Microsoft's CEO Discusses F3Q 2014 Results - Earnings Call Transcript

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Microsoft Corporation (MSFT) F3Q 2014 Earnings Conference Call April 24, 2014 5:30 PM ET

Executives

Chris Suh - General Manager, Investor Relations

Satya Nadella - Chief Executive Officer

Amy Hood - Chief Financial Officer

Frank Brod - Chief Accounting Officer

John Seethoff - Deputy General Counsel

Analysts

Brent Thill - UBS

Mark Moerdler - Sanford Bernstein

Keith Weiss - Morgan Stanley

Rick Sherlund - Nomura

Heather Bellini - Goldman Sachs

John DiFucci - JPMorgan

Phil Winslow - Credit Suisse

Walter Pritchard - Citigroup

Karl Keirstead - Deutsche Bank

Ed Maguire - CLSA

Raimo Lenschow - Barclays

Ross MacMillan - Jefferies

Operator

Welcome to the Third Quarter 2014 Microsoft Corporation Earnings Conference Call. At this time, all participants 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.

I would like to turn the call over to Chris Suh, General Manager of Investor Relations. Chris, please proceed.

Chris Suh - General Manager, Investor Relations

Thank you, operator. Good afternoon and thank you for joining us today. On the call with me today are Satya Nadella, Chief Executive Officer; Amy Hood, Chief Financial Officer; Frank Brod, Chief Accounting Officer; and John Seethoff, Deputy General Counsel.

On our website, microsoft.com/investor, we have posted a document summarizing our quarterly results, as well as a slide deck, which is intended to follow the quarterly results document and provide a reconciliation of differences between GAAP and non-GAAP financial measures. Please keep in mind that all growth comparisons relate to the corresponding period of last year. Unless otherwise specified, all impacted numbers have been adjusted for the cumulative effect of last year’s revenue deferrals and recognition related to the Windows Upgrade Offer, the Office Deferral, the Video Game Deferral, and the expense related to the non-tax deductible European Commission Fine. As a reminder, in our segment reporting structure, we have consolidated revenue adjustments of this nature into Corporate and Other to provide better comparability of operating results.

We will post this call’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 in any future use of the recording. You can replay the call and view the transcript at the Microsoft Investor Relations website until April 24, 2015.

During this call, we will be making forward-looking statements, which are predictions, projections, or other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ because of factors discussed in today’s earnings press release, in the comments made during this conference call, and in the Risk Factors section of our Form 10-K, 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 will turn the call over to Satya.

Satya Nadella - Chief Executive Officer

Thank you, Chris. It’s great to have the opportunity to join today’s call. From my first day, I have said I am committed to an ongoing dialogue with investors. Joining these investor calls going forward is going to be a big part of that, and I am enthusiastic about today’s call. It’s been an incredibly busy couple of months. In addition to executing on our plan and announcing new products and services, I have spent a lot of time gathering feedback and exchanging ideas with customers, partners, employees and investors. It is important and valuable to see the company with a fresh perspective to get grounded both our current realities and future opportunities.

As I have told our employees, our industry does not respect tradition, it only respects innovation. This applies to us and everyone else. When I think about our industry over the next 5, 10 years, I see a world where computing is more ubiquitous and all experiences are powered by ambient intelligence. Silicon, hardware systems and software will co-evolve together and give birth to a variety of new form factors. Nearly everything we do will become more digitized, our interactions with other people, with machines and between machines. The ability to reason over and draw insights from everything that’s been digitized will improve the fidelity of our daily experiences and interactions. This is the mobile-first and cloud-first world. It’s a rich canvas for innovation and a great growth opportunity for Microsoft across all our customer segments.

To thrive in this world, we will continue to zero in on the things customers really value and Microsoft can uniquely deliver. We want to build products that people love to use. And as a result, you will see us increasingly focus on usage as the leading indicator of long-term success. To that end, we are already making progress.

Amy will provide additional detail, but I wanted to say a few words about the quarter itself. Today’s results demonstrate the breadth and strength of our overall business. We saw strong momentum in cloud services. Our commercial cloud business more than doubled year-over-year with Office 365 and Azure both performing extremely well. Business customers continue to make Windows their overwhelming platform of choice, with solid growth in both Windows Pro and Windows volume licensing revenues. We saw continued improvement in search, with our U.S. search share growing to 18.6% and search revenue increasing by 38%. Bing continues to deliver platform capabilities across our products. One recent example of this is the recently announced Cortana virtual assistant for Windows Phone. And very importantly, across all our businesses we continued to have a rigorous focus on execution and cost discipline, resulting in solid revenue and earnings per share.

I sum up this quarter in two words execution and transition. We delivered solid financial results and we took several steps to reorient Microsoft. In recent weeks, we talked about how we are advancing Office, Windows and our data platform and how we think holistically about the constituencies we serve IT, developers and people at the center in a mobile first cloud, first world. We will continue to invest in our cloud capabilities including Office 365 and Azure in the fast growing SaaS and cloud platform markets. We are committed to ensuring that our cloud services are available across all device platforms that people use. We are delivering a cloud for everyone on every device. At the same time, we have bold plans to move Windows forward. We are investing and innovating in every dimension from form-factor to software experiences to price. Windows platform is unique in how it brings together consistent end user experiences across small to large screens, broadest platform opportunity for developers and control and assurance for IT. And with the addition of Nokia’s talented people and their depth in mobile technologies we will enhance our device capabilities.

The past two and a half months have been a period of significant change at Microsoft, but also a period of nailing the basics and delivering against our product and financial plans. In the months ahead, we will continue to be intensely be focused on two things rock-solid execution and pivoting the company towards the future. We will continue to push hard and move quickly and you will see the proof of that month after month in the products and services we build for the mobile-first, cloud-first world. What you can expect of Microsoft is courage in the face of reality. We will approach our future with a challenger mindset. We will be bold in our innovation. We will be accountable to our customers, partners and shareholders.

And with that, I will turn it over to Amy to go further into the details of our quarter. And then we will be happy to take your questions after that.

Amy Hood - Chief Financial Officer

Thank you, Satya and good afternoon everyone. Let me start with a few things I think are notable this quarter. Then, I will give our outlook before moving on to Q&A. We had a very good third quarter with solid results across our businesses and strong momentum in our most strategic areas. At the same time we remained focused and disciplined in our spending. Total revenue was $20.4 billion, up 8%, and earnings per share grew 5%. We had outstanding momentum and results in our cloud services. As Satya mentioned, Commercial Cloud revenue more than doubled again this quarter. Office 365 is now on an annual revenue run rate of $2.5 billion and Azure revenue grew over 150%, driven by both new customers and increased usage.

In our Office 365 Home service, we added nearly 1 million new users this quarter and now have over 4.4 million subscribers. We continued to enhance its value proposition with new features, premium services and cross platform functionality. As we cross the one year anniversary since launch, we are pleased with the renewal rates we are experiencing thus far. With Bing, we made clear progress again this quarter. We grew our U.S. share and improved RPS significantly. Display revenue related to portal and email declined, while we saw ad revenue growth in products like Skype and Xbox.

Importantly, we are innovating while expanding our cloud gross margins through both improved scale and continuous engineering efforts to drive efficiency. Businesses are clearly expressing their overwhelming preference for Windows. Windows Pro revenue grew 19% driven by growth in business PCs, mix shift to developed markets where attach is higher, continued strength in the enterprise, and an increased mix of Pro in small and medium businesses. Windows Volume Licensing also had a solid 11% revenue growth. Windows XP End of Support contributed in part to this growth we saw this quarter as did a general hardware refresh.

Our commercial results reflect ongoing strength and we again outperformed the enterprise IT market. Customer movement from transactional purchasing to subscriptions and multi-year agreements was better than our expectations. Therefore, our commercial unearned revenue grew 12% this quarter, which was above our expectations and our contracted not billed balance exceeded $22 billion. We had double-digit growth in SQL, System Center, Windows Server Premium and Lync. Clearly, our value proposition and product roadmap is resonating.

Xbox One has sold in over 5 million units since launch and engagement has been high with users spending nearly 5 hours per day on their console. We will continue to extend the unique entertainment value proposition of Xbox One, particularly in markets outside of the U.S. where some services aren’t as mature. Xbox 360 sales exceeded our expectations this quarter. And across the platform, Xbox Live members continued to embrace the service with transactional revenue growing 17%. We do expect to work through some inventory in Q4. We continue to enhance the value proposition of Surface through both hardware and software innovation, which makes Surface one of the best high value productivity devices available. This quarter, the mix of sales moved to our second generation and Pro devices. And this change had a positive impact on gross margin.

Now, let’s turn to operating expenses. As a result of our ongoing prioritization efforts, OpEx was favorable to what we expected in January. Across the company, we are focused on continually aligning our resources to our top priorities, which includes investing in the next wave of innovation for our customers. We are devoting resources to our sales team and partner ecosystems to ensure they are positioned for the migration to cloud services. And finally, our agility is also improving. As planned, marketing spend was redeployed from Q3 to Q4 in support of a commercial cloud campaign.

With that summary of Q3 results, I would like to talk about our outlook. Given the Nokia Devices and Services transaction is closing tomorrow, the guidance I will walk through next excludes any related impact. Let’s start with Devices and Consumer. In licensing, we expect revenue to be $4.1 billion to $4.3 billion. This range reflects an expectation that the benefits of XP End of Support will moderate. In hardware, we expect revenue to be $1.3 billion to $1.5 billion in what is a seasonally slower hardware quarter. This number also reflects channel inventory drawdown for Xbox consoles. In devices and consumer other, we expect revenue to be about $1.9 billion. We expect to see continued growth in Office 365 Home and Bing as we drive additional usage.

Moving on to commercial, we expect revenue across our two segments to be $13.1 billion to $13.3 billion. Within this, we expect commercial other revenue to be about $2.1 billion on the strength of the transition to our cloud. And in Corporate, we expect to defer revenue of about $100 million. We expect COGS to be $5.7 billion to $5.8 billion, with variability primarily due to hardware.

And moving on to operating expenses. For the fourth quarter, we expect OpEx to be $8.4 billion to $8.6 billion when adjusting for the prior year European Commission Fine. This represents full year operating expense growth of about 4%. This is on the low end of our original guidance that we provided a year ago of 4% to 6%, as we invested in R&D and sales efforts while rationalizing our marketing spend. As a reminder, other income and expense includes dividend and interest income offset by interest expense and the net cost of hedging. We expect these items to generally offset each other.

We expect a higher tax rate in Q4 and the full year tax rate to be between 18% and 20%. We expect capital expenditure to be about $1.5 billion as we build out our cloud infrastructure. We are concentrating on hardware, software and datacenter optimization and supply chain efficiencies to maximize the benefits of our cloud scale. The benefits of this work are realized in improving gross margins. We expect unearned revenue to grow in line with normal seasonality.

Now, let me share some thoughts regarding Nokia Devices and Services. The acquisition will close tomorrow, which is about four months later than the deal economics we outlined in September assumed. Since then, the Nokia business results have also changed. We are focused on the transition from planning to implementation which accelerates with the deal closing tomorrow. Given this is a complex body of work that will take time we do not intend to update our financial guidance for any Nokia impacts during the quarter. However, I want to share the following to help as you update your models.

Under the existing commercial agreement between Microsoft and Nokia, license sales and platform payments are reported in the D&C Licensing segment. Once the acquisition closes, results for Nokia Devices and Services will be reported in the D&C Hardware segment. For Q4, we will clearly show the impact of the ending of the commercial agreement, Nokia’s ongoing operations and any one-time integration and severance costs. And we remain committed to achieving annual cost synergy targets of at least $600 million within 18 months of close.

Now, looking towards fiscal 15, Satya and I, along with the rest of the senior leadership team are working together to solidify our plans for the year ahead. Our goals are clear get more out of the tremendous resources we have available, drive innovation in products that people love to use and execute in areas where Microsoft can uniquely succeed in today’s mobile-first, cloud-first world.

And with that, let me turn it back over to Chris and we can move to Q&A.

Chris Suh - General Manager, Investor Relations

Thanks Amy. And with that we will move to Q&A. Operator please go ahead and repeat your instructions.

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