Welcome to the Second Quarter Fiscal Year 2015 Microsoft Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to Chris Suh, General Manager of Investor Relations. Chris, please proceed.

Thank you. Good afternoon and thank you for joining us today. On the call with me today are Satya Nadella, Chief Executive Officer; Amy Hood, Chief Financial Officer; Frank Brod, Chief Accounting Officer; and John Seethoff, Deputy General Counsel. On our website, microsoft.com/investor, we have posted our press release and a slide deck to provide a summary of our results of the quarter. Unless otherwise specified, all growth comparisons we make on the call today relate to the corresponding period of last year. Additionally any mention of operating expense refers to segment operating expenses as defined in the footnote of our 10-Q and includes research and development, sales and marketing and general and administrative, but excludes integration and restructuring charges. We’ll post the prepared remarks to our website immediately following the call until the complete transcript is available. Today’s call is being webcast live and recorded. If you ask a question, it will be included in our live transmission, in the transcript and in any future use of the recording. You can replay the call and view the transcript on the Microsoft Investor Relations website until January 26, 2016. During this call, we will be making forward-looking statements which are predictions, projections or other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ, because of factors discussed in today’s earnings press release, in the comments made during this conference call and in the Risk Factor section of our Form 10-K, Form 10-Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. And with that, I’ll turn the call over to Satya.

Thank you, Chris. Good afternoon everyone. Today I'll focus my topline thoughts on our progress this quarter and the progress we're making in transforming our business. This quarter we reached $26.5 billion in revenue, with an operating income of $7.8 billion. This quarter's results show the product and business transformation underway at Microsoft. We saw success in a number of our strategic areas including cloud adoption, redefining and revitalizing the Windows Ecosystem and improving economics in our hardware portfolio. We also saw some challenges this quarter. As expected, the one-time benefit of Windows XP end-of-life PC refresh cycle has now tailed off. Additionally, we ran into unexpected issues in select geographies. Where there are execution issues, we will address them. Where there are macroeconomic challenges, we will weather them. With that in mind, I'll walk you through the quarter. Let's start with our Cloud business, an area where we're extending our leadership position and accelerating our innovation. In commercial cloud, we saw continued customer and revenue growth across a growing footprint of cloud services, Office 365, Azure, Enterprise Mobility Suite and Dynamic CRM Online. In fact this quarter is the sixth consecutive quarter of triple digit revenue growth in commercial cloud and we're now at a run rate of $5.5 billion. Azure services continue to grow in appeal to enterprise IT and developers with rapid improvements across hybrid services, premium cloud storage and virtual machine offerings, enhanced data and data analytics offerings. Microsoft Enterprise Mobility Suite is one key area of product innovation that I would like to highlight given the growth and the uniqueness of this offering. Microsoft offers a comprehensive solution for all devices that brings together mobile device management, mobile application management, hybrid identity management and data protection into one unified offering through EMS. Office 365 now…

Thanks, and good afternoon, everyone. As Satya shared in Q2 we again made solid progress on our business transformation. We had strong growth in our cloud and subscription businesses, our annuity renewals were healthy as customers remained committed to our enterprise portfolio and our hardware products performed well during the holiday season. As we expected our year-over-year growth rates were impacted by the prior year benefits that we realized in our OEMs and office transactional businesses following the Windows XP end of support refresh cycle. Beyond that, our results in China and Japan fell short of our expectations. In Japan, the PC market lagged due to the macroeconomic environment along with the combined impact of XP end of support and the VAT increase last year. Our Office attach rate to PCs is very high there, so the weak PC market also impacted Office revenue. With that said, let me take you through the financial highlights of our second quarter. Revenue was $26.5 billion up 8% and would have been one point better without the impact of foreign exchange. Gross margin grew slightly this quarter even when comparing against a year ago that benefited from the XP Refresh cycle. Our commitment to ongoing execution improvement and thoughtful folio management helped improve the gross margin percentage in each of our operating segments. Operating income declined 2% which included $243 million of integration and restructuring expenses. Excluding that, operating income grew 1%. Our reported GAAP earnings per share was $0.71, which included $0.02 negative impact from integration and restructuring expense and $0.04 income tax charge for an IRS audit adjustment. Foreign exchange had $0.01 negative impact on EPS. As we discussed last quarter, FX movement first impact of bookings growth and unearned revenue on our balance sheet are contracted but not billed balance…

Thanks Amy. With that, we will now move to the Q&A. Operator, can you please repeat your instructions?

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question comes from the line of Mark Moerdler with Bernstein. Please proceed with your questions.

Thank you very much. I appreciate. Amy, can you give us a bit more details on what's driving the increase in cloud margins within the commercial other segment as well as any sense for how accretive the cloud is becoming? And then I have a follow-up question.

Sure, why don’t I talk a little bit about that from a math perspective and I'll let Satya add from some more engineering improvements, which I think are important. Mark, as I talked a bit about, we've seen a mix shift as we have moved Office 365 and Azure to our premium service and to premium SKUs within our cloud environment, that is one of the drivers that helps improve margin growth. In addition, we've done a lot of hard engineering work I believe over the past six quarters to be able to take advantage of more utilization and capacity over time and I'll let Satya maybe add a little bit technically.

Overall, the shift to the higher layer services is the real driver here, which is obviously Office 365 and its various levels is one factor. The other one is what I talked about in the Enterprise Mobility Suite, that's really got fantastic momentum in the marketplace because the solution has really come together and is fairly unique, as well as Dynamic CRM. So these are all got a different profile in terms of margin and they are all now pretty high growth businesses for us. So when you think about our cloud, you got to think about the low-level infrastructure. Even there we now have premium offerings and then we have higher level services. So that aggregate portfolio is what helps us move up the margin curve.

Excellent and one quick follow-up, how should we think about monetization Satya for the Windows devices sub 9 inch?

One of the comments I had made in my remarks was some momentum we're seeing in our consumer cloud services. So for example, the store monetization, Bing monetization, Xbox Live monetization as Xbox Live monetization as Xbox Live now in fact is going to span devices are all things that drive monetization for below 9 inches. So I think of device gross margin in some cases because we are building devices like the phones as well as this post sale monetization using our consumer cloud services as the two additional levers that we have in order to be able to monetize Windows devices.

Excellent, thank you, I appreciate Mark.

We'll move to the next question please.

Our next question comes from the line of Brent Thill with UBS. Please proceed.

Thanks. Amy, just on the XP tail-off, are there other commercial products that you're seeing being impacted? I just wanted be clear there are a lot of questions that is there some type of Halo impact from the XP taking drop down on the other solutions?

Sure Brent, thanks for the question. I think it's the exact product portfolio that we talked about last year when the impact was happening, so let me take this opportunity to sort of walk you through those components again. Obviously there's a very direct impact, which we've talked the most about in terms of Windows Pro and its mix would attach to business PCs. The other important component of that was when people bought a PC as we talked through the year, they often took the chance whether generally in the business segment which impacts in our world commercial licensing as a reporting unit to buy Office and generally on a non-annuity basis. So if you think about that being the next major transactional type purchase that was driven a year ago as the first externality, the second was in Windows [DL] [ph] we also saw non-annuity purchases in Windows DL which again is in our commercial licensing segment. So if you think about it from a product portfolio, it really is Windows and Office. If you think about it from our reporting segments it's the D&C licensing segment as well as our commercial licensing segment and specifically our transactional revenue growth year-over-year.

Okay. And just a quick follow-up, just on the reduction in operating expenses for the full year, is this across the Board Amy? Is there a particular area that you're finding more opportunity to cut?

Brent, thanks again. I actually think of it as a general concept. I think really we're trying to invest behind opportunities where we see them. Some of those are more public as we talk about in terms of our sales and marketing adjustments or Ad campaigns that we run by the commercial cloud. Others I think you don't have the opportunity to see until we launch products like we did last week where we were able to reassert our product portfolio and really move our talent to invest in, I guess mind blowing is the word Satya used, in terms of product portfolio in that way. So I'm not sure that all of it Brent I would say is across a line in that way. They're short-term optimizations and longer-term portfolio optimizations that I think we've talked about this before. I think the entire Senior Leadership Team views it as an opportunity to think about where we can best innovate and drive the highest value of every dollar that we invest and I think we've made great progress as a team and I think you're seeing that both in the long-term guidance and in frankly our day-to-day execution through the quarter.

Thank you.

And I will just add that we're also making pretty significant changes in just the very workflow of our engineering teams and that also leads to us getting more out of our current investments. So there is significant I would say combination of culture change as well as how we work change that drives more innovation for the same dollar.

Thank you.

Thank you, Brent. We will move to the next question please.

Thank you. Our next question comes from the line of Walter Pritchard with Citigroup. Please proceed.

Hi thanks. Two questions, just one on execution it sounds like you highlighted some issues in Japan and we've heard about VAT from companies. Can you just talk about what you're doing to address some of those issues and is there any concern that that might spread beyond what you've seen in Japan and China?

Thanks Walter. Is that both your questions, I just want to make sure I get them?

No, I'm just trying to understand generally that issue, I had one other, but it's just on…

I'll just start by just talking about China. We have in China currently a set of geopolitical issues that we are working through. We're very committed to China as a market. We have in fact pockets of good growth in China with our cloud doing fairly well, but at the same time we're grounded that in the fact that we need more work to do and we're working through them and then as and when they will work out, we will let you know.

And I'll talk a little bit about Japan and Walter to answer your question, I don't have any concerns if that expands such that in this unique issue beyond Japan, with the Windows end of XP plus the VAT increase, I do think, as well as some of the macroeconomic environments, it tightened far faster than we had anticipated and Japan in particular because of its model for us, it is a non-annuity geography for us. So impacts in Japan more directly come to the P&L as opposed to on our under C&B balances and that's why this quarter, you saw some weakness in commercial licensing, but when adjusted for FX, our unearned balance and bookings actually felt quite good from our commercial perspective.

And then just question on the Office 365 commercial, can you talk about deployment rates. I know you've done a good job of getting those into contracts, how many customers are actually running it, running their email and share point and other products in the cloud versus just having the rights to it.

Thanks Walter. I think with all products, I think about the complete sales cycle and I am really encouraged by the fact that we're doing a good job of moving from the initial sales through deployment, through adding on services and back to renewals and I think the importance of that customer lifecycle is really how we think about our workloads and our workload health in the cloud. The workload that we're furthest along on is obviously exchange. It happens also come with directory implementation and so we generally think of a fast deployment also and then adding on workloads and premium workflow cycles. And then as you might imagine, that provides an interesting environment for us to add on some of the products actually that Satya mentioned very directly in his comments such as EMS or Enterprise Mobility Suite. So while I think there is always a lag, the actual goal is the commitment that the customers show to the movement to the cloud and then moving them quickly as we can, but also at their own pace through deployment.

Great. Thank you.

Thanks Walter.

We'll move to the next question please.

Thank you. Our next question comes from the line of Keith Weiss with Morgan Stanley. Please proceed.

Excellent. Thank you, guys for taking our question. I just wanted to dig into Windows OEM ASPs a little bit and just trying to sort of better understand the dynamic theme of what we see in the marketplace when we look at industry analysts that we're looking at basically sort of flat to slightly down unit growth and the down 13% OEM revenue growth that you guys are seeing. Some of this mix and some of this ASP, I was wondering if you could help us with a little bit more color in terms of exactly what that ASP dynamic is going on in terms of these lower entry level additions what's that doing to the overall ASP of what you're able to extract from the market?

Thanks Keith. I'll take the opportunity actually to do it for both Pro as well as non-Pro because I wasn’t sure which category you were talking about. Let me start at the highest level, which is if I work at industry analyst as well as many of our peers in the ecosystem, I actually think we agree with most of the benchmarks in terms of PC unit health across business, which has been stable since FY '13 and across consumer where we see meaningful progress made in unit growth both last quarter and especially this one. So then I'll take a second and talk about sort of the distinction between the revenue growth versus the unit growth. Let me start first in Pro. There they're really two key dynamics, the first is the return to the XP levels that we saw prior to the XP refresh. They're consistent, the dynamic mix in terms of emerging markets and developed as well as enterprise sizing is not an ASP problem in Pro. It is a return to the attach level we saw before. The component that actually has impacted -- the second component in Pro that is a quote unquote “ASP/mix comment” is the academic licenses that I referred to earlier where we did lower the price and saw an increased unit number. So that was a second component of the revenue piece, but the larger component was the XP reversion and again that's not an ASP comment. When you come to non-Pro, I think this really refers back to Satya's comments, which is we saw device growth in low price devices opening price points, we actually made I believe a strategic decision to increase our ability to put devices on the shelf, especially at retail at prices under $200 to $249 is how to think about the price points that were the most impacted. We do have the Windows with things skewed there. It is a lower RPL than our traditional non-Pro OEM licenses, but I do believe it drove meaningful ecosystem health and as well drove good competitive dynamics in the channel. And so overall while it did have an RPL impact, which does explain along with mix shift, the minus 13% in non-Pro OEM versus the PC license growth that we saw, I think really Satya covered the actual logic to that in terms of overall ecosystem health as we feel quite good about.

And if I could squeeze in one follow-up, have you guys done any assessment in terms of the set you're seeing in Surface Pro 3 definitely is a real productivity device. To what extent is that cannibalistic from what would have been Windows PC sales and to what extent do you think you're expanding the market opportunity with that device?

I think it's definitely expanding the market opportunity. One of the things that I feel very good about is the risk we took to introduce the two-in-one category and I feel now that we see that in fact inspire even a lot of activity in our own OEM ecosystem and we see many good designs coming because it's viewed as a category that drives growth. And so from that perspective I feel good about leading because that's one of our strategic goals, which is we want to create new categories, foster more demand for the entire ecosystem.

Excellent. Thank you very much guys.

Thank you.

We'll take the next question please operator.

Thank you. Our next question comes from the line of Rick Sherlund with Nomura. Please proceed.

Thanks for Satya, could you talk about the implications of Windows 10 for a moment? I am thinking in terms of the new platform for innovation and maybe you can talk about post-sale monetization. What do you think the impact is on demand in the industry and the opportunities for Microsoft around the new platform?

Thanks Rick for the question. As I said in my remarks, I am very optimistic about what Windows 10 means for our customers, partners and Microsoft. The core idea of Windows 10 is to build a device operating system that spans the gamut from no screens to small screens, to PCs and even large screens. In fact if you look at our innovation, we're perhaps unique in the large screen innovation that we're doing with Surface Hub, Hollow Lands as well as some of the two-in-one form factors. So overall I think the most strategic objective for us is to get developer momentum with Windows 10 and that's where we're focusing on with a lot of different actions. One is the one unified developer platform, which I think is perhaps the most strategic piece of Windows 10 along with the unified store. And now couple that with the call we've made to provide an upgrade offer. We're creating great opportunity for every developer to write these universal windows application that will run on the desktop as well as on our phone and tablets, as well as on Surface Hub and in fact Hollow Lands runs universal applications.` No one else provides that kind of a unified market place for developers and especially the changes we've made to the desktop user interface means these universal applications are in fact very naturally discoverable right where we have high usage, which is the desktop. So that's the combination of things that we think are going to play out effectively and of course we're in beta right now or previews right now and getting daily feedback across the length and breadth of Windows 10, but overall I am very optimistic of what it means, both as a platform as well as a set of end user features.

Thanks Rick. Operator, we'll take the next question please.

Thank you. Our next question comes from the line of Philip Winslow with Credit Suisse. Please proceed.

Thanks guys. Just got a question on the commercial other line, obviously that continues to show strong growth and have been climbing up in the cloud business whether it be Azure, Office 365, but I just wanted to double click on the Azure side. Wondering if you could help us parse through sort of the infrastructure server as in the platform as server side and the trends there and any sort of joint benefit I guess that you're seeing and being able to offer both as to and also such as this business does scale and then Amy. I would love you to chime in hereto, how do you think about the gross margin and just operating margin characteristics once again as the revenue just continues to grow here?

Thanks Phil. So let me start. Overall, what we're seeing is, clearly there is increased usage of infrastructure as a service because a lot of people will move an existing workload into the cloud. But the interesting thing that happens once you move your initial workload is you build around it. Especially for example, if you move a VM with some data into the cloud, you may want to use the same data to build a mobile front end and that’s when you're starting to use some of our platform as a service components like our Azure Mobile Services, Azure Media Services. So we see the combination and they're not all happening coincident, but there is time lag in it but therefore that’s one of the reasons why we want to be very aggressive in getting the workloads on to Azure both storage and compute; and even in the storage and compute, we now have premium offerings for higher SLA, for higher performance, higher VM sizes and then on top of that, we have these managed services which have a different margin profile. So media services, mobile services, WAB which is another place where we actually have lot of traction. And then that’s all just on Azure. Once you get beyond Azure, you have things like CRM Online, you have enterprise mobility suite and of course the Office 365 line up and when we think about our capital and in fact the core infrastructure, we don’t have different infrastructure for these different services. It’s one common infrastructure and one common data center footprint between O365 Azure, CRM, Xbox Live everything. So that’s why utilization of that entire infrastructure is how we think about even total return on invested capital for our cloud business.

Great.

Thanks Phil. We'll move to the next question please.

Thank you. Our next question comes from the line of Heather Bellini with Goldman Sachs. Please proceed.

Great. Thank you for taking my question. I just wanted to follow up Amy, your commercial other business continues to have fantastic growth and I am just wondering when you juxtaposed that with the growth in the commercial licensing business, I heard you in terms of the headwinds that you faced. But when we think about it more than one quarter out and think about the revenue transition as you guys continue to build market share in the cloud, how do we think about the trends in the commercial licensing business in the next year or so?

Let me -- I think in general, let me start by saying all -- all up right. So in our commercial business, I think we’ve done a very good job of continuing to outpace IT spend on an overall basis by continuing to push customers to our annuity business whether they are on -- on premise or the cloud. That is our strategic goal as well as impacts in both segments. Now let me talk about sort of uniquely commercial licensing and how to think about it. While I won’t give specific guidance, I will talk about how to think about the impact in particular from XP. Our transactional revenue will have a headwind from XP. That doesn’t and shouldn’t be interpreted as customers not continuing to be committed or not committing to move to annuity over the longer term, which is exactly I think the question that you're asking. And so while we have a comparability issue that will show itself most directly as weakness in commercial licensing and most specifically as weakness in Office transactional licensing which will be a headwind, the overall goal of continuing to have more customers every quarter move to the cloud or whether or not they move, adding cloud services even if they have on prem because they believe in a hybrid model, is actually the structural guide post we have on a multi-year -- on a multi-year journey.

Thanks Heather. Operator, we'll move to the next question please.

Thank you. Our next question comes from the line of Raimo Lenschow with Barclays. Please proceed.

Okay. Thanks for taking my question. Two quick questions. Satya, I wanted to follow up on Phil Winslow’s question earlier on the -- on Azure and the used cases there. In theory you have a huge opportunity given your install base on the server side. Can you talk a little bit about what -- what you're seeing the SMB customer base doing. Are we kind of in it? People trying bursting or where is that huge customer base in terms of adoption on Azure?

On Azure itself, one of the other elements that I did not actually talk about in response to Phil’s question is the hybrid offering. One of the products that's doing very, very well for us is the store simple product, which is essentially a storage product that cloud Tiers virtualization storage from on-premise to the cloud. We also have built now into windows server backup and disaster recovery, same thing with SQL server. So that's the first thing that we're seeing is increased usage of our servers with the cloud component. Bursting is something for sure a lot of people do but that’s more on the high end because in the SMB segment, the real movement there is more to Office 365. In fact, one of the things in Office 365 is we're getting people to effectively use servers, which now happens to be in cloud who never bought servers from us ever before because they didn’t have exchange, they didn’t have link, they didn’t have any of the core capabilities of Office 365. So those are the two trends we're seeing.

Perfect, and a quick follow-up for Amy, if you look at the changes on the operating side that you talked about, it obviously seems to -- as a cultural shift. What’s more, if you budget, it’s more dynamic budgeting it's very much a return base culture that you seem to be introducing here. But it’s something that kind of needs to be feed through the organization and it’s more a cultural change. Where are you in terms of like innings in terms of having it fully through the organization?

Thanks for that question. I think we've talked about this in prior quarters while I think many people want to see it as a finance concept, it’s not. It’s a senior leadership team concept and the leadership environment that I think we're making collective decisions faster. I think we are applying our resources to opportunities when we see them. I think we have a freedom to make those choices quickly and I feel very good those about the decisiveness that comes with it, but also the empowerment that we give to people within our organizations to make those calls, to increase our performance without waiting to an annual budget process. I think some people call it dynamic budgeting. I think for us, I think it’s more about -- thinking about opportunities we have and stack ranking those every day to improve both our execution and our returns.

Thank you.

Thanks. We'll move to the next question please.

Thank you. Our next question comes from the line of Brendan Barnicle with Pacific Crest Securities. Please proceed.

Thanks so much. Amy, when we first started talking about Office 365, I think at that time, you were suggesting that the move from an Office CAL to an Office 365 license would increase gross profit by about 50%. Now that you had a couple of quarters with Office 365, do you think those changes to the model still make sense and more importantly, are there may be other changes that you're seeing that are more accurate?

Thanks for the question. In general, I think we're still on the early ends of seeing the opportunity that we have in that segment. As you pointed out, there is a couple components that make gross profit dollars per seat or the life time value of a customer depending on the terms you want to use improve and increase over the life cycle. The very first thing and I think Satya even mentioned it in its most direct in SMB is moving from buying a copy of Office, which was a very static concept to the idea where you could buy Office and frankly get all the benefits that those who used to deploy servers used to get only with IT departments of their own. So as you move Office, it’s simply the first step. So, even though obviously it comes at a little lower gross margin percentage, our ability to add workloads, add premium services and to increase our overall footprint inside a customer is really where the life time value goes up. And frankly over time and watching, I think both the creativity and the pace of innovation we’ve seen coming out of our engineering teams particularly in Azure and Office 365 and our CRM team online, I actually even have more confidence in our ability to attach and grow that gross profit over time. We mentioned simply one that didn’t exist I think Brendan when we first started having this conversation, which was our EMS suite and I look and say, those opportunities as well as the creativity of our people I think gives me more confidence if not less in the structural integrity of the lifetime value of a customer argument.

Great. Thank you so much.

Thanks. Operator, we will have time for one last question please.

Thank you. And our last question comes from the line of Ed Maguire with CLSA. Please proceed.

Yes. Thank you. Over the last several quarters and particularly Satya, you’ve opened up a number of the products to different platforms, Office in Android and with Minecraft and Skype, you've got a number of really multiplatform products and services. Could you quantify so far to what extent you’ve seen benefit and as this plays into the free upgrade for Windows 10 at least for a limited period, how you expect this to play out benefitting the business case of your products across the portfolio?

Yeah so overall at the highest level, our strategy here is to make sure that the Microsoft Services i.e. cloud services be it Azure, Office 365, CRM Online or Enterprise Mobility suite are covering all the devices out there in the marketplace. So that, that way we maximize the opportunity we have for each of these subscription and capacity based services. So that’s the core rational for why we are doing cross platform. Now the next question is what’s the uniqueness of Windows? And the uniqueness of Windows comes because we don’t think of these services and their application end points as apps, but fundamentally core to the Windows experience. So we are building them natively into windows. So for example, when you log into Windows, you are logging in with Microsoft account or Azure ID. When you have files, they are synching with one drive. Outlook is the email client for Windows. So that’s how Windows will differentiate and not to mention, our Gaming and Xbox Live experiences. So overall, we will build a differentiated Windows because our application experiences for our cloud end points will be native in windows and at the same time, we will make sure that our services are available on all end points driving more usage, more subscription growth. So the best way to measure our progress is Office 365 subscription growth, Azure growth and EMS growth.

Great. Thank you.

Great. Thanks. That wraps up the Q&A portion of today’s earning call. We look forward to seeing many of you in the coming months at various investor conferences. For those unable to attend in person, these events will generally be webcast and you can follow our comments at microsoft.com/investor. Please contact us if you need any additional detail and thank you for joining us today.

Thank you.

Thank you.

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.