Slowing Down Is Inevitable (Microsoft Phone Meeting Minutes)

The following is a summary of Microsoft's 2Q earnings call in Fiscal Year 2023, with detailed financial analysis in " Azure's resilience can't save Microsoft in the cycle,"

1. Management Remarks

1.1 Overall Overview

Customers accelerated their digital spending during the pandemic and are now optimizing it. Due to macroeconomic uncertainties, they have become more cautious. As Microsoft turns the world's most advanced AI models into new computing platforms, the next wave of computing is emerging.

The company firmly believes in three things: helping customers achieve more value from their technology spending, establishing long-term loyalty and market share positions, maintaining Microsoft's internal cost structure consistent with revenue growth, and the long-term trend of digital spending as a percentage of GDP.

Against this backdrop, Microsoft's cloud business revenue exceeded $27 billion in the quarter, an increase of 22% (29% on a fixed-exchange-rate basis).

2. Commercial Remaining Performance Obligation

The remaining contract balance for unfulfilled enterprise contracts is $189 billion, an increase of 29% year over year. 45% will be recognized as revenue within one year, an increase of 24% year over year. The remaining part, which will be recognized over one year, increased by 32% year over year.

3. Azure

Enterprises have moved millions of compute cores to Azure, and the number of cores running on Microsoft's cloud has doubled from two years ago. Microsoft continues to maintain its hybrid computing power through Azure Arc. Today, Microsoft has over 12,000 Arc customers, twice as many as a year ago, including Citrix, Northern Trust, and PayPal.

4. AI

Microsoft has the most powerful AI supercomputing infrastructure in the cloud, such as OpenAI, for training the most advanced models and services, such as ChatGPT. Microsoft has announced the completion of the next phase of its agreement with OpenAI. Microsoft will become its exclusive cloud provider and will deploy OpenAI's models in consumer and enterprise products. All of these innovations are driving growth in Azure AI services, with Azure ML revenue growing by over 100% for five consecutive quarters.

5. Power Platform

Power Automate has over 45,000 customers, with year-over-year growth exceeding 50%.

6. Office System

Microsoft 365 has over 63 million users, a year-over-year increase of 12%. Microsoft has launched Microsoft 365 Basic to offer advanced products to a wider range of users. In the current quarter, the monthly active users of Teams exceeded 280 million and continued to lead in collaboration, chat, meetings, and calls categories. The number of third-party applications with over 10,000 users increased by nearly 40% YoY, and more than 500,000 active Team Rooms devices grew by 70% YoY.

80% of enterprise customers use five or more Microsoft 365 applications.

7. Windows

The shipment of personal computers has declined this quarter, but the usage time of Windows per computer has increased by nearly 10%. The monthly active devices this quarter also reached a historical high. As for business customers, the adoption rate of Windows 11 continues to grow. In addition, cloud-delivered Windows implementations have grown, with a YoY increase of over 2/3 in the usage rate of Windows 365 and Azure Virtual Desktop.

8. Security

In the past 12 months, security business revenue has exceeded $20 billion, helping clients protect digital assets on cloud and endpoint platforms. Microsoft is the only company with comprehensive end-to-end tools spanning identity, security, compliance, device management, and privacy, leading in all major categories served.

9. LinkedIn

LinkedIn has achieved a new high with over 900 million member engagements, with more than three members registering every second, and over 80% of these members coming from countries and regions other than the USA. As members come to LinkedIn to learn and share professional knowledge, newsletter creation has increased by 10x YoY.

LinkedIn offers over 20,000 courses in 11 languages, and the company is also shifting towards a skill-based approach to identify top talent, with over 45% of LinkedIn recruiters explicitly using skill data to improve positions. LinkedIn's marketing solutions are leaders in B2B digital advertising.

10. Advertising

Despite headwinds in the advertising market, the company continues to innovate in first and third-party advertising. Microsoft Edge browser has maintained its lead for the seventh consecutive quarter. Bing's share in the US continues to grow, and daily users of personalized content source, Start, have increased by over 30% YoY. The company is now licensing to retailers and expanding third-party inventory.

11. Gaming

Game Pass subscriptions, game streaming time, and monthly active devices have reached new heights, with over 120 million monthly active users this quarter. This quarter, Microsoft partnered with Riot Games to offer its PC and mobile games to users. AAA-level games from ZeniMax and Xbox studios are coming soon.

12. Financial Performance

Excluding the impact of depreciation policy adjustments, the gross profit margin this quarter was down by about 2pct YoY, mainly due to the decreasing share of OEM revenue, and more revenue has changed from a licensing model to a cloud service model. As of the end of December, the company's total number of employees increased by 19% year-on-year, but the month-on-month growth was less than 1%.

13. Exchange Rate Impact

We expect exchange rate factors to cause a 3% decrease in revenue growth, a 1% decrease in cost growth, and a 2% decrease in operating cost growth.

14. Guidance

We expect Windows and hardware businesses to continue to decline year-on-year until the pre-epidemic level. LinkedIn and search businesses will continue to be adversely affected by the macro environment. Other businesses will continue the trend of this quarter in the next quarter.

New signed enterprise contract amount (commercial booking) is expected to remain flat year-on-year.

Excluding the impact of depreciation adjustments, Microsoft Cloud gross margin will be reduced by about 1pct due to the impact of Azure.

On a constant currency basis, the growth rate of enterprise Office 365 will decrease by 1pct month-on-month, and the year-on-year growth rate of traditional perpetual Office products will decrease by 20+%. The growth rate of personal Office business is in the low single digits.

We expect LinkedIn's growth rate to be in the mid-single digits, and Dynamics' growth rate to exceed 10%.

We expect Azure's growth rate under unchanged exchange rate basis to further decrease by 4-5% from around 35%.

We expect other cloud service revenues to decline by a low single-digit percentage year-on-year. We expect enterprise service revenues to decline by a mid-single-digit percentage year-on-year.

We expect Windows OEM revenue to decline by more than 30% year-on-year, and we expect hardware business revenue to decline by more than 40%.

We expect commercial business revenue to grow by 20% year-on-year in the first half of FY2023, and growth will slow in the second half of the fiscal year.

Q&A Section

Q: What is the impact of Microsoft's additional investment in OpenAI on its computing power and service reach, and what is the timing of its positive impact on solution portfolios such as Bing?

**A: Microsoft firmly believes that AI is ushering in a new wave of revolution, bringing disruptive changes to many industries. The AI capability is why Microsoft can become a leader in robotic process and workflow automation.

Microsoft expects OpenAI's innovation, and OpenAI expects its commercialization, to jointly promote the development of AI. Based on Microsoft's experience in AI, innovation and competition can be differentiated.

Q: Opinion on the macro environment

**A: In the long run, the proportion of technology in GDP will increase, and the key is the economic growth multiple adjusted for inflation.

Customers are optimizing (maximizing) the value of their spending. But optimization will eventually end, and the funds saved from prior optimization can be used to increase cloud computing loads. Therefore, the company's key focus is to ensure that it gains share in this area and maintains long-term cooperative relationships with customers.

Q: In the guidance, how much of the slowdown in cloud computing and Azure development is due to customers optimizing their existing products and services, and how much is due to reduced demand caused by macro factors? A: Two reasons for slowing growth: First, customers want to do more with less money. Second, customers are optimizing investments or reducing new projects. Currently, the optimization cycle growth period is explained and the new project investment cycle will begin. In fact, usage of Teams and Office 365 has increased after the epidemic. When the investment cycle starts again, seats and profits will grow. The upcoming release of Teams Pro and others will drive ARPU growth.

Data shows a very high renewal rate. Although independent sales of new products are not easy, sales of E5 packages are very strong. The potential consistency between Microsoft 365's ARPU growth and renewal rate performance is evident.

Q: Duration of optimization cycle

A: Two-year period was accelerated during the epidemic for existing workloads. Currently, optimization is underway and it is not believed to continue for two years, but this year will be. After the optimization cycle ends, the new project launch cycle will not start immediately and will gradually expand.

Q: Is Azure's 4-5 point drop based on the overall 38% of the December quarter or the 35% growth rate at the end of December?

A: It is based on Azure's 35% growth rate at the end of December, which dropped by 4-5 points.

Q: Will the balance between seats and ARPU increase as the ROI of E5 business starts to accelerate as seats approach 400 million in the commercial version of Office 365?

A: When seat growth slows, E5's ARPU creates stability in Office 365's commercial revenues. Seat growth is still benign now, and E5 is also entering a healthy state.

The company is also investing in individual user products outside Microsoft 365, developing a new suite called Power Platform, and even independent products such as Teams Pro. Therefore, there are still many new products to be launched in addition to the already launched suites.

Q: Future plans for Azure's large customers

A: Large customers are optimizing workload scale and saving money to invest in new project reserves.

Q: Quantify the potential contribution of AI, or quantify the contribution of Azure's GPU drivers in recent quarters

A: Personally, it is still too early to separate AI from other workloads in some way. Even the workload itself, AI will become a core part of the workload in Azure. Therefore, over time, every application will become an AI application.

Q: What are the changes in the number of employees and expenses this year in reducing expenses, and what are the judgment criteria when making these decisions?

A: As Nuance and Xandr were both acquired at the same time, at the end of 4Q, except for priority decisions, the year-over-year growth of staff will be very slow to keep the cost structure consistent with revenue. With increasing investment, the year-on-year growth rate will be very small.

Previous Microsoft Research:

Financial report review

October 26, 2022 teleconference meeting "Can Microsoft safely emerge from the economic downturn? (1Q23 minutes)"

October 26, 2022 financial report review "No one can be immune to the cycle, and Microsoft can't hold on either"

July 27, 2022 teleconference meeting "How Microsoft views its performance for the 23 financial year (minutes)"

July 27, 2022 financial report review "Microsoft: Under paralysis is a stronger confidence"

April 27, 2022 teleconference meeting "Microsoft's journey is the real starry sky and ocean (third quarter teleconference minutes)"

April 27, 2022 financial report review "Strong Microsoft is the strongest pillar in the US stock market"

January 26, 2022 teleconference meeting "[Nadella: 'Microsoft is strong in being able to see trends before consensus'] (https://longbridgeapp.com/topics/1873067)"

January 26, 2022 financial report review "Without groundless fear, Microsoft is still 'reliable'"

October 27, 2021 teleconference meeting "Is digital technology the deflationary force of the inflationary era? See Nadella's explanation (minutes)"

October 27, 2021 financial report review "Microsoft: Overwhelming and magnificent, the most beautiful giant in the post-epidemic era! | Dolphin Analyst Research" In-depth research

May 30, 2022 "Microsoft is fine, killing prices is even better"

February 15, 2022 "Microsoft: Don't focus on poor expectations, having orders and reserves is the way to go"

November 22, 2021 "Alibaba, Tencent are declining before they get old, why is Microsoft still going strong?"

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