Microsoft Corporation (MSFT) Earnings Call Transcript

Greetings, and welcome to the Microsoft conference call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Brett Iversen, Vice President of Investor Relations.

Good afternoon. Thank you for joining us as we share more about our advertising business, the opportunity in front of us and the announcement today regarding Microsoft's new Bing and new Edge, your AI-powered copilot for the web. On the call with us today are Amy Hood, Chief Financial Officer of Microsoft; and Phil Ockenden, Chief Financial Officer of the Windows, Devices and Search businesses. On our Investor Relation's website is a slide deck, which is intended to follow today's presentation. And following the call, you can also replay this webcast and view the transcript. During this call, we will make 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 differ materially because of factors discussed in today's webcast and in the Risk Factors 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 statements. And with that, I'll turn the call over to Amy.

Thank you, Brett, and good afternoon, everyone. As you heard in our earnings commentary 2 weeks ago, and as you saw from Satya and Yusuf in the presentation earlier today, Microsoft is at the forefront of the AI platform shift. We have built the world's most powerful AI supercomputing infrastructure in the cloud, having invested for years for this wave. And we've already released products like GitHub Copilot, putting that investment and its benefits in the hands of our customers. Going forward, as customers select their cloud providers and invest in new workloads, we are well positioned as an AI leader and as the world's largest commercial cloud provider. Today, we introduced our new AI-powered copilot for the web on Bing and Edge. We are reimagining the search and browser experience with AI. As Satya mentioned, during today's announcement, we're going to have fun innovating at a fast pace in search. And of course, I'm even more excited for people to get started using it. Sam discussed it earlier today, but our partnership with OpenAI began when we made our initial investment in 2019. Just a few weeks ago, we announced our latest investment and our expanded partnership that includes joint research and development, as well as commercial agreements across the company. As an example, through our joint R&D, we are combining a new next generation OpenAI model that is more powerful than ChatGPT with Bing's real-time information to create a proprietary collection of capabilities that will power the new Bing and the new Edge. Through our new commercial agreement, we will benefit from each other's successes. Before I move on to the business opportunity, I want to address our ongoing commitment to responsible AI. In addition to our comments this morning during the webcast last week, Brad Smith published a blog on responsible AI that I urge each of you to read. We are committed to the advancement of AI driven by ethical principles that put people first. With that, let's turn to why we're investing in a new AI-powered search and browser experience. At Microsoft, we position ourselves in markets with large and growing total addressable markets where we can profitably take share with high-value differentiated experiences, and digital advertising is one of those markets. As people continue to spend more time online, advertising dollars follow. The overall digital advertising market, which includes spend from search, social, display and video, was over $0.5 trillion in 2022, growing in the high teens and highly profitable. Approximately 40% of that market was in search advertising, and we expect this opportunity to continue to grow. I'm going to turn it over to Phil to talk a bit more about our advertising business.

Thanks, Amy. At Microsoft, our 2 largest digital advertising businesses are search and news advertising and LinkedIn Marketing Solutions. Over the last 12 months, our total advertising revenue was nearly $18 billion, and the businesses continue to be profitable. Today, I'm going to share an update on our Search business, the growth we've seen to date and how we expect the new AI-powered search and browser experience will expand growth opportunities going forward. For a long time, we've invested in our Search and News businesses, organically improving quality, creating the new Edge browser and increasing the pace of releases, adding user value in places like shopping and weather. And more recently, we have completed acquisitions such as PromoteIQ and Xandr to ensure we could better meet the needs of advertisers. Those investments mean we have a breadth of advertising solutions across our first and third-party portfolios, and we have a world-class browser with Edge, which is taking share for 7 consecutive quarters. Our search and news advertising revenue ex-TAC has grown double digits over the past 8 quarters faster than the market, and we have done that profitably and with growing margins. With that strong foundation, we are well positioned to transform the search and browser experience with AI technology, and Windows is the best place to use it. We have more than 1.4 billion monthly active Windows devices and are seeing increased engagement that is up 10% versus pre-pandemic. We innovate the users in the activities they do the most, which includes working in the Microsoft 365 productivity suite, communicating and collaborating in Teams and gaming in the Xbox ecosystem. Most of the time spent on the PC, however, is browsing, searching, shopping and consuming the news. The new Bing and the new Edge will help customers do this better and more efficiently in 4 ways. First, better search. Users will get a better search experience, including improved ranking and more relevant results. Second, complete answers instead of just a list of relevant links, Bing reviews results from across the web to find and summarize the answer you're actually looking for. For example, you can ask for a comparison of top-rated car seats or what to use as a substitute for eggs in any recipe. Next, chat. The integrated chat experience lets you naturally interact and refine complicated research queries to better tailor your answers for areas like travel, planning and shopping. For example, it would not only give you links for how to plan a trip, but rather plan one for you. Instead of giving you results for hotels in Paris, it will recommend the best hotels fitted for your preferences. And finally, spark creativity. You are no longer limited by searching for what already exists. Bing will help you create new content with just a description such as writing a poem, drafting in e-mail or translating either of those into a different language. These new AI-powered search capabilities will also be in the sidebar within Edge, creating a better browsing experience. Simply put, the new Bing and the new Edge will drive revenue growth through increased volume and increased rates. Because our search and browser will deliver a better customer experience, will increase our volumes by attracting new users and driving higher engagement across our existing user base. A higher volume of users will attract more advertisers to our platforms. Additionally, the new Bing will have the context into what the user is trying to accomplish. Ads will become more personalized, and while the user may see fewer ads, they will be of higher value to advertisers. While this new experience will be delivered at a higher cost-to-serve, gross margin dollars will grow as usage grows. Importantly, we'll bring more experiences to more entry points over time, including mobile, where getting an answer is more helpful and efficient, given the smaller screen. Therefore, the volume and rate growth opportunities will materialize gradually as the full experiences, rollout and advertisers see the benefits of this innovation. New users, higher engagement and increased advertising rates will fuel revenue growth. As Amy mentioned earlier, the digital advertising TAM is over $0.5 trillion. And within that, approximately 40% is in search advertising. For every 1 point of share gain in the search advertising market, it's a $2 billion revenue opportunity for our advertising business. Today, our share of the search advertising market is mostly on Windows PCs, which is where we expect to see the initial benefits from the volume and rate growth. We particularly have an opportunity to grow in international markets, given the large language models enable better transformation and a better understanding of local market content. And now, I'll hand it back to Amy for some closing thoughts.

Thanks, Phil. I'm excited for the position we are in after years of investment into the AI platform. We've been delivering AI innovations through our OpenAI partnership to customers since 2021, and the pace of releases is clearly accelerating with Teams Premium, Viva Sales and your copilot for the web on Bing and Edge in the last 7 days. And we are pleased to be OpenAI's exclusive cloud provider. As a company, we will continue to invest in additional capacity to support the near-term and long-term demand we see for all AI workloads. And as we said at earnings, AI is the next big platform shift. For us, this will impact every part of our tech stack, creating new solutions and new opportunities. We believe value is created when companies lead and platform shifts, and we're going to lead in this AI era. With that, let's go to Q&A, Brett.

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

[Operator Instructions] Our first question comes from the line of Keith Weiss with Morgan Stanley.

Really fascinating announcements and great demos. I was just watching the video. I think what a lot of investors are wondering about right now from you, Amy, is the cost side of the equation. We've seen OpenAI and Sam Altman talked about a couple of cents per query, and you guys are talking about there's 10 billion queries done every day, and that could add up pretty quickly. How should we think about the underlying expense that, that Microsoft is going to be taking on? Does this materially change gross profit forecast in the near term, or CapEx forecast in the near term? Or is this already incorporated into what you guys were thinking about for the year?

Thanks, Keith. And that's a great question because I think there's lot of a nuance to it, and it gives me a time to talk about first a couple of things. While we'll focus on the cost side in the second, it always starts with the size of the opportunity. This is probably, and I think Satya said it today in the intro comments on the webcast. This is the largest software category that exists. And it's incredibly profitable, incredibly large and still growing. And we're a very small share player today. Even though we gained share over the past 7 quarters, grown in excess of the market for 2 years, there is a lot of upside in this category for us. And so what's important is that the platform, which we are using to deliver the AI is the same platform that we're using, whether it's the Azure APIs that are being utilized across first party and third party, whether it's some of the new experiences you've seen us launch in the applications that will be Viva Sales or Teams Premium. This is -- the scale for us will be applied at every layer of the stack. And so when you think about to the search experience specifically, you heard us say the first and most important thing is we're going to see usage growth. We're going to continue to roll this out. We said to millions over the coming weeks. As we see usage grow, you'll see revenue growth. And for each of those new users or increased usage that's incremental gross margin dollars for us even at the cost-to-serve that we're discussing. And so I tend to put this in the category of its net new and net new profitably at both the GM line and the operating income line, which is encouraging. And it's a leverage platform that starts at the supercomputer layer, which means we can use the utilization and the cost that will, by the way, continue to come down over time. We've seen platform shifts before. And so, cost per tends to come down with scale, of course. And I think we're starting with a pretty robust platform to be able to do that.

Thanks, Keith. Joe, next question, please.

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

Amy, can you talk about the ramp time of how quick you can influence advertisers to come on? What does this duration look like to bring them into the fold?

Thanks, Brent. What's great about this is we already have a substantial advertising business. I've talked about it's an $18 billion business that's been growing in excessive market rates for quite a while. And because of that, we've made investments over the past 2 years to really build a robust advertising platform. And it's why I still happen to mention the acquisitions we've done, PromoteIQ and Xandr. This has really been a vision that we've invested in. As we've seen the AI platform shift coming for a number of years, we've strengthened the platform that we have for advertisers to be able to take advantage of it. And we've seen wins from third parties, some of which are big names that you're all familiar of, who've chosen our advertising platform to fuel their growth, too. So we're actually relatively mature in that process. So what we're looking for really here is to make sure advertisers can see with this new experience, the higher quality of the ads and the rates that they'll be able to see. This is actually good for customers in terms of the experience you're getting to use and you saw on the webcast, but also good for advertisers. But I don't think it requires ramp time for our advertisers. It's more about rolling it out to users and seeing them get engaged.

Thanks, Brent. Joe, next question, please.

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