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Operator
,>> Operator Greetings and welcome to the Microsoft second-quarter fiscal-year 2014 earnings conference call.
(Operator Instructions)
As a reminder, this conference is being recorded.
It is now my pleasure to introduce your host, Chris Suh, General Manager, Investor Relations for Microsoft.
Thank you, Chris.
You may begin.
- General Manager IR
Thank you, operator.
On our website, Microsoft.com/investor, is our financial summary slide deck which is intended to follow prepared remarks and provide the reconciliation of differences between GAAP and non-GAAP financial measures.
As a reminder, we will post today's prepared remarks to our website immediately following the call until the complete transcript is available.
Today's call is being webcast live and recorded.
If you ask a question, it will be included in our live transmission, in the transcript and any future use of the recording.
You can replay the call and view the transcript at the Microsoft investor relations website until January 23, 2015.
During this call we will be making forward-looking statements, which are predictions projections or other statements about future events.
These statements are based on current expectations and assumptions that are subject to risks and uncertainties.
Actual results could materially differ because of factors discussed in today's earnings press release, in the comments made during this conference call and in the risk factor section of our form 10-K, form 10-Q and other reports and filings with the Securities and Exchange Commission.
We do not undertake any duty to update any forward-looking statements.
Before I hand the call over to Amy, please keep in mind all growth comparisons we make on the call today will relate to the corresponding period of last year.
Also unless specified otherwise, all impacted numbers to the current quarter have been adjusted for the cumulative effect of last year's revenue deferrals and recognitions related to Windows, Office and Xbox video games.
As a reminder, with our new segment reporting structure we have consolidated adjustments of this nature into corporate and other to provide better comparability of operating results.
You can find details of the adjustments and reconciliations of differences between GAAP and non-GAAP financial measures in our financial summary slide deck.
With that, I'll turn it over to Amy.
- CFO
Thank you, Chris.
Good afternoon and thank you all for joining us today.
As I look back on the quarter, I am pleased with the results as they exceeded expected revenue growth while continuing to maintain focus on improved execution and cost management.
Our devices and consumer segments had a very good quarter and grew 13% with a successful holiday.
Our commercial segment had another great quarter and grew 10% to over $12 billion as we continue to deliver on our differentiated cloud strategy.
We performed well this quarter and you see it in our financial results.
This holiday we continued to make significant progress in the consumer space, headlined by Xbox One which launched in 13 markets and sold in 3.9 million units in just over five weeks.
According to NPD Group figures, Xbox One was the leading console in the US for the month of December, which was its first full month in market.
When adding in Xbox 360, which held the third spot, Xbox led the US market with 46% share in December.
We are excited by this enthusiastic response from our loyal customers and are working to increase the availability of Xbox One.
With Surface, demand continued to grow, benefiting from improved execution at retail and favorable reviews of the new Surface devices.
Sequentially, both units and revenue more than doubled this quarter with customers recognizing Surface's differentiated value propositions as one device for everything in their life.
We feel good about the progress we have made over the past couple of quarters and are enthusiastic about the overall opportunity ahead with Surface.
The Windows ecosystem as a whole is also making important progress.
Earlier this fall, we launched Windows 8.1, which enabled smarter, faster and more personalized devices and our OEM partners are taking advantage of this.
Over the last few months they've delivered a breadth of differentiated devices designed to meet a wide range of customer needs.
We are encouraged by what we have been able to accomplish with our partners and collectively we will continue to focus on driving the Windows ecosystem forward.
Now, let me share some perspective on what we saw in the PC market, which was slightly better than our expectation.
Business PCs grew again for the third consecutive quarter and benefited from an improving macro environment, better availability of innovative new hardware and a refresh cycle ahead of Windows XP end of support.
Additionally growth was higher in large enterprises than small- and medium-sized businesses.
Consumer PCs, while better than our expectations, continued to be soft as they faced challenges from competing form factors.
And as a general theme, developed markets outperformed emerging markets.
Windows continues to be the platform of choice for business.
This quarter Windows Pro revenue grew 12% and out-paced the underlying business PC market.
This was proven by faster growth in both enterprises and developed markets where Pro attach is higher.
Windows non-Pro revenue however was down 20%, reflecting dynamics of the consumer PC market.
Now let's move to our commercial business where key metrics remain strong.
Bookings grew 12% and renewal rates remained in line across our product portfolio even with the large expiring base in the quarter.
Unearned revenue grew 12% and our contracted not-billed balance is at a record level of over $23 billion.
To me this is important, as these long-term commitments demonstrate the confidence that customers have in our product road map, where we are investing in key areas such as big data, infrastructure management, and cloud computing.
In big data our upcoming release for SQL Server 2014 builds on the momentum we've established.
Offering complete business intelligent solution for big data, SQL Server is driving significant memory performance gains.
Additionally it enabled hybrid cloud solutions with cloud back up and disaster recovery as well as providing enhanced availability and security.
Hybrid infrastructure and management offerings also continue to be important priorities.
Windows Server, Azure and System Center are the centerpieces of our hybrid cloud strategy and together they enable portability and scalability of workloads.
Using our suite of products customers get high-scale virtualization, built-in software-defined networking and hybrid business continuity that enables their modern data centers.
As CIOs look to cloud computing to reduce cost and deliver business agility, they are turning to our cloud services.
Office 365 and Dynamics CRM online offer customers the ability to transition easily to the cloud and benefit from enterprise-class features and a familiar user interface.
Additionally Windows Azure provides the scalability and flexibility that addresses their evolving infrastructure and platform needs.
In summary, we had a very good quarter across our consumer and commercial business.
We are taking share with many products and seeing improvements in areas where we needed to be better.
As we do this, we continue to prioritize the deployment of our resources to areas that accelerate innovation and deliver products that our customers love.
With that overview of the quarter, I'll hand it over to Chris to give more details about our performance before I come back and share thoughts on our outlook.
- General Manager IR
Thanks, Amy.
First, I am going to review our overall results and then I'll move on to the details by reporting segment.
We had a successful holiday quarter and our broad diversified portfolio helped us deliver record revenue in Q2.
Total revenue was up 11% to $24.5 billion, and without the impact of foreign exchange, revenue would have been higher by $196 million or 1 percentage point.
Cost of goods sold increased 46%.
This increase was primarily due to costs associated with the new Xbox and Surface products which launched this quarter, and also growth in cloud infrastructure supporting our consumer and commercial offerings.
Even as we invest in our devices and services initiatives, gross margin was flat at $16.2 billion.
Operating expenses grew at 3% which was below our guidance, as we continue to focus on prioritizing spend toward strategic growth initiatives.
Operating income and earnings per share both declined 4% to $8.0 billion and $0.78 respectively.
This quarter we returned $4.3 billion of cash to shareholders in buybacks and dividends, our highest amount in the last 12 quarters.
I am now going to talk through the performance of each of our reporting segments.
In our devices and consumer segment revenue grew 13%.
Within this, the licensing segment, which primarily includes Windows OEM, Consumer Office and Windows Phone declined 6%, reflecting overall PC and device market trend.
We continue to see similar dynamics to the previous quarter.
Total Windows OEM revenue declined 3%.
As Amy described 12% growth in Windows Pro was offset by 20% declines in Windows non-Pro.
Excluding the impact of China where we continue to draw down inventory levels, Windows non-Pro revenue declined 14%.
Office attach, including our cloud offerings, was up again this quarter.
Traditional consumer Office licensing revenue declined 24%.
However, we estimate that approximately 16 percentage points of this decline was due to the shift to Office 365 Home Premium.
Excluding this impact, traditional consumer Office out-performed the underlying consumer PC market.
Next I'll move to our hardware segment where revenue grew $1.9 billion or 68%, driven by a good holiday quarter for our consumer devices.
Xbox One had a record launch and together with Xbox 360 we shipped 7.4 million consoles.
For Surface we saw improved sales of Surface RT and also introduced Surface 2 and Surface Pro 2 into the market.
Moving to the devices and consumer other segment.
As a reminder, this segment includes our online marketplaces, advertising, Xbox Studios, Office 365 Home Premium and other consumer products and services.
Revenue in this segment declined 10% when compared to last year when we launched Halo 4.
Search advertising revenue grew 34% driven by continued revenue per search improvements and query volume growth.
Bing has now grown its share of search queries to 18.2% in the US.
Office 365 Home Premium adoption continues to be strong.
With this service customers are always running the most up-to-date version, have content available across their devices with SkyDrive integration and get free Skype minutes.
The overall value proposition is resonating well with customers and we now have more than 3.5 million subscribers.
For the quarter it accounted for more than 15% of total consumer Office licenses sold.
Turning now to our commercial segment.
All our commercial revenue and gross margin across both on-premise and cloud services grew 10%.
Commercial licensing segment, which reflects our traditional software licensing, grew 7%.
And our commercial other segment, which captures our commercial cloud services as well as our enterprise services business, grew 28% to $1.8 billion.
As economies of scale benefits accrue to these online services, we are seeing gross margin expansion in our commercial other segment.
We saw continuing strength across our commercial portfolio.
Server product revenue grew 12%.
In the data center the premium version of Windows Server which targets tier 1 application work loads, saw significant revenue growth again this quarter.
Revenue for System Center grew double-digits and Hyper-V, our virtualization product gained 5 points of share over the last year.
In our data platform business, SQL Server continued to out-pace the market and revenue grew double-digits, with SQL Server Premium revenue growing over 25%.
Our commercial Office product also remains strong, growing 10%.
Within this, our productivity server offerings, SharePoint, Exchange and Lync continue to perform well with Lync growing over 25%.
We're excited about the unified communications opportunity as we combine the enterprise richness of Lync and the global reach of Skype to transform the communications experience.
We are pleased with our momentum in cloud services.
This quarter revenue for commercial cloud services again grew over 100% as customers of all sizes continued to leverage our cloud services to improve productivity, reduce costs, and leverage a secure and trusted platform.
We are seeing broad-based adoption as Office 365 seats, Azure customers and Dynamics CRM net seat at all grew over 100%.
We now have 70% of the Fortune 500 companies using at least one of our cloud services.
Having now reviewed our results for this past quarter, let me turn it over to Amy to discuss our forward-looking guidance.
- CFO
Thanks, Chris.
Before I get into our expectations for the quarter, let me quickly touch on Nokia.
We continue to expect that the deal will close this quarter, but are still in the process of securing all regulatory approvals and meeting closing conditions.
So all guidance here assumes no impact from Nokia.
Assuming the deal closes this quarter, we will include Nokia in our guidance starting in the fourth quarter.
Looking ahead to the third quarter, we are expecting a similar macro environment to what we saw this quarter.
As such, many of the dynamics from the second quarter will likely continue into the third.
With that, let's get into the outlook, starting with devices and consumer.
In licensing we expect revenue to be $4.1 billion to $4.3 billion.
This range reflects similar dynamics to what we saw in the second quarter with business PCs growing, strong Pro mix and headwinds in consumer PCs.
In hardware, we expect revenue to be $1.9 billion to $2.0 billion.
This reflects continued post-launch momentum with Surface 2, Surface Pro 2, and Xbox One, with the upcoming launch of the Xbox exclusive game, Titanfall.
And in devices and consumer other we expect revenue to be about $1.8 billion.
Moving onto commercial.
In what is a seasonally slower quarter, we are confident in our ability to continue to be the vendor of choice with our productivity and infrastructure offerings.
In commercial licensing we expect revenue to be $10.4 billion to $10.6 billion.
In commercial other we expect revenue to be about $1.8 billion, reflecting continued momentum in our commercial cloud business.
We expect COGS to be $6.1 billion to $6.3 billion next quarter.
This range primarily reflects variability associated with our hardware business.
Moving on to operating expenses.
We expect OpEx to grow 5% to 6% to $7.7 billion to $7.8 billion.
We are also reducing and narrowing the range for our full-year guidance to $31.2 billion to $31.5 billion.
As a reminder, other income and expense includes dividend and interest income, offset by interest expense and the net cost of hedging.
We expect these items to generally offset one another.
We still expect our full-year tax rate to be between 18% and 20%.
We now expect full-year capital expenditures to be about $6 billion, which is down about $500 million from our prior guidance.
This reduction is primarily driven by improved capacity utilization and scale benefits, as we converge our online services infrastructure platforms while continuing to support the strong demand that we see in business.
Adjusting for prior year tech guarantees and product deferrals, we expect unearned revenue to sequentially decline, as it has in prior years.
So in summary, I feel good about the financial results this quarter.
We are executing well across the Company as demonstrated by share gains in our commercial business.
And we are also making important inroads with our consumer offerings.
Looking ahead, there is a lot to be excited about as we continue our transformation around One Microsoft.
With that, I'll turn it back to Chris and we'll take your questions.
- General Manager IR
Thanks, Amy.
With that, we'll move on to Q&A.
Operator, please repeat your instructions.
Operator
Thank you.
(Operator Instructions)
Our first question comes from the line of John DiFucci with JPMorgan Chase.
Please proceed with your question.
- Analyst
Thank you.
Obviously nice upside on the hardware business and with Surface and Xbox.
But my question is on the licensing business, so bear with me a little bit here.
You had both licensing businesses, device and consumer and commercial licensing, they were both better than expected at least by about $100 million each.
At the same time, deferred revenue was shy by something like $250 million.
But there is some conflicting things.
I am just trying to get my head around this.
The contract not billed, Amy, you pointed out was really strong, saw a big jump by somewhere around $2 billion sequentially.
And you also saw some nice traction, the commercial cloud services more than doubled.
Assuming it's small.
Here's my question.
With all that happening, is there a shift happening with your on-premise corporate business to more transactional versus ratable contracts?
That would help out, to help offset the financial implications as you shift to cloud services on the corporate side.
Is that's what's happening with all these movements?
Sorry about all the detail.
- CFO
I really appreciate the question because it's going to let me help expand on a couple of dynamics, which I think are at work here.
So now I am going to ask you to bear with me with a little bit of a long answer.
Let me start by your comments, I think, around the overall commercial licensing bucket, which I am going to expand to include, as you did, the overall commercial business, both cloud and licensing.
There are a number of metrics that I tend to look at together, as opposed to individually, to think about how we did in the quarter.
You touched on one, unearned, which grew 12% this quarter which is quite good.
The second is bookings, which grew 12% in the quarter which is very good.
Renewal rates, which were in line across our products.
And finally, the CNB balance, the contracted not billed balance, being up sequentially $2 billion, as you point out is very big.
If you think about those together as a group, those data points are very important.
Because together I would say any, I think you said $200 million short on unearned.
With those data points together, I would say there is no shortage in terms of commercial licensing and commercial other strengths all up.
As you know, contracted but not billed tends to be at the end of the quarter.
We signed a bunch of contracts that we can't bill for until the very beginning of the next.
Think about that as business done in quarter.
We'll see that come into the unearned balance, frankly, in Q3 as well as into adjusted.
So that dynamic answers away the first question and a part of the question you asked.
Now, that could have -- that's sort of a separate piece.
Then you said, well, some of the dynamic could be explained by some strong transactional business in the quarter.
I would say there is one place, and I would actually separate these things because the first was good and the second was better than we thought.
Office non-annuity or transactional did a little better than we thought in quarter, as well.
And so that's a good point that we didn't bring out that that is another component of the 10% all up commercial growth.
Now, so I guess my answer is, I agree with your transactional comment but I disagree that it's probably the overall -- it's a component of a quote, unquote shortfall and unearned.
I would say both actually are quite good.
- Analyst
Thanks, Amy.
That's fairly helpful but actually just a clarification on the contracted not yet billed.
You said, and yes, contracts get signed at the end of the quarter.
So, what you're saying that the big jump primarily was because they just hadn't been billed yet versus signing.
I could see if you were just signing longer-term deals that you are going to bill annually, but that's not what's happening?
It's more about just -- is that accurate?
Either one could happen.
- CFO
Yes, that's right.
If something was actually billed at the end of the quarter, it goes into unearned.
Contracted but not billed is actually that the contract was signed, but because the billing won't quite take place until after the end of the fiscal quarter, it ends up in contracted but not billed as opposed to unearned.
- Analyst
Right, but are we seeing any -- typically your contracts are three years.
But are we seeing any extension on the average contract length?
- CFO
No, no, that's not one of the impacts.
Thanks, John.
- Analyst
Great.
Thank you.
- General Manager IR
We'll move to the next question, please.
Operator
Thank you.
Our next question comes from the line of Mark Moerdler with Sanford C. Bernstein.
Please proceed with your question.
- Analyst
Thank you very much.
Two quick questions.
The first one is can you give us any sense of how much of the Office 365 and the Home Premium could be generated by net new users as compared to simply the move over existing users?
And then I'll ask the second one.
- CFO
Mark, that's actually -- here's how I think about the value prop.
Because I can't really say these are sales through retail and through OEM generally, whether it's a net new user or not.
What I can say is that attach overall went up in the Office consumer business, which I would say is and could be a sign that some of those are net new.
And I would hope that to be the case.
The value prop of Office 365 Home Premium really does expand the footprint.
It allows for multiple users.
It has cross platform capabilities with Office for Mac.
It's got mobile capabilities as well, and allows for easier trial.
So, it does lower many of the barriers to experience and try the product.
So while I can't point and say there is an exact number that is a new user, I can certainly say with attach going up that dynamic is helpful.
- Analyst
Excellent.
The second quick question is on the Windows side.
Any sense whether or not -- we've seen, obviously, an improvement on the numbers on here.
Do you believe that's being driven purely by an improvement going on on the market?
It's the Windows 7 refresh accelerating as we get closer to the day?
Any sense of what the drivers are, both on the consumer and enterprise side as to why we're seeing the pick up?
- CFO
Sure.
I covered it a little bit in my comments, but it's probably worth spending a little bit more time.
Let me start with the business market.
I think there really are three factors that I would point to particularly in the business environment.
And the first one may, Mark, also help on the consumer side.
The overall macro spending environment is better.
It's a little bit better than we thought.
In businesses we are seeing it.
You are seeing it in some of the IT spend forecasts you all put out.
They're being raised and I think that has an impact.
The second is, I think our partners have done a very good job expanding the types and availability of new and interesting hardware.
That brings people to the store and I think is an encouraging sign.
Finally, as you asked, at the end of life of XP, that has been an impact.
We expect it to continue to be, as we said, in Q3.
But I wouldn't point to simply one of the factors as being the reason, but it is a combination of those factors.
- Analyst
Perfect.
I do appreciate.
Thank you.
- CFO
Thank you, Mark.
- General Manager IR
Thanks, Mark.
We'll move to the next question please, operator.
Operator
Our next question comes from the line of Phil Winslow with Credit Suisse.
Please proceed with your question.
- Analyst
Thanks, guys.
Congratulations on the great quarter.
I have a question back on the Windows volume licensing side.
You kind of touched on it earlier, but you saw 10% growth year over year this quarter verses 6% last quarter.
So you continue to have very healthy growth here.
One of the questions I've been getting from some clients is, A, what's driving that?
And B, as we get closer and then actually pass the official end of life of XP, how do you think that's going to affect the growth in Windows licensing beyond that point?
- CFO
Thanks, Phil.
I'm going to take the opportunity to make your question two questions.
One is to talk about Windows volume licensing overall, and secondly allow me to talk a little bit about the places that you could see the impact of Windows XP in the current quarter.
And I think that will help as you think about Q3 going forward.
In volume licensing, you are right, it did grow 10% in Q2.
And we do believe we are seeing some of the benefit of that growth is the end of life of Windows XP.
But it's also reflective of the value many of our bigger customers are seeing in upgrading to the enterprise version of Windows.
The enterprise SKU includes things like DirectAccess, Windows To Go, the Corporate Image, App Blocker.
Those really are differentiating and they really do matter to many CIOs.
So I think specifically on VL while end of life of XP is one component it's certainly not the only component.
Now, if I expand your question to -- and I think in a way Mark asked about it too, is the end of life of XP.
One place that we've talked about it was Windows and how does it play into the business PC growth?
The second we talked about was volume licensing.
And the third, which I actually talked about in John's question, was Office and some transactional strengths.
Some of the strengths that we saw in Office transactionally really can be linked back to the end of life of XP.
As people refresh a PC and that they're buying Pro, those people often are Office customers.
And so if they tend to buy on a transactional basis, it also sees some impact through Office.
I think you can tie that back to some of the out-performance we saw the quarter as well.
- General Manager IR
Thanks, Phil.
Operator, next question please.
Operator
Thank you.
Our next question comes from the line of Heather Bellini with Goldman Sachs.
Please proceed with your question.
- Analyst
Great.
Thank you.
Nice execution in the quarter.
Amy, I wanted to ask if you could share with us how you see the gross margin profile of the Company changing as you continue with your journey to be a devices and services Company?
And as you look out to when the transition is complete, and I know you probably don't know when exactly that's going to occur, how do we think about what it will look like?
- CFO
Heather, thanks.
This is one of those questions that I think is best taken in a bit of a chunk.
You know, first of all, I think if you look at our commercial segment, I will do it all up as I think it's relatively easy with that break down.
In general, and you saw it this quarter, even as we continue to invest in the infrastructure to support our cloud conversion of our commercial customers to AGR and Office 365 and CRM Online, our actual gross margin remains flat.
Which means we're increasing our utilization and growing gross margin in the commercial cloud business as we continue to see traction.
Over time, I continue to believe our commercial business in the absolute moving to the cloud is a net positive, as we talked about before, to overall profit, including increasing the amount of gross margin we make as a Company.
That, I think, this quarter was 83%ish, so that I would take as a separate bucket from our devices and consumer business.
And there, what's interesting is we have a couple of business models there with different gross margin profiles.
And you're actually seeing the impact of some of that in this quarter.
Xbox, as we know, especially with new consoles like the One, tend to be gross margin negative on the front.
This is a heavy quarter for that over time, through the attach of first, second, third party games and other services, the margin profile with any console life changes.
But it's never going to be at 83% gross margin because of different business even for the market leader and even successfully generating cash and return.
That is different from other businesses we also have in D&C.
I think the important thing that I tend to focus on as I go through all these businesses, is continued margin improvement within the business, continued efficiency within the business, and continued focus on the absolute profit within each of those areas.
And then the mix then becomes more of a math equation, as we continue to grow the overall amount of cash and profit the Company generates.
- General Manager IR
Okay.
Thank you, Heather.
- CFO
Thanks, Heather.
- General Manager IR
Next question please.
Operator
Thank you.
Our next question comes from the line of Brent Thill with UBS.
Please proceed with your question.
- Analyst
Hi, Amy.
Back on contracted not billed, you had four quarters over $21 billion and jumping up obviously to north of $23 billion.
That jump that happened, can you help us understand what the buckets that made that jump up this quarter was?
Is there an easier way to think through where that actually came from?
- CFO
Yes.
Yes and no, of course.
Brent, let me say contracted but not billed is related to the number of expirations we have in the quarter.
Chris and, I think, I both talked about we did have a lot of expirations in the quarter.
When those tend to fall at the end, they can impact the actual magnitude is the absolute number of expirations.
And then the timing of when those fall in the quarter can also impact how it's recognized.
That's why I never really look at it separately from unearned bookings and renewals together.
And so, because timing is one thing, that's why I tend to put them in a bucket and say together it's a good and healthy trajectory.
- Analyst
Real quick on the multi-year agreements mentioned, the healthy renewals.
Any color you can add to the re-up on the size of what you are seeing in general across some of those bigger multi-year agreements?
- CFO
I think in general it reflects the same trends we've been seeing.
It's across our broad portfolio.
You see it across Windows Office and Server.
If you look at our KPIs I think that points out that it's pretty broad-based.
So I don't think there's any one particular area I would call out.
It's really more about platform health and commitment.
- Analyst
Thank you.
- CFO
Thanks, Brent.
- General Manager IR
Thanks, Brent.
Next question please.
Operator
Thank you.
Our next question comes from the line of Walter Pritchard with Citigroup.
Please proceed with your question.
- Analyst
Thanks.
Question on the consumer retail side.
This is the first year I think you've had full retail store presence.
You also, I believe, had some presence in some of the Best Buys with mini stores in there.
I am wondering what your take-away is from the holiday season, and if those efforts you think were a part of the reason why you had a pretty successful holiday season, especially on the PC side?
And what that experience suggests that you should do in the future in terms of retail store build-out and general investment around retail?
- CFO
Thanks, Walter.
When we talk about improved retail execution, I really think that's a partnership, as you said, with retailers, with our OEMs and with our efforts to really improve both the devices, the assortment, and the experience of buying in the PC aisle.
So I do feel good about the investments we've made there.
And we've made them, I think, thoughtfully and continue to keep a focus on cost and expense as we do that.
So do I think it had an impacted?
I do.
But I really think the broader impact was investments and commitments we had with our partners to also improve the retail buying experience.
- General Manager IR
Thank you, Walter.
- Analyst
Thanks.
- General Manager IR
Next question please.
Operator
Thank you.
Our next question comes from the line of Keith Weiss with Morgan Stanley.
Please proceed with your question.
- Analyst
Excellent.
Thank you for taking my question.
Very nice quarter.
I want to dig into gross margins in the quarter.
By my estimates you guys outperformed the guidance for gross margins that you gave on the quarter, despite the fact that you saw significant out-performance in D&C hardware.
Which, as you were saying especially for something like Xbox One, which is just out of the gate, we had expectations of being very low if not negative gross margins.
Can you help us understand a little bit of where that gross margin out-performance came from?
Was any of it in D&C hardware getting better yields or better gross margins on those products than your expectations?
If not, where did the out-performance come from?
- CFO
Thanks, Keith.
I'm glad you asked that question.
With our out-performance, as you pointed out, in D&C hardware, we did actually see increased COGS related to that.
However, that was offset by some COGS improvements and savings we saw across other areas, as we continue to focus on efficiency and execution.
And so, you're right, we did see COGS grow with hardware, but we were able to find savings elsewhere as we focused on improved execution.
- General Manager IR
Thanks, Keith.
- Analyst
Thank you.
- General Manager IR
We'll move to the next question please.
Operator
Our next question comes from the line of Rick Sherlund with Nomura Securities.
Please proceed with your question.
- Analyst
Thanks.
Congratulations on the margins, cost management and execution.
And also, Amy, I think we all appreciate your very substantive answers to the questions.
Just a follow up to an earlier question on the contracted but unbilled.
We're seeing with VMWare that they had a surge of three-year contracts coming out of recession, and a lot of those are coming back for renewal now.
Is that what you were suggesting as you've got an unusually large volume of contracts coming up for renewal?
- CFO
Rick, yes.
In many ways you have seen this over-covering our Company for a while.
Expirations can be chunkier.
That's not a year statement.
This quarter we had a big expiry base.
I wouldn't characterize it as abnormally large.
But the timing is a bit related to three years ago, and the timing of some of the contracts.
So it's probably a consistent driver.
- Analyst
Okay.
And last quarter we talked a bit about, are there any metrics you can help us to understand better what the effect of your revenues is from the shift to the cloud?
I think on Office it's more of a net, a delta that, I think you said it hurts you about $150 million in the previous quarter.
Is there any way you can give us a sense of what the net impact is on the business from the shift to cloud?
- General Manager IR
Hi, Rick.
It's Chris.
I think I talked about this a little bit.
The place where you can see most direct impact is in the consumer Office business.
We talked about business on a traditional license basis being down 24 points.
But our estimate is approximately 16 points of that decline is accounted for by the shift to Office 365 Home Premium.
That gives you a good estimation of the direct impact we're seeing particularly on the consumer side.
- Analyst
That implies it would only be down about 8% were it not for the shift to the cloud?
- General Manager IR
That's one way to look at it, yes.
The net number would be about 8%.
- Analyst
Perfect, thank you.
- General Manager IR
Thanks.
Next question please.
Operator
Our next question comes from the line of Ed Maguire with CLSA.
Please proceed with your question.
- Analyst
Yes.
Good afternoon.
I wanted to ask about phone, because you had not discussed Windows Phone on the call so far.
How it's tracking based on your expectations, whether you are planning on continuing to invest with non-Nokia OEMs.
And also, Amy, whether any of your expectations or investment plans for the integration with Nokia have changed in any meaningful way since you announced the deal?
Thanks.
- CFO
Thanks, Ed.
That's a good point.
We didn't have a chance to discuss the phone results.
We did see growth in Windows Phone, both in the licensing and in the mobile phone IP revenues.
Both grew this quarter.
I think, regarding Nokia, we continue to see the growth in many of the places we have seen it historically, unsubsidized markets, as well as with entry-level smart phone devices.
So I think many of those dynamics haven't really changed.
Do I have any updates to how to think about Nokia other than we continue to expect it to close in the quarter?
I don't.
We mostly remain focused on working hard to get to the point.
We're working together as one team to drive that business forward.
- Analyst
Thank you.
- CFO
Thanks, Ed.
- General Manager IR
Thanks, Ed.
Next question please.
Operator
Thank you.
Our next question comes from the line of Kash Rangan with Merrill Lynch.
Please proceed with your question.
- Analyst
Hi.
Thank you very much, Amy.
I appreciate the fact that you are trying to improve the margins in each of the commercial and the consumer businesses.
But the margin differential between these two businesses is still -- is a pretty wide one.
It looks like the consumer business is growing.
The two dynamics that I can see are the of consumer business -- the three are: one is the margin differential is too wide.
You try to improve it.
The marginal difference is too wide.
The consumer business trend-wise is growing faster than commercial.
And third is that you have the shift to the cloud.
Unless you do something like an Adobe or Autodesk where you force transition to happen quickly, there is the risk that you get a lot of growth, which is fantastic.
There's a lot of progress to share, but the margin inflection point could be delayed for several years.
I think that what one of the questions that was spurred behind, I think presumably Heather's question, was -- that's what I'm trying to get at.
So how long you are going to get this shift to result in a way that we may not see the earnings growth rate, but we have to wait to some point in time?
Or are you at the point where you can actually force this shift to happen much quicker?
Thank you very much.
- CFO
Thanks, Kash.
I think the way I think about it is we have a broad portfolio.
And we address customers of all types.
And in many ways our biggest goal is to meet the needs of our customers whether they be CIOs or consumers.
And setting our business model to support the products and the adoption curve that we want needs to be married with the adoption curve and timing of our customers.
I feel like we have done a very good job of balancing the pace of that.
I have been encouraged by the pace of adoption of many of our cloud services.
You heard the Home Premium numbers today, as well as talking about the commercial cloud.
And so for me it's hard to say is there too big of a delta?
It's really about managing each of these things toward absolute growth and absolute improvement and having customer adoption.
So, I probably just have a different perspective on that than you have.
- Analyst
Thank you very much.
- CFO
Thanks, Kash.
- General Manager IR
Thanks, Kash.
We'll go to the next question please.
Operator
Our next question comes from the line of Ross MacMillan with Jefferies.
Please proceed with your question.
- Analyst
Thanks a lot, and my congratulations, as well.
Amy, you said that Office 365 Home Premium was more than 15% of total consumer Office licenses sold.
And I wonder if you think about your commercial business.
And we either think about it as a percentage of total Office 365 or as a percentage of what's traditionally been transactional, whether you have a similar metric in terms of percentage of total Office licenses sold.
- CFO
That's actually a good question.
We only recently started selling the Office client in our volume licensing agreements through a subscription.
So that is actually good feedback for us to think, going forward, about talking about the Office-specific business that way.
In general we think of Office 365 as being a broad set of assets, including Exchange, SharePoint, Lync and Office in the commercial business.
And we haven't really talked about it given the newness of the model in the enterprise, as being as meaningful as it has been in the consumer.
The shift is far faster there on the client.
- Analyst
I just think that would be helpful, especially as we think about it with respect to your traditional commercial transactional business.
Maybe if I could slip in one other one just to go back on the contracted not billed.
I just want to be clear in my own mind because I've heard two things.
One thing I heard you say was we had stronger transactional business late in the quarter, but I also heard you say there were, frankly, more renewals on multi-year that would have resulted in that balance going up, especially if those were late in the quarter.
Am I right to think it's those two factors that are at play here?
Both stronger transactional and a larger pool, if you will, of multi-year renewals?
And is it relatively evenly balanced between the two?
Thank you.
- CFO
Thanks.
Actually transactional execution in the quarter is recognized all in-quarter.
That's non-annuity.
It doesn't go to either the unearned balance or the contracted not billed balance.
So that's not an impact that results in a change to unearned or CNB.
The latter, which is the absolute size of the expiration dates, frankly, could or couldn't impact CNB.
It can impact things like unearned growth, but it also can impact CNB depending on if it's contracted in-quarter but not billed until after the end of the quarter.
- Analyst
That's really helpful.
Thank you for the clarification.
- General Manager IR
Thanks.
We'll move to the next question please.
Operator
Thank you.
Our next question comes from the line of Brad Reback with Stifel.
Please proceed with your question.
- Analyst
Hi, how are you guys doing?
- CFO
Hi, Brad.
- Analyst
Amy, in the Q it talks about the Surface still losing money, even at the almost $900 million run rate of revenue in the quarter.
Can you give us any sense of what type of volume you need for that business to have the scale to make some money?
- CFO
Thanks, Brad.
When we launched Surface just a year ago, our goal was really to create a product that showcased what can happen when you innovate in hardware, in the service and in the software.
As you know we've learned a lot over the course of this journey, and we have to make more meaningful progress.
But I think for us, we've remained focused as we launch the second version of Surface to stay focused on both price point and gross margin.
I think we've made a big Leap from D1 to D2.
And I look forward to making leaps as we go forward in our product road map.
But I do think it's more to think about it as a goal we absolutely have as we continue to innovate the line.
- Analyst
Great.
Thank you.
- CFO
Thanks.
- General Manager IR
We'll move to the next question please.
Operator
Thank you.
Our next question comes from the line of Gregg Muskowitz with Cowen and Company.
Please proceed with your question.
- Analyst
Thank you very much.
Amy, despite the healthy gross margins, your XBox platform revenue grew $1.2 billion year over year, but your related cost of foods sold went up by $1.6 billion.
I realize there may be additional costs related to launch.
Wondering if you could talk to expected profitability levels for XBox for the balance of fiscal 2014.
- CFO
Thanks.
We'll continue to be in launch mode for Xbox One, especially as many people are excited about launch of Titanfall in March.
And we'll continue to add and expand markets over the course of the year.
I would continue to think about our investment in being the leading next-generation console as certainly extending.
- Analyst
Okay.
Thank you.
- General Manager IR
Thank you.
So we have time for one more question.
Operator
Thank you.
Our last question comes from Brendan Barnicle with Pacific Crest Securities.
Please proceed with your question.
- Analyst
Thanks so much.
Amy, you mentioned briefly in your comments some of the strengths you had seen in SQL Server.
That seems to be taking market share.
You highlighted a couple of the features, but what do you think is driving that market share gain?
And a similar question over on the server side where you seem to have better server numbers than what we have seen in units.
What would be accounting for that additional strength?
- CFO
Thank you.
You're right.
I only pointed out a few of the value props of SQL Server.
And actually dating back years the real value prop of SQL has been the breadth of its offerings: analytics, reporting and core data base functionality.
Over the years I think the balance of those things, and continuing to add and innovate at very good value, has continued to be appealing.
As we move forward and add some cloud capabilities into our hybrid model and continue to add features into the premium levels, when you are the established, and I think in many ways, unit leader then you can focus on continuing to move up the stack, adding value and increasing your premium mix.
The team has really done a terrific job of doing that, so it's nice to be asked so that I can talk about it.
And I think I mentioned it briefly, but Systems Center is another where we've gained share in virtualization.
I think we're quite proud of the progress we've made especially in that area.
That's enabled a lot of growth as well.
So I actually appreciate the question.
It's good to be able to talk so positively about those assets.
- General Manager IR
Thank you, Brendan.
Okay, so that wraps up the Q&A portion of today's earnings call.
Just a quick reminder that Build, our developer conference, will kick off the morning of April 2 in San Francisco.
We encourage investors to watch the key notes live via webcast.
We'll also look forward to seeing many of you at the coming months in various investor's conferences.
For those of you unable to attend in person, these events will generally be webcast and you will be able to follow comments at the microsoft.com/investor website.
Please contact us if you need additional details.
Thanks again for joining us today and take care.
- CFO
Thank you, everyone.
Operator
Thank you.
This concludes today's teleconference.
You may disconnect your lines at this time and thank you for your participation.