Microsoft's CEO Discusses F1Q 2014 Results - Earnings Call Transcript

October 25, 2013

Microsoft Corporation (MSFT) F1Q 2014 Earnings Call October 24, 2013 5:30 PM ET

Executives

Chris Suh - General Manager of Investor Relations

Amy Hood - Chief Financial Officer, Executive Vice President

Analysts

Brent Thill - UBS

Phil Winslow - Credit Suisse

John DiFucci - JPMorgan Chase

Ken Wong - Citigroup

Keith Weiss - Morgan Stanley

Heather Bellini - Goldman Sachs

Mark Moerdler - Sanford Bernstein

Rick Sherlund - Nomura Securities

Ross Macmillan - Jefferies

Ed Maguire - CLSA

Jason Maynard - Wells Fargo

Kash Rangan - Bank of America Merrill Lynch

Raimo Lenschow - Barclays

Brendan Barnicle - Pacific Crest Securities

Gregg Moskowitz - Cowen & Company

Kirk Materne - Evercore

Operator

Greetings and welcome to the Microsoft fiscal year first quarter 2014 earnings. At this time, all lines are in a listen-only mode A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure and now I will introduce and turn the call over to Chris Suh, General Manager of Investor Relations for Microsoft. Thank you, Chris. You may begin.

Chris Suh

Our website microsoft.com/investor is our financial summary slide deck, which is intended to follow our prepared remarks and provides a reconciliation of differences between GAAP and non-GAAP financial measures.

Our website also includes information related to our new financial report segments, which were announced on September 19, 2013, and discuss with investors on our conference call on September 26.

As a reminder, we will post today's 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 any future use of the recording. You can replay the call and view the transcript at the Microsoft Investor Relations website until October 24, 2014.

During this call, we will be making forward-looking statements which are prediction, 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.

Before I hand the call over to Amy, I would like to remind you that all growth comparisons we make on the call today will relate to the corresponding period of last year. Also, please keep in mind that with our new segment reporting structure, adjustments for items such as upgrade offers, tech guarantees and presales are consolidated into corporate other to provide a comparison of operating results.

Unless specified otherwise, all impacted numbers for the current quarter have been adjusted for the cumulative effect of last year's revenue deferral related to the Windows upgrade offer, Windows 8 presale, the Office offer and a $113 million revenue deferral in the current quarter, primarily related to Windows 8.1 presale. You can find details of adjustments and reconciliations of differences between GAAP and non-GAAP financial measures in our financial summary slide deck.

With that I will turn it over to Amy.

Amy Hood

Good afternoon and thank you for joining us today. By now you had a chance to look our press release, earning slide deck, key performance indicators and our 10-Q. Our results have been reported using the new reporting framework I first discussed in our financial analyst meeting in September.

Since this is a new way to think about our business, I am sure you will have a lot of questions, so after our prepared remarks, we will allow a little more time than usual for Q&A.

With that, let me dive right in.

This quarter, we delivered record first quarter revenue. We did it while working through a significant affirmation of our organization and while making significant move to implement our new strategy. Our company is focused and delivering. Our enterprise business remained strong despite a macro environment that some had characterized as tough. We are driving our business forward with industry-leading solutions in the areas like collaboration, unified communications and cloud services, and high customer satisfaction is driving high enterprise agreement renewal rate.

At the same time, we are making meaningful progress in our consumer business. We saw growing engagement and adoption across our major consumer services, including office 365 Home Premium, Skype, Bing and SkyDrive. With the new Windows, we are building high value experiences for our consumers that allow people to use our devices and services all day long whether at work or at home.

From a geographic perspective, we saw broad based revenue growth. Overall both, developed and emerging markets showed strengths. The U.S. and parts of Western Europe were particularly strong, while China was weak.

Now, let me share some quick thoughts on the PC market which turned out better than we had expected. We are seeing signs of stabilization in the business segment with two consecutive quarters of growth and a relatively stable outlook for the next couple of quarters. While the consumer segment is more volatile with increasing competition for share of wallet and also performed better than expected, particularly in developed markets.

With that backdrop, let's move onto Windows. We are seeing favorable reviews and customer enthusiasm for Windows 8.1, which became available last week. Windows 8.1 delivers on Microsoft promise of a quick innovation cadence launching less than one year after Windows 8. Based on extensive customer feedback, we added more customization capabilities, made the UI simpler and easier to use, added new and smart ways to search, improved power management and allowed multi-tasking, even on a tablet. Combined with the progress our OEM partners are making, we are collectively increasing the selection of compelling windows devices available to meet the dynamic needs of all segments of the market.

This holiday, we will see competitive opening price points on tablets and laptops, such as the Dell Inspiron 15 for less than $300. We will also see exciting mobile devices from six inch phones to 10 inch tablets, many with Microsoft Office. In the six inch category, we are incredibly excited by the Nokia Lumia 1520 tablet announced this past Tuesday. For eight inch tablets, Toshiba, Dell, Lenovo will have devices available for less than $300. And for 10 inch tablets, we of course like the Nokia Lumia 2520 with LTE.

In addition to third-party devices, we are also excited about our first-party lineup. With Surface, we are making progress with better end market executions. As a result, we more than doubled the number of units we sold over the prior quarter. In terms of mix, Surface RT did better than expected. With Surface Pro, we saw some customers delay purchase in anticipation of Surface Pro 2 which delivers significantly improved battery and processor performance.

Moving on to the enterprise, where demand for our solutions continues to be strong. Earlier this month, we announced our fall wave of enterprise products and services, which touches nearly every aspect of IT. We are seeing solid growth. We are outperforming our competitors and we are taking share in areas like virtualization and the data platform.

Our hybrid infrastructure and management offerings continue to be tough choices for CIOs with Windows Server Premium and System Center growing double digits again in this quarter. The latest versions of Windows Server, System Center and Windows Intune deliver enhancements in networking, storage and device management for Windows and alternative platforms. These enhancements will help customers realize the promise of hybrid cloud computing across their data centers, hosted clouds and Windows Azure.

In the data platform, SQL Server continues to outpace the market. The next version, SQL Server 2014, will offer new in-memory and cloud capabilities that will increase performance and unlock new hybrid scenarios. Later this month, we will make Windows Azure HDInsight, our Hadoop-based the Big Data solution generally available. We continue to bring additional value to the Windows Azure platform. This quarter, delivered a number of updates that enable faster connectivity, improve security and integrate access and identity across on-premise and cloud application. With all of the innovation we are delivering to our enterprise customers, we continue to be uniquely positioned to capture more and more of the addressable market.

Before handing it off to Chris, I would like to say a couple of additional things. As part of our new reporting framework, we have disclosed segment gross margin. The segment breakout is important in understanding our performance because each of our businesses are impacted by the different dynamics and have different margin profiles. In devices and consumer, the sequential change in gross margin dollars reflects the progress we are making towards our strategy of delivering a compelling family of devices and services.

While we feel good about the increased traction we saw with Surface this quarter, we know there is more to do. We are intensely focused on improving our capabilities in key areas like demand-planning and supply chain management and on achieving scale as quickly as possible. In commercial, we are already seeing the benefits of the investments we have made to transform our business model from perpetual software licensing to services.

In our commercial cloud business, which includes Office 365, Azure and other Microsoft services, we saw year-over-year gross margin expansion. With regards to our pending acquisition of substantially all of Nokia's devices and services business, we still expect the transaction to close in the first quarter of calendar 2014. We will provide an update to the EPS impact, if any, post-closing.

So in summary, we are executing better, getting our customers what they want and making meaningful progress through the early stages of our transformation. And we have accomplished all of this while also working through the One Microsoft realignment and several significant announcements. We are committed to executing and delivering and so far that's what we have done.

With that backdrop for the quarter, I will hand it over to Chris to give more details about our performance before I come back and share thoughts on the outlook.

Chris Suh

Thanks, Amy. First, I will review our overall results and then I will move on to the details by business segment.

Total revenue was up 7% to $18.6 billion and came in at about $700 million better than our expectations. Without the impact of foreign exchange, revenue would have been $200 million or one percentage point better.

Annuity revenue was particularly strong and grew 11%, driven by commercial performance. Cost of goods sold increased 23%, which was in line with our expectation of over 20% growth. This increase was primarily due to service cost and also higher depreciation related to the CapEx investments we made this quarter for cloud services strategy. As a result, gross margin grew 3% to $13.5 billion, reflecting the changing mix of our revenue.

All up, operating expenses grew 8%, which was generally in line with our expectations with the exception of G&A, which declined due to lower legal expenses. We continue to be thoughtful and diligent in how and where we focus our resources, in advertising, the [keynote], embraced One Microsoft and the benefits are already accruing with improved messaging and results.

In R&D, we are continuing to focus our resources while accelerating our cadence. Operating income and earnings per share, both declined 3% to $6.4 billion and $0.63, respectively.

Unearned revenue grew a healthy 14% to $20.1 billion and our contracted not billed balance grew to over $21 billion, driven by commercial strength. Our inventory balance sequentially increased by $675 million, mostly due to build the Xbox 360 and Xbox One. Ahead of holiday selling season, Xbox represents over half of our inventory balance.

Inventory for Surface products declined sequentially even as we built levels ahead of this week Surface 2 and Surface Pro 2 launches. This quarter, we announced a 22% increase in our quarterly dividend to 28% and also announced $40 billion share repurchase program. We returned $3.8 billion of cash to shareholders, our high quarterly amount since the second quarter of fiscal 2011.

I am now going to talk about the performance in each of our reporting segments. Our devices and consumer licensing segment is comprised principally of Windows OEM, consumer office and Windows Phone, including related patent licensing. Our Windows OEM business performed better than expected, declining 7% versus our expectation of a mid-teens decline.

As Amy noted, we believe we are seeing stabilization in business PCs, which grew again this quarter and drove Pro revenue growth of 6%. We also saw better than expected performance in the consumer part of our business.

Non-Pro revenue declined 22%, but with several points better than expected. Excluding the impact of China, which continues to have a different dynamics than other emerging markets, non-Pro revenue declined 17%.

Together with our OEM and retail partners, we brought an incredible breadth of Windows devices to market. We have also made meaningful improvements to our advertising campaigns which now clearly highlight the value proposition of our devices.

As we head into holiday, we are excited by the opportunities to bring the new Windows experience to even more users around the globe. Consumer Office licensing revenue declined this quarter. The financial impact of the shift to Office 365 Home Premium was generally in line with our expectations.

Office 365 subscribers benefit from the natural integration of services such as SkyDrive and Skype and have the flexibility to access the service from numerous end points. Whether via traditional licensing or subscription, customers continue to see the value in Office and overall attach of Office increased this quarter.

The Windows Phone ecosystem is seeing sustained growth. While we have work to do, our share is growing in many geographies, the device portfolio is expanding and the number of apps available in the marketplace is increasing.

about Ubuntu our devices and consumer hardware segment, where revenue grew $401 million, driven almost entirely by Surface. With improved sales and marketing effort, combined with pricing and promotional activities, we saw Surface units and revenue growth sequentially from Q4, with the mix of sale shifting towards 32 gigabyte RT device. Demand increased for this device both, in retail and in education. From a gross margin perspective, in addition to product costs, which grew as a result of increased Surface sale, we also incurred non-product expenses as we readied inventory line for the new Surface lineup in the holiday sales cycle.

Moving to devices and consumer other. As a reminder, this segment includes our online marketplaces, advertising, Xbox Studio, Office 365 Home Premium and other consumer products and services. This quarter revenue growth in this segment was driven by both an increase in advertising revenue and also volumes in our online marketplaces. Search advertising revenue grew 47% driven by continued revenue per search improvements and query volume growth. Bing has now grown its share of search queries in the U.S. to 18%. Gross margin declined slightly due to higher royalty costs and also infrastructure cost growth as we expanded geographic footprint of our services.

Turning now to our commercial business. With all up commercial revenue across both on-premise and cloud services grew 10% this quarter. Notably even as we invest for growth, we saw gross margin expansion in our commercial cloud business. Across our commercial portfolio, we saw healthy renewal, a continued shift to premium products and strong adoption of our cloud services. Our enterprise cloud strategy is resonating with customers and server product revenue grew 12%. SQL Server revenue grew double-digit with SQL Server Premium revenue growing over 30%. Our commercial

Office products also remained strong and grew 11%. Within this, SharePoint, Exchange and Lync collectively grew double-digits with Lync growing nearly 30%. Helping to drive this demand for our Server and Office product is deployment of hybrid cloud solution. This quarter, revenue for our commercial cloud services grew over 100% as services such as Office 365, our innovative Azure services for comprehensive cloud solution. Importantly, we are seeing strong customer adoption with Office 365 seats and Azure customers both growing triple-digits. Dynamics CRM Online is also expanding its base, with two-thirds of new Dynamics CRM customers opting for the cloud.

With that overview of our Commercial business, let me share the financial performance in each of our Commercial reported segments. Revenue in the Commercial Licensing segment grew 7% and in our Commercial Other segment, revenue grew 28% to $1.6 billion. As a reminder, Corporate and Other is where we consolidate adjustments for tech guarantees, pre-sales and the like. In the comparable quarter of last year, we had aggregate deferrals of $1.4 billion for Windows and Office and this quarter we deferred $113 million, primarily related to Windows 8.1 pre-sale.

Having now talked through our results for this past quarter, let me turn it over to Amy to discuss our forward looking guidance.

Amy Hood

Thanks, Chris. As we look towards the second quarter, we are assuming the macro environment remains generally the same. With this, we expect many of the dynamics we saw in the first quarter to continue with strong performance in our commercial business and ongoing improvement in our consumer business. Importantly, we are set up for a terrific holiday season. We will have a wide variety of Windows-based devices in market.

Earlier this week, we launched Surface 2 and Surface Pro 2, and in November, we will launch our next generation console, Xbox One. Building on the performance and unique experiences that gamers love, it will also deliver an innovative entertainment experience by bringing movies, music, sports and live TV together in one place.

With that, let's get into the outlook. Starting with Devices and Consumer. In Licensing, we expect revenue to be $5.2 billion to $5.4 billion. This range reflects similar dynamics to what we saw in the first quarter. As I noted earlier, we expect the business PC market to be stable, however, the consumer PC market is subject to more volatility.

In Hardware, we expect revenue to grow 35% to 45% to $3.8 billion to $4.1 billion, reflecting the expanded Surface line up and the much anticipated Xbox One launch. The 10 percentage point range reflects variability in device unit volumes. In the consumer hardware business, such variability is not uncommon, especially during launches and the holiday season.

In Devices and Consumer Other, we expect revenue to be $1.7 billion to $1.8 billion. Search revenue should continue to grow reflecting improved revenue per search and query volume. As a reminder, in Q2 of the prior year, we launched Halo 4, which contributed $380 million of revenue to this segment.

Now, moving onto Commercial. We expect revenue to grow 9% to 11%, in line with the first quarter. As we think about this part of the business, we are confident in our ability to continue to add value to our products while providing low total cost of ownership for our customers.

In Commercial Licensing, we expect revenue to be $10.7 billion to $10.9 billion, with similar dynamics to what we saw in the first quarter. This includes healthy renewals and strong annuity revenue growth from volume licensing with Software Assurance.

In Commercial Other, we expect revenue to be $1.7 billion to $1.9 billion, reflecting ongoing momentum in our commercial cloud business and enterprise services. As CIOs increasingly look to capitalize on the opportunities of cloud computing, we are confident they will continue to look to Microsoft for their IT solutions.

Moving on to cost of revenue, which we expect to be $7.9 billion to $8.3 billion next quarter. This range primarily relates to the unit variability assumed in hardware revenue. In Surface, we are still in the early stages of the lifecycle. As you know, there are many things that go into bringing hardware to market, including both variable and fixed costs. We are intensely focused on building volumes and achieving scale to cover these costs and get to profitability.

As you think about the economic model for Xbox, you should keep in mind that console margins are just one aspect of the overall platform's financial performance. Attach with games, accessories and Xbox LIVE services, also contribute to the economic model. We expect the launch of Xbox One to be the biggest in Xbox history and we feel great about our ability to continue our leadership position in the living room.

Moving onto operating expenses. We expect OpEx to grow 6% to 8%, to $8.5 billion to $8.6 billion. We also reaffirm our full-year guidance of $31.3 billion to $31.9 billion. We continue to invest in innovative experiences for our customers while remaining focused on expenses.

We still expect full year capital expenditures to be about $6.5 billion, even though we only spent $1.2 billion in the first quarter. Given the nature of the investments, there is variability from quarter-to-quarter due to our success based approach as well as the timing of delivery and completion.

We expect our tax rate for the full year to be between 18% and 20%, depending on our geographical mix of earnings. When adjusting for tech guarantees and product deferrals, we expect unearned revenue to be roughly in line with historical trends.

In summary, I am really pleased with our results this quarter. It was a great start to the fiscal year as we executed and delivered across all of our businesses. We are on track with implementing the transformation of the company around the One Microsoft strategy, and at the same time are not missing a beat in executing faster.

As we look forward to the second quarter, our enterprise business will remain strong and we are also set up for a fantastic holiday season with Surface, Xbox One and a host of devices from our partners, which will allow us to reach new customers and drive increased engagement.

With that, I will turn it to Chris and we will take your questions.

Chris Suh

Thanks, Amy. With that, we are going to move on to the Q&A. Operator, please go head and repeat your instructions.

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