentences or clicks. Finally, Power Apps remains the market leader in low-code no-code development, now with 20 million monthly active users, up 40% year-over-year. Now on to business applications, overall Dynamics 365 took share for the 10th consecutive quarter. We're using this AI inflection point to redefine our role in business applications. We are becoming the Copilot-led business process transformation layer on top of existing CRM systems like Salesforce. For example, our Sales Copilot helps sellers at more than 15,000 organizations, including Rockwell Automation, Sandvik Coromant, Securitas, and Teleperformance, personalize customer interactions based on data from third-party CRMs. We're also bringing Copilot to Dynamics 365 to help with everything from suggested actions and content ideas to faster access to valuable business data. This quarter, we introduced Copilot in Dynamics 365 Field Service to help streamline frontline tasks. Now on to industry and cross-industry clouds. In healthcare, our Dragon Ambient Experience solution helps clinicians automatically document patient interactions at the point of care. It's been used across more than 10 million interactions to date. And with DAX Copilot, we are applying generative AI models to draft high-quality clinical notes in seconds, increasing physician productivity and reducing burnout. For example, Atrium Health, a leading provider in the Southeast United States, credits DAX Copilot with helping its physicians save up to 40 minutes per day in documentation time. We are also introducing healthcare data solutions in Microsoft Fabric, enabling providers like Northwestern Medicine and SingHealth to unify health data in a secure, compliant way. And with our Microsoft Cloud for sovereignty, which will become generally available by the end of the calendar year, we offer industry-leading data sovereignty and encryption controls, meeting the specific needs of public sector customers around the world. Now on to the future of work. Copilot is your everyday AI assistant, helping you be more creative in Word, more analytical in Excel, more expressive in PowerPoint, more productive in Outlook, and more collaborative in Teams. Tens of thousands of employees at customers like Bayer, KPMG, Mayo Clinic, Suncorp, and Visa, including 40% of the Fortune 100, are using Copilot as part of our early access program. Customers tell us that once they use Copilot, they can't imagine work without it, and we are excited to make it generally available for enterprise customers next week. This quarter, we also introduced a new hero experience in Copilot, helping employees tap into their entire universe of work, data, and knowledge using chat. The new Copilot Lab helps employees build new work habits for this era of AI by helping them turn good prompts into great ones. When it comes to Teams, usage continues to grow with more than 320 million monthly active users, making Teams the place to work across chat, collaboration, meetings, and calling. This quarter, we introduced a new version of Teams that is up to 2 times faster, while using 50% less memory and includes seamless cross-tenant communications and collaboration. We've seen nine consecutive quarters of triple-digit revenue growth for Teams Rooms, and more than 10,000 paid customers now use Teams Premium. Teams has also become a multiplayer canvas for business processes. There are more than 2,000 apps in the Teams Store, and collaborative apps from Adobe, Atlassian, and Workday each exceeded 1 million monthly active users on Teams. With Viva, we have created a new market category for employee experience, helping companies like Dell, Lloyds Banking Group, and PayPal build high-performance organizations. With skills in Viva, we are bringing together information from Microsoft 365 and LinkedIn to help employers understand workforce gaps and suggest personalized learning content to address it, all in the flow of work. Overall, we continue to see more organizations choose Microsoft 365, and companies across the private and public sectors, including Cerberus, Chanel, and DXC Technology, all rely on our Premium E5 offerings for advanced security compliance, voice, and analytics. Now on to Windows. The PC market unit volumes were at roughly pre-pandemic levels, and we continue to innovate across Windows, adding differentiated AI-powered experiences to the operating system. We rolled out the biggest update to Windows 11 ever, adding 150 new features including new AI-powered experiences in apps like Clipchamp, Paint, and Photos, and we introduced Copilot in Windows, the Everyday AI companion, which incorporates the context to the web, your work data, and what you are doing on the PC to provide better assistance. We are seeing accelerated Windows 11 deployments worldwide from companies like BP, Eurowings, Kantar, and RBC. Finally, with Windows 365 Boot and Switch, we're making it easier than ever for employees at companies like Crocs, Hamburg Commercial Bank, and ING Bank to get a personalized Windows 365 Cloud PC with Copilot on any device. Now on to security. The speed, scale, and sophistication of cyberattacks today is unparalleled, and security is the number one priority for CIOs worldwide. We see high demand for Security Copilot, the industry's first and most advanced generative AI product, which is now seamlessly integrated with Microsoft 365 Defender. Dozens of organizations including Bridgewater, Fidelity National Financial, and Government of Alberta have been using Copilot in Preview, and early feedback has been positive. We look forward to bringing Copilot to hundreds of organizations in the coming months as part of the new early access program so they can improve the productivity of their own security operation centers and stop threats at machine speeds. More broadly, we continue to take share across all major categories we serve, and our SIEM, Microsoft Sentinel, now has more than 25,000 customers in revenue, surpassing a $1 billion annual run-rate. Customers in every industry, like Booz Allen Hamilton, Grant Thornton, and MetLife use our end-to-end solutions to protect their environments. Now on to LinkedIn. We are now applying this new generation of AI to transform how the 985 million members learn, sell, and get hired. Membership growth has now accelerated each quarter for over two years in a row. This quarter, we introduced new AI-driven features across all of our businesses, including our learning coach that gives members personalized content guidelines, and tools to help employers find qualified candidates and sellers and marketers attract buyers in a single step. Since introducing AI-assisted messages for recruiters five months ago, three-fourths of them say it saved them time. We have seen a nearly 80% increase in members watching AI-related learning courses this quarter. More broadly, we continue to see record engagement and knowledge sharing on the platform. We now have more than 450 million newsletter subscriptions globally, up 3x year-over-year. Premium subscription sign-ups were up 55% year-over-year, and our hiring business took share for the fifth consecutive quarter. Now on to search, advertising, and news. With our Copilot for the Web, we are redefining how people use the Internet to search and create. Bing users have engaged in more than 1.9 billion chats, and Microsoft Edge has now gained share for 10 consecutive quarters. This quarter, we introduced new personalized answers, as well as support for DALL-E 3, helping people get more relevant answers and create incredibly realistic images with more than 1.8 billion images created to date. With our Copilot and Shopping, people can find more tailored recommendations and better deals. We're also expanding to new endpoints, bringing Bing to Meta's AI chat experience in order to provide more up-to-date answers, as well as access to real-time search information. Finally, we are integrating this new generation of AI directly into our ad platforms to more effectively connect marketers to customer intent in chat experiences, both from us as well as customers like Axel Springer and Snap. Now on to gaming. We were delighted to close our acquisition of Activision Blizzard King earlier this month. Together, we will advance our goal of bringing great games to players everywhere on any endpoint. Already with Game Pass, we're redefining how games are distributed, played, and discovered. We set a record for hours played per subscriber this quarter. We released Starfield this quarter to broader acclaim, with more than 11 million people having played the game to date. Nearly half of the hours played have been on PC, and on launch day, we set a record for the most Game Pass subscriptions added on a single day ever. Minecraft has now surpassed 300 million copies sold, and with Activision Blizzard King, we now add significant depth to our content portfolio. We will have $13 billion-plus franchises from Candy Crush, Diablo, Halo, Warcraft, Elder Scrolls, and Gears of War. We're looking forward to one of our strongest first-party holiday lineups ever, including new titles like Call of Duty: Modern Warfare 3 and Forza Motorsport. In closing, we are rapidly innovating to expand our opportunity across our consumer and commercial businesses as we help our customers thrive in this new era. In just a few weeks, we'll be holding our flagship Ignite Conference, where we will introduce more than 100 new products and capabilities, including exciting new AI innovations. I encourage you to tune in.

Thank you, Satya, and good afternoon, everyone. This quarter's revenue was $56.5 billion, up 13% and 12% in constant currency. Earnings per share was $2.99, an increase of 27% and 26% in constant currency. Consistent execution by our sales teams and partners drove a strong start to the fiscal year. Results exceeded expectations, and we saw share gains again this quarter across many businesses as customers adopt our innovative solutions to transform their businesses. In our commercial business, the trends from the prior quarter continued. We saw healthy renewals, particularly in Microsoft 365 E5, and the growth of new business continued to be moderated for standalone products sold outside the Microsoft 365 suite. In Azure, as expected, the optimization trends were similar to Q4. Higher-than-expected AI consumption contributed to revenue growth in Azure. In our consumer business, PC market unit volumes are returning to pre-pandemic levels. Advertising spend landed roughly in line with our expectations, and in gaming, strong engagement, helped by the Starfield launch, benefited Xbox content and services. Commercial bookings increased 14% and 17% in constant currency, in line with expectations, primarily driven by strong execution across our core annuity sales motions, with continued growth in the number of $10 million-plus contracts for both Azure and Microsoft 365. Commercial remaining performance obligation increased 18% to $212 billion, and roughly 45% will be recognized in revenue in the next 12 months, up 15% year-over-year. The remaining portion, which will be recognized beyond the next 12 months, increased 20% and this quarter, our annuity mix was 96%. FX did not have a significant impact on our results and was roughly in line with our expectations on total company revenue, segment-level revenue, COGS, and operating expense growth. Microsoft Cloud revenue was $31.8 billion, growing 24% and 23% in constant currency, ahead of expectations. Microsoft Cloud's gross margin percentage increased slightly year-over-year to 73%, a point better than expected, primarily driven by improvements in Azure. Excluding the impact of the change in accounting estimate for useful lives, Microsoft Cloud's gross margin percentage increased roughly 2 points, driven by the mentioned improvement in Azure as well as Office 365, partially offset by the impact of scaling our AI infrastructure to meet growing demand. Company gross margin dollars increased 16% and 15% in constant currency, and gross margin percentage increased year-over-year to 71%. Excluding the impact of the change in accounting estimate, the gross margin percentage increased roughly 3 points, driven by the improvement in Azure and Office 365 as well as a sales mix shift to higher-margin businesses. Operating expenses increased 1%, lower than expected due to cost-efficiency focus as well as investments that shifted to future quarters. Operating expense growth was driven by marketing, LinkedIn, and cloud engineering, partially offset by devices. At a total company level, headcount at the end of September was 7% lower than a year ago. Operating income increased 25% and 24% in constant currency. Operating margins increased roughly 5 points year-over-year to 48%. Excluding the impact of the change in accounting estimate, operating margins increased roughly 6 points, driven by improved operating leverage through cost management and the higher gross margin noted earlier. Now to our segment results. Revenue from Productivity and Business Processes was $18.6 billion and grew 13% and 12% in constant currency, ahead of expectations, driven by better-than-expected results in Office 365 Commercial and LinkedIn. Office Commercial revenue grew 15% and 14% in constant currency. Office 365 Commercial revenue increased 18% and 17% in constant currency, slightly better than expected with a bit more in-period revenue recognition, while billings remained relatively in line with expectations. Growth continues to be driven by healthy renewal execution and ARPU growth, as E5 momentum remains strong. Paid Office 365 Commercial seats grew 10% year-over-year, with installed-base expansion across all customer segments. Seat growth was again driven by our small and medium business and frontline worker offerings with continued impact from the growth trends in new standalone business noted earlier. Office Commercial licensing declined 17%, in line with the continued customer shift to cloud offerings. Office Consumer revenue increased 3% and 4% in constant currency, with continued momentum in Microsoft 365 subscriptions, which grew 18% to 76.7 million. LinkedIn revenue increased 8%, ahead of expectations, driven by slightly better-than-expected performance across all businesses. Growth was driven by Talent Solutions, though we continue to see negative year-over-year bookings there from the weaker hiring environment in key verticals. Dynamics revenue grew 22% and 21% in constant currency, driven by Dynamics 365, which grew 28% and 26% in constant currency with continued growth across all workloads. Segment gross margin dollars increased 13% and gross margin percentage increased slightly year-over-year. Excluding the impact of the change in accounting estimate, gross margin percentage increased roughly 1 point, driven by improvements in Office 365. Operating expenses increased 2% and operating income increased 20% and 19% in constant currency. Next, the Intelligent Cloud segment. Revenue was $24.3 billion, increasing 19% and ahead of expectations, with better-than-expected results across all businesses. Overall, server products and cloud services revenue grew 21%. Azure and other cloud services revenue grew 29% and 28% in constant currency, including roughly 3 points from AI Services. While the trends from the prior quarter continued, growth was ahead of expectations, primarily driven by increased GPU capacity and better-than-expected growth in our per-user business. In our on-premises server business, revenue increased 2% ahead of expectations, driven primarily by demand in advance of Windows Server 2012 end of support. Enterprise and partner services revenue increased 1% and was relatively unchanged in constant currency ahead of expectations, driven by a better-than-expected performance in Enterprise Support Services. Segment gross margin dollars increased 20% and 19% in constant currency, and gross margin percentage increased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage increased roughly 2 points, driven by the improvement in Azure noted earlier, even as we scale our AI infrastructure to meet growing demand. Operating expenses increased 2% and 1% in constant currency, operating income grew 31% and 30% in constant currency. Now to More Personal Computing, revenue was $13.7 billion, increasing 3% and 2% in constant currency, above expectations, with better-than-expected results across all businesses. Windows OEM revenue increased 4% year-over-year, significantly ahead of expectations, driven by stronger-than-expected consumer channel inventory builds and the stabilizing PC market demand noted earlier, particularly in commercial. Windows Commercial products and cloud services revenue increased 8%, driven by demand for Microsoft 365 E5. Devices revenue decreased 22%, ahead of expectations due to stronger execution in the commercial segment. Search and news advertising revenue, ex-TAC increased 10% and 9% in constant currency, slightly ahead of expectations. We saw increased engagement on Bing and Edge share gains again this quarter, although search revenue growth continues to be impacted by a third-party partnership. In gaming, revenue increased 9% and 8% in constant currency, ahead of expectations, driven by better-than-expected subscriber growth in Xbox Game Pass as well as first-party content, primarily due to the Starfield launch. Xbox content and services revenue increased 13% and 12% in constant currency, and Xbox hardware revenue declined 7% and 8% in constant currency. Segment gross margin dollars increased 13% and 12% in constant currency, and gross margin percentage increased roughly 5 points year-over-year, driven primarily by sales mix-shift to higher-margin businesses. Operating expenses declined 1% and operating income increased 23% and 22% in constant currency. Now back to total company results. Capital expenditures, including finance leases, were $11.2 billion to support cloud demand, including investments to scale our AI infrastructure. Cash paid for PP&E was $9.9 billion. Cash flow from operations was $30.6 billion, up 32% year-over-year, driven by strong cloud billings and collections. Free cash flow was $20.7 billion, up 22% year-over-year. This quarter, other income and expense was $389 million, higher than anticipated, driven by interest income, partially offset by net losses on investments and foreign currency remeasurement. Our effective tax rate was approximately 18%. Finally, we returned $9.1 billion to shareholders through share repurchases and dividends. Now moving to our Q2 outlook, which unless specifically noted otherwise is on a U.S. dollar basis. The Activision acquisition closed on October 13. So my commentary includes the net impact of the deal from the date of acquisition. Our outlook includes purchase accounting impact, integration, and transaction-related expenses based on our current understanding of the purchase price allocation and related deal accounting. The net impact includes adjusting for the movement of Activision content from our prior relationship as a third-party partner to first party. Now to FX. Based on current rates, we expect FX to increase total revenue and segment-level revenue growth by approximately one point. We expect FX to have no impact on COGS and operating expense growth. In commercial bookings, we expect consistent execution across our core annuity sales motions, including healthy renewals. The growth will be impacted by a low growth expiry base. Therefore, we expect bookings growth to be relatively flat. Microsoft Cloud gross margin percentage to be relatively flat year-over-year, excluding the impact from the accounting estimate change. Q2 Cloud gross margin percentage will be up roughly 1 point, primarily driven by improvements in Azure and Office 365, partially offset by the impact of scaling our AI infrastructure to meet growing demand. We expect capital expenditures to increase sequentially on a dollar basis, driven by investments in our cloud and AI infrastructure. As a reminder, there can be normal quarterly spend variability in the timing of our cloud infrastructure buildout. Next to segment guidance. In Productivity and Business Processes, we expect revenue to grow between 11% and 12%, or $18.8 billion to $19.1 billion. Growth in constant currency will be approximately 1 point lower. In Office Commercial, revenue growth will again be driven by Office 365 with seat growth across customer segments and ARPU growth through E5. We expect Office 365 revenue growth to be up roughly 16% in constant currency. We're excited for Microsoft 365 Copilot general availability on November 1st, and expect the related revenue to grow gradually over time. In our on-premise business, we expect revenue to decline in the mid-to-high teens. In Office Consumer, we expect revenue growth in the mid-single-digits, driven by Microsoft 365 subscriptions. For LinkedIn, we expect revenue growth in the mid-single-digits, driven by Talent Solutions and Marketing Solutions. Growth continues to be impacted by the overall market environment for recruiting and advertising, especially in the technology industry, where we have significant exposure. And in Dynamics, we expect revenue growth in the high teens, driven by Dynamics 365. For Intelligent Cloud, we expect revenue to grow between 17% and 18%, or $25.1 billion to $25.4 billion. Revenue growth in constant currency will be approximately 1 point lower. Revenue will continue to be driven by Azure, which, as a reminder, can have quarterly variability, primarily from our per-user business and from in-period revenue recognition, depending on the mix of contracts. In Azure, we expect revenue growth to be 26% to 27% in constant currency, with an increasing contribution from AI. Growth continues to be driven by the Azure consumption business and we expect the trends from Q1 to continue into Q2. Our per-user business should continue to benefit from Microsoft 365 suite momentum, though we expect continued moderation in seat growth rates, given the size of the installed base. For H2, assuming the optimization and new workload trends continue, and with the growing contribution from AI, we expect Azure revenue growth in constant currency to remain roughly stable compared to Q2. Our on-premises server business is expected to have revenue growth that is roughly flat with continued hybrid demand, particularly from licenses running in multi-cloud environments. In enterprise and partner services, revenue should decline by low-to-mid single digits. Now to more Personal Computing, which includes the net impact from the Activision acquisition. We expect revenue of $16.5 billion to $16.9 billion. Windows OEM revenue growth should be mid-to-high single digits with PC market unit volumes expected to look roughly similar to Q1. In devices, revenue should decline in the mid-teens as we continue to focus on our higher-margin premium products. In Windows Commercial products and cloud services, customer demand for Microsoft 365 and our advanced security solutions should drive revenue growth in the low-to-mid teens. Search and news advertising ex-TAC revenue growth should be mid-single digits with roughly 4 points of negative impact from a third-party partnership. Growth should be driven by volume strength, supported by Edge browser share gains and increasing Bing engagement, as we expect the advertising spend environment to be similar to Q1. A reminder that this ex-TAC growth will be roughly 4 points higher than overall search and news advertising revenue. In gaming, we expect revenue growth in the mid-to-high 40s. This includes roughly 35 points of net impact from the Activision acquisition, which as a reminder includes adjusting for the third-party to first-party content change noted earlier. We expect Xbox content and services revenue growth in the mid-to-high 50s, driven by roughly 50 points of net impact from the Activision acquisition. Now back to company guidance. We expect COGS between $19.4 billion to $19.6 billion, including approximately $500 million of amortization of acquired intangible assets from the Activision acquisition. We expect operating expenses of $15.5 billion to $15.6 billion, including approximately $400 million from purchase accounting adjustments, integration and transaction-related costs from the Activision acquisition. Other income and expense should be roughly negative $500 million, as interest income will be more than offset by interest expense, primarily due to a reduction in our investment portfolio balance and the issuance of short-term debt, both for the Activision acquisition. As a reminder, we are required to recognize gains or losses on our equity investments, which can increase quarterly volatility. We expect our Q2 effective tax rate to be between 19% and 20%. Now, some additional thoughts on H2 as well as the full fiscal year. First, FX, assuming current rates remain stable, we expect FX to have no meaningful impact on full-year revenue COGS or operating expense growth. Therefore, in H2, we expect FX to decrease revenue COGS and operating expense growth by 1 point. Second, we expect approximately $900 million for purchase accounting adjustments as well as integration and transaction-related costs in each quarter in H2. For full FY '24, we remain committed to investing for the cloud and AI opportunity while also maintaining our disciplined focus on operating leverage. Therefore, as we add the net impact of Activision, inclusive of purchase accounting adjustments as well as integration and transaction-related expenses, we continue to expect full-year operating margins to remain flat year-over-year. In closing, with our strong start to FY '24, I am confident that as a team we will continue to deliver healthy growth in the year ahead, driven by our leadership in commercial cloud and our commitment to lead the AI platform wave. With that, let's go to Q&A, Brett.

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

Excellent. Thank you for taking the question and very nice quarter. The pace of innovation you guys have been putting out has been pretty amazing. And the new products garnering traction probably faster than we've expected on our side of the equation. But we're also working in an overall spending environment that remains volatile, and I think investors are getting more concerned about it. So two questions on this: one, based on sort of the new products and the innovation, do you think you guys can sustain the type of commercial growth that we saw in Q1 as we go through the year, or is the environment too tricky for that? And then when it relates to investment, Amy, you've been able to keep overall OpEx growth very low, and it was very low this quarter. At some point, should we be thinking about a return to a more aggressive investment behind all this product innovation?

Maybe I can start, Keith, and Amy you can add to it. Overall, there are multiple things happening simultaneously. If you just take Azure and try to characterize where the growth for Azure is coming from or what sort of drivers for Azure numbers, there are three things occurring in parallel. For example, consider cloud migrations. A good reminder of where we are in even the core cloud migration story is the new Oracle announcement. Once we announced that the Oracle databases are going to be available on Azure, we saw a bunch of new customers who have significant Oracle estates that have not yet moved to the cloud because they needed to rendezvous with the rest of the app estate in a single cloud. We're excited about that. In some sense, the financial services sector is a good example where a lot of Oracle needs to move to the cloud. The second is the workloads start; then workloads get optimized, and then new workloads begin, and that cycle continues. We'll see some of those optimization cycles that were fairly extreme in the second half of our fiscal year. The third aspect is new workloads starting around AI. Given our leadership position, we are seeing completely new projects form, which are AI projects. AI projects leverage various cloud metrics as well. That gives you one side of what's happening in terms of enterprise. On the SaaS side, obviously, again, this is a new product going through the enterprise adoption cycle. The results around productivity, which we demonstrated with GitHub Copilot, are giving us good confidence and our customers, more importantly, good confidence in what these products represent in terms of value. We are in the early innings here, and we look forward to seeing the traction for these products going forward.

Keith, maybe just a few things to add and then I'll talk a little bit about the operating leverage, which is the second part of your question. In general, we saw very consistent execution from Q4 to Q1, and that’s what we're talking about moving into Q2. This speaks to our value proposition, where Satya went. It ensures that customers are realizing a very quick return on value, real productivity improvements, and substantial savings. Therefore, when we're discussing renewal, or talking about E5 upgrades or mentioning AI services, these come with real promises of high-value scenarios. I think that is an important piece regarding stability and commercial demand. Regarding operating leverage, although you're correct that our operating expense comparables in H2 get more challenging than in H1, we are focused on ensuring every dollar we allocate is directed back toward our priorities of commercial cloud leadership and leading the AI wave. I believe that focus is really helping with both execution and leverage.

Excellent. Thank you, guys.

Thanks, Keith. Joe, next question, please.

Thank you very much, and congratulations on a really strong quarter. AI has been far stronger than expected, beating your guidance for Azure this quarter. While you discussed higher utilization and more GPUs helping, has the fact that Microsoft has a full AI dev stack, Copilot reference architecture, and plugin architecture been a meaningful factor, not just from a revenue perspective but also potentially from a margin perspective? Can you provide any color on whether Azure GPU is predominantly for model training or are we seeing a lot of inferencing yet from clients? Thanks.

Thank you for the question, Mark. Yes, it's true that we have taken a full stack approach, whether it's ChatGPT, Bing Chat, or all our Copilots, which all share the same model. Essentially, one of the strengths we have is the extensive leverage of the single model we trained, which is applied for inference at scale. This advantage extends down to both internal utilization and the use by third parties. Over time, you can observe optimization across the stack down to the silicon level; as the abstraction layer developers are using is much higher than low-level kernels. Thus, our technical approach involves making Copilots and their complete stack available. That doesn’t exclude training for open-source or proprietary models; fine-tuning, and RLHF takes place as well. However, we possess scale leverage of one substantial model that serves for training and inference across all our first-party SaaS applications and Azure AI services.

The reason that's particularly important, Mark, is that it allows us to leverage the infrastructure we are building out efficiently. We do not have a preference for how clients use that infrastructure, and this provides us an excellent opportunity to see swift revenue conversion.

Additionally, it’s crucial to maintain discipline regarding both our tech stack and capital investments. The lessons learned from the cloud side highlight that we shouldn’t be operating like a conglomerate with disjointed businesses; rather it is all one cohesive tech stack throughout Microsoft's portfolio, which is vital considering the spending climate. Any business that lacks discipline when managing capital across all their divisions could face difficulties.

Extremely helpful. Thank you so much.

Thanks, Mark. Joe, next question, please.

Thanks, Amy. Good to see the 12% growth. Many investors are asking if you can sustain double-digit growth, especially with a stronger AI boost coming in the next several quarters.

Looking at our results, Q1 was a strong start to the year, and Q2 certainly implies that. We’ve discussed stability for Azure into the second half of the year, aligning with what we’re seeing for Q2. Therefore, we feel good about our ability to execute, but more importantly, our capacity to continue to gain market share.

Thanks, Brent. Joe, next question, please.

Hey. Thank you. You sound very optimistic about the opportunity in the office space with Copilot coming out now very soon. Can you speak a little bit about what you're seeing in the customer base that tested this already in terms of how excited they were about the special features there, and what it means in terms of the adoption curve for that going forward once you go GA on the 1st of November? Thank you.

Thanks for the question, Raimo. Fortunately, we have good news on two fronts: first, 40% of the Fortune 100 are already in the preview and are using the product. The feedback has been overwhelmingly positive. Interestingly, the feedback is that it's not any one specific tool; the consensus indicates that users appreciate the full suite of options. They are leveraging the Copilot button across every application—be it Word for document creation, Excel for analysis, PowerPoint, Outlook, or Teams. The intelligent recap feature for Teams, for instance, is not just an ordinary transcript; it acts like a knowledge base of all meetings that can be queried and contribute to the enterprise's knowledge base. We are experiencing broad usage across different functions, whether it's finance or sales, and we are seeing significant productivity gains similar to what we witnessed with developers and GitHub Copilot. Thus far, so good in terms of data and feedback, and we are eagerly anticipating our Ignite conference, where we will delve deeper into various use cases and articulate the value further while providing prescriptive guidance on deployment. Overall, it’s promising to see such a level of usage and excitement around a new product.

Thank you.

Thanks, Raimo. Joe, next question, please.

Okay. Great. Thanks, Amy. Congrats on the 28% constant currency Azure growth; that's terrific. I wanted to press you a little bit on the outlook for Azure. You're guiding to a 1 to 2-point deceleration in December and then stable thereafter. However, why would it be stable? Why wouldn't it accelerate in the second half of your fiscal year if the AI contribution is increasing as you bring on more GPU capacity? Is this a function of continued core ex-AI Azure spend optimization continuing or maybe even getting slightly worse? Why couldn't we see some upside in that Azure number? I know you're being conservative, but I’d love to understand it.

Thanks, Karl. A couple of points: as I discussed concerning Q2 and then into H2, we've been consistently noting that the optimization trends have been stable for us across a couple of quarters. Customers are expected to continue to apply optimization practices, which are a normal part of managing workloads. This is not new. There were certainly some quarters where it was more pronounced. However, that is a pattern inherent to having customers create room for new workload adoption while continuing to develop new capabilities. It’s particularly key to identify that we expect emerging workload starts, and at this scale, stability within our Azure business means we will have numerous new workload starts, primarily driven by AI workloads. AI workloads, as you know, do not solely leverage AI services—they also use data services and other offerings. So, competitively, our execution has been solid, and we feel confident about gaining share going forward, which is why I feel assured about our guidance.

Okay. Terrific. Thanks.

Thanks, Karl. Joe, next question, please.

Wonderful. Thanks so much. It's very impressive to see the Office 365 commercial seat growth holding steady in the double-digit range, especially considering the scale of that business. We think about Office as having such a dominant market position. I’m curious how you view the sources of that seat growth and the overall target market potential: how many more of those seats are left to capture?

Thanks for the question, Brad. Generally, our seat growth does originate from all segments but has shown particular strength in small and mid-sized businesses as well as the frontline worker opportunity. This continues to be the predominant source of our seat growth over many quarters. Although the growth has seen some slowdown per your point, the fact that we can still add seats at this level reflects the broadening applicability of Microsoft 365, which presents a compelling value proposition to more people. Many have suggested we might have reached saturation given our existing customer base, but we contend that when you expand the definition of what Microsoft 365 offers—including security, analytics, Teams, and various other propositions—it becomes relevant for a wider variety of workers. The value proposition is potent, particularly for small businesses, and many perceive it as an excellent allocation of their expenditures.

Thank you.

Thanks, Brad. Joe, next question, please.

Thank you. Good afternoon. One observation that stood out to me was the intelligent cloud segment operating margins. These came in at the highest level in six years, despite elevated AI investments. Was there a one-time tailwind that helped this, or are you at a stage where Azure has economies of scale, where Microsoft could sustain high margins even with an ambitious AI investment cycle?

Thanks for that question. I would say a couple of factors were involved here, and it was indeed a strong leverage quarter for the segment. Firstly, the Azure revenue growth and stability we are witnessing absolutely helps with operating leverage. Secondly, within our core Azure business, the team has made thoughtful decisions that improved gross margin across both technical decisions and implementations. Our infrastructure teams have achieved considerable advances in delivering that as well. Of course, on the operating expenses side, there's been a strong focus on maintaining operational efficiency while positioning ourselves for the AI transition with Azure. Even while investing in AI infrastructure—which will and should translate to revenue— expenses should remain manageable, allowing for good margin performance. It’s important to note that we have easier comparisons in Q1 and Q2, given our highest growth operating expense quarters occurred a year ago.

Makes sense. Thank you.

Thanks, Brent. Joe, we have time for one last question.

Okay. Thank you very much for taking the question. To follow up on what Brent asked, but focusing on the gross margin line. Amy, the Microsoft cloud gross margin is up 2 points year-over-year, excluding the useful life change—more improvement than we've seen for some time. Some investors were worried it might shift in the other direction because of increased AI investments. Looking ahead, do you think that you can drive continued gross margin improvement over the medium term and even as higher CapEx filters into the model? Thanks.

Certainly! Let me split this into two components, as both are essential and a good question, Gregg. Concerning our core business—Azure, Office 365, Dynamics, etc.—we continue to deliver year-over-year improvements in gross margin, so that has certainly contributed to this quarter. Furthermore, as Satya mentioned in an earlier question, a consistent infrastructure spanning our platform allows us to optimize our spending according to revenue generated. This means our capital investments, regardless of the utilization—whether at the SaaS level, infrastructure level, or for training workloads—can quickly translate to revenue in our core offerings. Yes, investing in AI will influence COGS growth, but we are focused on securing leverage and ensuring revenue growth keeps pace. At times, you might see one outpace the other by one or two points in a quarter, but overall, we’re committed to maintaining a close alignment.

I'll further add that this discipline regarding our tech stack and capital allocation means you could expect good results at the company level. While I appreciate that each of you closely tracks segments and specific KPIs, I too share that focus; however, our overarching stack operates uniformly across all segments and products.

Very helpful. Thanks.

Thanks, Gregg. 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.