Amy E. Hood
Thank you, Satya, and good afternoon everyone.
This quarter revenue was $29.1 billion, up 19% and 18% in constant currency. Gross margin dollars increased 18%. Operating income increased 29% and 28% in constant currency and earnings per share was $1.14, increasing 36% and 33% in constant currency, another quarter of double-digit revenue and operating income growth drove a record start to the fiscal year. We saw strength across each of our segments with strong sales execution by our partners and sales teams. Customer demand for our hybrid and cloud offerings drove the quarter and we continued to benefit from favorable macroeconomic and IT spending trends.
Now to our commercial business.
As a reminder, starting this quarter, the commercial portion of LinkedIn is included in these metrics.
Our commercial revenue annuity mix increased 1 point year-over-year to 90%. Commercial unearned revenue was $27.3 billion, growing 22% and 21% in constant currency, in line with expectations. On an expiry base that was roughly flat year-over-year, commercial bookings were better than expected and increased 15% and 16% in constant currency, benefiting from larger long-term Azure contracts, growth in Azure consumption overages and pay-as-you-go contracts and strength in on-premises revenue. These contract types impact bookings, reported revenue and unearned revenue in different ways.
Let me explain.
First, under ASC 606, hybrid and on-premises offerings drive bookings growth and more in-period revenue recognition. Therefore, there's less impact on unearned revenue.
Second, growth in Azure consumption overages and pay-as-you-go contracts drive bookings growth and in-period revenue, but have little impact on unearned revenue. And finally, long-term Azure contracts drive significant bookings growth, but have a smaller impact on in-period revenue and unearned revenue. The inclusion of LinkedIn results was immaterial to the growth rates of commercial unearned and commercial bookings. Commercial cloud revenue was $8.5 billion, growing 47% and 46% in constant currency with strong performance in the U.S., Western Europe and the UK. Commercial cloud gross margin percentage increased 4 points to 62%, driven again by significant improvement in Azure gross margin. Company level, gross margin percentage was 66%, down slightly year-over-year, with sales mix shift to gaming and commercial cloud. FX increased overall company and Productivity and Business Processes revenue by 1 point, in line with guidance. The impact to Intelligent Cloud and More Personal Computing revenue was immaterial, 1 point less favorable than expected. FX impact was immaterial to COGS and operating expenses, about 1 point less favorable than expected. Even with that headwind, operating expenses grew 8%, in line with expectations.
Our engineering and sales capacity investments in large growing markets continue to deliver differentiated value for our customers, while generating material operating income leverage.
This quarter, we increased operating margin nearly 3 points year-over-year.
Now to the segment results. Revenue from Productivity and Business Processes was $9.8 billion, increasing 19% and 18% in constant currency, ahead of expectations, driven by both the on-premises and cloud businesses. Office commercial revenue grew 17% and 16% in constant currency, driven by continued Office 365 commercial growth and approximately 3 points of growth from increased demand ahead of a price increase with the launch of Office 2019. Office 365 commercial revenue grew 36% and 35% in constant currency, with installed base expansion across all customer segments and ARPU growth as customers shift to E3 and E5 workloads. Office 365 commercial seats grew 29%, and in line with last quarter, benefited from strong performance of our Microsoft 365 academic offers. Office consumer revenue increased 16% and 17% in constant currency, driven by growth in Office 365 subscription revenue and approximately 5 points of growth from increased channel demand ahead of a price increase with the launch of Office 2019. Office 365 consumer subscribers grew to 32.5 million. Dynamics revenue grew 20%, including a few points from a greater mix of contracts with higher in-period recognition under ASC 606. Dynamics 365 grew 51% and 49% in constant currency. LinkedIn revenue increased 33% with strong execution across all businesses. Segment gross margin dollars grew 18% and 17% in constant currency and gross margin percentage declined slightly year-over-year as cloud mix offset LinkedIn and Office 365 margin expansion. Operating expenses increased 7% and 8% in constant currency with ongoing investments in LinkedIn, cloud engineering and commercial sales capacity to support top-line growth. Operating income increased 29% and 27% in constant currency. Revenue from Intelligent Cloud was $8.6 billion, increasing 24%, better than anticipated, driven by demand for our hybrid offerings. Server products and cloud services revenue grew 28%. Azure revenue increased 76%, in line with our expectations with strong growth across both consumption and per-user base businesses.
Our on-premises server business grew 10% and 9% in constant currency, driven by continued demand for premium versions and hybrid solutions, as well as increased demand ahead of Q2 price increases for certain versions of our server products. Enterprise services revenue grew 6% as growth in Premier Support Services and Microsoft Consulting Services was partially offset by a decline in custom support agreements for Windows Server 2003. Segment gross margin dollars increased 28% and 27% in constant currency. Gross margin percentage increased year-over-year as material improvement in Azure gross margin percentage offset the growing mix of Azure IaaS and PaaS revenue. Operating expenses increased 19% and 20% in constant currency, driven by ongoing investments in cloud and AI engineering and commercial sales capacity. Operating income grew 37% and 35% in constant currency.
Now to more Personal Computing. Revenue was $10.7 billion, increasing 15% with significantly better than expected results in gaming. Gaming revenue increased 44% and 45% in constant currency with better than expected results across both software and services and hardware. Xbox software and services revenue grew 36%, with continued strength from a third-party title. Xbox hardware revenue grew 94% and 96% in constant currency with earlier than expected sell-in of holiday hardware bundles. In Windows, we saw healthy Windows 10 commercial deployments as the OEM ecosystem continued to benefit from customer demand for modern and secure software and hardware. OEM Pro revenue grew 8%, a few points ahead of the commercial PC market from a higher mix of premium licenses. Windows commercial products and cloud services revenue increased 12%. In consumer, OEM non-Pro revenue declined 5%, below the consumer PC market with continued pressure in the entry-level price category. Inventory levels were within the normal range. Search revenue ex-TAC increased 17%, driven by Bing rate growth and increased volume in U.S. and international markets. In Surface, revenue grew 14%, driven by Surface Book 2 and Surface Go. Segment gross margin dollars grew 10% and gross margin percentage decreased due to sales mix to our lower-margin gaming business. Operating expenses declined 1%.
As a result, operating income grew 23%.
Now back to our total company results.
As expected, capital expenditures including financed leases were up sequentially to $4.3 billion, driven by ongoing investment to meet demand for our cloud services. Cash paid for property, plant and equipment was $3.6 billion. Free cash flow was $10.1 billion and decreased 2% year-over-year due to higher capital expenditures in support of our cloud business. Cash flow from operations increased 10% year-over-year with strong cloud billings and collections, partially offset by our first annual TCJA payment of $1.5 billion.
Excluding the TCJA payment, free cash flow grew 12% and operating cash flow grew 22%. Other income was $266 million, higher than anticipated, due to realized gains in the recording of mark-to-market gains under the new accounting rules for financial investments.
Our effective tax rate was 14%.
As a reminder Q1 and Q3 rates are impacted by the volume of equity vest during those quarters. This Q1, the impact was a bit more than expected due to the movement of our share price within the quarter. And finally, in line with our continued commitment, we returned $6.1 billion to shareholders through dividends and share repurchases, an increase of 27% year-over-year.
Now let's turn to our outlook.
Given that we expect the GitHub acquisition to close shortly, my commentary includes the full impact of the deal including purchase accounting, integration and transaction-related expenses based on our current understanding of the purchase price allocation and related deal accounting.
We continue to expect the deal to be minimally dilutive to FY 2019 and FY 2020 EPS on a non-GAAP basis and accretive to FY 2020 operating income on a non-GAAP basis.
For Q2, first FX.
Assuming current rates remain stable, we expect no impact to revenue growth. FX should decrease COGS and operating expense growth by approximately 1 point.
Second, our commercial business.
We expect another quarter of healthy performance with solid bookings growth. Commercial unearned revenue is expected to grow approximately 19% year-over-year even with the ongoing shift toward the cloud contracts discussed earlier. Commercial cloud gross margin percentage should continue to improve on a year-over-year basis though at a more moderated rate than prior years given the continued mix of revenue toward Azure consumption-based services. Margin improvement will continue to vary on a quarterly basis driven by revenue mix, seasonality and the timing of infrastructure spend.
Third, we expect ongoing year-over-year growth in capital expenditure as we support growing demand.
Given infrastructure spend timing, Q2 CapEx should be roughly in line with Q1.
Now to our segment guidance. In Productivity and Business Processes, we expect revenue between $9.95 billion and $10.15 billion. Office commercial and Dynamics should continue to exhibit double-digit growth, driven by strong cloud performance but with some moderation due to the on-premise drivers discussed earlier. Office consumer will see continued momentum in new subscribers but overall revenue growth will be negatively impacted as channel inventories normalize. LinkedIn revenue growth should remain healthy though on a stronger prior-year comparable.
For Intelligent Cloud, which includes GitHub, we expect revenue between $9.15 billion and $9.35 billion. In Azure, we expect healthy growth across our consumption and per-user base businesses though per-user services growth will moderate given the size of the installed base. In More Personal Computing, we expect revenue between $12.8 billion and $13.2 billion. OEM Pro revenue growth should be in line with the commercial PC market.
As a reminder, prior year comparables strengthened throughout the remainder of the year. In Windows commercial products and cloud services, we expect continued strength, as well as the benefit of a low prior-year comparable. And for OEM non-Pro, we expect similar dynamics to Q1. In Surface, revenue growth should accelerate, with the impact of recently launched devices including Surface Pro 6 and Surface Laptop 2. Search ex-TAC results should be similar to Q1 with durable growth in rate and volume. In gaming, we expect revenue growth to moderate due to a prior year comparable that included the launch of Xbox One X.
Software and services growth should be similar to Q1, with continued benefit from a third-party title plus overall platform strength.
Now back to our company results.
We expect COGS of $12.2 billion to $12.4 billion and operating expenses of $9.8 billion to $9.9 billion. Other income and expense should be approximately $50 million as interest income and investment gains are partially offset by interest expense. And finally we expect our Q2 effective tax rate to be slightly above the full year estimate of 17%.
Now a few comments on the fiscal year.
Assuming current rates remain stable, we expect a 1 point headwind to full-year revenue growth with any benefit in H1 offset in H2. FX should decrease COGS and operating expense growth by approximately 1 point.
Second, operating expenses. We remain unchanged in our commitment to invest in strategic priorities that are key to driving long-term value creation.
With the addition of GitHub as a strategic priority, we now expect operating expenses to grow roughly 8%. Growth excluding GitHub is expected to be in line with our prior guidance of roughly 7%.
Third, on operating margin. Even with the full GAAP impact of GitHub purchase accounting now included in our guidance, we continue to expect our operating margin to be up slightly year-over-year. Margin leverage is a direct result of our focused investments in the right technology trends coupled with consistent execution.
For CapEx, we continue to expect the growth rate for the year to moderate even as we meet demand for our cloud services.
Regarding the GitHub acquisition, we remain committed to an incremental share buyback beyond the normal quarterly pace, though it's expected to fully offset stock consideration issue in the transaction by the end of the fiscal year. And finally, we continue to expect the full year effective tax rate to be roughly 17% with quarterly variability. And with that, Mike, let's go to Q&A.