Microsoft: AI features steadily advancing, driving demand recovery

Summary of Microsoft FY2024Q1 Conference Call

1. Product Updates

Infrastructure: In this quarter, we announced the full launch of the next-generation H100 virtual machine. Azure AI provides access to cutting-edge models from OpenAI and open-source models, including our own models as well as those from Meta and Hugging Face. Customers can use these models to build their own AI applications while meeting specific cost, latency, and performance requirements. Currently, over 18,000 organizations are using Azure OpenAI services, including new customers using Azure.

We continue to see more cloud migrations. With Azure Arc, we can meet customers' needs to run applications across on-premises, edge, and multi-cloud environments. We now have 21,000 Arc customers, a YoY growth of 140%. We are the only cloud provider running Oracle database services, enabling customers to easily migrate their on-premises Oracle databases to our cloud.

2. Data: With GitHub Copilot, we have increased developers' productivity by 55%. We have over 1 million paid Copilot users. Additionally, over 37,000 organizations have subscribed to Copilot for Business, a MoM growth of 40%. This quarter, we added new features to GitHub Copilot Chat, which are being used by digital-native enterprises like Shopify, as well as leading companies like Maersk and PwC, to enhance the productivity of their software developers.

Since our acquisition five years ago, the number of developers using GitHub has quadrupled. We have also introduced Copilot to the Power Platform. So far, over 126,000 organizations, including 3M, Equinor, Lumen Technologies, Nationwide, PG&E, and Toyota, have used Copilot in the Power Platform. This quarter, we added new Copilot features to Power Pages, allowing users to build data-driven websites with just a few sentences or clicks. Finally, Power Apps remains the market leader in low-code/no-code development, with 20 million monthly active users, a YoY growth of 40%.3. Business Applications: We are becoming the leading business process transformation layer on top of existing CRM systems like Salesforce. For example, our Sales Copilot helps over 15,000 organizations (including Rockwell Automation, Shantui Construction Machinery, Securitas, Teleperformance) enable personalized customer interactions based on third-party CRM data. This quarter, we introduced Copilot in Dynamics 365 Field Service to help streamline frontline tasks.

4. Industry Cloud: In the healthcare field, our Dragon Ambient Experience solution helps clinical doctors automatically document patient interactions at the point of care. To date, it has been used for over 10 million interactions. With the help of DAX Copilot, our AI-powered model generates high-quality clinical records in seconds, improving physician efficiency and reducing burnout.

5. Teams: With continuous growth in usage, Teams has surpassed 320 million monthly active users, making it the workplace for chat, collaboration, meetings, and calls. This quarter, we launched a new version of Teams that is twice as fast and uses 50% less memory, including seamless cross-tenant communication and collaboration. We have seen triple-digit revenue growth for Teams Rooms for nine consecutive quarters. There are now over 10,000 paying customers using Teams Premium. Teams Store has over 2,000 applications, with collaboration apps from Adobe, Atlassian, and Workday all having over 1 million monthly active users in Teams.

6. Windows: PC market sales are roughly at pre-pandemic levels. We continue to innovate on Windows, adding differentiated AI experiences to the operating system. We introduced the largest update to Windows 11 ever, with 150 new features, including AI-based experiences in apps like Clipchamp, Paint, and Photos. We introduced Copilot in Windows, your everyday AI companion that combines web context, your work data, and what you do on your PC to provide better assistance.

7. Security: The speed, scale, and complexity of today's cyberattacks are unprecedented - security is the top priority for global CIOs. We see tremendous demand for Security Copilot. It is the industry's first and most advanced generative AI product, now seamlessly integrated with Microsoft 365 Defender. Dozens of organizations, including Bridgewater, Fidelity National Financial, and the Government of Alberta, are already using Copilot in preview.And the early feedback has been very positive. As part of our new Early Access program, we look forward to introducing Copilot to hundreds of organizations in the coming months so they can increase productivity in their security operations centers and stop threats at machine speed. More broadly, we continue to gain share across all major categories we serve. Our SIEM Microsoft Sentinel now has over 25,000 customers with annual revenue exceeding $1 billion. Customers from various industries such as Booz Allen Hamilton, Grant Thornton, and MetLife are using our end-to-end solutions to protect their environments.

8. LinkedIn: We are now applying next-generation artificial intelligence to transform the way our 985 million members learn, sell, and find jobs. Membership growth has now accelerated for more than two consecutive years each quarter. We have introduced new AI-driven features across all our businesses, including Learning Coaches that provide personalized content guidance to members and tools to help employers find qualified candidates and attract buyers.

Since introducing AI-assisted insights for recruiters five months ago, three-quarters of them say it has saved them time. We have seen nearly an 80% increase in the number of members watching AI-related learning courses this quarter. More broadly, we continue to see record engagement and knowledge sharing on the platform. We now have over 450 million newsletter subscriptions globally, triple the YoY growth. Premium subscription sign-ups grew by 55% YoY. Our recruiting business has maintained its share for the fifth consecutive quarter.

9. Search, Advertising, and News: With our Copilot for the Web, we are redefining how people use the internet for search and creation. Bing users have engaged in over 1.9 billion chats. Microsoft Edge's market share has grown for ten consecutive quarters. This quarter, we introduced more personalized answers and support for Dall-E 3, helping people get more relevant answers and create highly realistic images, resulting in over 1.8 billion images created so far.

Through our shopping Copilot, people can find more personalized recommendations and better deals. We are bringing Bing into Meta's AI chat experience to provide more up-to-date answers and access to real-time search information. Lastly, we are integrating next-generation AI directly into our advertising platform to better connect marketers with customer intent in our chat experiences, as well as with customers from Axel Springer, Snap, and others.

10. Gaming: We are excited to have completed the acquisition of Activision Blizzard earlier this month. Together, we will advance the goal of bringing amazing games to players worldwide, on any endpoint. Through Game Pass, we have redefined how games are distributed, played, and discovered.In this quarter, we set a new record for the game time of each subscriber. We released "Starfield" this quarter, which has received widespread acclaim.

After the acquisition of Blizzard, we will have a series of games worth over $13 billion, including "Candy Crush Saga," "Diablo," "Halo," "Warcraft," "The Elder Scrolls," and "Gears of War." We are looking forward to one of the strongest first-party holiday lineups ever, including new games such as "Call of Duty: Modern Warfare III" and "Forza Horizon." Finally, we are innovating rapidly to expand our opportunities in consumer and commercial businesses, helping our customers thrive in this new era. In a few weeks, we will hold our flagship Ignite conference, where we will unveil over 100 new products and features, including exciting new AI innovations. I encourage you to tune in.

2. Performance Analysis:

In Azure, higher-than-expected AI consumption drove revenue growth. In our consumer business, PC market sales are recovering to pre-pandemic levels. Advertising spending is roughly in line with our expectations. In the gaming sector, the strong engagement brought by the release of Starfield has benefited Xbox content and services. Calculated at fixed exchange rates,

Commercial Bookings grew by 17% at fixed exchange rates, in line with expectations, primarily due to the strong execution of our core annuity sales motion and the continued growth in the number of contracts valued at over $10 million for Azure and Microsoft 365. Commercial remaining performance obligations increased by 18% to $212 billion. Approximately 45% will be recognized as revenue in the next 12 months, a 15% YoY increase. The remaining portion will be recognized after the next 12 months, increasing by 20%.

Microsoft Cloud gross margin increased slightly YoY to 73%, better than expected, mainly due to improvements in Azure. Excluding the impact of changes in depreciation periods, the gross margin percentage of Microsoft Cloud increased by approximately 2 percentage points, driven by improvements in Azure and Office 365, but partially offset by the impact of increased investments in our AI facilities.

Operating expenses increased by 1%, lower than expected, as some expenses were shifted to future quarters. Overall, the number of employees as of the end of September decreased by 7% compared to the same period last year.

Office 365 commercial revenue grew by 17% at fixed exchange rates, slightly better than expected. Growth was driven by strong momentum in E5, healthy renewal execution, and ARPU growth. Paid Office 365 commercial seats grew by 10% YoY, with seat growth once again driven by our small and medium-sized enterprises.LinkedIn's revenue grew by 8%, exceeding expectations. The growth was driven by talent solutions, although we still saw a negative year-on-year booking volume due to a weak recruitment environment in key vertical industries.

On a fixed exchange rate basis, Azure and other cloud service revenues grew by 29% and 28% respectively, with AI services revenue growing by approximately 3 percentage points. The growth exceeded expectations mainly due to an increase in GPU capacity and better-than-expected GPU utilization in AI services.

Windows OEM revenue grew by 4% year-on-year, significantly exceeding expectations, thanks to stronger-than-expected consumer channel inventory build-up and stable PC market demand, especially in the commercial sector.

On a fixed exchange rate basis, search and news advertising revenue, excluding TAC, grew by 10% and 9% respectively, slightly higher than expected. Although search revenue growth continues to be affected by third-party partnerships, this quarter we saw an increase in Bing and Edge market share.

In the gaming sector, revenue grew by 8%, surpassing expectations, driven by better-than-expected user growth in Xbox Game Pass and first-party content. Xbox content and services revenue grew by 12% on a fixed exchange rate basis. Gross margin increased by approximately 5 percentage points year-on-year, mainly due to a shift in sales mix towards higher-margin businesses.

Finally, this quarter we returned $9.1 billion to shareholders through stock repurchases and dividends.

Q2 Outlook:

We expect FX to contribute approximately 1 percentage point to total revenue and segment revenue growth. We do not anticipate any impact on cost of goods sold and operating expenses from foreign exchange.

In terms of Commercial Booking, our core annuity sales actions will remain steady but will be impacted by the end of the low-growth base period. We expect booking volume growth to be relatively stable. Microsoft Cloud gross margin should remain relatively flat year-on-year. Excluding the impact of accounting estimate changes, cloud gross margin is expected to increase by approximately 1 percentage point in the second quarter, primarily due to improvements in Azure and Office 365, partially offset by the impact of expanding AI infrastructure to meet growing demand.

We anticipate that capital expenditures will continue to increase in US dollars driven by investments in cloud and AI infrastructure.

In the Office Commercial segment, revenue growth will once again be driven by Office 365, seat growth across the customer base, and ARPU growth achieved through E5. We expect Office 365 revenue to grow by approximately 16% on a fixed exchange rate basis. We anticipate that Microsoft 365 Copilot will be fully launched on November 1st and expect related revenue to gradually increase over time. In the Office Consumer segment, we expect revenue to achieve mid-single-digit growth driven by Microsoft 365 subscriptions.Regarding LinkedIn, we expect revenue to achieve mid-single-digit growth driven by talent solutions and marketing solutions. The growth will continue to be influenced by the overall market environment for recruitment and advertising.

In terms of Dynamics, we expect revenue to achieve double-digit growth driven by Dynamics 365.

For Intelligent Cloud, we anticipate revenue growth of 17% to 18%, or $25.1 billion to $25.4 billion. Revenue growth calculated at a fixed exchange rate is expected to decrease by approximately one percentage point. Revenue will continue to be driven by Azure.

Within Azure, as the contribution of artificial intelligence continues to increase, we expect revenue growth calculated at a fixed exchange rate to be 26% to 27%.

More on Personal Computing, including the net impact of the Activision Blizzard acquisition. We expect revenue to be $16.5 billion to $16.9 billion. Windows OEM revenue growth should be in the high single digits, with unit sales in the PC market expected to be roughly similar to the first quarter.

Search and News advertising revenue growth, excluding TAC, should be in the mid-single digits, with approximately a 4 percentage point negative impact from third-party partnerships. Growth excluding TAC will be approximately 4 percentage points higher than overall search and news advertising revenue.

In the Gaming segment, we expect revenue growth to be around 40%. This includes a net impact of approximately 35 points from the Activision acquisition. We expect Xbox content and services revenue to grow around 50%, primarily benefiting from a net impact of approximately 50 percentage points from the Activision acquisition.

We expect operating expenses to be $15.5 billion to $15.6 billion, with approximately $400 million coming from purchase accounting adjustments, integration, and transaction-related costs from the Activision acquisition.

Throughout fiscal year 2024, we remain committed to investing in cloud and AI opportunities while maintaining a strict focus on operating leverage. Therefore, when we include the net impact of Activision Blizzard (including purchase accounting adjustments, integration, and transaction-related costs), we continue to expect full-year operating margin to be in line with the same period last year. Finally, with our strong start to fiscal year 2024, I believe that as a team, we will continue to achieve healthy growth in the coming year, driven by our leadership position in the commercial cloud space and our commitment to leading the wave of AI platforms.

Q1: Two questions: First, do you believe you can sustain the type of commercial growth we saw in the first quarter of this year? And second, should we consider more aggressive investments behind all these product innovations?

A1: Let's take cloud migration as an example. The new products announced by Oracle serve as a good reminder of the position we hold in the core cloud migration story. Once we announced that Oracle databases would be available on Azure, we saw a significant influx of new customers who have substantial Oracle assets but have not yet migrated to the cloud. We are excited about this. For example, the financial services industry is a good place where there are still many Oracle assets that need to be migrated to the cloud.Q2: Does Microsoft have a complete AI dev stack copilot reference architecture and plug-in architecture?

A2: We do adopt a full-stack approach, whether it's ChatGPT, Bing Chat, or all of our Copilots, they all share the same models. This advantage will continue to permeate both internal and third-party utilization. And over time, you can see this stack optimization extending to all aspects. This doesn't mean that we don't train models with open source or proprietary models. We have a lot of open source models, and we have done a lot of fine-tuning and reinforcement learning with them.

Q3: Can you maintain double-digit growth, especially with the stronger push of artificial intelligence in the coming quarters?

A3: I think the first quarter is a good start to this year. We believe Azure will remain stable going forward and consistent with what we have seen in the second quarter. So, I think we are satisfied with our execution capability, but more importantly, we continue to improve our ability to gain market share.

Q4: Can you talk about what you have seen in terms of customer and beta testing? What does this mean for the adoption curve once it is officially released on November 1st?

A4: 40% of Fortune 100 companies are already using the product in the preview version. It's not just a single tool, but a continuous Copilot button on every interface, whether it's creating documents in Word, analyzing data in Excel, or in PowerPoint, Outlook, or Teams. It's like having a knowledge base of all meetings that you can query and add to the essential knowledge terms of the enterprise.

Whether it's in the finance field or the sales field, divided by roles, we have seen an increase in productivity, just like what we have seen with developers in GitHub Copilot. So far, everything is going well in terms of data and feedback, and the pricing of such products is incremental.

Q5: Your goal is to decelerate the growth rate by 1 to 2 points in the December quarter and then stabilize. But why stabilize? If the contribution of artificial intelligence increases as you increase GPU capacity, why isn't there an acceleration in the second half of the fiscal year?

A5: We have always seen the trend of customers optimizing cloud computing consistently over the past few quarters. In some quarters, it's faster, but this pattern is customers making room for new workloads. I think this trend will continue for the remaining time this year, and my view on this hasn't changed.

The key part is always the launch of new workloads. Being able to maintain the stability of the Azure business does mean that we will be launching a significant number of new workloads.Q6: Office has a dominant market position. I'm curious how much market share can still be gained?

A6: Our seat growth comes from all segments of the market, but we particularly have an advantage in the opportunities for small and medium-sized enterprises as well as frontline workers. Looking back at the past few quarters, our seat growth rate has been a bit slow, but the fact that we can still continue to increase seats at this level demonstrates the wide applicability of Microsoft 365. It is more suitable for more people. As you expand the capabilities of Microsoft 365, whether it's in terms of security, analytics, or Teams, it becomes applicable to more types of employees, especially in the small business sector. It is still a very attractive product.

Q7: The operating profit margin of the Intelligent Cloud division caught my attention. I believe that despite increased investments in artificial intelligence, the profit margin has reached its highest level in six years. Was it a one-time "tailwind" effect, or has Azure reached a scale where Microsoft can sustain high profit margins?

A7: First of all, the growth in Azure revenue and the stability we see is definitely a healthy operating leverage. Secondly, in our core Azure business, our team continues to provide thoughtful gross margin improvements in both technology and decision software implementation. Our team in infrastructure construction has done an outstanding job in achieving this goal.

In terms of operating expenses, we have always focused on leveraging Azure to drive the transformation of artificial intelligence. Therefore, even as we invest in artificial intelligence infrastructure, it still brings good profit margins. However, considering that a year ago was one of the quarters with the highest growth in operating expenses in our company's history, the operating expenses in the first and second quarters have indeed eased slightly.

Q8: Do you believe that you can continue to drive continuous improvement in gross margin in the medium term, even as higher capital expenditures penetrate the model?

A8: In our core business, Azure business, Office 365, M365 business, and Dynamics business, we will continue to achieve year-on-year improvement in gross margin.

If you have a consistent infrastructure from the platform to its various layers, every dollar of capital we spend, if we optimize revenue based on it, we will have a great leverage because no matter where the demand arises, whether it's at the SaaS layer, the infrastructure layer, or the training workload, we are able to quickly use our infrastructure to generate revenue - or for our Bing workload. I mean, I should mention that all consumer workloads use the same framework.