Microsoft Earnings Call: New-Business ‘Slowdown,’ Big AI Bets

‘Just as we saw customers accelerate their digital spend during the pandemic, we are now seeing them optimize that spend. Also, organizations are exercising caution given the macroeconomic uncertainty,’ Microsoft CEO Satya Nadella said on the company’s second-quarter earnings call.

Microsoft CEO Satya Nadella

Microsoft will invest in artificial intelligence and helping customers get more out of their spend with the vendor as it navigates a temporary “slowdown in growth of new business” for certain offerings.

Microsoft Chairman and CEO Satya Nadella told analysts on the company’s Tuesday earnings call for the second quarter of its fiscal year, which ended Dec. 31, that the slowdown is temporary and a result of customers spending a lot of money on digital tools during the height of the pandemic and now wanting to get the most out of what they bought before spending more money with the Redmond, Wash.-based vendor.

“Just as we saw customers accelerate their digital spend during the pandemic, we are now seeing them optimize that spend,” he said. “Also, organizations are exercising caution given the macroeconomic uncertainty.”

[RELATED: Satya Nadella Confirms 10,000 Microsoft Layoffs]

Microsoft’s Second-Quarter Earnings, Business “Slowdown,” AI Bets

Microsoft CFO Amy Hood blamed a “slowdown in growth of new business” for having an effect on revenue from various businesses within the company, including revenue from stand-alone Office 365, Enterprise Mobility and Security (EMS) and Windows commercial products sold outside the Microsoft 365 suite.

The slowdown led to Windows commercial products and cloud services revenue declining by 3 percent— increasing by 3 percent ignoring foreign exchange—and prevented further growth in the EMS business, which still grew 16 percent year over year to 241 million seats.

Performance in the U.S. “was weaker than expected” during the quarter, Hood said.

That slowdown in new business will also affect some of next quarter’s results, Hood said. Windows commercial products and cloud services will see “relatively flat” revenue growth year over year due in part to the slowdown. And Microsoft also expects “relatively flat” growth in commercial bookings year over year in part due to the slowdown.

Microsoft’s “Optimization Cycle”

In Microsoft’s consumption business, customers have been “looking to bank some savings on some workloads and then start [a new project],” Nadella said on the call. “So that’s where I think a little bit of what has to happen is a cycle time, where the optimization cycle finishes, the projects start and then the projects wrap.”

For the company’s per-user license business, customers who bought more licenses for knowledge and frontline workers previously are “now making sure that they’re all getting used,” he said.

Usage growth in products such as Teams are a sign that the business is still healthy. And Microsoft is looking at new offerings—a Teams Premium offering set to become generally available in February—that could give partners more ways to upsell customers.

And even with customer spending slowing, Nadella sees investments Microsoft can make to lead when spending returns to previous levels.

“One of the key things we’re watching for … is to make sure that we are gaining share in this phase through our value propositions and even build loyalty with our customers so that, long term, we are well positioned for share gain,” he said.

Although Nadella recently called the next two years “the most challenging” for tech “because, after all, we did have a lot of acceleration during the pandemic and there is some amount of normalization of that demand,” he said on the call that he does not expect this “optimization cycle” to last two years.

“I don’t think we’re going to take two years to optimize,” Nadella said. “But we’re going to take this year to optimize and then as we optimize, a new project starts. And the new project starts don’t start instantly at their peak usage. They start and then they scale. And so those are the two cycles that will happen, where there will be a time lag.”

Microsoft’s CEO remained optimistic on the cloud overall. “We’re still in the early innings when it comes to long-term cloud opportunity,” Nadella said.

Economic Climate A Factor

Customers trying to get the most out of their existing Microsoft spending is related to the economic climate, CFO Hood told analysts on the call.

“When you start to say, ‘What’s the best ROI I can get on every budget dollar I spend?’ our job as a partner to so many of these customers is to help them do that,” Hood said.

In the per-user business, Microsoft saw “very high renewal rates and very good suite performance at renewal”—a measure Microsoft also calls “recapture”—but the vendor had “some more challenges on maybe a stand-alone sale of a new product, where the cycle is going to be a little longer,” Hood said.

“You’re going to have to show that cost savings,” she said. “But the suite sale, the value in that showed itself in terms of strong E5 [license sales]. You can see the ARPU [average revenue per user] growth. And you can see the consistency potentially in both renewal rate and in … Microsoft 365 performance.”

Microsoft has seen four or five “really good quarters of E5 adoption,” she said, noting that customers have been motivated to upgrade for more analytics and security offerings.

“As we see some of these moderating seat growth—whether that’s some of the new SKU weakness that we had talked about, some of the stand-alone stuff—you’re starting to also see E5 ARPU happen at the same time. So it does create some stability in that Office 365 commercial revenue number. So we’re seeing, still, good seat growth. Still growth across all workloads.”

Microsoft’s AI Era

On the more positive side of Microsoft’s latest earnings report, Nadella promised that Microsoft’s investments in AI within the company and investment in ChatGPT creator OpenAI will pay off because “every app is going to be an AI app.”

“The next major wave of computing is being born as we turn the world’s most advanced AI models into a new computing platform,” Nadella said on the call.

“We‘re going to lead in the AI era knowing that maximum enterprise value gets created during platform shifts,” he said.

Microsoft already has “the first at-scale AI product built for this era” in its GitHub Copilot offering, which has more than 1 million users to date, he said.

“The age of AI is upon us and Microsoft is powering it,” he said. “We are witnessing nonlinear improvements in capability of foundation models, which we are making available as platforms. And as customers select their cloud providers and invest in new workloads, we are well-positioned to capture that opportunity as a leader in AI. We have the most powerful AI supercomputing infrastructure in the cloud.”

Microsoft made its Azure OpenAI Service broadly available this month and has more than 200 customers using it. Customers will be able to use ChatGPT in their own applications soon, he said.

Azure ML revenue more than doubled for five quarters in a row, he said, with customers including FedEx and H&R Block.

Microsoft Layoffs

When asked about the 10,000 Microsoft employees getting laid off from the vendor, Hood said that Microsoft’s fourth fiscal quarter will end with “very moderated head count growth” year over year.”

“We take decisions like the one we had to make to get our cost structure more in line with revenue just incredibly seriously because we have lots of very talented people who were impacted by that,” she said.

Hood said that Microsoft’s head count at the end of December was 19 percent higher year over year, with 6 points from the acquisition of voice-to-text company Nuance and advertising technology company Xandr.

Without mentioning the layoffs directly, Nadella ended his prewritten remarks on the call by saying he wants “to extend my deepest gratitude to our employees for their continued dedication to our mission, customers and partners.”

More Microsoft Product Highlights

Microsoft now has more than 12,000 Azure Arc customers, Nadella said. Microsoft 365 has more than 63 million consumer subscribers, up 12 percent year over year.

Teams surpassed more than 280 million monthly active users during the quarter, “showing durable momentum since the pandemic, and we continue to take share across every category—from collaboration to chat to meetings to calling.”

“One of the things was, what’ll happen to Teams usage after the pandemic?” Nadella said. “Guess what? They’re up. So that’s good news. And now once we cycle through that, again, the seats will get added.”

Teams applications from Adobe, Atlassian, Poly, ServiceNow and Workday have each surpassed 500,000 active users. The number of third-party apps with more than 10,000 users increased about 40 percent year over year.

The more than 500,000 active Teams Rooms devices is a 70 percent increase year over year. The number of customers with more than 1,000 rooms doubled year over year.

Microsoft has added more than 5 million public switched telephone network (PSTN) seats for Teams Phone over the last 12 months. Nadella called Teams Phone “the market leader in cloud calling.”

GitHub has 100 million developers. Power Automate has more than 45,000 customers, up 50 percent year over year

Eighty percent of Microsoft enterprise customers use five or more Microsoft 365 applications.

The number of PCs shipped during the quarter declined to pre-pandemic levels, but “usage intensity of Windows continues to be higher than pre-pandemic,” Nadella said. Time spent per PC is up about 10 percent and monthly active devices during the quarter reached “an all-time high.”

Windows 365 and Azure Virtual Desktop use is up by more than two-thirds year over year. And over the past 12 months, Microsoft’s security business surpassed $20 billion in revenue.

“We are the only company with integrated end-to-end tools spanning identity, security, compliance, device management and privacy informed and trained on over 65 trillion signals each day,” Nadella said. “We’re taking share across all major categories we serve. Customers are consolidating on our security stack in order to reduce risk, complexity and cost. The number of organizations with four or more workloads increased over 40 percent year over year.”

Microsoft Second-Quarter Results

Microsoft saw $52.7 billion in revenue during the quarter, an increase year over year of 2 percent.

Using GAAP, Microsoft’s operating income was $20.4 billion, down 8 percent year over year. Net income was $16.4 billion, down 12 percent year over year.

Microsoft Cloud revenue was $27.1 billion, an increase of 29 percent year over year ignoring foreign exchange.

Microsoft’s productivity and business process segment brought in $17 billion during the quarter, up 13 percent year over year ignoring foreign exchange.

Within this segment, Office Commercial products and cloud services revenue grew 14 percent ignoring foreign exchange. Microsoft did not break out exact revenue figures for this and other divisions within productivity and business processes.

Hood called the growth “slightly better than expected” due to “healthy renewal execution and ARPU growth as E5 momentum remains strong.”

Office 365 Commercial revenue grew 18 percent. Hood said that small and midsize businesses—a segment partners usually work in—and frontline worker offerings drove seat growth in this part of the business. But the slowdown in new business growth hindered higher growth for this part of Microsoft’s revenue.

Dynamics products and cloud services revenue grew by 20 percent year over year, with Dynamics 365 revenue growing 29 percent.

Microsoft’s intelligent cloud segment brought in $21.5 billion in revenue during the quarter, an increase of 24 percent year over year ignoring foreign exchange.

Within this segment, server products and cloud services revenue grew 26 percent. Azure and other cloud services revenue grew 38 percent. Microsoft did not break out exact revenue figures for these parts of the intelligent cloud business. Hood said that growth moderated in December.

Microsoft’s “more personal computing” segment brought in $14.2 billion, down 16 percent ignoring foreign exchange, “below expectations,” Hood said. Microsoft’s business in Surface, Windows commercial and search helped drive the segment.

Within this segment, Windows OEM revenue decreased 39 percent year over year. Microsoft did not break out revenue numbers for this and other parts of the “more personal computing” segment, which also includes Microsoft’s gaming, search and advertising businesses.

Device revenue decreased 34 percent year over year ignoring foreign exchange. Hood said this number came in “below expectations due to execution challenges on new product launches.”

For the first half of the fiscal year, Microsoft’s commercial business revenue grew 20 percent, Hood said.

Microsoft’s stock traded at $239.60 a share after hours Tuesday, a decrease of about 1 percent from market close.

Microsoft Third-Quarter Guidance

Giving her guidance for Microsoft’s next fiscal quarter, Hood said that she expects Windows OEM and devices will continue to decline “as the PC market returns to pre-pandemic levels.”

She expects Microsoft’s commercial business to be “relatively flat year over year” due in part to “cautious” customer spending, a declining expiry base and strong performance in large Azure contracts the year prior.

The productivity and business process segment revenue should grow between 11 percent and 13 percent next quarter ignoring foreign exchange—$16.9 billion to $17.2 billion. Office 365 revenue growth will decrease sequentially by a point.

Microsoft’s on-premises business should see revenue decline around 25 percent. Dynamics revenue growth should be in”the low to midteens” thanks to Dynamics 365, which is more than 80 percent of that business.

The intelligent cloud segment should grow between 17 percent and 19 percent—$21.7 billion to $22 billion. Azure will drive this segment’s revenue.

Hood expects Microsoft 365 suite momentum to “continue to benefit” the Azure per-user business, but with moderation in growth rate due to the size of the install base, she said.

Next quarter, she expects Azure growth to decelerate 4 to 5 points from the 38 percent growth Azure saw in the second fiscal quarter.

Microsoft expects on-premises server business revenue down in the “low single digits” due to foreign exchange rates.

Enterprise services revenue should drop by the “low to mid single digits,” driven by Microsoft consulting services.

The “more personal computing” segment revenue should bring in $11.9 billion to $12.3 billion. Windows OEM revenue should drop by “mid to high 30s,” similar to the overall PC market. Device revenue should decline around 45 percent.

“We expect Q3 PC units to be similar to pre-pandemic levels,” she said.

In the second half of the fiscal year, Microsoft expects a deceleration in business revenue growth, with full-year operating margins dropping by 2 points in U.S. dollars, “even with the headwinds from materially lower OEM revenue and higher energy cost,” Hood said. Microsoft expects to pay $500 million in energy costs for the year, actually lower than the previous estimate of $800 million.

“In the first half of the year, over 70 percent of our revenue came from our commercial business and over 70 percent of that from Microsoft Cloud,” she said. “We have a resilient foundation and durable growth markets where we are gaining share. I’m confident in the ability of our Microsoft team to manage the near term by continuing to position ourselves for the future.”