Microsoft Q4 2023 Earnings Call Transcript

There are 10 speakers on the call.

Operator

Greetings, and welcome to the Microsoft Fiscal Year 2023 4th Quarter Earnings Conference Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Brett Iverson, Vice President of Investor Relations.

Operator

Mr. Iverson, please go ahead.

Speaker 1

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, 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. On this call, we will discuss certain non GAAP items.

Speaker 1

The non GAAP financial measures provided should not be considered as a substitute for or superior to the measures of financial performance prepared in accordance with GAAP. They are included as additional clarifying items to aid investors in further understanding the company's 4th quarter performance in addition to the impact these items and events have on the financial results. All growth comparisons we make on the call today relate to the corresponding period of last year unless otherwise noted. We will also provide growth rates in constant Currency, when available, as a framework for assessing how our underlying businesses performed, excluding the effect of foreign currency rate fluctuations. Where growth rates are the same in constant currency, we will refer to the growth rate only.

Speaker 1

We will post our prepared remarks to our website immediately following the call until the complete transcript is available. Today's call is being webcast live and recorded. If you ask a question, it will be included in our live transmission, In the transcript and in any future use of the recording, you can replay the call and view the transcript on the Microsoft Investor Relations website. During this call, we will be making forward looking statements, which are predictions, projections or other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties.

Speaker 1

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 ks, 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.

Speaker 2

Thank you very much, Brett. We had a solid close to our fiscal year. The Microsoft Cloud surpassed $110,000,000,000 in annual revenue, up 27% in constant currency with Azure all up accounting for more than 50% of the total for the first time. Every customer I speak with is asking not only how, but how fast they can apply next generation AI to address the biggest opportunities and challenges they face and to do so safely and responsibly. To that end, we remain focused on 3 key priorities.

Speaker 2

1st, helping customers use the breadth and depth Microsoft Cloud to get the most value onto their spend. 2nd, investing to lead in the new AI platform shift by infusing AI across Every layer of the tech stack and third, driving operating leverage. Now I'll highlight examples of our progress starting with infrastructure. Azure continues to take share as customers migrate their existing workloads and invest in new ones. We continue to see more cloud migrations as it remains early when it comes to long term cloud opportunity.

Speaker 2

We are also seeing increasing momentum with Azure which now has 18,000 customers up 150% year over year including Carnival Corp, Domino's, Thermo Fisher. And Azure AI is ushering in new born in the cloud AI first workloads with the best selection of frontier and open models, including Meta's recent announcements including IKEA, Volvo Group, Zurich Insurance as well as digital natives like Flipkart, Humane, Kahoot, Miro, Typeface use the service. That's nearly 100 new customers added every day this quarter. Mercedes Benz, for example, is bringing Chat GPT via Azure opened AI to more than 900,000 vehicles in the United States, making its in car voice assistant more intuitive And Moody's built its own internal co pilot to improve productivity of its 14,000 employees. We are also partnering broadly to scale this next generation of AI to more customers.

Speaker 2

Snowflake, for example, will increase its Azure as it builds new integrations with Azure OpenAI and KPMG has announced a multibillion dollar commitment to our cloud and AI services to transform professional services. Now on to data. Every AI app starts with data and having a comprehensive data and analytics platform is more important than ever. Our intelligent data platform brings together operational databases, analytics and governance, so organizations can spend more time creating value and less time integrating their data estate. We introduced Microsoft Fabric this 8,000 customers have signed up to trial the service and are actively using it and over 50% are using 4 or more workloads.

Speaker 2

All up, we once again took share with our analytics solutions with customers like Bridgestone, Chevron and Equinor turning to our stack. Now on to developers. New Azure AI Studio is becoming the tool of choice for AI development in this new era, helping organizations When it comes to how developers code every day, nearly 90% of GitHub Copilot sign ups are self-service indicating strong organic interest and pull through. More than 27,000 organizations up 2x quarter over quarter have chosen Getup Copilot for business to increase the productivity of their developers including Airbnb, Dell and Scandinavian Airlines. We're also applying AI across low code, no code tool chain to help domain experts automate work flows create apps and web pages, build virtual agents or analyze data using just natural language.

Speaker 2

Copilot and Power BI combines the Power of large language models with an organization's data to generate insights faster and Copilot and Power Pages makes it easier to create secure low code business websites. One of our tools that's really taken off is CoPilot and Power Virtual Agents, which is delivering one of the biggest benefits of this new era of AI, helping customer service agents be significantly more productive. HP and Virgin Money, for example, have both built Chatbots with CoPilot and Power Virtual agents that were trained to answer complex customer inquiries. All up more than 63,000 organizations have used AI powered capabilities in Power Platform, up 75% quarter over quarter. Finally, Power Automate now has 10,000,000 monthly active users at companies like Jaguar, Land Rover, Repsol, Rolls Royce, up 55% year over year.

Speaker 2

And we're going further with new process mining capabilities in Power Automate, which are helping organizations We are taking share in every category as we help organizations across the private and public sector from Avis to Albertsons to Breville to Equinox And the U. S. Department of Veterans Affairs transformed their mission critical business processes. All up dynamics surpassed $5,000,000,000 in revenue over the past fiscal year with our customer experience service and finance and supply chain businesses all surpassing $1,000,000,000 in annual sales. This quarter, we brought Dynamics 365 CoPilot to our ERP portfolio, including finance, Project Operations and Supply Management and with our new Microsoft sales co pilot, sellers can ground their customer interactions With data from CRM systems including both Salesforce and Dynamics to personalize customer interactions and close more deals.

Speaker 2

Number 1 to our industry and cross industry clouds. Our Microsoft Cloud for Sustainability is helping customers like Costco, Land O'Lakes and REI take to meet their environmental goals and in healthcare, hundreds of organizations are using our Nuance DAX Ambient Intelligence solution to This quarter, we expanded our collaboration with Epic to integrate Nuance, DAX Express directly into their industry leading EHR system. Now on to future of work. Across industries, customers like Ahold Delhaize, Deutsche Bank, Novartis, Siemens, Wells Fargo are choosing Microsoft 365 by premium offerings for differentiated security, compliance, voice and analytics value. And 4 months ago, we introduced a new pillar of customer value with Microsoft 365 Copilot.

Speaker 2

We are now rolling out Microsoft 365 Copilot to 600 paid customers through our early access program And feedback from organizations like Emirates, NBD, General Motors, Goodyear and Lumen is that it's a game changer for employee productivity. We continue to build momentum in Microsoft Teams across collaboration, chat, meetings and calling. We now have more than 1900 Since teams app store and companies in every industry from British Airways to Dentsu to Eli Lilly and Manulife have built over 145,000 Seats as companies like BNY Mellon, Clifford Chance, PepsiCo and Starbucks chose the add on for advanced features like end to end encryption and real time translation. Teams Phone is the market leader in cloud calling with more than 17,000,000 PSTN users, up 45% year over year. Teams Room is used by more than 70% of the Fortune 500 including L'Oreal, United Airlines and U.

Speaker 2

S. Bank and revenue more than doubled year over year this quarter. And with Microsoft Veeva, we are creating a new market category for employee experience. Veeva now has 35,000,000 monthly active users as companies like CBRE, Fujitsu and Unisys turn Form to build data driven high performance organizations. Now on to Windows.

Speaker 2

The number of devices running Windows 11 has more than doubled in the last And we are seeing continued growth in Windows 11 commercial deployments worldwide by companies like AT and T, Cronos and Westpac. We're also transforming how Windows is experienced and managed for enterprise customers with Azure Virtual Desktop and Windows 365, which together surpassed $1,000,000,000 in revenue for the first time over the past 12 months. Enbridge, Eurowings, Marriott International and TD Roland TD Bank Group, for example, all chose cloud delivered Windows this quarter. Windows 11 is also rapidly becoming a powerful new canvas in this new era of AI. We introduced Windows Copilot I'm excited to put it in the hands of more people in the coming months.

Speaker 2

Now on to security. More than 1,000,000 organizations now Count on our comprehensive AI powered solutions to protect their digital estate across clouds and endpoint platforms, up 26% year over year. More than 60%, including leading enterprises like ABN AMRO, Dow and Heineken used 4 or more of our security products, up 33% year over year underscoring our end to end differentiation. And we once again took share And we are adding SSE to our ENTRE product family to complement our leading identity solution and secure access to Any app or resource from anywhere. Finally, our security Copilot, the first product to apply this next generation of AI to SecOps We'll be available to customers via paid early access program this fall.

Speaker 2

Now on to LinkedIn. LinkedIn's revenue surpassed $15,000,000,000 for the first time this fiscal year and membership growth has now accelerated for 8 quarters in a row, A testament to how mission critical the platform has become to help more than 950,000,000 members connect, learn, sell and get hired. Our Talent Solutions business surpassed $7,000,000,000 in revenue for the first time over the past 12 months and our hiring business took share for the 4th consecutive Quarter. We continue to use AI to help our members and customers connect to opportunities and tap into experiences of experts on the platform. Our AI powered collaborative articles are now the fastest growing traffic driver in LinkedIn.

Speaker 2

And finally, we are helping LinkedIn stay trusted and authentic. More than 7,000,000 members have verified who they are or where they work, many using new integrations with Microsoft Entra as well as Clear and HyperVerge. Now on to search, advertising and news. While it's early in our journey, we are reshaping daily search and web habits with our co pilot for the web. This quarter we introduced new AI powered features including multimodal capabilities with visual search and Bing Chat.

Speaker 2

We are expanding to businesses with BingChat Enterprise, which offers commercial data protection, providing an easy on ramp for any organization looking to get the benefit of this next generation of AI today. Bing is also the default search experience for OpenAI's ChatGPT bringing timelier answers with links to our reputable sources to ChatGPT users. To date, Bing users have engaged in more than 1,000,000,000 chats and created more than 750,000,000 images with Bing Image Creator And Microsoft Edge took share for the 9th consecutive quarter. More broadly, we are growing our ad network, which is now available in 187 markets spanning search display native retail media video and connected TV. Now on to gaming.

Speaker 2

Last week, we extended our Activision Blizzard merger agreement deadline to October. We continue to work through the regulatory approval process and remain confident about getting the deal done. We are committed to bringing more games to more players everywhere. Great content is key to our approach and our pipeline has never been stronger. We announced our most ambitious lineup of games ever at our showcase last month, including 21 titles that will be available via Xbox Game Pass.

Speaker 2

And we're looking forward to the release of Starfield as fall, Bethesda's first new universe in 25 years. All up, we set new 4th quarter highs for monthly active users driven by strength of console as well as monthly active devices, And we saw record 4th quarter engagement across Game Pass with hours played up 22% year over year. And just last week, we announced Game Pass Call, bringing together online play from Xbox Live and content from Game Pass into a single offering. In closing, I'm energized about the opportunities ahead. We continue to innovate across the tech Stack to help our customers thrive in the new era of AI.

Speaker 2

And with that, let me turn it over to Amy.

Speaker 3

Thank you, Satya, and good afternoon, everyone. This quarter revenue was $56,200,000,000 up 8% and 10% in constant currency. Earnings per share was $2.69 increase 21% 23% in constant currency. In our largest quarter of the year, results exceeded expectations with focused execution by our sales and partner teams. These execution efforts led to share gains again this quarter in Azure, Dynamics, Security and Edge.

Speaker 3

In our commercial business, we continue to see healthy renewal strength, which includes our upsell and attach motions, particularly with Microsoft 365e5. Growth of new business continued to be moderated for products sold As expected in Azure, we saw a continuation of the optimization and new workload trends from the prior quarter. In our consumer business, The PC market overall was in line with expectations, although the early timing of back to school inventory builds benefited Windows OEM. Advertising spend was slightly lower than anticipated, which impacted search and news advertising and LinkedIn marketing solutions. Commercial bookings decreased 2% and 1% in constant currency, in line with expectations against the prior year comparable It was our largest commercial bookings quarter ever.

Speaker 3

In addition to the healthy execution across our renewal sales motions mentioned earlier, We saw a record number of $10,000,000 plus contracts for both Azure and Microsoft 365. And the average annualized value for our large long term Azure contracts was the highest it's ever been, driven by customer demand for our innovative cloud solutions today as well as interest in AI opportunities ahead. Commercial remaining performance obligation increased 19% 18% in constant currency to $224,000,000,000 Roughly 45% will be recognized in revenue in the next 12 months, up 13% year over year. The remaining portion, which we recognize beyond the next 12 months, increased 22%. And this quarter, our annuity mix increased to 97%.

Speaker 3

FX impact on total company revenue, Segment level revenue and operating expense growth was as expected. FX decreased COGS growth by 1 point, 1 point favorable to expectations. Microsoft Cloud revenue was $30,300,000,000 and grew 21% and 23% in constant currency, slightly ahead of expectations. Microsoft Cloud gross margin percentage increased roughly 3 points year over year to 72%, also slightly ahead of expectations. Excluding the impact of the change in accounting estimate for useful lives, Microsoft Cloud gross margin percentage increased slightly, driven by improvements in Office 365, partially offset by lower Azure margin and the impact of scaling our AI infrastructure to meet growing demand.

Speaker 3

Company gross margin dollars increased 11 13% in constant currency, including 2 points due to the change in accounting estimate. Gross margin percentage increased year over year to 70%. Excluding the impact of the change in accounting estimate, gross margin percentage increased slightly, driven by improvements in Office 365. Operating expense increased 2% in line with expectations as savings across the company from our focus on prioritization and efficiency were offset by the charge related to the Irish Data Protection Commission matter. At a total company level, headcount at the end of June was flat compared to a year ago.

Speaker 3

Operating income increased 18% and 21% in constant currency, including 4 points due to the change in accounting estimate. Operating margins increased roughly 4 points year over year to 43%. Excluding the impact of the change in accounting estimate, Operating margins increased roughly 2 points driven by improved operating leverage through disciplined cost management. Now to our segment results. Revenue from Productivity and Business Processes was $18,300,000,000 and grew 10% and 12% in constant currency, ahead of expectations with better than expected results in Office Commercial, partially offset by LinkedIn.

Speaker 3

Office Commercial revenue grew 12% 14% in constant currency. Office 365 Commercial revenue increased 15% 17% in constant currency, a bit better than expected with particular strength in E5 up expansion across all workloads and customer segments. Seat growth was again driven by our small and medium business and frontline worker offerings. Office commercial licensing declined 20% 18% in constant currency with better than expected transactional purchasing. Office consumer revenue increased 3% 6% in constant currency with continued momentum in Microsoft 365 subscriptions, which grew 12% to $67,000,000 LinkedIn revenue increased 5% and 7% in constant currency, driven by growth in Talent Solutions With some continued bookings impact from the weaker hiring environment in key verticals, growth was partially offset by a decline in marketing solutions due to the lower ad spend noted earlier.

Speaker 3

Dynamics revenue grew 19% and 21% in constant currency, driven by Dynamics 365, which grew 26% 28% in constant currency with continued healthy growth across all workloads. Segment gross margin dollars increased 14% 16% in constant currency and gross margin percentage increased roughly 3 points 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 decreased slightly and operating income increased 25% and 29% in constant currency, including 3 points due to the change in accounting estimate. Next, the Intelligent Cloud segment.

Speaker 3

Revenue was $24,000,000,000 increasing 15% 17% in constant currency, slightly ahead of expectations. Overall, server products and cloud Services revenue increased 17% 18% in constant currency. Azure and other cloud services revenue grew 26% and 27% in constant currency, including roughly one point from AI Services as expected. In our per user business, the Enterprise Mobility and Security installed base grew 11% to over 256,000,000 seats with impact from the continued growth trends in new business noted earlier. In our on premises server business, revenue decreased 1% and was relatively unchanged in constant currency, driven by a slight decrease in new annuity contracts, which carry higher in period revenue recognition.

Speaker 3

Enterprise Services revenue grew 4% 5% in constant currency with better than expected performance across Enterprise Support Services and Industry Solutions. Segment gross margin dollars increased 16% 17% in constant currency and gross margin percentage increased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage declined roughly 2 points driven by sales mix shift to Azure and the lower Azure margin noted earlier. Operating expenses increased 10%. Operating income grew 20% 22% in constant currency with roughly 6 points from the change in accounting estimate.

Speaker 3

Now to more personal computing. Revenue was $13,900,000,000 partially offset by gaming. Windows OEM revenue decreased 12% year over year ahead of expectations due to 7 points of benefit from early back to school inventory builds, while the overall PC market was as expected. Devices revenue decreased 20% and 18% in constant currency, roughly in line with expectations. Windows Commercial Products and Cloud Services revenue increased 2% and 3% in constant currency, ahead of expectations due to the renewal strength noted earlier, even with the moderated growth of new business and standalone offerings.

Speaker 3

Search and news advertising revenue ex TAC increased 8%, a bit behind expectations due to lower ad spend noted earlier. Higher search volumes, share gains again this quarter for our Edge browser and the benefit from the Xandr acquisition were partially offset by the impact from third party partnerships. Ending gaming. Revenue increased 1% 2% in constant currency, lower than expected due to weakness in 1st party and third party content performance. Xbox content and services revenue increased 5% and 6% in constant currency and Xbox hardware revenue declined 13%.

Speaker 3

Segment gross margin dollars declined 2% and were relatively unchanged in constant currency and gross margin percentage increased roughly 1 point year over year driven by sales mix shift to higher margin businesses. Operating expenses declined 9% 8% in constant currency. Operating income increased 4% 6% in constant currency. Now back to total company results. Capital expenditures including finance leases were $10,700,000,000 to support cloud demand, including investments in AI infrastructure.

Speaker 3

Cash paid for PP and E was $8,900,000,000 Cash flow from operations was $28,800,000,000 up 17% year over year as strong cloud billings and collections were partially offset by a tax payment related to the R and D capitalization provision. Free cash flow was $19,800,000,000 up 12% year over year. Excluding the impact of this tax payment, cash flow from operations increased 22% and free cash flow increased 19%. This quarter, other income and expense was $473,000,000 higher than anticipated, driven by net gains on foreign currency remeasurement. Our effective tax rate was approximately 19%.

Speaker 3

And finally, we returned $9,700,000,000 to shareholders through share repurchases and dividends, bringing our total cash return to our shareholders to over $38,000,000,000 for the full fiscal year. Now Let's turn to next fiscal year and start with a few reminders. First, the change in accounting estimate for the useful life of server and network equipment resulted in $3,700,000,000 of depreciation expense shifting from FY2023 to future periods. Our FY2023 operating income and margins benefited from this change in accounting estimate and that will be a headwind to growth in FY 2024 as the benefit reduces to $2,100,000,000 Next, my outlook commentary for both the full year and next quarter is on a U. S.

Speaker 3

Dollar basis unless specifically noted otherwise. And my outlook does not include any impact from the Activision acquisition, which we continue to work towards closing, subject to obtaining required regulatory approvals. Now for some thoughts on the full year of FY 2024. With the weaker U. S.

Speaker 3

Dollar and assuming current rates remain stable, we expect FX to increase full year revenue growth by approximately one point With no impact to COGS or operating expense growth, the impact in H1 is expected to be greater in H2. At a total company level, revenue growth from our commercial business will continue to be driven by the Microsoft Cloud and will again outpace the growth from our consumer business. Even with strong demand and a leadership position, growth from our AI services will be gradual as Azure AI scales and our copilots reach general availability dates. So for FY 2024, the impact will be weighted towards H2. To support our Microsoft cloud growth and demand for our AI platform, we will accelerate investment in our cloud infrastructure.

Speaker 3

We expect capital expenditures to increase sequentially each quarter through the year as we scale to meet demand signals. We are committed to driving operating leverage And therefore, we will manage our total cost growth across COGS and operating expense in line with the demand signals we see, as well as revenue growth. Increased capital spend will drive higher COGS growth than in FY2023 FY 2024 operating expense growth will remain low as we prioritize our spend. Therefore, we expect full year operating margins to remain flat to be around 19%. Now to the outlook for the Q1.

Speaker 3

First, FX. Based on current rates, We expect FX to increase total revenue and operating expense growth by approximately 1 point with no impact to COGS growth. Within the segments, we expect FX to increase revenue growth in Intelligent Cloud by one point with no impact to productivity and business processes or more personal computing. In commercial bookings, strong execution across our core annuity sales motions, including our renewal and upsell motions, along with long term measure commitments should drive healthy growth on a growing expiry base. Microsoft Cloud gross margin percentage should decrease roughly 1 point year over year, driven by the accounting estimate change headwind noted earlier.

Speaker 3

Excluding that impact, Q1 cloud gross margin percentage will be up roughly 1 point, primarily driven by improvements in Azure and Office 365, partially offset by sales mix shift to Azure and the impact of scaling our AI infrastructure to meet Growing demand. We expect capital expenditures to increase sequentially on a dollar basis as noted earlier, driven by investments in our AI infrastructure. Reminder, there can be normal quarterly spend variability in the timing of cloud infrastructure build out. Next, the segment guidance. In productivity and business processes, we expect revenue to grow between 9% and 11% or 18% to 18,300,000,000 In Office Commercial, revenue growth will again be driven by Office 365 with seat growth across customer segments and ARPU growth through E5.

Speaker 3

We expect Office 365 revenue growth to be roughly 16% in constant currency. In our on premises business, we expect revenue to decline in the low 20s. In Office Consumer, we expect revenue growth to be in the lowtomidsingledigits driven by Microsoft 365 subscriptions. For LinkedIn, we expect revenue growth in the low to mid single digits. Even with share gains in our hiring business, growth will continue to be impacted by the overall markets for recruiting Advertising, especially in the technology industry where we have significant exposure.

Speaker 3

And in Dynamics, we expect revenue growth in the mid to driven by continued growth in Dynamics 365. For Intelligent Cloud, we expect revenue to grow between 15% 16% Of 14% 15% in constant currency, revenue should be $23,300,000,000 to $23,600,000,000 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 25% to 26% in constant currency, including roughly 2 points from all Azure AI Services. Growth continues to be driven by our Azure consumption business And we expect the trends from Q4 to continue into Q1. Our per user business should continue to benefit from Microsoft 365 Suite Momentum, So we expect continued moderation in growth rates given the size of the installed base.

Speaker 3

In our on premises server business, We expect revenue to decline lowtomidsingle digits against the prior year comparable that benefited from annuity purchasing ahead of the SQL Server 2022 launch. And in Enterprise Services, revenue should decline low to mid single digits year over year as growth in Enterprise Support Services will be more than offset by a decline in Industry Solutions. In More Personal Computing, we expect revenue of $12,500,000,000 to $12,900,000,000 Windows OEM revenue should decline low to mid teens, including 5 points of negative impact from the earlier back to school inventory builds that were pulled into the 4th quarter. Our guide assumes no significant changes to the PC demand environment. In devices, revenue should decline in the mid-30s Due to the overall PC market and adjustments we made in our portfolio with an increased focus on our higher margin premium products.

Speaker 3

The Windows Commercial Products and Cloud Services customer demand for Microsoft 365 and our advanced security solutions should drive revenue growth in the mid to high single digits. Search and news advertising ex TAC revenue growth should be mid to high single digits, roughly 5 points higher than overall search and news advertising revenue, driven by continued volume strength supported by Edge browser share gains. Growth will continue to be impacted by the advertising spend environment 3rd party partnerships mentioned earlier. We continue to be excited by Bing usage signals and the longer term opportunity as we invest in AI. And in gaming, we expect revenue growth in the mid single digits.

Speaker 3

We expect Xbox content and services revenue growth in the mid to high single digits, driven by 1st party and third party content as well as Xbox Game Pass. Now back to company guidance. We expect COGS between US16.6 billion dollars to US16.8 billion dollars and operating expense of US13.5 billion dollars to US13.6 This does not include any impact from Activision on interest income and expense, and we are required to recognize mark to market gains or losses on our equity portfolio, which can increase quarterly volatility. We expect our Q1 effective tax rate to be around 19%. And finally, As a reminder for Q1 cash flow, we expect to make a $2,700,000,000 cash tax payment related to the TCJA transition tax.

Speaker 3

We do not expect payment related to the R and D capitalization provision in Q1. In closing, as a company, We delivered on the FY 2023 financial commitments we discussed a year ago on revenue and operating margin. A focus on operational excellence allowed us to achieve these targets, While we delivered near term value to customers and prioritized our investments to continue to lead in the future. As we start FY24, we are excited for the opportunities ahead and remain focused on delivering the 3 key priorities Satya mentioned. We'll maintain our lead as the top commercial cloud by helping customers use the breadth and depth of the Microsoft Cloud.

Speaker 3

We'll continue to invest in our cloud and AI infrastructure, while scaling with growing demand, so we can lead the AI platform wave. And finally, we'll align our costs with growth as we are committed to driving operating leverage. With that, let's go to Q and A, Brett.

Speaker 1

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

Speaker 2

Yes.

Operator

And our first question comes from the line of Keith Weiss with Morgan Stanley. Please proceed.

Speaker 4

Excellent. Thank you guys for taking Shinnan, very nice end to a great fiscal year. Sati, you started out your comments talking about how every customer conversation has the asking you about utilizing generative AI technology and how fast it could utilize that generative AI technology. What's the answer? What do you tell them in terms of the pace with which that could get into the marketplace and your customers can start using it?

Speaker 4

And then for Amy, how should investors think about just the fundamental gross margins behind these generative AI technologies? We understand there's going to be a lot of CapEx to ramp up underneath these, but what should we expect in terms of what the ultimate gross margin looks like underneath all these new generative AI solutions? Thank you.

Speaker 2

Thank you, Keith, for the question. The fundamental guidance and conversation that we have with customers is twofold. 1 is The easiest path to value auto generated AI is to adopt certain solutions. For example, GitHub Copilot, In some sense, it's sort of the no brainer to add productivity leverage for all of the software developers in any organization, whether you're a bank, You're a retailer or you're a software company. It applies to everyone.

Speaker 2

So that's probably one of the things that we have seen very good Yes, even productivity data and great adoption. And then obviously the excitement that there is already around the M365 copilot. So first thing we sort of talk about is how we ourselves are deploying all these co pilots across whether it's sales co pilot or M365 co pilot or data co pilot, how You get maximum value out of these horizontal tool chain. And then on top of that, we have taken what we did underneath these Products and built it out as a 1st class tech stack, which we talked at our developer conference call, the Copilot stack. And then with ArrayEye, tooling made it possible for someone like Moody's to build their own co pilot for their people.

Speaker 2

So to us, we want to be able to help customers build their generative AI applications on top of Azure AI and with Speed, if you will. And so those are the two things that we asked them to identify where they can get the maximum productivity leverage. And then we even swarmed with our own resources to help them get those things done. And the last comment I'd make is The cloud and data in the cloud enables all this because I think the diffusion cycle here is in some sense we have a new set of Cloud meters that are getting adopted faster because of everything else that came before it in the cloud. So those would be the observation.

Speaker 3

And to your question, Keith, on gross margins and how I think about those going forward, the first thing I would say is that I expect Gross margins here to transition over time just like they did in the prior pilot transition. I would also say, I expect workloads and the gross margins of the workloads to be different, just like they are in the cloud today. I would also add one thing that's different than last time. We've talked a bit about this before is that we start out in a different place with more of a shared platform, which allows us to scale those gross margins a bit faster than last time. And we do expect, as you asked and Satya talked about, the pace of this adoption curve, we do Back to be faster.

Speaker 3

So you're seeing the CapEx spend accelerate in Q4 and then again in Q1 and we've talked about what Now that being said, we're talking about all that And going through that transition while delivering in FY 2024 over FY2023, Effectively, a point higher operating margins because if it's flat Year over year as we guided, with the headwind from the useful life change, when you correct for that, it's about a point higher. So I think the real focus here is being able to be aggressive in meeting the demand curve and Focusing on the transition and growth in gross margins and delivering the operating leverage.

Speaker 5

Excellent. Thank you, guys.

Speaker 1

Thanks, Keith. Operator, next question please.

Operator

Our next question comes from the line of Brent Thill with Jefferies. Please proceed.

Speaker 4

Thank you. Satya, on the optimization headwinds that you continue to see, when do you think we hit Peak optimization, are we getting close to hitting that peak and getting some relief in the back half of the year and maybe AI helping provide as a tailwind? Any color from what you're seeing from your perspective would be helpful.

Speaker 2

Sure, Brent. Thank you for the question. Yes, a couple of observations. One is, I think overall in the cloud, you do see new project starts and then those project starts get optimized. And then you Sort of time series, all of that, and that's sort of what you see in the normal course.

Speaker 2

What happened here was During the pandemic, obviously, there were lots of new project starts and optimization in some sense was postponed and that's where you're seeing, I'll call it, catch up Optimization, and that's something that, to your point, we will lap going into the next couple of quarters. I think it will come down. And we are seeing new projects starts, both traditional type of project starts, even cloud migrations, Data applications and of course, obviously, the AI applications. But we'll get back to, I'll call it, the normal pace of new project Stocks and optimizations going forward, Ben, we will cycle through, I think, in the next couple of quarters, what is the last catch up optimization.

Speaker 3

I would just add, but I think to Satya's point and maybe to build a bit of a line for you. I think it felt very similar to last quarter where we made the same comments, Which is we're seeing sort of the normal optimization plus we're seeing new workload starts across these workloads Satya talked about. And I think Through

Speaker 1

H2. Thanks. Thanks, Brent. Operator, next question please.

Operator

The next question comes from the line of Mark Moerdler with Bernstein Research. Please proceed.

Speaker 6

Thank you very much for taking the question And congrats on the quarter. Amy, Cat Box moved up significantly Q over Q and year over year and it's increasing moving forward. Can you give us some color? Is it physical data centers? Is this predominantly servers?

Speaker 6

Is it predominantly AI driven? How should we think about the useful life of it? And then Quickly for Satya, can you give us some where we have status on the general availability of the full CoPilot development stack and how long it's taking clients and partners to build co pilots? Thanks.

Speaker 3

Well, I start on the CapEx question, Sasha, then I'll turn it over to Mark, really, first of all, both in Q4 and then talking about Q1, the acceleration is really quite broad. It's both on both the data centers and the physical basis plus CPUs and GPUs and networking equipment, think of it in a broad sense as opposed to a narrow sense. So it's overall increases of acceleration of overall capacity. And I think if you look back over really FY 2023, You wouldn't have seen some of the pace on normal, what I would say, capacity adds even for the normal Azure workload. So you're seeing both accelerations, the normal Azure workloads plus some of the AI workloads is partially the reason.

Speaker 3

So it's why I do comment quite often that it's both overall commercial cloud demand and Building out capacity for AI, it's both.

Speaker 2

Yes. And I think just for perspective, I think it's sort of always good To think about it, right, where we have about 111 bill commercial cloud business growing at, what, 22% year over year. And then you had a CapEx growth, which is around the same number, 23%, 24%. So in some sense, It's sort of replacement capital plus some new capital that is going to drive new growth. So that's I think the scale and we feel good about That structure of overall growth rates and how it translates into future TAM opportunity for us.

Speaker 2

To your other question on how all this translates into project starts effectively, the Copilot stack is available today on Azure. So we have everything from Azure AI toolchain where you can use obviously Azure OpenAI or even you can use open models from Llama and other hugging face models. You have all the fabric and all of our operational data stores for what is one of the most useful patterns around generative AI is what is Retrieval augmented generation, which is you take the data that you have in the data stores, use it in a prompt to generate completion summaries, what have you. And so that's Something that we've seen a lot of in the CoPilot are fundamentally orchestrations of that. And so we have all of these services available.

Speaker 2

The thing that's fascinating is when you use something like Power Virtual Agent, you have a low code, no code tool to build effectively these AI products or full fledged co pilots like we've built and all of the underlying primitives for that are available on Azure. The Tool chain is available on Azure and the speed with which customers are able to deploy them, ISVs are able to build them is pretty impressive.

Speaker 6

Thank you. I appreciate it.

Speaker 1

Thanks, Mark. Operator, next question please.

Operator

The next question comes from the line of Kash Rangan with Goldman Sachs. Please proceed.

Speaker 5

Hi, thank you very much. Congratulations on the quarter. If I could, I just wanted to get your Todd, to shift the discussion away from COGS and CapEx to more of the top line outlook, it looks like Azure growth rate is definitely starting Stabilize and generative AI contribution to Azure is measurably improving quarter by quarter and optimization in a broader sense is also starting to settle Where does this leave with the company's outlook for Azure growth rate in the future quarters? Are we at a point where we've bottomed out

Speaker 2

and we could start to

Speaker 5

see some acceleration due to the trends we discussed? And also if you take the superset of Microsoft Cloud, When you throw in the new pricing for CoPilot, it certainly looks like the TAMs are opening up in a pretty significant way. So when you take the broader lens, That 21%, 22% growth rate that Satya and Amy referred to, what is the what could be the outlook? Could we be too optimistic in attaining hopes of Some kind of acceleration in the years ahead? Or how do you think about the outlook on the top line?

Speaker 5

Thank you so much.

Speaker 2

Sure, Thanks for the question. So maybe I'll start and then Amy you can add. Because I think we do think about what's the long term TAM here, right? I mean this is You heard me talk about this as a percentage of GDP, what's going to be tech spend. If you believe that, let's say, the 5% of GDP is going to go to 10% of GDP is going to go to 10% of GDP, maybe that gets accelerated because of the AI wave.

Speaker 2

Then the question is how much of that goes to the various parts About commercial cloud and then how competitive are we in each layer, right? So if you sort of break it down, you Talked about how Microsoft 365, we think of this Copilot as a 3rd pillar, right? We had the creation tools. We then had all the communication and collaboration services, and we think the AI co pilot is a 3rd pillar. So we are excited about it.

Speaker 2

Amy talked about how we want to get it out first as part of this preview. And then in the second half of the next fiscal year, we'll start getting some of the real revenue signal from it. So we're looking forward to it. But we think of it long term as a 3rd pillar like we thought about Something like, say, Teams or SharePoint back in the day or what have you. Then Azure, The way I think about it is we still are whatever inning 2 or inning 3 of even the cloud migration, especially if you view it, right, whether By industry moves to the cloud, segment move to the cloud as well as country adoption So there's still early innings of the cloud migration itself, so there's a lot there still.

Speaker 2

And then on top of that, there is this complete new world of AI driving a set of new workloads. And so we think of that again being pretty from our TAB opportunity and will play it out. So but at the same time, as we are 100 $10,000,000,000 $11,000,000,000 commercial cloud that has grown in 20s. And so therefore, we do It's law of large numbers. But that said, we do think that this is a business that can have sustained high growth, which is something that we are excited about.

Speaker 3

And I think the only thing, Kash, I would add is, I think in some ways what we're really pointing to is there's a process here. We see the demand signals quite strong. It remains strong. I'm thrilled with all the product announcements we've made. I'm thrilled with them Moving to BriefView and then moving to GA, they absolutely are expansive in terms of addressable market.

Speaker 3

They reach new budget pools is almost the way I talk about it a lot in terms of how CIOs or CFOs that I talk 2, think about that investment, so a growing opportunity. And as you know, we're focused on executing against that. And then Revenue is an outcome, but it certainly does require the demand signal requires the capital expense and then creates The opportunity and that's why I think in some ways we're spending a little more time talking about some of that investment is because it is the demand signal.

Speaker 5

Awesome. Thank you so much.

Speaker 1

Thanks, Kash. Operator, next question please.

Operator

Our next question comes from the line of Karl Keirstead with UBS. Please proceed.

Speaker 7

Okay, great. Amy, if I could double click a little bit on the exciting news around M365 CoPilot as everybody on the line looks to Layer that opportunity into our models, I just wanted to get your views. Are there any guardrails you'd offer us to sort of keep us in line? Is there a degree of gross margin pressure in the office segment? In other words, is it a fairly cost intensive New product that we should keep in mind?

Speaker 7

And also could it pull along Azure in the sense that you need Azure AD and perhaps some of the other Cybersecurity Products, so a little color there might help everybody with their modeling exercise tonight and in the coming weeks.

Speaker 3

Thanks, Carl. I think maybe I'll first start with the process we have when we release new products. And I absolutely understand we are excited too by the demand signal, the customer reaction, Really, the request we're getting to be in the paid preview, it's all encouraging. As you know, last week, we announced pricing. Then we'll continue to work through the paid Preview process, get good feedback, then we'll announce the general availability date, then we'll get to the GA date, Then, we'll, of course, be able to sell it and then recognize revenue.

Speaker 3

And that is why I Continue to say that I am just as excited as everyone else about this and it should be more H2 weighted. And we've, I think, given you some sizing opportunities and I think I would use all that, but I do think this is really About pacing and of course, we've still got to get our security co pilot and some of the dynamics workloads And we'll continue to work toward that. And of course, I think one of the things that people often, I think Overlook is, I thought you mentioned it briefly when you go back to the pull along Azure. I think in many ways, Lots of these AI products pull along Azure because it's not just the AI solution services that you need to build an app. And so it's less about Microsoft 365 pulling it along or any one co pilot.

Speaker 3

It's that when you're building these, it requires data And it requires the AI services. So you'll see them pull both core Azure and AI Azure along with them. And I think that's an Important nuance

Speaker 2

as well. Yes. Chief, I could just add to what Amy said. The platform effect here is really all about the extensibility of the co pilots. You see that today when people build applications in teams that are built on Power Apps and those Power Apps happen to use something like SQL DB on Azure, that's quite a classic line of business extension.

Speaker 2

So you'll see the same thing. When I have a Copilot plug in, That plug in uses Azure AI, Azure Meters, Azure Data Sources, Azure Semantic Search. So you'll see obviously a pull through not only on the identity or security layer, but in the core PaaS Services of Azure plus the Copilot extensibility in M365.

Speaker 7

Terrific. Thank you.

Speaker 1

Thanks, Carl. Operator, next question please.

Operator

The next question comes from the line of Mark Murphy with JPMorgan. Please proceed.

Speaker 8

Yes. Thank you very much. Sanjay, there's so much evidence now that GitHub Copilot is boosting developer productivity by 40% to 50% or more, And it's resulting in higher quality code. Do you envision a similar level of productivity boost for the Microsoft 365 Co Pilot, the security co pilot, sales co pilot. In other words, can every room in the house be remodeled To a similar extent such that that value proposition is pretty elevated across the entire stack.

Speaker 2

Yes. Judson Altoff would love you for having used his metaphor of remodeling every room of the house with AI Because you're absolutely right. I mean that's the opportunity we see. I think what you're also referencing is now there is good empirical evidence and data around the GitHub Copilot and the productivity stats around it. And we're actively working on that for M365 Copilot.

Speaker 2

Also for things like the role based ones like sales co pilot, service co pilot, we see these business processes having very high Proximity gains. And so yes, over the course of the year, we will have all of that evidence. And I think at the end of the day, as Amy referenced, every CFO and CIO He's also going to take a look at this. I do think for the first time or rather, I do think people are going to look at how can they complement their OpEx Spend with essentially these co pilots in order to drive more efficiency and quite frankly even reduce the burden And drudgery of work on their OpEx and their people and so on. So therefore, I think you're going to see all of that Translated into Product 2 d stats and we're looking forward to getting that day out.

Speaker 8

Thank you very much.

Speaker 1

Thanks Mark. Operator, next question please.

Operator

The next question comes from the line of Alex Zukin with Wolfe Research. Please proceed.

Speaker 8

Hey guys, thanks for taking the question. I guess maybe just a multiparty. You mentioned a couple of times that With the AI workload adoption that you're seeing on Azure, it's starting to look maybe a little bit different from an incremental share gain Can you maybe expand upon that? How should that drive for Azure consumption, particularly as we get through the year? And do you see a scenario where either the combination of lapping the optimization, Edwed, plus The AI contribution plus this incremental tailwind that you're seeing around the workloads actually does drive A reacceleration at Azure, particularly in the second half, when you're going to start to see some of those things kick in?

Speaker 2

Yes. I mean, the thing that we are both seeing and excited about is Both the new workloads, I mean if you think about Azure, we Have grown Azure over the years coming from behind. And here we are as a strong number 2 in the lead when it comes to these new workloads. So for example, we are seeing new logos. Customers who may have used it not on the cloud For most of what they do are for the first time sort of starting to use Azure for some of their new AI workloads.

Speaker 2

We also have even customers who've used multiple clouds, who used us for a class of Sort of workloads. Also start new projects when it's in data and AI, which they were using other clouds for. So What I think you will see us is more share gains, more logo gains, reducing our CAC even. And so those are the things, the points of leverage. But at the same time, we are not a small business anymore in any of these things.

Speaker 2

These are we are We are at significant scale. And so yes, we celebrate. That's why we're even giving you the visibility of one point of it showing up this Quarter, a couple of points showing up next quarter and those are material numbers. And so that's kind of what I think will I think Amy mentioned it because we want there are 2 parts to even the AI, right? There is the models themselves with our partnership with OpenAI, That's sort of one type of spend on compute and the other is much more revenue driven, right, which is we will track the inference cost to the revenue and demand and You're already seeing both of those play out.

Speaker 1

Thanks, Al. Thank you. Operator, we have time for one last question.

Operator

Our last question will come from the line of Kirk Materne with Evercore ISI. Please proceed.

Speaker 9

Yes. Thanks for Squeezing me in. Satya, I was wondering if you could expand a little bit on your comments on data platforms. I think we've heard a lot over the last Quarter or so about if you don't have a data strategy, it's tough to have an AI strategy. Can you just talk about where customers are right now in that journey to have a more, I guess thoughtful data strategy.

Speaker 9

And what does that mean in terms of their ability to adopt AI services? Meaning do they have to sort of Tackle the data issue first before they can really take advantage of all the AI services? Or how should we think about that sort of juxtaposition? Thanks.

Speaker 2

Yes, sure. Thank you, well, for the question. Yes, absolutely. I think having your data in particular in the cloud is Key to how you can take advantage of essentially these new AI reasoning engines to complement, I'll call it, your databases because These AI engines are not databases, but they can reason over your data and to help you then get more insights, more completions, more predictions, More summaries and what have you. So those are the things when we say CoPilot design pattern, that's sort of what that design pattern is all about.

Speaker 2

The thing that perhaps even in the last quarter and I had that in my remarks What's most exciting is how with Microsoft Fabric, especially for the analytics workloads, We brought together compute, storage, governance with a very disruptive business model. I mean to give you a flavor for it, right, Drew. So you have Your data in an Azure data lake, you can bring SQL compute to it, you can bring Mark, to it, you can bring Azure AI or Azure OpenAI to it, right? So the fact is you have storage separated from all these compute meters And they're all interchangeable, right? So you don't have to buy each of these separately.

Speaker 2

That's the disruptive business model. So I feel that we are well Soft is very well positioned with the way our data architecture lays out our business model around data and how people will plan to use data with AI services. So that's kind of what I mean by getting your data estate in order. And it's Just not getting data estate in order, but you have to have it structured such that you can have the flexibility that allows you to exercise the data And compute in combination that makes sense with this new age.

Speaker 1

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

Speaker 2

Thank you all.

Operator

Thank you, everyone. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.

Earnings Conference Call
Microsoft Q4 2023
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