Microsoft (MSFT) Q1 FY27 Earnings Call Transcript

Operator00:00

Greetings and welcome to the Microsoft fiscal year 2027 first 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.

Operator00:15

If anyone should require operator assistance please press star zero on your telephone keypad. As a reminder this conference is being recorded. It is now my pleasure to introduce Jonathan Neilson, Vice President Investment Relations.

Jonathan Neilson00:33

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 Brian Defoe, Deputy General Counsel and Corporate Secretary.

Jonathan Neilson00:50

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.

Jonathan Neilson01:01

More detailed outlook slides will be available on the Microsoft Investor Relations website when we provide outlook commentary on today's call.

Jonathan Neilson01:14

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

Jonathan Neilson01:26

They are included as additional clarifying items to aid investors in further understanding the company's first quarter performance in addition to the impact these items and events have on the financial results.

Jonathan Neilson01:47

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 business performed excluding the effect of foreign currency rate fluctuations.

Jonathan Neilson01:54

Where growth rates are the same in constant currency we will refer to the growth rate only.

Jonathan Neilson02:20

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

Jonathan Neilson02:35

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 subjects to risks and uncertainties.

Jonathan Neilson02:52

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 factor section of our Form 10-K, Forms 10-Q, and other reports and filings with the Securities and Exchange Commission.

Jonathan Neilson03:01

We do not undertake any duty to update any forward-looking statement. And with that, I'll turn the call over to Satya.

Prepared remarks

Satya Nadella03:26

Thank you very much, Jonathan. It was a fast start to our fiscal year. Microsoft Cloud revenue surpassed $63 billion with growth accelerating to 30% year over year. We are focused on three things, designing AI to empower people, ensuring every organization has sovereignty over its own learning and building trust with controls that ensure agent safety and security.

Satya Nadella03:46

Now let's talk about how we are making progress on those goals as we build the new tech stack starting with Copilot. We announced our biggest update to Copilot to date this quarter bringing together chat, co-work, autopilot and code into one unified experience. It's one product experience across commercial and consumer and comes with all of Office built in.

Satya Nadella04:03

We think of Copilot as the new OS for work. Customers are increasingly turning to Copilot to get real work done. automated tasks is nearly doubled since July daily users are up nearly 50% quarter over quarter and over 5x year over year.

Satya Nadella04:19

User satisfaction improved nearly 20% quarter over quarter to another all-time high and 90% of Copilot queries use auto mode which dynamically routes tasks across models optimizing for quality speed and cost.

Satya Nadella04:37

These improvements are translating into larger purchases. The number of customers with more than 50,000 Copilot seats increased over 8x year over year including Capgemini, HCL Tech, Hitachi Group, Truist Financial and UK Revenue and Customs Department.

Satya Nadella04:46

And just last week Volkswagen announced plans to deploy Copilot to more than 330,000 employees one of the largest deployments to date in Europe.

Satya Nadella05:05

We're also seeing strong momentum with E7 which brings together Copilot, E5 Entra and Agent 365 thousands of customers in every industry have purchased the suite to date including Amadeus, BlackRock, Fiserv and New South Wales Health Department and Zeiss.

Satya Nadella05:17

Our business model is expanding from per seat subscriptions to include consumption expanding our TAM and ARPU. The subscription brings increasingly capable everyday intelligence to every user.

Satya Nadella05:34

Typically IT funds this consolidating frontier advances for everyone across the organization and as agents take on higher value work consumption opens up business funded demand with spending tied directly to the value these agents deliver.

Satya Nadella05:42

The number of Copilot customers actively consuming credits through usage based billing grew over 75% over the quarter. quarter.

Satya Nadella05:58

When it comes to software development, all major coding agents have shown up to work on GitHub. Agent generated PRs have increased 6x over the past six months and agents now open more than a third of all PRs on the platform.

Satya Nadella06:11

We are very hard at work on reliability as agentic activity on GitHub soars. At GitHub Universe this morning, we shared how we're expanding capacity and rebuilding the core Git architecture for the agentic wave.

Satya Nadella06:27

Also at Universe, we announced broad availability of Copilot Fusion, which is all about bringing multi-model orchestration to software development. It delivers frontier level quality up to 40% faster and at up to 77% lower cost.

Satya Nadella06:40

Credit consumption from agentic features on GitHub has more than doubled since usage based billing went into effect and we're also helping developers secure their code and turn AI generated code into high quality software.

Satya Nadella06:51

GitHub Advanced Security revenue increased over 50% year over year as customers use its AI capabilities to scan entire repos and fix vulnerabilities in real time.

Satya Nadella07:07

In the business application space we are extending this vision of Copilot as the new OS for work bringing the business logic and capabilities of Dynamics 365 directly into Copilot and helping every organization stand up their own infinite SaaS factory.

Satya Nadella07:18

This quarter we introduced 30 new Copilot skills across Dynamics 365 which enables customers to access CRM and ERP capabilities directly in the flow of work.

Satya Nadella07:29

In recruiting, more than 10 million LinkedIn members use our LinkedIn AI powered job search daily and 25,000 customers are using our agentic hiring solutions.

Satya Nadella07:39

Recruiters using Hiring Assistant are finding interview quality applicants 33% faster while reviewing 83% fewer profiles to find qualified match.

Satya Nadella07:51

In healthcare, we automated 30 million patient encounters this quarter up 70% year over year helping clinicians spend less time on administrative work and more time with patients.

Satya Nadella08:05

10 providers including Advocate Health, Mass General Brigham, Mercy, Intermountain Health and others have used our solutions to document over 1 million encounters each since the beginning of the calendar year.

Satya Nadella08:18

And in science, our FDE teams are working with customers to use Discovery to accelerate scientific progress. A great example is Saint-Gobain which used Discovery to accelerate the development of low carbon construction materials.

Satya Nadella08:34

Underneath our first party agentic experience is a commonly important driver of our growth Foundry helps organizations build learning loops grounded in their business context and deploy agents safely at scale.

Satya Nadella08:41

We now have over 120,000 Foundry customers with revenue more than tripling year over year.

Satya Nadella09:02

Foundry's model choice and feature set coupled with its deep integration across our stack is driving differentiation Azure OpenAI directly benefited in the last quarter with big advances in OpenAI models and when you couple this with our model choice built into Foundry customers are able to build solutions optimizing across quality cost and performance.

Satya Nadella09:16

In fact the number of customers building agentic solutions with multiple models increased 5x year over year and revenue from open source models on Foundry increased 10x. We also continue to make rapid progress with our first party models.

Satya Nadella09:31

Our goal is to advance the cost to outcome frontier which means delivering capabilities comparable to leading models within three to six months of their release at a fraction of the training cost thereby allowing us to transfer those cost benefits to customers.

Satya Nadella10:07

And you see this in our products today. MAI Cyber now powers over 40% of the scans in our agentic MDash code scanner at 18% lower cost per scan MAI transcribe is the most accurate and cheapest transcription model in the world supporting Dragon Copilot's multilingual workflow MAI Code Flash has 3 million users in GitHub Copilot last month alone helping developers get more out of their AI credits Microsoft Decision One is our new model for structured decision making outperforming both LLMs and other decision models in latency and quality.

Satya Nadella10:25

Over 4,000 customers including Atos Group, Equinor and RBI have already used it in the first month since its release. And we recently completed pre-training MAI Base 2 which outperforms other open weight models we tested with 4 to 12 times greater training compute efficiency.

Satya Nadella10:38

This base model will be used in the upcoming MAI models across thinking, code and cyber. Beyond models, we're making the harness behind our own Copilot experience available to customers in Foundry.

Satya Nadella10:45

It gives customers while preserving their choice of model.

Satya Nadella10:56

Another critical layer is data. We now have 44,000 paid

Satya Nadella11:25

Foundry and fabric closer together so you can build your own agents. Customers are also rapidly deploying our AI optimized databases including Postgres SQL, SQL DB, Hyperscale, Cosmos DB to give agents fast secure access to the data and context they need.

Satya Nadella11:35

Postgres SQL growth accelerated for the fourth consecutive quarter and the number of Postgres SQL customers also using Foundry accelerated to 90% year over year.

Satya Nadella11:50

We also have one of the most important databases for any enterprise, which is the knowledge underneath Microsoft 365 spanning people, their relationships, documents, emails, meetings, chats, projects, and other artifacts.

Satya Nadella12:04

Work IQ makes this context available to every agentic workload. And with Microsoft IQ, we're bringing together Work IQ, Fabric IQ, and Foundry IQ as a unified context for agentic systems.

Satya Nadella12:13

Nearly 60,000 customers are accessing context across Microsoft IQ up 25% quarter over quarter.

Satya Nadella13:07

As enterprises deploy more agents, they also need to govern them at scale. With Agent 365, we provide a platform for AI observability enabling customers to manage, secure, and optimize the performance and cost of their agents over 50 million agents are now in the registry up over 30% quarter over quarter and finally as agents gain greater access to enterprise data and systems security becomes even more critical our approach is to separate intelligence from authority enforcing identity permissions monitoring and containment outside the model itself Last week, we expanded perception with new capabilities to help customers secure and contain agentic insiders including expanded agent discovery across local and cloud environments, and continuous risk assessment.

Satya Nadella13:12

We also introduced

Satya Nadella13:18

To help prevent unsafe actions before they are

Satya Nadella13:28

And we are seeing encouraging feedback on perception overall from

Satya Nadella13:34

Preview Salentis more broadly

Satya Nadella13:48

We are helping customers have used Microsoft Purview to audit over 7.6 billion underlying everything I've talked about so far is our infrastructure

Satya Nadella14:00

We are building against a growing book of business with a fungible fleet that allows us to dynamically allocate capacity to

Satya Nadella14:06

The highest accelerating demand led to

Satya Nadella14:25

Us adding 24 new and we are bringing capacity online faster reducing doctor live times by about 20% quarter over quarter for new GB 300s in our biggest regions which make up

Satya Nadella14:58

200 is already delivering up to 1.7 times more

Satya Nadella15:11

Tokens per watt across the AI experiences in Teams and Copilot and Maya 300 will drive further gains delivering 40% more tokens per watt compared to the leading GPU based systems.

Satya Nadella15:14

Our growth extends beyond GPUs.

Satya Nadella15:32

We continue to see strong adoption of our cloud native Cobalt CPUs improving price performance for general purpose cloud workloads all up Azure growth was broad based across both enterprises and small and medium business segments and spanning both core cloud services and AI infrastructure.

Satya Nadella15:35

Finally, let me turn to devices and consumer.

Satya Nadella15:44

In Windows, we are executing on our vision to bring hybrid intelligence to every desk and every home, making every PC a secure agent box.

Satya Nadella16:11

As more capable models run locally, we see an opportunity to make it more intelligence effectively unmeted. We are working with the broader hardware ecosystem to bring these capabilities to a new generation of PCs across AMD's Ryzen AI 400 series, Intel Core Ultra Series 3, Qualcomm Snapdragon X2 series, and earlier this month, we also announced new PCs powered by NVIDIA's RTX Spark and DGX Station for Windows.

Satya Nadella16:27

With these new devices, you can run last year's Frontier models on your laptop and last quarter's model at your desk. We are bringing together Windows and Agent 365 so agents can work with secure boundaries on device.

Satya Nadella16:40

We introduced Microsoft Execution Containers, a policy driven execution layer that governs and contains agents across Windows and other platforms integrated with Agent 365 for governance and observability.

Satya Nadella16:51

Agents like OpenAI Codex, Anthropic Claude Code, Meta Muse are adopting MXC and customers like Meta are starting to deploy it across their enterprise environments.

Satya Nadella17:26

In search and advertising, Bing and Edge once again took share in LinkedIn, engagement continues to deepen across our more than 1.4 billion members with time spent viewing content in the feed up 15% year over year and finally in gaming we remain focused on building great games and reaching players wherever they choose to play across console PC mobile and cloud Minecraft delivered a record quarter reaching all-time highs in both engagement and revenue while World of Warcraft had its largest beta in franchise history.

Satya Nadella17:40

We enter the holiday season with one of our strongest first and third party lineups in years including Modern Warfare 4 which launched last week to the best reviews for a Call of Duty game in more than a decade and Grand Theft Theft Auto 6 which is coming to Xbox next month.

Satya Nadella17:54

In closing, based on the demand we see, the strength of our products and the efficiency we are driving across the stack, I've never been more confident in the long-term returns for our investments, with that, let me turn it over to Amy.

Amy Hood18:04

Thank you, Satya, and good afternoon, everyone. Our results exceeded expectations across revenue, operating income, and earnings per share, driven by strong demand across the Microsoft cloud.

Amy Hood18:28

This quarter, revenue was $92.3 billion, up 19%. Gross margin dollars increased 17% and gross margin percentage was 68%. Operating income increased 21% and 22% in constant currency earnings per share was $4.89 an increase of 18% and 19% 19% in constant currency when adjusted for the impact for our investment in OpenAI.

Amy Hood18:38

And FX was roughly in line with guidance. Operating expenses increased 6% driven by continued investments in R&D compute capacity and talent.

Amy Hood18:48

Operating margins increased slightly year over year to 50% driven by strong revenue growth, platform efficiency gains, and focused investments across our portfolio.

Amy Hood19:00

Partially offset by sales mix shift to Azure. When adjusted for the impact for our investments in OpenAI, other income and expense was negative $234 million slightly lower than expected.

Amy Hood19:07

Capital expenditures were $45.2 billion as some third party capacity deliveries we expected in Q1 were delayed.

Amy Hood19:21

Roughly three quarters of our capex was for short lived assets primarily CPUs and GPUs including higher memory and storage cost as we continue to invest in the infrastructure required for our customers to build and scale AI applications.

Amy Hood19:26

The remaining spend was for long-lived assets, this quarter financed leases were $7.4 billion.

Amy Hood19:37

As a reminder we recognize the full principal value of financed leases in capex at the time of lease commencement. and cash paid for PP&E was $39.4 billion.

Amy Hood19:44

Cash flow from operations was $58 billion up 29% driven by strong cloud billings and collections.

Amy Hood19:49

And free cash flow was $18.6 billion reflecting higher capital expenditures.

Amy Hood19:55

And finally we returned $10.2 billion to shareholders through dividends and share repurchases.

Amy Hood20:24

Now to our segment results reported under the updated segment structure announced in September. Revenue from Agents and Infra was $76.8 billion, and grew 25%, reflecting strength across the connected layers of our platform. commercial bookings decreased 12% and 11% in constant currency driven by the impact from large Azure commitments in the prior year partially offset by healthy growth in our commercial sales motions including a large Azure commitment this quarter.

Amy Hood20:37

Commercial remaining performance obligation grew 73% to $677 billion with a smaller sequential decline relative to historical seasonality due to the large Azure commitment this quarter.

Amy Hood20:46

Our RPO has a weighted average duration of 2.3 years and roughly 30% will be recognized in revenue in the next 12 months up 29% year over year.

Amy Hood20:54

The remaining portion recognized beyond the next 12 months increased 98% Now to Microsoft Cloud.

Amy Hood21:05

Revenue was $63.9 billion and growth accelerated to 30% and 31% in constant currency with sequential dollars added nearly doubling year over year.

Amy Hood21:10

Reflecting strong demand across Azure and M365 commercial cloud.

Amy Hood21:10

Azure

Amy Hood21:21

Azure revenue was ahead of expectations and increased 48% even with the three P capacity delays noted earlier. Driven by Foundry and improved CPU monetization.

Amy Hood21:37

Foundry revenue more than tripled year over year with upside driven by efficiency gains across our GPU fleet that allowed us to allocate additional capacity to customers as well as higher revenue per token that we benefited from in the quarter.

Amy Hood21:48

Across our CPU fleet engineering work enabled us to identify and monetize underutilized capacity this quarter helping us serve more of the growing demand with our existing capacity.

Amy Hood22:01

The timing of engineering efficiencies like these as well as 3P GPU lease deliveries our own capacity build outs and ARPU changes from model mix can create quarterly variability in the year over year growth rate.

Amy Hood22:13

M365 commercial cloud revenue increased 18% and 19% in constant currency when adjusted for the prior year comparable that benefited from one point of in period revenue recognition.

Amy Hood22:19

On a reported basis revenue growth was 17% and 18% in constant currency.

Amy Hood22:24

Results were ahead of expectations driven by stronger GitHub Copilot adoption and usage.

Amy Hood22:31

Partially offset by weaker sales execution in our M365 E3 and standalone SKUs.

Amy Hood22:42

We continue to evolve our sales motions to balance those more traditional SKU per seat rhythms with the newer premium E7, M365 Copilot and usage based productivity offerings.

Amy Hood22:46

Year over year growth was driven by both ARPU and seats.

Amy Hood23:01

ARPU growth was led by our premium seat based offerings including M365 Copilot, E5 and E7 which has already reached millions of paid seats with additional contribution from usage based offerings primarily GitHub Copilot.

Amy Hood23:09

And Copilot revenue growth accelerated quarter over quarter with continued adoption across M365, GitHub, and Security.

Amy Hood23:16

Paid M365 commercial seats grew 5% with some impact from the weaker sales execution noted earlier.

Amy Hood23:34

Growth was driven by install base expansion across all customer segments though primarily in our SMB and frontline worker offerings. M365 consumer cloud revenue increased 17% and 16% in constant currency down sequentially as we begin to lap the benefit from the price increase in the prior year.

Amy Hood23:51

Productivity and server licensing revenue decreased 3% and 2% in constant currency primarily driven by a decrease in transactional purchasing as we lap the benefit from product launches in the prior year partially offset by a greater mix of contracts that carry higher in period revenue recognition.

Amy Hood24:01

Industry solutions cloud revenue increased 10% with growth in Dynamics 365 and LinkedIn Talent Solutions though booking trends continued to moderate.

Amy Hood24:47

And in Frontier and Support Services revenue increased 4% and 5% in constant currency driven by support. Microsoft cloud gross margin percentage declined year over year to 66% driven by sales mix shift to Azure partially offset by product level margin improvements primarily in Azure. and for the segment gross margin dollars increased 20% and 21% in constant currency operating expenses increased 10% driven by the R&D investments noted earlier operating income grew 24% and 25% in constant currency and operating margins decreased slightly year over year to 53% as strong revenue growth platform efficiency gains and focused investments across our portfolio were more than offset by sales mix shift to Azure.

Amy Hood25:04

Now to devices and consumer revenue was 15.5 billion dollars and declined 3% Search and advertising revenue ex-TAC increased 12% and was ahead of expectations driven by higher volume and rate across LinkedIn, Edge, and Bing.

Amy Hood25:17

Xbox revenue decreased 2% and Xbox content and services revenue decreased 2% and 1% in constant currency driven by declines in third party content and Xbox Game Pass partially offset by growth in first party content.

Amy Hood25:36

And Windows OEM and devices revenue decreased 22%. Windows OEM revenue was below expectations and decreased 27% and 28% in constant currency driven by the Windows 10 end of support demand in the prior year inventory drawdowns by OEM and channel partners and weaker PC market demand.

Amy Hood25:50

Inventory levels remain elevated. Segment gross margin dollars were relatively unchanged year over year and operating expenses decreased 3% driven by Xbox. Partially offset by the continued investments in R&D noted earlier.

Amy Hood26:06

Operating income increased 2% and 3% in constant currency and operating margins increased year over year to 35% driven by lower amortization of intangible assets from the Activision acquisition partially offset by the impact from a lower mix of Windows OEM revenue.

Amy Hood26:24

Now moving to the outlook for our second quarter which unless specifically noted otherwise is on a US dollar basis. Based on current rates we expect FX to have no meaningful impact on total revenue COGS or operating expense growth or on revenue growth in either segment.

Amy Hood26:44

Starting with segment guidance we expect revenue from agents and infra of 80.1 to 80.7 billion US dollars or growth of 24 to 25% in commercial bookings we expect healthy growth in our commercial sales motions though results will be impacted by the significant Azure commitments signed in the prior year.

Amy Hood26:55

Timing related to significant Azure commitments like these will result in material volatility in bookings making quarterly growth rates less indicative of underlying sales execution.

Amy Hood27:11

In Azure we expect revenue growth of 49 to 50% in constant currency with continued efficiency gains across our CPU and GPU fleet helping to offset some 3P GPU as a service contracts that have been delayed to H2.

Amy Hood27:28

Customer demand continues to exceed available supply. And looking beyond Q2, year over year growth will continue to reflect the timing and scale of engineering efficiencies delivered in the quarter and new capacity adds as well as a strong prior year comparable that included accelerating growth in the second half.

Amy Hood27:38

In M365 commercial cloud we expect growth of approximately 19% in constant currency with FX expected to reduce reported growth by less than a point.

Amy Hood27:47

We expect continued momentum across our premium per seat offerings and usage based offerings along with some improvement in execution across E3 and our standalone SKUs.

Amy Hood28:03

Growth will be driven primarily by ARPU with additional contribution from seats and we continue to expect revenue growth to accelerate through the year. M365 consumer cloud revenue should grow in the low teens down sequentially as we lap the price impact noted earlier. noted earlier.

Amy Hood28:35

Productivity and server licensing revenue should decline in the mid to high single digits down sequentially due to a lower expected mix of contracts that carry higher in period revenue recognition. quarterly growth can vary materially based on contract mix product launch timing and other transactional purchasing trends in industry solutions cloud we expect revenue growth to be in the mid to high single digits with continued impact from the bookings trends noted earlier and in frontier and support services we expect revenue to grow in the low to mid single digits.

Amy Hood28:46

Microsoft cloud gross margin percentage should be roughly 65% down year over year as continued improvement in product level margins is more than offset by sales mix shift to Azure.

Amy Hood29:04

In devices and consumer we expect revenue to be 15.9 to 16.4 billion US US dollars search and advertising revenue ex-TAC growth should be in the low double digits driven by consistent trends in rate and volume with overall search and advertising revenue expected to grow at a similar rate.

Amy Hood29:15

And in Xbox content and services we expect revenue growth to be in the mid to high single digits up sequentially driven by the timing of content launches across both third and first party.

Amy Hood29:27

With content launch patterns through the year we expect growth to be the strongest in the second quarter with some deceleration in Q3 and further moderation in Q4. Hardware revenue in Q2 should decline year over year.

Amy Hood30:13

Windows OEM and devices revenue should decline in the mid 30s. Growth will continue to be impacted by elevated inventory levels, PC market demand, and a prior year comparable that benefited from Windows 10 end of support as in prior quarters the range of potential outcomes remains wider than normal we expect these trends to continue through the rest of the fiscal year therefore at a total company level revenue should be between 96 96 and 97.1 billion US dollars or growth of 18 to 19% we expect COGS at 32.7 to 32.9 billion US dollars or growth of 26 to 27% and operating expense of 18.5 to 18.6 billion US dollars or growth of 9% driven by continued investment in R&D compute capacity and talent.

Amy Hood30:23

Our cost guidance across both COGS and OPEX includes an estimate for the recently announced employee voluntary exit offer. Operating margins should be down slightly year over year.

Amy Hood30:37

Excluding Excluding any impact from our investments in OpenAI, other income and expense is expected to be roughly negative $300 million as interest income will be more than offset by interest expense which includes the interest payments related to data center finance leases.

Amy Hood30:44

And we expect our Q2 effective tax rate to be approximately 20%. Next, capital expenditures.

Amy Hood30:56

In Q2, we expect capex spend will be over $50 billion. Therefore, for the calendar year, spend should be approximately $170 billion due to the 3P capacity delays noted earlier.

Amy Hood31:29

In the second half of the fiscal year, we currently expect capex spend to accelerate primarily from CPUs inclusive of higher memory and storage costs and GPUs as well as the 3P capacity deliveries that shifted to H2 and as we continue to improve the efficiencies of our infrastructure each dollar of capex has the potential to support more revenue and higher returns over time Given our strong business performance, we expect to continue to remain free cash flow positive in FY27. To complement cash generated by the business and preserve financial flexibility,

Amy Hood31:41

We will access additional sources of funding when we believe it is attractive to do do so. In closing, we are off to a strong start to FY27 with accelerated growth across the Microsoft cloud.

Amy Hood31:51

Product improvements along with efficiency gains across our data center infrastructure and our first party apps and agents are increasing the value and improving the outcomes we deliver to our customers.

Amy Hood31:58

Delivering that value to our customers positions us for durable long term growth. With that let's go to Q&A Jonathan.

Jonathan Neilson32:13

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

Questions and answers

Operator32:28

Thank you. Ladies and gentlemen if you would like to ask a question please press star one on your telephone keypad and a confirmation tone will indicate your line is in the question queue.

Operator32:44

You may press star two if you would like to remove your question from the queue. For participants using speaker equipment it may be necessary to pick up your handset before pressing the star keys. One moment please as we poll for questions.

Operator32:53

And our first question comes from the line of Adam Wood with Morgan Stanley. Please proceed.

Adam Wood32:57

Hi. Thanks so much.

Adam Wood33:19

Alongside lower than expected capex and those better cloud gross margins sequentially. Can I ask as incremental AI capacity comes online, what do you see as likely to be the more important driver of returns over the next few years, improving utilization and unit costs within Azure or your ability to monetize more layers of each workload across Fabric, Foundry and Copilot?

Unidentified speaker33:40

Thanks for the question, Adam. I'd say all of the above. But I think the way we're coming at this is we have one pool and we want to get the pool to be as efficient

Satya Nadella35:13

And fungible, right? That's sort of the place where if I sort of think about all of the physics of how we're building out the data centers all the operational rigor with which we can bring up the capacity and then of course how do we run the workloads that are optimized on that infrastructure and once you do that then it's just a function of how we allocate it by looking at the demand signal and even there even in our new segment reporting I think you kind of see it which is Copilot Copilot stateful database underneath it is Work IQ that gets used in Foundry which is where people will build let's say a multi-agent system for supply chain that spans both unstructured and structured Of course, it uses a Postgres database in Azure and so and then by the way all the agentic work is registered in the Agent 365 and perception manages the security of it, right? So to us at least we look at all of this as the same infrastructure of course we report to you in a variety of different products but your core question of where is the margin going to come from where's the leverage is going to come from it's not going to come from any one it's going to come from every one of them and it compounds when we work them across.

Satya Nadella35:23

I think that's And Adam, I'm sorry if we missed the front half of your question. I think we at least caught the back half.

Adam Wood35:24

That's great.

Satya Nadella35:24

Thanks, Adam.

Adam Wood35:27

Yeah, it's very helpful. Thank you.

Jonathan Neilson35:30

Operator, next question, please.

Operator35:37

The next question comes from the line of Carl Keirstead with UBS. Please proceed.

Karl Keirstead36:08

Okay, thank you. Amy and Satya, I'm wondering if you could unpack what I thought was one of the key metrics from this call and that is the guidance for Azure growth of 49 to 50% constant currency in December. I can imagine there's a number of variables that capacity you're putting up the allocation to third party customers probably OpenAI strength but perhaps you could comment a little bit on what some of the key drivers are given how good that number seems at least to me thank you

Amy Hood37:46

Thanks Carl for the question maybe I'll start by talking a little bit about Q1 and I think that'll help to think through Q2 and even going forward and it's not unrelated really to Adam's question at some level as well in Q1 I would say the engineering teams have really delivered very very good work in terms of improving efficiency at the platform layer that is not just a statement around the efficiency of GPUs it's a statement around the efficiency of every layer how the app utilizes the platform and how Foundry utilizes the platform as well as the Azure platform itself those efficiencies you know they're sort of ground out every week and you have good ideas a lot work some don't and you stay at it so they're not maybe as predictable in terms of how much impact we'll get in quarter Q1 they did a very good job and you saw some of that result in us being able to put more allocation into Foundry in the quarter that's a great thing because we're as I said in the call we still have demand that exceeds supply so where we can have our engineering teams deliver those efficiencies we do really try to put it into Foundry when we can because it's so important as Satya talked about into how customers broadly are building what I would call against the new stack.

Amy Hood39:35

Secondly, and you mentioned it, token pricing will create a little bit of variability. We had higher token pricing than we expected in the quarter listen high quality models that we're able to take advantage of and see good margins on do benefit us in the quarter that did happen in Q1 and I think also in that number in Q1 was the efficiencies I talked about applied not just to our GPU fleet but I think people sort of underestimated when the example Satya gave for Adam's question that's a GPU CPU storage memory workload I mean it takes all of the pieces and so our ability to also create additional capacity within our existing fleet gave us some room to be able to convert that actually pretty quickly as well in Q1 so in Q2 we've got those efficiency gains which is great and those will continue into Q2 we need to find some more which we're counting on enable to get to that guidance that I gave because I have faith in the team's work in Q1 continuing into Q2 but we also need that work to be able to help us a little bit because we had some supply we were counting on Q2 move out into H2 and so you know I think and to your point there's also some unknown on some token pricing through the quarter that stuff can change so you know I think I feel good in terms of the efficiency gains that we saw when we're able and when I'm able to see those and put them in I feel good about guiding to that but as other things are less predictable I mean I hope that's helpful on the levers Carl

Karl Keirstead39:38

Yeah, it is. Thanks, Amy.

Jonathan Neilson39:43

Thanks, Carl. Operator, next question, please.

Operator39:49

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

Mark Moerdler40:41

Thank you very much for taking my question. Congratulations on the solid quarter and solid guidance it's really nice to see how well you guys are executing I'd like to get a sense on the drivers of the AI strength in Azure being from enterprise versus digitally native in general or AI native with inferencing starting to ramp and Microsoft the go-to for enterprises how should we think Amy about the mix of enterprise customer workloads within overall workloads at this point and Satya with the strong growth of the Azure AI platform offering can you give us color on what's driving that is it again enterprise is it digitally native obviously it's a mix of both but any color that shows the ramp of that enterprise I think would be valuable

Amy Hood40:46

Yeah, thanks for the question, Mark. Maybe I'll start and maybe you can add to it.

Amy Hood41:38

The, I was even in Europe just last week and it was great to see the quality of the agentic systems, right, that are just broadly getting deployed, right? When Unilever deploys what is their automated order taking and trade coupon dispute management stuff all as a fully agentic touchless system Rolls Royce deploys a system to really manage all of their maintenance of whatever their jet engines with 30,000 parts a pretty complex supply chain both planning execution inventory management system you know all built on Foundry agentic systems

Amy Hood43:37

RBI which is an Austrian bank you know showed me 20 plus business processes end to end and they were talking about like whether it's in for credit or what have you how they are able to now do that so much more optimally right so the breadth the quality their ability oh by the way the multi-model nature of it right they look they start with a frontier model many of them in fact the Unilever one they just dropped an MAI model trained using our traces so even the degree of sophistication of what I think of as model optimization workload optimization token optimization was just great to see so the breadth is starting finally it does feel like the enterprise workloads they feel like to me you know like the database you know applications enterprises built in the past that I grew up with is happening now when it comes to AI and in fact if anything some of the you know the shiny object stuff is waning right which is it's not about the next big thing they're really more about wow can I build a system can I own the weights can I manage my costs can I have reliability what about security and so in that sense the enterprise breadth motion is starting but like everything else the enterprise stuff is not like a quarter over quarter it's a you know a decade long thing and that's what I've been waiting for as opposed to like four customers who buy a lot of capacity from you and you can show a few quarters of growth and that's not a business as far as I'm concerned. So I want the breadth we are well positioned on the breadth and we have you know large customers who want to buy from us and we're open for business with it and as long as the pricing is right we may sell them some if not we will be patient about building the breadth business.

Jonathan Neilson43:44

Thanks, Mark. Operator, next question, please.

Operator43:52

The next question comes from the line of Gabriela Borges with Goldman Sachs. Please proceed.

Gabriela Borges44:07

Hi, good evening. Thank you. you. Satya, I want to stay on this topic of breadth because you had a comment in the prepared remarks talking about how MAI can now be comparable to leading models within three to six months of their release.

Gabriela Borges44:25

At the same time, you have OpenAI at 11% of revenue in the quarter. So maybe just take a step back and give us your latest thinking on how you think token mix and token value is going to evolve between the Frontier, MAI, and maybe what some of your more sophisticated enterprise customers are doing from a proprietary AI strategy standpoint.

Satya Nadella44:27

Thank you.

Satya Nadella45:36

Yeah, so I think in fact I would say there you should think of three things perhaps as in the toolbox for any workload. The first is a new model drops and it's got some great performance and you want you can eval max on whatever that matters to you i.e. the outcome that matters to you by using it people should use it we saw that with some of the OpenAI models in the last quarter they were fantastic models and we're obviously very thrilled about the progress OpenAI has made with Astra and also what's to come and I thought we saw some good demand on that then the next thing people do is hey can I actually put multiple of the frontier models because these got these have very different prices in fact this morning artificial analysis had the you know what I think is the real benchmark which is the coding agents using our Fusion and I think we were number two or number three there which is awesome to see right which is you can now get frontier performance 45% faster 75% cheaper like why who would want to

Satya Nadella46:02

Right, which is like if you're a coding agent user, you want in fact Anthropic and OpenAI by the way to compete for your workload, not like once a quarter but for every task uh and that to me is what the value of these routers and auto fusion uh stuff routing does and we are very excited about it.

Satya Nadella46:21

And then the last thing is another important one. A lot of customers are saying, hey, look, take the Unilever one, right? It's their system. They they would ultimately take even the traces after having done even a bunch with frontier models and they just want to train their own model uh so it can be open weights or in this case, it was MAI model.

Satya Nadella47:10

Uh and so I think all of that needs to be as options that are available um and then depending on pricing, depending on the need of the customer, they will exercise it and there's a temporality to it. It's never like oh I start one place and that's where I stop, right? It's like I may start at the frontier, I may go to an open weight, I may go to an MAI model, I may go back to the frontier for the next drop for a few months, come out like that's how I think the how dynamic these workloads are and that's where when we think about foundry or when we think about fabric or when we think about Copilot and GitHub Copilot, we really want to build a model system that delivers customers value continuously versus you know get you know them being stuck in any one thing.

Gabriela Borges47:14

Thank you for the

Jonathan Neilson47:18

Thanks Gabriela. Operator, next question please.

Operator47:26

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

Brent Thill47:50

Thanks, Amy. Good to see Azure approaching 50%. You have another line item approaching 50% and that's your operating margin I think many ask you know how can you sustain this level of growth with a 50 on the top and a 50 on the bottom maybe you can discuss the operational improvements you continue to put forward to maintain that that high level on the bottom line.

Amy Hood49:10

Um thanks Brent um let me first say uh the net solution here is revenue growth um and so I would say I tend to start and focus there even though I think many people seem to think I start at the bottom of the P&L and work up uh the right answer is you always start at the top of the P&L and work down and so what we've been focused on and I think really it's almost inherent in all of the commentary is we change segments because we're changing how we deliver product and services to customers we're changing it because we're delivering new and different products with a lot of value in them and those products are far more integrated than they were before I think when you see that revenue accelerate at the top line of course it does in a pretty healthy way contribute to positive margin and part of the positive margin dollars which I think I need people to also focus on the second piece is this real focus on efficiency because efficiency when we say the word I think people believe it's cost related the outcome is cost related but the real benefit of efficiency is stability it's security it's reliability.

Amy Hood49:32

It's that it delivers the highest quality unit at the lowest possible cost. And so it's operational excellence. And so I think when you think about you can deliver product excellence, which is what we're really focused on, I think we did a very good job on product quality in the past quarter, which I think teams should be proud of in lots of places.

Amy Hood49:48

I think then you have this sort of operational focus on improvement and then it is a real focus in terms of operating expense to make sure it's going toward building the new thing or providing security and quality.

Amy Hood50:09

And I think that's we've made a I think a very active choice to be really focused on those two things especially in this environment and how important it is and I I think when you do those things and you happen to be in a good market with breadth and breadth in customers and a global business we've seen a good result.

Amy Hood50:22

Um this quarter in particular you know when you're delivering a lot of efficiency gains in a quarter and you can deliver revenue growth without spending additional costs, you of course see a benefit, which we did.

Amy Hood50:30

But I feel good about what's behind that number, which is, I think, a focus on the right levers.

Jonathan Neilson50:37

Thanks, Brent. Operator, next question, please.

Operator51:08

Hello?

Operator51:10

We up.

Unidentified speaker51:12

Hi.

Unidentified speaker51:14

Sorry about

Operator51:19

Our next question comes from the line of Brad Zelnick with Stifel.

Brad Zelnick51:33

Great. Sorry about that. I did not hear my name. On M365 consumption, when you all shifted GitHub from a per seat model to a consumption model it unlocked a ton of revenue growth for y'all.

Brad Zelnick51:51

As you think about the tools in place now unlock on the consumption side for the core M365 customer do you think the unlocks as fast and without sales effort or is it going to take you know a fair amount of effort to get those meters spinning? Thanks.

Satya Nadella52:59

Yeah, thanks for the question. I think on the coding side, um, it will be faster just because I think people are used to paying um on this pay go as the sort of the general market uh and how it works and if anything hopefully you know some of the things that we announced even at GitHub Universe today with Fusion are a more attractive way right because you even if you think about it right you buy a bunch of credits and you want to use those credits most efficiently that's the promise of GitHub Copilot Fusion so we are very optimistic about making progress on that and then when it comes to Copilot itself right we are trying to make sure that we in some sense are driving more and more value into the subscription with every model drop and essentially consolidating the frontier gains for broad deployment. And in many instances as my remark said IT funds this right as the thing that you want to have standard issue across the board.

Satya Nadella53:34

And at the same time you have uh your pay as you go or consumption meters for places where you need it um and so uh so both of those options are open and I think that's why uh the sec you know in with Copilot as Amy referenced which is we're trying to make sure that customers understand both options they're able to use the most the two options in the optimal way that benefits them uh we don't want them to overbuy one thing and then feel like they're token maxing because that doesn't serve anybody's purpose.

Satya Nadella53:59

Uh we want to make sure that they understand the value of the subscription um and how it is a continually improving value it's not even static and at the same time you can exercise this uh consumption meter and so that that's a little bit of the degree of sophistication in both in our sales motions even in customers understanding that I think coming together uh we feel very good about the progress but a lot more to do.

Satya Nadella54:26

And I think I would say it's also why we've made the investment into the frontier company here coupled with changes in our sales motion, which I talked a little bit about, you know, we need both of those things to make sure customers are because what I think we want them to utilize both the Copilot license to its fullest and understand when the consumption meter is delivering value to them.

Satya Nadella54:40

The investment in the FDE organization or the frontier core as well as new motions within our modern work and Microsoft 365 sales teams are both meant to do that.

Amy Hood54:54

And I think to Sathya's point, it will be a slower move outside of coding but I also still think we're still seeing encouraging signs and I feel positive about that.

Brad Zelnick54:56

Thank you.

Jonathan Neilson55:03

Thanks, Brad. Operator, we have time for one last question.

Operator55:11

The next question will come from the line of Tal Liani with Bank of America. Please proceed.

Tal Liani55:29

Hey, just clarification on something you just said. Did you disclose the Copilot numbers this quarter? But my question is more about the capital commitment or the capital strategy. You said in the prepared remarks that you will approach raising capital if need be in the future. future.

Tal Liani55:38

Can you discuss your strategy around it between debt and equity and other sources? How do you intend to raise capital if need be? if need be? Thanks.

Amy Hood55:53

Great. I'll take that. I think what I said is if it's attractive and makes sense, we're lucky we have a lot of flexibility in terms of our capacity to raise financing. I've talked about this before.

Amy Hood56:33

There's a form of financing called leasing and we've been using that one as a vehicle there's also we're fortunate to have access in the debt markets given that where our rates ratings are and sort of we haven't been able to and we haven't yet I would say tap that and then of course there's other options but I think the way I see it is we're feeling good that we're free cash flow positive we feel good that the return on every dollar of capex we're spending we're confident in that and therefore we feel like we have lots of options to be able to tap the financing markets when they make sense and they're attractive.

Amy Hood56:43

And we did not disclose to answer your direct question update on the Copilot number this quarter we talked about momentum in revenue and usage

Tal Liani56:44

Thank you

Jonathan Neilson56:53

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

Amy Hood56:55

Thank you.

Closing

Operator57:06

Thank you. This concludes today's conference. You may disconnect your lines at this time. And we thank you for your participation.