Note About Forward-Looking Statements
This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Risk Factors" (Part II, Item 1A of this Form 10-Q). These forward-looking statements generally are identified by the words "believe," "project," "expect," "anticipate," "estimate," "intend," "strategy," "future," "opportunity," "plan," "may," "should," "will," "would," "will be," "will continue," "will likely result," and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Quantitative and Qualitative Disclosures about Market Risk" (Part I, Item 3 of this Form 10-Q), and "Risk Factors". We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to help the reader understand the results of operations and financial condition ofMicrosoft Corporation . MD&A is provided as a supplement to, and should be read in conjunction with, our Annual Report on Form 10-K for the year endedJune 30, 2022 , and our financial statements and the accompanying Notes to Financial Statements (Part I, Item 1 of this Form 10-Q). OVERVIEW Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. We are creating the platforms and tools that deliver better, faster, and more effective solutions to support new startups, improve educational and health outcomes, and empower human ingenuity. We generate revenue by offering a wide range of cloud-based and other services to people and businesses; licensing and supporting an array of software products; designing, manufacturing, and selling devices; and delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees; designing, manufacturing, marketing, and selling our products and services; datacenter costs in support of our cloud-based services; and income taxes.
Highlights from the second quarter of fiscal year 2023 compared with the second quarter of fiscal year 2022 included:
• Microsoft Cloud revenue increased 22% to
• Office Commercial products and cloud services revenue increased 7% driven
by Office 365 Commercial growth of 11%. • Office Consumer products and cloud services revenue decreased 2% and Microsoft 365 Consumer subscribers increased to 63.2 million. • LinkedIn revenue increased 10%. • Dynamics products and cloud services revenue increased 13% driven by Dynamics 365 growth of 21%.
• Server products and cloud services revenue increased 20% driven by Azure
and other cloud services growth of 31%.
• Windows original equipment manufacturer licensing ("Windows OEM") revenue
decreased 39%. • Windows Commercial products and cloud services revenue decreased 3%. • Xbox content and services revenue decreased 12%.
• Search and news advertising revenue excluding traffic acquisition costs
increased 10%. • Devices revenue decreased 39%. 31
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PART I Item 2 Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces.
Economic Conditions, Challenges, and Risks
The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user's choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in infrastructure and devices will continue to increase our operating costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. We compete for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one's career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. Our devices are primarily manufactured by third-party contract manufacturers, some of which contain certain components for which there are very few qualified suppliers. For these components, we have limited near-term flexibility to use other manufacturers if a current vendor becomes unavailable or is unable to meet our requirements. Extended disruptions at these suppliers and/or manufacturers could lead to a similar disruption in our ability to manufacture devices on time to meet consumer demand. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than theU.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Fluctuations in theU.S. dollar relative to certain foreign currencies reduced reported revenue and expenses from our international operations for the three and six months endedDecember 31, 2022 . OnJanuary 18, 2023 , we announced decisions we made to align our cost structure with our revenue and customer demand, prioritize our investments in strategic areas, and consolidate office space. As a result, we recorded a$1.2 billion charge in the second quarter of fiscal year 2023 ("Q2 charge"), which included employee severance expenses of$800 million , impairment charges resulting from changes to our hardware portfolio, and costs related to lease consolidation activities. First, we are reducing our overall workforce by approximately 10,000 jobs through the third quarter of fiscal year 2023, which represents less than 5% of our total employee base. While we are eliminating roles in some areas, we will continue to hire in key strategic areas. Second, we are allocating both our capital and talent to areas of secular growth and long-term competitiveness, while divesting in other areas. Third, we are consolidating our leases to create higher density across our workspaces, which will also impact our financial results through the remainder of fiscal year 2023, and we may make similar decisions in future periods as we continue to evaluate our real estate needs.
Refer to Risk Factors (Part II, Item 1A of this Form 10-Q) for a discussion of these factors and other risks.
Seasonality
Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period.
32 -------------------------------------------------------------------------------- PART I Item 2
Change in Accounting Estimate
InJuly 2022 , we completed an assessment of the useful lives of our server and network equipment. Due to investments in software that increased efficiencies in how we operate our server and network equipment, as well as advances in technology, we determined we should increase the estimated useful lives of both server and network equipment from four years to six years. This change in accounting estimate was effective beginning fiscal year 2023. Based on the carrying amount of server and network equipment included in property and equipment, net as ofJune 30, 2022 , the effect of this change in estimate for the three months endedDecember 31, 2022 was an increase in operating income of$945 million and net income of$768 million , or$0.10 per both basic and diluted share. The effect of this change for the six months endedDecember 31, 2022 was an increase in operating income of$2.0 billion and net income of$1.6 billion , or$0.22 per both basic and diluted share. It is estimated this change will increase our fiscal year 2023 annual operating income by$3.7 billion .
Reportable Segments
We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. We have recast certain prior period amounts to conform to the way we internally manage and monitor our business.
Additional information on our reportable segments is contained in Note 17 - Segment Information and Geographic Data of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q).
Metrics
We use metrics in assessing the performance of our business and to make informed decisions regarding the allocation of resources. We disclose metrics to enable investors to evaluate progress against our ambitions, provide transparency into performance trends, and reflect the continued evolution of our products and services. Our commercial and other business metrics are fundamentally connected based on how customers use our products and services. The metrics are disclosed in the MD&A or the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q). Financial metrics are calculated based on financial results prepared in accordance with accounting principles generally accepted inthe United States of America ("GAAP"), and growth comparisons relate to the corresponding period of last fiscal year. In the first quarter of fiscal year 2023, we made updates to the presentation and method of calculation for certain metrics, most notably expanding our Surface metric into a broader Devices metric to incorporate additional revenue streams, along with other minor changes to align with how we manage our businesses.
Commercial
Our commercial business primarily consists of Server products and cloud services, Office Commercial, Windows Commercial, the commercial portion of LinkedIn, Enterprise Services, and Dynamics. Our commercial metrics allow management and investors to assess the overall health of our commercial business and include leading indicators of future performance.
Commercial remaining performance obligation Commercial portion of revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods Microsoft Cloud revenue Revenue from Azure and other cloud services, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties Microsoft Cloud gross margin percentage Gross margin percentage for our Microsoft Cloud business 33
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PART I Item 2
Productivity and Business Processes and Intelligent Cloud
Metrics related to our Productivity and Business Processes and Intelligent Cloud segments assess the health of our core businesses within these segments. The metrics reflect our cloud and on-premises product strategies and trends.
Office Commercial products and cloud services revenue growth Revenue from Office Commercial products and
cloud
services (Office 365 subscriptions, the
Office 365
portion of Microsoft 365 Commercial
subscriptions, and Office licensed on-premises),
comprising
Office, Exchange, SharePoint,
Microsoft
Teams, Office 365 Security and
Compliance,
and Microsoft Viva
Office Consumer products and cloud services revenue growth Revenue from Office Consumer products and cloud
services,
including Microsoft 365 Consumer
subscriptions, Office licensed on-premises, and
other Office
services
Office 365 Commercial seat growth The number
of Office 365 Commercial seats at end
of period
where seats are paid users covered by
an Office
365 Commercial subscription
Microsoft 365 Consumer subscribers The number
of Microsoft 365 Consumer subscribers
at end of
period
Dynamics products and cloud services revenue growth Revenue from
Dynamics products and cloud
services,
including Dynamics 365, comprising a
set of
intelligent, cloud-based applications
across ERP,
CRM, Customer Insights, Power Apps,
and Power
Automate; and on-premises ERP and CRM
applications LinkedIn revenue growth Revenue from LinkedIn, including Talent Solutions,
Marketing Solutions, Premium
Subscriptions, and Sales Solutions
Server products and cloud services revenue growth Revenue from
Server products and cloud services,
including
Azure and other cloud services; SQL
Server,
Windows Server, Visual Studio, System
Center, and
related Client Access Licenses
("CALs"); and Nuance and GitHub More Personal Computing Metrics related to our More Personal Computing segment assess the performance of key lines of business within this segment. These metrics provide strategic product insights which allow us to assess the performance across our commercial and consumer businesses. As we have diversity of target audiences and sales motions within the Windows business, we monitor metrics that are reflective of those varying motions. Windows OEM revenue growth Revenue
from sales of Windows Pro and non-Pro
licenses
sold through the OEM channel
Windows Commercial products and cloud services revenue growth Revenue from Windows Commercial products and
cloud
services, comprising volume licensing of
the Windows
operating system, Windows cloud
services,
and other Windows commercial offerings
Devices revenue growth Revenue
from Devices, including Surface,
HoloLens,
and PC accessories
Xbox content and services revenue growth Revenue
from Xbox content and services,
comprising
first- and third-party content
(including
games and in-game content), Xbox Game
Pass and
other subscriptions, Xbox Cloud Gaming,
third-party
disc royalties, advertising, and
other cloud
services
Search and news advertising revenue (ex TAC) growth Revenue
from search and news advertising
excluding
traffic acquisition costs ("TAC") paid
to Bing Ads
network publishers and news partners
34 --------------------------------------------------------------------------------
PART I Item 2 SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share Three Months Ended Percentage Six Months Ended Percentage amounts) December 31, Change December 31, Change 2022 2021 2022 2021 Revenue$ 52,747 $ 51,728 2%$ 102,869 $ 97,045 6% Gross margin 35,259 34,768 1% 69,929 66,439 5% Operating income 20,399 22,247 (8)% 41,917 42,485 (1)% Net income 16,425 18,765 (12)% 33,981 39,270 (13)% Diluted earnings per share 2.20 2.48 (11)% 4.54 5.19 (13)% Adjusted gross margin (non-GAAP) 35,411 34,768 2% 70,081 66,439 5% Adjusted operating income (non-GAAP) 21,570 22,247 (3)% 43,088 42,485 1% Adjusted net income (non-GAAP) 17,371 18,765 (7)% 34,927 35,979 (3)% Adjusted diluted earnings per share (non-GAAP) 2.32 2.48 (6)% 4.67 4.76 (2)% Adjusted gross margin, operating income, net income, and diluted earnings per share ("EPS") are non-GAAP financial measures. Current year non-GAAP financial measures exclude the impact of the Q2 charge, which includes employee severance expenses, impairment charges resulting from changes to our hardware portfolio, and costs related to lease consolidation activities. Prior year non-GAAP financial measures exclude the net income tax benefit related to transfer of intangible properties in the first quarter of fiscal year 2022. Refer to Note 11 - Income Taxes of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion. Refer to the Non-GAAP Financial Measures section below for a reconciliation of our financial results reported in accordance with GAAP to non-GAAP financial results.
Three Months Ended
Revenue increased
Cost of revenue increased
Gross margin increased$491 million or 1% driven by growth in Intelligent Cloud and Productivity and Business Processes and the change in accounting estimate, offset in part by a decline in More Personal Computing. • Gross margin percentage decreased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage decreased 2 points driven by reductions in More Personal Computing and Intelligent Cloud, offset in part by sales mix shift.
• Microsoft Cloud gross margin percentage increased 2 points to 72%.
Excluding the impact of the change in accounting estimate, Microsoft Cloud
gross margin percentage decreased 1 point driven by sales mix shift to Azure and other cloud services and higher energy costs.
Operating expenses increased
Key changes in operating expenses were:
• Research and development expenses increased
investments in cloud engineering, impairment charges resulting from
changes to our hardware portfolio, and LinkedIn. Research and development
included a favorable foreign currency impact of 2%.
• Sales and marketing expenses increased$300 million or 6% driven by the Nuance acquisition and investments in commercial sales. Sales and marketing included a favorable foreign currency impact of 3%. • General and administrative expenses increased$953 million or 69% driven by employee severance expenses. General and administrative included a favorable foreign currency impact of 2%. 35
-------------------------------------------------------------------------------- PART I Item 2
Operating income decreased
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 5%, 7%, and 8%, respectively. Cost of revenue and operating expenses both included a favorable foreign currency impact of 2%.
Current year gross margin, operating income, net income, and diluted EPS were
negatively impacted by the Q2 charge, which resulted in decreases of
Six Months Ended
Revenue increased$5.8 billion or 6% driven by growth in Intelligent Cloud and Productivity and Business Processes, offset in part by a decline in More Personal Computing. Intelligent Cloud revenue increased driven by Azure and other cloud services. Productivity and Business Processes revenue increased driven by Office 365 Commercial and LinkedIn. More Personal Computing revenue decreased driven by declines in Windows, Devices, and Gaming, offset in part by growth in Search and news advertising.
Cost of revenue increased
Gross margin increased$3.5 billion or 5% driven by growth in Intelligent Cloud and Productivity and Business Processes and the change in accounting estimate, offset in part by a decline in More Personal Computing. • Gross margin percentage decreased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage decreased 2 points driven by reductions in More Personal Computing and Intelligent Cloud, offset in part by sales mix shift.
• Microsoft Cloud gross margin percentage increased 2 points to 72%.
Excluding the impact of the change in accounting estimate, Microsoft Cloud
gross margin percentage decreased 1 point driven by sales mix shift to Azure and other cloud services and higher energy costs. Operating expenses increased$4.1 billion or 17% driven by investment in cloud engineering, employee severance expenses, LinkedIn, the Nuance acquisition, and commercial sales.
Key changes in operating expenses were:
• Research and development expenses increased
investments in cloud engineering and LinkedIn. • Sales and marketing expenses increased$879 million or 9% driven by investments in commercial sales and the Nuance acquisition. Sales and marketing included a favorable foreign currency impact of 4%. • General and administrative expenses increased$1.1 billion or 40% driven by employee severance expenses. General and administrative included a favorable foreign currency impact of 3%.
Operating income decreased
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 5%, 7%, and 8%, respectively. Cost of revenue and operating expenses included a favorable foreign currency impact of 2% and 3%, respectively.
Current year gross margin, operating income, net income, and diluted EPS were negatively impacted by the Q2 charge, which resulted in decreases of$152 million ,$1.2 billion ,$946 million , and$0.13 , respectively. Prior year net income and diluted EPS were positively impacted by the net tax benefit related to the transfer of intangible properties, which resulted in an increase to net income and diluted EPS of$3.3 billion and$0.43 , respectively. 36 -------------------------------------------------------------------------------- PART I Item 2 SEGMENT RESULTS OF OPERATIONS (In millions, except Three Months Ended Percentage Six Months Ended Percentage percentages) December 31, Change December 31, Change 2022 2021 2022 2021 Revenue Productivity and Business $ Processes$ 17,002 $ 15,936 7%$ 33,467 30,975 8% Intelligent Cloud 21,508 18,262 18% 41,833 35,174 19% More Personal Computing 14,237 17,530 (19)% 27,569 30,896 (11)% Total$ 52,747 $ 51,728 2%$ 102,869 $ 97,045 6% Operating Income Productivity and Business $ Processes$ 8,175 $ 7,688 6%$ 16,498 15,269 8% Intelligent Cloud 8,904 8,323 7% 17,882 16,004 12% More Personal Computing 3,320 6,236 (47)% 7,537 11,212 (33)% Total$ 20,399 $ 22,247 (8)%$ 41,917 $ 42,485 (1)% Reportable Segments
Three Months Ended
Productivity and Business Processes
Revenue increased
• Office Commercial products and cloud services revenue increased
million or 7%. Office 365 Commercial revenue grew 11% with seat growth of
12%, driven by small and medium business and frontline worker offerings,
as well as growth in revenue per user. Office Commercial products revenue
declined 30% driven by continued customer shift to cloud offerings.
• Office Consumer products and cloud services revenue decreased
or 2%. Microsoft 365 Consumer subscribers grew 12% to 63.2 million.
• LinkedIn revenue increased
• Dynamics products and cloud services revenue increased 13% driven by Dynamics 365 growth of 21%.
Operating income increased
• Gross margin increased
Commercial. Gross margin percentage increased. Excluding the impact of the
change in accounting estimate, gross margin percentage decreased slightly
driven by sales mix shift to cloud offerings.
• Operating expenses increased
LinkedIn and employee severance expenses.
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 6%, 8%, and 11%, respectively. Operating expenses included a favorable foreign currency impact of 2%.
Intelligent Cloud
Revenue increased
• Server products and cloud services revenue increased
driven by Azure and other cloud services. Azure and other cloud services
revenue grew 31% driven by growth in our consumption-based services.
Server products revenue decreased 2%.
• Enterprise Services revenue increased$39 million or 2% driven by growth inEnterprise Support Services , offset by a decline in Microsoft Consulting Services. 37
-------------------------------------------------------------------------------- PART I Item 2
Operating income increased
• Gross margin increased
other cloud services and the change in accounting estimate. Gross margin
percentage decreased slightly. Excluding the impact of the change in
accounting estimate, gross margin percentage decreased 3 points driven by
sales mix shift to Azure and other cloud services and higher energy costs. • Operating expenses increased$1.6 billion or 34% driven by employee
severance expenses, investments in Azure, and the Nuance acquisition.
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 6%, 6%, and 8%, respectively. Operating expenses included a favorable foreign currency impact of 3%.
More Personal Computing
Revenue decreased
• Windows revenue decreased
Windows OEM. Windows OEM revenue decreased 39% on a strong prior year
comparable, driven by continued PC market weakness and 3 points of
negative impact from the prior year Windows 11 revenue deferral. Windows
Commercial products and cloud services revenue decreased 3% driven by a decline in standalone product sales.
• Devices revenue decreased
market weakness and execution challenges on new product launches.
• Gaming revenue decreased
content and services and Xbox hardware. Xbox content and services revenue
decreased 12% on a strong prior year comparable impacted by first-party
game launches, driven by declines in first-party content and a lower rate
of monetization in third-party content, offset in part by growth inXbox Game Pass subscriptions. Xbox hardware revenue decreased 13% driven by lower price and volume of consoles sold.
• Search and news advertising revenue increased
and news advertising revenue excluding traffic acquisition costs increased
10% driven by higher search volume and the
part by lower revenue per search.
Operating income decreased
• Gross margin decreased
and Devices. Gross margin percentage decreased driven by reductions in
Devices, including the impact of impairment charges resulting from changes
to our hardware portfolio, and sales mix shift to lower margin businesses.
• Operating expenses increased
severance expenses and investments in Search and news advertising, offset in part by a decline in Devices.
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 3%, 5%, and 7%, respectively. Operating expenses included a favorable foreign currency impact of 3%.
Six Months Ended
Productivity and Business Processes
Revenue increased
• Office Commercial products and cloud services revenue increased
billion or 7%. Office 365 Commercial revenue grew 11% with seat growth of
12%, driven by small and medium business and frontline worker offerings,
as well as growth in revenue per user. Office Commercial products revenue
declined 29% driven by continued customer shift to cloud offerings.
• Office Consumer products and cloud services revenue increased
or 2% with continued growth in Microsoft 365 Consumer subscription revenue.
• LinkedIn revenue increased
• Dynamics products and cloud services revenue increased 14% driven by Dynamics 365 growth of 23%. 38
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PART I Item 2
Operating income increased
• Gross margin increased
Commercial and LinkedIn. Gross margin percentage increased. Excluding the
impact of the change in accounting estimate, gross margin percentage
decreased slightly driven by sales mix shift to cloud offerings.
• Operating expenses increased
LinkedIn and cloud engineering, as well as employee severance expenses.
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 6%, 7%, and 10%, respectively. Operating expenses included a favorable foreign currency impact of 3%.
Intelligent Cloud
Revenue increased
• Server products and cloud services revenue increased
driven by Azure and other cloud services. Azure and other cloud services
revenue grew 33% driven by growth in our consumption-based services.
Server products revenue decreased 1%.
• Enterprise Services revenue increased
in
Consulting Services.
Operating income increased
• Gross margin increased
other cloud services and the change in accounting estimate. Gross margin
percentage decreased slightly. Excluding the impact of the change in
accounting estimate, gross margin percentage decreased 3 points driven by
sales mix shift to Azure and other cloud services and higher energy costs.
• Operating expenses increased
Azure, the Nuance acquisition, and employee severance expenses.
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 6%, 7%, and 8%, respectively. Operating expenses included a favorable foreign currency impact of 3%.
More Personal Computing
Revenue decreased
• Windows revenue decreased
Windows OEM. Windows OEM revenue decreased 28% driven by continued PC
market weakness. Windows Commercial products and cloud services revenue
increased 2% driven by demand for Microsoft 365, offset in part by a decline in standalone product sales. • Devices revenue decreased$893 million or 24% driven by continued PC market weakness and execution challenges on new product launches.
• Gaming revenue decreased
content and services and Xbox hardware. Xbox content and services revenue
decreased 8% driven by declines in first-party content and in third-party
content, with lower rate of monetization and engagement hours, offset in
part by growth in
decreased 5% driven by lower price of consoles sold.
• Search and news advertising revenue increased
and news advertising revenue excluding traffic acquisition costs increased
13% driven by higher search volume and the
part by lower revenue per search.
Operating income decreased
• Gross margin decreased
Devices, and Gaming. Gross margin percentage decreased driven by
reductions in Devices, including the impact of impairment charges
resulting from changes to our hardware portfolio, and sales mix shift to
lower margin businesses.
• Operating expenses increased
Search and news advertising and employee severance expenses, offset in part by a decline in Devices. 39
-------------------------------------------------------------------------------- PART I Item 2
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 3%, 5%, and 7%, respectively. Operating expenses included a favorable foreign currency impact of 3%.
OPERATING EXPENSES Research and Development Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change 2022 2021 2022 2021 Research and development$ 6,844 $ 5,758 19%$ 13,472 $ 11,357 19% As a percent of revenue 13% 11% 2ppt 13% 12% 1ppt
Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content.
Three Months Ended
Research and development expenses increased
Six Months Ended
Research and development expenses increased
Sales and Marketing
Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change 2022 2021 2022 2021 Sales and marketing$ 5,679 $ 5,379 6%$ 10,805 $ 9,926 9%
As a percent of revenue 11% 10% 1ppt 11% 10% 1ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs.
Three Months Ended
Sales and marketing expenses increased$300 million or 6% driven by the Nuance acquisition and investments in commercial sales. Sales and marketing included a favorable foreign currency impact of 3%.
Six Months Ended
Sales and marketing expenses increased$879 million or 9% driven by investments in commercial sales and the Nuance acquisition. Sales and marketing included a favorable foreign currency impact of 4%. 40 --------------------------------------------------------------------------------
PART I Item 2 General and Administrative Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change 2022 2021 2022 2021 General and administrative$ 2,337 $ 1,384 69%$ 3,735 $ 2,671 40% As a percent of revenue 4% 3% 1ppt 4% 3% 1ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, employee severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees.
Three Months Ended
General and administrative expenses increased
Six Months Ended
General and administrative expenses increased
OTHER INCOME (EXPENSE), NET
The components of other income (expense), net were as follows:
Three Months Ended Six Months Ended (In millions) December 31, December 31, 2022 2021 2022 2021 Interest and dividends income$ 700 $ 503 $ 1,341 $ 1,023 Interest expense (490 ) (525 ) (990 ) (1,064 ) Net recognized gains (losses) on investments (15 ) 300 (2 ) 671 Net gains (losses) on derivatives (199 ) 7 (190 ) 0 Net losses on foreign currency remeasurements (18 ) (13 ) (96 ) (78 ) Other, net (38 ) (4 ) (69 ) 2 Total$ (60 ) $ 268 $ (6 ) $ 554
We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net.
Three Months Ended
Interest and dividends income increased due to higher yields, offset in part by lower portfolio balances. Interest expense decreased due to a decrease in outstanding long-term debt due to debt maturities. Net recognized losses on investments increased due to losses on equity securities in the current period compared to gains in the prior period. Net losses on derivatives increased due to losses on a forward purchase agreement for shares of the London Stock Exchange Group.
Six Months Ended
Interest and dividends income increased due to higher yields, offset in part by lower portfolio balances. Interest expense decreased due to a decrease in outstanding long-term debt due to debt maturities. Net recognized losses on investments increased due to losses on fixed income securities in the current period compared to gains in the prior period, and lower gains on equity securities in the current period. Net losses on derivatives increased due to losses on a forward purchase agreement for shares of the London Stock Exchange Group. 41 --------------------------------------------------------------------------------
PART I Item 2 INCOME TAXES Effective Tax Rate Our effective tax rate was 19% and 17% for the three months endedDecember 31, 2022 and 2021, respectively, and 19% and 9% for the six months endedDecember 31, 2022 and 2021, respectively. The increase in our effective tax rate for the three months endedDecember 31, 2022 compared to the prior year was primarily due to a decrease in tax benefits relating to stock-based compensation. The increase in our effective tax rate for the six months endedDecember 31, 2022 compared to the prior year was primarily due to a$3.3 billion net income tax benefit in the first quarter of fiscal year 2022 related to the transfer of intangible properties and a decrease in tax benefits relating to stock-based compensation. In the first quarter of fiscal year 2022, we transferred certain intangible properties from ourPuerto Rico subsidiary to theU.S. The transfer of intangible properties resulted in a$3.3 billion net income tax benefit in the first quarter of fiscal year 2022, as the value of futureU.S. tax deductions exceeded the current tax liability from theU.S. global intangible low-taxed income tax. Our effective tax rate was lower than theU.S. federal statutory rate for the three and six months endedDecember 31, 2022 , primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations center inIreland .
Uncertain Tax Positions
We settled a portion of the Internal Revenue Service ("IRS") audit for tax years 2004 to 2006 in fiscal year 2011. InFebruary 2012 , theIRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of theIRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of theIRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of theIRS audits for tax years 2004 to 2013 and made a payment of$1.7 billion , including tax and interest. We remain under audit for tax years 2004 to 2017. As ofDecember 31, 2022 , the primary unresolved issues for theIRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside theU.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2022, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NON-GAAP FINANCIAL MEASURES Adjusted gross margin, operating income, net income, and diluted EPS are non-GAAP financial measures. Current year non-GAAP financial measures exclude the impact of the Q2 charge, which includes employee severance expenses, impairment charges resulting from changes to our hardware portfolio, and costs related to lease consolidation activities. Prior year non-GAAP financial measures exclude the net income tax benefit related to transfer of intangible properties in the first quarter of fiscal year 2022. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP. 42 -------------------------------------------------------------------------------- PART I Item 2
The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results:
(In millions, except percentages and per share Three Months Ended Percentage Six Months Ended Percentage amounts) December 31, Change December 31, Change 2022 2021 2022 2021 Gross margin$ 35,259 $ 34,768 1%$ 69,929 $ 66,439 5% Severance, hardware-related impairment, and lease consolidation costs 152 0 * 152 0 * Adjusted gross margin (non-GAAP)$ 35,411 $ 34,768 2%$ 70,081 $ 66,439 5% Operating income$ 20,399 $ 22,247 (8)%$ 41,917 $ 42,485 (1)% Severance, hardware-related impairment, and lease consolidation costs 1,171 0 * 1,171 0 * Adjusted operating income (non-GAAP)$ 21,570 $ 22,247 (3)%$ 43,088 $ 42,485 1% Net income$ 16,425 $
18,765 (12)%
946 0 * 946 0 * Net income tax benefit related to transfer of intangible properties 0 0 * 0 (3,291 ) * Adjusted net income (non-GAAP)$ 17,371 $ 18,765 (7)%$ 34,927 $ 35,979 (3)% Diluted earnings per share$ 2.20 $
2.48 (11)%
0.12 0 * 0.13 0 * Net income tax benefit related to transfer of intangible properties 0 0 * 0 (0.43 ) * Adjusted diluted earnings per share (non-GAAP)$ 2.32 $ 2.48 (6)%$ 4.67 $ 4.76 (2)% * Not meaningful. LIQUIDITY AND CAPITAL RESOURCES We expect existing cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities, such as dividends, share repurchases, debt maturities, material capital expenditures, and the transition tax related to the Tax Cuts and Jobs Act ("TCJA"), for at least the next 12 months and thereafter for the foreseeable future.
Cash, Cash Equivalents, and Investments
Cash, cash equivalents, and short-term investments totaled$99.5 billion and$104.8 billion as ofDecember 31, 2022 andJune 30, 2022 , respectively. Equity investments were$7.1 billion and$6.9 billion as ofDecember 31, 2022 andJune 30, 2022 , respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantlyU.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. 43 --------------------------------------------------------------------------------
PART I Item 2 Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such asU.S. government securities, common and preferred stock, and mutual funds. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments, such as commercial paper, certificates of deposit,U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Level 3 investments are valued using internally-developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.
Cash Flows
Cash from operations decreased$4.7 billion to$34.4 billion for the six months endedDecember 31, 2022 , mainly due to an increase in cash paid to employees and suppliers and cash used to pay income taxes, offset in part by an increase in cash received from customers. Cash used in financing decreased$6.0 billion to$22.2 billion for the six months endedDecember 31, 2022 , mainly due to a$4.1 billion decrease in common stock repurchases and a$3.1 billion decrease in repayments of debt. Cash used in investing increased$5.9 billion to$10.3 billion for the six months endedDecember 31, 2022 , due to a$5.4 billion decrease in cash from net investment purchases, sales, and maturities, an$882 million increase in additions to property and equipment, and a$655 million increase in other investing to facilitate the purchase of components, offset in part by a$1.0 billion decrease in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets.
Debt Proceeds
We issue debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. Refer to Note 10 - Debt of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.
Unearned Revenue
Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include Software Assurance ("SA") and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. 44 -------------------------------------------------------------------------------- PART I Item 2
The following table outlines the expected future recognition of unearned revenue
as of
(In millions) Three Months EndingMarch 31, 2023 $ 18,324 June 30, 2023 11,215 September 30, 2023 4,888 December 31, 2023 2,555 Thereafter 2,644 Total$ 39,626
If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Refer to Note 12 - Unearned Revenue of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.
Material Cash Requirements and Other Obligations
Income Taxes
As a result of the TCJA, we are required to pay a one-time transition tax on deferred foreign income not previously subject toU.S. income tax. Under the TCJA, the transition tax is payable in interest-free installments over eight years, with 8% due in each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. We have paid transition tax of$7.7 billion , which included$1.5 billion during the six months endedDecember 31, 2022 . The remaining transition tax of$10.5 billion is payable over the next three years, with$2.5 billion payable within 12 months. Provisions enacted in the TCJA related to the capitalization for tax purposes of research and experimental expenditures became effective onJuly 1, 2022 . These provisions require us to capitalize research and experimental expenditures and amortize them on theU.S. tax return over five or fifteen years, depending on where research is conducted. The final foreign tax credit regulations, also effective onJuly 1, 2022 , introduced significant changes to foreign tax credit calculations in theU.S. tax return. While these provisions are not expected to have a material impact on our fiscal year 2023 effective tax rate on a net basis, our cash paid for taxes would increase unless these provisions are postponed or modified through legislative processes.
Share Repurchases
For the six months endedDecember 31, 2022 and 2021, we repurchased 37 million shares and 41 million shares of our common stock for$9.2 billion and$12.4 billion , respectively, through our share repurchase programs. All repurchases were made using cash resources. As ofDecember 31, 2022 ,$31.5 billion remained of our$60 billion share repurchase program. Refer to Note 15 - Stockholders' Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion. Dividends For the six months endedDecember 31, 2022 and 2021, our Board of Directors declared quarterly dividends of$0.68 per share and$0.62 per share, respectively. We intend to continue returning capital to shareholders in the form of dividends, subject to declaration by our Board of Directors. Refer to Note 15 - Stockholders' Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.
Other Planned Uses of Capital
OnJanuary 18, 2022 , we entered into a definitive agreement to acquire Activision Blizzard, Inc. ("Activision Blizzard") for$95.00 per share in an all-cash transaction valued at$68.7 billion , inclusive of Activision Blizzard's net cash. The acquisition has been approved by Activision Blizzard's shareholders. We are continuing to engage with regulators reviewing the transaction and are working toward closing it in fiscal year 2023, subject to obtaining required regulatory approvals and satisfaction of other customary closing conditions. 45 -------------------------------------------------------------------------------- PART I Item 2 We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities, Microsoft Experience Centers, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. CRITICAL ACCOUNTING ESTIMATES Our consolidated financial statements and accompanying notes are prepared in accordance with GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Critical accounting estimates are those estimates that involve a significant level of estimation uncertainty and could have a material impact on our financial condition or results of operations. We have critical accounting estimates in the areas of revenue recognition, impairment of investment securities, goodwill, research and development costs, legal and other contingencies, income taxes, and inventories.
Revenue Recognition
Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. Judgment is required to determine the stand-alone selling price ("SSP") for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. 46 -------------------------------------------------------------------------------- PART I Item 2
Impairment of
We review debt investments quarterly for credit losses and impairment. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. This determination requires significant judgment. In making this judgment, we employ a systematic methodology that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery, then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Equity investments without readily determinable fair values are written down to fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than carrying value. We perform a qualitative assessment on a periodic basis. We are required to estimate the fair value of the investment to determine the amount of the impairment loss. Once an investment is determined to be impaired, an impairment charge is recorded in other income (expense), net.Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach.Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.
Research and Development Costs
Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products.
Legal and Other Contingencies
The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. 47 --------------------------------------------------------------------------------
PART I Item 2 Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity's financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements.
Inventories
Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. 48
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