Microsoft’s (MSFT) CEO Satya Nadella on Q4 2014 Results – Earnings Call Transcript

Source: Seeking Alpha

 

Microsoft Corporation (NASDAQ:MSFT)

Q4 2014 Earnings Conference Call

July 22, 2014 5:30 PM ET

Executives

Chris Suh – General Manager, IR

Amy Hood – EVP and CFO

Satya Nadella – CEO

Analysts

Mark Moerdler – Sanford Bernstein

Brent Thill – UBS

Keith Weiss – Morgan Stanley

Phil Winslow – Credit Suisse

Rick Sherlund – Nomura

Walter Pritchard – Citigroup

Heather Bellini – Goldman Sachs

Ed Maguire – CLSA

Karl Keirstead – Deutsche Bank

Jim Moore – FBR Capital

Brad Reback – Stifel

Operator

Greetings and welcome to Microsoft’s Fourth Quarter Fiscal Year 2014 Earnings. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder this conference is being recorded.

I would now like to turn the conference over to your host, Chris Suh, General Manager, Investor Relations for Microsoft. Thank you, Chris. You may begin.

Chris Suh

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

On our website, microsoft.com/investor, we have posted a slide deck which provides summary of our financial results, a reconciliation of differences between GAAP and non-GAAP financial measures and the table of noted items to aid in understanding our results this quarter. Additionally, the slide deck contains detailed information regarding the impact of the Nokia devices and services acquisition on our financial results. Our press release is also on the website and includes an addendum with additional information about our fourth quarter performance.

Microsoft is reporting the financial performance and acquired Nokia devices and services business in a new segment called Phone Hardware. Additionally, the devices and consumer hardware segment was renamed the Computing and Gaming Hardware. The products included in this renamed segment remain the same.

Current year information reflects the financial performance of the acquired business beginning on April 25, 2014. Any reference to operating expense includes research and development, sales and marketing and general and administrative, but excludes integration and restructuring charges.

Please keep in mind that all growth comparisons we make on the call today relate to the corresponding period of last year, unless otherwise specified all impacted numbers have been adjusted for non-GAAP and noted items which are detailed in our press release in slide deck. We will post the 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 in any future use of the recording. You can replay the call and view the transcript on the Microsoft Investor Relations website, until July 22, 2015.

During this call, we will be making forward-looking statements which are predictions, projections or other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ, because of factors discussed in today’s earnings press release and the comments made during this conference call and in the risk factor section of our Form 10-K, Form 10-Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement.

And with that, I’ll turn the call over to Amy.

Amy Hood

Thanks Chris, and good afternoon everyone. This month is an important time for Microsoft, as the leadership team we’re taking bold and decisive action to evolve our organization and culture. This includes difficult steps, but they are necessary to position Microsoft for future growth and industry leadership. Today, we’ll spend more time talking about the significant changes we’re driving. However, let me first start with this quarter’s results, after that Satya will talk more about our past forward and then I’ll share our financial outlook before we take your questions.

As I think about our strong execution this quarter, there are three things that stand out to me, significant momentum with our cloud services, progress in a number of our consumer businesses and continued cost discipline.

Our total fourth quarter revenue was $23 billion including $2 billion from the phone hardware segment. As you know our Q4 guidance did not include the impact of the acquisition of Nokia’s devices and services business. Excluding that we grew revenue 10% exceeding the high-end of our guidance range.

Moving on to earnings per share. Before the impact of the acquisition and the noted items Chris highlighted earlier EPS grew 12% to $0.66. These details can be found in the earnings slide deck on our Investor Relations website. Geographically, performance was strong across most markets, particularly in North America and in Europe. We did, however, see challenging conditions in China or like many other multinationals we’re experiencing a weak business environment which we do not expect to change in the near term.

Our commercial cloud revenue grew 147% this quarter, driven by both Office 365 and Azure. Our commercial cloud annual revenue run rate more than doubled this year and now exceeds $4.4 billion and with this rapidly growing scale we continue to expand our cloud gross margins.

We saw strong commercial C growth across Office 365 particularly with SMB customers. Additionally, we added over 1 million new subscribers to Office 365, Home and Personal and we ended the quarter with 5.6 million users. Azure has also grown dramatically, the storage doubling and compute tripling this year.

Along with increased usage of our core services, over 50% of our Azure customers are now also using higher value services like the enterprise mobility suite, which are seeing strong adoption since the May launch. We’re pleased that our customers are enthusiastically embracing Office 365, Azure, CRM Online and our other cloud services, especially considering it’s still early in the cloud transition.

Each customer has unique deployment needs and as a result CIOs value the flexibility that our hybrid cloud offerings provide. You can see this in our commercial bookings, which grew 23% this quarter and our contracted not billed balance now exceeds $24 billion. As we previously discussed in fiscal year 2014 both the quarter and the year presented a large renewal opportunity are differentiated value proposition combined with strong execution kept our renewal rates very high.

In addition to transitioning to the cloud, our customers continue to invest in premium versions of our on-prem server products like Window Server, System Center and SQL Server. As a result, our server licensing revenue grew 14% this quarter. We feel good about the progress we’re making with Windows. Developed markets continue to show stability and we’re encouraged by the initial response from OEMs to our new consumer offerings like Windows with Bing.

This quarter OEM revenue grew 3% as we saw the commercial hardware refresh cycle continue with businesses updating our devices and renewing their commitment to the Windows platform. XP end of support contributed to the double-digit growth in both Windows Pro and volume licensing, though the benefits moderated throughout the quarter.

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In Bing, we continue to see growth in both usage and monetization. This quarter U.S. search query share exceeded 19% and RPS grew double-digits again. As we saw in prior quarters, display revenue remains soft. In late June, we launched Surface Pro 3. While it’s still early sales are outpacing earlier versions of Surface Pro and we are excited to bring the device to many more markets this summer.

During the quarter, we reassessed our product roadmap and decided not to ship a new form factor that was under development. Combined with the transition of production to our latest Surface offering, we made inventory adjustments which impacted our gross margins.

Also in June, we released our new Xbox One offering and we’re pleased with the response. Adding three, we reasserted our focus on games, the blockbuster titles and key exclusive coming this holiday. With the progress we are making in channel inventories, the new market for Xbox One and our exciting game line up, we feel well-positioned heading into the holiday season.

With the closing of the Nokia devices and services acquisition during the quarter, we established a new segment Phone Hardware to provide transparency into the progress we’ll make as we improve and grow the phone business. This quarter, Lumia device sales were primarily driven by good performance in the lower price point 500 and 600 series.

Sales of non-Lumia devices were in line with the overall feature phone market dynamics. Our gross margins were impacted by decisions we made to rationalize the device portfolio, as well as acquisition related amortization expense.

Across the company, we grew gross margin by $1 billion or 7%. While the faster growing cloud and hardware businesses impacted our overall company gross margin percentage is important to note, we continue to drive margin growth in key areas with improved discipline and business process.

In D&C other revenue from search advertising and subscriptions are driving gross margin growth, in commercial other margins expanded again in this quarter benefiting from both improved business scale and datacenter efficiency in our cloud services. And we’ve made key changes to our hardware business, which have been discussed by both Satya and Stephen Elop in the past two weeks.

We’ve also kept our focus on rigorous operating expense discipline. Excluding the addition of about $750 million from NDS, our Q4 operating expense came in at the low end of our guidance. And for the full year, with disciplined decision-making, we grew revenue 9% before NDS more than twice as fast operating expense which grew 4. Our effective tax rate was higher this quarter. Part of this was due to an adjustment to prior year taxes related to intercompany transfer pricing.

Beyond that, the increase was driven by the inclusion of NDS results and are changing geographic mix. In Q4, we returned $3.4 billion in cash to shareholders through buybacks and dividends to finish this fiscal year at $15.7 billion, an increase of 28% over the prior year.

With that overview, let me turn it over to Satya to share some thoughts.

Satya Nadella

Thank you, Amy. Hello everyone. I’m proud of the results we delivered this quarter and across the fiscal year. In Q4, on an operating basis we grew revenue 10% and operating income 12%. We accelerated our commercial cloud business to a $4.4 billion annual run rate. And perhaps more importantly we made bold and disciplined decisions to define our core as the productivity and a platform company for the mobile-first and cloud-first world.

Before I get into the investment principles and decisions, I want to explain how our focus on productivity and platforms needs us to participate in cloud and mobile markets. Mobility for us goes beyond just devices, while we are certainly focused on building great phones and tablets, we think of mobility more expansively.

We think the opportunity that comes from running our productivity experiences on Windows, iOS and Android device. Office 365 and dynamic SaaS offerings are targeted here. We also see great opportunity in simplifying and managing the user experiences spanning multi-devices ecosystems with our identity management, device management and data security. This is the focus of our enterprise mobility suite.

Similarly, when it comes to the cloud opportunity, we run an upscale public cloud service and provide servers for private and hybrid clouds. Azure, StorSimple, InMage and our datacenter additions of server products across Window Server & System Server and SQL Server all help us participate in the cloud growth.

Our mobile and cloud opportunity views and forms our decisions on what to build and where to invest. More specifically, we use the following three principles to guide our investments. First, focus investments on the core, productivity experiences and platform investments will prioritize across engineering sales, marketing as well as M&A.

Second, consolidate overlapping efforts. This means one operating system that covers all screen sizes and consolidated dual use productivity services that cross life and work.

Third, run all businesses in an economically sound way. We will get crystal clear on the core businesses that drive long-term differentiation and the businesses that support them. For those supporting efforts such as MSN retail stores and hardware, we will also ensure disciplined financial execution.

Now let’s talk about the specific investments. We will be relentless in our focus on our core digital work and life experiences and the two platforms that support it, the cloud operating system and the device operating system and hardware.

Everything we do starts with digital work and life experiences to delight dual users; these are users who use technology both at work and in their personal life. This is how we reinvent productivity. Last year, we started to take steps in this direction now OneDrive and OneDrive for business are one team. Outlook and Exchange are one team, Skype and Lync are one team all focused on those dual user scenarios.

We are clear that our experiences are going to be available on all devices. We have a specific goal for multiple Microsoft applications to be available on every home screen. This is why we brought Office to the iPad and now there are more than 35 million downloads, the Word, Excel, PowerPoint and OneNote.

We believe productivity experiences will go beyond individual applications to deliver ambient intelligence that spans applications. To that end, we introduced Cortana, our personnel assistant in Windows Phone 8.1. We also believe that productivity includes group collaboration and business processes within organization.

In February, we announced our Power BI suite to help customers harness the power of big data in order to drive a data culture and greater productivity within their organizations. Power BI suite enables you to ask natural language questions do rich visualizations and collaborate around data. Customers are loving it, in the fact; the average monthly users have grown over 130%.

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We are pleased to see all up dynamics growth at 13% for the quarter with CRM online nearly doubling. And it’s great now to have dynamic CRM in the Gartner leaders’ quadrant in both sales and service, the two-most relevant areas in the CRM space.

Looking forward in fiscal year 2015, we are increasing our investment in R&D and sales for our digital work and life businesses even as we cut total operating expenses. We have a rich roadmap going forward. Two examples of our innovation are what we are doing with Delve and Skype Translator.

Delve is an Office 365 cloud-based service that is the first in the new breed of intelligent and social work experiences. Delve will turn enterprise search on its head as information that is relevant to you finds you. Think of this as the Facebook new suite for productivity.

Skype Translator will break down the language barriers in our communications and impact everything from everyday conversations with friends to education to global business.

Additionally, I’m pleased to see the progress with Bing now more than 19% U.S. query share and strong RPS growth. Going forward, we will drive our Bing related investments to contribute to the core digital work in life experiences such as Cortana, Smart Search, Delve, Power Q&A and many others. We expect Bing to be profitable on a standalone basis in FY16.

Now let’s transition to the Cloud OS. Our Cloud OS represents the fastest growing opportunity for Microsoft. Quarter-after-quarter, we drive growth and customer adoption. Our server products benefit from our public cloud. The fact that we use our servers to run our cloud make our server software, the most capable enabling others to build and operate their clouds. This has led to growth in Hyper-V share, which is now at 30.6% and has helped grow datacenter additions, the Window server and system center both up more than 40% for the year.

We also had another breakout year for SQL server. With SQL server 14, we released industry leading in-memory technology across all database workloads of online transaction processing, data warehousing and business intelligence. And we grew our SQL business by more than 19%. Our business Azure business is growing rapidly and we further accelerated growth last year. We grew our datacenter footprint into Australia, Brazil, Japan and China while doubling our capacity in existing regions.

In FY14, we also started to see the adoption of our high-value services on top of our base cloud infrastructure. We announced the enterprise mobility suite a comprehensive cloud solution to address the consumerization of IT challenges such as Bring Your Own Device and SaaS application adoption. EMS brings together identity management, device management and data security into one IT control plane and architecture. The early data from customer adoption for EMS is very encouraging. We announced the Azure intelligence system service, our IOT service in the cloud that enables organization to securely connect manage and capture machine generated data from a variety of sensors and devices.

To support these high value services in Azure, I have prioritized acquisition such as GreenButton for Big Compute, Capptain for Mobile backend services. And just in the past few weeks InMage for disaster recovery for hybrid clouds. In FY15, we will make investments to drive this strategy forward. We will expand our Azure datacenter footprint and increase capacity in existing regions. We will launch new high level services including Azure machine learning that currently is in preview. We will expand our hybrid solutions with new services such as StorSimple, InMage as well as our server products all offering cloud tearing. We will continue to build out the EMS value proposition and we will expand our sales efforts to drive growth.

Let’s transition to our device OS and hardware, the third component of our core. In everything we do with our Windows OS and first party devices, we will line up our digital work and life experiences. We are approaching the Windows OS business with a bold challenging mindset and pushing both the product and business model forward.

We start with a focus on business customers in FY14, we saw these customers recommit to Windows. In April, we released an update to Windows 8.1. To start, we improved the core desktop experience with mouse and keyboard advancements. For Enterprises, we released Internet Explorer Enterprise Mode and extended our mobile device management capability. With Windows 8.1 update, we also lowered hardware spec required so that OEMs can build tablets and clamshells at lower price points.

In addition, we made the decision to evolve the Windows business model. Now, Windows licenses are $0 for any OEM building a device less than 9 inches. We also added a low cost Windows offering with Bing integration for OEM. This new offering combine with lower hardware spec means OEMs will bring a fantastic line up of value based notebooks and tablets to the markets this holiday.

In June, we launched Surface Pro 3. The most productivity tablet on the market today. The reason it’s the most productivity tablet on the market is because we top through the experience end-to-end. For example, one of the things you will notice with Surface Pro 3 is how it excels at note taking. You can jot down your thoughts rapidly just like with the pen and paper. To make this work in an integrated natural way, our developers pulled together one vision to right code that resides in the firmware and the Surface Pro 3 pen, the Windows shell and its inking support to reduce the [parallel x] [ph] header as well as in OneNote.

And as Amy said, we are optimistic given the early sign from the Surface Pro 3s performance in the market.

On phones, we saw a good early start to Lumia 630 and 635 as well as Lumia 930 especially in Europe. In the year ahead, we are investing in ways that will ensure our device OS and first party hardware aligned to our core. We will streamline the next version of Windows from three operating systems into one single converged operating system for screens of all sizes.

We will unify our stores, commerce and developer platforms to drive a more coherent user experience and a broader developer opportunity. We look forward to sharing more about our next major wave of Windows enhancements in the coming months. Our approach to first party hardware going forward is clear. At times, we will develop new categories like we did with Surface and we will responsibly make the market for Windows phone. However, we are not in the hardware for hardware sake, and the first party device portfolio will be aligned to our strategic direction as the productivity and platform company.

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As I said before, going forward all the devices will be created with an explicit purpose to light up our digital work and life experiences. Good examples of this today are what we are doing with Surface Pro 3 for note taking and PPI for meetings. You can expect to see this type of innovation in our hardware including phones. Amy will talk more on our plans for disciplined execution on our hardware business going forward.

I want to make a few comments on Xbox. It’s important for us to have a core that’s thriving. It’s equally important to play smart bold bets in other areas where we have the ability to add value and have impact that’s what we are doing with Xbox. We made the decision to manage Xbox to maximize enterprise value with a focus on gaming. Gaming is the largest digital live category in a mobile first-cloud first world. It’s also the place where our past success a revered brand and passionate fan base present us a special opportunity.

With our decision to specifically focus on gaming, we expect to close Xbox entertainment studios and streamline our investments in music and video. We will invest in our core console gaming in Xbox live with a view towards the broader PC and mobile opportunity.

I hope you can see that we have bold ambitions and we have made a lot of progress. Also know that we are well on the way in evolving our organization and culture to deliver on these bold ambitions. This includes simplifying how we work and modernizing our engineering processes.

In all that we do, we will be accountable to our customers, partners and shareholders empowering everybody individual and organization to do more and achieve more in a mobile first cloud first world is a huge undertaking and it is one that Microsoft is uniquely qualified to take on and change the world.

Thank you. And with that let me turn it over to Amy to give you more guidance on FY15.

Amy Hood

Thanks Satya. Before going into details about our outlook, let me first say that all forward-looking information assumes the macroeconomic environment remain stable throughout this coming fiscal year.

As Satya detailed, we are taking bold steps to move Microsoft forward with a renewed sense of clarity and alignment. Our investment plan reflects those changes as to reallocate resources to aggressively drive toward our goals and pursue the highest growth and financial return businesses. Even as we invest for growth, we expect our total operating expense in fiscal year 2015 to be down from this past year before considering the addition of the Nokia cost structure and integration and restructuring cost.

Now, let me address phone separately. In fiscal year 2014, we recorded about $750 million of operating expense for the phone business for the period post the acquisition. Annualized this would have been about $4.5 billion, but we are aggressively working to drive synergies across key functions such as development, supply chain and operations as we integrate and right-size the business.

We set to realize more than $1 billion in synergies and as a result we will be on a path to reach operating break-even for the phone business in fiscal year 2016. Including phone, we expect operating expense to be between $34.2 billion and $34.6 billion in fiscal year 2015.

In addition to the expense guidance I just provided and as we announced on July 17th, we expect to incur between $1.1 billion and $1.6 billion in restructuring expense. These will be substantially complete in the first half of the fiscal year. Separately, we will also incur about $150 million per quarter in integration cost such as systems work. Similar to this quarter, we will continue to report these items in a separate line item in the income statement.

Now, let me give our view on the first quarter starting with devices and consumer. In licensing, we expect revenue to be $4.1 billion to $4.2 billion. This range reflects an ongoing business PC refresh cycle, headwinds for consumer PCs and a continued moderation of the benefits from the XP end of support.

In computing and gaming hardware, we expect revenue to be $1.7 billion to $2 billion. This range reflects the continuing ramp of Surface Pro 3 and Xbox 1 as both products are introduced into new markets in Q1. In phone hardware, we expect revenue to be $1.9 billion to $2.3 billion as we de-align the device portfolio to our strategy. And in devices and consumer other, we expect revenue to be $1.8 billion to $1.9 billion.

Moving on to commercial. We expect revenue across our two segments to be $12.0 billion to $12.2 billion within this we expect commercial other revenue of $2.2 billion to $2.3 billion. And in corporate, we expect about $300 million of negative impact next quarter. We expect COGS to be $7.5 billion to $7.9 billion with variability being driven by both hardware segments.

We expect first quarter operating expense excluding integration of restructuring to be between $8.5 billion and $8.7 billion. As a reminder, other income and expense includes dividend interest income offset by interest expense and the net cost of hedging. We expect these items to generally offset one another.

We expect our full year tax rate to be between 21% and 23%. This is in line with the fourth quarter excluding the prior period tax adjustment. As a changing mix of our business, as well as the impact of the NDS acquisition will continue to influence our tax rate.

Investments in cloud infrastructure are necessary to support and enable the significant growth and momentum in our cloud services. In Q1, we expect CapEx to increase sequentially to further support our growth. Similar to fiscal year 2014, these investments are decided based on the thorough review of demand and capacity plans to ensure that the investments provide an appropriate return on capital.

We also remain focused on software driven innovation to increase the utilization and capacity of the capital we deploy. We expect our revenue to grow in line with normal seasonality.

In closing, Q1 is the start of an incredibly important year for Microsoft. We are making important changes to our organization and culture to enable and empower our people to do their very best work.

Mobility in cloud presents an enormous opportunity. And we are focusing resources on our core so we can capitalize and deliver on the next wave of innovation, growth and long-term shareholder value.

With that, I will turn it back over to Chris and we can move to Q&A.

Chris Suh

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

Question-and-Answer Session

 

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