Microsoft Q1 2024 Earnings Call Transcript

Company Management

Analysts

Keith Weiss

Thank you for taking the question and very nice quarter. The pace of innovation you guys have been putting out has been pretty amazing. And the new products garnering traction probably faster than we’ve expected on our side of the equation. But we’re also working in an overall spending environment, that remains volatile, and I think investors are getting more concerned on it.

So two questions on this, one, based on sort of the new products and the innovation, do you think you guys can sustain the type of commercial growth that we saw in Q1 as we go through the year or is the environment too tricky for that? And then when it relates to investment, Amy, you’ve been able to keep overall OpEx growth very low, and it was very low this quarter. At some point, should we be thinking about a return to a more aggressive investment behind all this product innovation?

Satya Nadella

Maybe I can start, Keith, and Amy you can add to it. Overall there are multiple things, Keith, they’re all happening obviously simultaneously. If you just take Azure and try to characterize, where’s the growth for Azure coming from or what sort of drivers for Azure numbers, there are three things all happening in parallel. Like, for example, take cloud migrations. A good reminder of where we are and even the core cloud migration story is the new Oracle announcement.

Once we announced that the Oracle databases are going to be available on Azure, we saw a bunch of unlock from new customers who have significant Oracle estates that have not yet moved to the cloud because they needed to rendezvous with the rest of the app estate in one single cloud. And so we’re excited about that. So in some sense, even the financial services sector, for example, is a good place where there’s a lot of Oracle that still needs to move to the cloud.

The second thing, of course, is the workloads start, then workloads get optimized, and then new workloads start, and that cycle continues. We’ll lap some of those optimization cycles that were fairly extreme perhaps in the second half of our fiscal. And the third thing is, for us, that’s unique and different is new workload starts around AI. Given our leadership position, we are seeing complete new projects start, which are AI projects. And as you know, AI projects are not just about AI meters, they have lots of other cloud meters as well. So that sort of gives you one side of what’s happening in terms of enterprise.

The other piece is on the SaaS side, obviously, again, this is a new product that’s going to go through the enterprise adoption cycle. The results around productivity, which we demonstrated with GitHub Copilot, is what’s giving us good confidence and our customers, more importantly, good confidence around what these products represent in terms of value. And so we are in the very early innings there, and so we look forward to seeing the traction for these products going forward.

Amy Hood

Keith, maybe just a few things to add and then I’ll talk a little bit about the operating leverage, which is the second part of your question. In general, we saw very consistent execution from Q4 to Q1, and that’s what we’re talking about into Q2. I think that speaks to our value prop, which is where Satya went. It speaks to making sure that customers are getting a very quick return on value, real productivity improvement, real savings, so that when we’re asking at renewal or talking about E5 upgrades or talking about AI services, that those come with real promises of high-value scenarios. And so I think that is an important piece as you think about, stability and commercial demand.

And then if you think about the nature of your question, it was partially why I talked about in my full-year guidance that, now, even with the addition of Activision and purchase accounting impacts, and integration impacts, we still feel confident we can deliver consistent operating margins to last year. And it speaks to, I think, some of the improvements, we’re making in Azure and even in Microsoft 365 gross margins, even in the core of the commercial cloud.

It speaks to the pace at which we are delivering AI revenue with the increasing cost expense and capital investment ahead with the demand we see. And, although you’re right, our operating expense comparables in H2 get more challenging than in H1, we’re really focused on making sure that every dollar we put and commit is back to the priorities we talked about, which is commercial cloud leadership and leading the AI wave. And so I think that focus is really helping on both execution and leverage.

Keith Weiss

Excellent. Thank you, guys.

Brett Iversen

Thanks, Keith. Joe, next question, please.

Mark Moerdler

Thank you very much and congratulations on a really strong quarter. AI has been far stronger than expected, beat your guidance for Azure this quarter. And while you discussed higher utilization and more GPUs have helped, has the fact that Microsoft has a full AI devstack Copilot reference architecture and plugin architecture bidding a meaningful factor, not just from a revenue perspective, but also even potentially from a margin perspective? In addition, can you give us any color on whether Azure GPU is predominantly model training or are we seeing a lot of inferencing yet from clients? Thanks.

Satya Nadella

No. Thank you for the question, Mark. Yeah, it is true that we have — the approach we have taken is a full stack approach all the way from whether it’s ChatGPT or Bing Chat or all our Copilots, all share the same model. So in some sense, one of the things that we do have is very, very high leverage of the one model that we used — which we trained, and then the one model that we are doing inferencing at scale. And that advantage sort of trickles down all the way to both utilization internally, utilization of third parties, and also over time, you can see the sort of stack optimization all the way to the silicon because the abstraction layer to which the developers are riding is much higher up than low-level kernels if you will.

So, therefore, I think there is a fundamental approach we took, which was a technical approach of saying we’ll have Copilots and Copilot stack all available. That doesn’t mean we don’t have people doing training for open source models or proprietary models. We also have a bunch of open source models. We have a bunch of fine-tuning happening, a bunch of RLHF happening. So there’s all kinds of ways people use it. But the thing is, we have scale leverage of one large model that was trained and one large model that’s being used for inference across all our first-party SaaS apps, as well as our API in our Azure AI service…

Amy Hood

And the reason, Mark, that’s important is that it means, even beyond the point Satya made is that, when it comes to our ability to leverage the infrastructure that we’re building out, we don’t really have a preference in terms of how people are utilizing that infrastructure, whether it’s through all the means that Satya mentioned. It gives us a good opportunity to see quick conversion into revenue.

Satya Nadella

Yeah. I mean, one other thing I’d just add to perhaps Mark’s question as well as Keith’s is, this platform transition, I think is very important for us to be very disciplined on both. I’ll call our tech stack as well as our capital spend all to be concentrated. The lesson learned from the cloud side is — we’re not running a conglomerate of different businesses, it’s all one tech stack up and down Microsoft’s portfolio, and that, I think, is going to be very important because that discipline, given what the spend like — it will look like for this AI transition any business that’s not disciplined about their capital spend accruing across all their businesses could run into trouble.

Mark Moerdler

Extremely helpful. Thank you so much.

Brett Iversen

Thanks, Mark. Joe, next question, please.

Brent Thill

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

Amy Hood

As I said, Q1 was a strong start to the year, Q2 certainly implies that. We’ve talked about stability for Azure into the second half of the year looking at and in line with what we’re seeing for Q2. And so I think we feel good about our ability to execute, but more importantly, our ability to continue to take share.

Brett Iversen

Thanks, Brent. Joe, next question, please.

Raimo Lenschow

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

Satya Nadella

No. Thanks. The question, Ramo, the good news is two-fold, one is the fact that, what is 40% of the Fortune 100 are already in the preview and are using the product and I think you all have also done lots of checks and the feedback is very, very positive. And, in fact, the interesting thing is, it’s not any one tool, right? Which is the feedback even sort of is very clear that it’s the all up.

You just keep hitting the Copilot button across every surface, right, whether it’s in Word to create documents, in Excel to, do analysis, or PowerPoint or Outlook or Teams just like that. Clearly, the Teams meeting, which is an intelligent recap, it’s not just a dumb transcript. It’s like having a knowledge base of all your meetings that you can query and add to essentially the knowledge terms of your enterprise.

And so we are seeing broad usage across and the interesting thing is, by different functions, whether it’s in finance or in sales by roles, we are seeing productivity gains like we saw with developers and GitHub Copilot. So that’s the data. We are very excited about our Ignite conference, where we will talk a lot more about all of the use cases and what’s — where’s the value and give more prescriptive guidance on how people can deploy.

But so far so good, as far as the data is and the feedback is. And of course, this is an enterprise product, I mean, at the end of the day, we are grounded on enterprise cycle times in terms of adoption and ramp, and it’s incrementally priced, so, therefore that all will apply still. But at least for something completely new to have this level of usage already and this level of excitement is something we’re very, very pleased with.

Raimo Lenschow

Thank you.

Brett Iversen

Thanks, Raimo. Joe, next question, please.

Karl Keirstead

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

Amy Hood

Thanks, Karl. A couple of things. As I talked about Q2 and then into H2. We’ve been very consistent that the optimization trends have been consistent for us through a couple of quarters now. Customers are going to continue to do that. It’s an important part of running workloads that is not new. There obviously were some quarters where it was more accelerated, but that is a pattern that is and has been a fundamental part of having customers, both make new room for new workload adoption and continue to build new capabilities.

And so I think that impact remains through the rest of the year, and my view is unchanged on that. And then of course, I think the key component has always been new workload starts. And at the scale we’re talking about, being able to have stability in our Azure business, does mean that we will have a lot of new workload starts. And primarily we’re expecting those to come from AI workloads. But AI workloads don’t just use our AI services. They use data services and they use other things. And so that combination, I think, looking on a competitive basis, we feel good about our execution, we feel good about taking share and we feel good about consistent trends. And so I feel good about that guide and what it says about where we are on share.

Karl Keirstead

Okay. Terrific. Thanks.

Brett Iversen

Thanks, Karl. Joe, next question, please.

Bradley Sills

Wonderful. Thanks so much. Very impressive to see the Office 365 commercial seat growth hanging in here in that double digit range. It’s very impressive just given the scale of that business. We think of Office as having such a dominant market position. Curious, how you think about the — where that seat is coming from and how many more of those seats are out there to go get?

Amy Hood

Thanks for that question, and maybe I’ll take that Satya if you — if you want to add. In general, our seat growth has — it does come from all segments, but with particular strength in small and mid-sized businesses, as well as what we call the frontline worker opportunity. And that has been, I would say, looking back a number of quarters where the majority of our seat growth has gone. And while obviously, it slowed a bit to your point, I think the fact that we’re still able to add seats at this level speaks to the broadening nature of what Microsoft 365 needs.

It’s more applicable to more people. And so I think many people have thought, oh my goodness, you’ve got a lot of customers already. And we look and say, how many people when you expand what Microsoft 365 means, whether it’s the security or it means analytics or it means Teams, it means lots of things in an expanding definition. It applies to more types of workers. And frankly, the value is such, especially on the small business front, where it’s to the point where I think people feel like it’s a great way to spend even the spend money they have is — this remains a pretty compelling offer.

Bradley Sills

Thank you.

Brett Iversen

Thanks, Brad. Joe, next question, please.

Brent Bracelin

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

Amy Hood

You think — thanks for that question. I think there are a couple things going on and I do — I would say in particular, this was a very good leverage quarter in that segment. Number one, the Azure revenue growth and the stability we’re seeing in it, absolutely is that help the operating leverage. The second component of that is in our core Azure business. The team continues to deliver thoughtful gross margin improvement across both technical decisions, software implementations. Our teams on the infrastructure build side have done really good work to deliver that, and so that’s been helpful as well.

And then, of course, on operating expenses, there’s been a good focus on continuing even within that segment, to make sure we’re focusing that work on leading in the AI transition with Azure. And so you’re right, even as we’re investing in AI infrastructure, which will and should show up as revenue, it’ll also show up in COGS and still deliver good margin. But this does have a slightly — as I talked about earlier, easier comp in Q1 and Q2, given it was some of our highest growth operating expense quarters in our company’s history a year ago.

Brent Bracelin

Makes sense. Thank you.

Brett Iversen

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

Gregg Moskowitz

Okay. Thank you very much for taking the question. And maybe just a follow-up to what Brent was just asking about, but on the gross margin line. Amy, the Microsoft cloud gross margin is up 2 points year-over-year, excluding the useful life change, a little more improvement than we’ve seen in some time and some investors were worried that it might go in the other direction, given increased AI investments. And so, as you look forward, do you think that you could drive some continued gross margin improvement over the medium term and even as higher CapEx will filter into the model? Thanks.

Amy Hood

Yeah. Let me break that into two components, because they’re both important and it’s a really good question, Gregg. On our core business, the core Azure business, the core Office 365, M365 business, Dynamics business, they’re — they continue to deliver gross margin year-over-year improvements in the core. And so that, like in other quarters has helped this quarter.

In addition, what Satya mentioned earlier in a question, and I just want to take every chance to reiterate it, if you have a consistent infrastructure from the platform all the way up through its layers, then every capital dollar we spend, if we optimize revenue against it, we will have great leverage, because wherever demand shows up in the layers, whether it’s at the SaaS layer, whether it’s at the infrastructure layer, whether it’s for training workloads, we’re able to quickly put our infrastructure to work generating revenue, or on our Bing workloads. I mean, I should have mentioned all the consumer workloads use the same frame.

And so when you think about our investment in AI, yes, it will — because we’re committed to leading this wave and see demand, you will see that impact in COGS growth. But what we’re committed to doing is making sure it’s highly leveraged and making sure you see the same growth in revenue. And I think on occasion, you may see something pick up 1 or 2 points and the other one not quite get there, but the point is, it’s going to be very well paired because of the choices we’ve made over the past, frankly, numerous years, to get to a point where that infrastructure is consistent.

Satya Nadella

And I’ll just add that it’ll be very well paired at the company level. I realize all of you care a lot about each one of our segments and each one of our KPIs, and I do too, but at the end of the day, our stack and the way it works, the way we do our capital allocation, the way we think about even the optimization of the demand to utilization is across the entirety of all of our segments and all of our products.

Gregg Moskowitz

Very helpful. Thanks.

Brett Iversen

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

Amy Hood

Thank you.

Satya Nadella

Thank you.