Welcome to Microsoft's Third Quarter Fiscal Year 2016 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would 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 and Corporate Secretary. On our website, microsoft.com/investor, you could find our earnings press release and financial summary slide deck, which is intended to supplement our prepared remarks during today's call and provide the reconciliation of differences between GAAP and non-GAAP financial measures. Unless otherwise specified, we will refer to non-GAAP metrics on the call. The non-GAAP measures exclude the net impact from revenue deferrals and the impact of integration and restructuring charges. 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. They are included as additional clarifying items to aid investors in further understanding the company's third quarter performance in addition to the impact that these items and events had on the financial results. All growth comparisons we make on the call relate to the corresponding period of last year, unless otherwise noted. We also provide growth rates in constant currency when available as a framework for assessing how our underlying businesses performed, excluding the effect of foreign currency rate fluctuations. At the segment level, we provide constant currency growth for both revenue and gross margin. However, due to recent change to our external reporting segments, we aren't able to provide segment-level constant currency operating expense growth and consequently, cannot derive constant currency segment operating income either. We do provide constant currency operating expense and operating income growth at the company-wide level. Please note that in the third quarter of fiscal 2016, we adopted a new standard issued by the FASB that made certain…

Thank you, Chris, and thanks to everyone on the phone for joining. Overall, we had a solid quarter. Amy and I look forward to sharing more about the results and what's ahead. We delivered $22.1 billion in revenue, with an operating income of $6.8 billion. We exceeded $10 billion in commercial cloud annualized revenue run rate. We are halfway to our FY '18 goal of $20 billion. This quarter, we surpassed 270 million monthly active devices running Windows 10. We're proud of our progress and look forward to making more as enterprise deployments accelerate. Now let's get to the specifics of each of our 3 segments, starting with Productivity and Business Process. We set out to reinvent Productivity and Business Process because we believe that people should get more out of every moment, and organizations should be able to reach new levels of effectiveness. This approach is opening up new growth opportunity for Microsoft in 3 ways: We can reach more users, enter new markets and build a developer platform. Let me talk through each. First, we are reaching new users and strengthening our productivity platform. Consumer subscriptions of Office grew to more than 22 million. Devices with our mobile apps grew approximately 4x year-over-year. Commercial Office 365 customers surpassed 70 million monthly active users and we grew seats by 57%. Second, we are expanding into new markets such as security, analytics and cloud voice where we see an opportunity and where we can differentiate. For example, the cybersecurity market is expanding rapidly and it's a place where we have unique capabilities like Advanced Threat Protection, cloud app security and advanced e-discovery. This combination drove a 35% quarter-over-quarter growth of monthly active users of our premium information protection services in Office 365. A key driver of this growth is our…

Thank you, Satya, and good afternoon, everyone. This quarter, revenue was $22.1 billion, up 2% and up 5% in constant currency. Gross margin declined slightly, but was up 4% in constant currency. We grew operating income this quarter by 1% and 10% in constant currency, and earnings per share was $0.62, flat year-over-year and up 10% in constant currency. Our effective tax rate was 24%, higher than we anticipated, which impacted our EPS. From a geographic perspective, our performance in most markets was as anticipated. However, Latin America, the Middle East and Africa were more unfavorable than we expected. In our commercial business, we continued to see healthy fundamentals, which led to a solid quarter of results. Commercial bookings increased 7%, up 9% in constant currency. Our total commercial annuity business had double-digit revenue growth in constant currency, and commercial annuity mix reached 86%, up 4 points year-over-year. Commercial unearned revenue grew to just under $18.8 billion, up 3% and 8% in constant currency, slightly below expectations due to a higher mix of contracts with more in-period recognition and some deal weakness in the geographic markets mentioned earlier. Our contracted not billed balance again exceeded $25 billion. Most important, as Satya mentioned earlier, our commercial cloud annualized revenue run rate surpassed $10 billion. This quarter, more than 65% of customers who signed enterprise agreements attached our commercial cloud offers, up 15 points from last year. Our customers continue to make long-term commitments based on our compelling road map. Our commercial cloud gross margin was 45% this quarter, declining year-over-year. This decrease was driven by a higher mix of Azure revenue, our ongoing investment in data center capacity and geographic expansion and the small FX headwind. As I mentioned last quarter, even as we are focused on gross margin improvement within…

Thanks, Amy. We'll now move to Q&A. Operator, can you please repeat your instructions?

[Operator Instructions] Our first question comes from the line of Brent Thill with UBS.

Amy, just on the Q4 guide. You're guiding below the Street on many of the individual line items on the top line. I'm just curious, is this more of a shift to the cloud? Or is there some demand execution issues that you're seeing in the business?

Thanks, Brent. It's really, as we talked about, transactional weakness in Productivity and Business Process. We're continuing to expect strong annuity growth. We're continuing to expect a strong mix of the cloud. We're continuing to expect ARPU increases, premium mix increases and installed-base growth. So really in that segment, it's the PC weakness in our traditional transactional Office business that's impacting that segment. In Intelligent Cloud, it's a very similar dynamic. We're expecting renewal rates to remain strong as they've been. We're expecting the mix to Azure to continue to grow. We're expecting annuity double-digit revenue growth. And again, it's the transactional weakness that you're seeing overall as well as some -- the very specific geo weakness we saw, which I called out earlier. And in More Personal Computing, the largest change in that segment is frankly the phone. So I would really focus on that in that segment. The rest of it frankly is quite good.

Our next question comes from the line of Philip Winslow with Credit Suisse.

I just want to focus in on Office here. Obviously, you called out Office 365 commercial seats growing 57% year-over-year, so very consistent with what last quarter was. And Satya, you mentioned the mix shift as well with the release of E5. Wondering if you could just provide some color there, sort of, I guess, a grade of kind of where you are right now, and then as you're contemplating your guidance for Q4 and then kind of thinking about 2017, how should we figure how are you guys thinking about sort of that Office 365 transition there, sort of units and pricing?

I can start, and then Amy, you can add. Overall, the thing that we are most focused on with Office 365 is how do we make sure that we have the Office 365 endpoints everywhere and good usage. And I talked about how the mobile endpoints has been growing and the mobile usage has been growing. I also talked about the 70 million monthly active users of Office. So we feel very good about that, which is users both in terms of coverage and usage. The next place where we are very focused on is really the new scenarios. And E5 is obviously a big element of it. I talked about it in some detail. The security value proposition, that is really showing a lot of good traction for us, but we're also seeing traction in analytics and voice. So we're in the very early innings of E5, but the value proposition and the TAM or the total addressable market of those 3 scenarios is huge, and so we remain very excited about it. The other thing that I'm also sort of excited about when it comes to Office 365 is for the first time, we're opening up Office 365 not just as a end user and a enterprise tool in the service but as a developer platform. In its own right, we think of Office as perhaps one of the most strategic developer assets we have. And with the Microsoft Graph API and what we see as activity around it, we think about the platform effects of that is also being very key. So that's, at least at the macro level, how I look at it and Amy, if you want to talk a little more about...

Yes, and I think the way that shows itself in our financial results is you'd expect to continue to see the strong mix shift to the cloud. You'd expect to continue to see installed base growth. As even some of the items Satya talked about have more relevance and continue to make us, the value prop higher even in small business, which is where you've seen the user adds. I would continue to expect to see ARPU growth as we see E5 have its impact through the year. And so think about these same dynamics fill for us where we focus on new users and ARPU increases as we shift to Office 365. Those are trends I'd expect to see obviously as we look into '17.

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

So if you look at Productivity and Process and Intelligent Cloud, obviously, we're having a margin decrease that's occurring and a good chunk of that is cloud. How should we think about the standalone license business in terms of the margin separated from the cloud side of it?

The standalone margins on the licensing business have been pretty stable just because transactionally, we understand and continue to bring down the fixed cost base there and any that's required. So I don't feel like you'd expect any material change in those, Mark.

Our next question comes from the line of Heather Bellini with Goldman Sachs.

Satya, I wanted to see if you could share a little bit on Azure, just how you're thinking about the competitive positioning versus Amazon, where you think your strengths are versus them. And also as the business continues to ramp at such a fast pace, how do we think about the progression in gross margins? I mean, Amazon gives us operating margins, but I guess, I'm wondering, is there a reason you shouldn't be able to reach similar operating margins with Azure at a similar scale if we went back and looked at the progression that Amazon's been disclosing?

Sure, Heather. Thanks for the question. First of all, when Amy and I think about both our CapEx as well as our OpEx, both on the engineering side as well as on our sales and marketing side, we think about they're still at Microsoft Cloud level, just because if you take something like Enterprise Mobility Suite, that gives you an indication of how, for example, that attach to Office 365, essentially an infrastructure service that has SaaS-like margins or even some of our application services in Azure that attach to Office developer experiences. So we think about this more holistically and same thing with Dynamics. But having said that is to your specific question of where our differentiation lies. The first one is hybrid. Most people think about hybrid where they think about the cloud as the edge of their server. We obviously support that with all of our service. Every server product of ours has cloud enrollment right, whether it be SQL, whether it be Windows Server, and you will see that increasingly even in this next wave of servers. But we also think of, in fact, our servers at the edge of our cloud. That I think is where the world is going to go to, where distributed computing will remain distributed. So Azure Stack is completely unique to Microsoft. No one else who is in the public cloud business at any scale has that kind of capability. So I would say that's another point of differentiation. So to your point about margins, I feel that we actually will have software licenses with hybrid rights. That's a different margin structure. We will have IaaS services, and you talked about the existence proof at least from Amazon about what margins at scale can be achieved there. We have PaaS services in infrastructure like EMS that have SaaS-like rev margins. And then, of course, we have SaaS services in Office 365. So I think the mix of our growth -- rather, that mix will define our long-term gross margin and operating margin for our cloud services. But the mix will also shift each quarter just because the mix is not a stable mix. We'll see growth in different parts at different times.

Our next question comes from the line of Keith Weiss with Morgan Stanley.

Amy, when you're talking about the transactional declines, particularly [indiscernible] and the server portion of that, can you help us understand how much of that is due to maybe more macro factors, weaker overall server spending environment? And how much of that comes from perhaps demand being reallocated towards Infrastructure as a Service offerings that you guys have in Azure? Is there something like a cannibalization taking place within that transactional business today?

Keith, it's a good question. Let me go through a number of factors that really impact transactional business. First, you're right. There's clearly a macro impact, especially on the transactional business. Transactional businesses tend to be more impacted in emerging markets where we have a higher percentage of non-annuity business, transactional business. Those have been the weakest markets in this macro environment. And specifically, some of the geos we called out have more exposure in this place. And so you're certainly seeing the macro impact in the Intelligent Cloud segment and the server weakness is there. And because frankly, we saw that macro weakness, you've even seen it in terms of server shipments, right? If you look at server shipments, you'd say that's actually a macro statement. We didn't see it in any one particular workload. It's weakness across workloads, which tends to make more sense frankly with a macro or a budget IT spend constraint. And so I actually think between those 2 items, it's the biggest impact that we've seen in the quarter. And I expect to see it again next quarter, given I don't think the macro or IT spend environment should change in any way between these 2 quarters. So I think less about it being cannibalistic because so many of the scenarios in this time period we've seen the growth we expected. We've seen it across our premium services as well as core compute. I should also say most of the weakness we saw was in the standard workloads, which I think lends itself to again some of those pressures. We also saw, and I would expect, annuity shifts there, which is the final component. Our annuity numbers and renewal numbers were very good in Intelligent Cloud. And in fact, they came right where we expected in terms of unearned balances. And so for me, I do tend to think it's a bit more of the macro pressure and budget impacts than it is frankly any other statement or execution.

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

Amy, this one's for you. I wouldn't mind asking about the gross margin guidance. If I take the midpoint of your revenue guidance, midpoint of your COGS guidance, it looks like you're guiding to another roughly 200 basis point decline in gross margins in the June quarter, which is about what you did in March. So if we look out to fiscal '17, I know you touched on it a little bit, but just to be clear, it feels like you're guiding to a further year-over-year decline in gross margins, but sounds like that'll be offset in part by continued good OpEx control. So is that the right way to think about it? And is there any way that you could sort of bracket what the gross margin percentage decline might be in fiscal '17? You probably don't want to give specific guidance, but maybe some high-level color.

Directional -- Karl, thanks for the question. And you're right. In general, let me spend a few seconds on that. You're right. We saw about 200 basis point change this quarter. It's entirely due to the shift to the cloud, both in our Productivity and Business Process segment as well as the Intelligent Cloud segment. Those are the exact same drivers in the gross margin change that we guided to in Q4. And I would expect stability as we've seen it in our More Personal Computing segment. And so as you think about '17, with the continued acceleration of our cloud mix and actually continued momentum in annuity, I would expect to see those same pressures continue to exist. And you're right in that our strong operating expense focus, because really this is the quarter when you've been able to see actually in Q2 and Q3 now, us really pivoting that investment in OpEx to our Intelligent Cloud and the opportunity we see there across engineering sales and marketing. And you're right, we do expect to see and continue to do that as we lead into '17 within the overall envelope I discussed.

Our next question comes from the line of Walter Pritchard with Citi.

Amy, my question just on guidance and your posture on guidance, a 2-part question. I think we've seen you give very conservative guidance, say for the first half of this year. And in Q3, you ended up sort of, put it all together, at the lower end of your guidance. And I'm wondering, your posture just generally around guidance, if it's changed at all that you're factoring things differently and we should think about that range going forward, should it be more like it's been in the past where you've had very conservative assumptions or more like what you just did here? And then the second part is if you look forward maybe towards longer-term guidance and the prospects of giving longer-term guidance because I don't think I've seen an estimate spread on a company as large as this in a long time, how are you thinking about possibly giving long-term guidance? What are the factors that are influencing your comfort in doing that? Or is it more philosophical and it's something you're just -- you're not going to do that's not necessarily dependent on your view of the business?

Thanks, Walter. My philosophical position doesn't change much. I give the guidance that I expect for the quarter, and I do it on the earnings call to the best of my ability. What you've seen this quarter is, in fact, the biggest in-quarter delta for us all the time is the non-annuity performance. And in our -- all of our segments, that is transactional business. That is the most impacted in quarter by budget changes or macro changes. And so the inherent volatility that you are talking about really is about changes in in-quarter that we see and the impact of that. So I don't think it's a philosophical shift. It's just where you see volatility in quarter has always been in the transactional side of our business. The guidance we gave and our annuity positions in terms of renewals and where we saw them were exactly frankly what we expected, with the small exception of the geos that I called out. So I tend to think -- I'll talk a little bit about '17 as I always do, come July, give you all more of a shape to that. But I tend to think -- I'd like to focus on where the company is going, which is cloud mix shift, annuity growth and overall world view of bringing Windows and the ecosystem grow through MPC.

Our next question comes from the line of Ross MacMillan with RBC Capital.

Amy, I just wanted to go back on the Intelligent Cloud. We did see that deceleration in server product growth. But the comp was very tough and as you commented, your annuity was up and your deferred growth accelerated. That server product line has grown about 5% constant currency in the last 12 months. I guess the question is, is there any structural reason why, going back to Keith's question, why that would decelerate more ex macro? And then another question I just had is related to this. Can you just remind us, in the server product ex Azure line and in the commercial Office traditional non-365 line, how much is transactional in those 2 segments?

Sure, Ross. Let me try to take those -- the first question around, is there anything structural or different in that server product line? Really it has been and is that transactional component. You're right, we continue to see the annuity growth. We continue to see the growth through Azure and the offset to that has been the transactional business. I'm not sure that I would say that there's any structural reason other than this change in my world view other than maybe the budget in macro pressure tends to exert itself on that transactional business. But overall, continuing to see the renewals we've seen, continuing to see the cloud growth we've seen, I'm not sure I think of it as a fundamental trajectory change outside of that component we discussed. In terms of overall rough orders of magnitude, the Intelligent Cloud segment has the least exposure to the transactional business. It's still less than 20%. But that 20%, right, lends itself in quarter to the volatility you see. The Productivity and Business Process segment has a bit more transactional exposure just because it has both the consumer and the commercial Office business, which is more attached on a transactional basis to PC. So it's slightly higher all up.

Our next question comes from the line of Kash Rangan with Bank of America Merrill Lynch.

A question for Amy. Amy, you've been able to grow your op income on constant-currency basis nicely double digits as you've been investing in the cloud. As you look at the results this quarter and as you pointed out the op margins in Intelligent Cloud and business process productivity were impacted due to the shift to the cloud. Do you think that as you look into next year, that the cloud business is at scale that it continues to grow and take share relative to overall revenue? The transaction business, who knows? It could be a bit of a macro pressure. Do you think we're at a point where we could continue to entertain a scenario that op income could still continue to grow nicely as it has in the last 3, 4 quarters? Or is there some other structural change with respect to the margin of the cloud business or maybe the transaction business drops off a lot more dramatically that it may be hard to sustain this nice double-digit op income at a very high level without going into the details?

Yes, at a very high level, Kash, let me talk about the opportunity. The opportunity for us across what the cloud mix that's possible for our commercial business and this moment in time that I'm a believer in of where companies are going to change their businesses to rely more deeply on technology than they ever have. I believe that our setup for that is the investments we've been making for the past couple of years as well as the investments we're going to make for the next couple. I mean that both in the capital concept but also in my operating expense line. We've managed to do that by continuing to pivot to what I believe are these very high ROI opportunities and pivoting away from opportunities where we've had a chance to become more efficient and where the returns are not going to be as high or the structural growth isn't there. And so for me, to your point, at a high level, I think we can continue to drive revenue, especially annuity and cloud revenue. I think we can continue to improve gross margin percentages in the cloud across all the core cloud services. I think that we can grow profit dollars. And I think that we can do that in the OpEx guidance I gave you for '17 as we continue to pivot to that opportunity. So I think this is one where my optimism frankly for the structure of the market in the segment you chose and my optimism for positioning within that market is reflected in that investment number that you have seen. And so I would continue to expect to see us do it.

It's good to see that you still expect profit to grow because this seems like the new Microsoft where you're balancing the need to invest strategically, but the same time, trying to grow profits in the near term versus the old Microsoft where the investments were made but with more of a "longer term" you never knew when the payoff was going to happen. So it's good to see emphasize that you're still focused on profit growth, notwithstanding the mix of factors that you cannot forecast.

Our next question comes from the line of Mark Murphy with JPMorgan.

Satya, regarding the announcement that you will release your SQL Server database on the Linux platform, I was wondering if you can walk us through your decision tree just in terms of what you think the potential risks are and what you think the potential rewards are of reaching for that level of openness, if you will. And just how impactful do you think that, that product can be in enhancing Microsoft's share of the database market?

Thanks for the question. So the decision logic was driven primarily by what I'd say the increased competitiveness of SQL Server. If you think about where SQL Server now with this new release, SQL Server 2016, it's become a fantastic database for many, many of the workloads, everything from OLTP to data warehousing to BI to advanced analytics. For the Tier 1, this is a capability that's been multiple decades in the work, but here we are with very competitive total cost of ownership, price competitiveness but with a technology that is, in many cases, as Gartner talks about, at the top of the charts when it comes to all of these workloads. So now that we find yourselves with that capability, we're saying, "Look, what's the way to think about market -- all the markets that we can, in fact, take this product to." And the Linux operating system database market is not something that -- which is mostly primarily a Tier 1 segment, is something that we never worked in. And so, therefore, we look at that as an expansion opportunity so we take that. We've already made the call that Azure Linux's FirstClass. We already have 20-plus points of -- or 20-plus percent of VMs in Azure or Linux and we'll all increasingly have Linux via big share of percentage of what is happening in Azure. So for the first time now, we have the ability to go to an enterprise and talk about that entire data estate across Windows and Linux. People don't really move between operating systems. Those choices have been made. But at the same time, now they have a choice around database. And so we think that, that's a very good incremental opportunity for us.

And our last question will come from the line of Kirk Materne with Evercore ISI.

Satya, I wanted to talk a little bit about just the ISV ecosystem on top of Azure and where you think that is today and where you'd hope that potentially to be in 12 months when we think about the opportunity around sort of Platform as a Service and building out more enterprise apps. I think you made some comments around some IoT applications that are now sitting on Azure. What's sort of a good -- what should we be looking for in terms of new partners from survey ISV perspective? You've had companies like Blackbaud sort of replatform. I'm wondering, do you expect that sort of momentum to potentially accelerate as we get in further into the calendar year?

Yes, thanks for the question. I mean, I think, overall for me, across all of our product lines, whether it be Windows or whether it be Office 365 or Azure, developer momentum, ISV momentum, is super important priority for us, both in terms of our developer evangelism, our product engineering teams as well as everything that we will do to even create success for our partners through our field sales organization is a top-of-mind priority, and this is something that Kevin Turner, myself and Amy and all of our leadership team is very focused on. So you will only increasingly see us deliver more design wins there. In fact, I'm looking forward to our partner conference to talk much more about what it is that we will be doing in the coming year to drive more success for our partners, and in particular, ISVs. The thing that I'm seeing a lot of is we've had traditional strength with SQL as well as .NET. They're moving a significant number of them to the cloud, and in fact, re-platting to be even more multi-tenant and cloud native. At the same time, we're also seeing a lot of open-source ISVs also be part of the Azure marketplace. if you go up to the Azure marketplace today, you'll see that. So we're not only bringing people who have traditionally worked with us, helping them re-plat to a completely new model, but we're also bringing a lot of new ISVs into the fold as well, and that's pretty exciting to see.

Great. So that wraps up the Q&A portion of today's earnings 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 be webcast at the Microsoft Investor Relations website. Thank you -- thanks for joining us today.

Thank you very much.

Thank you.

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