Microsoft Corporation
Q4 2021 Earnings Call Transcript

Published: 27 Jul 2021

[Operator:]

Greetings, and welcome to the Microsoft Fiscal Year 2021 Fourth 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. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Brett Iversen, General Manager of Investor Relations. Thank you. You may begin.

[Brett Iversen:]

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 Keith Dolliver, Deputy General Counsel.

[Satya Nadella:]

Thanks much, Brett. We had a very strong close to our fiscal year. Our commercial cloud surpassed $69 billion in annual revenue, up 34%. We have seen revenue growth across industries, customer segments and geographies with over 50% of sales coming from outside the United States. We continue to grow new franchises for Microsoft in large and growing markets. In the past three years alone, gaming, security and now LinkedIn, have all surpassed $10 billion in annual revenue.

[Amy Hood:]

Thank you, Satya, and good afternoon, everyone. This quarter, revenue was $46.2 billion, up 21% and 17% in constant currency. Earnings per share was $2.17, increasing 49% and 42% in constant currency. In our largest quarter of the year, focused execution by our sales and partner teams, along with broad-based strength across geographical markets and customer segments drove another very strong quarter of top and bottom line growth. In our commercial business, healthy demand for our differentiated hybrid and cloud offering as well as increased long-term commitment to our platform drove significant growth in the number of $10 million-plus Azure and Microsoft 365 contracts. Customer reliance on the Microsoft Cloud drove sequential increases in usage across Teams, Power Platform and our Advanced Security and identity offerings, which are empowering organizations to shift to hybrid work and modernize business processes. And in LinkedIn Talent Solutions business, an improving job market drove strength in annual contracts and job postings. In our on-premises business, strong annuity performance across Officer, Server and Windows also benefited from a greater mix of contracts with higher in-period revenue recognition under ASC 606. In our Consumer business, Windows OEM and Surface were impacted by the ongoing constraints in the supply chain. Search and LinkedIn benefited from an improved advertising market. And in gaming, we again saw strong engagement across our platform, while demand for Xbox Series X and S consoles continued to exceed supply. As a reminder, Q4 was the first full quarter impacted by COVID-19 a year ago across revenue and operating expense. This quarter, even with a declining exploration base, commercial bookings grew 30% and 25% in constant currency, significantly ahead of expectations, driven by strong execution across our core annuity sales motions and an increase in the number of larger long-term Azure contracts. As a result, commercial remaining performance obligation increased 32% and 31% in constant currency to $141 billion. Roughly 45% will be recognized in revenue in the next 12 months, up 25% year-over-year. The remaining portion, which will be recognized beyond the next 12 months, increased 38% year-over-year, highlighting the growing long-term commitment to our Microsoft Cloud. And our annuity mix increased 1 point year-over-year to 95%. Commercial cloud revenue, also better than expected, was $19.5 billion as growth accelerated to 36% and 31% in constant currency. Commercial cloud gross margin percentage expanded 4 points year-over-year to 70%, with roughly 1 point from the change in accounting estimate for the useful life of server and network equipment assets. Excluding this impact, commercial cloud gross margin percentage increased despite revenue mix shift to Azure, driven by improvement across all our cloud services on a prior year comparable impacted by strategic investments we made to support significant customer engagement and usage in remote work scenarios, including free trials, flexible financing options and capacity for cloud infrastructure usage. With the weaker U.S. dollar, FX increased growth by approximately 4 points, about 1 point more favorable than anticipated. FX increased COGS growth by approximately 1 point and operating expense growth by approximately 2 points, both in line with expectations. Gross margin dollars increased 25% and 20% in constant currency. Gross margin percentage was 70%, up 2 points year-over-year, with roughly 1 point of favorable impact from the change in accounting estimate. Excluding this impact, Company gross margin percentage increased despite sales mix shift to the cloud, driven by commercial cloud gross margin percentage improvement noted earlier. Operating expense grew 6% and 4% in constant currency, in line with expectations on a prior year comparable that included roughly 4 points of impact from the realignment of our retail storage strategy and 2 points of impact from an increase in bad debt expense. Overall, Company headcount grew again this quarter, up 12% year-over-year as we continue to invest across key areas like cloud engineering, sales and customer deployment. Operating income increased 42% and 35% in constant currency, and operating margins expanded 6 points year-over-year to 41%, including roughly 2 points of impact from the retail stores charge and increase in bad debt expense in the prior year and nearly 1 point of favorable impact from the change in accounting estimate. Now, to our segment results. Revenue from Productivity and Business Processes was $14.7 billion and grew 25% and 21% in constant currency with better-than-expected performance across all businesses. Office Commercial revenue grew 20% and 15% in constant currency. Office 365 Commercial revenue grew 25% and 20% in constant currency, again driven by installed base expansion across all workloads and customer segments, as well as higher ARPU. Paid Office 365 Commercial seats increased 17% year-over-year, with continued recovery driving acceleration in our small and medium business and frontline worker offerings. Demand for Microsoft 365, particularly for security, compliance and voice drove strong E5 momentum again this quarter. E5 now accounts for 8% of our Office 365 Commercial installed base. And on a low prior year comparable impacted by a slowdown in transactional purchasing, Office Commercial licensing was ahead of expectations, down 8% and 11% in constant currency, also benefiting from higher in-period revenue recognition noted earlier. In Office Consumer, revenue grew 18% and 15% in constant currency, driven by continued momentum in Microsoft 365 subscriptions, which grew to 51.9 million, up 22% year-over-year. Dynamics revenue grew 33% and 26% in constant currency, better than expected. Dynamics 365 revenue growth was 49%, and 42% in constant currency, with strong momentum in Power Apps and Power Automate, reflecting growing demand for our modern solutions to build apps and automate workflows. Dynamics 365 now accounts for over 70% of total Dynamics revenue. LinkedIn revenue increased 46% and 42% in constant currency, ahead of expectations against the comparable impacted by the advertising and job markets of a year ago. Segment gross margin dollars increased 33% and 27% in constant currency, and gross margin percentage was up 5 points year-over-year, primarily driven by improvement in our cloud services against a low prior year comparable impacted mostly by increased usage. The change in accounting estimate drove roughly 1 point of favorable impact. Operating expense increased 8% and 6% in constant currency, and operating income increased 62% and 53% in constant currency, including 4 points due to the change in accounting estimate. Next, the Intelligent Cloud segment. Revenue was $17.4 billion, increasing 30% and 26% in constant currency. We exceeded expectations across our consumption and per-user Azure businesses as well as in our on-premises server products business. Overall, server products and cloud services revenue increased 34% and 29% in constant currency. Azure revenue grew 51% and 45% in constant currency, driven by strong performance across our core and premium consumption-based services. In our per user business, the enterprise mobility and security installed base increased 29% to over 190 million seats. Our on-premise server business increased 16% and 12% in constant currency, driven by strong annuity performance and benefiting roughly 4 points from the higher in-period revenue recognition noted earlier, particularly in some of our largest deals in the quarter. Enterprise Services revenue grew 12% and 9% in constant currency, driven by growth in premier support services and Microsoft consulting services. Segment gross margin dollars increased 32% and 27% in constant currency. Gross margin percentage increased 1 point year-over-year with roughly 1 point of favorable impact from the change in accounting estimate. Operating expense increased 14% and 12% in constant currency, and operating income grew 46% and 39% in constant currency, including 3 points due to the change in accounting estimate. Now to More Personal Computing. Revenue was $14.1 billion, increasing 9% and 6% in constant currency, with better-than-expected performance in Windows Commercial, gaming and search offsetting OEM and Surface weakness from supply chain constraints. OEM revenue declined 3% and Surface declined 20% and 23% in constant currency as both were impacted by the significant supply chain constraints noted earlier in a good demand environment. Windows Commercial products and cloud services revenue grew 20% and 14% in constant currency, driven by demand for Microsoft 365, with some benefit from the higher in-period revenue recognition, noted earlier. Search revenue ex TAC increased 53% and 49% in constant currency, benefiting from the improved advertising market. And in gaming, revenue increased 11% and 7% in constant currency. Xbox hardware revenue grew 172% and 163% in constant currency, driven by demand for our new consoles. Xbox content and services revenue declined 4% and 7% in constant currency against a high prior year comparable. Segment gross margin dollars increased 8% and 4% in constant currency. Gross margin percentage decreased roughly 1 point year-over-year, driven by sales mix shift to gaming hardware. Operating expense decreased 6% and 7% in constant currency, including approximately 13 points of impact from the retail stores charge in the prior year. And operating income grew 19% and 13% in constant currency. Now, back to our total Company results. Capital expenditures, including finance leases, were $7.3 billion, in line with expectations, driven by ongoing investment to support growing global demand and usage of our cloud services. Cash paid for PP&E was $6.5 billion. Cash flow from operations was $22.7 billion, increasing 22% year-over-year, driven by strong cloud billings and collections. Free cash flow was $16.3 billion, up 17%, reflecting higher capital expenditures in support of our growing cloud business. For FY21, we generated over $76 billion in operating cash flow, up 26% year-over-year, and over $56 billion in free cash flow, up 24% year-over-year. This quarter, other income and expense was $310 million, higher than anticipated, primarily driven by net gains on investments. As a reminder, we are required to recognize mark-to-market gains or losses on our equity portfolio. Our effective tax rate was approximately 15%. And finally, we returned $10.4 billion to shareholders through share repurchases and dividends, bringing our total cash returned to shareholders to over $39 billion for the full fiscal year. Now, before we turn to our outlook, I’d like to provide a few reminders for next fiscal year. Revenue growth rates across all segments will reflect the impact from COVID-19 a year ago, though the impacts do shift as we move through the year. Also, our FY21 operating income and margin benefited from two factors that will be headwinds in FY22

[Brett Iversen:]

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

[Operator:]

Our first question is coming from the line of Keith Weiss with Morgan Stanley.

[Keith Weiss:]

Thank you for taking the question, guys. And congratulations on a great FY21 and a great end to the fiscal year. Satya, last year at this time, you made a comment that I think really defined the conversation in software over the past year. When you’re talking about an acceleration in digital transformation you saw coming out of COVID, and I think that’s evident in the results that we see here with 25% growth in your commercial bookings growth. What I want to ask you is the durability of that growth on a going-forward basis. Was that acceleration a pull forward of demand and at some point we’re going to have that hard comp, or do you see durability in this acceleration on a go-forward basis? Is there a lot more to come? And then, Amy, to you, a similar kind of question but more on sort of the margin side of the equation. I think your entire tenure at Morgan -- at Microsoft has really been defined by good operational controls and ability to grow gross profit dollars well ahead of OpEx. Is that durable longer term? Is there still enough sort of efficiency gains at Microsoft to be able to keep that up over the medium term, if you will?

[Satya Nadella:]

Thanks so much, Keith, for the question. I mean, the way we see the results today reflect that, but more importantly, on a secular basis, as I think about -- I always go back to that number, which is 5% of the world GDP is tech spend, it’s projected to double. I think that doubling will happen in a more accelerated pace. And we feel well-positioned because of the innovation across the stack. Because if you think about it, what’s going to happen is every business, whether you’re a retailer or a manufacturer, in the service sector, public sector or private sector, digital adoption is the way you’re going to be both, resilient as well as transform the core business processes. And the strength we have is that entirety of the Microsoft Cloud stack, right? So, it’s not just about infrastructure or any application, it’s the entirety of what we do. And so, I think it is durable. Quarter-to-quarter, depending on what happened during the pandemic, depending on the segments that were impacted, for example, the consumer segments that were impacted are coming back and then they’ll normalize. Whereas in our case, we do, in fact, one of the things I love about sort of our exposure is both, it’s a worldwide exposure and it has got the right balance between the consumer segments and the enterprise business-to-business segment. So, it’s a very durable long-term growth prospect that we have tough competition, we need to keep innovating, which is what we’ll stay focused on.

[Amy Hood:]

And maybe turning to your margin question, and while I am obviously proud of the work we’ve done, Keith, that you referenced as a team on margins and returns, I would say, in general, our focus remains and has been for the duration of really Satya and I’ve work together along with the rest of the SLT on consistently moving our resources and talent to our highest growth and most differentiated places. When you do that in expansive total addressable markets in the way that I believe we’re focused on as an organization, you do see the type of operating leverage that you’re referring to in margins. And that along, as you see sort of mathematically with a shift in our revenue to higher overall gross margin segments, you do get the results we’ve seen. So, I feel very good about the work we’ve done. And as you heard, I’m quite optimistic about the opportunities we have to invest, leading into FY22 as well.

[Operator:]

Our next question comes from the line of Mark Moerdler with Bernstein Research.

[Mark Moerdler:]

Thank you very much for taking the question. And again, also, congrats on the quarter, and Amy, thanks for the details and color, especially in the guidance. So, I want to ask about seasonality in Azure. Traditionally, we’ve seen seasonality in the Azure numbers in Q4. And obviously, last year, we didn’t see it because of COVID, but we also didn’t see it this year. Has something changed that has changed the seasonality of the business? And does that continue going forward? And then, as a follow-up question, Keith asked about OpEx efficiency overall, but I’d like to ask specifically on the cloud. Is there any reason that cloud OpEx shouldn’t continue to grow slower than revenue, obviously, on an annual basis, not a quarterly basis? Thank you.

[Amy Hood:]

Thanks, Mark, for the question. Let me cover your first one, which is the seasonality in the Azure business. In some ways, Mark, some of that seasonality frankly was because Azure has two fundamental components. It’s got a consumption model as well as a per-user model. The per-user model, which as you well know is far more aligned to our end-of-year and can be more aligned to our end-of-year rhythms. It also can have more quarterly volatility in terms of accounting, in terms of revenue recognition, the same topic we often talk about when it comes to Microsoft 365 in terms of more in-quarter recognition. What you’ve seen is that did historically represent a larger component of Azure, so added volatility to Q4. As we’ve seen our consumption businesses grow and grow consistently, thus far becoming a larger percentage of Azure, you do have more stability, Mark. And so, you start seeing less of that volatility that we’ve historically seen from Q3 to Q4. We still have some of it, as we talked about, but I think it’s an interesting observation and it’s a very good question. In terms of your comment on cloud revenue and OpEx, yes, I do believe that’s durable. We get a lot of focus. We’ll continue to invest. There’s lots of opportunity there, but the market certainly warrants it.

[Operator:]

Our next question is coming from the line of Brent Thill with Jefferies.

[Brent Thill:]

Amy, a lot of questions on margins, I’m curious if you think there is the ceiling in the near term on margins, or do you feel that you’ve got an elevated flight level, if you will, and we shouldn’t have to be worrying about that level of margins? Can you just give us any more color as it relates to how you’re thinking about that? Thank you.

[Amy Hood:]

Well, I think for FY22 on operating margins, which is really where I focus most of my thoughts, as I said, when you exclude the useful life change, I feel very good about margin improvement in FY22. But, what sits behind that, Keith is -- I mean, sorry, Brent, is this focus on the first thing I said, which is with every operating expense dollar we invest, are we continuing to invest in the highest growth places? If you continue to invest in high-growth places with differentiation that customers care about and you add value, you continue to see improvements in this area. From time to time, I’m sure there’ll be quarters where that isn’t the case, if we have some mix shift in hardware, et cetera. But in general, over a longer period of time, you’ve seen us focus on this. And so, if you remove a little of the noise and some of the useful life changes and look back a few years, I do think you’d see the biggest needle mover being where we invest the dollars as opposed to the overall amount of them, which should grow based on the opportunity.

[Operator:]

Our next question comes from the line of Karl Keirstead with UBS.

[Karl Keirstead:]

Thanks very much. Amy, thank you for giving more formal Azure guidance for the next quarter. That’s very helpful. So, if Azure is going to remain stable in constant currency, I guess at 45%, and you had indicated that EMS growth should moderate, effectively, you’re saying that the consumption piece of Azure might accelerate in the September quarter. So, I’m wondering if you could unpack that a little bit. Is this as simple as prior period commitments simple as prior period commitments ramping at an accelerated pace? I’d love to hear your thoughts. Thank you.

[Amy Hood:]

Thanks, Karl. I think, in general, you’ve got the right trajectory. And I do think it’s both things. You’ve heard me say, it’s both some of our core as well as premium SKUs. We’ve seen some nice execution. And I think Satya mentioned some of these differentiated places in the Azure stack, where I think we also can see some growth. Data services is a very good point where I feel like we’ve made a lot of progress, have a real differentiation, have seen some acceleration in the past couple of quarters.

[Operator:]

Our next question is coming from Mark Murphy with JP Morgan.

[Mark Moerdler:]

Satya, at the Ignite Conference a few months ago, you commented that cloud architectures have reached peak centralization. I’m wondering what developments are you seeing that inform your viewpoint. And Amy, do you sense uplift in some of those intelligent edge products such as Azure Stack or others contributing to the improvement in server products growth that we saw this quarter?

[Satya Nadella:]

Thanks so much for that question. A couple of things that are happening. One is that all up, even what we consider the cloud infrastructure is getting increasingly distributed. If you think about the approach we took to our data center architecture, the fact that we have more regions, is to meet, I would say, both the real-world needs for the computing architecture side but also the regulatory and data residency requirements. So, we feel we picked the right approach. And that’s paying dividends today just even in terms of our geographic coverage, our coverage of all of the regulatory requirements. Then, the second piece, of course, is distributed computing will remain distributed. And what we are seeing with edge is going to be the case where we will see more of both the old workloads with hybrid benefits and hybrid deployments as well as new workloads, right? So, if you take the AB InBev Digital Twin meets IoT type of scenario, that’s going to require a lot more compute close to their factories. And so, to me, those new scenarios -- or 5G, I mean, think about what AT&T is planning to do, which is a hybrid deployment in a completely new space where there is going to be compute that’s located to be able to take core network traffic and use cloud economics. So, that’s what we think of going forward, which is really compute will remain distributed, both because of their needs across geographies, regulation and the very nature of compute architecture.

[Amy Hood:]

And to the question you asked on how to think about the edge and where to see that in results, really, it shows up. This is one where I would focus on the overall server products and cloud services number, which I think, Mark, was at the heart of your question because through our purchasing vehicles, the most effective way to purchase for flexibility with and across the edge in the cloud is sometimes some of the on-prem licensing with hybrid rights. So, you do see that both in our Azure results but also depending on how it’s purchased and server KPI.

[Operator:]

Our next question comes from Brent Bracelin with Piper Sandler.

[Brent Bracelin:]

A question for you really around $10 million-plus contracts. You called out momentum this quarter and last quarter. My question is around the drivers of these large enterprise commitments. Is this driven by just the larger scope of deals, or are you seeing kind of broader attach rate across the whole breadth of Microsoft Cloud products? Thanks.

[Amy Hood:]

Thanks, Brent. Maybe, Satya, I’ll take this one first and if you want to add anything. Brent, unfortunately, I’m going to answer it’s everything, and let me talk about why I say that. When you see the size of the contracts increase, it’s about the entire scope of what’s offered under the Microsoft Cloud. We’re seeing both really strong renewals of our core contracts, really strong additions across Dynamics, Power Apps, Power Automate, M365, premium SKUs, security, compliance, voice, which, of course, increases those commitment sizes. And you’re seeing the addition of Azure commitments, which we often talk about as these multiyear longer-term contracts. And so, then you do, of course, see them just have longer duration on -- especially in the case of Azure. So, in many ways, what we focus on are the components that make up the larger contracts is each component being additive to selling the value that’s present across all of our pieces of the Microsoft Cloud. And this was a good execution quarter for us. You see it in the bookings number even more. When you have a declining expiry base and then bookings growth that’s that high you have to do all those things well. And that’s I think really what’s reflected ultimately and transactionally, meaning those larger $10 million-plus contracts being done.

[Operator:]

Our next question comes from Alex Zukin with Wolfe Research.

[Alex Zukin:]

I guess my main question maybe for Satya, you’ve taken -- you’ve noted the future of work having changed, and you talked about the fusion of Teams into both, the application stack, the operating system stack and really amongst the entire Microsoft portfolio. Is that driving -- given the acceleration you’re seeing in Dynamics, can you talk to the fact, is that driving larger deals, new bites at the apple, or how is that changing the landscape? And how do you think about that versus what your competitors are doing?

[Satya Nadella:]

Yes. That’s a great question. Thanks for that. Multiple things happening and both -- some of them are independent secular growth trends and they do reinforce each other. Let’s just take Dynamics. It’s probably one of the most exciting things we are seeing is that coming out of this pandemic, there is an absolute new chapter for a complete new suite all the way from whether it’s sales, to customer service, to marketing, to supply chain, or digital manufacturing, that’s all going to be re-implemented. So, there’s going to be a complete new cycle of business process automation that is going to be AI-first and collaboration-first. And that second part is where that intersection between Teams and Business Process or Dynamics comes through, because you do not want to have a system of record for anything, whether it is a customer or a part or a forecast that you don’t want to collaborate on, that you don’t want to communicate on. And by the way, the communications and the collaboration artifacts are part of the record. And that’s what I think that this new generation of software will enable. And so, you see it in two fronts. One is, Teams has become a platform, not just for Dynamics, even for Salesforce, for SAP, for Adobe, for ServiceNow. They’re all building great integrations into Teams and we’ll foster that. And Dynamics itself of course will integrate deeply with Teams and embed Teams or Azure Communication Services. So, when you think about our omnichannel customer service module, it doesn’t look like anything that -- from two years ago. It’s a completely rebuilt omnichannel customer service system, which has all the communication functionality built in. So, it’s a pretty exciting space. And it also speaks to a lot of the questions around where is the margin, how is it going to sort of evolve? I think tracking what’s happening with Power Platform, Dynamics and Teams, I think probably and its intersection to even some of our data layers in Azure is perhaps the best indication of some of our competitive differentiation at scale already.

[Operator:]

Our final question comes from the line of Keith Bachman with Bank of Montreal.

[Keith Bachman:]

Amy, I wanted to direct this to you and go back to margins for a second. Is there any comments or color that you could provide? I know you said you focused on the operating margin side, but on the trends that you anticipate this year in ‘22 around gross margins with or without the depreciation schedules. Part B is, on the last quarter call, you indicated that operating expenses might grow kind of mid-teens or low teens, I should say, in ‘22. I was wondering if you would want to update the comments on how we should be thinking about operating expense trends as we look at FY22. Thank you.

[Amy Hood:]

Thanks, Keith. When I think about your operating expense comments, no, I don’t have any update to that. I think if you think about our headcount growth at 12%, plus through the year, continuing to invest in some of the places where we saw savings through the year on COVID, I would expect that that is still a good placeholder for people as we work through the year. I mean, with the opportunity we see in the market, I think it supports that level. And given our execution, when we do invest, which leads me to margin, I feel very good about that. At the gross margin level, we’ll continue I feel very good always focused on, which is continuing across our cloud services to see improving margins. You’ll continue to see a mix shift to Azure, given the growth we expect there. And we’ll continue to see gross margin improvements across individual services that make up many of our components across the Company. So, in general, I feel like the gross margin trends are quite healthy heading into ‘22.

[Brett Iversen:]

Thanks, Keith. So, 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 all of you soon.

[Amy Hood:]

Thank you, everyone.

[Satya Nadella:]

Thank you.

[Operator:]

Ladies and gentlemen, this concludes today’s conference. We thank you for your participation, and you may disconnect your lines at this time.