United States Securities and Exchange Commission
Washington, D.C. 20549
FORM 10-K
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED JUNE 30, 20032006
OR
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 0-14278
MICROSOFT CORPORATION
WASHINGTON | 91-1144442 | |
(STATE OF INCORPORATION) | (I.R.S. ID) |
ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399
(425) 882-8080
Securities registered pursuant to Section 12(b) of the Act:
NONECOMMON STOCK
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCKNONE
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ Nox
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesx No¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the registrant is an accelerated filera shell company (as defined in Rule 12b-2 of the Exchange Act). Yesx¨ No¨x
TheAs of December 31, 2005, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $233,926,876,964 based on the closing sale price as reported on the NASDAQ National Market System. As of August 15, 2003 was $235,404,995,887.
The number18, 2006, there were 9,969,991,800 shares of shares outstanding of the registrant’s common stock as of August 15, 2003 was 10,813,984,831.
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on November 11, 200314, 2006 are incorporated by reference into Part III.
FORM 10-K
For The Fiscal Year Ended June 30, 2003
2006
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Special Note About Forward-Looking Statements
Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, 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. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “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 which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” (refer to Item 1A). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
GENERAL
Microsoft Corporation was founded as a partnership in 1975 and incorporated in 1981. Our mission is to enable people and businesses throughout the world to realize their full potential,potential. We work to achieve our mission through technology that transforms the way people work, play, and communicate. Since our vision is empowering people through great software – any time, any place, and on any device.founding in 1975, we have been a leader in this transformation. We develop manufacture, license, and supportmarket software, services, and solutions that we believe deliver new opportunity, convenience, and value to people’s lives. We do business throughout the world and have offices in more than 100 countries.
We generate revenue by developing, manufacturing, licensing, and supporting a wide range of software products for a multitude ofmany computing devices. Our software products include scalable operating systems for servers, personal computers, (PCs), and intelligent devices; server applications for client/serverdistributed computing environments; information worker productivity applications; business solutionssolution applications; high-performance computing applications, and software development tools. We provide consulting services and product support services, and we train and certify computer system integrators and developers. We sell the Xbox 360 video game console along withand games, PC games, and peripherals. Our online businesses include theOnline offerings and information are delivered through our Windows Live, Office Live, and MSN subscriptionportals and the MSN network of Internet productschannels.
We also research and services.
Microsoft also researches and developsdevelop advanced technologies for future software products. A significant portionWe believe that delivering breakthrough innovation and high-value solutions through our integrated software platform is the key to meeting our customers’ needs and to our future growth. We believe that over the past few years we have laid the foundation for long-term growth by delivering innovative new products, creating opportunities for partners, improving customer satisfaction, putting many of our most significant legal challenges behind us, and improving our internal processes. Our focus is to build on this foundation by continuing to innovate on our .NET architecture. Using common industry standards basedintegrated software platform, delivering compelling value propositions to customers, responding effectively to customer and partner needs, and continuing to focus internally on Extensible Markup Language (XML), a universal language for describingproduct excellence, business efficacy, and exchanging data, our goal isaccountability. Our research and development facilities are located primarily in Redmond, Washington. We also have smaller research facilities in other parts of the United States and around the world, including, but not limited to, enable seamless sharing of information across many platformsChina, Denmark, England, India, Ireland, and programming languages, and over the Internet, with XML Web services. In addition, we have embarked on a long-term initiative called Trustworthy Computing that aims to bring an enhanced level of security, privacy, reliability, and business integrity to computer systems.
Israel.
PRODUCTOPERATING SEGMENTS
We revised our productOur segments for fiscal year 2003. Our seven product segments are Client, Server and Tools, Information Worker, Microsoft Business Solutions, MSN, Mobile and Embedded Devices, and Home and Entertainment.
Changes in our segments are designed to provide management with a comprehensive financial view of our key businesses; promote betterbusinesses. The segments provide a framework for the alignment of strategies and objectives amongacross the development, sales, marketing, and services organizations; provideorganizations, and for morethe timely and rational allocation of development, sales, marketing, and marketingservices resources within businesses;businesses. The segments also help focus strategic planning efforts on key objectives and initiatives;initiatives across our businesses.
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Due to our integrated business structure, operating costs included in one segment may benefit other segments. Therefore, these segments are not designed to measure operating income or loss that is directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and give business owners more autonomy in detailed planning.used to compensate or charge each segment for such shared costs and to motivate shared effort. Segments should not be viewed as discrete or easily separable businesses.
For the fiscal years covered by this filing, our seven segments were: Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. See Note 2118 – Segment Information of the Notes to Financial Statements for financial information regarding segment reporting. PriorOn July 17, 2006, we announced a change in our operating segments reflecting the culmination of the business realignment announced in September 2005. These changes will be effective for fiscal year segment information has been restated to conform to2007; the seven new segments.
segments discussed in this section are presented in the way we internally managed and monitored performance at the business group level in fiscal year 2006, 2005, and 2004.
Client
Client segment includes Windows XP, Windows 2000, and other standard Windows operating systems. Windows XP extends the personal computing experience by uniting PCs, devices, and services, while enhancing reliability, security, and performance. Windows XP Home Edition is designed for individuals or families and includes capabilities for digital photo, music, video, home networking, and communications. Windows XP Professional includes all the features of Home Edition, plus remote access, security, performance, manageability, and multilingual features to help users improve productivity and connectivity. Windows XP was the successor to Windows 2000.
Client has overall responsibility for the technical architecture, engineering and product delivery engineeringof our Windows product family, and technical architectureis also responsible for the Microsoft Windows operating system, and new media technology, as well as our relationships with manufacturers of personal computers and non-PC devices,computer manufacturers, including multinational and regional original equipment manufacturer (OEM) accounts.manufacturers (“OEMs”). The segment includes sales and marketing expenses focused on businessfor the Windows client operating system and product development efforts for the Windows platform, as well as integrationplatform. Client revenue growth is correlated with the growth of our technologiespurchases of personal computers from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue.
The next generation of the Windows operating system, Windows Vista, is under development. This development phase represents a major investment that we expect will result in a significantly more manageable and products into non-PC devices.
powerful PC operating system than previously released by Microsoft. Windows Vista will include advances in security, digital media, user interfaces, and other areas that will enhance the user and developer experience.
Products: Windows XP Professional and Home; Media Center Edition; Tablet PC Edition; and other standard Windows operating systems.
Competition
Client faces strong competition from well-established companies with differing approaches to the PC market. Competing commercial software products, including variants of Unix, are supplied by competitors such as Apple Computer, Hewlett-Packard, IBM, and Sun Microsystems. The Linux operating system, which is also derived from Unix and is available without payment under a General Public License, has gained some acceptance as competitive pressures lead PC OEMs to reduce costs. The Windows operating system also faces competition from alternative platforms and new devices that may reduce consumer demand for traditional personal computers. Competitors such as Mozilla offer software that competes with the Internet Explorer Web browsing capabilities of Windows products. Apple Computer, Real Networks, and others compete with Windows Media Player. Our operating system products compete effectively by delivering innovative software, a familiar, easy-to-use interface, compatibility with a broad range of hardware and software applications, and the largest support network for any operating system.
Server and Tools
Server and Tools segment consists of server software licensesdevelops and client access licenses (CALs) formarkets Windows Server SQLproducts, including Windows Server Exchangeoperating systems. Windows Server and other servers. It also includes developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft consulting services. Microsoftproducts are integrated server products offer a comprehensive range of solutions designed to meet the needs of developers and IT professionals, andinfrastructure software that are designed to flexibly runsupport end-to-end software applications and tools built on the programs and solutions that enable information workers to obtain, analyze, and share information quickly and easily. Microsoft servers provide capabilities ranging from messaging and collaboration to database management and ranging from e-commerce to mobile information access.
Windows Server 2003 is a multipurpose operating system capable of handling a diverse set ofsystem. Windows Server products include the server roles in either a centralized or a distributed fashion. SQL Server is a Web-enabled databaseplatform, operations, security, applications and data analysis package, providing core support for XMLcollaboration software. The segment also builds standalone and the ability to query across the Internet. Microsoft Exchange delivers a reliable, scalable, and manageable infrastructure with 24×7 messaging and collaboration. Systems Management Server delivers cost-effective, scalable change and configuration management for Windows–based desktop and server systems. Small Business Server is a network solution that includes the Windows 2003 Server network operating system and is designed to help small businesses. Developer tools focus on coordinating the overall programming model for the client and server, creatingsoftware development lifecycle tools for the .NET platform,software architects, developers, testers and fostering synergies between Windows and the Windows Server System offerings.project managers.
Server and Tools segment includes the integrated product development and marketing that delivers Microsoft Windows Server System products. In addition, the segment provides information about the extended Microsoft platform through a variety of content offerings, such as web-based training for developers and IT managers. Through this segment, weWe offer a broad range of consulting services for advanced technology requirements, including custom solutions services, enterprise application planning, architecture and design services, and proof-of-concept services. We also provide product support services alignedservices. The segment also provides training and certification to developers and information technology professionals about our enterprise customers. TheServer and PC platform products. Server and Tools segmentalso includes ourthe Enterprise and Partner Group, which is responsible for enterprise sales, partner management and partner programs for medium and large organizations; and the Public Sector sales and marketing organization.
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strategy, enterprise sales learningApproximately half of Server revenue comes from multi-year licensing agreements, one third is purchased through fully packaged product and readiness, enterprise solution selling, enterprise partner sales strategy,transactional volume licensing programs, and enterprise field communications. This group is also responsible for technical selling, field competitive strategy,approximately 10% comes from licenses sold to OEMs. Approximately 15% of revenue comes from consulting and all competitive sales engagements.
product support services.
Products and Services: Windows Server operating system; Microsoft SQL Server; Exchange Server; Microsoft Consulting Services; product support services; Visual Studio; System Center products; Forefront security family of products; and Biz Talk Server, among others.
Competition
Our server operating system products face intense competition from a wide variety of server operating systems and server applications, offered by companies with a variety of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Sun Microsystems offer their own variant of Unix preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system. IBM’s endorsement of Linux has aided the acceptance of Linux as an alternative to Unix and Windows server operating systems. Linux’s competitive position has also benefited from the large number of compatible applications now produced by many leading commercial software developers and non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat.
We compete in the business of providing enterprise-wide computing solutions with several companies that provide solutions and middleware technology platforms. IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software developers that provide competing server applications for PC-based distributed client/server environments include CA, IBM, and Oracle.
Numerous commercial software vendors offer competing commercial software applications for connectivity (both Internet and intranet), security, hosting, and e-business servers. System Center competes with BMC, CA, and IBM in the Management of IT infrastructures, while Forefront Security competes with McAfee, Symantec, and Trend Micro in protecting both client and server applications. In addition, IBM has a large installed base of Lotus Notes and cc:Mail, both of which compete with our collaboration and e-mail products. Non-commercial software products, including the widely-deployed Apache Web Server, also compete with our solutions. Our products for software developers compete against offerings from Adobe, BEA Systems, Borland, IBM, Oracle, Sun Microsystems, and other companies. We believe that our server products provide customers with advantages in innovation, performance, total costs of ownership, and productivity, by delivering superior applications development tools and development environment, compatibility with a broad base of hardware and software applications, security, and manageability.
Information Worker
Information Worker segment is responsible for developing and delivering technologies that focus on improving productivity for information workers in corporations. It consists of the new Microsoft Office Systemsystem of programs, servers, services, and solutions. Microsoft Office System is the successor of Microsoft Office XP and is expected to be released to market in the first half of fiscal 2004. The Microsoft Office System includes the Microsoft Office 2003 Editions, which include (depending on the edition): Microsoft Office Outlook 2003, Microsoft Office Excel 2003, Microsoft Office PowerPoint 2003, Microsoft Office Word 2003, and Microsoft Office Access 2003. Other products in the Microsoft Office System include Microsoft Office Visio 2003, Microsoft Office Project 2003, Microsoft Office Project Server 2003, Microsoft Office InfoPath 2003, Microsoft Office OneNote 2003, Microsoft Office Publisher 2003, Microsoft Office FrontPage 2003, and Microsoft Office SharePoint Portal Server 2003. Microsoft Office has evolved from a suite of personal productivity products to a more comprehensive and integrated system of products for information worksoftware solutions designed to increase personal, team, and organization productivity. The Office system offerings generate over 85% of Information Worker revenue. Revenue growth depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as enterprise content management, collaboration, unified messaging, and business intelligence.
Approximately 40% of Information Worker revenue has come from multi-year license agreements with large enterprises. Revenues from these licenses generally depend upon the number of information workers in a licensed enterprise. Revenue from this category of agreements is therefore relatively independent of the number of PCs sold in a given year. Consequently, general employment levels, particularly in North America and Europe, significantly affect Information Worker revenue. Approximately 40% of Information Worker revenue comes from new licenses acquired through fully packaged product and volume licensing programs to individual consumers and enterprises of all sizes. Most of this revenue is sensitive to information technology budgets, which often depend on general economic conditions. The remaining approximately 20% of Information Worker revenue comes from licenses to OEMs for new PCs and is affected by the level of PC shipments. The next wave of our flagship product, the 2007 Microsoft Office System features integration withsystem, is currently under development.
Products: Microsoft intranet collaboration technologies, Information Rights Management,Office; Microsoft Project; Microsoft Visio; SharePoint Portal Server CAL; Microsoft Live Meeting; One Note; and support for industry standard XML. The Information Worker segment also includes Microsoft Office Live Meeting, resulting from our acquisition of PlaceWare, Inc., Microsoft Office Live Communications Server 2003, and an allocation for CALs. The segment also includes professional product support.Communication Server.
The segment includes the Small and Mid-Market Solutions & Partners (SMS&P) organization, which is responsible for sales, partner management, partner programs, and customer segment marketing for the small and mid-market businesses. In fiscal year 2004, SMS&P group will integrate the sales and marketing assets of the Microsoft Business Solutions segment with the existing Worldwide Small and Medium Business groups. We believe this combined effort will lead to expanded opportunity for Microsoft and our customers and partners by making available the complete range of Microsoft products and services to small and mid-market businesses, creating increased growth opportunities for the independent software vendor (ISV) community.
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Competition
Competitors to the Microsoft Office system include many software application vendors such as Apple, Corel, Google, IBM, Novell, Oracle, Red Hat, Sun Microsystems, and local application developers in Europe and Asia. IBM (Smartsuite) and Corel (WordPerfect Suite) have measurable installed bases with their office productivity products. Apple may distribute certain of their application software products with various models of their PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors to sell under their brands, including IBM, Novell, Red Hat, and Sun. Corel’s suite and many local software suites around the world are aggressively priced for OEMs to preinstall on low-priced PCs. In addition to traditional client-side applications, Web-based offerings such as AjaxWrite, gOffice, iNetOffice, SimDesk, ThinkFree, wikiCalc, or other small projects competing with individual applications, can also provide an alternative to Microsoft Office system products. Google has announced spreadsheet and word processing applications as web-based offerings and also provides an enterprise search offering that competes with SharePoint and our new enterprise search product. IBM has many different points of competition with Office system products with its Notes and Workplace offerings.
As we continue to respond to market demand for additional functionality and products, we will compete with additional vendors, most notably in enterprise content management, collaboration tools, unified messaging, and business intelligence. These competitors include WebEx, and a number of business intelligence vendors such as Business Objects, Cognos, and Hyperion.
Microsoft Business Solutions
Microsoft Business Solutions segment includes the businesses of Great Plains,is responsible for Microsoft bCentral, and Navision. Microsoft Business Solutions develops and markets a wide range ofDynamics brand business applications designed to helpfor small and mid-marketmid-size businesses, become more connected with customers, employees, partners,large organizations and suppliers. Microsoft Business Solutions applications provide end-to-end automation fordivisions of global enterprises. It offers financial reporting, distribution, project accounting, electronic commerce, human resources and payroll, manufacturing,management, customer relationship management, supply chain management, business intelligence,and analytics applications. Revenue is derived from software and services sales, with software sales representing a large majority of total revenue. Software revenues include both new software licenses and marketing management,enhancement plans, which provide customers with future software upgrades and customer service and support. Microsoft Business Solutions products are designed to meeton-line training over the broad spectrumperiod of business application needs of small to mid-market businesses, a group that generally consist of businesses with $1 million to $800 million in annual revenue.the plan. The business solutions are fully and seamlessly integrated across the application areas of enterprise resource management (ERM), customer relationship management (CRM), supply chain management (SCM) and business intelligence. These business solutions are sold, implemented, and supporteddelivered through a partnerworldwide network consisting of more than 4,500 value added resellers, systems integrators, consultants, ISVs, accounting firms (national, regional,channel partners and local), application service providers (ASPs),independent software vendors that provide services, additional related software, and eBuilders.local support.
Products: Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Small Business Solutions partners provide strong distribution, marketing, training,Accounting.
Competition
Our competition varies based upon the size and supportgeographic location of the customer for whom we are competing. We compete with well-known vendors such as Intuit and Sage in the market focused on providing solutions for small and mid-sized businesses. The market for large organizations and divisions of global enterprises continues to be intensely competitive with a small number of primary vendors including Oracle and SAP. Additionally, these large enterprise-focused vendors are repositioning some of their business application customer segment.
applications to focus on small and mid-sized businesses. We believe our products compete effectively with these vendors based on our strategy of providing integrated, adaptable solutions that work like and with Microsoft technologies our customers already have.
MSN
MSN segment includes MSN Subscriptions and MSN Network services. MSN Subscription services include MSN Internet access and premiumprovides personal communications services, such as e-mail and instant messaging, and online information offerings such as MSN Extra Storage,Search, MapPoint, and the MSN portals and channels around the world. MSN also provides a variety of online paid offerings. MSN manages many of its own properties, including health, autos, and shopping. MSN also creates alliances with third parties for many channels, including CareerBuilder.com, Expedia.com, Foxsports.com, Match.com, and MSNBC.com.
MSN generates revenue primarily from advertisers on MSN, from consumers and partners through subscriptions and transactions, and from MSN narrowband Internet access subscribers. In fiscal year 2006, we launched MSN adCenter – our internally developed advertising platform – in certain international markets and throughout the U.S. where it now serves 100 percent of paid search traffic on our online properties. We believe MSN adCenter will enable us to increase both display and search advertising revenues by reducing our reliance on third parties for delivering
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ads. In fiscal year 2006, we announced Windows Live™, a set of Internet services and software designed to improve the users’ connected experience and we released Windows Live Messenger to consumers in 58 countries.
Products: MSN Search; MapPoint; MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, MSN Bill Pay, and MSN Radio PlusPlus); Windows Live; and MSN Mobile whichServices.
Competition
MSN competes with AOL, Google, Yahoo!, and a wide array of Web sites and portals that provide content and online offerings of all types to end users. We compete with these organizations to provide advertising opportunities for merchants. MSN also competes for narrowband Internet access users with AOL, Earthlink, and other ISPs for dial-up internet access in the United States. Due to the continuing trend of consumers migrating from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to continue to decline as we de-emphasize this portion of our business. The Internet advertising industry has grown significantly over the past several years, and we anticipate that this trend will continue. Competitors are offeredaggressively developing Internet offerings that seek to consumers regardlessprovide more effective ways of their Internet Service Provider. The MSN Network delivers onlineconnecting advertisers with audiences through enhanced functionality in communication services, such as email and online instant messaging through its MSN Hotmail and MSN Messenger products. It also delivers popularimprovements in information services such as MSN SearchInternet search, and improved advertising infrastructure and support services. We have developed our own algorithmic search engine to provide end users with more relevant search results, a broader selection of content, from top partners like MSNBC, ESPN, Expedia, and Access Hollywood.
The segment is responsible for buildingexpanded search services. To support the growth of our advertising business, we also are investing in our communication services, technology, operations, and operatingsales efforts. We will continue to introduce new products and services, including the MSN NetworkWindows Live set of services that are aimed at attracting additional users through improvements in the user online experience. We believe that we can compete effectively across the breadth of our Internet services by providing users with software innovation in the form of information and for delivering MSN Subscription services. Revenue is principally generated from subscribers to MSN’s Internet accesscommunication services that help them find, discover, and premium servicesexperience what they want online and from advertisers on the MSN Network. MSN delivers its services direct via its MSN Networkby providing merchants with effective advertising results through improved systems and through partnerships with network operators such as Verizon, Qwest, Charter Communications, and Bell Canada.
sales support.
Mobile and Embedded Devices
Mobile and Embedded Devices develops and markets products that extend the Windows platform to mobile devices such as PDAs and phones, and to embedded devices. Microsoft’s vision for mobile devices is rooted in the convergence of the computing and wireless industries, which we believe creates new opportunities to improve communication and information access for customers. We see software as a key differentiator in making smart devices and wireless data services valuable to customers through rich experiences such as mobile messaging, location-based services, media, and speech recognition. We are working closely with mobile operators and with hardware and software partners to accelerate the development and availability of smart devices and services, and to provide a broad range of choices for customers. The segment consistsis also responsible for managing our company-wide sales and customer relations with device manufacturers and other communication-sector customers, which includes network service providers and media and entertainment companies. Windows Embedded is a suite of operating systems, tools, and technologies that are specifically designed for today’s advanced embedded devices.
Products: Windows Mobile software platform; Windows Embedded device operating systems, MapPoint,system; and Windows Automotive.
Competition
Windows Mobile software powers Pocket PC, Pocket PC Phone Edition,faces substantial competition from Nokia, Openwave Systems, Palm, QUALCOMM, Research In Motion, and Smartphone products. Windows Embedded, including Windows CE.NET, Windows XP Embedded and Windows NT Embedded, is a family ofSymbian. The embedded operating system software used in non-PC computingsegment is highly fragmented with many competitive offerings. Key competitors include IBM, Wind River, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. The telematics market is also highly fragmented, with competitive offerings from IBM and automotive suppliers building on various real-time operating system platforms from commercial Linux vendors, QNX Software Systems, Wind River, and others. We believe that our products compete effectively by providing a familiar development framework, which enables developers to easily write and deploy innovative applications for mobile or embedded devices. Windows Embedded software is used widely in advanced consumer electronics devices including digital televisions, IP-based set top boxes, network gateways, and portable media players, as well as in enterprise devices including industrial controllers, retail point of sale systems, and voice-over-IP phones. The MapPoint family of location-enabled products and services includes the MapPoint Web Service,We also compete by providing a hosted programmable XML web serviceflexible platform that allows developerscustomers and partners to integrate location intelligence in applications,build differentiated and profitable business processesmodels, and web sites,by providing end users with benefits such as ease of use, personal productivity, and businessbetter information management and consumer oriented mapping CD-ROM products. Windows Automotive is an automotive grade software platform that provides developers with the building blocks to quickly and reliably create a broad range of advanced telematics solutions.
Mobile and Embedded Devices segment develops and markets the product lines described above. Further, the segment manages relationships with device manufacturers and with network service providers, including telecommunications, cable and wireless companies and host and network equipment providers.control.
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Home and Entertainment
Home and Entertainment segment includesis responsible for development, production, and marketing for the Microsoft Xbox video game system, PCincluding consoles and accessories, third-party games, games published under the Home Products Division (HPD),Microsoft brand, and TV platform products. Microsoft Xbox released in fiscal 2002, is our next-generation video game console system that delivers high quality graphicsLive operations, research, and audio experiences. Wesales and support. In addition to Xbox, we offer several types of entertainment products, including classicPC software games, online games, simulations, and sport and strategy games. HPDother devices. The segment also leads the development efforts of our Consumer Productivity Experience Group (“CPxG”) which includes Microsoft’s line of consumer hardwaresoftware and softwarehardware products, such as the Encarta line of learning products and services, application software for Macintosh computers, and Microsoft PC hardware products such as mice and keyboards. In addition, the Picture It! consumer publishing and productivity line of products and services, the Macintosh applications business, and the Microsoft hardware products.
Home and Entertainment segment oversees development and business strategy for the Microsoft Xbox video game system, including hardware, third-party games development, games development published under the Microsoft label, Xbox and Xbox Live operations, marketing, research, and sales and support. The segment leads the development efforts of our HPD product lines. The segment also carries out all retail sales and marketing for Microsoft Office and the Windows operating systems (for which it receives an inter-segment commission), Xbox, PC games, and HPDCPxG products. The segmentIt also is responsible for the development, sales, and deployment of Microsoft’s TV platform products for the interactive television industry.industry, including MSTV Foundation Edition and Internet Protocol TV products.
Products: Xbox 360; Xbox; Xbox Live; CPxG (consumer software and hardware products); and IPTV.
Competition
The home and entertainment business is highly competitive, characterized by rapid product life cycles, frequent introductions of new products and titles, and the development of new technologies. The markets for our products are characterized by significant price competition. We anticipate continued pricing pressure from our competitors. From time to time, we have responded to this pressure by reducing prices on certain products. Our competitors vary in size from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of product innovation, quality and variety, timing of product releases, and effectiveness of distribution and marketing.
Our Xbox hardware business competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. The lifecycle for video game consoles averages 5 to 7 years. We released Xbox 360, our next generation console in November 2005. Nintendo and Sony have also announced new versions of their game consoles, which have not been released. Success in the transition to the next generation of consoles will depend on the availability of games for the console, providing exclusive game content that gamers seek, the computational power of the console, and the ability to create new revenue sources such as advertising and downloadable content. We believe the Xbox 360 is positioned well against competitive console products based on significant innovation in hardware architecture, new developer tools, expanded revenue sources, and continued strong exclusive content from our own game franchises such as Halo.
In addition to competing against software published for non-Xbox platforms, our games business also competes with numerous companies that we have licensed to develop and publish software for the Xbox consoles. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners. Our MSTV business faces competition primarily from ad hoc solutions that address sub-segments of the TV delivery platform, but that do not provide end-to-end solutions for the network operator.
OPERATIONS
To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we “localize” many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text.
Our operational centers support all operations in their regions, including customer contract and order processing, credit and collections, information processing and vendor management and logistics. The regional center in Ireland supports the EMEA region; the center in Singapore supports the Japan, Greater China and Asia-Pacific region; and the centers in Fargo, Puerto Rico, Reno, and Redmond support North America and Latin America.
We contract most of our manufacturing activities to third parties who produce the Xbox, various retail software packaged products, and Microsoft hardware. Our products may include some components that are available from only one or limited sources. Our Xbox 360 console includes certain key components that are supplied by a single source. The central processing unit is purchased from IBM and the graphics chips and embedded dynamic random access memory chips for the graphics processing unit are purchased from Taiwan Semiconductor Manufacturing Company and NEC Corporation, respectively. Although we have chosen to initially source these key Xbox 360 components from
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INTERNATIONAL OPERATIONS
Microsoft develops and sells products throughout the world. Our three major geographic sales and marketing organizationsa single supplier, we are the Americas Region, the Europe, Middle East, and Africa Region, and the Japan and Asia-Pacific Region. Pressureunder no obligation to globalize our pricing structure might require that we reduce the sales price of our softwareexclusively source components from these vendors in the United Statesfuture. Beyond the exceptions noted, we generally have the ability to use other custom manufacturers if the current vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and other countries. A number of other factors could also havecomponents, and are often able to acquire component parts and materials on a negative effect on our business and results from operations outside of the United States, including changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; unexpected changes in regulatory requirements for software; social, political, labor, or economic conditions in a specific country or region, including foreign exchange rates; difficulties in staffing and managing foreign operations; and potential adverse foreign tax consequences. A portion of international revenue is hedged, thus offsetting a portion of the currency translation exposure.
volume discount basis.
EQUITY METHOD INVESTMENTSPRODUCT DEVELOPMENT
We have entered into joint venture arrangements to take advantage of creative talent and content from other organizations. For example, we own 50 percent of MSNBC Cable L.L.C., a 24-hour cable news and information channel, and 50 percent of MSNBC Interactive News L.L.C., an interactive online news service. National Broadcasting Company (NBC) owns the remaining 50 percent of each of these joint ventures.
PRODUCT DEVELOPMENT
During fiscal years 2001, 2002,2006, 2005, and 2003,2004, research and development expense was $4.38$6.58 billion, $4.31$6.10 billion, and $4.66$7.74 billion, respectively. Those amounts represented 17.3%14.9%, 15.2%15.3%, and 14.5%21.0%, respectively, of revenue in each of those years. During fiscal year 2001, $272 million of goodwill amortization was included in research and development expense. No goodwill amortization is included in fiscal years 2002 and 2003, in accordance with Statement of Financial Accounting Standards (SFAS) 142,Goodwill and Other Intangible Assets.We plan to continue spending significant amounts forinvestment in a broad range of research and product development.
Most of our software products are developed internally. We also purchase technology, license intellectual property rights, and oversee third-party development and localization of certain products. We do not believe we are not materially dependent upon licenses and other agreements with third parties relating to the development of our products. Internal development allows us to maintain closer technical control over our products andproducts. It also gives us the freedom to designatedecide which modifications and enhancements are most important and when they should be implemented. We work to devise innovative solutions in computer science, such as making computers easier to use, designing software for the next generation of hardware, improving the software design process, and investigating the mathematical underpinnings of computer science. We have created a substantial body of development tools and have evolved development methodologies for creating and enhancing our products. These tools and methodologies areGenerally, we also designed to simplify a product’s portability among different operating systems, microprocessors, and computing devices. Productcreate product documentation is generally created internally. We strive to obtain information at the earliest possible time about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide to application vendors with a range of resources and guidelines for development, training, and testing.
Business and Product Development Strategy. Innovation is a key factor affecting Microsoft’s growth. In fiscal year 2006, we received our 5,000th patent. We continue our long-term commitment to research and development, including advanced work aimed at innovations in a wide spectrum of technologies: tools and platforms; communication, collaboration and expression; information access and organization; entertainment; business and e-commerce; and devices. Through innovations in these areas, we expect to grow revenue via three principal strategies:
Leading the Software Services Transformation
Internet-based services are transforming the way people create, deploy, manage and use technology. We are committed to playing a Web service-connected IT architecture: serversleadership role in the software services transformation through our efforts to host Webcreate our services (Windows Server Systemplatform for the next generation of applications, communications, and commerce. Across the company, software services are at the core of our development efforts.
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In fiscal year 2006, we introduced Windows Live and Office Live, which provides small businesses with affordable Internet-based business services hosted by Microsoft. We rolled out new search services, including beta releases of Windows Live Search and Windows Server 2003)Live Academic Search. We introduced new and enhanced services for computer safety and computer maintenance (Windows Live SafetyCenter and Windows Live OneCare), developmentcommunications (Windows Live Mail and Windows Live Messenger), and entertainment (Xbox Live). We also created Live Labs, an applied research program that targets Internet products and services.
Because software services offer strong opportunities for growth, we will continue to refine and improve adCenter, our advertising engine for Windows Live, MSN and other online offerings. We will deploy new service-based solutions, including Dynamics CRM Live, which we announced in July 2006. We will also continue to build out our services infrastructure, providing new tools to help partners and businesses create them (Microsoft Visual Studio .NET 2003 and the .NET Framework), applications and smart devices that use them (Microsoft Office System, smart phones, Pocket PCs and PCs), and a worldwide network of more than 35,000 Microsoft Certified Partner organizations – people whose skills and experience can help businesses get the most from their IT investments. Built on industry standards, Web services enable applications to communicate and share data over the Internet or an intranet, regardless of operating system or programming language.
We believe that establishing trust in computing will be critical to our future success. Trustworthy Computing means helping ensure a safe and reliable computing experience that is both expected and taken for granted. Achieving Trustworthy Computing will require the collaboration of hardware and software companies, academic and government research institutions, and policy leaders. For us, Trustworthy Computing is a company-wide initiative aimed at changing how we do business that will take fundamental research and advances in engineering, as well as changes to business culture and business processes to accomplish. We think there are four factors that affect the level of trust that people place in computing: Security, Privacy, Reliability, and Business Integrity. Security means the customer can expect that systems are resilient to attack, and that the confidentiality, integrity, and availability of the system and its data are protected. Privacy means the customer is able to control personal information and feel confident it is not only safe and used appropriately, but in a way that provides value. A reliable system or
Part I, Item 1
service is one the customer can depend on to fulfill its functions. Business Integrity involves being responsive to customers, addressing problems effectively with products orhost services, and being transparent and responsive in customer interactions.
To serve the needs of users around the world, we “localize” many of our productsadding new data centers to reflect local languages and conventions and to improve the quality and usability of the product in international markets. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text.
meet growing consumer demand for services.
MANUFACTURING
We contract out most of our manufacturing activities to third parties. Outside manufacturers produce the Xbox, various retail software packaged products, and hardware. Our products may include some components that are available from only one or from limited sources. Key components that are currently obtained from a single source include the Xbox central processing unit (CPU) from Intel Corporation and the Xbox graphics processing unit (GPU) from NVIDIA Corporation. With the exception of the Xbox CPU and GPU, we generally have the ability to use other custom manufacturers if the current manufacturing vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and components and are often able to acquire component parts and materials on a volume discount basis.
OPERATIONS
We have regional operations centers in Ireland, Singapore, and the greater Seattle area. The centers support all operations in their regions, including information processing and vendor management and logistics. The regional center in Dublin, Ireland supports the Europe, Middle East, and Africa region, the center in Singapore supports the Japan and Asia-Pacific region, and the center in the greater Seattle area supports North and South America. Microsoft Licensing, Inc., a wholly-owned subsidiary in Reno, Nevada, manages our original equipment manufacturer (OEM) and certain organizational licensing operations.
DISTRIBUTION, SALES AND MARKETING
We distribute our products primarily through the following channels: OEM; distributors and resellers; and online services and products. Our three major geographic sales and marketing organizations are the Americas Region; the Europe, Middle East, and Africa Region; and the Japan and Asia-Pacific Region.
online.
OEMOEM.
Microsoft Our operating systems are licensed primarily to OEMs under agreements that grant the OEMs the right to distribute copies of our products with theirbuild computing devices based on our operating systems, principally PCs. WeUnder similar arrangements, we also market and license certain server operating systems, desktop applications, hardware devices, and consumer software products to OEMs under similar arrangements.OEMs. We have OEM agreements covering one or more of our products with virtually all of the major PC OEMs, including Acer, Actebis, Dell, eMachines, Fujitsu, Fujitsu Siemens Computers, Gateway, HP, IBM,Hewlett-Packard, Lenovo, NEC, Samsung, Siemens Computers, Sony, and Toshiba. A substantial amount of OEM business is also conducted with system builders, which are low-volume customized PC vendors.
vendors operating in local markets.
Distributors and ResellersResellers.
We distribute our finished goods products primarily through independent non-exclusive distributors, authorized replicators, resellers and retail outlets.license software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products. Organizations license our products primarily through Large Account Resellers (LARs)large account resellers (“LARs”), Direct Market Resellers (DMRs),direct market resellers, and value added resellers.value-added resellers (“VARs”). Many organizations that license products through Enterprise Agreements (EAs) nowenterprise agreements (“EAs”) transact directly with us, with sales support from our Enterprise Software Advisor channel partners. These Enterprise Software Advisors typically are also typically authorized as LARs and operate as resellers for our other licensing programs. Although all of our typeseach type of reselling partners reachpartner reaches organizations of all sizes, LARs are primarily engaged with large organizations and value added resellersVARs typically reach the breadth of smallsmall- and medium sizedmedium-sized organizations. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include Software Spectrum,CDW, Dell, Insight Enterprises, Software House International, Dell, CDW, and Insight Enterprises.Software Spectrum. Our business solutions software offerings are licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute our finished goods products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain our products primarily through retail outlets, including Best Buy, Wal-Mart,Target, and Target.Wal-Mart. We have a network of field sales representatives and field support personnel who solicitthat solicits orders from distributors and resellers and provideprovides product training and sales support.
We license software toOur arrangements for organizations under arrangements that allow the end-user customer to acquire multiple licenses of product. These arrangementsproducts are designed to provide organizationsthem with a means of acquiring multiple licenses,doing so without having to acquire separate packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they are as follows:
include:
Open. Targeted at small Designed primarily for small-to-medium organizations (5 to medium organizations,over 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, rights to future versions of software products over a specified time period (generally two years). The offering that conveys rights to future versions of certain software product over the contract period is called Software Assurance. Software Assurance also provides support, tools, and training to help customers deploy and use software efficiently. Under the Open program, customers can acquire licenses only, or licenses with Software Assurance. They can also renew Software Assurance upon the expiration of existing volume licensing agreements.
Select. Targeted at medium to large Designed primarily for medium-to-large organizations (greater than 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, Software Assurance, which consists of rights to future versions of certain software products, support, tools, and training over a specified time period (generally three years). Similar to the Open program, customers can acquire licenses only, acquire licenses with Software Assurance, or renew Software Assurance upon the expiration of existing volume licensing agreements.
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Enterprise Agreement. The Enterprise Agreement is targeted at medium and large organizations that want to acquire perpetual licenses to software products for all or substantial parts of their entire enterprise, along with rights to future versions of certain software products, support, tools, and training over a specified time period (generally three year period.years).
Part I, Item 1
Enterprise Subscription Agreement. The Enterprise Subscription Agreement (ESA) is a time-based, multi-year licensing arrangement. Under an ESA, customers acquire the right to use the current version of software products and the future versions that are released during the three year term of the arrangement. At the end of the arrangement term, customers may either renew their ESA arrangement or exercise a buy-out option to obtain perpetual licenses for the latest version of the covered products. If they do not elect one of these options, then all covered software must be uninstalled.
Online Services and ProductsServices.
We distribute online content and services through MSN Subscription services, MSN Network services, bCentral small business portal, and other online services.channels. MSN Subscription services deliverdelivers Internet access and othervarious premium services and tools to consumers. MSN Network services deliveralso delivers online emaile-mail and messaging communication services as well asand information services such as online search, advertising, and premium content. The bCentralHome and Entertainment operates the Xbox Live service which allows customers to participate in the gaming experience with other subscribers online. Microsoft Business Solutions operates the Microsoft Small Business Center portal, which is delivered online. This portal provides tools and expertise for small businesssmall-business owners to build, market, and manage their businesses online. Other services delivered online include Microsoft Developer Networks (MSDN) subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling Microsoftour products and solutions.
CUSTOMERS
Our customers include individual consumers, small-small and medium-sizemedium-sized organizations, enterprises, governmental institutions, educational institutions, Internet Service Providers, application developers, and OEMs. Consumers and small- and medium-sizemedium-sized organizations obtain Microsoftour products primarily through resellers and OEMs. No single customerSales to Dell and its subsidiaries in the aggregate accounted for approximately 11% of fiscal year 2006 and 10% or morein each of revenue in 2001, 2002, or 2003.fiscal year 2005 and 2004 revenue. These sales were made primarily through our OEM and volume licensing channels and cover a broad array of products including Windows PC operating systems, Microsoft Office, and server products. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant.
COMPETITIONEXECUTIVE OFFICERS OF THE REGISTRANT
The software business is intensely competitive and subject to rapid technological change, evolving customer requirements, and changing business models. We face significant competition in all areas of our current business activities. The rapid pace of technological change continually creates new opportunities for existing competitors and start-ups and can quickly render existing technologies less valuable. Customer requirements and preferences continually change as other information technologies emerge or become less expensive, and as emerging concerns such as security and privacy become of paramount concern. We face direct competition with firms adopting alternative business models to the commercial software model. Firms adopting the Open Source model typically provide customers with Open Source software at nominal cost and earn revenue on complimentary services and products, without having to bear the full costs of research and development for the Open Source software. Additionally, global software piracy – the unlawful copying and distribution of our copyrighted software products – deprives us of large amounts of revenue on an annual basis. Further, the existing versions of our products licensed to our installed base of users compete with future versions. This means that future versions must deliver significant additional value in order to induce existing customers to purchase a new version of our product.
Our competitive position may be adversely affected in the future by one or moreexecutive officers as of the factors described in this section.
Client
Although we are the leader in operating system software products, we face strong competition from well established companies and entities with differing approaches to the market. Competing commercial software products, including variants of Unix, are supplied by competitors, suchAugust 25, 2006 were as IBM, Hewlett-Packard, Apple Computer, Sun Microsystems and others, who are vertically integrated in both software development and hardware manufacturing and have developed operating systems that they preinstall on their own computers. Personal computer OEMs who preinstall third party operating systems may also license these firms’ operating systems or Open Source software, especially offerings based on Linux. Variants of Unix run on a wide variety of computer platforms and have gained increasing acceptance as desktop operating systems, in part due to the increasing performance of standard hardware components at decreasing prices. The Linux open source operating system, which is also derived from Unix and is available without payment under a General Public License, has gained increasing acceptance as its feature set increasingly resembles the distinct and innovative features of Windows and as competitive pressures on personal computer OEMs to reduce costs continue to increase. The Microsoft Windows operating systems also face competition from alternative platforms such as those based on Internet browsing software and Java technology promoted by Sun Microsystems, as well as innovative form factors that may reduce consumer demand for traditional personal computers. We believe our operating system products compete effectively by delivering better innovation, overall value, an easy-to-use interface, compatibility with a broad range of hardware and software applications, and the largest support network for any operating system.
Server and Tools
Our server operating system products face intense competition from a wide variety of competing server operating systems and server applications offered by firms with a variety of market approaches. Several vertically integrated computer manufacturers, such as IBM, Hewlett-Packard, Apple Computer, Sun Microsystems and others offer their own variant of Unix preinstalled on server hardware, and virtually all computer manufacturers offer server hardware for the Linux operating system. IBM’s endorsement of Linux has accelerated its acceptance as an alternative to both traditional Unix and Windows server operating systems. Linux’s competitive position has also benefited from the large number of compatible applications now produced by many leading commercial software developers as well as Open Source community developers. A number of companies supply versions of Linux, including Red Hat and VA Linux.
We compete in the business of providing enterprise-wide computing solutions with several companies that provide competing solutions as well as middleware technology platforms. IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software developers that provide competing server applications for the PC-basedfollows:
Name | Position with the Company | |||
William H. Gates III | 50 | Chairman of the Board | ||
Steven A. Ballmer | 50 | Chief Executive Officer | ||
Robert J. (Robbie) Bach | 44 | President, Microsoft Entertainment and Devices Division | ||
Lisa E. Brummel | 46 | Senior Vice President, Human Resources | ||
Kevin R. Johnson | 45 | Co-President, Microsoft Platforms and Services Division | ||
Christopher P. Liddell | 48 | Senior Vice President and Chief Financial Officer | ||
Jeffrey S. Raikes | 48 | President, Microsoft Business Division | ||
Bradford L. Smith | 47 | Senior Vice President, Legal and Corporate Affairs; General Counsel and Secretary | ||
Brian Kevin Turner | 41 | Chief Operating Officer |
Mr. Gates co-founded Microsoft in 1975 and served as its Chief Executive Officer from the time the original partnership was incorporated in 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. In June 2006, Mr. Gates stepped down as Chief Software Architect and announced a two-year transition plan out of a day-to-day role in the Company. Mr. Gates has served as Chairman since our incorporation.
Mr. Ballmer was appointed Chief Executive Officer in January 2000. He served as President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. He joined Microsoft in 1980.
Mr. Bach was named President, Microsoft Entertainment and Devices Division in September 2005. He had been Senior Vice President, Home and Entertainment since March 2000. Before holding that position, he had been Vice President, Home and Retail since March 1999, and Vice President, Learning, Entertainment and Productivity, and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined Microsoft in 1988.
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distributed client/server environments include Oracle, IBM, Computer Associates, Sybase, and Informix. There are alsoMs. Brummel was named Senior Vice President, Human Resources in December 2005. She had been Corporate Vice President, Human Resources since April 2005. From 1995 to April 2005, she had been Corporate Vice President of the Home & Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of Open Source server applications available.management positions at Microsoft, including general manager of Consumer Productivity business, product unit manager of the Kids business and product unit manager of Desktop and Decision reference products.
Numerous commercial software vendors offer competing commercial software applications for connectivity (both InternetMr. Johnson was named Co-President, Microsoft Platforms and intranet), security, hosting,Services Division in September 2005. He had been Group Vice President, Worldwide Sales, Marketing and e-business servers. Additionally, IBM has a large installed baseServices since March 2003. Before that position, he had been Senior Vice President, Microsoft Americas since February 2002 and Senior Vice President, U.S. Sales, Marketing, and Services since August 2001, and prior to assuming that role, he had been Vice President, U.S. Sales, Marketing and Services. He joined Microsoft in 1992.
Mr. Liddell was named Senior Vice President and Chief Financial Officer of Lotus Notesthe Company in May 2005. Mr. Liddell served as Senior Vice President and cc:Mail, bothChief Financial Officer of which compete with our collaborationInternational Paper Company since March 2003, and email products. There are also a significant numberprior to becoming Chief Financial Officer, he held the positions of Open Source software products that compete with Microsoft solutions, including Apache Web Server.Vice President-Finance and Controller. Mr. Liddell served as Chief Executive Officer of Carter Holt Harvey Limited, an affiliate of International Paper, from 1999 to 2002 and Chief Financial Officer from 1995 to 1998.
The Open Source model of Linux and other server programs enables both services and hardware companies to provide customers with Open Source software at nominal cost and earn revenue on complimentary services and products, without having to bear the full costs of research and development for the Open Source software. For example, IBM, with the largest hardware and services businesses in the industry, promotes Linux extensively and seeks to earn revenues and profits on the sale of its consulting services to implement the Linux server solution as well as related hardware and commercial software products that run on Linux.
Our developer products compete against offerings from BEA Systems, Borland, IBM, Macromedia, Oracle, Sun Microsystems, Sybase, and other companies.
We believe that our server products provide customers with significant advantages in innovation, performance (both relative to total costs of ownership and in absolute terms), productivity, applications development tools and environment, compatibility with a broad base of hardware and software applications, security, and manageability.
Information Worker
While we are the leader in business productivity software applications, competitors to the Microsoft Office System include many software application vendors, such as Apple, Corel, IBM, Oracle, QUALCOMM, Sun Microsystems, and local application developers in Europe and Asia. IBM and Corel have significant installed bases with their spreadsheet and word processor products, respectively, and both have aggressive pricing strategies. Also, Apple and IBM preinstall certain of their application software products on various models of their PCs, competing directly with our applications. Corel’s suite and Sun Microsystems’ Star Office are aggressively priced and attractive for OEMs to pre-install on low-priced PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that is gaining popularity in certain market segments. In addition to traditional client-side applications, web-based applications hosting services such as SimDesk provide an alternative to Microsoft Office and are gaining some support. We believe that our products compete effectively by providing customers significant benefits, such as easy-to-use personal productivity, support for effective teaming and collaboration, and better information management and control.
Mr. Raikes was named President, Microsoft Business SolutionsDivision in September 2005. He had been Group Vice President, Information Worker Business since June 2004. Before that position, he had been Group Vice President, Productivity and Business Services since August 2000 and Group Vice President, Sales and Support since July 1998. Mr. Raikes joined Microsoft in 1981.
Mr. Smith was appointed Senior Vice President, Legal and Corporate Affairs, General Counsel and Secretary in November 2001. Mr. Smith was also named Chief Compliance Officer effective July 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. He joined Microsoft in 1993.
The smallMr. Turner was appointed Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President and mid-market business applications market globally is highly fragmentedPresident and is intensely competitive in all sectors. We face competition from a large number of companies in this business. Well-known vendors focused on small and mid-market business, such as Intuit and Sage, compete against us for a portion of this segment. In addition, large-enterprise focused vendors, such as Oracle, Peoplesoft and SAP, also compete against us for a portion of this segment. However, the competition for a significant majorityChief Executive Officer of the total business applications market includes thousandsSam’s Club division of much smaller vendors in specific localities or industries who offer their own enterprise resource planning, customer relationship management, and/or analytic solutions.
Wal-Mart Stores, Inc. From September 2001 to August 2002, he served as Executive Vice President and Chief Information Officer of Wal-Mart’s Information Systems Division. From March 2000 to September 2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division.
MSNEMPLOYEES
MSN competes with AOL-Time Warner, Google, Yahoo!, and a vast array of Web sites and portals that offer content of all types, such as email, instant messaging, calendaring, chat, search, and shopping services. As the broadband access market grows, we expect to have increasing opportunity to deliver premium subscription services for consumers. AOL and Yahoo! are both pursuing similar strategies and will be competitors in this emerging category. While the movement to broadband access may cause our Internet Access dial-up business to continue to decline, we will strive to convert customers to MSN premium subscription services via partnerships with network providers and Internet software services offered directly from MSN. We believe our strengths are our heritage of technology innovation, particularly in communication services, distribution partnerships, and the large base of users of our free MSN Network. Additionally, while our advertising business has grown considerably over the last year, evolving market conditions, particularly paid search, will impact our strategy over the next year. We currently are building our own search engine and investing to support the continued growth of our advertising business.
Mobile and Embedded Devices
Windows Mobile software faces substantial competition from Nokia, Openwave Systems, PalmSource, QUALCOMM, and Symbian. The embedded operating system market is highly fragmented with many competitive offerings. Key competitors include IBM, Wind River, and versions of embeddable Linux from commercial Linux vendors, such as Metrowerks and MontaVista Software. MapPoint competitors include DeLorme, MapInfo, Mapquest.com, Rand McNally, Webraska Mobile Technologies, and Yahoo!. The telematics market is also highly fragmented, with competitive offerings from IBM and automotive suppliers building on various real-time operating system platforms from commercial Linux vendors, QNX Software Systems, Wind River, and others.
Home and Entertainment
The home and entertainment business is highly competitive and is characterized by limited platform life cycles, frequent introductions of new products and titles, and the development of new technologies. The markets for our products are characterized by significant price competition, and we anticipate continued pricing pressure from our competitors. These pressures have, from time to time, required us to reduce prices on certain products. Our competitors vary in size from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of price, product quality and variety, timing of product releases, and effectiveness of distribution and marketing.
Part I, Item 1, 2, 3, 4
Our Xbox hardware business competes with console platforms from Nintendo and Sony, both of which have a large established base of users. In addition to competing against software published for non-Xbox platforms, our games business also competes with numerous companies that have been licensed by Microsoft to develop and publish software for the Xbox console. These competitors include Acclaim Entertainment, Activision, Atari, Capcom, Eidos, Electronic Arts, Sega, Take-Two Interactive, Tecmo, THQ, and Ubi Soft, among others. Success in the games business is increasingly driven by hit titles, which are difficult to develop and require substantial investments in development and marketing. In addition, other forms of entertainment, such as music, motion pictures, and television, compete against our entertainment software for consumer spending. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners.
EMPLOYEES
As of June 30, 2003,2006, we employed approximately 55,00071,000 people on a full-time basis, 36,50044,000 in the United States and 18,50027,000 internationally. Of the total, 23,20028,000 were in product research and development, 25,10021,000 in sales and marketing, 13,000 in product support and support, 2,400consulting services, 2,000 in manufacturing and distribution, and 4,3007,000 in financegeneral and administration. Our success is highly dependent on our ability to attract and retain qualified employees. Competition for employees is intense in the software industry. We believe we have been successful in our efforts to recruit qualified employees, but we cannot guarantee that we will continue to be as successful in the future. None of our employees are subject to collective bargaining agreements. We believe that our relations with our employees are excellent.
AVAILABLE INFORMATION
Our Internet address is www.microsoft.com. There we make available, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with or furnish it to the SEC.Securities and Exchange Commission (“SEC”). Our SEC reports can be accessed through the investor relations section of our Web site. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC.
Challenges to our business model may reduce our revenues and operating margins. Our business model has been based upon customers paying a fee to license software that we developed and distributed. Under this license-based software model, software developers bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from the distribution of their products. We believe the license-based software model has had substantial benefits for users of software, allowing them to rely on our expertise and the expertise of other software developers that have powerful incentives to develop innovative software that is useful, reliable, and compatible with other software and hardware. In recent years
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certain “open source” software business models have evolved into a growing challenge to our license-based software model. Open source commonly refers to software whose source code is subject to a license allowing it to be modified, combined with other software and redistributed, subject to restrictions set forth in the license. A number of commercial firms compete with us using an open source business model by modifying and then distributing open source software to end users at nominal cost and earning revenue on complementary services and products. These firms do not have to bear the full costs of research and development for the software. A prominent example of open source software is the Linux operating system. While we believe our products provide customers with significant advantages in security and productivity, and generally have a lower total cost of ownership than open source software, the popularization of the open source software model continues to pose a significant challenge to our business model, including continuing efforts by proponents of open source software to convince governments worldwide to mandate the use of open source software in their purchase and deployment of software products. To the extent open source software gains increasing market acceptance, sales of our products may decline, we may have to reduce the prices we charge for our products, and revenue and operating margins may consequently decline.
Another development is the software-as-a-service business model, by which companies provide applications, data, and related services over the Internet. Providers use primarily advertising or subscription-based revenue models. Recent advances in computing and communications technologies have made this model viable and enabled the rapid growth of some of our competitors. We are devoting significant resources toward developing our own software-as-a-service strategies. It is uncertain whether these strategies will prove successful.
We face intense competition. We continue to experience intense competition across all markets for our products and services. Our competitors range in size from Fortune 100 companies to small, specialized single-product businesses and open source community-based projects. While we believe the breadth of our businesses and product portfolio offers benefits to our customers that are a competitive advantage, our competitors that are focused on a narrower product line may be more effective in devoting technical, marketing, and financial resources to compete with us. In addition, barriers to entry in our businesses generally are low. The Internet as a distribution channel and the non-commercial software model described above have reduced barriers to entry even further. Open source software vendors are devoting considerable efforts to developing software that mimics the features and functionality of our products. In response to competitive factors, we are developing versions of our products with basic functionality that are sold at lower prices than the standard versions. These competitive pressures may result in decreased sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenue, gross margins and operating income.
We may not be able to protect our intellectual property rights against piracy, infringement of our patents by third parties, or declining legal protection for intellectual property. We defend our intellectual property rights and combat unlicensed copying and use of software and intellectual property rights through a variety of techniques. Preventing unauthorized use or infringement of our rights is difficult. Piracy of our products represents a loss of revenue to us. While this adversely affects U.S. revenue, the impact on revenue from outside the United States is more significant, particularly in countries where laws are less protective of intellectual property rights. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Future legal changes could make this even more challenging. Throughout the world, we actively educate consumers about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may fail to enhance revenue. Reductions in the legal protection for software intellectual property rights or compliance with additional intellectual property obligations impacting the rights of software developers could both adversely affect revenue.
Third parties may claim we infringe their intellectual property rights. From time to time we receive notices from others claiming we infringe their intellectual property rights. The number of these claims may grow. Responding to these claims may require us to enter into royalty and licensing agreements on less favorable terms, require us to stop selling or to redesign affected products, or to pay damages or to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements. If we are required to enter into such agreements or take such actions, our operating margins may decline as a result. We have made and expect to continue making significant expenditures to settle claims related to the use of technology and intellectual property rights as part of our strategy to manage this risk.
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Part I
Item 1A
We may not be able to protect our source code from copying if there is an unauthorized disclosure of source code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. While we license certain portions of our source code for various software programs and operating systems to a number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially lose future trade secret protection for that source code. The loss of future trade secret protection could make it easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code could also increase certain risks described in the next paragraph.
Security vulnerabilities in our products could lead to reduced revenues or to liability claims. Maintaining the security of computers and computer networks is a critical issue for us and our customers. Hackers develop and deploy viruses, worms, and other malicious software programs that attack our products. While this is an industry-wide problem that affects computers across all platforms, it affects our products in particular because hackers tend to focus their efforts on the most popular operating systems and programs and we expect them to continue to do so. We devote significant resources to address these critical issues. We focus on engineering even more secure products, enhancing security and reliability options and settings when we deliver products, and providing guidance to help our customers make the best use of our products and services to protect against computer viruses and other attacks on their computing environment. In addition, we are working to improve the deployment of software updates to address security vulnerabilities discovered after our products are released. We are also investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed. We advise customers on how to help protect themselves from security threats through the use of our online automated security tools, our published security guidance, and the deployment of security software such as firewalls, anti-virus, and other security software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security vulnerabilities in our products could lead some customers to seek to return products, to reduce or delay future purchases, or to use competing products. Customers may also increase their expenditures on protecting their existing computer systems from attack, which could delay adoption of new technologies. Any of these actions by customers could adversely affect our revenue. In addition, actual or perceived vulnerabilities may lead to claims against us. While our license agreements typically contain provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will be held effective under applicable laws and judicial decisions.
We are subject to government litigation and regulatory activity that affects how we design and market our products. As a leading global software maker we receive scrutiny from government agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights of action for competitors or consumers based on alleged anti-competitive conduct. For example, we have been involved in the following actions.
Lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions were resolved through a Consent Decree that took effect in November 2001 and a Final Judgment entered in November 2002. These proceedings imposed regulatory constraints on our Windows operating system businesses, including limits on certain contracting practices, required disclosure of certain software program interfaces, limits on Microsoft’s ability to ensure the visibility of certain Windows features in new PCs, and required licensing of certain communications protocols. While we believe we currently are in full compliance with the Decree and Judgment, if we fail to comply with them in the future additional restrictions could be imposed on us that would adversely affect our business.
In March 2004, the European Commission determined that we must create new versions of Windows that do not include certain multimedia technologies, many of which are required for certain Web sites, software applications and other aspects of Windows to function properly, and we must provide our competitors with specifications for how to implement certain communications protocols supported in Windows. Microsoft has appealed both determinations to European courts. As a result of the Commission decision, we have incurred and will (absent a reversal of this ruling) continue to incur duplicative development costs. The Commission ruling obligates Microsoft to make available specifications for certain Windows communications protocol technologies on licensing terms that are closely regulated by the Commission. The availability of these licenses may enable competitors to develop software products that better mimic the functionality of Microsoft’s own products which could result in a reduction in sales of our products. Pending resolution of Microsoft’s appeal, there will remain uncertainty about the legal principles that govern
PAGE | 14 |
Part I
Item 1A
product design issues for future releases of Microsoft products in Europe. These uncertainties could cause Microsoft to modify product design and delay release dates for Windows or other products.
In December 2005, the Korean Fair Trade Commission (“KFTC”) completed an investigation of whether including streaming media technology or instant messenger technology in Windows, or including Windows Media Services as an optional component of Windows Server, violates the Korean Fair Trade Law. The KFTC ruled that we had violated the law and issued a remedial order requiring us to offer two versions of Windows PC operating systems, one with Windows Media Player and Instant Messenger removed and another with those functionalities but also including opportunities for OEMs to install competing media player and instant messenger programs. If upheld on appeal, these remedies could adversely affect the utility and competitive position of Windows PC operating systems in the Korean market.
We believe our integrated approach to delivery of product innovation benefits consumers and business. Current or future government regulatory efforts and court decisions may hinder or delay our ability to provide these benefits thereby reducing the attractiveness of our products and the revenues that come from them. Moreover, there always remains the risk of new legal action, either by these or other governments or private claimants including with respect to products or features that haven’t been scrutinized or been the subject of objections in the past. The outcome of such legal actions could adversely affect us in a variety of ways, including:
Our online offerings are subject to government regulation of the Internet domestically and internationally in areas such as user privacy, data protection, and online content. The application of these laws and regulations to our business is often unclear and sometimes may conflict. Compliance with these regulations may involve significant costs or require changes in business practices that result in reduced revenue. Noncompliance could result in penalties being imposed on us or orders that we cease conducting the noncompliant activity.
Our business depends largely on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and services may be adversely affected.
Delays in product development schedules may adversely affect our revenues. The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Significant delays in new product releases or significant problems in creating new products could adversely affect our revenue.
We make significant investments in new products and services that may not be profitable. We have made and will continue to make significant investments in research, development, and marketing for new products, services, and technologies, including Windows Vista, the 2007 Microsoft Office system, Xbox 360, MSN Search, Windows Server and Windows Live. Investments in new technology are inherently speculative. Commercial success depends on many factors including innovativeness, developer support, and effective distribution and marketing. Significant revenue from new product and service investments may not be achieved for a number of years, if at all. Moreover, new products and services may not be profitable, and even if they are profitable, operating margins for new products and businesses may not be as high as the margins we have experienced historically.
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Part I
Item 1A
Declines in demand for software could occur. If overall market demand for PCs, servers, and other computing devices declines significantly, or consumer or corporate spending for such products declines, our revenue will be adversely affected. In addition, our revenue would be unfavorably impacted if customers reduce their purchases of new software products or upgrades to existing products because new product offerings are not perceived as providing significant new functionality or other value to prospective purchasers. We are making significant investments in Windows Vista and the 2007 Microsoft Office system. If these products are not perceived as offering significant new functionality or value to prospective purchasers, our revenue and operating margins could be adversely affected.
We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. Adverse outcomes in some or all of the claims pending against us may result in significant monetary damages or injunctive relief against us that could adversely affect our ability to conduct our business. While management currently believes that resolving all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial position or results of operations, the litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. There exists the possibility of a material adverse impact on our financial position and the results of operations for the period in which the effect of an unfavorable final outcome becomes probable and reasonably estimable.
We may have additional tax liabilities. We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. Based on the results of an audit or litigation, a material effect on our income tax provision, net income or cash flows in the period or periods for which that determination is made could result.
We may be at risk of having insufficient supplies of certain Xbox 360 components or console inventory. Some components of the Xbox 360 are obtained from a single supplier and others may be subject to an industry-wide supply shortage. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be unable to obtain replacement supplies on a timely basis, resulting in reduced console and game sales. Components are ordered based on forecasted console demand so we may experience component shortages for the Xbox 360 or, alternatively, excess console inventory that may require us to record charges to cost of revenue. Xbox 360 consoles will be assembled in Asia; disruptions in the supply chain may result in console shortages that would affect our revenues and operating margins.
If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to earnings. Under generally accepted accounting principles, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least annually. Factors that may be considered a change in circumstances indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable include a decline in stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in our industry. We may be required to record a significant charge to earnings in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively impacting our results of operations.
Changes in accounting may affect our reported earnings and operating income. Generally accepted accounting principles and accompanying accounting pronouncements, implementation guidelines, and interpretations for many aspects of our business, such as revenue recognition for software, accounting for investments, and treatment of goodwill or amortizable intangible assets, are highly complex and involve subjective judgments. Changes in these rules or their interpretation or changes in our products or business could significantly change our reported earnings and operating income and could add significant volatility to those measures, without a comparable underlying change in cash flow from operations. See Note 1 in “Item 8. Financial Statements and Supplementary Data” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” of this report.
We operate a global business that exposes us to additional risks. We operate in over 100 countries and a significant part of our revenue comes from international sales. Pressure to make our pricing structure uniform might
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Part I
Item 1A
require that we reduce the sales price of our software in the United States and other countries. Operations outside of the United States may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; unexpected changes in regulatory requirements for software; social, political, labor or economic conditions in a specific country or region; and difficulties in staffing and managing foreign operations. While we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our net revenues.
General economic and geo-political risks may affect our revenue and profitability. Inflation, softness in corporate information technology spending, or other changes in general economic conditions that affect demand for computer hardware or software could adversely affect our revenue or our investment portfolio. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries or generally and could require changes in our operations and security arrangements, thus increasing our operating costs. These conditions may lend additional uncertainty to the timing and budget for technology investment decisions by our customers.
Catastrophic events may disrupt our business. We are a highly automated business and a disruption or failure of our systems in the event of a major earthquake, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales and providing services. Our corporate headquarters, a significant portion of our research and development activities, and certain other critical business operations are located in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical business or information technology systems could severely affect our ability to conduct normal business operations and, as a result, our future operating results could be adversely affected.
Acquisitions and joint ventures may have an adverse effect on our business. We expect to continue making acquisitions or entering into joint ventures as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we don’t realize a satisfactory return on the investment we make, or that we may experience difficulty in the integration of new employees, business systems, and technology, or diversion of management’s attention from our other businesses. These factors could adversely affect our operating results or financial condition.
We have limited insurance. We maintain third party insurance coverage against various liability risks and risks of property loss. Because of the unavailability or high cost of conventional insurance arrangements, we have entered into captive insurance arrangements for the purpose of protecting against possible catastrophic and other risks not covered by traditional insurance markets. As of June 30, 2006, the face value of captive insurance arrangements was $2.0 billion. Actual value at any particular time will vary due to deductibles, exclusions, other restrictions, and claims. While we believe these arrangements are an effective way to insure against liability and property damage risks, the potential liabilities associated with the risks discussed in this report or other events could exceed the coverage provided by such arrangements.
Improper disclosure of personal data could result in liability and harm our reputation. We store and process significant amounts of personally identifiable information as we offer a large array of products and services to our customers. It is possible that our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of personally identifiable information. Such disclosure could harm our reputation and subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products also enable our customers to store and process personal data. Perceptions that our products do not adequately protect the privacy of personal information could inhibit sales of our products.
Other risks that may affect our business. Other factors that may affect our performance may include:
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Part I
Item 1B, 2, 3, 4
ITEM 1B. UNRESOLVED STAFF COMMENTS
We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more preceding the end of our fiscal year 2006 that remain unresolved.
Our corporate offices consist of approximately 9.011.0 million square feet of office building space located in King County, Washington, of which 6.1Washington: 8.5 million square feet of owned space that is corporate campus space situated on slightly more than 300approximately 500 acres of land which is ownedwe own in our corporate campus and approximately 2.92.5 million square feet which is leased. We are constructing one building with approximately 302,000 square feet of space that will be occupied in the second quarter of fiscal year 2004. To accommodate future expansion needs we purchased approximately 38 acres, and have an option to purchase approximately 112 additional acres, of land in Issaquah, Washington, which can accommodate 2.9 million square feet of additional office space.lease. We own approximately 594,000533,000 square feet of office building space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately 3.42.7 million square feet of office building space.
We leaseoccupy many sites internationally, totaling approximately 5.46.9 million square feet includingthat is leased and approximately 883,000 square feet that is owned. These facilities include our European Operations Center and localization division that leases a 411,000 square-foot187,000 square foot campus in Dublin, Ireland, a 54,000 square-foot56,000 square foot disk duplication facility in Humacao, Puerto Rico, and a 36,000 square-foot159,000 square foot facility in Singapore for our Asia Pacific Operations Center.Center and Regional headquarters. Leased office building space includes the following locations: Tokyo, Japan 343,000408,000 square feet; Unterschleissheim, Germany 381,000 square feet; United Kingdom campus 242,000 square feet; Les Ulis, France 229,000262,000 square feet; Vedbaek, Denmark 186,000 square feet; Mississauga, Canada 160,000 square feet; Taipei, Taiwan 116,000 square feet; Sydney, Australia 116,000Reading, England 241,000 square feet; and Beijing, China 115,000Mississauga, Canada 161,000 square feet. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described in “Operations” above.
Our facilities are fully used for current operations of all segments, and suitable additional space is available to accommodate expansion needs. We own 63 acres of land in Issaquah, Washington, which can accommodate 1.2 million square feet of office space and we have an agreement with the City of Redmond under which we may develop an additional 2.2 million square feet of facilities at our campus in Redmond, Washington.
ITEM 3. Legal ProceedingsLEGAL PROCEEDINGS
On May 22, 2006, the Korean Fair Trade Commission (“KFTC”) denied our motion for reconsideration of the formal written ruling against us in its competition law investigation of the company. As part of its decision, however, the KFTC dropped the requirement prohibiting us from including Windows Media Player or Windows Messenger, or any feature with similar functionality, in any product other than the Windows client operating system for which we have a 50% or greater market share. Our request to stay the KFTC corrective order was denied on July 31, 2006. Our appeal of the KFTC’s decision to the Seoul High Court is still pending.
On July 12, 2006, the European Commission announced its determination that we had not complied with the technical documentation requirements in its 2004 Decision against us, and levied a fine of€281 million ($351 million). We intend to appeal this fine to the Court of First Instance. We have completed the written and oral procedures in our appeal of the Commission’s underlying March 2004 decision finding Microsoft in violation of European competition law and accompanying€497 million ($605 million) fine and are awaiting a decision by the Court of First Instance.
See Note 20—17 – Contingencies of the Notes toin “Item 8. Financial Statements (Item 8)and Supplementary Data” for information regarding other legal proceedings.proceedings in which we are involved.
ITEM 4. Submission of Matters to a Vote of Security HoldersSUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2003.year 2006.
PAGE |
Part II
Part I, Item 45
EXECUTIVE OFFICERS OF THE REGISTRANT
Our executive officers as of September 4, 2003 were as follows:
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Mr. Gates co-founded Microsoft in 1975 and served as its Chief Executive Officer from the time the original partnership was incorporated in 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. Mr. Gates has served as Chairman since our incorporation.
Mr. Ballmer was named Chief Executive Officer and a director of the Company in January 2000. He served as President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. He joined Microsoft in 1980.
Mr. Allchin was named Group Vice President, Platforms Group in December 1999. He had been Senior Vice President, Platforms since March 1999. He was previously Senior Vice President, Personal and Business Systems since February 1996. Mr. Allchin joined Microsoft in 1990.
Mr. Bach was named Senior Vice President, Home and Entertainment in March 2000. He had been Vice President, Home and Retail since March 1999. Before holding that position, he had been Vice President, Learning, Entertainment and Productivity and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined Microsoft in 1988.
Mr. Burgum joined the Company upon Microsoft’s acquisition of Great Plains Software, Inc. in April 2001. Mr. Burgum became Great Plains’ first outside investor in March 1983. He was named President of Great Plains in 1984 and subsequently named Chairman and Chief Executive Officer.
Mr. Cole was named Senior Vice President, MSN and Personal Services Group in November 2001. Before holding that position, he had been Senior Vice President, Services Platform Division since August 2000. He had been Senior Vice President, Consumer Services since December 1999 and Vice President, Consumer Windows since March 1999. Previously, he was Vice President, Web Client and Consumer Experience and Vice President, Internet Client and Collaboration. Mr. Cole joined Microsoft in 1986.
Mr. Connors was named Senior Vice President and Chief Financial Officer in December 1999. He had been Vice President, Worldwide Enterprise Group since March 1999. Mr. Connors had been Vice President, Information Technology Group, and Chief Information Officer since July 1996. He joined Microsoft in 1989.
Mr. Courtois was named Senior Vice President and Chief Executive Officer, Microsoft Europe, Middle East, and Africa in March 2003. He had been Senior Vice President and President, Microsoft Europe, Middle East, and Africa since July 2000. Before holding that position, he had been Vice President, Worldwide Customer Marketing since July 1998. Mr. Courtois joined Microsoft in 1984.
Mr. DiPietro joined Microsoft in January 2003 as Corporate Vice President, Human Resources. Prior to joining Microsoft, he was Vice President of Human Resources for the Americas at Dell Computer Corporation. Before joining Dell, he was Senior Vice President of Human Resources at Pepsi-Cola International.
Mr. Johnson was named Group Vice President, Worldwide Sales, Marketing and Services in March 2003. He had been Senior Vice President, Microsoft Americas since February 2002. Mr. Johnson had been Senior Vice President, U.S. Sales, Marketing, and Services since August 2001, and before that, Vice President, U.S. Sales, Marketing and Services. He joined Microsoft in 1992.
Ms. Mathews was named Corporate Vice President, Marketing in August 2001. Before holding her current position, Ms. Mathews had been Vice President Corporate Public Relations since 1999. Ms. Mathews joined Microsoft in 1993.
Mr. Mundie was named Senior Vice President and Chief Technical Officer, Advanced Strategies and Policy in August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. He joined Microsoft in 1992.
Mr. Raikes was named Group Vice President, Productivity and Business Services in August 2000. He had been Group Vice President, Sales and Support since July 1998. Mr. Raikes joined Microsoft in 1981.
Mr. Rudder was named Senior Vice President, Developer and Platform Evangelism in October 2001. He had been Vice President, Technical Strategy. Mr. Rudder joined Microsoft in 1988.
Mr. Smith was named Senior Vice President, General Counsel and Secretary in November 2001. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing our European Law and Corporate Affairs Group, based in Paris. He joined Microsoft in 1993.
Mr. Vaskevitch was named Senior Vice President and Chief Technical Officer, Business Platform in August 2001. He had been Senior Vice President, Business Applications since March 2000. Mr. Vaskevitch had been Senior Vice President, Developer since December 1999. Before holding that position, he had been Vice President, Distributed Applications Platform. He joined Microsoft in 1986.
Part II, Item 5, 6, 7
PART II
ITEM 5. Market for Registrant’s Common Stock and Related Stockholder MattersMARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded on The NASDAQ Stock Market under the symbol MSFT. On August 15, 2003,18, 2006, there were 131,580148,993 registered holders of record of our common stock. The high and low common stock prices per share were as follows:
Quarter Ended | Sept. 30 | Dec. 31 | Mar. 31 | June 30 | Year | Sep. 30 | Dec. 31 | Mar. 31 | June 30 | Year | ||||||||||||||||||||
Fiscal 2002 | ||||||||||||||||||||||||||||||
Common stock price per share(1): | ||||||||||||||||||||||||||||||
Fiscal year 2005 | ||||||||||||||||||||||||||||||
Common stock price per share: | ||||||||||||||||||||||||||||||
High | $ | 36.29 | $ | 34.75 | $ | 34.93 | $ | 30.19 | $ | 36.29 | $ | 29.00 | $ | 29.98 | $ | 26.84 | $ | 26.07 | $ | 29.98 | ||||||||||
Low | 24.86 | 25.90 | 29.00 | 24.31 | 24.31 | 26.88 | 26.53 | 23.92 | 24.12 | 23.92 | ||||||||||||||||||||
Fiscal 2003 | ||||||||||||||||||||||||||||||
Common stock price per share(1): | ||||||||||||||||||||||||||||||
Fiscal year 2006 | ||||||||||||||||||||||||||||||
Common stock price per share: | ||||||||||||||||||||||||||||||
High | $ | 27.43 | $ | 29.12 | $ | 28.49 | $ | 26.37 | $ | 29.12 | $ | 27.76 | $ | 28.16 | $ | 28.15 | $ | 27.74 | $ | 28.16 | ||||||||||
Low | 21.42 | 21.89 | 22.80 | 23.67 | 21.42 | 24.65 | 24.30 | 26.28 | 21.51 | 21.51 | ||||||||||||||||||||
In January 2003,See Note 12 – Stockholders’ Equity of the Notes to Financial Statements (Item 8) for information regarding dividends approved by our Board of Directors declared our first annual common stock dividend, of $0.08 per share, which was paid in March 2003. Our dividend policy is impacted by, among other items, our views on potential future capital requirements relating to researchfiscal years 2006 and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model.2005.
In connection with Microsoft’s acquisition of Navision a/s, pursuant to a voluntary offer to acquire all Navision ordinary shares, Microsoft issued 29.1 million shares of its common stock to Navision shareholders onOn July 12, 2002, in exchange for 19.4 million Navision ordinary shares, nominal value DKK 1 per share. The price paid by Microsoft in connection with the offer was DKK 300 per each Navision share, payable at each Navision shareholder’s election in either cash or Microsoft shares, on the basis of an exchange ratio of 1.49982 shares of Microsoft common stock for each Navision ordinary share. These issuances of Microsoft common stock were not registered under the Securities Act of 1933 on the basis of the exemption provided by Rule 802 thereunder. Rule 802 exempts offers and sales in an exchange offer for a class of securities of a foreign private issuer in a business combination transaction, if certain conditions are met. Since20, 2006, we announced the completion of the acquisition,repurchase program approved by our Board of Directors on July 20, 2004, to buy back up to $30 billion in Microsoft common stock. The repurchases were made using our cash resources. We repurchased common stock in each quarter of fiscal year 2006 as follows:
Period | Total number of shares purchased | Average price paid per share | |||
July 1, 2005 – September 30, 2005 | 114,134,218 | $ | 26.54 | ||
October 1, 2005 – December 31, 2005 | 283,112,246 | $ | 27.08 | ||
January 1, 2006 – March 31, 2006 | 180,720,830 | $ | 27.00 | ||
April 1, 2006 – June 30, 2006 | 175,609,060 | $ | 23.78 |
Common stock repurchases in the fourth quarter of fiscal year 2006 were as follows:
Period | (a) Total number of shares purchased | (b) Average price paid per share | (c) Total number of shares purchased as part of publicly announced plans or programs | (d) Maximum number of shares (or approximate dollar value) of shares that may yet be purchased under the plans or programs (in millions) | ||||||
April 1, 2006 – April 30, 2006 | 38,041,415 | $ | 27.08 | 38,041,415 | $ | 5,394 | ||||
May 1, 2006 – May 31, 2006 | 8,618,036 | $ | 24.37 | 8,618,036 | $ | 5,184 | ||||
June 1, 2006 – June 30, 2006 | 128,949,609 | $ | 22.76 | 128,949,609 | $ | 2,249 | ||||
175,609,060 | 175,609,060 | |||||||||
On July 20, 2006, we have issued 23,009announced that our Board of Directors authorized two new share repurchase programs: a $20 billion tender offer which was completed on August 17, 2006; and authorization for up to an additional $20 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common stockshares outstanding, for approximately $3.8 billion at a price per share of $24.75.
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Part II
Item 5, 6
On August 18, 2006, we announced that the authorization for the ongoing share repurchase program, previously announced on July 20, 2006, had been increased by approximately $16.2 billion. As a result, the company is authorized to 16 employeesrepurchase additional shares in exchange for 10,136 ordinary shares of Navision that were acquired upon exercise of warrants and stock options issuedan amount up to employees of Navision and its subsidiaries that were outstanding at the time of the acquisition. The issuances were not registered under the Securities Act.$36.2 billion through June 30, 2011.
ITEM 6. Selected Financial DataSELECTED FINANCIAL DATA
FINANCIAL HIGHLIGHTS
Financial Highlights
(In millions, except earnings per share) | ||||||||||||||||||||||||||||||
Year Ended June 30 | 1999 | 2000 | 2001(2) | 2002(3) | 2003(4) | |||||||||||||||||||||||||
(In millions, except per share data) | ||||||||||||||||||||||||||||||
Fiscal Year Ended June 30 | 2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||||||||||||
Revenue | $ | 19,747 | $ | 22,956 | $ | 25,296 | $ | 28,365 | $ | 32,187 | $ | 44,282 | $ | 39,788 | $ | 36,835 | $ | 32,187 | $ | 28,365 | ||||||||||
Operating income | 10,010 | 11,006 | 11,720 | 11,910 | 13,217 | 16,472 | 14,561 | 9,034 | 9,545 | 8,272 | ||||||||||||||||||||
Income before accounting change | 7,785 | 9,421 | 7,721 | 7,829 | 9,993 | |||||||||||||||||||||||||
Net income | 7,785 | 9,421 | 7,346 | 7,829 | 9,993 | 12,599 | 12,254 | 8,168 | 7,531 | 5,355 | ||||||||||||||||||||
Diluted earnings per share before accounting change(1) | 0.71 | 0.85 | 0.69 | 0.70 | 0.92 | |||||||||||||||||||||||||
Diluted earnings per share(1) | 0.71 | 0.85 | 0.66 | 0.70 | 0.92 | |||||||||||||||||||||||||
Cash dividends per share | – | – | – | – | 0.08 | |||||||||||||||||||||||||
Diluted earnings per share | $ | 1.20 | $ | 1.12 | $ | 0.75 | $ | 0.69 | $ | 0.48 | ||||||||||||||||||||
Cash dividends declared per share | $ | 0.35 | $ | 3.40 | $ | 0.16 | $ | 0.08 | $ | – | ||||||||||||||||||||
Cash and short-term investments | 17,236 | 23,798 | 31,600 | 38,652 | 49,048 | 34,161 | 37,751 | 60,592 | 49,048 | 38,652 | ||||||||||||||||||||
Total assets | 38,321 | 51,694 | 58,830 | 67,646 | 79,571 | 69,597 | 70,815 | 94,368 | 81,732 | 69,910 | ||||||||||||||||||||
Long-term obligations | 7,051 | 5,823 | 4,574 | 2,846 | 2,722 | |||||||||||||||||||||||||
Stockholders’ equity | 28,438 | 41,368 | 47,289 | 52,180 | 61,020 | 40,104 | 48,115 | 74,825 | 64,912 | 54,842 |
PAGE |
Part II
Item 7
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS FOR FISCAL YEARS 2006, 2005, AND 2004
OVERVIEW
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of Financial Conditionoperations and Resultsfinancial condition of OperationsMicrosoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial statements (“Notes”).
We develop, manufacture, license, and support a wide range of software products for many computing devices. Our software products include operating systems for servers, PCs, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; and software development tools. We provide consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, PC games, and PC peripherals. Online communication and information services are delivered through our MSN portals and channels around the world.
Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Home and Entertainment segment is particularly subject to seasonality as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, Home and Entertainment has generated over 40% of its yearly segment revenues in our second fiscal quarter. We believe the seasonality of revenue is likely to continue in the future.
We intend to sustain the long-term growth of our businesses through technological innovation, engineering excellence, and a commitment to delivering high-quality products and services to customers and partners. Recognizing that one of our primary challenges is to help accelerate worldwide PC adoption and software upgrades, we continue to advance the functionality, security, and value of Windows operating systems. We also are increasing our focus on emerging markets and reducing the amount of unlicensed software in those markets. In addition, we continue to develop innovative software applications and solutions that we believe will enhance the productivity of information workers, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for small and mid-sized businesses. To sustain the growth of our Server and Tools business amid competition from other vendors of both proprietary and open source software, our goal is to deliver products that provide the best platform for network computing – the easiest to deploy and manage and most secure – with the lowest total cost of ownership.
We continue to invest in research and development in existing and new lines of business, including business solutions, mobile computing, communication, entertainment, and others that we believe may contribute to our long-term growth. We also research and develop advanced technologies for future software products. We believe that delivering innovative and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth.
We believe that over the last few years we have laid a foundation for long-term growth by delivering innovative products, creating opportunities for partners, improving customer satisfaction with key audiences, putting some of our most significant legal cases behind us, and improving our internal business processes. Our focus in fiscal year 2007 is building on this foundation and executing well in key areas, including continuing to innovate on our integrated software platform, responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business efficacy, and accountability across the company.
Key market opportunities include:
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Results of OperationsWorldwide macroeconomic factors have a strong correlation to business and consumer demand for 2001, 2002,our software, services, games and 2003Internet service offerings. We expect a broad continuation in the economic conditions and demand in fiscal year 2007 as compared to fiscal year 2006.
Management’s DiscussionAs open source software development and Analysis (MD&A) contains statementsdistribution evolves, we continue to seek to differentiate our products from competing products that are forward-looking. These statements are based on current expectationsopen source software. We believe that Microsoft’s share of server unit operating systems increased in fiscal year 2006.
Summary of Results for Fiscal Years 2006, 2005, and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in “Issues and Uncertainties” and elsewhere in this report.
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REVENUE2004
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||
Revenue | $ | 44,282 | $ | 39,788 | $ | 36,835 | 11% | 8% | |||||
Operating income | $ | 16,472 | $ | 14,561 | $ | 9,034 | 13% | 61% |
Our revenue growth rate was 10% infor fiscal 2001, 12% in fiscal 2002, and 13% in fiscal 2003. Revenue growth in fiscal 2003year 2006 was driven primarily by multi-yeargrowth in SQL Server following the launch of SQL Server 2005 in the second quarter, Windows Server and other server applications, increased Xbox revenue resulting from the Xbox 360 launch in the second quarter, growth in licensing that occurred beforeof Windows client operating systems through OEMs, and increased licensing of Office and other Information Worker products. Based on our estimates, total worldwide PC shipments from all sources grew approximately 12% to 14% and total server hardware shipments grew approximately 11% to 13% during fiscal year 2006. Foreign currency exchange rates did not have a significant impact on consolidated or operating segment revenue during the transitionfiscal year.
Revenue growth for fiscal year 2005 was driven by growth in licensing of Windows Server operating systems and other server applications, licensing of Windows client operating systems through OEMs, and increased licensing of Office and other Information Worker products. The November 2004 launch of the “Halo 2” Xbox game also contributed to our new licensing program (Licensing 6.0)overall revenue growth for the company. Total worldwide PC shipments from all sources grew approximately 11% to 13% and total server hardware shipments grew approximately 13% to 14% during fiscal year 2005 as compared to fiscal year 2004. The net impact of foreign exchange rates on revenue was positive in 2005, primarily due to relative strengthening of most foreign currencies, particularly the euro and Japanese yen, against the U.S. dollar. Partially offsetting revenue growth rates was a $1.08 billion decline in earned revenue from Upgrade Advantage in fiscal year 2005. This revenue was recognized over fiscal year 2003 and fiscal year 2004 and in the first quarter of fiscal 2003. Prior toyear 2005 when the July 31, 2002 transition date to Licensing 6.0, we experienced significantcontract period expired. Fiscal year 2004 revenue growth was primarily driven by the growth in multi-year licensing arrangements as customers enrolled in our maintenance programs, including Upgrade Advantage and Software Assurance. The revenue growth also reflected a $933 million or 13% increase associated with OEM licensing of Microsoft Windows client operating systems through OEMs, Windows Server operating systems, Office and other server applications as a $309 million or 23% increase in revenue from Microsoft Xbox video game consoles. Revenueresult of growth in fiscal 2002PC and server hardware shipments. The worldwide PC shipment growth rate from all sources was led byestimated at 13% and the addition of $1.35 billion of Xbox video game system revenue and $1.20 billion of revenue growth from Microsoft Windows XP Professional and Home operating systems. Revenue growthserver shipment was estimated at 18% in fiscal 2001year 2004 as compared to fiscal year 2003. The net impact of foreign exchange rates on revenue was driven primarily by licensingpositive in fiscal year 2004 due to a relative strengthening of Microsoft Windows 2000 Professional with $1.01most foreign currencies versus the U.S. dollar. This resulted in approximately $1.10 billion growth in total revenue.
Operating income for fiscal year 2006 increased primarily reflecting the revenue increase and a $991 million decrease in costs for legal settlements and legal contingencies. These changes were partially offset by a $1.62 billion increase in cost of revenue primarily related to Xbox 360 and a $1.26 billion increase in sales and marketing expense primarily as a result of increased investments in partner marketing and product launch-related spending. Headcount-related costs, including stock-based compensation expense, increased $682 million or 7% resulting from Professional operating systems,both an increase in salaries and benefits for existing headcount and a 16% growth in headcount over the past twelve months. Stock-based compensation expense decreased $733 million or 30% reflecting a continuing decline in stock option amortization expense.
Operating income increased in fiscal year 2005 due to a decline in stock-based compensation expense; increased revenue in Server and Tools, revenue growthClient and Information Worker, which have higher gross margins as compared to other segments; and a reduction in legal costs associated with major litigation. In addition, strong sales of $852 million.Halo 2 reduced the overall operating loss for the Home and Entertainment segment for fiscal year 2005. The $3.29 billion decrease in stock-based compensation expense was partially offset by increased operating expenses of $562 million related to increased salary and benefits for new and existing headcount. General and administrative expenses related to major litigation declined in fiscal year 2005 due to the $2.53 billion of charges related to the settlement of Sun
During
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Microsystems litigation and the fine imposed by the European Commission in fiscal year 2004. This effect was partially offset by legal expenses of $2.08 billion related to settlements with IBM, Novell, Gateway, and end-user class action plaintiffs to resolve antitrust issues and other matters. In fiscal year 2004, the operating income decline was caused primarily by $2.53 billion of legal charges and $2.21 billion of stock-based compensation expense related to our employee stock option transfer program, mainly offset by an increase in revenue.
We implemented changes in employee compensation in fiscal year 2004 whereby employees are granted stock awards rather than stock options. We also completed an employee stock option transfer program in the second quarter of fiscal 2002, we launchedyear 2004 in which employees could elect to transfer all of their vested and unvested stock options with a new licensing program, Licensing 6.0, for volume licensing customers. Licensing 6.0 simplifies and improves our volume licensing program with Software Assurance,strike price of $33.00 or higher to JPMorgan Chase Bank (“JPMorgan”). The unvested options that were transferred to JPMorgan became vested upon the transfer. A total of 345 million of the 621 million eligible options were transferred, which gives customers the right to install any new releaseresulted in additional stock-based compensation expense of products covered$2.21 billion in the licensing agreement duringsecond quarter of fiscal year 2004. As a result of these changes, stock-based compensation expense decreased in fiscal years 2006 and 2005, and we expect stock-based compensation expense related to stock options to continue to decrease in fiscal year 2007.
Fiscal Year 2007 Outlook
In fiscal year 2007, we expect continued double digit revenue growth primarily as a result of the termupcoming launches of their coverage. The levelWindows Vista and the 2007 Microsoft Office system. We estimate worldwide PC shipments will grow between 8% and 10%. We expect that PC unit growth rates will be higher in the consumer segment than in the business segment and higher in emerging markets than in mature markets. We estimate worldwide server unit shipments will grow between 10% and 12% in fiscal year 2007 as compared to fiscal year 2006. We do not expect a significant impact from year-over-year foreign currency exchange rates in fiscal year 2007.
We expect our operating income growth rate to lag our revenue growth rate in the first half of customer adoption of our new volume licensing programs will affect thefiscal year 2007 due to an increasing mix of multi-year licensing agreements with a resulting impact on the timing ofXbox 360 console revenue recognition. In addition, the timing and extent of a recovery in consumer and corporate spending on PCs and information technology will be factors affecting revenue growth.
CONSOLIDATED OPERATING INCOME
Operating income grew 6% in fiscal 2001, 2% in fiscal 2002, and 11% in fiscal 2003. In fiscal 2003, the growth in operating income reflected an increase of $3.82 billion in revenue, partially offset by an increase of $2.52 billion in operating expenses, primarily related to employee and related costs, associatedcoupled with additional headcount and increased legal settlement expenses. Insignificant investments in preparation for the launches of our flagship products. We expect this trend to reverse in the second half of the fiscal 2002, the growth inyear when we expect operating income reflected an increase of $3.07 billion in revenue, substantially offset by an increase of $2.88 billion in operating expenses, which included the onset of costs related to Xbox video game systems. In fiscal 2001, the growth in operating income reflected an increase of $2.34 billion in revenue, partially offset by an increase of $1.63 billion in operating expenses.
grow faster than revenue.
SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)
We revisedOur seven segments were Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. On July 17, 2006, we announced a change in our operating segments reflecting the culmination of our realignment announced in September 2005. These changes will be effective for fiscal year 2003. Our2007; the seven segments are:
discussed in this analysis are presented the way we internally managed and monitored performance at the business group level in fiscal years 2006, 2005, and 2004.
The revenue and operating income/(loss) amounts in this MD&Asection are presented in accordanceon a basis consistent with U.S. GAAP. Segment InformationGenerally Accepted Accounting Principles (“GAAP”) and include certain reconciling items attributable to each of the segments. The segment information appearing in Note 2118 – Segment Information of the Notes to Financial Statements areis presented on a basis consistent with the Company’s internal management reporting, in accordance with SFASStatement of Financial Accounting Standards (“SFAS”) No. 131,Disclosures about Segments of an Enterprise and Related Information. Certain corporate level expenses have been excluded from our segment operating results and are analyzed separately. Fiscal years 2005 and 2004 amounts have been restated for certain internal reorganizations and to conform to the fiscal year 2006 presentation.
Client
The following table presents our segment revenue and operating income, determined in accordance with U.S. GAAP:
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||
Revenue | $ | 13,209 | $ | 12,151 | $ | 11,556 | 9% | 5% | |||||
Operating income | $ | 10,203 | $ | 9,464 | $ | 8,740 | 8% | 8% |
(In millions) | Revenue | Operating Income/(Loss) | ||||||||||||
Year Ended June 30 | 2002 | 2003 | 2002 | 2003 | ||||||||||
Client | $ | 9,360 | $ | 10,394 | $ | 7,576 | $ | 8,400 | ||||||
Server and Tools | 6,157 | 7,140 | 2,048 | 2,457 | ||||||||||
Information Worker | 8,212 | 9,229 | 6,448 | 7,037 | ||||||||||
Microsoft Business Solutions | 308 | 567 | (176 | ) | (254 | ) | ||||||||
MSN | 1,571 | 1,953 | (641 | ) | (299 | ) | ||||||||
Mobile and Embedded Devices | 112 | 156 | (157 | ) | (157 | ) | ||||||||
Home and Entertainment | 2,453 | 2,748 | (874 | ) | (924 | ) | ||||||||
Other | 192 | — | (2,314 | ) | (3,043 | ) | ||||||||
Consolidated | $ | 28,365 | $ | 32,187 | $ | 11,910 | $ | 13,217 | ||||||
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Client revenue was $8.17 billion, $9.36 billion, and $10.39 billion in 2001, 2002, and 2003. Client includes revenue fromconsists of premium edition operating systems, including Windows XP Professional, and Home, Windows 2000 Professional,Media Center Edition, Tablet PC Edition, and other standard Windows operating systems. In 2003,systems, including Windows XP Home. Premium offerings are Windows operating systems sold at a premium above Windows XP Home. Client revenue growth wascorrelates with the growth of purchases of PCs from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue.
Client revenue increased in fiscal year 2006 reflecting $1.18 billion or 12% growth in OEM revenue driven by 17% growth in OEM licensing revenue growth of $933 million and a 9 percentage point increase of the mix of the higher priced Windows Professional operating systems, the majority of which was in the OEM channel. Windows Professional revenue growth for fiscal 2003 was $1.59 billion or 31% compared to fiscal 2002,license units from increased PC unit shipments, partially offset by a $573$118 million declineor 6% decrease in revenue of
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earlier versionsfrom commercial and retail licensing of Windows operating systems. During the year, the mix of OEM Windows operating systems licensed with premium edition operating systems as a percentage of total OEM Windows operating systems licensed (“OEM Premium Mix”) increased two percentage points to 52%. OEM revenue growth included an increase to revenue of $89 million resulting from the alignment of our billings associated with OEM distributors in our system builder channel with both industry standards and other Microsoft channels. The differences between unit growth rates and revenue growth rates from year to year are affected by changes in the OEM Premium Mix, changes in the geographical mix, and the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders. Client revenue increased in fiscal year 2005 driven by 12% growth in OEM license units and $886 million or 10% growth in OEM revenue from increased PC unit shipments, partially offset by a $198 million or 9% decrease in revenue from commercial and retail licensing of Windows operating systems. The OEM Premium Mix remained flat at 50% of total OEM Windows operating systems as compared to the previous year. Revenue earned from Upgrade Advantage declined by $99 million in fiscal year 2005 contributing to the decrease in commercial and retail licensing revenue.
Client operating profitincome increased in fiscal year 2006 reflecting the increase in OEM revenue partially offset by a $224 million increase in sales and marketing expenses, excluding headcount-related costs, mainly driven by increased investments in partner marketing and Windows Vista pre-launch programs. Headcount-related costs increased 6% in fiscal year 2006 reflecting both a 13% increase in headcount primarily associated with Windows Vista and further investments in our sales and marketing organization, and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Client operating income increased in fiscal 2003 increased 11%year 2005 primarily asdue to an increase in OEM revenue and a result of the 11% growth$444 million decrease in revenue,stock-based compensation expense. These factors were partially offset by an increase in operatingsales and marketing expenses largely attributed toassociated with “Start Something,” a globally launched advertising campaign, marketing for security initiatives, and an increase in salary and benefits for new and existing headcount. The additional headcount additionsfor research and related costs.
In fiscal 2002, the growth in Client revenue reflected strong multi-year licensing revenue growth and a continued shift of salesdevelopment was primarily devoted to the higher priced Windows 2000 and Windows XP Professional operating system licensed through OEMs. OEM revenue grew $939 million, despite a 5% decline in reported OEM unit shipments. Fiscal 2001 revenue growth reflected the strong adoptioncontinued development of Windows 2000 Professional with professional operating systems revenue growth of $1.01 billion and a 7 percentage point mix increase to the higher priced Windows 2000 Professional and Windows NT Workstation operating systems, and a $91 million increase in revenue from Windows Me and Windows 98 operating systems.
We do not expect the revenue growth attributed to the mix toward the higher priced Windows Professional operating system to continue at previous levels into fiscal 2004. Additionally, variability between the reported OEM unit shipments and the underlying PC Market may continue as a result of the transition to new OEM licensing terms at the beginning of fiscal year 2003, under which OEMs are billed upon their acquisition of Certificates of Authenticity (COAs) rather than upon the shipment of PCs to their customers.
Vista.
Server and Tools
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||
Revenue | $ | 11,467 | $ | 9,938 | $ | 8,590 | 15% | 16% | |||||
Operating income | $ | 4,323 | $ | 3,291 | $ | 1,474 | 31% | 123% |
Server and Tools revenue was $5.84 billion, $6.16 billion, and $7.14 billion in 2001, 2002, and 2003. Server and Tools consists of server software licenses and client access licenses (CALs)(“CAL”) for Windows Server, Microsoft SQL Server, Exchange Server and other servers.server products. It also includes developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft consultingConsulting Services. Server and Tools concentrates on licensing products, applications, tools, content and services that make information technology professionals and developers more productive and efficient. The segment uses multiple channels for licensing including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. The licenses are sold both as one-time licenses and as multi-year volume licenses. Server and Tools uses product innovation and partnerships with information technology professionals to drive the adoption and sales growth of its products.
Server and Tools revenue increased during fiscal year 2006 mainly driven by growth in SQL Server, Windows Server, and Core CAL. SQL Server 2005 and Visual Studio 2005 were launched in the second quarter of fiscal year 2006 and produced revenue growth in these product lines. Revenue is impacted by overall server hardware shipments which we estimate grew 11% to 13% in fiscal year 2006. Server and Server applications revenue, including CAL revenue, and developer tools, training and certification revenue grew $1.31 billion or 16% during fiscal year 2006. The results reflect broad adoption of Windows Server products, especially SQL Server, which grew over 30% for
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the year. Consulting, Premier and Professional product support services revenue increased $218 million or 15% primarily due to higher demand for services. In fiscal year 2005, Server and Server application revenue, including CAL revenue, grew $1.10 billion or 17%. Consulting, Premier, and Professional product support services revenue increased $241 million or 19% compared to the previous year. Foreign currency exchange rate changes accounted for $284 million or three percentage points of total Server and Tools revenue growth, which was offset by a $314 million decline in Upgrade Advantage revenue earned.
Server and Tools operating income increased during fiscal year 2006 primarily reflecting increased revenue, partially offset by increased sales and marketing expenses. Excluding headcount-related costs, sales and marketing expenses increased $274 million due to additional spending to support long-term strategies and marketing expenses primarily related to the launch of SQL Server 2005 and Visual Studio 2005. Total Server and Tools headcount-related costs increased 5% related to both an 11% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. In fiscal year 2005, Server and Tools operating income increased primarily due to increased revenue grew $983 million or 16%and a $1.07 billion decrease in fiscal 2003, drivenstock-based compensation expense. This increase was partially offset by an increase in Windows-based server shipmentssales and growth in SQL Servermarketing costs and Exchange revenue. Server revenue, including CALs, grew $787 million or 18% from fiscal 2002headcount-related costs as a result of increased newheadcount and anniversary multi-yearan increase in salaries and benefits for existing headcount.
Information Worker
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||
Revenue | $ | 11,756 | $ | 11,169 | $ | 10,748 | 5% | 4% | |||||
Operating income | $ | 8,285 | $ | 8,025 | $ | 7,458 | 3% | 8% |
Information Worker primarily consists of the Microsoft Office system of programs, servers, solutions, and services designed to increase personal, team, and organization productivity. Information Worker includes Microsoft Office, Microsoft Project, Microsoft Visio, SharePoint Portal Server CAL, and other information worker products including Office Communications Server and OneNote. Revenue growth depends on the ability to add value to the core Office product set and expand our product offerings in other information worker areas such as enterprise content management, collaboration, unified communications, and business intelligence.
Information Worker revenue increased in fiscal year 2006 primarily reflecting a $521 million or 5% increase in volume licensing, agreements. Consultingretail packaged products, and Premierpreinstalled versions of Office in Japan, while OEM revenue increased $66 million or 4%. Information Worker revenue increased in fiscal year 2005 primarily reflecting a $269 million or 3% increase in volume licensing, retail packaged product, support services increasedand pre-installed versions of Office in Japan, a $91 million or 10% compared to fiscal 2002. Revenue from developer tools, training, certification, Microsoft Press6% increase in OEM revenue, and other services increased $105the impact of foreign currency exchange rates, partially offset by reduced Upgrade Advantage earned revenue. Changes in foreign currency exchange rates accounted for approximately $367 million or 13%. Server operating profitthree percentage points of the revenue growth for fiscal 2003 grew 20%,year 2005, offset by a $663 million decline in Upgrade Advantage earned revenue.
Information Worker operating income increased in fiscal year 2006 primarily due to the revenue growth, partially offset by a $283 million or 15% increase in sales and marketing expenses related to supporting field sales efforts and a $71 million or 10% increase in research and development expenses. Headcount-related costs increased 14% during fiscal year 2006 reflecting both an 18% increase in headcount related to supporting field sales efforts and research and development investments in future products and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Information Worker operating income growth for fiscal year 2005 was primarily due to the revenue growth and a $304 million decrease in stock-based compensation expense. Operating expenses were also impacted by a reduction in marketing campaign costs from the previous period associated with the launch of Office 2003. This decline was offset by an increase in headcount-related costs as a result of the 16%an increase in revenue.headcount and an increase in salaries and benefits for existing headcount.
In fiscal 2002, Server
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Microsoft Business Solutions
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||||
Revenue | $ | 919 | $ | 784 | $ | 742 | 17% | 6% | |||||||
Operating income (loss) | $ | 24 | $ | (171 | ) | $ | (291 | ) | * | 41% |
* | Not meaningful |
Microsoft Business Solutions provides business management software solutions targeted to businesses of varying sizes. The main products consist of enterprise resource planning (“ERP”) solutions, customer relationship management (“CRM”) software, retail solutions, Microsoft Partner Program (“MSPP”), and Toolsrelated services. Microsoft Business Solutions also includes the Small and Mid-market Solutions and Partners (“SMS&P”), which focuses on sales to customers and partners in the small and mid-market customer segments. Revenue is derived from software and services sales, with software sales representing a significant amount of total revenue. Software revenues include both new software licenses and enhancement plans, which provide customers with future software upgrades over the period of the plan. Our solutions are delivered through a worldwide network of channel partners that provide services and local support.
Microsoft Business Solutions revenue increased 5% compared toin fiscal 2001. Server revenue, including CALs, increased 9% versus fiscal 2001,year 2006 driven by a 5% overallnew users for Microsoft CRM and existing Dynamics ERP customers purchasing functionality and user licenses. The increase in Windows-based server shipmentsMicrosoft Business Solutions revenue in fiscal year 2005 was mainly due to 10% revenue growth in software partially offset by 25% decline in services revenue. The software revenue increase was driven by 9% growth in license revenue and 16% growth in enhancement revenue and was attributed to growth in ERP and CRM solutions and an increase in MSPP subscriptions.
Microsoft Business Solutions operating income increased deployment of Windows 2000 Server. Consultingin fiscal year 2006 reflecting the increase in revenue accompanied by a $56 million decrease in sales and Premier product support services revenue was up $137 million or 17% compared to fiscal 2001, while revenue from developer tools, training, certification, Microsoft Press and other services was down $183 million or 18% from fiscal 2001. In fiscal 2001, Server and Tools revenue increased $852 million or 17% versus the prior year,marketing expense as a result of the continued adoption of the Microsoft Enterprise Server offerings.
Information Worker
Information Worker revenue was $8.42 billion, $8.21 billion, and $9.23 billion in 2001, 2002, and 2003. Information Worker includes revenue from Microsoft Office, Microsoft Project, Visio, other information worker products, SharePoint Portal Server CALs, and professional product support services. The $1.02 billion or 12%decreased net SMS&P spending. Headcount-related costs increased 3% reflecting both a 10% increase in Information Worker revenueheadcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Microsoft Business Solutions operating loss declined in fiscal year 2003 compared to fiscal 2002, was2005 primarily due to growtha $175 million decline in Office suitesstock-based compensation expense, an increase in product revenue, associated with new and anniversary multi-year licensing agreements and a $264decline in amortization of acquired intangibles. The reduction in operating loss was partially offset by a net increase in sales and marketing expense driven by incremental costs in the SMS&P organization. In addition, we increased our marketing and product development spending in our ERP and CRM portfolios.
MSN
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | |||||||||
Revenue | $ | 2,298 | $ | 2,344 | $ | 2,270 | (2)% | 3% | ||||||
Operating income (loss) | $ | (77 | ) | $ | 412 | $ | 98 | * | 320% |
* | Not meaningful |
MSN includes personal communications services, such as e-mail and instant messaging, and online information offerings, such as MSN Search, and the MSN portals and channels around the world. MSN also provides a variety of online paid services in addition to MSN Internet Access and MSN Premium Web Services. Revenue is derived primarily from advertisers on MSN, from consumers and partners through subscriptions and transactions generated from online paid services, and from MSN narrowband Internet access subscribers. In fiscal year 2006, we launched MSN adCenter – our internally developed advertising platform – in certain international markets and throughout the U.S. where it now serves 100 percent of paid search traffic on our online properties. We believe MSN adCenter will enable us to increase both display and search advertising revenues by reducing our reliance on third parties for delivering ads. Effective July 1, 2005, functions related to MapPoint previously reported in Mobile and Embedded
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Devices were moved to MSN. Mobile and Embedded Devices and MSN operating results for the prior periods have been restated for this reorganization. We announced in fiscal year 2006, Windows Live™, a set of Internet services and software designed to improve the users’ connected experience, including Windows Live™ Local and Windows Live Messenger.
MSN revenue decreased in fiscal year 2006 primarily reflecting a $195 million or 28% increasedecline in revenue from the combined total of Project, Visio, and other standalone applications. Information Worker operating profit for fiscal year 2003 grew 9% compared to fiscal year 2002 led by the 12% increase inaccess revenue, partially offset by a 24%$126 million or 9% increase in advertising revenue and a $23 million or 9% increase in revenue from subscription and transaction services other than access. As of June 30, 2006, MSN had 2.1 million access subscribers compared with 2.7 million at June 30, 2005. In addition, MSN had over 261 million active Hotmail accounts and over 243 million active Messenger accounts as of June 30, 2006. The increase in advertising revenue reflects growth in operating expenses related to headcount additionsdisplay advertising for portals, channels, email, and marketing expenses.
In fiscal 2002, Information Worker licensing revenue declined $228 million or 3% during the year due to a shift in the sales mix to multi-year licensing agreements,messaging services, which deferred revenue recognition to future years, and a $294 million or 14% decrease in consumer purchases in the Asia-Pacific region, most notably Japan, partially offset by a $189 million or 22% growth in OEM licensing revenue. In fiscal 2001, Information Worker revenue growth was less than 1% or $30 million.
Microsoft Business Solutions
Microsoft Business Solutions revenue was $106 million, $308 million, and $567 million in 2001, 2002, and 2003. Microsoft Business Solutions includes Microsoft Great Plains, Navision, and bCentral. Microsoft Business Solutions revenue for fiscal 2003 grew $259 million from fiscal 2002, of which $246 million was attributable to the acquisition of Navision at the beginning of the fiscal year. Microsoft Business Solutions operating loss for fiscal 2003 increased 44%, primarily due to operating losses associated with Navision, increases in sales and marketing expenses, research and development expenses, and acquisition related costs.
MSN
MSN revenue was $1.32 billion, $1.57 billion, and $1.95 billion in 2001, 2002, and 2003. MSN includes MSN Subscriptions and MSN Network services. Although total MSN subscribers at the end of fiscal 2003 were flat compared to the end of fiscal 2002, MSN Subscriptions revenue grew $112 million or 11% in fiscal year 2003 reflecting an increase in the number of non-promotion subscribers. MSN Network services revenue grew $270 million or 48% in fiscal 2003 as a result of growth in paid search and strong general advertising sales across all geographic regions. MSN operating loss for fiscal 2003 decreased 53%, primarily as a result of the growth in revenue and lower relative subscription acquisition and support costs.
In fiscal 2002, MSN Subscriptions revenue increased $229 million or 29% as a result of both a higher subscriber base and higher average revenue per subscriber due to a reduction in promotional subscriber programs. Revenue from MSN Network services increased $27 million or 5% led by online advertising. In fiscal 2001, revenue from MSN Network services grew $197 million or 58% led by online advertising. MSN Subscriptions revenue also grew $141 million or 22% from fiscal 2000 as a result of an increased subscriber base, partially offset by a decline in search revenue due to the averagetransition to adCenter. In fiscal year 2005, MSN revenue per subscriberincreased reflecting $193 million or 16% growth in advertising revenue primarily as a result of industry and market growth and continued growth of MSN display advertising revenue and $84 million or 88% growth in subscription and transaction services revenue. These increases were partially offset by the search clarity in advertising program, the impact of the homepage redesign, and a decline of $219 million or 24% in access revenue, driven by the continued migration of Internet Access subscribers to broadband or other competitively priced Internet service providers.
MSN operating income decreased in fiscal year 2006 due to a larger mix$230 million or 39% increase in research and development costs, a $126 million or 22% increase in sales and marketing expenses, and a $67 million or 9% increase in cost of subscribers contracted under rebate programs.
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revenue as we continue to invest in MSN adCenter, Windows Live, and other new platforms. Headcount-related costs increased 25% reflecting a 44% increase in headcount and increased salaries and benefits for existing employees, partially offset by a decrease in stock-based compensation. In fiscal year 2005, MSN operating income increased mainly due to a $241 million decrease in stock-based compensation expense, reduced costs associated with the Internet Access business, and increased advertising and subscription revenue. Partially offsetting the decreased expenses were increased headcount-related costs as a result of increased headcount and an increase in salaries and benefits for existing headcount.
Mobile and Embedded Devices
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||||
Revenue | $ | 377 | $ | 262 | $ | 193 | 44% | 36% | |||||||
Operating income (loss) | $ | 2 | $ | (65 | ) | $ | (237 | ) | * | 73% |
Mobile and Embedded Devices revenue was $86 million, $112 million, and $156 million in 2001, 2002, and 2003. * Not meaningful
Mobile and Embedded Devices includes Windows Mobile software, Windows Embedded device operating systems, MapPoint, and Windows Automotive. RevenueThese products extend the advantages of the Windows platform to mobile devices such as PDAs, phones, and a wide range of embedded devices. The business is also responsible for fiscal 2003 grew $44 million drivenmanaging sales and customer relationships for Microsoft overall with device manufacturers and communication sector customers. The communication sector includes network service providers (such as wireless, wireline and cable operators) and media and entertainment companies. The market for products in these segments is intensely competitive. Competitive alternatives vary based on product lines and include product offerings from commercial and non-commercial mobile operating system providers, and proprietary software developed by increased Pocket PC shipmentsOEMs and mobile operators. Effective July 1, 2005, functions related to MapPoint licensing. Operating loss for fiscal 2003 was flat with the prior year as higher marketing expenses and headcount-related costs associated with product development offset the growthpreviously reported in revenue. Prior year revenue and operating loss for Mobile and Embedded Devices were moved to MSN. Mobile and Embedded Devices and MSN operating results for the prior periods have been restated to reflect the reorganizations of MapPoint from Information Worker and Windows embedded device operating systems from Client to for this reorganization.
Mobile and Embedded Devices.Devices revenue increased in fiscal year 2006 primarily due to unit volume increases in major product lines, especially Windows Mobile software sales and Windows Embedded operating systems. Increased revenue for Windows Mobile software was primarily driven by increased market demand for phone-enabled devices, partially offset by a decline in shipments for stand-alone PDAs. In fiscal year 2006, revenue for Windows Mobile software increased $55 million or 37% while revenue for Windows Embedded operating systems increased $49 million or 47%, which was primarily due to the product being included in new product designs for both new and existing customers. Unit volume increases in major product lines drove revenue growth for fiscal year 2005 over fiscal
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year 2004, primarily driven by increased market demand for phone-enabled devices, and increased growth in shipments for standalone PDAs. In fiscal year 2005, revenue for Windows Mobile software increased $46 million or 45% and revenue for Windows Embedded operating systems increased $19 million or 21%. Unit volume increases in major product lines drove revenue growth for fiscal year 2005 over fiscal year 2004, primarily driven by increased market demand for phone-enabled devices, and increased growth in shipments for standalone PDAs.
Mobile and Embedded Devices generated operating income for fiscal year 2006 as opposed to the operating loss in fiscal year 2005 primarily due to increased revenue, partially offset by a $42 million or 21% increase in both research and development and general and administrative expenses. Headcount-related costs increased 15% reflecting both a 24% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. The operating loss for fiscal year 2005 decreased compared to fiscal year 2004 primarily due to a $95 million decrease in stock-based compensation, as well as the growth in revenue and a decrease in sales and marketing expense. This improvement was partially offset by increased salary and benefit costs from increased headcount, and increased investment in research and development.
Home and Entertainment
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | |||||||||||
Revenue | $ | 4,256 | $ | 3,140 | $ | 2,737 | 36% | 15% | ||||||||
Operating loss | $ | (1,262 | ) | $ | (485 | ) | $ | (1,337 | ) | (160)% | 64% |
Home and Entertainment includes the Microsoft Xbox video game console system, PC games, CPxG (consumer software and hardware products), and TV platform products for the interactive television industry. The success of video game consoles is determined by console innovation, the portfolio of video game content for the console, online offerings, and the market share of the console. Our Xbox business is transitioning to a new console, the Xbox 360, which launched in the second quarter of fiscal year 2006. We believe that the functionality of our new console, games portfolio, and online offerings are well-positioned relative to forthcoming competitive consoles. We also believe launching in advance of competitive consoles will provide a strategic advantage for the long-term success of Xbox 360. Revenue from the first generation of Xbox products has declined and is expected to continue to decline as a result of the introduction of Xbox 360.
Home and Entertainment revenue was $1.14 billion, $2.45 billion, and $2.75 billionincreased in 2001, 2002, and 2003. Home & Entertainment includesfiscal year 2006 primarily due to the launch of the Xbox video360 console partially offset by a decline in first party Xbox game system, PC games, consumer software and hardware, and TV platform. Home and Entertainmentsales primarily resulting from the significant impact of Halo 2 in fiscal year 2005. We sold approximately 5 million Xbox 360 consoles during fiscal year 2006. The revenue increased $295growth was also attributable to $140 million or 15% growth from our other product lines, primarily as a result of an increase in PC games sales due to significant new game releases, especially “Age of Xbox video game systemsEmpires III”, and related gamesan increase in MSTV revenue due to deployments in fiscal year 2006. Revenue increased in fiscal year 2005 primarily due to significant new product launches, which were available for all of fiscal 2003. Xbox revenue grew $309resulted in a $416 million or 23% increase in Xbox revenue. Halo 2 was introduced in the second quarter of fiscal year 2005 and generated over $300 million in revenue in fiscal 2003 reflecting a $779 million increase from higher volumes for Xbox consoles, games, and peripherals partially offset by a $470 million decrease due to price changes.year 2005. Revenue from consumer hardware and software, and PC games, and TV platforms declined $14$50 million or 1%5% compared to fiscal year 2004 due to lower PC games software sales.
Home and Entertainment operating loss increased in fiscal 2003. Operatingyear 2006 primarily as a result of a $1.64 billion increase in cost of revenue resulting from the number of Xbox 360 consoles sold and higher Xbox 360 unit costs, partially offset by the revenue growth. Our fiscal year 2006 operating loss increased due to the significant impact of Halo 2 in fiscal year 2005. Headcount-related costs increased 5% reflecting both a 19% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. The fiscal 2003 increased 6% fromyear 2005 operating loss decreased primarily due to an increase in high margin Xbox software sales, lower Xbox console units costs, a $90 million lower-of-cost-or-market inventory adjustment recorded in fiscal year 2004, and a $219 million decrease in stock-based compensation expense. The decrease was partially offset by an increase in costs associated with Xbox 360 console development and related launch efforts.
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Corporate-Level Activity
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||||
Corporate-level expenses | $ | 5,026 | $ | 5,910 | $ | 6,871 | (15 | )% | (14 | )% |
Certain corporate-level expenses are not allocated to our segments. Those expenses primarily include corporate operations related to broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, and legal settlements and contingencies.
Corporate-level expenses decreased in fiscal year 2006, primarily reflecting a $991 million decrease in costs for legal settlements and legal contingencies partially offset by an $84 million increase in headcount-related costs. We incurred $1.32 billion in legal charges during fiscal year 2006 including settlement expense of $361 million related to our settlement with RealNetworks, Inc. as well as other intellectual property and antitrust matters, and the€281 million ($351 million) fine imposed by the European Commission in July 2006 related to its 2004 decision in its competition law investigation of Microsoft, as compared to $2.31 billion in legal charges incurred during the prior year primarily related to settlements with Novell, Inc., Gateway, IBM, and other antitrust and competition law matters. Headcount-related costs increased 5% during the twelve months ended June 30, 2006 reflecting both a 23% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation.
Corporate-level expenses decreased in fiscal year 2005, primarily as a result of a $736 million reduction in stock-based compensation expense and decreased costs for legal settlements and legal contingencies. In fiscal year 2005, we recognized $2.31 billion in legal charges as compared to $2.53 billion in fiscal year 2004 which included a $1.92 billion charge for a settlement with the Sun Microsystems, Inc., and the fine of€497 million ($605 million) imposed by the European Commission.
Change to Financial Reporting Structure
On July 17, 2006, we announced that effective the first quarter of fiscal year 2007, we will report our businesses under five operating segments, reflecting completion of the previously announced changes in our organizational structure and how we will manage our business beginning in fiscal year 2007. Each of the five segments will be organized under one of the three operating divisions announced earlier in fiscal year 2006:
The five operating segments are described below. The first three of these will comprise the Platforms and Services Division.
Client will include the former Client segment. Products will include Windows XP Professional and Home, Media Center Edition, Tablet PC Edition, and other standard Windows operating systems.
Server and Tools will include the former Server and Tools segment, excluding the Exchange Server business and certain client access licenses related to products residing in the Microsoft Business Division. Products will include the Windows Server operating system, Microsoft SQL Server, Microsoft Consulting Services, product support services, Visual Studio, System Center products, the Forefront security family of products, and Biz Talk Server, among others.
Online ServicesBusiness will include the former MSN segment and Windows Live. Products will include MSN Search, MapPoint, MSN Internet Access, MSN Premium Web Services, MSN Mobile Services, and Windows Live.
Microsoft Business Division will include the former Information Worker and Microsoft Business Solutions segments, as well as the Exchange Server business and certain client access licenses, formerly included in the Server and Tools segment. Products will include Microsoft Office, Microsoft Project, Microsoft Visio, SharePoint Portal Server CAL, Microsoft Live Meeting, One Note, Office Communication Server, Microsoft Dynamics AX, Microsoft
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Dynamics CRM, Microsoft Dynamics GP, Microsoft Dynamics NAV, Microsoft Dynamics SL, Microsoft Dynamics Retail Management System, Microsoft Partner Program, and Microsoft Office Small Business Accounting.
Entertainment and Devices Division will include the former Home and Entertainment and Mobile and Embedded Devices segments. Products will include Xbox 360, Xbox, Xbox Live, CPxG (consumer software and hardware products), IPTV, Windows Mobile software platform, Windows Embedded device operating system, and Windows Automotive.
Our historical results under this new segmentation for the four quarters in fiscal years 2006 and 2005 were as follows:
Revenue
For the quarter ended | For the quarter ended | |||||||||||||||||||||||||||||
(In millions) | September 30, 2005 | December 31, 2005 | March 31, 2006 | June 30, 2006 | Fiscal Year 2006 | September 30, 2004 | December 31, 2004 | March 31, 2005 | June 30, 2005 | Fiscal Year 2005 | ||||||||||||||||||||
Segments | ||||||||||||||||||||||||||||||
Client | $ | 3,187 | $ | 3,459 | $ | 3,187 | $ | 3,376 | $ | 13,209 | $ | 2,980 | $ | 3,193 | $ | 2,964 | $ | 3,014 | $ | 12,151 | ||||||||||
Server and Tools | 2,127 | 2,438 | 2,398 | 2,690 | 9,653 | 1,906 | 2,161 | 2,058 | 2,245 | 8,370 | ||||||||||||||||||||
Online Services Business | 564 | 594 | 561 | 580 | 2,299 | 559 | 606 | 581 | 598 | 2,344 | ||||||||||||||||||||
Microsoft Business Division | 3,283 | 3,689 | 3,608 | 3,908 | 14,488 | 3,086 | 3,413 | 3,384 | 3,637 | 13,520 | ||||||||||||||||||||
Entertainment and Devices | 580 | 1,657 | 1,146 | 1,250 | 4,633 | 658 | 1,445 | 633 | 667 | 3,403 | ||||||||||||||||||||
Total revenue | $ | 9,741 | $ | 11,837 | $ | 10,900 | $ | 11,804 | $ | 44,282 | $ | 9,189 | $ | 10,818 | $ | 9,620 | $ | 10,161 | $ | 39,788 | ||||||||||
Operating Income / (Loss)
For the quarter ended | For the quarter ended | |||||||||||||||||||||||||||||||||||||||
(In millions) | September 30, 2005 | December 31, 2005 | March 31, 2006 | June 30, 2006 | Fiscal Year 2006 | September 30, 2004 | December 31, 2004 | March 31, 2005 | June 30, 2005 | Fiscal Year 2005 | ||||||||||||||||||||||||||||||
Segments | ||||||||||||||||||||||||||||||||||||||||
Client | $ | 2,569 | $ | 2,638 | $ | 2,471 | $ | 2,504 | $ | 10,182 | $ | 2,387 | $ | 2,513 | $ | 2,331 | $ | 2,172 | $ | 9,403 | ||||||||||||||||||||
Server and Tools | 606 | 762 | 746 | 903 | 3,017 | 455 | 660 | 515 | 479 | 2,109 | ||||||||||||||||||||||||||||||
Online Services Business | 81 | 58 | (26 | ) | (190 | ) | (77 | ) | 79 | 130 | 101 | 101 | 411 | |||||||||||||||||||||||||||
Microsoft Business Division | 2,251 | 2,466 | 2,414 | 2,544 | 9,675 | 2,160 | 2,355 | 2,316 | 2,285 | 9,116 | ||||||||||||||||||||||||||||||
Entertainment and Devices | (182 | ) | (296 | ) | (422 | ) | (437 | ) | (1,337 | ) | (202 | ) | 28 | (198 | ) | (235 | ) | (607 | ) | |||||||||||||||||||||
Corporate-Level Activity | (1,279 | ) | (971 | ) | (1,295 | ) | (1,443 | ) | (4,988 | ) | (1,385 | ) | (937 | ) | (1,736 | ) | (1,813 | ) | (5,871 | ) | ||||||||||||||||||||
Total operating income | $ | 4,046 | $ | 4,657 | $ | 3,888 | $ | 3,881 | $ | 16,472 | $ | 3,494 | $ | 4,749 | $ | 3,329 | $ | 2,989 | $ | 14,561 | ||||||||||||||||||||
Our outlook for fiscal year 2007 based on the five operating segments is as follows:
Client We expect revenue to grow reflecting improvement in the commercial and retail portion of the business due to our upcoming launch of Windows Vista. We expect revenue generated from OEMs to grow slower than the PC hardware market due to increased concentration among larger OEMs, consumer hardware shipments growing faster than business shipments, and relatively faster growth in emerging markets. We expect PC shipments to grow 8% to 10% for fiscal year 2007. We believe that PC unit growth rates will be higher in the consumer segment than in the business segment and higher in emerging markets than in mature markets.
Server and Tools We expect continued momentum from recent product launches and the expansion of our products in security, management and designer tools will help drive our overall revenue growth in fiscal year 2007. We estimate overall server hardware unit shipments will grow 10% to 12% in fiscal year 2007. However, we face competition from Linux-based, Unix, and other server operating systems as well as competition in server applications.
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Online Services Business We expect increased growth in display advertising revenue as the portals, channels, and communications services continue to expand globally and the overall Internet advertising industry continues to expand. Our search revenue is expected to grow in fiscal year 2007 as a result of continued ramp up of adCenter. We expect revenue from narrowband Internet Access to continue to decline in fiscal year 2007.
Microsoft Business Division We expect Microsoft Business Division revenue to grow in fiscal year 2007. We feel that our customers’ continued preference to purchase annuity contracts indicates enthusiasm for the 2007 Microsoft Office system. We also expect continued demand for our Dynamics products, building on the fiscal 2006 momentum.
Entertainment and Devices Division We expect revenue to increase from fiscal year 2006 due to the increased availability of the Xbox 360 console unit during the entire fiscal year, including the second holiday season after the launch in fiscal year 2006. In fiscal year 2007, we expect to introduce a music and entertainment device, the first in a new family of hardware and software products for the consumer market. The availability of a commercial IPTV product is expected to drive significant growth in MSTV revenue across several geographies. Revenue from existing mobility and embedded devices is expected to increase due to unit volume increases of Windows Mobile software driven by increased market demand for phone-enabled devices and Windows Embedded operating systems. Short product life cycles in product lines such as Windows Mobile software may impact our continuing revenue streams. Xbox 360 console unit costs are expected to decline.
As we implement our long-term growth strategy, we expect to increase our level of spending in four key areas in fiscal year 2007: increased product costs associated with Xbox consoles; marketing and field sales spending including launch costs; quickening the increased Xbox console salespace of development in growth areas such as business intelligence, security, management and unified communications (including acquisitions); and increased marketing expense more than offset the 12% increase in revenue.
In fiscal 2002, Home and Entertainment revenue growth from fiscal 2001 stemmed from $1.35 billion of sales of the Xbox video game system releasedcosts to execute on our online services strategy. While these investments will translate into increased operating expenses in fiscal 2002. Learningyear 2007, we believe they will help lay the groundwork for future growth and productivity software revenue and PC and online games declined $39 million or 3% in fiscal 2002 compared to fiscal 2001. In fiscal 2001, Home and Entertainment revenue declined $214 million or 16% from fiscal 2002.
profitability.
OtherOperating Expenses
Revenue in the Other segment represents our majority ownershipCost of Expedia, Inc., which was sold in February 2002, resulting in a decline in revenue from fiscal 2001. Acquisitions of Travelscape.com and VacationSpot.com by Expedia, Inc. in fiscal 2001 and increased product offerings from Expedia led to the strong revenue growth in fiscal 2001.
Operating loss includes Expedia, Inc. revenue and operating expenses, general and administrative expenses ($1.55 billion in 2002 and $2.10 billion in 2003), broad-based research and development expenses ($202 million in 2002 and $210 million in 2003), and certain corporate level sales and marketing costs ($526 million in 2002 and $688 million in 2003).
Foreign Currencies ImpactRevenue
Our operating results are affected by foreign exchange rates. Approximately 27%, 25%, and 28% of our revenue was collected in foreign currencies during 2001, 2002, and 2003. Had the rates from fiscal 2002 been in effect in fiscal 2003, translated international revenue billed in local currencies would have been approximately $700 million lower. Certain manufacturing, selling distribution and support costs are disbursed in local currencies, and a portion of international revenue is hedged, thus offsetting a portion of the translation exposure.
OPERATING EXPENSES
Cost of Revenue
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||
Cost of revenue | $ | 7,650 | $ | 6,031 | $ | 6,596 | 27% | (9)% | |||||
As a percent of revenue | 17% | 15% | 18% | 2ppt | (3)ppt |
Cost of revenue includes manufacturing and distribution costs for products sold and programs sold, operationlicensed, operating costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, and costs associated with the delivery of consulting services. Cost of revenue as a percent of revenue was 13.7% in 2001, 18.3% in 2002, and 17.7% in 2003. For fiscal 2003, cost of revenue was $5.69 billion compared to $5.19 billion in fiscal 2002. The primary driver of the decrease asyear 2006 increased mainly due to a percentage of revenue$1.64 billion increase in fiscal 2003 was a 0.2 percentage point decrease from Home and Entertainment products due to lower volumesas a result of an increase in the number of total Xbox consoles sold and improved margins ofhigher Xbox video game consoles and a 0.4 percentage point decrease from MSN product and service costs in fiscal 2003 compared to fiscal 2002.
360 unit costs. Cost of revenue in fiscal 2002 was $5.19 billion compared to $3.46 billion in fiscal 2001. The increase as a percentage of revenue in fiscal 2002 wasyear 2005 decreased due to an increase of 5.3 percentage points from Homea $363 million decrease in stock-based compensation expense, a $140 million reduction in costs associated with a decrease in the MSN Internet Access subscriber base, and Entertainment primarilya $169 million reduction in other product costs mainly due to costs related to Xbox consoles cost efficiency, partially offset by a 0.7 percentage point decrease due to a higher mix of revenue from licensing business. In fiscal 2001, cost of revenue was $3.46 billion, an increase of $453 million compared to fiscal 2000. The higher sales associated with MSN Subscription and MSN Network services resultingincreased costs in increasedproduct support and service costs drove 0.4 of the 0.6 percentage point increase in total costs as a percentage of revenue.
consulting services costs.
Research and Development
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||
Research and development | $ | 6,584 | $ | 6,097 | $ | 7,735 | 8% | (21)% | |||||
As a percent of revenue | 15% | 15% | 21% | –ppt | (6)ppt |
Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related costs associated with product development. Research and development expenses also
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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. Research and development expenses forcosts increased during fiscal 2003 were $4.66 billion,year 2006 primarily due to increased development costs associated with new and upcoming offerings such as MSN adCenter, the 2007 Microsoft Office system, Windows Vista, Xbox 360, and corporate research activities. Headcount-related costs increased 3% during fiscal year 2006 reflecting both a 17% increase in headcount and an increase of 8% compared to fiscal 2002. The increase reflectsin salaries and benefits for existing headcount, partially offset by a 7% increasedecrease in headcount-related costs, a 25% increase in third-party product development costs, and a 29% increase in testing laboratory equipment andstock-based compensation expense. In fiscal 2002,Our research and development expenses were $4.31 billion compared to $4.38 billiondecreased in fiscal 2001. The decrease from fiscal 2001 wasyear 2005 due to a $1.88 billion decrease in stock-based compensation expense. This expense decline was partially offset by increased headcount and product development costs associated with the discontinuation of amortization of goodwillXbox 360 console and related games, SQL Server 2005, Windows Vista, and product development in accordance with SFAS 142,GoodwillMobile and Other Intangible Assets, $272 million which offset the 15% growth in headcount-related costs. In fiscal 2001, researchEmbedded Devices.
Sales and development expenses were $4.38 billion, an increase of 16% compared to fiscal 2000. The increase in research and development expenses resulted from a 11% increase in headcount-related costs and a 23% increase in investments in new product development.Marketing
Part II, Item 7
Sales and Marketing
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||
Sales and marketing | $ | 9,818 | $ | 8,563 | $ | 8,195 | 15% | 4% | |||||
As a percent of revenue | 22% | 22% | 22% | –ppt | –ppt |
Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense and other headcount-related costs associated with sales and marketing personnel and advertising, promotions, tradeshows,trade shows, seminars, and other programs. Sales and marketing expense as a percentage of revenue was 19.3%expenses increased during fiscal year 2006 primarily due to increased headcount-related costs, investments in 2001, 19.1% in 2002,partner marketing and 20.3% in 2003. Sales and marketing expenses were $6.52 billion in 2003, compared to $5.41 billion inproduct launch-related spending. Headcount-related costs increased 13% during fiscal 2002. The increase in absolute dollars was due toyear 2006 reflecting both a 20% increase in sales expenses related to headcount additions, principally related to the Enterprise and Small/Medium Business sales forces, and a 21%an increase in marketing expenses.
In fiscal 2002, salessalaries and marketing expenses were $5.41 billion, an increase of 11% from fiscal 2001. The sales and marketing expenses in absolute dollars increased due to a 20% increase in headcount-related costsbenefits for existing headcount, partially offset by a 25% declinedecrease in MSN customer acquisition marketing costs and a 4% decline in all other marketing costs. Instock-based compensation expense.
For fiscal 2001,year 2005, sales and marketing expenses were $4.89 billion comparedexpense increased slightly due to $4.13 billion in fiscal 2000. The 18% increase in$470 million higher headcount-related costs from increased headcount and general salary increases; higher sales and marketing from fiscal 2000 was primarily due to a 21% growth in headcount-related costs and to a lesser extent, a 3% growth in higherdriven by product planning, reseller marketing, and sales expenses associated with MSNadvertising campaign costs mainly related to launch of the“Start Something” campaign; launch of “Halo 2”; and other new sales initiatives.
launch arrangements for Xbox 360. The increase was offset mainly by a $660 million decrease in stock-based compensation expense.
General and Administrative
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | ||||||||
General and administrative | $ | 3,758 | $ | 4,536 | $ | 5,275 | 17% | 14% | |||||
As a percent of revenue | 8% | 11% | 14% | (3)ppt | (3)ppt |
General and administrative costs include payroll, employee benefits, stock-based compensation expense and other headcount-related costs associated with the finance, legal, facilities, certain human resources, other administrative headcount, and legal and other administrative fees. General and administrative costs decreased in fiscal 2003year 2006 primarily reflecting decreased costs for legal settlements and legal contingencies. We incurred $1.32 billion in legal charges during fiscal year 2006 as compared to $2.31 billion in legal charges incurred during fiscal year 2005. Headcount-related costs increased $554 million due to a charge of $750 million related to a settlement with AOL/Time Warner7% during the twelve months ended June 30, 2006 reflecting both an 18% increase in the fourth quarter of 2003headcount and also due to a $256 million charge reflecting an increase in our estimate of costs related to resolving pending state antitrustsalaries and unfair competition consumer class action lawsuits.benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. General and administrative expenses in fiscal 2002 increased due to a charge of approximately $660 million for estimated expenses related to resolving pending state antitrust and unfair competition consumer class action lawsuits and a 10% increase in headcount-related costs. In fiscal 2001, general and administrative costs decreased due to a lawsuit settlement charge recorded in fiscal 2000, partially offset by a 3% growthyear 2005 primarily reflecting decreased stock-based compensation expense and decreased costs for legal settlements and legal contingencies. In fiscal year 2005, we recognized $277 million of stock-based compensation expense as compared to $664 million in headcount-related costs.fiscal year 2004. In fiscal year 2005, we recognized $2.31 billion in legal charges as compared to $2.83 billion in fiscal year 2004.
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NON-OPERATING ITEMS, INVESTMENT INCOME/(LOSS), AND INCOME TAXES Part II
Non-operating items
Losses on equity investees and other consist of our share of income or loss from investments accounted for using the equity method, and income or loss attributable to minority interests. The decrease in losses on equity investees and other in fiscal 2003 and 2002 was due to the divestiture of certain equity investments in fiscal 2002 in conjunction with the underlying performance of such entities. The increase in losses on equity investees and other in fiscal 2001 reflected an increase in the number of such investments during the year.Item 7
Investment Income/(Loss)Income and Other
We recorded netThe components of investment income/(loss) in each yearincome and other were as follows:
(In millions) | ||||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | |||||||||
Dividends | $ | 377 | $ | 357 | $ | 260 | ||||||
Interest | 1,808 | 1,762 | 1,697 | |||||||||
Net recognized gains/(losses) on investments: | ||||||||||||
Net gains on the sales of investments | 3,175 | 2,379 | 909 | |||||||||
Other-than-temporary impairments | (4,804 | ) | (4,323 | ) | (1,148 | ) | ||||||
Net unrealized losses attributable to derivative instruments | (592 | ) | (480 | ) | (141 | ) | ||||||
Net recognized gains/(losses) on investments | (2,221 | ) | (2,424 | ) | (380 | ) | ||||||
Investment income/(loss) | $ | (36 | ) | $ | (305 | ) | $ | 1,577 | ||||
(In millions) | 2006 | 2005 | 2004 | |||||||||
Dividends and interest | $ | 1,510 | $ | 1,460 | $ | 1,892 | ||||||
Net gains on investments | 161 | 856 | 1,563 | |||||||||
Net losses on derivatives | (99 | ) | (262 | ) | (268 | ) | ||||||
Income/(losses) from equity investees and other | 218 | 13 | (25 | ) | ||||||||
Investment income and other | $ | 1,790 | $ | 2,067 | $ | 3,162 | ||||||
For fiscal year 2006, dividends and interest income increased due to higher interest rates received on our fixed-income investments, partially offset by a decline in the average balance of dividend and interest-bearing investments as a result of the $32.64 billion special dividend paid on December 2, 2004, and stock repurchases made throughout fiscal year 2006. Dividends and interest income declined $432 million in fiscal year 2005 due to the combination of a greater allocation of funds to lower yielding, more liquid asset classes in preparation for the $32.64 billion special dividend paid on December 2, 2004, and a lower portfolio balance following payment of the special dividend.
For fiscal year 2006, net recognized gains on investments were comprised of net gains on sales of equity investments, net losses on sales of fixed-income investments and other-than-temporary impairments on both equity and fixed-income investments. Net recognized gains decreased in fiscal year 2006 primarily due to increased net losses on sales of fixed-income investments, higher other-than-temporary impairments and fewer net gains on equity investments in the current period as compared to fiscal year 2005. For fiscal year 2006, other-than-temporary impairments were $408 million, as compared to $152 million in fiscal year 2005. The increase in other-than-temporary impairments in fiscal year 2006 was driven by planned sales of certain investments in an unrealized loss position in order to raise funds for the $20 billion tender offer announced on July 20, 2006. Net gains on investments declined $707 million in fiscal year 2005 primarily due to greater sales of investments in the previous fiscal year in preparation for the special dividend paid on December 2, 2004. Net gains on investments also include other-than-temporary impairments of $152 million in fiscal year 2005 compared to $82 million in fiscal year 2004. Net realized gains on sales were $1.65 billion in fiscal year 2004 as we moved to more liquid investment asset classes.
Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary.other than temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, we evaluate general market conditions, the duration and extent to which the fair value is less than cost, as well asand our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary,other than temporary, an impairment charge is recorded and a new cost basis in the investment is established.
InWe lend certain fixed-income and equity securities to enhance investment income. The loaned securities continue to be carried as investments on our balance sheet.
We use derivative instruments to manage exposures to interest rates, equity prices, and foreign currency markets and to facilitate portfolio diversification. Net losses on derivatives were as follows:
(In millions) | 2006 | 2005 | 2004 | |||||||||
Net gain/(losses) on equity derivatives | $ | 192 | $ | (202 | ) | $ | 118 | |||||
Net gains on commodity derivatives | 101 | 46 | – | |||||||||
Net losses on interest rate derivatives | (79 | ) | (53 | ) | (102 | ) | ||||||
Net losses on foreign currency contracts | (313 | ) | (53 | ) | (284 | ) | ||||||
Net losses on derivatives | $ | (99 | ) | $ | (262 | ) | $ | (268 | ) | |||
During fiscal 2003, other-than-temporary impairments decreased mainlyyear 2006, we experienced lower net losses on derivatives as compared to fiscal year 2005 primarily due to the lack of significant continued impairmentsnet gains on non-designated equity derivatives in the cablecurrent fiscal year as compared to net losses in the prior
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fiscal year and telecommunications sectors. Interest income decreased $65 million due to declining interest rateshigher net gains on commodity positions in the current fiscal year driven by increases in the related commodity indices. These gains were partially offset by higher net losses in time value on foreign exchange contracts used to hedge anticipated foreign currency revenues and higher net losses on interest rate derivative contracts.
The net gains on equity derivatives during fiscal year 2006 are primarily due to changes in the market value of non-designated equity derivatives. Gains and losses arising from non-designated derivatives are economically offset by unrealized losses and gains, respectively, in the underlying equity securities which are recorded as a larger investment portfolio. Dividendcomponent of other comprehensive income. Commodity derivatives are held for the purpose of portfolio diversification. Net losses related to foreign currency contracts relate primarily to changes in time value of options used to hedge anticipated foreign currency revenues. Additionally, net gains and losses on foreign exchange contracts include the changes in the fair value of derivatives used as economic hedges. These gains and losses are partially offset economically by unrealized losses and gains, respectively, in the underlying assets which are included in other comprehensive income decreased $97 million
Net derivative losses in fiscal year 2005 were primarily related to losses on equity derivatives, interest rate derivatives, and foreign currency contracts. During fiscal year 2005, losses related to equity derivatives used to economically hedge against a decline in equity prices were $202 million and losses related to interest rate derivatives were $53 million. These losses were offset by the combination of realized gains on sales of securities and unrealized gains related to increases in the market value of the underlying assets included as a component of other comprehensive income. Net losses related to foreign currency contracts were $53 million, related to changes in time value of options used to hedge anticipated foreign currency revenues and economically hedging foreign currency based investment exposures. Losses related to hedging foreign currency-based investment exposures were offset by unrealized gains in the underlying assets which are included in other comprehensive income. Net losses on derivatives also included gains related to commodity positions used to provide portfolio diversification. Gains on commodity positions were $46 million during fiscal year 2005.
Derivative losses were $268 million in fiscal year 2004 primarily due to net losses in time value on foreign exchange of AT&T 5% convertible preferred debt for common shares of AT&T Corporation during the year.contracts used to hedge anticipated foreign currency revenues.
In the second quarter of fiscal 2002, other-than-temporary impairments primarilyyear 2006, we entered into an agreement with NBC Universal, Inc. (“NBC”) that restructured our joint venture relationships for MSNBC Cable L.L.C. (“CJV”) and MSNBC Interactive News, L.L.C. (“IJV”). As a result, we divested 32% of CJV for $331 million and NBC acquired the right, exercisable in the following two years, to buy the remaining 18% interest. In addition, we modified our agreement with NBC to grant to IJV a U.S. content license and to remove the exclusivity obligation on both NBC and Microsoft for local and non-U.S. news content. As part of the MSNBC restructuring agreements, we paid a $200 million fee to effectively terminate IJV’s prior content license agreement and we also prepaid the remaining $14 million license fee to NBC. In the fourth quarter of fiscal year 2006, NBC exercised its option to buy our remaining 18% interest in CJV. For fiscal year 2006, we recognized a net gain of $195 million related to our investment in AT&T and other cable and telecommunication investments. Net gains on the sales of investments included a $1.25 billion gain on sale of our share of Expedia. Interest and dividend income decreased $66 million from fiscal 2001 as a result of lower interest rates and dividend income.
In fiscal 2001, other-than-temporary impairments primarily related to cable and telecommunication investments. Net gains from the sales of investments in fiscal 2001 included a gain from our investment in Titus Communications (which was merged with Jupiter Telecommunications) and the closing of the sale of Transpoint to CheckFree Holdings Corp. Interest and dividend income increased $591 million from fiscal 2000, reflecting a larger investment portfolio.
Part II, Item 7
above transactions.
Income Taxes
Our effective tax rate for fiscal 2003year 2006 was 32%, reflecting31% as compared to 26% for fiscal year 2005. During fiscal year 2006, we recorded a one-timetax benefit in the second quarter of $126$108 million from the resolution of state audits. The increased rate in fiscal year 2006 resulted primarily from the European Commission fine of€281 million ($351 million) which is not tax deductible, and a lower rate in fiscal year 2005 as a result of reversal of $776 million of previously accrued taxes. Thetaxes upon settling an Internal Revenue Service examination for fiscal year 1997 – 1999 and a tax reversal stems frombenefit of $179 million generated by the decision to repatriate foreign subsidiary earnings under a 9th Circuit Courttemporary incentive provided by the American Jobs Creation Act of Appeals ruling in December 2002 overturning a previous Tax Court ruling that had denied tax benefits on certain revenue earned from the distribution of software to foreign customers. Excluding this reversal, the effective tax rate would have been 33%. The2004. Our effective tax rate for fiscal 2001 and fiscal 2002year 2004 was 33% and 32%, respectively.
ACCOUNTING CHANGES
Effective July 1, 2001, we adopted SFAS 141,Business Combinations,and SFAS 142,Goodwill and Other Intangible Assets. SFAS 141 requires business combinations to be accounted for using the purchase method of accounting. It also specifies the types of acquired intangible assets that are required to be recognized and reported separate from goodwill. SFAS 142 requires that goodwill and certain intangibles no longer be amortized, but instead tested for impairment at least annually. There was no impairment of goodwill upon adoption of SFAS 142. Goodwill amortization (on a pre-tax basis) was $311 million in fiscal 2001.
Effective July 1, 2000, we adopted SFAS 133,Accounting for Derivative InstrumentsFinancial Condition
Cash and Hedging Activities,which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. The adoption of SFAS 133 resulted in a cumulative pre-tax reduction to income of $560 million ($375 million after-tax) and a cumulative pre-tax reduction to other comprehensive income (OCI) of $112 million ($75 million after-tax). The reduction to income was mostly attributable to a loss of approximately $300 million reclassified from OCI for the time value of options and a loss of approximately $250 million reclassified from OCI for derivatives not designated as hedging instruments. The reduction to OCI was mostly attributable to losses of approximately $670 million on cash flow hedges offset by the reclassifications out of OCI of the approximately $300 million loss for the time value of options and the approximately $250 million loss for derivative instruments not designated as hedging instruments.
STOCK-BASED COMPENSATION
On July 8, 2003, we announced changes in employee compensation designed to help us continue to attract and retain the best employees, and to better align employee interests with those of our shareholders. Employees will be granted Stock Awards instead of stock options. The Stock Award program offers employees the opportunity to earn actual shares of our stock over time, rather than options that give employees the right to purchase stock at a set price. As part of the changes, we announced that a significant portion of stock-based compensation for more than 600 of our senior leaders will depend on growth in the number and satisfaction of our customers. We also indicated that we are working on a plan to enable employees to realize some value on the portion of their stock options that are currently out-of-the-money, by selling their options to a third-party financial institution. If approved, we expect to implement this plan by the end of 2003.
In addition to announcing changes to our employee compensation arrangements, we also indicated that we will adopt the fair value recognition provisions of SFAS 123,Accounting for Stock-Based Compensation, effective July 1, 2003, and will report that change in accounting principle using the retroactive restatement method described in SFAS 148,Accounting for Stock-Based Compensation—Transition and Disclosure. Note 16 of the Notes to the Financial Statements provides pro forma income statements for 2001, 2002, and 2003 as if compensation cost for our stock option and employee stock purchase plans had been determined as prescribed by SFAS 123.
FINANCIAL CONDITION
Our cashequivalents and short-term investment portfolioinvestments totaled $49.05$34.16 billion atand $37.75 billion as of June 30, 2003, an increase of $10.40 billion from fiscal year 2002. The2006, and 2005, respectively. This investment portfolio consists primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar denominatedU.S.-dollar-denominated securities, but also includes foreign currency positions in order to diversify financial risk. The portfolio is primarily invested in short-term securities to minimize interest rate risk and facilitate rapid deployment for immediate cash needs. Equity and other investments were $9.23 billion and $11.00 billion as of June 30, 2006, and 2005, respectively. As a result of the special dividend paid in the second quarter of fiscal year 2005 and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $18.90 billion at June 30, 2006. Our retained deficit is not expected to impact our future ability to operate or pay dividends given our continuing profitability and strong cash and financial position.
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Unearned Revenue
Unearned revenue from volume licensing programs represents customer billings, paid either upfront or annually at the beginning of each billing coverage period, that are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other licensing arrangements revenue attributable to undelivered elements, including free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the life cycle of the related product. Other unearned revenue includes services, TV Platform, Microsoft Business Solutions, advertising, and subscriptions for which we have been paid upfront and earn the revenue when we provide the service or software or otherwise meet the revenue recognition criteria.
Unearned revenue as of June 30, 2003 was $9.02 billion, increasing $1.272006, increased $1.74 billion from June 30, 2002,2005, reflecting the addition of new and anniversary multi-year licensing agreements, partially offset by continued recognition ofadditions to unearned revenue from multi-year licensing that outpaced recognitions by $1.66 billion, a $53 million decrease in prior periods.revenue deferred for undelivered elements, and a $127 million increase primarily in unearned revenue for services and subscription services.
The following table outlines the expected recognition of $10.9 billion of unearned revenue as of June 30, 2006:
(In millions) | Recognition of Unearned Revenue | ||
Three months ended: | |||
September 30, 2006 | $ | 3,483 | |
December 31, 2006 | 2,687 | ||
March 31, 2007 | 1,899 | ||
June 30, 2007 | 1,069 | ||
Thereafter | 1,764 | ||
Unearned revenue | $ | 10,902 | |
Cash Flows
Cash flow from operations was $15.80 billion for fiscal 2003,year 2006 decreased 13% to $14.40 billion primarily due to increased payments to fund a $987 million increase in inventory and product costs related to Xbox 360 and increased payments to employees resulting from a 16% growth in headcount. These factors were partially offset by increased cash receipts from customers driven by our 11% revenue growth and $1.74 billion increase in unearned revenue. Cash used in financing was $20.56 billion in fiscal year 2006, a decrease of $20.52 billion from the previous year driven by a $32.57 billion reduction in cash dividend payments. This impact was partially offset by an $11.15 billion increase in common stock repurchases. Net cash from investing was $8.00 billion in fiscal year 2006, a decrease of $1.29$7.02 billion from fiscal 2002. The increase reflectsyear 2005 driven primarily by an $8.93 billion decrease in cash from combined purchase, sales, and maturities of investments and a $2.16 billion$766 million increase in net incomeadditions to property and equipment. These factors were partially offset by $3.12 billion of cash proceeds from our securities lending program.
Cash flow from operations for fiscal year 2002 and2005 increased 14% to $16.61 billion primarily due to an increase of $1.37 billionin cash receipts from customers driven by our 8% revenue growth combined with a 12% increase in unearned revenue, offset by anrevenue. Cash payments in fiscal year 2005 resulting from significant legal settlements were approximately $1.8 billion lower than in the previous year, adding to the overall increase of $2.36 billion in recognition of unearned revenue.operating cash flow. Partially offsetting these factors were increased payments to employees resulting from a 7% increase in full-time employees. Cash used for financing was $5.22$41.08 billion in fiscal 2003,year 2005, driven by $36.11 billion of cash dividends paid in fiscal year 2005 compared to $1.73 billion paid in fiscal year 2004. The increase was also partially driven by $8.06 billion in cash used for common stock repurchases, an increase of $651$4.67 billion in cash used for share repurchases compared to the previous year, reflecting 312 million from the prior year. The increase reflects a cash dividend payment of $857 millionshares repurchased in 2003 andfiscal year 2005, an increase of $417188.5 million shares compared to the previous year. Net cash from investing was $15.03 billion in fiscal year 2005, an increase of $18.37 billion from fiscal year 2004, primarily due to a $23.59 billion increase in investment maturities that occurred to fund cash dividends paid in fiscal year 2005, partially offset by a $5.32 billion decrease in cash from combined investment purchase and sale activity.
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Cash flow from operations for fiscal year 2004 decreased $1.17 billion to $14.63 billion. The decrease primarily reflects the combined cash outflows of $2.56 billion related to the Sun Microsystems settlement and the European Commission fine partially offset by increased cash receipts from customers driven by the rise in revenue billings. Cash used for financing was $2.36 billion in fiscal year 2004, a decrease of $2.86 billion from the previous year. The decrease reflects that we did not repurchase common stock repurchase, offsetting $623in the fourth quarter of fiscal year 2004 combined with a $628 million received for commonincrease primarily from stock issued.issuances related to employee stock options exercises, partially offset by an $872 million increase in cash dividends paid. We repurchased 238.2123.7 million shares of common stock under our share repurchase program in fiscal 2003.year 2004. Cash used for investing was $7.21$3.34 billion in fiscal 2003,year 2004, a decrease of $3.63$3.88 billion from fiscal 2002, due to stronger portfolio performance on sold and matured investments.
Cash flow from operations was $14.51 billion for fiscal 2002, an increase of $1.09 billion from fiscal 2001. The increase reflected strong growth in unearned revenue as a result of the significant number of customers that purchased Upgrade Advantage during the Licensing 6.0 transition period. This resulted in an increase in billings and a corresponding increase in the unearned revenue amount. Cash used for financing was $4.57 billion in fiscal 2002, a decrease of $1.01 billion from the prior year. The decrease reflected the repurchase of put warrants in the prior year. We repurchased 245.6 million shares of common stock under our share repurchase program in fiscal 2002. In addition, 10.2 million shares of common stock were acquired in fiscal 2002 under a structured stock repurchase transaction. We entered into the structured stock repurchase transaction in fiscal 2001, which gave us the right to acquire 10.2 million of our shares in exchange for an up-front net payment of $264 million. Cash used for investing was $10.85 billion in fiscal 2002, an increase of $2.11 billion from fiscal 2001.
Part II, Item 7
Cash flow from operations was $13.42 billion in fiscal 2001, an increase of $2.00 billion from the prior year. The increase was primarily attributable to the growth in revenue and other changes in working capital, partially offset by a decrease in the stock option income tax benefit, reflecting decreased stock option exercises by employees. Cash used for financing was $5.59 billion in fiscal 2001, an increase of $3.39 billion from the prior year. The increase primarily reflected the repurchase of put warrants in fiscal 2001, compared to the sale of put warrants in the prior fiscal year as well as an increase in common stock repurchased. All outstanding put warrants were either retired or exercised during fiscal 2001. During fiscal 2001, we repurchased 178.1 million shares. Cash used for investing was $8.73 billion in fiscal 2001, a decrease of $658 million from the prior year.2003.
We have no material long-term debt. Stockholders’ equity at June 30, 20032006, was $61.02$40.10 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities and computer systems for R&D,research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $117$234 million on June 30, 2003. 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 or requirements for capital resources.
We believe existing cash and short-term investments together with funds generated from operations should be sufficient to meet operating requirements. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, as well as equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We continuously assess our investment management approach in view of our current and potential future needs.
Off-balance sheet arrangements
2006. We have operating leases for most U.S. and international sales and support offices and certain equipment. Rentalequipment under which we incurred rental expense for operating leases was $281totaling $276 million, $318$299 million, and $290$331 million in 2001, 2002,fiscal year 2006, 2005 and 2003,2004, respectively. Future minimum rental commitments under noncancellable leases, in millions of dollars, are: 2004, $218; 2005, $202; 2006, $172; 2007, $134; 2008, $116; and thereafter, $429.
We have unconditionally guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of Jupiter Telecommunication, Ltd., a Japanese cable company (Jupiter). Theseissued residual value guarantees arose on February 1, 2003 in conjunction with the expiration of prior financing arrangements, including previous guarantees by us. The financing arrangements were entered into by Jupiter as part of financing its operations. As part of Jupiter’s new financing agreement, we agreed to guarantee repayment by Jupiter of the loans of approximately $51 million. The estimated fair value and the carrying value of the guarantees was $10.5 million and did not result in a charge to operations. The guarantees are in effect until the earlier of repayment of the loans, including accrued interest and fees, or February 1, 2009. The maximum amount of the guarantees is limited to the sum of the total due and unpaid principal amounts, accrued and unpaid interest, and any other related expenses. Additionally, the maximum amount of the guarantees, denominated in Japanese yen, will vary based on fluctuations in foreign exchange rates. If we were required to make payments under the guarantees, we may recover all or a portion of those payments upon liquidation of Jupiter’s assets. The proceeds from such liquidation cannot be accurately estimated due to the multitude of factors that would affect the valuation and realization of the proceeds in the event of liquidation.
In connection with various operating leases, we issued residual valueleases. These guarantees which provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2003,2006, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability to us currently exists. 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 requirements for capital resources.
In fiscal year 2006, our Board of Directors declared $0.35 per share cash dividends, with $2.69 billion paid as of June 30, 2006. A quarterly dividend of $0.09 per share (or $906 million) was declared by our Board of Directors on June 21, 2006 to be paid to shareholders of record as of August 17, 2006, on September 14, 2006.
On July 20, 2006, we announced the completion of the repurchase program initially approved by our Board of Directors on July 20, 2004 to buy back up to $30 billion in Microsoft common stock. The repurchases were made using our cash resources. During fiscal year 2006, we repurchased 754 million shares, or $19.75 billion, of our common stock under this plan. On July 20, 2006, we also announced that our Board of Directors authorized new share repurchase programs, comprised of a $20 billion tender offer which was completed on August 17, 2006, and an additional $20 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of our common stock, or approximately 1.5% of the common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. On August 18, 2006, we announced that the authorization for the ongoing share repurchase program, previously announced on July 20, 2006, had been increased by approximately $16.2 billion. As a result, the company is authorized to repurchase additional shares in an amount up to $36.2 billion through June 30, 2011.
We believe existing cash and short-term investments, together with funds generated from operations should be sufficient to meet operating requirements, quarterly dividends and planned share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, and equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs.
Off-Balance Sheet Arrangements and Contractual Obligations
Off-Balance Sheet Arrangements
We provide indemnifications of varying scope and sizeamount to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. We evaluate estimated losses for such indemnifications under SFAS No. 5,Accounting for Contingencies,, as interpreted by FIN 45.FASB Interpretation No. (“FIN”) 45,Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. We consider factors such factors as the degree of probability of an unfavorable outcome and the
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ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any material liabilities related to such indemnifications in our financial statements.
Contractual Obligations
The following table summarizes our outstanding contractual obligations as of June 30, 2006:
(In millions)(1) | |||||||||||||||
Payments due by period | |||||||||||||||
Fiscal Years | 2007 | 2008-2010 | 2011-2013 | 2014 and thereafter | Total | ||||||||||
Long-term debt | $ | – | $ | – | $ | – | $ | – | $ | – | |||||
Construction commitments(2)(4) | 234 | – | – | – | 234 | ||||||||||
Lease obligations: | |||||||||||||||
Capital leases | – | – | – | – | – | ||||||||||
Operating leases(3) | 250 | 436 | 158 | 41 | 885 | ||||||||||
Purchase commitments(4) | 2,219 | 9 | – | – | 2,228 | ||||||||||
Other long-term liabilities(5) | 4 | 66 | 1 | – | 71 | ||||||||||
Total contractual obligations | $ | 2,707 | $ | 511 | $ | 159 | $ | 41 | $ | 3,418 | |||||
(1) | We have excluded the $970 million long-term contingent liability related to the antitrust and unfair competition class action lawsuits referred to in Note 17 – Contingencies of the Notes to Financial Statements as the timing and amount to be resolved in cash versus vouchers is subject to uncertainty. |
(2) | We have certain commitments for the construction of buildings. We expect to fund these commitments with existing cash and cash flows from operations. |
(3) | Our future minimum rental commitments under noncancellable leases comprise the majority of the operating lease obligations presented above. We expect to fund these commitments with existing cash and cash flows from operations. |
(4) | The amount presented above as purchase and construction commitments includes all known open purchase orders and all known contracts that are take-or-pay contracts. We expect to fund these commitments with existing cash and our cash flows from operations. |
(5) | We have excluded other obligations of $5.22 billion from other long-term liabilities presented above as the amount that will be settled in cash is not known. We have also excluded unearned revenue of $1.76 billion. |
RECENTLY ISSUED ACCOUNTING STANDARDS
In January 2003,November 2005, the FASB issued Interpretation 46,Staff Position (“FSP”) FAS123(R)-3,Consolidation of Variable Interest Entities.In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resourcesTransition Election to Accounting for the Tax Effects of Share-Based Payment Awards.This FSP requires an entity to support its activities. Interpretation 46 requiresfollow either the transition guidance for the additional-paid-in-capital pool as prescribed in SFAS No. 123(R),Share-Based Payment, or the alternative transition method as described in the FSP. An entity that adopts SFAS No. 123(R) using the modified prospective application may make a variable interestone-time election to adopt the transition method described in this FSP. An entity may take up to be consolidated by a company if that company is subject to a majority of the risk of lossone year from the variable interest entity’s activitieslater of its initial adoption of SFAS No. 123(R) or entitledthe effective date of this FSP to receive a majority ofevaluate its available transition alternatives and make its one-time election. We elected to adopt the entity’s residual returns or both. The consolidation requirements of Interpretation 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to transactions entered into prior to February 1, 2003transition method as described in the first fiscal year or interim period beginning after June 15, 2003. CertainFSP as of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The adoption of the Interpretation on July 1, 20032005. This method change did not have a materialan impact on our financial statements.
In April 2003,June 2006, the FASB issued SFAS 149,FIN No. 48,AmendmentAccounting for Uncertainty in Income Taxes – an interpretation of FASB Statement 133 on Derivative Instruments and Hedging ActivitiesNo. 109,, which amends and clarifies the accounting for derivative instruments, including certain derivative instruments embeddeduncertainty in other contracts,income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109,Accounting for Income Taxes.The interpretation prescribes a recognition threshold and measurement attribute for hedging activities under SFAS 133. The Statementthe financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 requires recognition of tax benefits that satisfy a greater than 50% probability threshold. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective (with certain exceptions) for contracts entered into or modified after June 30, 2003.us beginning July 1, 2007. We do not believeare assessing the potential impact that the adoption of this StatementFIN No. 48 will have a material impact on our financial statements.
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In May 2003,June 2006, the FASB issued SFAS 150,ratified the Emerging Issues Task Force (“EITF”) consensus on EITF Issue No. 06-2, “Accounting for Certain Financial Instruments with CharacteristicsSabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43”. EITF Issue No. 06-2 requires companies to accrue the costs of both Liabilities and Equity. The Statement establishes standards for how an issuer classifies and measures certain financial instruments with
Part II, Item 7
characteristics of both liabilities and equity. It requires that an issuer classifycompensated absences under a financial instrument that is within its scope as a liability (or an asset in some circumstances). Itsabbatical or similar benefit arrangement over the requisite service period. EITF Issue No. 06-2 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective atus beginning July 1, 2007. The cumulative effect of the application of this consensus on prior period results should be recognized through a cumulative-effect adjustment to retained earnings as of the beginning of the first interim period beginning after June 15, 2003. While we do not believeyear of adoption. Elective retrospective application is also permitted. We are currently evaluating the adoptionfinancial impact of this Statementguidance and the method of adoption that will have a material impact on our financial statements, we continue to assess the impact this Statement will have on certain of our share repurchase programs.
be used.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, accounting for income taxes, and accounting for income taxes.stock-based compensation.
We account for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP)(“SOP”) 97-2,Software Revenue Recognition.Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE)(“VSOE”) of fair value exists for those elements. End usersCustomers receive certain elements of our products over a period of time. These elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products.
SFAS No. 115,Accounting for Certain Investments in Debt and Equity Securities, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB)SEC SAB 59,Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value of an investment is less than its cost; the financial health of and near-term business outlook for the investee, including factors such as industry and sector performance, changes in technology, and operational and financing cash flow;cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.
SFAS No. 142,Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (July 1st for Microsoft)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 certain circumstances.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, assigningassignment of assets and liabilities to reporting units, assigningassignment of goodwill to reporting units, and determiningdetermination of the fair value of each reporting unit. Significant judgments required to estimate theThe fair value of each reporting units include estimatingunit is estimated using a discounted cash flow methodology. This requires significant judgments including estimation of future cash flows, determining appropriate discount rateswhich is dependent on internal forecasts, estimation of the long-term rate of growth for our business, the useful life over which cash flows will occur, and other assumptions.determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit. We allocate goodwill to reporting units based on the reporting unit expected benefit from the combination. We evaluate our reporting units on an annual basis and if necessary, reassign goodwill using a relative fair value allocation approach.
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Item 7
We account for research and development costs in accordance with several accounting pronouncements, including SFAS No. 2,Accounting for Research and Development Costs, and SFAS No. 86,Accounting for the Costs ofComputer Software to be Sold, Leased, or Otherwise Marketed.Marketed. SFAS No. 86 specifies that costs incurred internally in creatingresearching and developing a computer software product should be charged to expense when incurred as research and development until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be 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 shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established arehave not been material, and accordingly, we expensehave expensed all research and development costs when incurred.
We are subject to variousThe outcomes of legal proceedings and claims the outcomes of whichbrought against us are subject to significant uncertainty. SFAS No. 5,Accounting for Contingencies,, requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be 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. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. WeIn 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 financial position or our results of operations.
SFAS No. 109,Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of 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. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. FluctuationsVariations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations, or cash flows. Accruals for tax contingencies are provided for in accordance with the requirements of SFAS No. 5.
We account for stock-based compensation in accordance with SFAS No. 123(R),Share-Based Payment. Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of share-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations.operations could be materially impacted.
PAGE | 39 |
Part II
Item 7
ISSUES AND UNCERTAINTIESStatement of Management’s Responsibility for Financial Statements
This Annual Report on Form 10-K containsManagement is responsible for the preparation of the consolidated financial statements and related information that are forward-looking. Thesepresented in this report. The consolidated financial statements, arewhich include amounts based on current expectationsmanagement’s estimates and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of issues and uncertainties such as those listed below and elsewherejudgments, have been prepared in this report, which, among others, should be consideredconformity with accounting principles generally accepted in evaluating our financial outlook.
Challenges to our Business Model
Since our inception, our business model has been based upon customers agreeing to pay a fee to license software developed and distributed by us. Under this commercial software model, software developers bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenues received from the distribution of their products. We believe the commercial software model has had substantial benefits for users of software, allowing them to rely on our expertise and the expertise of other software developers that have powerful incentives to develop
Part II, Item 7
innovative software that is useful, reliable, and compatible with other software and hardware. In recent years, there has been a growing challenge to the commercial software model, often referred to as the Open Source model. Under the Open Source model, software is produced by loosely associated groups of unpaid programmers, and the resulting software and the intellectual property contained therein is licensed to end users at substantially no cost. The most notable example of Open Source software is the Linux operating system. While we believe that our products provide customers with significant advantages in security and productivity, and generally have a lower total cost of ownership than Open Source software, the popularization of the Open Source model continues to pose a significant challenge to our business model, including recent efforts by proponents of the Open Source model to convince governments worldwide to mandate the use of Open Source software in their purchase and deployment of software products. To the extent the Open Source model gains increasing market acceptance, sales of our products may decline, we may have to reduce the prices we charge for our products, and revenues and operating margins may consequently decline.
Intellectual Property Rights
We defend our intellectual property rights, but unlicensed copying and use of software and intellectual property rights represents a loss of revenue to us. While this adversely affects U.S. revenue, the impact on revenue from outside the United States is more significant, particularlyof America.
The Company maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel and a program of internal audits.
The Company engaged Deloitte & Touche LLP, independent auditors, to audit and render an opinion on the consolidated financial statements and management’s report on its assessment and the effectiveness of internal control over financial reporting in countries where laws are less protective of intellectual property rights. Throughoutaccordance with the world, we actively educate consumers about the benefits of licensing genuine products and educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may not affect revenue positively and further deterioration in compliance with existing legal protections or reductions in the legal protection for intellectual property rights of software developers could adversely affect revenue.
From time to time we receive notices from others claiming we infringe their intellectual property rights. The number of these claims may grow. Responding to these claims may require us to enter into royalty and licensing agreements on unfavorable terms, require us to stop selling or to redesign affected products, or to pay damages or to satisfy indemnification commitments with our customers.
We have made and expect to continue making significant expenditures to acquire the use of technology and intellectual property rights, including via cross-licenses of broad patent portfolios.
New Products and Services
We have made significant investments in research, development and marketing for new products, services and technologies, including Microsoft .NET, Xbox, business applications, MSN, mobile and wireless technologies, and television. Significant revenue from new product and service investments may not be achieved for a number of years, if at all. Moreover, these products and services may never be profitable, and even if they are profitable, operating margins for these businesses are not expected to be as high as the margins historically experienced by us.
Litigation
As discussed in Note 20 – Contingenciesstandards of the Notes to Financial Statements, we are subject to a varietyPublic Company Accounting Oversight Board (United States).
The Board of claims and lawsuits. While we believe that noneDirectors, through its Audit Committee, consisting solely of independent directors of the litigationCompany, meets periodically with management, internal auditors and our independent auditors to ensure that each is meeting its responsibilities and to discuss matters in which we are currently involved willconcerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have a material adverse impact on our financial position or results of operations, it is possible that one or more of these matters could be resolved in a manner that ultimately would have a material adverse impact on our business,full and could negatively impact our revenues, operating margins, and net income.
Declines in Demand for Software
If overall market demand for PCs, servers and other computing devices declines significantly, or consumer or corporate spending for such products declines, our revenue will be adversely affected. Additionally, our revenues would be unfavorably impacted if customers reduce their purchases of new software products or upgrades to existing products because new product offerings are not perceived as adding significant new functionality or other value to prospective purchasers. A significant number of customers purchased license agreements providing upgrade rights to specific licensed products priorfree access to the transition to Licensing 6.0 in July 2002. These agreements will expire in 2004 and 2005 and the rate at which such customers renew these contracts could adversely affect future revenues. We are also committing significant investments in the next release of the Windows operating system, codenamed Longhorn. If this system is not perceived as offering significant new functionality or value to prospective purchasers, our revenues and operating margins could be adversely affected.
Product Development Schedule
The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Significant delays in new product releases or significant problems in creating new products, particularly any delays in the Longhorn operating system, could adversely affect our revenues.
General Economic and Geo-Political Risks
Continued softness in corporate information technology spending or other changes in general economic conditions that affect demand for computer hardware or software could adversely affect our revenues. Terrorist activity and armed conflict pose the additional risk of general economic disruption and could require changes in our international operations and security arrangements, thus increasing our operating costs. These conditions lend additional uncertainty to the timing and budget for technology investment decisions by our customers.
Competition
We continue to experience intensive competition across all markets for our products and services. These competitive pressures may result in decreased sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenues, gross margins and operating income.
Taxation of Extraterritorial Income
In August 2001, a World Trade Organization (“WTO”) dispute panel determined that the tax provisions of the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (“ETI”) constitute an export subsidy prohibited by the WTO Agreement on Subsidies
Audit Committee.
Part II, Item 7, 7A
and Countervailing Measures. The U.S. government appealed the panel’s decision and lost its appeal. If the ETI provisions are repealed and financially comparable replacement tax legislation is not enacted, the loss of the ETI tax benefit to us could be significant.
Other Potential Tax Liabilities
We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different than that which is reflected in historical income tax provisions and accruals. Should additional taxes be assessed as a result of an audit or litigation, a material effect on our income tax provision and net income in the period or periods for which that determination is made could result.
Finite Insurance Programs
In addition to conventional third party insurance arrangements, we have entered into captive insurance arrangements for the purpose of protecting against possible catastrophic and other risks not covered by traditional insurance markets. As of June 30, 2003, potential coverage available under captive insurance arrangements was $1.0 billion, subject to deductibles, exclusions, and other restrictions. While we believe these arrangements are an effective way to insure against such risks, the potential liabilities associated with certain of the issues and uncertainties discussed herein could exceed the coverage provided by such arrangements.
Other
Other issues and uncertainties may include:
Steven A. Ballmer Chief Executive Officer |
Christopher P. Liddell Senior Vice President, Finance and |
Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer |
PAGE |
Part II
Item 7A
ITEM 7A. Quantitative and Qualitative Disclosures about Market RiskQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to foreign currency, interest rate, fixed-income, equity, and fixed income and equitycommodity price risks. A portion of these risks is hedged, but fluctuations could impact our results of operations and financial position. We hedge a portion of anticipated revenue and accounts receivable exposure to foreign currency fluctuations, primarily with option contracts. We monitor our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Principal currencies hedged include the Euro,euro, Japanese yen, British pound, and Canadian dollar. Fixed incomeFixed-income securities are subject primarily to interest rate risk. The portfolio is diversified and structured to minimize credit risk. We routinely use options to hedge a portion of our exposure to interest rate risk in the event of a catastrophic increase in interest rates. Securities held in our equity and other investments portfolio are subject to price risk, and are generally not hedged. However, we use options to hedge our price risk on certain highly volatile equity securities that are held primarily for strategic purposes. Commodity derivatives held for the purpose of portfolio diversification are subject to commodity price risk.
We use a value-at-risk (VAR)(“VaR”) model to estimate and quantify our market risks. VARVaR is the expected loss, for a given confidence level, in fair value of our portfolio due to adverse market movements over a defined time horizon. The VARVaR model is not intended to represent actual losses in fair value, but is used as a risk estimation and management tool. The model used for currencies, equities, and equitiescommodities is geometric Brownian motion, which allows incorporation of optionality with regard to these risk exposures. For interest rate risk, the mean reverting geometric Brownian motion isexposures such as key rate durations and spread durations are used toin calculations that reflect the principle that fixed-income securitiessecurity prices revert to maturity value over time.
Value-at-riskVaR is calculated by first, simulating 10,000computing the exposures of each holding’s market price pathsvalue to a range of over 20 days for equities, interest1,000 equity, fixed-income, foreign exchange, and commodity risk factors. The exposures are then used to compute the parameters of a distribution of potential changes in the total market value of all holdings, taking into account the weighted historical volatilities of the different rates and foreign exchange rates, taking into accountprices and the weighted historical correlations among the different rates and prices. Each resulting unique set of equities prices, interest rates, and foreign exchange ratesThe VaR is applied to substantially all individual holdings to re-price each holding. The 250th worst performance (out of 10,000) representsthen calculated as the value-at-risk over 20 daystotal loss that will not be exceeded at the 97.5th percentile confidence level.level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, credit risk, and legal risk.
Certain securities in our equity portfolio are held for strategic purposes. We hedge the value of a portion of these securities through the use of derivative contracts such as put-call collars. In these arrangements, we hedge a security’s marketequity price risk below the purchased put strike and forgo most or all of the benefits of the security’s appreciation above the sold call strike, in exchange for the premium received for the sold call. We also hold equity securities for general investment return purposes. We have incurred material impairment charges related to these securities.securities in previous periods.
At the beginning of the second fiscal quarter of fiscal year 2006, we changed the methodology we use to calculate VaR. We previously used a Monte Carlo simulation-based methodology to calculate VaR. In the second quarter of fiscal year 2006, we adopted a factor-based parametric methodology. The VARfactor-based parametric methodology can be performed more frequently (resulting in more timely data), divides the aggregated VaR into its component risk factor groups, and is incrementally more accurate than the previously used simulation-based methodology in evaluating diversification effects of commodity risk factors and interactions between equity and currency factors. While we believe the efficiencies gained by changing to the parametric methodology are significant, we do not believe this methodology produces results that are significantly different from the simulation-based methodology.
The VaR amounts disclosed below are used as a risk management tool and reflect an estimate of potential reductions in fair value of our portfolio. Losses in fair value over a 20-daythe specified holding period can exceed the reported VARVaR by significant amounts and can also accumulate over a longer time horizon than the 20-dayspecified holding period used in the VARVaR analysis. VARVaR amounts are not necessarily reflective of potential accounting losses, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP.
The VARVaR numbers are shown separately for interest rate, currency rate, equity price, and equitycommodity price risks. These VARVaR numbers include the underlying portfolio positions and related hedges. We use historical data to estimate VAR.VaR. Given the reliance on historical data, VARVaR is most effective in estimating risk exposures in markets in which there are no fundamental changes or shifts in market conditions. An inherent limitation in VARVaR is that the distribution of past changes in market risk factors may not produce accurate predictions of future market risk.
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Part II
Item 7A 8
The following table sets forth the VAR calculationsone-day VaR for substantially all of our positions:positions as of June 30, 2006 and 2005, and for the fiscal year ended June 30, 2006:
(In millions) | As of June 30 | Year ended June 30, 2003 | ||||||||||||||||||||||||||||
Year ended June 30, 2006 | ||||||||||||||||||||||||||||||
Risk Categories | 2002 | 2003 | Average | High | Low | 2006 | 2005 | Average | High | Low | ||||||||||||||||||||
Interest rates | $ | 472 | $ | 448 | $ | 609 | $ | 762 | $ | 448 | $ | 66 | $ | 88 | $ | 82 | $ | 127 | $ | 62 | ||||||||||
Currency rates | $ | 310 | $ | 141 | $ | 156 | $ | 333 | $ | 41 | 91 | 52 | 33 | 91 | 11 | |||||||||||||||
Equity prices | $ | 602 | $ | 869 | $ | 838 | $ | 1,083 | $ | 523 | 88 | 164 | 116 | 168 | 84 | |||||||||||||||
Commodity prices | 12 | 14 | 15 | 18 | 12 | |||||||||||||||||||||||||
The total VARTotal one-day VaR for the combined risk categories is $987was $158 million at June 30, 20032006 and $908$195 million at June 30, 2002.2005. The total VARVaR is 32%38% less at June 30, 20032006 and 34%39% less at June, 30 20022005 than the sum of the separate risk categories for each of those years in the above table due to the diversification benefit of the combination of risks. The reasons for the change in risk in portfolios include: larger investment portfolio size, asset allocation shifts, and changes in foreign exchange exposures relative to the U.S. dollar.
PAGE | 42 |
Part II
Item 8
ITEM 8. Financial Statements and Supplementary DataFINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INCOME STATEMENTS
(In millions, except per share amounts) | |||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||||||
Revenue | $ | 44,282 | $ | 39,788 | $ | 36,835 | |||||||
Operating expenses: | |||||||||||||
Cost of revenue | 7,650 | 6,031 | 6,596 | ||||||||||
Research and development | 6,584 | 6,097 | 7,735 | ||||||||||
Sales and marketing | 9,818 | 8,563 | 8,195 | ||||||||||
General and administrative | 3,758 | 4,536 | 5,275 | ||||||||||
Total operating expenses | 27,810 | 25,227 | 27,801 | ||||||||||
Operating income | 16,472 | 14,561 | 9,034 | ||||||||||
Investment income and other | 1,790 | 2,067 | 3,162 | ||||||||||
Income before income taxes | 18,262 | 16,628 | 12,196 | ||||||||||
Provision for income taxes | 5,663 | 4,374 | 4,028 | ||||||||||
Net income | $ | 12,599 | $ | 12,254 | $ | 8,168 | |||||||
Earnings per share: | |||||||||||||
Basic | $ | 1.21 | $ | 1.13 | $ | 0.76 | |||||||
Diluted | $ | 1.20 | $ | 1.12 | $ | 0.75 | |||||||
Weighted average shares outstanding: | |||||||||||||
Basic | 10,438 | 10,839 | 10,803 | ||||||||||
Diluted | 10,531 | 10,906 | 10,894 | ||||||||||
Cash dividends declared per common share | $ | 0.35 | $ | 3.40 | $ | 0.16 |
See accompanying notes.
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Part II
Item 8
INCOME STATEMENTSBALANCE SHEETS
(In millions, except earnings per share) | ||||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | |||||||||
Revenue | $ | 25,296 | $ | 28,365 | $ | 32,187 | ||||||
Operating expenses: | ||||||||||||
Cost of revenue | 3,455 | 5,191 | 5,686 | |||||||||
Research and development | 4,379 | 4,307 | 4,659 | |||||||||
Sales and marketing | 4,885 | 5,407 | 6,521 | |||||||||
General and administrative | 857 | 1,550 | 2,104 | |||||||||
Total operating expenses | 13,576 | 16,455 | 18,970 | |||||||||
Operating income | 11,720 | 11,910 | 13,217 | |||||||||
Losses on equity investees and other | (159 | ) | (92 | ) | (68 | ) | ||||||
Investment income/(loss) | (36 | ) | (305 | ) | 1,577 | |||||||
Income before income taxes | 11,525 | 11,513 | 14,726 | |||||||||
Provision for income taxes | 3,804 | 3,684 | 4,733 | |||||||||
Income before accounting change | 7,721 | 7,829 | 9,993 | |||||||||
Cumulative effect of accounting change (net of income taxes of $185) | (375 | ) | – | – | ||||||||
Net income | $ | 7,346 | $ | 7,829 | $ | 9,993 | ||||||
Basic earnings per share(1): | ||||||||||||
Before accounting change | $ | 0.72 | $ | 0.72 | $ | 0.93 | ||||||
Cumulative effect of accounting change | (0.03 | ) | – | – | ||||||||
$ | 0.69 | $ | 0.72 | $ | 0.93 | |||||||
Diluted earnings per share(1): | ||||||||||||
Before accounting change | $ | 0.69 | $ | 0.70 | $ | 0.92 | ||||||
Cumulative effect of accounting change | (0.03 | ) | – | – | ||||||||
$ | 0.66 | $ | 0.70 | $ | 0.92 | |||||||
Weighted average shares outstanding(1): | ||||||||||||
Basic | 10,683 | 10,811 | 10,723 | |||||||||
Diluted | 11,148 | 11,106 | 10,882 | |||||||||
(In millions) | ||||||||||
June 30 | 2006 | 2005 | ||||||||
Assets | ||||||||||
Current assets: | ||||||||||
Cash and equivalents | $ | 6,714 | $ | 4,851 | ||||||
Short-term investments (including securities pledged as collateral of $3,065 and $-) | 27,447 | 32,900 | ||||||||
Total cash and short-term investments | 34,161 | 37,751 | ||||||||
Accounts receivable, net of allowance for doubtful accounts of $142 and $171 | 9,316 | 7,180 | ||||||||
Inventories, net | 1,478 | 491 | ||||||||
Deferred income taxes | 1,940 | 1,701 | ||||||||
Other | 2,115 | 1,614 | ||||||||
Total current assets | 49,010 | 48,737 | ||||||||
Property and equipment, net | 3,044 | 2,346 | ||||||||
Equity and other investments | 9,232 | 11,004 | ||||||||
Goodwill | 3,866 | 3,309 | ||||||||
Intangible assets, net | 539 | 499 | ||||||||
Deferred income taxes | 2,611 | 3,621 | ||||||||
Other long-term assets | 1,295 | 1,299 | ||||||||
Total assets | $ | 69,597 | $ | 70,815 | ||||||
Liabilities and stockholders’ equity | ||||||||||
Current liabilities: | ||||||||||
Accounts payable | $ | 2,909 | $ | 2,086 | ||||||
Accrued compensation | 1,938 | 1,662 | ||||||||
Income taxes | 1,557 | 2,020 | ||||||||
Short-term unearned revenue | 9,138 | 7,502 | ||||||||
Securities lending payable | 3,117 | — | ||||||||
Other | 3,783 | 3,607 | ||||||||
Total current liabilities | 22,442 | 16,877 | ||||||||
Long-term unearned revenue | 1,764 | 1,665 | ||||||||
Other long-term liabilities | 5,287 | 4,158 | ||||||||
Commitments and contingencies | ||||||||||
Stockholders’ equity: | ||||||||||
Common stock and paid-in capital – shares authorized 24,000; outstanding 10,062 and 10,710 | 59,005 | 60,413 | ||||||||
Retained earnings (deficit), including accumulated other comprehensive income of $1,229 and $1,426 | (18,901 | ) | (12,298 | ) | ||||||
Total stockholders’ equity | 40,104 | 48,115 | ||||||||
Total liabilities and stockholders’ equity | $ | 69,597 | $ | 70,815 | ||||||
See accompanying notes.
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Part II
Item 8
BALANCE SHEETSCASH FLOWS STATEMENTS
(In millions) | ||||||
June 30 | 2002 | 2003 | ||||
Assets | ||||||
Current assets: | ||||||
Cash and equivalents | $ | 3,016 | $ | 6,438 | ||
Short-term investments | 35,636 | 42,610 | ||||
Total cash and short-term investments | 38,652 | 49,048 | ||||
Accounts receivable, net | 5,129 | 5,196 | ||||
Inventories | 673 | 640 | ||||
Deferred income taxes | 2,112 | 2,506 | ||||
Other | 2,010 | 1,583 | ||||
Total current assets | 48,576 | 58,973 | ||||
Property and equipment, net | 2,268 | 2,223 | ||||
Equity and other investments | 14,191 | 13,692 | ||||
Goodwill | 1,426 | 3,128 | ||||
Intangible assets, net | 243 | 384 | ||||
Other long-term assets | 942 | 1,171 | ||||
Total assets | $ | 67,646 | $ | 79,571 | ||
Liabilities and stockholders’ equity | ||||||
Current liabilities: | ||||||
Accounts payable | $ | 1,208 | $ | 1,573 | ||
Accrued compensation | 1,145 | 1,416 | ||||
Income taxes | 2,022 | 2,044 | ||||
Short-term unearned revenue | 5,920 | 7,225 | ||||
Other | 2,449 | 1,716 | ||||
Total current liabilities | 12,744 | 13,974 | ||||
Long-term unearned revenue | 1,823 | 1,790 | ||||
Deferred income taxes | 398 | 1,731 | ||||
Other long-term liabilities | 501 | 1,056 | ||||
Commitments and contingencies | ||||||
Stockholders’ equity: | ||||||
Common stock and paid-in capital – shares authorized 24,000; Shares issued and outstanding 10,718 and 10,771 | 31,647 | 35,344 | ||||
Retained earnings, including accumulated other comprehensive income of $583 and $1,840 | 20,533 | 25,676 | ||||
Total stockholders’ equity | 52,180 | 61,020 | ||||
Total liabilities and stockholders’ equity | $ | 67,646 | $ | 79,571 | ||
(In millions) | ||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | |||||||||
Operations | ||||||||||||
Net income | $ | 12,599 | $ | 12,254 | $ | 8,168 | ||||||
Depreciation, amortization, and other noncash items | 903 | 855 | 1,186 | |||||||||
Stock-based compensation | 1,715 | 2,448 | 5,734 | |||||||||
Net recognized gains on investments | (270 | ) | (527 | ) | (1,296 | ) | ||||||
Stock option income tax benefits | – | 668 | 1,100 | |||||||||
Excess tax benefits from stock-based payment arrangements | (89 | ) | – | – | ||||||||
Deferred income taxes | 219 | (179 | ) | (1,479 | ) | |||||||
Unearned revenue | 16,453 | 13,831 | 11,777 | |||||||||
Recognition of unearned revenue | (14,729 | ) | (12,919 | ) | (12,527 | ) | ||||||
Accounts receivable | (2,071 | ) | (1,243 | ) | (687 | ) | ||||||
Other current assets | (1,405 | ) | (245 | ) | 478 | |||||||
Other long-term assets | (49 | ) | 21 | 34 | ||||||||
Other current liabilities | (145 | ) | 396 | 1,529 | ||||||||
Other long-term liabilities | 1,273 | 1,245 | 609 | |||||||||
Net cash from operations | 14,404 | 16,605 | 14,626 | |||||||||
Financing | ||||||||||||
Common stock issued | 2,101 | 3,109 | 2,748 | |||||||||
Common stock repurchased | (19,207 | ) | (8,057 | ) | (3,383 | ) | ||||||
Common stock cash dividends | (3,545 | ) | (36,112 | ) | (1,729 | ) | ||||||
Excess tax benefits from stock-based payment arrangements | 89 | – | – | |||||||||
Other | – | (18 | ) | – | ||||||||
Net cash used in financing | (20,562 | ) | (41,078 | ) | (2,364 | ) | ||||||
Investing | ||||||||||||
Additions to property and equipment | (1,578 | ) | (812 | ) | (1,109 | ) | ||||||
Acquisition of companies, net of cash acquired | (649 | ) | (207 | ) | (4 | ) | ||||||
Purchases of investments | (51,117 | ) | (68,045 | ) | (95,005 | ) | ||||||
Maturities of investments | 3,877 | 29,153 | 5,561 | |||||||||
Sales of investments | 54,353 | 54,938 | 87,215 | |||||||||
Net proceeds from securities lending | 3,117 | – | – | |||||||||
Net cash from (used in) investing | 8,003 | 15,027 | (3,342 | ) | ||||||||
Net change in cash and equivalents | 1,845 | (9,446 | ) | 8,920 | ||||||||
Effect of exchange rates on cash and equivalents | 18 | (7 | ) | 27 | ||||||||
Cash and equivalents, beginning of period | 4,851 | 14,304 | 5,357 | |||||||||
Cash and equivalents, end of period | $ | 6,714 | $ | 4,851 | $ | 14,304 | ||||||
See accompanying notes.
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Part II
Item 8
STOCKHOLDERS’ EQUITY STATEMENTS
(In millions) | ||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | |||||||||
Common stock and paid-in capital | ||||||||||||
Balance, beginning of period | $ | 60,413 | $ | 56,396 | $ | 49,234 | ||||||
Common stock issued | 1,939 | 3,223 | 2,815 | |||||||||
Common stock repurchased | (4,447 | ) | (1,737 | ) | (416 | ) | ||||||
Stock-based compensation expense | 1,715 | 2,448 | 5,734 | |||||||||
Stock option income tax benefits/(deficiencies) | (617 | ) | 89 | (989 | ) | |||||||
Other, net | 2 | (6 | ) | 18 | ||||||||
Balance, end of period | 59,005 | 60,413 | 56,396 | |||||||||
Retained earnings (deficit) | ||||||||||||
Balance, beginning of period | (12,298 | ) | 18,429 | 15,678 | ||||||||
Net income | 12,599 | 12,254 | 8,168 | |||||||||
Other comprehensive income: | ||||||||||||
Net gains/(losses) on derivative instruments | 76 | (58 | ) | 101 | ||||||||
Net unrealized investments gains/(losses) | (282 | ) | 371 | (873 | ) | |||||||
Translation adjustments and other | 9 | (6 | ) | 51 | ||||||||
Comprehensive income | 12,402 | 12,561 | 7,447 | |||||||||
Common stock cash dividends | (3,594 | ) | (36,968 | ) | (1,729 | ) | ||||||
Common stock repurchased | (15,411 | ) | (6,320 | ) | (2,967 | ) | ||||||
Balance, end of period | (18,901 | ) | (12,298 | ) | 18,429 | |||||||
Total stockholders’ equity | $ | 40,104 | $ | 48,115 | $ | 74,825 | ||||||
See accompanying notes.
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Part II
Item 8
CASH FLOWS STATEMENTS
(In millions) | ||||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | |||||||||
Operations | ||||||||||||
Net income | $ | 7,346 | $ | 7,829 | $ | 9,993 | ||||||
Cumulative effect of accounting change, net of tax | 375 | – | – | |||||||||
Depreciation, amortization, and other noncash items | 1,536 | 1,084 | 1,439 | |||||||||
Net recognized losses on investments | 2,221 | 2,424 | 380 | |||||||||
Stock option income tax benefits | 2,066 | 1,596 | 1,376 | |||||||||
Deferred income taxes | (420 | ) | (416 | ) | 336 | |||||||
Unearned revenue | 6,970 | 11,152 | 12,519 | |||||||||
Recognition of unearned revenue | (6,369 | ) | (8,929 | ) | (11,292 | ) | ||||||
Accounts receivable | (418 | ) | (1,623 | ) | 187 | |||||||
Other current assets | (482 | ) | (264 | ) | 412 | |||||||
Other long-term assets | (330 | ) | (9 | ) | (28 | ) | ||||||
Other current liabilities | 774 | 1,449 | 35 | |||||||||
Other long-term liabilities | 153 | 216 | 440 | |||||||||
Net cash from operations | 13,422 | 14,509 | 15,797 | |||||||||
Financing | ||||||||||||
Common stock issued | 1,620 | 1,497 | 2,120 | |||||||||
Common stock repurchased | (6,074 | ) | (6,069 | ) | (6,486 | ) | ||||||
Repurchases of put warrants | (1,367 | ) | – | – | ||||||||
Common stock dividends | – | – | (857 | ) | ||||||||
Other, net | 235 | – | – | |||||||||
Net cash used for financing | (5,586 | ) | (4,572 | ) | (5,223 | ) | ||||||
Investing | ||||||||||||
Additions to property and equipment | (1,103 | ) | (770 | ) | (891 | ) | ||||||
Acquisitions of companies, net of cash acquired | – | – | (1,063 | ) | ||||||||
Purchases of investments | (66,346 | ) | (89,386 | ) | (89,621 | ) | ||||||
Maturities of investments | 5,867 | 8,654 | 9,205 | |||||||||
Sales of investments | 52,848 | 70,657 | 75,157 | |||||||||
Net cash used for investing | (8,734 | ) | (10,845 | ) | (7,213 | ) | ||||||
Net change in cash and equivalents | (898 | ) | (908 | ) | 3,361 | |||||||
Effect of exchange rates on cash and equivalents | (26 | ) | 2 | 61 | ||||||||
Cash and equivalents, beginning of year | 4,846 | 3,922 | 3,016 | |||||||||
Cash and equivalents, end of year | $ | 3,922 | $ | 3,016 | $ | 6,438 | ||||||
See accompanying notes.
Part II, Item 8
STOCKHOLDERS’ EQUITY STATEMENTS
(In millions) | ||||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | |||||||||
Common stock and paid-in capital | ||||||||||||
Balance, beginning of year | $ | 23,195 | $ | 28,390 | $ | 31,647 | ||||||
Common stock issued | 5,154 | 1,801 | 3,012 | |||||||||
Common stock repurchased | (394 | ) | (676 | ) | (691 | ) | ||||||
Repurchases of put warrants | (1,367 | ) | – | – | ||||||||
Stock option income tax benefits | 2,066 | 1,596 | 1,376 | |||||||||
Other, net | (264 | ) | 536 | – | ||||||||
Balance, end of year | 28,390 | 31,647 | 35,344 | |||||||||
Retained earnings | ||||||||||||
Balance, beginning of year | 18,173 | 18,899 | 20,533 | |||||||||
Net income | 7,346 | 7,829 | 9,993 | |||||||||
Other comprehensive income: | ||||||||||||
Cumulative effect of accounting change | (75 | ) | – | – | ||||||||
Net gains/(losses) on derivative instruments | 634 | (91 | ) | (102 | ) | |||||||
Net unrealized investment gains/(losses) | (1,460 | ) | 5 | 1,243 | ||||||||
Translation adjustments and other | (39 | ) | 82 | 116 | ||||||||
Comprehensive income | 6,406 | 7,825 | 11,250 | |||||||||
Common stock repurchased | (5,680 | ) | (6,191 | ) | (5,250 | ) | ||||||
Common stock dividends | – | – | (857 | ) | ||||||||
Balance, end of year | 18,899 | 20,533 | 25,676 | |||||||||
Total stockholders’ equity | $ | 47,289 | $ | 52,180 | $ | 61,020 | ||||||
See accompanying notes.
Part II, Item 8
NOTES TO FINANCIAL STATEMENTS
NOTE 1 ACCOUNTING POLICIES
Note 1—Accounting PoliciesACCOUNTING PRINCIPLES
Accounting Principles
The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America.
Principles of ConsolidationPRINCIPLES OF CONSOLIDATION
The financial statements include the accounts of Microsoft Corporation and its subsidiaries (Microsoft).subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments in which we own at least 20% ofexercise significant influence but do not control and are not the voting securitiesprimary beneficiary are accounted for using the equity method, except for investmentsmethod. Investments in which the Company iswe are not able to exercise significant influence over the investee inand which case,do not have readily determinable fair values are accounted for under the cost method of accounting is used.
method.
Estimates and AssumptionsESTIMATES AND ASSUMPTIONS
Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include estimates of loss contingencies, and product life cycles, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrade/upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or goodwill impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.
We revised our expense classification policies during fiscal year 2006 which resulted in reclassifications of certain operating expenses. We have reclassified the prior period amounts to conform to the current year presentation. These reclassifications had no impact on total operating expenses, operating income and our net income.
Foreign CurrenciesFOREIGN CURRENCIES
Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are charged or credited to other comprehensive income (OCI)Other Comprehensive Income (“OCI”).
Revenue RecognitionREVENUE RECOGNITION
Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. We enter into certain arrangements where we are obligated to deliver multiple products and/or services (multiple elements). In these arrangements, we generally allocate the total revenue among the elements based on the sales price of each element when sold separately (vendor-specific objective evidence).
Revenue for retail packaged products, products licensed to original equipment manufacturers (OEMs)(“OEM”), and perpetual licenses for current products under our Open and Select volume licensing programs generally is generally recognized as products are shipped, with a portion of the revenue recorded as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of revenue allocated to undelivered elements is based on the sales pricevendor-specific objective evidence of fair value for those elements when sold separately (vendor-specific objective evidence) using the residual method. Under the residual method, the total fair value of the undelivered elements, as indicated by vendor-specific objective evidence, is recorded as unearned, and the difference between the total arrangement fee and the amount recorded as unearned for the undelivered elements is recognized as revenue related to delivered elements. Unearned revenue due to undelivered elements is recognized ratably on a straight-line basis over the related product’s life cycle, which is currently estimated at three and a half years for Windows operating systems and two years for desktop applications (primarily Office).cycle.
Revenue from multi-year licensing arrangements are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the billing coverage period. Certain multi-year licensing
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Item 8
arrangements include rights to receive future versions of software product on a when-and-if-available basis under Open and Select volume licensing programs (currently named Software Assurance and, previously, Upgrade Advantage)(Software Assurance). In addition, other multi-year licensing arrangements include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available basis under Open, Select, and Enterprise Agreement volume licensing programs. Premier support services agreements, MSN Internet Access subscriptions, Microsoft bCentral subscriptions,Xbox Live, and Microsoft Developer Network subscriptions are also accounted for as subscriptions.
Revenue related to our Xbox game console is recognized upon shipment of the product to retailers. Revenue related to games published by us is recognized when those games have been delivered to retailers. Revenue related to games published by third parties for use on the Xbox platform is recognized when manufactured for the game publishers. Online advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Revenue for fixed price services arrangements is recognized based on percentage of completion.
Costs related to insignificant obligations, which include telephone support for developer tools software, PC games, computer hardware, and Xbox, are accrued when the related revenue is recognized. Provisions are recorded for estimated returns, concessions, and bad debts.
Cost of RevenueRESEARCH AND DEVELOPMENT
Cost of revenue includes manufacturing and distribution costs for products and programs sold, operation costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, and costs associated with the delivery of consulting services.
Research and Development
Research and development expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with product development. TechnologicalWe have determined that technological feasibility for our software products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established arehave not been material, and accordingly, we expensehave expensed all research and development costs when incurred.
Sales and MarketingSALES AND MARKETING
Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costs as well as expenses related toassociated with sales and marketing personnel and advertising, promotions, tradeshows, seminars, and other marketing-related programs. Advertising costs are expensed as incurred. Advertising expense was $1.02$1.23 billion in 2001, $1.13 billionfiscal year 2006, $995 million in 2002,fiscal year 2005, and $1.06 billion$904 million in 2003.
Part II, Item 8
fiscal year 2004.
Income TaxesINCOME TAXES
Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes.
Financial InstrumentsFINANCIAL INSTRUMENTS
We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. Short-termIn general, investments generally mature betweenwith original maturities of greater than three months to nine years from the purchase date.and remaining maturities of less than one year are classified as short term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available for sale and are recorded at market value using the specific identification method; unrealized gains and losses (excluding other-than-temporary impairments) are reflected in OCI.
Equity and other investments may include both debt and equity instruments. Debt securities and publicly traded equity securities are classified as available for sale and are recorded at market using the specific identification method. Unrealized gains and losses (excluding other-than-temporary impairments) are reflected in OCI. All other investments, excluding those accounted for using the equity method, are recorded at cost.
We lend certain fixed incomefixed-income and equity securities to enhance investment income. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. The fair value ofCash collateral that we are permitted to sell or repledge was $499 million at both June 30, 2002 and 2003.is recorded as an asset with a corresponding liability.
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Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, as well asand our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.
We use derivative instruments to manage exposures to foreign currency, securityequity price, interest rate and credit risks.risks, to enhance returns, and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible.
Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure affects earnings. The ineffective portion of the gain or loss is recognized in earnings. For options designated either as fair-value or cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains and losses from changes in fair values of derivatives that are not designated as hedges for accounting purposes are recognized in earnings.
Foreign Currency Risk. Certain assets, liabilities, and forecasted transactions and assets are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Principal currencies hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Non U.S. dollar denominated securitiesOptions are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments under SFAS 133. Options used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flowcash-flow hedging instruments.instruments under Statement of Financial Accounting Standards (“SFAS”) No. 133,Accounting for Derivative Instruments and Hedging Activities. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Certain non-U.S. dollars denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments under SFAS No. 133. Certain options and forwards not designated as hedging instruments under SFAS No. 133 are also used to hedge the impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies.currencies and to manage other foreign currency exposures.
SecuritiesEquities Price Risk. Strategic equityEquity investments are subject to market price risk. From time to time, we use and designate options to hedge fair values and cash flows on certain equity securities. We determine the security, or forecasted sale thereof, selected for hedging by evaluating market conditions, up-front costs, and other relevant factors. Once established, the hedgesCertain options, futures and swap contracts, not designated as hedging instruments under SFAS No. 133, are not dynamically managed or traded, and are generally not removed until maturity.also used to manage equity exposures.
Interest Rate Risk. Fixed-income securities are subject to interest rate risk. The fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. We use exchange-traded option and future contracts and over-the-counter swap contracts, not designated as hedging instruments under SFAS No. 133, to hedge interest rate risk. In addition, we routinely use options, not designated as hedging instruments under SFAS 133, to hedge our exposure to interest rate risk in the event of a catastrophic increase in interest rates.
Other Derivatives. Swap contracts, not designated as hedging instruments under SFAS No. 133, are used to manage exposures to credit risks.risks, enhance returns, and to facilitate portfolio diversification. In addition, we may invest in warrants to purchase securities of other companies as a strategic investment. Warrants that can be net share settled are deemed derivative financial instruments and are not designated as hedging instruments. To“To Be AnnouncedAnnounced” forward purchase commitments of mortgage-backed assets are also considered derivatives in cases where physical delivery of the assets are not taken at the earliest available delivery date.
For options All derivative instruments not designated either as hedging instruments are recorded at fair value, or cash flow hedges,with changes in value recognized in earnings during the time value are excluded from the assessmentperiod of hedge effectiveness.change.
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Allowance for Doubtful AccountsALLOWANCE FOR DOUBTFUL ACCOUNTS
The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accountaccounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts iswas as follows:
(In millions) | ||||||||||||||
Year Ended June 30 | | Balance at beginning of period | | Charged to costs and expenses |
| Write-offs and other | | Balance at end of period | ||||||
2001 | $ | 186 | $ | 157 | $ | 169 | $ | 174 | ||||||
2002 | 174 | 192 | 157 | 209 | ||||||||||
2003 | 209 | 118 | 85 | 242 |
(In millions) | |||||||||||||
Year Ended June 30 | Balance at beginning of period | Charged to costs and expenses | Write-offs and other | Balance at end of period | |||||||||
2004 | $ | 242 | $ | 44 | $ | (120 | ) | $ | 166 | ||||
2005 | 166 | 48 | (43 | ) | 171 | ||||||||
2006 | 171 | 40 | (69 | ) | $ | 142 |
InventoriesINVENTORIES
Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories.
We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis.
Property and EquipmentPROPERTY AND EQUIPMENT
Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for internal use is depreciated using the straight-line method over the estimated useful life of the software, generally three years or less.
GoodwillGOODWILL
Beginning in fiscal 2002 with the adoption of SFAS 142,Goodwill and Other Intangible Assets,goodwill is no longer amortized, but instead tested for impairment at least annually. Prior to fiscal 2002,on an annual basis as of July 1, and between annual tests if indicators of potential impairment exist, using a fair-value-based approach. No impairment of goodwill was amortized usinghas been identified during any of the straight-line method over its estimated period of benefit.
periods presented.
Intangible AssetsINTANGIBLE ASSETS
Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to ten years. We periodically evaluate the recoverability of intangible assets periodically and take into account events or circumstances that warrant revised estimates of useful lives or that indicate that an impairment exists. All of our intangible assets are subject to amortization.
Employee Stock Plans
We follow Accounting Principles Board Opinion 25,Accounting for Stock Issued to Employees,to account for stock option and employee stock purchase plans, which generally does not require income statement recognition No impairments of options granted at the market price on the date of issuance. However, certain events, such as the accelerated vesting of options and the exchange of options in a business combination, can trigger recording an expense. In addition to announcing changes to our employee compensation arrangements in July 2003, we also indicated that we will adopt the fair value recognition provisions of SFAS 123,Accounting for Stock-Based Compensation, effective July 1, 2003 and will report that change in accounting principle using the retroactive restatement method described in SFAS 148,Accounting for Stock-Based Compensation – Transition and Disclosure.
The following table illustrates the effect on net income and earnings per share as if we had applied the fair value recognition provisions of SFAS 123:
(In millions, except earnings per share) | ||||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | |||||||||
Net income, as reported | $ | 7,346 | $ | 7,829 | $ | 9,993 | ||||||
Add: Stock-based employee compensation expense included in reported net income, | 144 | 99 | 52 | |||||||||
Deduct: Total stock-based employee compensation expense determined under | (2,406 | ) | (2,573 | ) | (2,514 | ) | ||||||
Pro forma net income | $ | 5,084 | $ | 5,355 | $ | 7,531 | ||||||
Earnings per share: | ||||||||||||
Basic – as reported | $ | 0.69 | $ | 0.72 | $ | 0.93 | ||||||
Basic – pro forma | $ | 0.48 | $ | 0.50 | $ | 0.70 | ||||||
Diluted – as reported | $ | 0.66 | $ | 0.70 | $ | 0.92 | ||||||
Diluted – pro forma | $ | 0.46 | $ | 0.48 | $ | 0.69 | ||||||
Note 2—Stock Split
In February 2003, outstanding shares of our common stock were split two-for-one. All prior share and per share amountsintangible assets have been restated to reflect the stock split.
Note 3—Accounting Changes
Effective July 1, 2000, we adopted SFAS 133 which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. The adoption of SFAS 133 on July 1, 2000, resulted in a cumulative pre-tax reduction to income of $560 million ($375 million after-tax) and a cumulative pre-tax
Part II, Item 8
reduction to OCI of $112 million ($75 million after-tax). The reduction to income was mostly attributable to a loss of approximately $300 million reclassified from OCI for the time value of options and a loss of approximately $250 million reclassified from OCI for derivatives not designated as hedging instruments. The reduction to OCI was mostly attributable to losses of approximately $670 million on cash flow hedges offset by reclassifications out of OCIidentified during any of the approximately $300 million loss for the time value of options and the approximately $250 million loss for derivative instruments not designated as hedging instruments. The net derivative losses included in OCI as of July 1, 2000 were reclassified into earnings during the twelve months ended June 30, 2001. The change in accounting from the adoption of SFAS 133 did not materially affect net income in 2001.periods presented.
Effective July 1, 2001, we adopted SFAS 141,Business Combinations, and SFAS 142. SFAS 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. It also specifies the types of acquired intangible assets that are required to be recognized and reported separate from goodwill. SFAS 142 requires that goodwill and certain intangibles no longer be amortized, but instead tested for impairment at least annually. There was no impairment of goodwill upon adoption of SFAS 142.NOTE 2 UNEARNED REVENUE
Net income and earnings per share for fiscal 2001 adjusted to exclude amortization expense (net of taxes) is as follows:
(In millions, except earnings per share) | |||
Year Ended June 30 | 2001 | ||
Net income: | |||
Reported net income | $ | 7,346 | |
Goodwill amortization | 252 | ||
Equity method goodwill amortization | 26 | ||
Adjusted net income | $ | 7,624 | |
Basic earnings per share: | |||
Reported basic earnings per share | $ | 0.69 | |
Goodwill amortization | 0.02 | ||
Equity method goodwill amortization | – | ||
Adjusted basic earnings per share | $ | 0.71 | |
Diluted earnings per share: | |||
Reported diluted earnings per share | $ | 0.66 | |
Goodwill amortization | 0.02 | ||
Equity method goodwill amortization | – | ||
Adjusted diluted earnings per share | $ | 0.68 | |
Note 4—Unearned Revenue
Unearned revenue from volumeis comprised of the following items:
Volume licensing programs represents – Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other licensing arrangements revenue attributable to undelivered
Undelivered elements including – Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis,basis. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home, approximately 5% to 15% of the sales price for Windows XP Professional, and approximately 5%1% to 15% of the sales price for desktop applications, depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three and a halfone-half years for Windows operating systems and two years for desktop applications. Unearned revenue also includes
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Other – Represents payments for post-delivery support and consulting services to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Business Solutions maintenance and paymentsenhancement billings, Xbox Live and other billings that are accounted for post-delivery supportas subscriptions, and other agreements where Microsoft is committed to the delivery of future enhancements, products, or services, to be performed inincluding the future.TV platform.
The components of unearned revenue were as follows:
(In millions) | ||||||
June 30 | 2002 | 2003 | ||||
Volume licensing programs | $ | 4,158 | $ | 5,472 | ||
Undelivered elements | 2,830 | 2,847 | ||||
Other | 755 | 696 | ||||
Unearned revenue | $ | 7,743 | $ | 9,015 | ||
(In millions) | ||||||
June 30 | 2006 | 2005 | ||||
Volume licensing programs | $ | 7,661 | $ | 6,000 | ||
Undelivered elements | 2,066 | 2,119 | ||||
Other | 1,175 | 1,048 | ||||
Unearned revenue | $ | 10,902 | $ | 9,167 | ||
Unearned revenue by segment was as follows:
(In millions) | ||||||||||||
June 30 | 2002 | 2003 | 2006 | 2005 | ||||||||
Client | $ | 3,023 | $ | 3,165 | $ | 2,850 | $ | 2,687 | ||||
Server and Tools | 1,595 | 2,185 | 3,792 | 3,048 | ||||||||
Information Worker | 2,757 | 3,305 | 3,609 | 2,814 | ||||||||
Other segments | 368 | 360 | 651 | 618 | ||||||||
Unearned revenue | $ | 7,743 | $ | 9,015 | $ | 10,902 | $ | 9,167 | ||||
NOTE 3 INVESTMENTS
The components of investments were as follows:
(In millions) | Cost basis | Unrealized gains | Unrealized losses | Recorded basis | Cash and equivalents | Short - term investments | Equity and other | |||||||||||||||
June 30, 2006 | ||||||||||||||||||||||
Cash | $ | 3,248 | $ | – | $ | – | $ | 3,248 | $ | 3,248 | $ | – | $ | – | ||||||||
Mutual funds | 723 | 11 | (1 | ) | 733 | 288 | 445 | – | ||||||||||||||
Commercial paper | 3,242 | – | – | 3,242 | 3,150 | 92 | – | |||||||||||||||
Certificates of deposit | 364 | – | – | 364 | – | 364 | – | |||||||||||||||
U. S. Government and Agency securities | 4,904 | 4 | (30 | ) | 4,878 | 14 | 4,790 | 74 | ||||||||||||||
Foreign government bonds | 6,034 | 21 | (73 | ) | 5,982 | – | 5,982 | – | ||||||||||||||
Mortgage backed securities | 4,285 | – | (42 | ) | 4,243 | – | 4,243 | – | ||||||||||||||
Corporate notes and bonds | 7,605 | 15 | (18 | ) | 7,602 | – | 7,475 | 127 | ||||||||||||||
Municipal securities | 4,008 | 5 | (45 | ) | 3,968 | 14 | 3,954 | – | ||||||||||||||
Common stock and equivalents | 6,933 | 1,846 | (34 | ) | 8,745 | – | – | 8,745 | ||||||||||||||
Preferred stock | 41 | 5 | – | 46 | – | – | 46 | |||||||||||||||
Other investments | 342 | – | – | 342 | – | 102 | 240 | |||||||||||||||
Total | $ | 41,729 | $ | 1,907 | $ | (243 | ) | $ | 43,393 | $ | 6,714 | $ | 27,447 | $ | 9,232 | |||||||
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(In millions) | Cost basis | Unrealized gains | Unrealized losses | Recorded basis | Cash and equivalents | Short - term investments | Equity and other | |||||||||||||||
June 30, 2005 | ||||||||||||||||||||||
Cash | $ | 1,911 | $ | – | $ | – | $ | 1,911 | $ | 1,911 | $ | – | $ | – | ||||||||
Mutual funds | 1,636 | 38 | – | 1,674 | 817 | 857 | – | |||||||||||||||
Commercial paper | 1,566 | 4 | – | 1,570 | 1,570 | – | – | |||||||||||||||
Certificates of deposit | 614 | – | – | 614 | 453 | 161 | – | |||||||||||||||
U. S. Government and Agency securities | 9,943 | 29 | (59 | ) | 9,913 | – | 9,913 | – | ||||||||||||||
Foreign government bonds | 5,486 | 194 | (2 | ) | 5,678 | – | 5,678 | – | ||||||||||||||
Mortgage backed securities | 123 | – | – | 123 | – | 123 | – | |||||||||||||||
Corporate notes and bonds | 8,053 | 50 | (31 | ) | 8,072 | 80 | 7,473 | 519 | ||||||||||||||
Municipal securities | 8,579 | 70 | (33 | ) | 8,616 | 20 | 8,596 | – | ||||||||||||||
Common stock and equivalents | 7,273 | 1,970 | (133 | ) | 9,110 | – | – | 9,110 | ||||||||||||||
Preferred stock | 1,067 | 4 | – | 1,071 | – | – | 1,071 | |||||||||||||||
Other investments | 403 | – | – | 403 | – | 99 | 304 | |||||||||||||||
Total | $ | 46,654 | $ | 2,359 | $ | (258 | ) | $ | 48,755 | $ | 4,851 | $ | 32,900 | $ | 11,004 | |||||||
Investments with continuous unrealized losses for less than and greater than 12 months and their related fair values were as follows:
Less than 12 months | 12 months or greater | Total | |||||||||||||||||||
(In millions) | Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses | |||||||||||||||
June 30, 2006 | |||||||||||||||||||||
Mutual funds | $ | 14 | $ | (1 | ) | $ | 4 | $ | – | $ | 18 | $ | (1 | ) | |||||||
U. S. Government and Agency securities | 2,303 | (24 | ) | 172 | (6 | ) | 2,475 | (30 | ) | ||||||||||||
Foreign government bonds | 2,523 | (56 | ) | 1,749 | (17 | ) | 4,272 | (73 | ) | ||||||||||||
Mortgage backed securities | 2,692 | (40 | ) | 102 | (2 | ) | 2,794 | (42 | ) | ||||||||||||
Corporate notes and bonds | 4,721 | (13 | ) | 359 | (5 | ) | 5,080 | (18 | ) | ||||||||||||
Municipal securities | 1,323 | (13 | ) | 1,192 | (32 | ) | 2,515 | (45 | ) | ||||||||||||
Common stock and equivalents | 266 | (33 | ) | 29 | (1 | ) | 295 | (34 | ) | ||||||||||||
Total | $ | 13,842 | $ | (180 | ) | $ | 3,607 | $ | (63 | ) | $ | 17,449 | $ | (243 | ) | ||||||
Less than 12 months | 12 months or greater | Total | |||||||||||||||||||
(In millions) | Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses | |||||||||||||||
June 30, 2005 | |||||||||||||||||||||
U. S. Government and Agency securities | $ | 7,490 | $ | (59 | ) | $ | – | $ | – | 7,490 | $ | (59 | ) | ||||||||
Foreign government bonds | 32 | (2 | ) | – | – | 32 | (2 | ) | |||||||||||||
Corporate notes and bonds | 4,536 | (31 | ) | – | – | 4,536 | (31 | ) | |||||||||||||
Municipal securities | 4,339 | (30 | ) | 239 | (3 | ) | 4,578 | (33 | ) | ||||||||||||
Common stock and equivalents | 1,168 | (111 | ) | 89 | (22 | ) | 1,257 | (133 | ) | ||||||||||||
Total | $ | 17,565 | $ | (233 | ) | $ | 328 | $ | (25 | ) | $ | 17,893 | $ | (258 | ) |
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Part II
Item 8
Of the $9.02 billion of unearned revenue atAt June 30, 2003, $2.65 billion is expected to be recognized in the first quarter2006 unrealized losses of fiscal 2004, $2.05 billion in the second quarter of fiscal 2004, $1.53 billion in the third quarter of fiscal 2004, $1.00 billion in the fourth quarter of fiscal 2004, and $1.79 billion thereafter.
Note 5—Cash and Short-Term Investments
(In millions) | Cost Basis | Unrealized Gains | Unrealized Losses | Recorded Basis | |||||||||
June 30, 2002 | |||||||||||||
Cash and equivalents: | |||||||||||||
Cash | $ | 1,114 | $ | – | $ | – | $ | 1,114 | |||||
Commercial paper | 260 | – | – | 260 | |||||||||
Certificates of deposit | 31 | – | – | 31 | |||||||||
Money market mutual funds | 714 | – | – | 714 | |||||||||
Corporate notes and bonds | 560 | – | – | 560 | |||||||||
Municipal securities | 337 | – | – | 337 | |||||||||
Cash and equivalents | 3,016 | – | – | 3,016 | |||||||||
Short-term investments: | |||||||||||||
Commercial paper | 552 | – | — | 552 | |||||||||
U.S. government and agency securities | 8,745 | 91 | (12 | ) | 8,824 | ||||||||
Corporate notes and bonds | 14,577 | 255 | (241 | ) | 14,591 | ||||||||
Mortgage-backed securities | 6,226 | 23 | (1 | ) | 6,248 | ||||||||
Municipal securities | 4,462 | 86 | – | 4,548 | |||||||||
Certificates of deposit | 873 | – | – | 873 | |||||||||
Short-term investments | 35,435 | 455 | (254 | ) | 35,636 | ||||||||
Cash and short-term investments | $ | 38,451 | $ | 455 | $ | (254 | ) | $ | 38,652 | ||||
(In millions) | Cost Basis | Unrealized Gains | Unrealized Losses | Recorded Basis | |||||||||
June 30, 2003 | |||||||||||||
Cash and equivalents: | |||||||||||||
Cash | $ | 1,308 | $ | – | $ | – | $ | 1,308 | |||||
Commercial paper | 774 | – | – | 774 | |||||||||
U.S. government and agency securities | 1,889 | – | – | 1,889 | |||||||||
Certificates of deposit | 28 | – | – | 28 | |||||||||
Money market mutual funds | 1,263 | – | – | 1,263 | |||||||||
Corporate notes and bonds | 744 | 95 | (11 | ) | 828 | ||||||||
Municipal securities | 348 | – | – | 348 | |||||||||
Cash and equivalents | 6,354 | 95 | (11 | ) | 6,438 | ||||||||
Short-term investments: | |||||||||||||
Commercial paper | 100 | – | – | 100 | |||||||||
U.S. government and agency securities | 5,316 | 126 | (28 | ) | 5,414 | ||||||||
Foreign government bonds | 5,364 | 79 | (16 | ) | 5,427 | ||||||||
Corporate notes and bonds | 15,440 | 735 | (86 | ) | 16,089 | ||||||||
Mortgage-backed securities | 6,257 | 65 | (3 | ) | 6,319 | ||||||||
Municipal securities | 8,733 | 265 | (6 | ) | 8,992 | ||||||||
Certificates of deposit | 269 | – | – | 269 | |||||||||
Short-term investments | 41,479 | 1,270 | (139 | ) | 42,610 | ||||||||
Cash and short-term investments | $ | 47,833 | $ | 1,365 | $ | (150 | ) | $ | 49,048 | ||||
Realized gains and (losses) from cash and short-term investments (excluding impairments) were $541$243 million and $(369)consisted of: $196 million in 2001, $816 million and $(558) million in 2002 and $1.42 billion and $(957) million in 2003.
Note 6—Inventories
(In millions) | ||||||
June 30 | 2002 | 2003 | ||||
Finished goods | $ | 505 | $ | 393 | ||
Raw materials and work in process | 168 | 247 | ||||
Inventories | $ | 673 | $ | 640 | ||
Part II, Item 8
Note 7—Property and Equipment
(In millions) | ||||||||
June 30 | 2002 | 2003 | ||||||
Land | $ | 197 | $ | 248 | ||||
Buildings | 1,701 | 1,854 | ||||||
Computer equipment and software | 2,621 | 2,464 | ||||||
Other | 1,372 | 1,512 | ||||||
Property and equipment – at cost | 5,891 | 6,078 | ||||||
Accumulated depreciation | (3,623 | ) | (3,855 | ) | ||||
Property and equipment – net | $ | 2,268 | $ | 2,223 | ||||
During 2001, 2002, and 2003, depreciation expense, the majority of which related to computer equipment, was $764investment grade fixed-income securities, $12 million $820related to investments in high yield and emerging market fixed-income securities, $2 million related to domestic equity securities and $929 million.
Note 8—Equity$33 million related to international equity securities. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and Other Investments
(In millions) | Cost Basis | Unrealized Gains | Unrealized Losses | Recorded Basis | |||||||||
June 30, 2002 | |||||||||||||
Debt securities recorded at market, maturing: | |||||||||||||
Within one year | $ | 485 | $ | 26 | $ | – | $ | 511 | |||||
Between 2 and 10 years | 893 | 46 | (4 | ) | 935 | ||||||||
Between 10 and 15 years | 541 | 19 | (2 | ) | 558 | ||||||||
Beyond 15 years | 3,036 | – | – | 3,036 | |||||||||
Debt securities recorded at market | 4,955 | 91 | (6 | ) | 5,040 | ||||||||
Common stock and warrants | 6,580 | 1,287 | (617 | ) | 7,250 | ||||||||
Preferred stock | 1,382 | – | – | 1,382 | |||||||||
Other investments | 519 | – | – | 519 | |||||||||
Equity and other investments | $ | 13,436 | $ | 1,378 | $ | (623 | ) | $ | 14,191 | ||||
(In millions) | Cost Basis | Unrealized Gains | Unrealized Losses | Recorded Basis | |||||||||
June 30, 2003 | |||||||||||||
Debt securities recorded at market, maturing: | |||||||||||||
Within one year | $ | 293 | $ | 9 | $ | – | $ | 302 | |||||
Between 2 and 10 years | 1,436 | 194 | (73 | ) | 1,557 | ||||||||
Debt securities recorded at market | 1,729 | 203 | (73 | ) | 1,859 | ||||||||
Common stock and warrants | 8,395 | 1,686 | (3 | ) | 10,078 | ||||||||
Preferred stock | 1,262 | – | – | 1,262 | |||||||||
Other investments | 493 | – | – | 493 | |||||||||
Equity and other investments | $ | 11,879 | $ | 1,889 | $ | (76 | ) | $ | 13,692 | ||||
Debtinternational equities are due to market price movements. At June 30, 2005 unrealized losses of $258 million consisted of: $112 million related to investment grade fixed-income securities, include corporate$13 million related to investments in high yield and government notesemerging market fixed income securities, $90 million related to domestic equity securities and bonds$43 million related to international equity securities. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and derivative securities. In connection with the definitive agreementinternational equities are due to combine AT&T Broadband with Comcast into a new company called Comcast Corporation, Microsoft exchanged its AT&T 5% convertible preferred debt for 115 million sharesmarket price movements. Management does not believe any unrealized losses represent an other-than-temporary impairment based on our evaluation of Comcast Corporation on November 18, 2002, resulting in a $20 million net recognized loss.available evidence as of June 30, 2006.
Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost. At June 30, 20022006 the recorded basis of these investments was $2.31$41 million, and their estimated fair value was $41 million. At June 30, 2005 the recorded basis of these investments was $1.05 billion, and their estimated fair value was $2.28 billion. At June 30, 2003, the recorded basis of these investments was $2.15 billion, and their estimated fair value was $2.56$1.27 billion. The estimate of fair value is based on publicly available market information or other estimates determined by management.
The maturities of debt securities, including fixed maturity securities, at June 30, 2006 were as follows:
(In millions) | Cost basis | Estimated fair value | ||||
Due in one year or less | $ | 5,680 | $ | 5,686 | ||
Due after one year through five years | 12,011 | 11,971 | ||||
Due after five years through ten years | 6,111 | 6,041 | ||||
Due after ten years | 6,741 | 6,683 | ||||
Total | $ | 30,543 | $ | 30,381 | ||
NOTE 4 INVESTMENT INCOME AND OTHER
The components of investment income and other were as follows:
(In millions) | ||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | |||||||||
Dividends and interest | $ | 1,510 | $ | 1,460 | $ | 1,892 | ||||||
Net gains on investments | 161 | 856 | 1,563 | |||||||||
Net losses on derivatives | (99 | ) | (262 | ) | (268 | ) | ||||||
Income/(losses) from equity investees and other | 218 | 13 | (25 | ) | ||||||||
Investment income and other | $ | 1,790 | $ | 2,067 | $ | 3,162 | ||||||
Net gains on investments include other-than-temporary impairments of $408 million in fiscal year 2006, $152 million in fiscal year 2005, and $82 million in fiscal year 2004. The increase in other-than-temporary impairments in fiscal year 2006 was driven by planned sales of certain investments in an unrealized loss position in order to raise funds for the $20 billion tender offer announced on July 20, 2006. Realized gains and (losses) from equity and other investmentssales of available-for-sale securities (excluding other-than-temporary impairments) were $3.03$1.11 billion and $(23)$(531) million in 2001, $2.24fiscal year 2006, $1.38 billion and $(121)$(376) million in 2002,fiscal year 2005, and $540 million$2.16 billion and $(88)$(518) million in 2003.
Note 9—Goodwill
During fiscal 2003, goodwill increased by approximately $1.7 billion. The increase related principally to the following acquisitions: Navision a/s with $1.2 billion allocated to Microsoft Business Solutions, $281 million for the Rare, Ltd. acquisition allocated to Home and Entertainment, and Placeware, Inc. with $180 million allocated to Information Worker. No impairment was charged to
Part II, Item 8
goodwill during fiscal 2003. During fiscal 2002, goodwill was reduced by $85 million, principally in connection with our exchange of all of the 33.7 million shares and warrants we owned of Expedia, Inc. to USA Networks, Inc. No goodwill was acquired or impaired during fiscal 2002. Goodwill by segment was as follows:
(In millions) | ||||||
June 30 | 2002 | 2003 | ||||
Client | $ | 26 | $ | 37 | ||
Server and Tools | 97 | 106 | ||||
Information Worker | – | 180 | ||||
Microsoft Business Solutions | 1,021 | 2,219 | ||||
MSN | 160 | 154 | ||||
Mobile and Embedded Devices | 5 | 28 | ||||
Home and Entertainment | 117 | 404 | ||||
Goodwill | $ | 1,426 | $ | 3,128 | ||
Note 10—Intangible Assets
During fiscal 2003, we recorded additions of $306 million in intangible assets, primarily related to the acquisition of Navision a/s and Rare, Ltd., with $19 million allocated to marketing related assets, $97 million to technology-based assets, $162 million to contract based assets, and $28 million to customer-related assets. Acquired intangibles are amortized over weighted average periods of five years for contract-based assets, four years for technology-based assets, four years for marketing-related assets, and nine years for customer-related assets. No significant residual value is estimated for these assets. Through the fiscal year 2003 acquisitions, $17 million was assigned to research and development assets that were written off2004.
NOTE 5 DERIVATIVES
For derivative instruments designated as hedges, hedge ineffectiveness, determined in accordance with FASB InterpretationSFAS No. 4 (FIN 4),133,Applicability of FASB Statement No. 2 to Business Combinations AccountedAccounting for by the Purchase Method. Those write-offs are included in ResearchDerivative Instruments and Development expenses.Hedging Activities, did not have a significant impact on earnings
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Part II
Item 8
for fiscal years 2006, 2005, or 2004. During fiscal 2002, changes in intangible assets primarily related to our acquisition of $25year 2006, $217 million in contracts and $27 million in technology, which will be amortized over approximately three years. No significant residual value is estimated for these intangible assets. Intangible assets amortization expense was $194 million for fiscal 2002 and $161 million for fiscal 2003. The components of intangible assets were as follows:
(In millions) | Gross Carrying | Accumulated Amortization | Gross Carrying | Accumulated Amortization | ||||||||||
June 30 | 2002 | 2003 | ||||||||||||
Contract-based | $ | 421 | $ | (290 | ) | $ | 584 | $ | (376 | ) | ||||
Technology-based | 172 | (71 | ) | 261 | (137 | ) | ||||||||
Marketing-related | 15 | (4 | ) | 34 | (9 | ) | ||||||||
Customer-related | – | – | 28 | (1 | ) | |||||||||
Total Intangible Assets | $ | 608 | $ | (365 | ) | $ | 907 | $ | (523 | ) | ||||
Amortization expense is estimated to be $151 million for fiscal 2004, $103 million for fiscal 2005, $56 million for fiscal 2006, $39 million for fiscal 2007, and $23 million for fiscal 2008.
Note 11—Derivatives
For fiscal 2001, investment income included a net unrealized loss of $592 million, comprised of a $214 million gain for changes in the time value of options forgains on fair value hedges $211 million loss forfrom changes in the time value of options forand $399 million in losses on cash flow hedges and $595 million loss forfrom changes in time value were excluded from the fair valueassessment of derivative instruments not designated as hedging instruments. For fiscal 2002,hedge effectiveness and included in investment income included a net unrealized loss of $480and other. During fiscal year 2005, $79 million comprised of a $30 million gain for changes in the time value of options forgains on fair value hedges a $331 million loss forfrom changes in the time value of options forand $116 million in losses on cash flow hedges and a $179 million net loss forfrom changes in time value were excluded from the fair valueassessment of derivative instruments not designated as hedging instruments. For fiscal 2003,hedge effectiveness and included in investment income included a net unrealized loss of $141and other. During fiscal year 2004, $31 million comprised of a $74 million loss for changes in the time value of options forgains on fair value hedges a $229 million loss forfrom changes in the time value of options forand $325 million in losses on cash flow hedges and a $162 million gain forfrom changes in time value were excluded from the fair valueassessment of derivative instruments not designated as hedging instruments.hedge effectiveness and included in investment income and other.
Derivative gains and losses included in OCI are reclassified into earnings at the time forecasted revenue or the sale of an equity investment is recognized. During fiscal 2001, $214year 2006, $166 million of derivative gains were reclassified to revenue and $416$23 million ofin derivative lossesgains were reclassified to investment income/(loss).income and other. During fiscal 2002, $234year 2005, $57 million of derivative gains were reclassified to revenue and $10$33 million ofin derivative lossesgains were reclassified to investment income/(loss).income and other. During fiscal 2003, $40year 2004, $14 million of derivative gains were reclassified to revenue and $2 million ofno derivative gains or losses were reclassified to investment income/(loss). income and other.
We estimate that $22$133 million of net derivative gains included in other comprehensive incomeOCI will be reclassified into earnings within the next twelve12 months. No significant amounts of gains or losses were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur for fiscal years 2006, 2005, and 2004.
For instruments designatedNOTE 6 INVENTORIES
(In millions) | ||||||
June 30 | 2006 | 2005 | ||||
Finished goods | $ | 1,013 | $ | 422 | ||
Raw materials and work in process | 465 | 69 | ||||
Inventories | $ | 1,478 | $ | 491 | ||
NOTE 7 PROPERTY AND EQUIPMENT
(In millions) | ||||||||
June 30 | 2006 | 2005 | ||||||
Land | $ | 362 | $ | 313 | ||||
Buildings and improvements | 2,228 | 2,014 | ||||||
Leasehold improvements | 918 | 851 | ||||||
Computer equipment and software | 2,682 | 2,318 | ||||||
Furniture and equipment | 1,033 | 879 | ||||||
Property and equipment, at cost | 7,223 | 6,375 | ||||||
Accumulated depreciation | (4,179 | ) | (4,029 | ) | ||||
Property and equipment, net | $ | 3,044 | $ | 2,346 | ||||
Property and equipment are stated at cost. Depreciation is computed principally on the straight-line method over the estimated useful lives of the assets. The useful lives for buildings range from five to 15 years, leasehold improvements range from two to ten years – representing the applicable lease terms plus reasonably assured extensions, computer equipment and software range from two to three years, and furniture and equipment range from one to five years. Land is not depreciated.
During fiscal years 2006, 2005, and 2004, depreciation expense was $863 million, $723 million, and $647 million, respectively. The majority of depreciation expense in all years related to computer equipment.
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Part II
Item 8
NOTE 8 GOODWILL
Changes in the carrying amount of goodwill for fiscal years 2006 and 2005 by segment were as hedges, hedge ineffectiveness, determinedfollows:
(In millions) | |||||||||||||||||||||||
Balance as of June 30, 2004 | Acquisitions / purchase accounting adjustments | Divestitures | Balance as of June 30, 2005 | Acquisitions | Other | Balance as of June 30, 2006 | |||||||||||||||||
Client | $ | 37 | $ | 6 | $ | – | $ | 43 | $ | 31 | $ | – | $ | 74 | |||||||||
Server and Tools | 106 | 135 | – | 241 | 29 | (14 | ) | 256 | |||||||||||||||
Information Worker | 178 | 47 | – | 225 | 246 | – | 471 | ||||||||||||||||
Microsoft Business Solutions | 2,207 | 3 | – | 2,210 | – | – | 2,210 | ||||||||||||||||
MSN | 154 | 17 | – | 171 | 263 | 21 | 455 | ||||||||||||||||
Mobile and Embedded Devices | 30 | – | – | 30 | – | (24 | ) | 6 | |||||||||||||||
Home and Entertainment | 403 | – | (14 | ) | 389 | 23 | (18 | ) | 393 | ||||||||||||||
Total | $ | 3,115 | $ | 208 | $ | (14 | ) | $ | 3,309 | $ | 592 | $ | (35 | ) | $ | 3,866 | |||||||
We test goodwill for impairment annually during the first quarter of each fiscal year at the reporting unit level using a fair value approach, in accordance with the provisions of SFAS 133,No. 142,Goodwill and Other Intangible Assets. Our annual testing resulted in no impairments of goodwill in fiscal years 2006 and 2005. 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, goodwill will be evaluated for impairment between annual tests.
During fiscal year 2005, we had no significant impact on earnings formaterial acquisitions. During the fiscal years 2001, 2002, and 2003. No significant fair value hedges or cash flow hedges were derecognized or discontinuedyear 2006, we acquired the following entities for fiscal years 2001, 2002, and 2003.a total consideration of $689 million, which was primarily paid in cash:
As a result of these acquisitions, we recorded $592 million of goodwill. None of that amount is expected to be deductible for tax purposes. Goodwill was assigned to our operating segments as follows: $29 million to Server & Tools, $263 million to MSN, $31 million to Client, $246 million to Information Worker, and $23 million to Home and Entertainment. We also recorded $125 million of technology-based intangible assets with a weighted-average amortization period of 3.25 years, and $26 million of other intangible assets with a weighted-average amortization period of 4.5 years. All of the entities have been consolidated into our financial statements since their respective acquisition dates. None of the acquisitions, individually or in the aggregate, are material to our consolidated results of operations. Accordingly, pro forma information has not been included.
PAGE |
Part II
Item 8
Note 12—Investment Income/(Loss)NOTE 9 INTANGIBLE ASSETS
The components of investment income/(loss) arefinite-lived intangible assets were as follows:
(In millions) | |||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | ||||||||
Dividends | $ | 377 | $ | 357 | $ | 260 | |||||
Interest | 1,808 | 1,762 | 1,697 | ||||||||
Net recognized gains/(losses) on investments: | |||||||||||
Net gains on the sales of investments | 3,175 | 2,379 | 909 | ||||||||
Other-than-temporary impairments | (4,804 | ) | (4,323 | ) | (1,148) | ||||||
Net unrealized losses attributable to derivative instruments | (592 | ) | (480 | ) | (141) | ||||||
Net recognized gains/(losses) on investments | (2,221 | ) | (2,424 | ) | (380) | ||||||
Investment income/(loss) | $ | (36 | ) | $ | (305 | ) | $ | 1,577 | |||
(In millions) | ||||||||||||||||||||
June 30 | 2006 | 2005 | ||||||||||||||||||
Gross carrying amount | Accumulated amortization | Net carrying amount | Gross carrying amount | Accumulated amortization | Net carrying amount | |||||||||||||||
Contract-based | $ | 954 | $ | (661 | ) | $ | 292 | $ | 957 | $ | (606 | ) | $ | 351 | ||||||
Technology-based | 458 | (255 | ) | 203 | 309 | (200 | ) | 109 | ||||||||||||
Marketing-related | 42 | (32 | ) | 10 | 35 | (25 | ) | 10 | ||||||||||||
Customer-related | 54 | (21 | ) | 33 | 40 | (11 | ) | 29 | ||||||||||||
Total | $ | 1,508 | $ | (969 | ) | $ | 539 | $ | 1,341 | $ | (842 | ) | $ | 499 | ||||||
Other than temporary impairmentsDuring fiscal year 2006 and 2005, we recorded additions to intangible assets of $189 million and $90 million, respectively. We estimate that we have no significant residual value related to our intangible assets. The components of finite-lived intangible assets acquired during fiscal years 2006 and 2005 were recorded as follows for the three most recent fiscal years:follows:
(In millions) | |||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | ||||||
Due to general market conditions | $ | 1,692 | $ | 2,793 | $ | 943 | |||
Due to specific adverse conditions | 3,112 | 1,530 | 205 | ||||||
Total Impairments | $ | 4,804 | $ | 4,323 | $ | 1,148 | |||
(In millions) | ||||||||||
Year Ended June 30 | 2006 | 2005 | ||||||||
Amount | Weighted average life | Amount | Weighted average life | |||||||
Contract-based | $ | 36 | 4 years | $ | 16 | 6 years | ||||
Technology-based | 140 | 4 years | 64 | 5 years | ||||||
Marketing-related | 5 | 3 years | – | – | ||||||
Customer-related | 8 | 4 years | 10 | 5 years | ||||||
Total | $ | 189 | $ | 90 | ||||||
Acquired intangibles are generally amortized on a straight-line basis over weighted average periods. Intangible assets amortization expense was $127 million for fiscal year 2006, $161 million for fiscal year 2005, and $170 million for fiscal year 2004. The estimated future amortization expense related to intangible assets as of June 30, 2006 is as follows:
(In millions) | |||
Year Ended June 30 | Amount | ||
2007 | $ | 150 | |
2008 | 126 | ||
2009 | 83 | ||
2010 | 60 | ||
2011 | 46 | ||
Total | $ | 465 | |
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Part II
Item 8
Note 13—Income TaxesNOTE 10 INCOME TAXES
The components of the provision for income taxes consisted of:were as follows:
(In millions) | ||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | |||||||
Current taxes: | ||||||||||
U.S. and state | $ | 3,243 | $ | 3,644 | $ | 3,861 | ||||
International | 514 | 575 | 808 | |||||||
Current taxes | 3,757 | 4,219 | 4,669 | |||||||
Deferred taxes | 47 | (535 | ) | 64 | ||||||
Provision for income taxes | $ | 3,804 | $ | 3,684 | $ | 4,733 | ||||
(In millions) | |||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||||
Current taxes: | |||||||||||
U.S. Federal | $ | 4,471 | $ | 3,401 | $ | 3,766 | |||||
U.S. State and Local | 101 | 152 | 174 | ||||||||
International | 882 | 911 | 1,056 | ||||||||
Current taxes | 5,454 | 4,464 | 4,996 | ||||||||
Deferred taxes (benefits) | 209 | (90 | ) | (968 | ) | ||||||
Provision for income taxes | $ | 5,663 | $ | 4,374 | $ | 4,028 | |||||
U.S. and international components of income before income taxes were:were as follows:
(In millions) | ||||||||||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | 2006 | 2005 | 2004 | ||||||||||||
U.S. | $ | 9,189 | $ | 8,920 | $ | 11,346 | $ | 11,404 | $ | 9,806 | $ | 8,088 | ||||||
International | 2,336 | 2,593 | 3,380 | 6,858 | 6,822 | 4,108 | ||||||||||||
Income before income taxes | $ | 11,525 | $ | 11,513 | $ | 14,726 | $ | 18,262 | $ | 16,628 | $ | 12,196 | ||||||
The items accounting for the difference between income taxes computed at the federal statutory rate and the provision for income taxes were as follows:
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||
Federal statutory rate | 35.0 | % | 35.0 | % | 35.0 | % | |||
Effect of: | |||||||||
Foreign earnings taxed at lower rates | (4.6 | )% | (3.1 | )% | (1.7 | )% | |||
Examination settlements | (0.6 | )% | (4.7 | )% | – | ||||
Other reconciling items | 1.2 | % | (0.9 | )% | (0.3 | )% | |||
Effective rate | 31.0 | % | 26.3 | % | 33.0 | % | |||
In 2001,The 2006 other reconciling items includes the effectiveimpact of the $351 million non-deductible European Commission fine. The 2005 other reconciling items include a $179 million repatriation tax rate was 33.0% and includedbenefit under the effectAmerican Jobs Creation Act of a 3.1% reduction2004. The 2004 other reconciling items include the $208 million benefit from the U.S. statutory rate for tax creditsresolution of an issue remanded by the Ninth Circuit Court of Appeals and a 1.1% increase for other items. The effective tax rate in 2002 was 32.0% and included the effectimpact of a 2.4% reduction from the U.S. statutory rate for the extraterritorial income exclusion tax benefit and a 0.6% reduction for other items. The effective tax rate in 2003 was 32.1% and included the effect of a one-time benefit of $126$605 million from the reversal of previously accrued taxes related to a favorable tax court ruling and a 2.0% reduction from the U.S. statutory rate for other items. Excluding this reversal, the effective tax rate in 2003 would have been 33.0%.non-deductible European Commission fine.
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The components of the deferred tax assets and liabilities were as follows:
(In millions) | ||||||||
June 30 | 2006 | 2005 | ||||||
Deferred income tax assets: | ||||||||
Stock-based compensation expense | $ | 3,630 | $ | 3,994 | ||||
Other expense items | 1,451 | 1,751 | ||||||
Unearned revenue | 1,028 | 915 | ||||||
Impaired investments | 989 | 861 | ||||||
Other revenue items | 102 | 213 | ||||||
Other | – | 173 | ||||||
Deferred income tax assets | $ | 7,200 | $ | 7,907 | ||||
Deferred income tax liabilities: | ||||||||
International earnings | $ | (1,715 | ) | $ | (1,393 | ) | ||
Unrealized gain on investments | (801 | ) | $ | (1,169 | ) | |||
Other | (133 | ) | (23 | ) | ||||
Deferred income tax liabilities | (2,649 | ) | (2,585 | ) | ||||
Net deferred income tax assets | $ | 4,551 | $ | 5,322 | ||||
Reported as: | ||||||||
Current deferred tax assets | $ | 1,940 | $ | 1,701 | ||||
Long-term deferred tax assets | 2,611 | 3,621 | ||||||
Net deferred income tax assets | $ | 4,551 | $ | 5,322 | ||||
Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when taxes were:
(In millions) | ||||||||
June 30 | 2002 | 2003 | ||||||
Deferred income tax assets: | ||||||||
Revenue items | $ | 2,261 | $ | 2,556 | ||||
Expense items | 945 | 1,048 | ||||||
Impaired investments | 2,016 | 1,525 | ||||||
Deferred income tax assets | $ | 5,222 | $ | 5,129 | ||||
Deferred income tax liabilities: | ||||||||
Unrealized gain on investments | $ | (887 | ) | $ | (1,584 | ) | ||
International earnings | (1,818 | ) | (1,809 | ) | ||||
Other | (803 | ) | (961 | ) | ||||
Deferred income tax liabilities | $ | (3,508 | ) | $ | (4,354 | ) | ||
are actually paid or recovered.
We have not provided fordeferred U.S. deferred income taxes or foreign withholding taxes on $1.64 billiontemporary differences of our undistributedapproximately $505 million resulting from earnings for certain non-U.S. subsidiaries allwhich are permanently reinvested outside the United States. The amount of which relateunrecognized deferred tax liability associated with these temporary differences is approximately $151 million.
The American Jobs Creation Act of 2004 (the “Act”) was enacted in October 2004. The Act creates a temporary incentive for U.S. corporations to fiscal 2002 and 2003repatriate foreign subsidiary earnings becauseby providing an elective 85% dividends received deduction for certain dividends from controlled foreign corporations. Under these earnings are intended to be reinvested indefinitely.
On September 15, 2000, the U.S. Tax Court issued an adverse ruling with respect to our claim that the Internal Revenue Service (IRS) incorrectly assessed taxes for 1990 and 1991. On December 3, 2002, the Ninth Circuit Court of Appeals substantially reversed the U.S. Tax Court decision. Income taxes, except for one issue remandedprovisions, we repatriated approximately $780 million in dividends subject to the elective 85% dividends received deduction and we recorded a corresponding tax provision benefit of $179 million from the reversal of previously provided U.S. Tax Court by the Ninth Circuit Court of Appeals for additional consideration, have been settled with the IRS for all years through 1996.deferred tax liabilities on these unremitted foreign subsidiary earnings in 2005. The IRS is examining our 1997 through 1999 U.S. income tax returns. Management believes any adjustments which may be required will not be material to the financial statements. dividend was paid in June 2006.
Income taxes paid were $1.3$4.8 billion in 2001, $1.9fiscal year 2006, $4.3 billion in 2002,fiscal year 2005, and $2.8$2.5 billion in 2003.fiscal year 2004.
Tax Contingencies. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes and recording the related assets and liabilities. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Accruals for tax contingencies are provided for in accordance with the requirements of SFAS No. 5,Accounting for Contingencies.
Although we believe we have appropriate support for the positions taken on our tax returns, we have recorded a liability for our best estimate of the probable loss on certain of these positions, the non-current portion of which is included in other long-term liabilities. We believe that our accruals for tax liabilities are adequate for all open years, based on our assessment of many factors including past experience and interpretations of tax law applied to the facts of each matter, which matters result primarily from inter-company transfer pricing, restructuring of foreign
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operations, tax benefits from the Foreign Sales Corporation and Extra Territorial Income tax rules, the amount of research and experimentation tax credits claimed, state income taxes, and certain other matters. Although we believe our recorded assets and liabilities are reasonable, tax regulations are subject to interpretation and tax litigation is inherently uncertain; therefore our assessments can involve both a series of complex judgments about future events and rely heavily on estimates and assumptions. Although we believe that the estimates and assumptions supporting our assessments are reasonable, the final determination of tax audit settlements and any related litigation could be materially different than that which is reflected in historical income tax provisions and recorded assets and liabilities. If we were to settle an audit or a matter under litigation, it could have a material effect on our income tax provision, net income, or cash flows in the period or periods for which that determination is made. Due to the complexity involved we are not able to estimate the range of reasonably possible losses in excess of amounts recorded.
The Internal Revenue Service (“IRS”) has completed and closed its audits of our consolidated federal income tax returns through 1999. The IRS is currently conducting an audit of our consolidated federal income tax return for tax years 2000 through 2003.
Note 14—Stockholders’ EquityNOTE 11 OTHER LONG-TERM LIABILITIES
(In millions) | ||||||
June 30 | 2006 | 2005 | ||||
Tax contingencies | $ | 4,194 | $ | 3,066 | ||
Legal contingencies | 1,022 | 961 | ||||
Employee stock option transfer program | – | 48 | ||||
Other | 71 | 83 | ||||
Other long-term liabilities | $ | 5,287 | $ | 4,158 | ||
NOTE 12 STOCKHOLDERS’ EQUITY
Shares of common stock outstanding were as follows:
(In millions) | ||||||||||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | 2006 | 2005 | 2004 | ||||||||||||
Balance, beginning of year | 10,566 | 10,766 | 10,718 | 10,710 | 10,862 | 10,771 | ||||||||||||
Issued | 378 | 208 | 291 | 106 | 160 | 215 | ||||||||||||
Repurchased | (178 | ) | (256 | ) | (238 | ) | (754 | ) | (312 | ) | (124 | ) | ||||||
Balance, end of year | 10,766 | 10,718 | 10,771 | 10,062 | 10,710 | 10,862 | ||||||||||||
We repurchase our common shares primarily to manageOn July 20, 2006, we announced the dilutive effectscompletion of our stock option and stock purchase plans, and other issuances ofthe $30 billion Microsoft common shares. In 2002, we acquired 10.2 million of our shares as a result of a structured stock repurchase transaction entered into in 2001, which gave us the right to acquire such shares in exchange for an up-front net payment of $264 million. To enhance our stock repurchase program we have sold put warrantsapproved by our Board of Directors on July 20, 2004. The repurchases were made using our cash resources. Our Board of Directors had previously approved a program to independent third parties. These put warrants entitled the holders to sellrepurchase shares of our common stock to us on certain dates at specified prices. stock. Under these repurchase plans, we have made the following share repurchases:
(share amounts in millions, dollars in billions) | |||||||||||||||
Fiscal year | 2006(1) | 2005(1) | 2004 | ||||||||||||
Shares | Amount | Shares | Amount | Shares | Amount | ||||||||||
First quarter | 114.1 | $ | 3.0 | 22.8 | $ | 0.6 | 43.3 | $ | 1.2 | ||||||
Second quarter | 283.1 | 7.7 | 23.6 | 0.7 | 30.5 | 0.8 | |||||||||
Third quarter | 180.7 | 4.9 | 95.1 | 2.4 | 49.9 | 1.4 | |||||||||
Fourth quarter | 175.6 | 4.1 | 170.7 | 4.3 | – | – | |||||||||
Total | 753.5 | $ | 19.7 | 312.2 | $ | 8.0 | 123.7 | $ | 3.4 | ||||||
(1) | All amounts repurchased in fiscal year 2005 and in fiscal year 2006 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2004. |
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In the third quarter of fiscal 2001, we issued 5.6 million shares to settle a portion of the outstanding put warrants. At June 30, 2001, 2002, and 2003 no put warrants were outstanding. In any period, cash used in financing activities related to common stock repurchased may differ from the comparable change in Stockholders’ Equity, reflecting timing differences between the recognition of share repurchase transactions and their settlement for cash.
On January 16, 2003,year 2006, our Board of Directors declared an annual dividend on our common stock of $0.08 per share, payable March 7, 2003 to shareholders of record at the close of business on February 21, 2003.following dividends:
Declaration Date | Dividend Per Share | Date of Record | Total Amount (in millions) | Payment Date | |||||||
September 23, 2005 | $ | 0.08 | November 17, 2005 | $ | 846 | December 8, 2005 | |||||
December 14, 2005 | $ | 0.09 | February 17, 2006 | $ | 926 | March 9, 2006 | |||||
March 27, 2006 | $ | 0.09 | May 17, 2006 | $ | 916 | June 8, 2006 | |||||
June 21, 2006 | $ | 0.09 | August 17,2006 | $ | 906 | (1) | September 14, 2006 |
In fiscal year 2005, our Board of Directors declared the following dividends:
Declaration Date | Dividend Per Share | Date of Record | Total Amount (in millions) | Payment Date | |||||||
July 20, 2004 | $ | 0.08 | August 25, 2004 | $ | 870 | September 14, 2004 | |||||
July 20, 2004 | $ | 3.00 | November 17, 2004 | $ | 32,640 | December 2, 2004 | |||||
September 15, 2004 | $ | 0.08 | November 17, 2004 | $ | 871 | December 2, 2004 | |||||
December 8, 2004 | $ | 0.08 | February 17, 2005 | $ | 868 | March 10, 2005 | |||||
March 23, 2005 | $ | 0.08 | May 18, 2005 | $ | 860 | June 9, 2005 | |||||
June 15, 2005 | $ | 0.08 | August 17, 2005 | $ | 857 | (1) | September 8, 2005 |
(1) | The dividend declared on June 15, 2005 was included in other current liabilities as of June 30, 2005. |
NOTE 13 OTHER COMPREHENSIVE INCOME
The activity in other comprehensive income and related tax effects were as follows:
(In millions) | ||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | |||||||||
Net gains/(losses) on derivative instruments: | ||||||||||||
Unrealized gains/(losses), net of tax effect of $(25) in 2006, $(63) in 2005, and $49 in 2004 | $ | (47 | ) | $ | (116 | ) | $ | 92 | ||||
Reclassification adjustment for losses included in net income, net of tax effect of $66 in 2006, $31 in 2005, and $5 in 2004 | 123 | 58 | 9 | |||||||||
Net gains/(losses) on derivative instruments | 76 | (58 | ) | 101 | ||||||||
Net unrealized investment gains/(losses): | ||||||||||||
Unrealized holding losses, net of tax effect of $(199) in 2006, $(69) in 2005, and $(994) in 2004 | (369 | ) | (128 | ) | (1,846 | ) | ||||||
Reclassification adjustment for losses included in net income, net of tax effect of $47 in 2006, $269 in 2005, and $524 in 2004 | 87 | 499 | 973 | |||||||||
Net unrealized investment gains/(losses) | (282 | ) | 371 | (873 | ) | |||||||
Translation adjustments and other | 9 | (6 | ) | 51 | ||||||||
Other comprehensive income /(loss) | $ | (197 | ) | $ | 307 | $ | (721 | ) | ||||
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Note 15—Other Comprehensive Income
(In millions) | ||||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | |||||||||
Cumulative effect of accounting change, net of tax effect of $(37) | $ | (75 | ) | $ | – | $ | – | |||||
Net gains/(losses) on derivative instruments: | ||||||||||||
Unrealized gains/(losses), net of tax effect of $246 in 2001, $30 in 2002, and $(69) in 2003 | 499 | 55 | (129 | ) | ||||||||
Reclassification adjustment for (gains)/losses included in net income, net of tax effect of $67 in 2001, $(79) in 2002, and $15 in 2003 | 135 | (146 | ) | 27 | ||||||||
Net gains/(losses) on derivative instruments | 634 | (91 | ) | (102 | ) | |||||||
Net unrealized investment gains/(losses): | ||||||||||||
Unrealized holding gains/(losses), net of tax effect of $(351) in 2001, $(955) in 2002, and $610 in 2003 | (1,200 | ) | (1,774 | ) | 1,132 | |||||||
Reclassification adjustment for (gains)/losses included in net income, net of tax effect of $(128) in 2001, $958 in 2002, and $60 in 2003 | (260 | ) | 1,779 | 111 | ||||||||
Net unrealized investment gains/(losses) | (1,460 | ) | 5 | 1,243 | ||||||||
Translation adjustments and other | (39 | ) | 82 | 116 | ||||||||
Other comprehensive income/(loss) | $ | (940 | ) | $ | (4 | ) | $ | 1,257 | ||||
The components of accumulated other comprehensive income were:were as follows:
(In millions) | |||||||||||||||||
June 30 | 2002 | 2003 | |||||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||||||||||
Net gains/(losses) on derivative instruments | $ | 86 | $ | (16 | ) | ||||||||||||
Net gains on derivative instruments | $ | 103 | $ | 27 | $ | 85 | |||||||||||
Net unrealized investment gains | 603 | 1,846 | 1,062 | 1,344 | 973 | ||||||||||||
Translation adjustments and other | (106 | ) | 10 | 64 | 55 | 61 | |||||||||||
Accumulated other comprehensive income | $ | 583 | $ | 1,840 | $ | 1,229 | $ | 1,426 | $ | 1,119 | |||||||
NOTE 14 EMPLOYEE STOCK AND SAVINGS PLANS
Note 16—Employee StockEffective July 1, 2005, we adopted SFAS No. 123(R),Share-Based Payment,using the modified prospective application transition method. Because the fair value recognition provisions of SFAS No. 123, Stock-Based Compensation, and Savings PlansSFAS No. 123(R) were materially consistent under our equity plans, the adoption of SFAS No. 123(R) did not have a significant impact on our financial position or our results of operations. Prior to our adoption of SFAS No. 123(R), benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows. SFAS No. 123(R) requires excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid.
The stock-based compensation and related income tax benefits were as follows:
(In millions) | 2006 | 2005 | 2004 | ||||||
Total stock-based compensation | $ | 1,715 | $ | 2,448 | $ | 5,734 | |||
Income tax benefits related to stock-based compensation | $ | 600 | $ | 857 | $ | 2,007 |
Employee Stock Purchase Plan
Plan.We have an employee stock purchase plan for all eligible employees. UnderCompensation expense for the employee stock purchase plan is recognized in accordance with SFAS No. 123(R). The administrative committee under the plan approved a change to the common stock purchase discount and approved the elimination of the related look back period and a change to quarterly purchase periods that became effective July 1, 2004. As a result, beginning in fiscal year 2005, shares of our common stock may presently be purchased by employees at three-month intervals at 90% of the fair market value on the last day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal year 2006 employees purchased 17.2 million shares at an average price of $23.02 per share. At June 30, 2006, 141.9 million shares were reserved for future issuance. During fiscal year 2005 employees purchased 16.4 million shares at average prices of $23.33 per share.
Under the plan in effect previous to fiscal year 2005, shares of our common stock could be purchased at six-monthsix month intervals at 85% of the lower of the fair market value on the first or the last day of each six-month period. Employees maycould purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During 2001, 2002, and 2003fiscal year 2004 employees purchased 11.4 million, 10.8 million shares and 15.216.7 million shares at average prices of $18.43, $25.26, and $22.56$22.74 per share. At June 30, 2003, 192.2 million shares were reserved for future issuance.
Savings Plan
Plan.We have a savings plan whichin the United States that qualifies under Section 401(k) of the Internal Revenue Code.Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 25%50% of their pretax salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $63$178 million, $77$154 million, and $88$141 million in 2001, 2002,fiscal years 2006, 2005, and 2003.2004, respectively. Matching contributions are invested proportionate to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in Microsoft common stock.
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Stock Option and Stock Plans
Plans.We have a stock option planplans for directors and a stock plan for officers, employees, consultants, and advisors. At June 30, 2006, an aggregate of 812 million shares were authorized for future grant under our stock plans, which cover stock options, stock awards, and shared performance stock awards. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. The options transferred to JPMorgan Chase Bank (“JPMorgan”) (see below) in fiscal year 2004 have been removed from our plans; any options transferred to JPMorgan that expire without being exercised will not become available for grant under any of our plans.
On November 9, 2004, our shareholders approved amendments to the stock plans that allowed our Board of Directors to adjust eligible options, unvested stock awards, and shared performance stock awards to maintain their pre-dividend value after the $3.00 special dividend. Additional awards were granted for options, stock awards, and shared performance stock awards by the ratio of post- and pre-special dividend stock price as of the ex-dividend date. Strike prices for options were decreased by the same ratio. Stock-based compensation was not affected by this adjustment. As a result of this approval and payment of the $3.00 special dividend on December 2, 2004, an adjustment to the prices and number of shares of existing awards was made resulting in a total of 96 million options and 6.7 million stock awards being issued to adjust the outstanding awards. In addition, the target shared performance stock awards were increased by 3.5 million shares.
We issue new shares to satisfy stock option exercises. On July 20, 2006, we announced the completion of the repurchase program initially approved by our Board of Directors on July 20, 2004 to buy back up to $30 billion in Microsoft common stock.
Stock Awards and Shared Performance Stock Awards. Stock awards are grants that entitle the holder to shares of common stock as the award vests. Our stock awards generally vest over a five-year period.
Shared Performance Stock Awards (“SPSAs”) are a form of stock award in which the number of shares ultimately received depends on our business performance against specified performance targets. The performance period for SPSAs issued in fiscal years 2004, 2005, and 2006 was July 1, 2003 through June 30, 2006 (January 1, 2004 through June 30, 2006 for certain executive officers). Following the end of the performance period, the Board of Directors determined that the number of shares of stock awards to be issued was 37.0 million, based on the actual performance against metrics established for the performance period. One-third of the awards will vest in the first quarter of fiscal year 2007. An additional one-third of the awards will vest over each of the following two years. Because the SPSAs covered a three-year period, SPSAs issued in fiscal year 2005 and 2006 were given only to newly hired and promoted employees which provideeligible to receive SPSAs.
The Company will grant SPSAs for nonqualifiedfiscal year 2007 with a performance period of July 1, 2006 through June 30, 2007. At the end of the performance period, the number of shares of stock subject to the award will be determined by multiplying the target award by a percentage ranging from 0% to 150%. The percentage will be determined based on performance against metrics for the performance period, as determined by the Compensation Committee of the Board of Directors in its sole discretion. An additional 15% of the total stock and stock awards will be available as additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each award will vest following the end of the performance period, and an additional one-quarter of the shares will vest over each of the following three years.
We measure the fair value of SAs and SPSAs based upon the market price of the underlying common stock as of the date of grant, reduced by the present value of estimated future dividends. SAs and SPSAs are amortized over their applicable vesting period (generally five years) using the straight-line method. The fair value of each award grant is estimated on the date of grant using the following assumptions:
(In millions) | 2006 | 2005 | 2004 | |||
Dividend per share | $0.08 - $0.09 | $0.08 | $0.16 | |||
Interest rates range | 3.2% - 5.3% | 1.3% - 4.3% | 0.9% - 4.2% |
The dividend per share amounts for fiscal year 2006 and fiscal year 2005 are quarterly dividend amounts. The dividend amount of $0.16 was the total dividend per share for fiscal year 2004.
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During fiscal year 2006, the following activity occurred under our existing plans:
Shares (in millions) | Weighted Average Grant-Date Fair Value | |||||
Stock awards: | ||||||
Nonvested balance at July 1, 2005 | 71.3 | $ | 23.92 | |||
Granted | 47.3 | 24.70 | ||||
Vested | (15.7 | ) | 23.85 | |||
Forfeited | (4.8 | ) | 23.60 | |||
Nonvested balance at June 30, 2006 | 98.1 | $ | 24.25 | |||
Shared performance stock awards: | ||||||
Nonvested balance at July 1, 2005 | 35.3 | $ | 23.54 | |||
Granted | 3.1 | 24.80 | ||||
Vested | – | – | ||||
Forfeited | (1.8 | ) | 24.92 | |||
Nonvested balance at June 30, 2006 | 36.6 | $ | 23.57 | |||
As of June 30, 2006, there were $1.69 billion and $383 million of total unrecognized compensation costs related to SAs and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 3.1 years and 2.2 years, respectively.
During the 12 months ended June 30, 2005 and June 30, 2004, the following activity occurred under our plans:
(In millions, except fair values) | Fiscal Year 2005 | Fiscal Year 2004 | ||||
Stock awards granted | 41.0 | 32.6 | ||||
Weighted average grant-date fair value | $ | 24.03 | $ | 24.09 | ||
Shared performance stock awards granted | 3.7 | 31.7 | ||||
Weighted average grant-date fair value | $ | 24.35 | $ | 23.62 |
Stock Options. In fiscal year 2004, we began granting employees stock awards rather than stock options as part of our equity compensation plans. Since then, stock options issued to employees have been issued primarily in conjunction with business acquisitions. Nonqualified stock options were granted to our directors under our non-employee director stock plan. Nonqualified and incentive stock options were granted to our officers and in the case of theemployees under our employee stock plan, stock awards. Options granted prior to 1995 generally vest over four and one-half years and expire ten years from the date of grant.plans. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and expire ten years from the date of grant. Options granted during and after 20022001 vest over four and one-half years and expire ten years from the date of grant. We have issuedApproximately 2.9 million stock awards underoptions were granted in conjunction with business acquisitions during fiscal year 2006. No stock options were granted during the plan for officers and employeesyear ended June 30, 2005. In fiscal year 2004, approximately two million stock options were granted, nearly all of which were granted in conjunction with business acquisitions.
During fiscal year 2004, we completed an employee stock option transfer program whereby employees earn actual sharescould elect to transfer all of stock. Intheir vested and unvested options with a strike price of $33.00 or higher to JPMorgan. The options transferred to JPMorgan were amended and restated upon transfer to contain terms and conditions typical of equity option transactions entered into between sophisticated financial counterparties at arm’s length using standard terms and definitions for equity derivatives. As a result of this program, we recorded additional stock-based compensation expense of $2.21 billion ($1.48 billion after-tax or $0.14 per diluted share) which was recorded in the second quarter of fiscal 2003, the company granted 4 million stock awards, which vest over five years.
Atyear 2004. As of June 30, 2003, stock2006, 237 million options for 774 million shares were vestedtransferred to JPMorgan remained outstanding but are excluded from the table below. These options have strike prices ranging from $28.60 to $89.58 per share and 866 million shares were available for future grants under the plans.have expiration dates extending through December 2006.
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StockEmployee stock options outstanding were as follows:
(In millions, except earnings per share) | |||||||||||||||||||
Price per Share | Shares (in millions) | Weighted Average Exercise Price | Weighted Average Remaining Contractual Term (years) | Aggregate (in millions) | |||||||||||||||
Shares | Range | Weighted Average | |||||||||||||||||
Balance, June 30, 2000 | 1,664 | $ 0.28 – $59.57 | $ | 20.62 | |||||||||||||||
Balance, July 1, 2005 | 864 | $ | 27.41 | ||||||||||||||||
Granted | 448 | 20.75 – 40.00 | 30.42 | 3 | 23.54 | ||||||||||||||
Exercised | (246 | ) | 0.30 – 42.91 | 5.57 | (76 | ) | 20.59 | ||||||||||||
Canceled | (70 | ) | 6.92 – 59.57 | 31.79 | (33 | ) | 32.13 | ||||||||||||
Forfeited | (8 | ) | 23.01 | ||||||||||||||||
Balance, June 30, 2001 | 1,796 | 0.28 – 59.57 | 24.77 | ||||||||||||||||
Granted | 82 | 24.31 – 36.29 | 31.25 | ||||||||||||||||
Exercised | (198 | ) | 0.51 – 34.91 | 6.41 | |||||||||||||||
Canceled | (76 | ) | 0.58 – 58.28 | 34.34 | |||||||||||||||
Balance, June 30, 2002 | 1,604 | 0.40 – 59.57 | 26.88 | ||||||||||||||||
Granted | 254 | 21.42 – 29.12 | 24.27 | ||||||||||||||||
Exercised | (234 | ) | 0.51 – 28.22 | 6.89 | |||||||||||||||
Canceled | (75 | ) | 2.13 – 59.56 | 34.33 | |||||||||||||||
Balance, June 30, 2003 | 1,549 | 0.40 – 59.56 | 29.30 | ||||||||||||||||
Balance, June 30, 2006 | 750 | $ | 27.92 | 4.16 | $ | 452 | |||||||||||||
Exercisable, June 30, 2006 | 673 | $ | 28.55 | 3.93 | $ | 343 |
For various price ranges,Included in the options outstanding balance are approximately five million options that were granted in conjunction with business acquisitions. While these options are included in the options outstanding balance, they are excluded from the weighted average characteristicsexercise prices presented. These options have an exercise price range of outstanding stock options at June 30, 2003 were as follows:
(In millions, except earnings per share) | ||||||||||||
Outstanding Options | Exercisable Options | |||||||||||
Range of Exercise Prices | Shares | Remaining Life (Years) | Weighted Average Price | Shares | Weighted Average Price | |||||||
$ 0.39 – $15.00 | 124 | 3.7 | $ | 6.29 | 117 | $ | 6.23 | |||||
15.01 – 25.00 | 359 | 5.6 | 21.30 | 131 | 16.54 | |||||||
25.01 – 33.00 | 415 | 5.8 | 28.24 | 177 | 27.92 | |||||||
33.01 – 41.00 | 387 | 3.2 | 34.26 | 196 | 34.34 | |||||||
41.01 – 59.56 | 264 | 2.4 | 44.90 | 153 | 44.73 | |||||||
We follow Accounting Principles Board Opinion 25$0 to account for stock option$150.93 and employee stock purchase plans. An alternative method of accounting for stock options is SFAS 123. Under SFAS 123, employee stock options are valued at grant date using the Black-Scholes valuation model, and this compensation cost is recognized ratably over the vesting period. In addition to announcing changes to our employee compensation arrangements in July 2003, we also indicated that we will adopt the fair value recognition provisions of SFAS 123 effective July 1, 2003 and will report that change in accounting principle using the retroactive restatement method described in SFAS 148.
Had compensation cost for our stock option and employee stock purchase plans been determined as prescribed by SFAS 123, pro forma income statements for 2001, 2002, and 2003 would have been as follows:
(In millions, except earnings per share) | ||||||||||||||||||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | |||||||||||||||||||||
Reported | Pro Forma | Reported | Pro Forma | Reported | Pro Forma | |||||||||||||||||||
Revenue | $ | 25,296 | $ | 25,296 | $ | 28,365 | $ | 28,365 | $ | 32,187 | $ | 32,187 | ||||||||||||
Operating expenses: | ||||||||||||||||||||||||
Cost of revenue | 3,455 | 3,775 | 5,191 | 5,699 | 5,686 | 6,059 | ||||||||||||||||||
Research and development | 4,379 | 6,106 | 4,307 | 6,299 | 4,659 | 6,595 | ||||||||||||||||||
Sales and marketing | 4,885 | 5,888 | 5,407 | 6,252 | 6,521 | 7,562 | ||||||||||||||||||
General and administrative | 857 | 1,184 | 1,550 | 1,843 | 2,104 | 2,426 | ||||||||||||||||||
Total operating expenses | 13,576 | 16,953 | 16,455 | 20,093 | 18,970 | 22,642 | ||||||||||||||||||
Operating income | 11,720 | 8,343 | 11,910 | 8,272 | 13,217 | 9,545 | ||||||||||||||||||
Losses on equity investees and other | (159 | ) | (159 | ) | (92 | ) | (92 | ) | (68 | ) | (68 | ) | ||||||||||||
Investment income/(loss) | (36 | ) | (36 | ) | (305 | ) | (305 | ) | 1,577 | 1,577 | ||||||||||||||
Income before income taxes | 11,525 | 8,148 | 11,513 | 7,875 | 14,726 | 11,054 | ||||||||||||||||||
Provision for income taxes | 3,804 | 2,689 | 3,684 | 2,520 | 4,733 | 3,523 | ||||||||||||||||||
Income before accounting change | 7,721 | 5,459 | 7,829 | 5,355 | 9,993 | 7,531 | ||||||||||||||||||
Cumulative effect of accounting change | (375 | ) | (375 | ) | – | – | – | – | ||||||||||||||||
Net income | $ | 7,346 | $ | 5,084 | $ | 7,829 | $ | 5,355 | $ | 9,993 | $ | 7,531 | ||||||||||||
Basic earnings per share | $ | 0.69 | $ | 0.48 | $ | 0.72 | $ | 0.50 | $ | 0.93 | $ | 0.70 | ||||||||||||
Diluted earnings per share | $ | 0.66 | $ | 0.46 | $ | 0.70 | $ | 0.48 | $ | 0.92 | $ | 0.69 | ||||||||||||
Part II, Item 8
The weighted average Black-Scholes value of options granted under the stock option plans during 2001, 2002, and 2003 was $14.66, $15.79, and $12.08. Value was estimated using a weighted average exercise price of $11.26.
As of June 30, 2006, there were $402 million of total unrecognized compensation costs related to stock options. These costs are expected lifeto be recognized over a weighted average period of 6.4approximately one year.
During fiscal years in 20012006, 2005, and 7.0 years in 2002 and 2003, no dividends in 2001 and 2002, a $0.08 per share dividend in 2003, volatility of .39 in 2001, .39 in 2002, and .42 in 2003, and risk-free interest rates of 5.3%, 5.4%, and 3.9% in 2001, 2002, and 2003.2004 the following activity occurred under our plans:
(In millions) | 2006 | 2005 | 2004 | ||||||
Total intrinsic value of stock options exercised | $ | 491 | $ | 940 | $ | 2,971 | |||
Total fair value of stock awards vested | 377 | 198 | 20 |
Cash received and income tax benefit from stock option exercises for fiscal year 2006 were $1.71 billion and $183 million, respectively.
Note 17—Earnings Per ShareNOTE 15 EARNINGS PER SHARE
Basic earnings per share is computed on the basis of the weighted average number of shares of common shares outstanding.stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common shares outstandingstock plus the effect of dilutive potential common shares outstanding put warrantsduring the period using the “reverse treasury stock” method andstock method. Dilutive potential common shares include outstanding stock options, using the “treasury stock” method.
stock awards, and shared performance stock awards. The components of basic and diluted earnings per share wereare as follows:
(In millions, except earnings per share) | |||||||||
Year Ended June 30 | 2001 | 2002 | 2003 | ||||||
Income before accounting change | $ | 7,721 | $ | 7,829 | $ | 9,993 | |||
Weighted average outstanding shares of common stock | 10,683 | 10,811 | 10,723 | ||||||
Dilutive effect of: | |||||||||
Put warrants | 42 | – | – | ||||||
Employee stock options | 423 | 295 | 159 | ||||||
Common stock and common stock equivalents | 11,148 | 11,106 | 10,882 | ||||||
Earnings per share before accounting change: | |||||||||
Basic | $ | 0.72 | $ | 0.72 | $ | 0.93 | |||
Diluted | $ | 0.69 | $ | 0.70 | $ | 0.92 | |||
(In millions, except earnings per share) | |||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||
Net income available for common shareholders (A) | $ | 12,599 | $ | 12,254 | $ | 8,168 | |||
Weighted average outstanding shares of common stock (B) | 10,438 | 10,839 | 10,803 | ||||||
Dilutive effect of employee stock options and awards | 93 | 67 | 91 | ||||||
Common stock and common stock equivalents (C) | 10,531 | 10,906 | 10,894 | ||||||
Earnings per share: | |||||||||
Basic (A/B) | $ | 1.21 | $ | 1.13 | $ | 0.76 | |||
Diluted (A/C) | $ | 1.20 | $ | 1.12 | $ | 0.75 | |||
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For the years ended June 30, 2001, 20022006, 2005, and 2003; 7022004, 649 million, 746854 million, and 1.091.2 billion shares, respectively, were attributable to outstanding stock options and were excluded from the calculation of diluted earnings per share because the effect was antidilutive.
Note 18—Acquisitions
In fiscalexercise prices of the stock options were greater than or equal to the average price of the common shares, and therefore their inclusion would have been anti-dilutive. For the year ended June 30, 2003, we acquired all2006, 1.2 million shared performance stock awards, out of the 36.6 million targeted amount outstanding, equity interestshave been excluded from the calculation of Navision a/s, Rare Ltd., and Placeware, Inc. Navision, headquartered in Vedbaek, Denmark,diluted earnings per share because the number of shares ultimately issued is a provider of integrated business solutions software for small and mid-sized businesses in the European market and will play a key role in the future development of the Microsoft Business Solutions segment. We acquired Navisioncontingent on July 12, 2002 for $1.465 billion consisting primarily of $662 million in cash and the issuance of 29.1 million common shares of Microsoft stock valued at $773 million. The value of the common shares issued was determined based on the average market price of our common shares over the 2-day period before and after terms of the acquisition were agreed to and approved. Rare is a video game developer located outside Leicestershire, England, that is expected to broaden the portfolio of games availableperformance against metrics established for the Xbox video game system. Rare was acquired on September 24, 2002 for $377 million consisting primarily of $375 millionperformance period, as discussed in cash. Placeware, located in Mountain View, CA, facilitates secure, highly reliable, cross-firewall web conferencing experiences allowing users to conduct business meetings online from a PC,Note 14 – Employee Stock and will become a part of Microsoft’s Real Time Collaboration business unit within the Information Worker segment. Placeware was acquired on April 30, 2003 for $202 million, consisting primarily of $189 million in cash. Navision, Rare, and Placeware have been consolidated into our financial statements since their respective acquisition dates. None of the acquisitions, individually or in the aggregate, are material to our consolidated results of operations. Accordingly, pro forma financial information is not included in this note.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisitions (in millions):
Navision a/s July 12, 2002 | Rare, Ltd. At September 24, 2002 | Placeware, Inc. April 30, 2003 | ||||||||||
Current assets | $ | 240 | $ | 25 | $ | 30 | ||||||
Property, plant, and equipment | 8 | 8 | 7 | |||||||||
Intangible assets | 169 | 75 | 30 | |||||||||
Goodwill | 1,197 | 281 | 180 | |||||||||
Total assets acquired | 1,614 | 389 | 247 | |||||||||
Current Liabilities | (148 | ) | (12 | ) | (32 | ) | ||||||
Long-term liabilities | (1 | ) | – | (13 | ) | |||||||
Total liabilities assumed | (149 | ) | (12 | ) | (45 | ) | ||||||
Net Assets Acquired | $ | 1,465 | $ | 377 | $ | 202 | ||||||
Of the $169 million of acquired intangible assets in the Navision acquisition, $2 million was assigned to research and development assets that were written off in accordance with FIN 4. Those write-offs are included in Research and Development expenses. The remaining $167 million of acquired intangible assets have a weighted average useful life of approximately five years. The intangible assets that make up that amount include technology of $48 million (four-year weighted-average useful life), contracts of $115 million (six-year weighted-average useful life), and marketing of $4 million (three-year weighted-average useful
Part II, Item 8
life). The $1,197 million of goodwill was assigned to the Microsoft Business Solutions segment. Of that total amount, approximately $900 million is expected to be deductible for tax purposes.
Of the $75 million of acquired intangible assets in the Rare acquisition, $13 million was assigned to research and development assets that were written off in accordance with FIN 4. Those write-offs are included in Research and Development expenses. The remaining $62 million of acquired intangible assets have a weighted average useful life of approximately five years. The intangible assets that make up that amount include technology of $36 million (five-year weighted average useful life), contracts of $16 million (five-year weighted average useful life), and marketing of $10 million (five-year weighted average useful life). The $281 million of goodwill was assigned to the Home and Entertainment segment. Of that total amount, approximately $270 million is expected to be deductible for tax purposes.
The $30 million of acquired intangible assets in the Placeware acquisition have a weighted average useful life of approximately eight years. The intangible assets that make up that amount include technology of $4 million (four-year weighted-average useful life), customers of $23 million (ten-year weighted-average useful life), contracts of $1 million (six-year weighted-average useful life), and marketing of $2 million (one-year weighted average useful life). The $180 million of goodwill was assigned to the Information Worker segment. None of the goodwill is expected to be deductible for tax purposes.
Savings Plans.
Note 19—Commitments and GuaranteesNOTE 16 COMMITMENTS AND GUARANTEES
We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for operating leases was $281$276 million, $318$299 million, and $290$331 million, in 2001, 2002,fiscal years 2006, 2005, and 2003.2004, respectively. Future minimum rental commitments under noncancellable leases in millions of dollars, are: 2004, $218; 2005, $202; 2006, $172; 2007, $134; 2008, $116; and thereafter, $429. are as follows:
(In millions) | |||
Year Ended June 30 | Amount | ||
2007 | $ | 250 | |
2008 | 193 | ||
2009 | 138 | ||
2010 | 105 | ||
2011 and thereafter | 199 | ||
$ | 885 | ||
We have committed $117$234 million for constructing new buildings.
In November 2002, the FASB issued Interpretation 45,Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45). FIN 45 elaborates on previously existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations does not apply to product warranties or to guarantees accounted for as derivatives. The initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002.
We have unconditionally guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of Jupiter Telecommunication, Ltd., a Japanese cable company (Jupiter). These guarantees arose on February 1, 2003 in conjunction with the expiration of prior financing arrangements, including previous guarantees by us. The financing arrangements were entered into by Jupiter as part of financing its operations. As part of Jupiter’s new financing agreement, we agreed to guarantee repayment by Jupiter of the loans of approximately $51 million. The estimated fair value and the carrying value of the guarantees was $10.5 million and did not result in a charge to operations. The guarantees are in effect until the earlier of repayment of the loans, including accrued interest and fees, or February 1, 2009. The maximum amount of the guarantees is limited to the sum of the total due and unpaid principal amounts, accrued and unpaid interest, and any other related expenses. Additionally, the maximum amount of the guarantees, denominated in Japanese yen, will vary based on fluctuations in foreign exchange rates. If we were required to make payments under the guarantees, we may recover all or a portion of those payments upon liquidation of the Jupiter’s assets. The proceeds from such liquidation cannot be accurately estimated due to the multitude of factors that would affect the valuation and realization of the proceeds in the event of liquidation.
In connection with various operating leases, we issued residual value guarantees, which provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2003,2006, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability to us currently exists.
We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. In addition, we also provide indemnification against credit risk in several geographical locations to our volume license resellers in case the resellers fail to collect from the end user. Due to the nature of the indemnification provided to our resellers, we cannot estimate the fair value, nor determine the total nominal amount of the indemnification. We evaluate estimated losses for such indemnifications under SFAS No. 5,Accounting for Contingencies, as interpreted by FIN 45.No. 45,Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others. We consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnifications in our financial statements.
Our product warranty accrual reflects management’s best estimate of our probable liability under its product warranties (primarily relating to the Xbox console). We determine the warranty accrual based on known product failures (if any), historical experience, and other currently available evidence. ChangesOur warranty accrual totals $10 million as of June 30, 2006. There has been no significant activity impacting the results of operations for any period presented.
NOTE 17 CONTINGENCIES
Government competition law matters. On March 25, 2004, the European Commission issued a decision in its competition law investigation of us. The Commission concluded that we infringed European competition law by refusing to provide our competitors with licenses to certain protocol technology in the product warranty accrual forWindows server operating systems and by including streaming media playback functionality in Windows desktop operating systems. The Commission ordered us to make the fiscal year ended June 30, 2003 were as follows (in millions):
Balance, beginning of period | $ | 8 | ||
Payments made | – | |||
Change in liability for warranties issued during the period | 29 | |||
Change in liability for preexisting warranties | (25 | ) | ||
Balance, end of period | $ | 12 | ||
Note 20—Contingenciesrelevant licenses to our technology available to our competitors and to develop
We are a defendant inU.S. v. Microsoftand New York v. Microsoft, companion lawsuits filed by the Antitrust Division of the U.S. Department of Justice (DOJ) and a group of eighteen state Attorneys General alleging violations of the Sherman Act and various state antitrust laws. After the trial, the District Court entered Findings of Fact and Conclusions of Law stating that we had violated Sections 1 and 2 of the Sherman Act and various state antitrust laws. A Judgment was entered on June 7, 2000 ordering, among
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other things, our breakup into two companies.and make available a version of the Windows desktop operating system that does not include specified software relating to media playback. The Judgment was stayed pendingdecision also imposed a fine of€497 million, which resulted in a charge in the third quarter of fiscal year 2004 of€497 million ($605 million). We filed an appeal. On June 28, 2001,appeal of the U.S. Court of Appeals for the District of Columbia Circuit affirmed in part, reversed in part, and vacated the Judgment in its entirety and remanded the casedecision to the District Court for a new trial on one Section 1 claim and for entry of a new judgment consistent with its ruling. In its ruling, the Court of Appeals substantially narrowedFirst Instance on June 6, 2004. On December 22, 2004, the basesCourt ordered that we must comply with the decision pending review on appeal and we are taking steps to ensure we are in compliance. The hearing on the appeal occurred in April 2006. We continue to contest the conclusion that European competition law was infringed and will defend our position vigorously. In December 2005, the Commission issued a Statement of liability found byObjections that preliminarily concluded we were not in full compliance with the District Court, but affirmed some2004 decree. In March 2006, the Commission conducted an oral hearing on the Statement of Objections and our response to the District Court’s conclusionsStatement. On July 12, 2006, the European Commission announced its determination that we had violated Section 2. We entered into a settlementnot complied with the United States on November 2, 2001. Nine states (New York, Ohio, Illinois, Kentucky, Louisiana, Maryland, Michigan, North Carolinatechnical documentation requirements of the 2004 Decision, and Wisconsin) agreedlevied a fine of€281 million ($351 million). We will appeal this fine to settle on substantially the same terms on November 6, 2001. On November 1, 2002, the Court approvedof First Instance.
On December 7, 2005, the settlement as beingKorean Fair Trade Commission (“KFTC”) announced a ruling in the public interest, conditioned upon the parties’ agreement to a modification to one provision related to the Court’s ongoing jurisdiction. Nine states and the Districtits investigation of Columbia continued to litigate the remedies phase ofNew York v. Microsoft. The non-settling states sought remedies that would have imposed much broader restrictions on our business than the settlement with the DOJ and nine other states. On November 1, 2002, the Court entered a Final Judgment in this part of the litigation that largely mirrored the settlement between us, the DOJ and the settling states, with some modifications and a different regime for enforcing compliance. The Court declined to impose other and broader remedies sought by the non-settling states. Two states, Massachusetts and West Virginia, appealed from this decision of the trial court, and West Virginia dismissed its appeal as part of a settlement with us of several other cases.
The European Commission has instituted proceedings in which it allegesholding that we have failed to disclose information that our competitors claim they need to interoperate fully with Windows 2000 clientsabused a market dominant position and servers and that we have engaged in discriminatory licensing of such technology, as well as improper bundling of multimedia playback technology inunfair trade practices under the Korean Fair Trade Law by incorporating instant messaging and media player functionality into the Windows PC operating system, and streaming media technologies into the Windows server operating system. The KFTC also announced the imposition of remedies, sought, though not fully defined, include mandatory disclosureincluding a fine of approximately $34 million. The KFTC issued its formal written ruling and corrective order on February 23, 2006. The KFTC held that our Windows operating system technology, either the removalintegration of Windows Media technology fromPlayer and Windows Messenger in Windows PC operating systems and integration of Windows Media Services in Windows server operating systems constituted an abuse of monopoly power and unlawful tying in violation of the Korean Fair Trade Act. Under the order, which became effective August 24, 2006, we can no longer distribute Windows in Korea as currently designed. We are required to develop and distribute in Korea versions of Windows XP and its successors that do not include Windows Media Player or Windows Messenger functionality. In addition, we also may distribute a “must carry” obligation requiring OEMssecond modified version of Windows that contains the removed functionality, provided the second version includes promotional links in the user interface that will enable consumers to install competitivelink to and download a select group of competing media players and instant messengers. We have appealed the KFTC’s decision to the Seoul High Court. On May 22, 2006, the KFTC denied our motion for reconsideration of its ruling. As part of that decision, the KFTC dropped the element of its ruling that prohibited us from including Windows Media Player or Windows Messenger, or any feature with similar functionality, in any product other than the Windows client operating system for which we have a 50% or greater market share. On August 23, 2006, we announced the release to manufacture of the mandated versions of Windows XP Home Edition and imposition of fines in an amount that could be as large as 10% of our worldwide annual revenue. We deny the European Commission’s allegations and intend to contest the proceedings vigorously. Windows XP Professional Edition.
In other ongoing investigations, various foreign governments and several state Attorneys General have requested information from us concerning competition, privacy, and security issues.
Antitrust, and unfair competition, and overcharge class actions.A large number of antitrust and unfair competition class action lawsuits have been filed against us in various state and Federal courts.federal courts on behalf of variously defined classes of direct and indirect purchasers of our PC operating system and certain software applications products. The Federalfederal cases have been consolidated in the U.S. District Court for Maryland. These cases allege that we have competed unfairly and unlawfully monopolized alleged markets for operating systems and certain software applications, and they seek to recover on behalf of variously defined classes of direct and indirect purchasersalleged overcharges we allegedly charged for these products. To date, courts have dismissed all claims for damages in cases brought against us by indirect purchasers under Federalfederal law and in 16 different18 states. NineTen of those state court decisions have been affirmed on appeal. There was no appeal in five states. In addition, courts in two states refused to certify classes, essentially bringing the litigation to a close. Claims under federal law brought on behalf of foreign purchasers have also been dismissed.dismissed by the U.S. District Court in Maryland as have all claims brought on behalf of consumers seeking injunctive relief under federal law. The ruling on injunctive relief and the ruling dismissing the federal claims of indirect purchasers were appealed to the United States Court of Appeals for the Fourth Circuit, together with a ruling denying certification of severalcertain proposed classes of these rulings are still pending. No trials have been held concerning any liability issues.U.S. direct purchasers. On April 18, 2006, the Court of Appeals affirmed the trial court decision dismissing the indirect purchaser claims. Courts in ten18 states have ruled that theseindirect purchaser cases may proceed as class actions, while courts in two states have denied class certification status, and another court has ruled that no class action is available for antitrust claims in that state. The Federal District Court has certified a class of direct purchasers of our operating system software that acquired the software from the shop.Microsoft.com Web site or pursuant to a direct marketing campaign and otherwise denied certification of the proposed classes. Members of the certified class licensed fewer than 550,000 copies of operating system software from Microsoft.actions. In 2003, we reached an agreement with counsel for the California plaintiffs to settle all claims in 27 consolidated cases in that state. Under the proposed settlement, class members will be able to obtain vouchers with a totalthat entitle the class members to be reimbursed up to the face value of up to $1.1 billion that may be redeemedtheir vouchers for cash against purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers issued will depend on the number of class members who make a claim and are issued vouchers. Two-thirds of the amount unclaimedvalue of vouchers unissued or unredeemed by class members then will be made available to certain
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schools in California in the form of vouchers that also may be redeemed for cash against purchasedpurchases of a wide variety of platform-neutral computer hardware, software, and related services. The court in California preliminarily approved this proposed settlement, but it still requires final approval by the court. In 2003, weWe also have reached similar agreements to settle all claims in Montana, Florida, West Virginia and North Carolina.a number of other states. The total face value of the Montana settlement is $12.3 million, the Florida settlement, $202 million, the West Virginia settlement, $21 million, and the North Carolina settlement, $89.2 million. These proposed settlements in these states are structured similarsimilarly to the California settlement, except that, among other differences, one-half of the amounts unclaimed byvalue of vouchers unissued to class members will be made available to certain schools in Montana, Florida, West Virginiathe relevant states. The maximum value of vouchers to be issued in these settlements, including the California settlement, is approximately $2.5 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and North Carolina.schools who are issued and redeem vouchers. The proposed settlements in Arizona, California, the District of Columbia, Florida, Kansas, Massachusetts, Minnesota, Montana, FloridaNebraska, New Mexico, New York, North Carolina, North Dakota, South Dakota, Tennessee, Vermont, and West Virginia have been preliminarily approved by the courts in those states, but still requirereceived final court approval. The parties have filed a motion for preliminary approval of the settlement in North Carolina and the Court has scheduled a hearing for later this year. We intend to continue vigorously defending the remaining lawsuits. We estimate the total cost to resolve all of these cases will range between $916 million$1.5 billion and $1.1$1.7 billion, with the actual cost dependent upon many unknown factors such as the quantity and mix of products for which claims will be made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims process. In accordance with SFAS No. 5,Accounting for Contingencies, and FIN No. 14,Reasonable Estimation of theAmount of a Loss,, the Company hasat June 30, 2006, we have recorded a contingent liability related to these claims of $916 million.approximately $1.2 billion, which reflects our estimated exposure of $1.5 billion less payments made to date of approximately $300 million, primarily for administrative expenses and legal fees.
Netscape Communications Inc.,Other antitrust litigation and claims. On August 27, 2004, the City and County of San Francisco, the City of Los Angeles, and Los Angeles, San Mateo, Contra Costa, and Santa Clara Counties filed a subsidiary of AOL-Time Warner Inc., filed suitputative class action against us in San Francisco Superior Court. The action was brought on January 22, 2002behalf of all governmental entities, agencies, and political subdivisions of the State of California that indirectly purchased our operating system or word processing and spreadsheet software during the period from February 18, 1995 to the date of trial in the action. The plaintiffs sought treble damages under California’s Cartwright Act and disgorgement of unlawful profits under its Unfair Competition Act resulting from our alleged combinations to restrain trade, deny competition, and monopolize the world markets for PC operating systems and word processing and spreadsheet applications (and productivity suites including these applications). We removed the case to the U.S. District Court for Maryland. Our motion to dismiss the Districtcomplaint was granted on April 18, 2005 with leave to file an amended complaint alleging claims under the Cartwright Act based on conduct within the four-year statute of Columbia, alleging violations of antitrust and unfair competition laws and other tort claims relating to Netscape and its Navigator browser. The case was transferred for pretrial purposeslimitation the court ruled applies to the District Courtplaintiffs’ claims. We have obtained final approval of settlement of this case, which resolves all claims asserted in Baltimore, Maryland and was being coordinated with the antitrust and unfair competition class actions described above. lawsuit.
On May 29, 2003, we and AOL Time Warner announced an agreement to settle the case. As part of the settlement, we paid $750 million to AOL Time Warner and provided AOL Time WarnerNovember 12, 2004, Novell, Inc. filed a royalty-free, seven-year license to use Microsoft Internet Explorer technologies with the AOL client. The parties agreed on various other technical provisions and entered into a separate agreement to collaborate on long-term digital media initiatives designed to accelerate the adoption of digital content. The two companies entered into a long-term, non-exclusive license agreement allowing AOL Time Warner to use our Windows Media 9 Series and future software for creating, distributing and playing back high-quality digital media. As a result of the settlement, the case has been dismissed with prejudice.
Be Incorporated, a former software development company whose assets were acquired by Palm, Inc. in August 2001, filed suit against us on February 18, 2002complaint in the U.S. District Court for Northern California, alleging violations of Federal and stateUtah asserting antitrust and unfair competition lawsclaims against us related to Novell’s ownership of WordPerfect and other tort claims. Be alleges that our license agreements with computer manufacturers, pricing
Part II, Item 8
policies,productivity applications during the period between June 1994 and business practices interfered with Be’s relationships with computer manufacturers and discouraged them from adopting Be’s own operating system for their products. We believeMarch 1996. On June 10, 2005, the total cost to resolve this case will not be material to our financial position or results of operations.
On March 8, 2002, Sun Microsystems, Inc. filed suit against us alleging violations of Federal and state antitrust and unfair competition laws as well as claims under the Federal Copyright Act. Sun seeks injunctive relief and unspecified treble damages along with its fees and costs. We deny these allegations and will vigorously defend this action. The case has been transferred for pretrial purposes to the U.S. District Court in Baltimore, Maryland and is being coordinated with the antitrust and unfair competition class actions described above. On January 21, 2003, the Court granted Sun’s motion for a preliminary injunction and entered an injunction requiring us to distribute certain Sun Java software with Microsoft Windows XP and certain other products. The injunction also prohibits us from distributing our version of Java software in a variety of ways. The U.S. Court of Appeals for the Fourth Circuittrial court granted our request for a staymotion to dismiss four of six claims of the preliminary injunction order. On June 26, 2003, a three judge panelcomplaint. An appeal of that ruling is now pending and the Fourth Circuit issued a unanimous opinion vacatingcase is effectively stayed during the preliminary injunction requiring us to distribute Sun Java software and upheld the preliminary injunction prohibiting us from distributing our version of Java software in certain ways.appeal.
Patent and intellectual property claims.We are thea defendant in more than 3035 patent infringement cases. Several of these cases that we are approaching trial.defending vigorously. In the case ofEolas Technologies, Inc. and University of California v. Microsoft, filed in the U.S. District Court for the Northern District of Illinois on February 2, 1999, the plaintiffs accusedalleged infringement by the browser functionality of Windows of infringement.Windows. On August 11, 2003, the jury awarded the plaintiffs approximately $520 million in damages for infringement from the date the plaintiffs’ patent was issued through September 2001. The plaintiffs are seeking an equitable accounting for damages from September 2001 to the present. We will appealOn January 14, 2004, the jury awardtrial court entered final judgment of $565 million, including post-trial interest of $45 million, and entered an injunction against distribution of any award on the equitable accounting issue upon conclusion of those aspectsnew infringing products, but stayed execution of the casejudgment and the injunction pending our appeal. We appealed and on March 2, 2005 the Court of Appeals for the Federal Circuit reversed the decision and vacated the judgment, ruling that remain to be completed before the trial court. While it iscourt had erred in excluding certain previous art evidence and ruling as a matter of law on other evidence. The appellate court also reversed the trial court’s decision that the inventors had not currently possibleengaged in inequitable conduct by failing to estimatereveal material previous art while obtaining the range of possible loss, wepatent. We believe the total cost to resolve this case will not be material to our financial position or results of operations. However, theThe actual costs arewill be dependent upon many unknown factors such as the outcome of issues remaining to be decided by the trial court, success on appeal, and the events of a retrial of the case shouldplaintiff’s claims. InMicrosoft v. Lucent, filed in the case be remandedU.S. District Court in San Diego on April 8, 2003, we are seeking a declaratory judgment that we do not infringe any valid patent among a number of patents Lucent has been asserting against computer manufacturers that sell computers with our software pre-installed. The first in a series of back-to-back trials on the various patent groupings is currently set to begin on November 20, 2006. On March 28, 2006, Lucent filed a new lawsuit against us in U.S. District Court in San Diego, claiming that Xbox 360 violates one of the patents that earlier
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had been dismissed from the older lawsuit. In response to Lucent’s new complaint, we asserted patent infringement counterclaims accusing Lucent of infringing ten Microsoft patents by its sales of various products. No trial following appeal.date has been set in the new lawsuit. InAmado v. Microsoft, filed in U.S. District Court for the Central District of California on March 7, 2003, the plaintiff has accused the link table functionality available in Microsoft Access when used with Microsoft Excel. After a jury trial, we were found to infringe one claim of the patent and damages of $8.9 million were awarded. The judge later found for us on our defense of laches, which reduced the damages award to $5.9 million. The court also imposed an injunction against further distribution of the accused feature as part of Microsoft Access, but stayed the injunction pending resolution of all appeals. The Court of Appeals for the Federal Circuit affirmed the judgment on appeal and Microsoft intends to seek review by the U.S. Supreme Court of one issue. InZ4 Technologies, Inc. v. Microsoft, the plaintiff alleged that Microsoft Windows and Office product activation functionality violates its patent rights. In April 2006, the jury rendered a $115 million verdict against us. In August 2006, the trial court increased damages by $25 million pursuant to the jury’s finding of willful infringement. We intend to appeal the verdict. InInterTrustVeritas Operating Corporation v. Microsoft, filed in the U.S. District Court for Northern Californiathe Western District of Washington on April 26, 2001, is anticipated in 2005. The plaintiff in this caseMay 18, 2006, a subsidiary of Symantec has accused a large numberfiled an action asserting claims of products, including Windowstrade secret misappropriation, breach of contract, and Office, of infringement. In each ofEolas andInterTrust, injunctive relief also may be awarded that could adversely impact distribution of Windows or Office.patent infringement relating to certain storage technologies. Adverse outcomes in some or all of the pending casesmatters described in this paragraph may result in significant monetary damages or injunctive relief against us.us, adversely affecting distribution of our operating system or application products. The risks associated with an adverse decision may result in material settlements.
Other.We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business.
While management currently believes that resolving all of these matters,claims against us, individually or in aggregate, will not have a material adverse impact on our financial position, or our results of operations, the litigation and other claims noted aboveor our cash flows, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.
As of June 30, 2006, we had accrued aggregate liabilities totaling $1.0 billion in other current liabilities and $1.0 billion in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, there exists the possibility of adverse outcomes which we estimate could be up to $1.0 billion in aggregate beyond recorded amounts. Were an unfavorable final outcome to occur, there exists the possibility of a material adverse impact on ourthe Company’s financial position and on the results of operations for the period in which the effect becomes reasonably estimable.
NOTE 18 SEGMENT INFORMATION
Note 21—Segment Informationrevenue and operating income/(loss) was as follows:
(In millions) | |||||||||||||||||
Year Ended June 30 | 2002 | 2003 | 2006 | 2005 | 2004 | ||||||||||||
Revenue | |||||||||||||||||
Client | $ | 9,350 | $ | 10,286 | $ | 13,001 | $ | 11,972 | $ | 11,293 | |||||||
Server and Tools | 5,632 | 6,519 | 10,542 | 9,197 | 8,031 | ||||||||||||
Information Worker | 8,328 | 9,718 | 12,380 | 11,702 | 10,990 | ||||||||||||
Microsoft Business Solutions | 308 | 577 | 906 | 776 | 735 | ||||||||||||
MSN | 1,924 | 2,363 | 2,488 | 2,486 | 2,498 | ||||||||||||
Mobile and Embedded Devices | 124 | 153 | 365 | 259 | 185 | ||||||||||||
Home and Entertainment | 2,411 | 2,779 | 4,292 | 3,110 | 2,731 | ||||||||||||
Reconciling Amounts | 288 | (208 | ) | ||||||||||||||
Reconciling amounts | 308 | 286 | 372 | ||||||||||||||
Consolidated Revenue | $ | 28,365 | $ | 32,187 | |||||||||||||
Consolidated | $ | 44,282 | $ | 39,788 | $ | 36,835 | |||||||||||
Operating Income/(Loss) | |||||||||||||||||
Client | $ | 7,529 | $ | 8,281 | |||||||||||||
Server and Tools | 1,409 | 1,848 | |||||||||||||||
Information Worker | 6,440 | 7,393 | |||||||||||||||
Microsoft Business Solutions | (196 | ) | (308 | ) | |||||||||||||
MSN | (746 | ) | (394 | ) | |||||||||||||
Mobile and Embedded Devices | (240 | ) | (175 | ) | |||||||||||||
Home and Entertainment | (866 | ) | (940 | ) | |||||||||||||
Reconciling Amounts | (1,420 | ) | (2,488 | ) | |||||||||||||
Consolidated Operating Income/(Loss) | $ | 11,910 | $ | 13,217 | |||||||||||||
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Segment information is presented in accordance with Part II
Item 8
(In millions) | ||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | |||||||||
Operating Income/(Loss) | ||||||||||||
Client | $ | 10,043 | $ | 9,418 | $ | 9,061 | ||||||
Server and Tools | 3,525 | 2,922 | 2,357 | |||||||||
Information Worker | 8,982 | 8,726 | 8,160 | |||||||||
Microsoft Business Solutions | 14 | (134 | ) | (91 | ) | |||||||
MSN | 111 | 477 | 393 | |||||||||
Mobile and Embedded Devices | (11 | ) | (37 | ) | (116 | ) | ||||||
Home and Entertainment | (1,283 | ) | (451 | ) | (1,011 | ) | ||||||
Reconciling amounts | (4,909 | ) | (6,360 | ) | (9,719 | ) | ||||||
Consolidated | $ | 16,472 | $ | 14,561 | $ | 9,034 | ||||||
SFAS No. 131,Disclosures about Segments of an Enterprise and Related Information.Information, establishes standards for reporting information about operating segments. This standard is based on a management approach, which requires segmentation based uponon our internal organization and reporting of revenue and operating income based upon internal accounting methods. Our financial reporting systems present various data for management to runoperate the business, including internal profit and loss statements (P&Ls) prepared on a basis not consistent with U.S. GAAP. Assets are not allocatedFiscal years 2005 and 2004 amounts have been restated for certain internal reorganizations and to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocationconform to each segment and it is
Part II, Item 8
impracticable for the Company to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.
On July 1, 2002, we revised our segments. These changescurrent period presentation. The segments are designed to promote better alignmentallocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as components of strategiesan enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and objectives between development, sales, marketing, and services organizations; provide for more timely and rational allocation of development, sales, and marketing resources within businesses; and focus long-term planning efforts on key objectives and initiatives.in assessing performance. Our chief operating decision maker is our Chief Executive Officer. Our seven new segments are:are Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. PriorOn July 17, 2006 we announced a change in our operating segments reflecting the culmination of our realignment announced in September 2005. These changes will be effective for fiscal year segment information has been restated to conform to2007; the seven new segments. It is not practical to discern operating income for 2001 forsegments discussed in this analysis are presented the current segments or operating income for 2003 forway we internally managed and monitored performance at the previous segments due to reorganizations.business group level in fiscal years 2006, 2005, and 2004.
The segmentstypes of products and services provided by each segment are designed to allocate resources internallysummarized below:
Client – Windows XP Professional and provide a framework to determine management responsibility. Due toHome; Media Center Edition; Tablet PC Edition; and other standard Windows operating systems.
Server and Tools –Windows Server operating system; Microsoft SQL Server; Exchange Server; Microsoft Consulting Services; product support services; Visual Studio; System Center products, Forefront security family of products; and Biz Talk.
Information Worker – Microsoft Office; Microsoft Project; Microsoft Visio; SharePoint Portal Server client access licenses; Microsoft LiveMeeting; OneNote; and Office Communication Server.
Microsoft Business Solutions – Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Small Business Accounting.
MSN – MSN Search; MapPoint; MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, MSN Bill Pay, and MSN Radio Plus); and MSN Mobile Services.
Mobile and Embedded Devices – Windows Mobile software platform; Windows Embedded device operating system; and Windows Automotive.
Home and Entertainment – Xbox 360; Xbox; Xbox Live; CPxG (consumer software and hardware products); and IPTV.
Because of our integrated business structure, operating costs included in one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to incent shared efforts. Management will continually
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Item 8
evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.
The ClientAssets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment includes revenue and operating expenses associated with Windows XP, Windows 2000,it is impracticable for us to separately identify the amount of amortization and other standard Windows operating systems. Server and Toolsdepreciation by segment consiststhat is included in the measure of revenue and operating expenses associated with server software licenses and client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other servers. It also includes developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft consulting services. Information Worker segment includes Microsoft Office, Microsoft Project, Visio, other information worker products, SharePoint Portal Server CALs, an allocation for CALs, and professional product support services. Microsoft Business Solutions includes Microsoft Great Plains, Navision, and bCentral. MSN includes MSN Subscription and MSN Network services. Mobile and Embedded Devices includes Windows Mobile software, Windows Embedded device operating systems, MapPoint, and Windows Automotive. Home and Entertainment includes the Xbox video game system, PC games, consumer software and hardware, and TV platform.profit or loss.
Reconciling amounts include adjustments to state revenue and operating income in accordanceconform with U.S. GAAP and corporate level expensescorporate-level activity not specifically attributed to a segment. ForSignificant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, period-end cut-off timing, and accelerated amortization for depreciation, stock awards, and performance-based stock awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity including certain legal settlements and accruals for legal contingencies.
Significant reconciling items include certain undelivered elements of unearned revenue and allowances for certain sales returns and rebates. Reconciling items for operating income/(loss) include general and administrative expenses ($1.55 billion in 2002 and $2.10 billion in 2003), broad-based research and development expenses ($202 million in 2002 and $210 million in 2003), and certain corporate level sales and marketing costs ($526 million in 2002 and $688 million in 2003). The internal segment operating income or loss also includes non-GAAP accelerated methods of depreciation and amortization. Additionally, losses on equity investees and minority interest are classified in operating income for internal reporting presentations.
Revenue attributable to U.S. operations includes shipments to customers in the United States, licensing to OEMs and certain multinational organizations, and exports of finished goods, primarily to Asia, Latin America, and Canada. Revenue from U.S. operations totaled $17.8 billion, $20.9 billion, and $22.1 billion in 2001, 2002, and 2003. Revenue from outside the United States, excluding licensing to OEMs and certain multinational organizations and U.S. exports, totaled $7.5 billion, $7.5 billion, and $10.1 billion in 2001, 2002, and 2003. No single customer accounted for 10% or more of revenue in 2001, 2002, or 2003.
Long-lived assets (principally property and equipment) totaled $2.0 billion and $1.9 billion in the United States in 2002 and 2003 and $220 million, and $294 million in other countries in 2002 and 2003.were as follows:
Part II, Item 8
QUARTERLY INFORMATION
(In millions, except earnings per share) (Unaudited) | Quarter Ended | |||||||||||||||||
Sept. 30 | Dec. 31 | Mar. 31 | June 30 | Year | ||||||||||||||
Fiscal 2001 | ||||||||||||||||||
Revenue | $ | 5,766 | $ | 6,550 | $ | 6,403 | $ | 6,577 | $ | 25,296 | ||||||||
Gross profit | 4,941 | 5,686 | 5,504 | 5,710 | 21,841 | |||||||||||||
Net income | 2,206 | (2) | 2,624 | 2,451 | 65 | (3) | 7,346 | |||||||||||
Basic earnings per share(1) | 0.21 | (2) | 0.25 | 0.23 | 0.01 | 0.69 | ||||||||||||
Diluted earnings per share(1) | 0.20 | (2) | 0.24 | 0.22 | 0.01 | 0.66 | ||||||||||||
Fiscal 2002 | ||||||||||||||||||
Revenue | $ | 6,126 | $ | 7,741 | $ | 7,245 | $ | 7,253 | $ | 28,365 | ||||||||
Gross profit | 5,242 | 6,197 | 5,850 | 5,885 | 23,174 | |||||||||||||
Net income | 1,283 | (4) | 2,283 | 2,738 | (5) | 1,525 | (6) | 7,829 | ||||||||||
Basic earnings per share(1) | 0.12 | 0.21 | 0.25 | 0.14 | 0.72 | |||||||||||||
Diluted earnings per share(1) | 0.12 | 0.21 | 0.25 | 0.14 | 0.70 | |||||||||||||
Fiscal 2003 | ||||||||||||||||||
Revenue | $ | 7,746 | $ | 8,541 | $ | 7,835 | $ | 8,065 | $ | 32,187 | ||||||||
Gross profit | 6,547 | 6,507 | 6,620 | 6,827 | 26,501 | |||||||||||||
Net income | 2,726 | 2,552 | 2,794 | 1,921 | 9,993 | |||||||||||||
Basic earnings per share | 0.25 | 0.24 | 0.26 | 0.18 | 0.93 | |||||||||||||
Diluted earnings per share | 0.25 | 0.23 | 0.26 | 0.18 | 0.92 | |||||||||||||
(In millions) | ||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | |||||||||
Operating income reconciling amounts: | ||||||||||||
Legal settlements and contingent liabilities | $ | (1,321 | ) | $ | (2,312 | ) | $ | (2,832 | ) | |||
Stock-based compensation expense | (127 | ) | (1,042 | ) | (4,516 | ) | ||||||
Revenue reconciling amounts | 308 | 286 | 372 | |||||||||
Corporate-level expenses(1) | (3,742 | ) | (3,493 | ) | (3,128 | ) | ||||||
Other | (27 | ) | 201 | 385 | ||||||||
Total | $ | (4,909 | ) | $ | (6,360 | ) | $ | (9,719 | ) | |||
(1) |
Sales to Dell and its subsidiaries in the aggregate accounted for approximately 11% of fiscal year 2006 and 10% of total fiscal year 2005 and 2004 revenue. These sales were made primarily through our OEM and volume licensing channels and were included in all operating segments.
Revenue, classified by the major geographic areas in which our customers are located, were as follows:
(In millions) | |||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||
United States(1) | $ | 29,730 | $ | 26,949 | $ | 25,046 | |||
Other countries | 14,552 | 12,839 | 11,789 | ||||||
Total | $ | 44,282 | $ | 39,788 | $ | 36,835 | |||
(1) | Includes shipments to |
Long-lived assets, classified by the geographic location of the controlling statutory company in which that company operates, were as follows:
(In millions) | ||||||
Year Ended June 30 | 2006 | 2005 | ||||
United States | $ | 6,661 | $ | 5,506 | ||
Other countries | 788 | 648 | ||||
Total | $ | 7,449 | $ | 6,154 | ||
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Item 8
NOTE 19 SUBSEQUENT EVENTS
On July 12, 2006, the European Commission imposed a fine of€281 million ($351 million) on Microsoft related to the Commission’s March 2004 decision in its competition law investigation. As of June 30, 2006, the total amount of the fine was included in other current liabilities.
On July 20, 2006, we announced that our Board of Directors authorized two new share repurchase programs, comprised of a $20 billion tender offer which was completed on August 17, 2006, and an additional $20 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of our common stock, or approximately 1.5% of our common stock outstanding, for approximately $3.8 billion at a per share price of $24.75.
On August 18, 2006, we announced that the authorization for the ongoing share repurchase program, previously announced on July 20, 2006, had been increased by approximately $16.2 billion. As a result, the company is authorized to repurchase additional shares in an amount up to $36.2 billion through June 30, 2011.
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Part II
Item 8
QUARTERLY INFORMATION
(In millions, except per share amounts) (Unaudited) | |||||||||||||||||||
Quarter Ended | Sep. 30 | Dec. 31 | Mar. 31 | June 30 | Total | ||||||||||||||
Fiscal year 2006 | |||||||||||||||||||
Revenue | $ | 9,741 | $ | 11,837 | $ | 10,900 | $ | 11,804 | $ | 44,282 | |||||||||
Gross profit | 8,488 | 9,598 | 8,872 | 9,674 | 36,632 | ||||||||||||||
Net income | 3,141 | (6) | 3,653 | 2,977 | (7) | 2,828 | (8) | 12,599 | |||||||||||
Basic earnings per share | 0.29 | 0.35 | 0.29 | 0.28 | 1.21 | ||||||||||||||
Diluted earnings per share | 0.29 | 0.34 | 0.29 | 0.28 | 1.20 | ||||||||||||||
Fiscal year 2005 | |||||||||||||||||||
Revenue | $ | 9,189 | $ | 10,818 | $ | 9,620 | $ | 10,161 | $ | 39,788 | |||||||||
Gross profit | 7,784 | 8,943 | 8,257 | 8,773 | 33,757 | ||||||||||||||
Net income | 2,528 | (3) | 3,463 | 2,563(4 | ) | 3,700 | (5) | 12,254 | |||||||||||
Basic earnings per share | 0.23 | 0.32 | 0.24 | 0.34 | 1.13 | ||||||||||||||
Diluted earnings per share | 0.23 | 0.32 | 0.23 | 0.34 | 1.12 | ||||||||||||||
Fiscal year 2004 | |||||||||||||||||||
Revenue | $ | 8,215 | $ | 10,153 | $ | 9,175 | $ | 9,292 | $ | 36,835 | |||||||||
Gross profit | 6,735 | 7,809 | 7,764 | 7,811 | 30,119 | ||||||||||||||
Net income | 2,614 | 1,549 | (1) | 1,315 | (2) | 2,690 | 8,168 | ||||||||||||
Basic earnings per share | 0.24 | 0.14 | 0.12 | 0.25 | 0.76 | ||||||||||||||
Diluted earnings per share | 0.24 | 0.14 | 0.12 | 0.25 | 0.75 |
(1) | Includes stock-based compensation charges totaling $2.2 billion for the employee stock |
(2) | Includes |
(3) | Includes |
(4) | Includes |
(5) | Includes |
(6) | Includes |
(7) | Includes charges of $397 million (pre-tax) related to various legal charges. |
(8) | Includes charge of€281 million ($351 million)(pre-tax) as a result of the fine imposed by the European Commission in |
PAGE |
Part II
Item 8
REPORT OF INDEPENDENT AUDITORS’ REPORT
REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Microsoft Corporation:
We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 20022006 and 2003,2005, and the related consolidated statements of income, cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2003.2006. These financial statements are the responsibility of the Corporation’sCompany’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditingthe standards generally accepted inof the United States of America.Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and subsidiaries as of June 30, 20022006 and 2003,2005, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 20032006, in conformity with accounting principles generally accepted in the United States of America.
As describedWe have also audited, in Note 3 toaccordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial statements,reporting as of June 30, 2006, based on the Company adopted Statementcriteria established inInternal Control—Integrated Framework issued by the Committee of Financial Accounting Standards No. 133,Accounting for Derivative InstrumentsSponsoring Organizations of the Treadway Commission and Hedging Activities, effective July 1, 2000,our report dated August 22, 2006, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and Statementan unqualified opinion on the effectiveness of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets, effective July 1, 2001.the Company’s internal control over financial reporting.
/s/ DELOITTE & TOUCHE LLP
Deloitte & Touche LLP
Seattle, Washington
July 17, 2003 (September 3, 2003 as to certain information in Note 20)August 22, 2006
PAGE |
Part II
Item 9, 9A Part III, Item 10, 11, 12, 13, 14
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial DisclosuresCHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
None.
ITEM 9A. Controls and ProceduresCONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14(c)13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective.
REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of company assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected.
Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework inInternal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of June 30, 2006. There were no changes in our internal control over financial reporting during the quarter ended June 30, 20032006 that have materially affected, or are reasonably likely to materially affect, our internal controlscontrol over financial reporting. Deloitte & Touche LLP has audited this assessment of our internal control over financial reporting; their report is included in Item 9A.
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Part II
Item 9A
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Microsoft Corporation:
We have audited management’s assessment, included in the accompanying Report of Management on Internal Control over Financial Reporting, that Microsoft Corporation and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of June 30, 2006, based on criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of June 30, 2006, is fairly stated, in all material respects, based on the criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2006, based on the criteria establishedin Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended June 30, 2006 of the Company and our report dated August 22, 2006 expressed an unqualified opinion on those financial statements.
/s/ DELOITTE & TOUCHE LLP
Seattle, Washington
August 22, 2006
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Part II, III
Item 9B, 10, 11, 12, 13, 14
Effective August 23, 2006, the Board of Directors amended the Company’s bylaws. The Board added a new Section 1.13 concerning the right of shareholders to amend the bylaws, which they already have pursuant to the Washington Business Corporation Act. The board also added a new paragraph to Section 2.2 to incorporate the Board’s previous governance policy on election of directors. The Board added additional procedures that would be followed if a director does not receive a majority of shares cast in an uncontested election.
ITEM 10. DirectorsDIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
A list of our executive officers and Executive Officersbiographical information appears in Part I, Item 1 of the Registrant
this report. Information with respect toabout our Directors may be found under the caption “Election of Directors and Management Information” of our Proxy Statement for the Annual Meeting of Shareholders to be held November 11, 200314, 2006 (the “Proxy Statement”). SuchThat information is incorporated herein by reference.
The information in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.
We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our website at www.microsoft.com/msft. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer or Chief Accounting Officer and Corporate Controller, we will disclose the nature of such amendment or waiver on that website or in a report on Form 8-K.
ITEM 11. Executive CompensationEXECUTIVE COMPENSATION
The information in the Proxy Statement set forth under the captions “Information Regarding Executive Officer Compensation” and “Information RegardingAbout the Board and its Committees – Director Compensation” is incorporated herein by reference.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersSECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information in the Proxy Statement set forth under the captions “Equity Compensation Plan Information” and “Information Regarding Beneficial Ownership of Principal Shareholders, Directors, and Management” is incorporated herein by reference.
ITEM 13. Certain Relationships and Related TransactionsCERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth under the captions “Certain Relationships and Related Transactions” of the Proxy Statement is incorporated herein by reference.
ITEM 14. Principal Accounting Fees and ServicesPRINCIPAL ACCOUNTANT FEES AND SERVICES
Information concerning principal accountant fees and services appears in the proxy statementProxy Statement under the heading “Fees Paid toBilled by Deloitte & Touche LLP” and is incorporated herein by reference.
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Part IV
Item 15
ITEM 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-KEXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Financial Statements and Schedules
The financial statements are set forth under Item 8 of this Annual Report on Form 10-K. Financial statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included.
(b) Reports on Form 8-K
We did not file any reports on Form 8-K during the quarter ended June 30, 2003. We furnished to the SEC reports on Form 8-K on April 15, 2003 and May 12, 2003. The April 15, 2003 Form 8-K was for the purpose of furnishing the press release announcing our financial results for the fiscal quarter ended March 31, 2003. The May 12, 2003 Form 8-K was for the purpose of furnishing our consolidated balance sheets as of June 30, 2002 and March 31, 2003, and the related consolidated statements of income, cash flows, and stockholders’ equity for the three and nine months ended March 31, 2002 and 2003 formatted in XBRL (Extensible Business Reporting Language).
(c) Exhibit Listing
Incorporated by reference | ||||||||||||
Exhibit number | Exhibit description | Filed herewith | Form | Period ending | Exhibit | Filing date | ||||||
3.1 | Amended and Restated Articles of Incorporation of Microsoft Corporation | 10-Q | 12/31/02 | 3.1 | 1/31/03 | |||||||
3.2 | Bylaws of Microsoft Corporation | X | ||||||||||
4 | Call Option Transaction Confirmation dated December 11, 2003 between Microsoft Corporation and JPMorgan Chase Bank | 10-K | 12/31/03 | 4 | 2/6/04 | |||||||
10.1* | Microsoft Corporation 2001 Stock Plan | 8-K | 99.2 | 7/21/06 | ||||||||
10.2* | Microsoft Corporation 1991 Stock Option Plan | 8-K | 99.1 | 7/21/06 | ||||||||
10.3* | Microsoft Corporation 1999 Stock Plan for Non-Employee Directors | 8-K | 10.3 | 11/15/04 | ||||||||
10.4* | Microsoft Corporation Stock Option Plan for Non-Employee Directors | 8-K | 10.4 | 11/15/04 | ||||||||
10.5* | Microsoft Corporation Stock Option Plan for Consultants and Advisors | 8-K | 10.5 | 11/15/04 | ||||||||
10.6* | Microsoft Corporation 2003 Employee Stock Purchase Plan | 10-K | 6/30/04 | 10.6 | 9/1/04 | |||||||
10.7* | Microsoft Corporation Deferred Compensation Plan | S-8 | 99.1 | 2/28/06 | ||||||||
10.8* | Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan | X | ||||||||||
10.9* | Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors | 10-K | 6/30/04 | 10.9 | 9/1/04 | |||||||
10.10* | Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the January 1, 2004 to June 30, 2006 performance period | 10-K | 6/30/04 | 10.10 | 9/1/04 |
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Part IV
Item 15
Incorporated by reference | |||||||||||||
Exhibit number | Exhibit description | Filed herewith | Form | Period ending | Exhibit | Filing date | |||||||
10.11* | Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the July 1, 2003 to June 30, 2006 performance period | 10-K | 6/30/04 | 10.11 | 9/1/04 | ||||||||
10.12* | Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan | 10-K | 6/30/04 | 10.12 | 9/1/04 | ||||||||
10.13* | Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors | 10-K | 6/30/04 | 10.13 | 9/1/04 | ||||||||
10.14 | Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of Washington as trustee) | 10-K | 6/30/02 | 10.8 | 9/6/02 | ||||||||
10.15 | Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee | 10-K | 6/30/03 | 10.8 | 9/5/03 | ||||||||
10.16* | Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors | S-8 | 99.2 | 2/28/06 | |||||||||
21 | Subsidiaries of Registrant | X | |||||||||||
23.1 | Consent of Independent Registered Public Accounting Firm | X | |||||||||||
31.1 | Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | X | |||||||||||
31.2 | Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | X | |||||||||||
32.1 | Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | X | |||||||||||
32.2 | Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | X |
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Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on September 4, 2003.August 25, 2006.
MICROSOFT CORPORATION | ||
By: | / | |
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Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on September 4, 2003.August 25, 2006.
Signature | Title | |
William H. Gates III | Chairman | |
/s/ STEVEN A. BALLMER Steven A. Ballmer | Director and Chief Executive Officer | |
/s/ JAMES I. CASH, JR. James I. Cash, Jr. | Director | |
/s/ DINA DUBLON Dina Dublon | Director | |
/s/ RAYMOND V. GILMARTIN Raymond V. Gilmartin | Director | |
/s/ ANN MCLAUGHLIN KOROLOGOS Ann McLaughlin Korologos | Director | |
/s/ DAVID F. MARQUARDT David F. Marquardt | Director | |
/s/
| Director | |
Helmut Panke | Director | |
/s/ JON A. SHIRLEY Jon A. Shirley | Director | |
/s/
| Senior Vice President, Finance and Administration; (Principal Financial Officer) | |
/s/ FRANK H. BROD Frank H. Brod | Corporate Vice President, Finance and Administration; (Principal Accounting Officer) |
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