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, 20062009
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
www.microsoft.com/msft
Securities registered pursuant to Section 12(b) of the Act:
COMMON STOCK NASDAQ
Securities registered pursuant to Section 12(g) of the Act:
NONE
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. Yes x No¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted to Rule 405 of Regulation S-T (§229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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.¨x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a non-accelerated filer.smaller reporting company. See definitionthe definitions of “large accelerated filer,” “accelerated filerfiler” and large accelerated filer”“smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Large accelerated filer x | Accelerated filer ¨ | Non-accelerated filer ¨ | Smaller reporting company ¨ | |||
(Do not check if a smaller reporting company) |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ Nox
As of December 31, 2005,2008, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $233,926,876,964$149,769,380,603 based on the closing sale price as reported on the NASDAQ National Market System. As of August 18, 2006,July 27, 2009, there were 9,969,991,8008,910,673,817 shares of common stock 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 14, 200619, 2009 are incorporated by reference into Part III.
FORM 10-K
For The Fiscal Year Ended June 30, 20062009
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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. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Business”, “Management’s Discussion and Analysis”, and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties 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 Part I, 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
Our mission is to enable people and businesses throughout the world to realize their full potential. We workSince the company was founded in 1975, we have worked to achieve ourthis mission throughby creating technology that transforms the way people work, play, and communicate. Since our founding in 1975, we have been a leader in this transformation. We develop and market software, services, hardware, and solutions that we believe deliver new opportunity,opportunities, greater convenience, and enhanced 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 and services for many different types of computing devices. Our software products and services include operating systems for servers, personal computers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutionsolutions applications; high-performance computing applications, andapplications; software development tools.tools; and video games. We provide consulting and product and solution support services, and we train and certify computer system integrators and developers. We also design and sell hardware including the Xbox 360 video game console, the Zune digital music and games, PC games,entertainment device, and peripherals. Online offerings and information are delivered through ourBing, Windows Live, Office Live, andour MSN portals and channels.channels, and the Microsoft Online Services platform which includes offerings for businesses such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on Bing through our proprietary adCenter platform.
We also conduct research and develop advanced technologies for future software products.products and services. We 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 laidwill continue to lay the foundation for long-term growth by delivering innovative new products and services, creating new 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 onthrough ongoing innovation in our integrated software platform,platforms; by delivering compelling value propositions to customers,customers; by responding effectively to customer and partner needs,needs; and by continuing to focus internally onemphasize the importance of product excellence, business efficacy, and accountability. 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, China, Denmark, England, India, Ireland, and Israel.
OPERATING SEGMENTS
We have five operating segments: Client, Server and Tools, Online Services Business, Microsoft Business Division, and Entertainment and Devices Division. Our segments provide management with a comprehensive financial view of our key businesses. The segments provide a framework forenable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for the timely and rational allocation of development, sales, marketing, and services resources within businesses. The segments also help focus strategic planning efforts on key objectives and 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 and services 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 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 18 – Segment Information of the Notes to Financial Statements for financial information regarding segment reporting. On 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 2007; the seven 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 has overall responsibility for the technical architecture, engineering, and product delivery of our Windows product family and is also responsible for our relationships with personal computer manufacturers, including multinational and regional original equipment manufacturers (“OEMs”). The segment includes sales and marketing expenses for the Windows client operating system and product development efforts for the Windows platform. Client revenue growth is correlated with thedirectly impacted by growth of PC purchases 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 differences between unit growth rates and revenue growth rates from year to year are affected primarily by changes in the mix of OEM Windows premium edition operating systems licensed as a percentage of total OEM Windows operating systems licensed (“OEM premium mix”). Additional differences in growth rates result from the impact from lower cost netbook PCs, which are sold with a lower cost version of Windows, changes in geographic mix, and changes in the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders.
The next generationmajority of revenue in fiscal year 2009 came from sales of Windows Vista, which was released in fiscal year 2007. Windows XP operating systems reached end-of-life for most editions and sales channels (Windows XP Home Edition will continue to be available on netbooks and other Windows XP editions will continue to be available in China). Windows 7, the latest version of Windows, was released to manufacturing in July 2009 and is expected to be generally available on October 22, 2009.
Client offerings consist of premium and standard edition Windows operating system,systems. Premium editions are those that include additional functionality and are sold at a price above our standard editions.
Products: Windows Vista, is under development. This development phase represents a major investment that we expect will result in a significantly more manageableincluding Home Basic, Home Premium, Ultimate, Business, Enterprise, and 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:Starter Edition; Windows XP, including Professional, and Home;Home, Media Center, Edition;and 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,Canonical, and Sun Microsystems.Red Hat. Apple takes an integrated approach to the PC experience and has made inroads in share, particularly in the U.S. and in the consumer segment. The Linux operating system, which is also derived from Unix and is available without payment under a General Public License, has gained some acceptance, especially in emerging markets, as competitive pressures lead PC OEMs to reduce costs. costs and new, lower-price PC form-factors gain adoption. Partners such as Hewlett-Packard and Intel have been actively working with alternative Linux-based operating systems.
The Windows operating system also faces competition from alternative platforms and new devices that may reduce consumer demand for traditional personal computers.PCs. Competitors such as Apple, Google, Mozilla, and Opera Software Company offer software that competes with the Internet Explorer Web browsing capabilities of Windows products. Apple Computer, Real Networks,User and others competeusage volumes on mobile devices are increasing around the world relative to the PC. OEMs have been working to make the Google Android mobile operating system more compatible with Windows Media Player. small form-factor PCs or netbooks.
Our operating system products compete effectively by delivering innovative software, giving customers choice and flexibility, 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 develops and markets software server products, software developer tools, services, and solutions. Windows Server products, including Windows Server operating systems. Windows ServerServer-based products are integrated server infrastructure and middleware software that are designed to support end-to-end software applications and tools built on the Windows Server 2003 operating system. Windows ServerServer-based products include the server platform including targeted segment solutions, database, storage, management and operations, service-oriented
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architecture platform, and security applications and collaborationidentity software. The segment also builds standalone and software development lifecycle tools for software architects, developers, testers, and project managers. Server products can be run on-site, in a partner-hosted environment, or in a Microsoft-hosted environment.
We offer a broad range of consulting services and provide product support services. The segmentservices that assist customers in developing, deploying, and managing Microsoft server and desktop solutions. We also providesprovide training and certification to developers and information technology professionals about our Server and PCTools, Microsoft Business Division, and Client platform products.
Approximately 50% of Server and Tools also includes the Enterprise Partner Group, which is responsible for sales, partner management and partner programs for medium and large organizations; and the Public Sector sales and marketing organization.
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Approximately half of Server revenue comes from multi-year licensing agreements, one thirdapproximately 20% is purchased through fully packaged product and transactional volume licensing programs, and approximately 10% comes from licenses sold to OEMs. Approximately 15%The remainder of Server and Tools revenue comes from consulting and product and solution support services.
Windows Server 2008 R2, the latest version of the Windows Server operating system was released to manufacturing in July 2009 and is expected to be generally available in September 2009.
Products and Services:Services: Windows Server operating system; Microsoft SQL Server; Exchange Server; Microsoft Consulting Services; product support services; Visual Studio; Silverlight; System Center products; Forefront security family of products; and Biz Talk Server, among others.Server; Microsoft Consulting Services; Premier product support services; and other products and services.
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 variantversions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system. IBM’s endorsementsystem and many contribute to Linux operating system development. The competitive position 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 have entered into business and technical collaboration agreements with Novell and other Linux providers to build, market, and support a series of solutions to enhance the interoperability of our products with their virtualization, management, and network security solutions, and to provide each other’s customers with patent coverage for their respective products.
We compete in the business of providingto provide enterprise-wide computing solutions with several companies that provideoffer solutions and middleware technology platforms. IBM, Oracle, 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, Inc., IBM, and Oracle. Our Web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP, and we compete against Java middleware such as Geronimo, JBoss, and Spring Framework.
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 server management and server virtualization platform providers, such as BMC, CA, Inc., Hewlett-Packard, IBM, and IBMVMWare in the Managementmanagement of IT infrastructures, whileinformation technology infrastructures. Forefront Security competessecurity products compete 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, other companies, and other companies.open-source projects. Open source projects include Eclipse (sponsored by CA, IBM, Oracle, and SAP), PHP, and Ruby on Rails, among others. 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 WorkerOnline Services Business
Information WorkerThe Online Services Business (“OSB”) consists of an online advertising platform with offerings for both publishers and advertisers, online information offerings such as Bing, MSN Portals and channels, and personal communications services such as email and instant messaging around the Microsoft Office system of programs,world. We earn revenue primarily from online advertising, including search, display, and email and messaging services. Revenue is also generated through subscriptions and transactions generated from online paid services, from advertiser and software solutions designedpublisher tools, and digital marketing and advertising agency services. We continue to increase personal, team,launch updated and organization productivity. The Office systemnew online offerings generate over 85% of Information Worker revenue. Revenue growth depends on our ability to add value to the core Office product set and expect to continue to expand our product offeringsdo so 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 fromfuture. During fiscal year 2009, we launched 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 wavereleases of our flagship product, the 2007 Microsoft Office system, is currently under development.proprietary advertising platforms, adCenter
Products: Microsoft Office; Microsoft Project; Microsoft Visio; SharePoint Portal Server CAL; Microsoft Live Meeting; One Note; and Office Communication Server.
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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 EuropeadExpert, and Asia. IBM (Smartsuite)launched a new release of our search engine named Bing. We also updated behavioral targeting tools, launched new releases of MSN properties globally, 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-sideadded 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 is responsible for Microsoft Dynamics brand business applications for small and mid-size businesses, large organizations and divisions of global enterprises. It offers financial management, customer relationship management, supply chain management, 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 enhancement plans, which provide customers with future software upgrades and on-line training over the period of the plan. The solutions are delivered through a worldwide network of channel partners and independent software vendors that provide services, additional related software, and local support.to our existing Windows Live suite.
Products:Products and Services: Bing; Microsoft Dynamics AX;adCenter/adExpert; 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.
Competition
Our competition varies based upon the size and geographic 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 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 provides personal communications services, such as e-mail and instant messaging, and online information offerings such as MSN Search, MapPoint, and theMedia Network (MMN); MSN portals, channels, 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 releasedmobile services; Windows Live Messenger to consumers in 58 countries.
Products: MSN Search; MapPoint; MSN Internet Access;suite of applications and mobile services; Atlas online tools for advertisers and publishers; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, MSN Bill Pay, and MSN Radio Plus)Software Services); Windows Live; and MSN Mobile Services.Razorfish media agency services.
Competition
MSNOSB 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.continue long-term. Competitors are aggressively developing Internet offerings that seek to provide more effective ways of connecting advertisers with audiences through enhanced functionality in communication services, improvements in information services such as Internet search, improvements in communication services, and improved advertising infrastructure and support services. We have developedbelieve our own algorithmic search engine, to provide endBing, helps users withmake faster, more informed decisions by providing more relevant search results, expanded search services, and a broader selection of content, and expandedcontent. We have also enhanced the user interface to bring a richer search services.experience, which we believe will differentiate us from our competitors. To support the growth of our advertising business, we also are investing in improving the scale of our advertising platform, seamless integration of content and offerings to the mobile platform, rich and relevant content for wider consumer reach, enhanced communication services, technology, and operations, andalong with sustained sales efforts. We will continue to introduce new products and services, including the Windows 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 communication services that help them find discover, and experience whatuse the information and experiences they want online and by providing merchants with effective advertising results through improved systems and sales support.
MobileMicrosoft Business Division
Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Embedded Devices
MobileMicrosoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and Embedded Devices developsorganization productivity through a range of programs, services, and markets products that extendsoftware solutions. Growth of revenue from the Windows platformMicrosoft Office system offerings, which generate over 90% of MBD revenue, depends on our ability to mobile devicesadd value to the core Office product set and to continue to expand our product offerings in other information worker areas such as PDAscontent management, enterprise search, collaboration, unified communications, and phones,business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and to embedded devices. Microsoft’s visionanalytics applications for mobile devices is rooted insmall and mid-size businesses, large organizations, and divisions of global enterprises.
We evaluate MBD results based upon the convergencenature of the computingend user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and wireless industries,Microsoft Dynamics revenue; and consumer revenue, 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 is also responsible for managing our company-wideincludes revenue from retail packaged product sales and customer relations with device manufacturersOEM revenue. Approximately 80% of MBD revenue is generated from sales to businesses. Revenue from this category generally depends upon the number of information workers in a licensed enterprise and other communication-sector customers, which includes network service providersis therefore relatively independent of the number of PCs sold in a given year. Approximately 20% of MBD revenue is derived from sales to consumers. Most of this revenue is generated from new licenses acquired through fully packaged products and medialicenses sold through OEMs for new PCs and entertainment companies. Windows Embedded is a suitegenerally affected by the level of operating systems, tools,PC shipments and technologies that are specifically designed for today’s advanced embedded devices.product launches.
Products:Products: Windows Mobile software platform; Windows Embedded device operating system;Microsoft Office; Microsoft Office Project; Microsoft Office Visio; Microsoft Office SharePoint Server; FAST ESP; Microsoft Exchange Server; Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communications Server; Microsoft Office Communicator; Microsoft Tellme Service; Microsoft Dynamics ERP products including AX, NAV, GP, SL, Retail Management System, and Windows Automotive.
Competition
Windows Mobile software faces substantial competition from Nokia, Openwave Systems, Palm, QUALCOMM, Research In Motion,Point of Sale; Microsoft Dynamics CRM; and Symbian. The embedded operating system segment 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. We also compete by providing a flexible platform that allows customers and partners to build differentiated and profitable business models, and by providing end users with benefits such as ease of use, personal productivity, and better information management and control.Microsoft Dynamics CRM Online.
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Home and EntertainmentCompetition
HomeCompetitors to the Microsoft Office system include many software application vendors such as Adobe, Apple, Corel, Google, IBM, Novell, Oracle, Red Hat, Zoho, and local application developers in Asia and Europe. Apple may distribute certain versions of its application software products with various models of its PCs and through its mobile devices. Corel (WordPerfect Suite) and IBM (Smartsuite) have measurable installed bases with their office productivity products. Corel’s suites, and many local software suites around the world, are aggressively priced for OEMs to preinstall them on low-priced PCs. Google provides Google Apps, a hosted messaging and productivity suite that competes with Microsoft Office, Microsoft Exchange, and Microsoft SharePoint Server, and also provides an enterprise search offering that competes with Microsoft Search Server. IBM competes with Office system products with its Notes and Workplace offerings. 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 Microsystems. Web-based offerings such as 37Signals, Adobe, AjaxWrite, gOffice, ShareOffice, Socialtext, ThinkFree, Zoho, or other small projects competing with individual applications, can also provide an alternative to Microsoft Office system products. Our Microsoft Dynamics products 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 is intensely competitive with a small number of primary vendors including Oracle and SAP. Additionally, Salesforce.com’s on-demand customer relationship management offerings compete directly with Microsoft Dynamics CRM Online and Microsoft Dynamic CRM’s on-premise offerings.
As we continue to respond to market demand for additional functionality and products, we will compete with additional vendors, most notably in content management and enterprise search, collaboration tools, unified communications, and business intelligence. These competitors include Autonomy, Cisco, Endeca, Google, IBM, Oracle, and SAP. We believe our products compete effectively with all of these vendors based on our strategy of providing flexible, easy to use solutions that work well with technologies our customers already have.
Entertainment and Devices Division
The Entertainment and Devices Division (“EDD”) is responsible for development, production,developing, producing, and marketing for the Xbox video game system, including consoles and accessories, third-party games, games published under the Microsoft brand, and Xbox Live operations, as well as research, and sales, and support.support of those products. In addition to Xbox, we offer several types ofEDD offers the Zune digital music and entertainment products, includingdevice and accessories; PC software games,games; online games,games; Mediaroom, our Internet protocol television software; the Microsoft Surface computing platform; and other devices. The segmentmobile and embedded device platforms. EDD also leads the development efforts of our Consumer Productivity Experience Group (“CPxG”) which includes Microsoft’s line of consumer software and hardware products such as the Encarta line of learning products and services,including application software for Macintosh computers and Microsoft PC hardware products, such as mice and keyboards. In addition, the segment carries outis responsible for 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 CPxG products. It also is responsible for the development, sales, and deployment of Microsoft’s TV platform products for the interactive television industry, including MSTV Foundation Edition and Internet Protocol TV products.systems.
Products:Products: Xbox 360; Xbox;360 console and games; Xbox Live; CPxG (consumerZune; Mediaroom; numerous consumer software and hardware products)products (such as mice and keyboards); Windows Mobile software and IPTV.services platform; Windows Embedded device operating system; Windows Automotive; and the Microsoft Surface computing platform.
Competition
The homeEntertainment and entertainment business isdevices businesses are 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 5five to 710 years. We released Xbox 360, our nextsecond generation console, in November 2005. Nintendo and Sony have also announcedreleased new versions of their game consoles which have not been released. Success in late 2006. We believe the transition to the next generationsuccess of video game consoles will depend onis determined by the availability of games for the console, providing exclusive game content that gamers seek, the computational power and reliability of the console, and the ability to create new revenue sources such as advertisingexperiences via online services, downloadable content, and downloadable content.peripherals. We believe
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think the Xbox 360 is positioned well against competitive console products based on significant innovation in hardware architecture, new developer tools, expanded revenue sources,online gaming services, and continued strong exclusive content from our own game franchises such as Halo.franchises.
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. Zune competes with Apple and other manufacturers of digital music and entertainment devices. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners. Our MSTV businessMediaroom faces competition primarily from ad hoc solutionsa variety of competitors that address sub-segmentsprovide elements of the TVan Internet protocol television delivery platform, but that do not provide end-to-end solutions for the network operator. Windows Mobile software and services faces substantial competition from Apple, Google, Nokia, Openwave Systems, Palm, QUALCOMM, Research In Motion, and Symbian. The embedded operating system business is highly fragmented with many competitive offerings. Key competitors include IBM, Intel, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software.
OPERATIONS
To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we “localize”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 EMEAEuropean, Middle Eastern, and African region; the center in Singapore supports the Japan, Greater China and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, and RedmondNevada support NorthLatin America and LatinNorth America. In addition to the operational centers, we also operate data centers throughout the United States and in Europe.
We contract most of our manufacturing activities to third parties who produce thefor Xbox 360 and related games, Zune, various retail software packaged products, and Microsoft hardware.hardware to third parties. 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.Company. Although we have chosen to initially source these key Xbox 360 components from
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a single supplier, we are under no obligation to exclusively source components from these vendors in the future. 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 components, and are often able to acquire component parts and materials on a volume discount basis.
PRODUCTRESEARCH AND DEVELOPMENT
During fiscal years 2006, 2005,2009, 2008, and 2004,2007, research and development expense was $6.58$9.0 billion, $6.10$8.2 billion, and $7.74$7.1 billion, respectively. ThoseThese amounts represented 14.9%15%, 15.3%14%, and 21.0%14%, respectively, of revenue in each of those years. We plan to continue to make significant investmentinvestments in a broad range of research and product development.development efforts.
MostWhile most of our software products are developed internally. Weinternally, we also purchase technology, license intellectual property rights, and oversee third-party development and localization of certain products. We 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. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. Generally, we also create product documentation internally. We strive to obtain information at the earliestas early as possible time about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing.
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Investing in Business and Product Development Strategy.
Innovation is a key factor affectingthe foundation for Microsoft’s growth. In fiscal year 2006,success. Our model for growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we received our 5,000th patent.develop and market. We continuemaintain our long-term commitment to research and development including advanced work aimed at innovations inacross a wide spectrum of technologies:technologies, tools, and platforms;platforms spanning communication collaboration and expression;collaboration; information access and organization; entertainment; business and e-commerce; advertising; and devices. Through innovations in these areas,
Increasingly, we expectare taking a global approach to grow revenue via three principal strategies:
We invest in innovation by focusing on the emerging markets.
Based on our assessment of key technology trends and our broad focus on long-term research and development of new opportunities. One exampleproducts and services, areas where we see significant opportunities to drive future growth include:
Cloud computing and software plus services
The ability to combine the power of desktop and server software with the reach of the Internet is unifiedcreating important opportunities for growth in almost every one of our businesses. Accordingly, we are focused on innovation and broadening our platform to develop a cloud computing ecosystem that positions us for success in areas including virtualization, management, and security identity. We are also focused on delivering end-to-end experiences that connect users to information, communications, which brings together telephony, email, instant messaging,entertainment, and people in new ways across their lives at home, at work, and the broadest possible range of mobile scenarios through investments in datacenters; new versions of Windows and Office that are designed to support a wide range of connected scenarios; solutions for businesses that can be deployed by a customer, by a service provider like Microsoft, or by a Microsoft partner; tools for developers and Web designers; and consumer products including Xbox 360 and Zune.
Natural user interfaces
The next few years will also see dramatic changes in the way people interact with technology as touch, gestures, handwriting, and speech recognition become a normal part of how we control devices. This will make technology more accessible and simpler to use and will create opportunities to reach new markets and deliver new kinds of computing experiences. Our long-term investments in natural user interfaces can be seen in products like Windows 7, the Microsoft Auto software platform, and Microsoft Surface.
New scenario innovation
Continuing improvement in the power of computers and devices and Web conferencing, in orderthe speed and ubiquity of networks is creating opportunities to streamline the way workers communicate. We believe new enterprise information management toolsdeliver innovation that will help knowledge workers create, find, use, and share business information more quickly and more effectively. In addition, we’ll offer new security capabilities, improved management products, and new development tools. We recently entered the high-performance computing business and we have new offerings and initiatives in industries such as life sciences and manufacturing.
Leading the Software Services Transformation
Internet-based servicesexample, computing will connect personal health information to medical research and help make healthcare more preventive, personalized, and cost-effective. Today, Microsoft products such as HealthVault and Amalga help individuals manage their personal health and enable healthcare professionals to integrate research and health information so they can deliver more effective care. We also believe that we are transforming the way people create, deploy, manage and use technology. We are committed to playingentering a leadershipperiod where personal computers will play an increasingly important role in the software services transformation through our efforts to create our services platform for the next generationvirtually every field of applications, communications,scientific research and commerce. Across the company, software services are at the core of our development efforts.discovery.
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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 Live Academic Search. We introduced new and enhanced services for computer safety and computer maintenance (Windows Live SafetyCenter and Windows Live OneCare), communications (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,
Intelligent computing
As computing power increases, 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 continueability to build out our services infrastructure, providingsoftware that has the intelligence to understand a user’s preferences based on the tools and information they have accessed in the past and anticipate their future needs is rapidly improving. This development will enable us to deliver a new toolsgeneration of software solutions that make people more productive by enabling them to help partnersfocus more on what they want to accomplish and businesses create and host services, and adding new data centersless on the steps needed to meet growing consumer demand for services.use technology.
DISTRIBUTION, SALES, AND MARKETING
We distribute our products primarily through the following channels: OEM; distributors and resellers; and online.
OEM. Our operating systems are licensed primarilyOEM
We license our software to OEMs under agreements that grantfor distribution as pre-installed software on new PCs. The most significant part of the OEMsOEM business for us is licensing of the right to build computing devices based on ourWindows operating systems, principally PCs. Under similar arrangements, wesystem. We also market and license certain server operating systems, desktop applications hardware devices,such as our Office productivity suite, and consumer software products and we market hardware devices, and software as services including our Windows Live Essentials suite to OEMs. We have OEM agreements covering one or more of our products with virtually all of the major PC OEMs, including Acer, ASUSTek, Dell, Fujitsu, Fujitsu Siemens Computers, Gateway, Hewlett-Packard, Lenovo, NEC, Samsung, Sony, and Toshiba. A substantial amount of OEM business is also conducted with system builders, which are low-volume, customized PC vendors operating in local markets.
Distributors and Resellers.Resellers
We 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”), direct market resellers, and value-added resellers (“VARs”). Many organizations that license products through enterprise agreements (“EAs”) transact directly with us, with sales support from our Enterprise Software Advisor channel partners. These Enterprise Software Advisors typically are also authorized as LARs and operate as resellers for our other licensing programs. Although each type of reselling partner reaches organizations of all sizes, LARs are primarily engaged with large organizations and VARs typically reach the breadth of small- and medium-sized organizations. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Insight Enterprises, Software House International, and Software Spectrum.Insight Enterprises. Our business solutionsMicrosoft Dynamics 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, Target, and Wal-Mart. We have a network of field sales representatives and field support personnel that solicits orders from distributors and resellers and provides product training and sales support.
Our arrangements for organizations to acquire multiple licenses of products are designed to provide them with a means of 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 include:
Open.Open licensing
Designed primarily for small-to-medium organizations (5 to over 250 licenses), this program allowsthese programs allow customers to acquire perpetual or subscription licenses and, at the customer’s election, rights to future versions of software products over a specified time period (generally two years)(two or three years depending on the Open program used). The offering that conveys rights to future versions of certain software productproducts over the contract period is called software assurance. Software Assurance. Software Assuranceassurance 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.software assurance. They can also renew Software Assurancesoftware assurance upon the expiration of existing volume licensing agreements.
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Select.Select licensing
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 trainingassurance over a specified time period (generally three years)years or less to align to the end of the agreement term). Similar to the Open program, the Select program allows customers canto acquire licenses only, acquire licenses with Software Assurance,software assurance, or renew Software Assurancesoftware assurance upon the expiration of existing volume licensing agreements.
Enterprise agreement licensing
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Enterprise Agreement. The Enterprise Agreement isagreements are targeted at medium and large organizations (greater than 250 licenses) that want to acquire perpetual licenses to software products, along with software assurance, for all or substantial parts of their enterprise, along with rightsenterprise. Enterprises can elect to future versions of certain software products, support, tools, and training overeither acquire perpetual licenses or, under the Enterprise Subscription program, can acquire non-perpetual, subscription agreements for a specified time period (generally three years).
Online
Online Services.We have an expanding portfolio of products, services, and solutions that we distribute online. We provide online content and services through Bing, Windows Live, Office Live, our MSN portals and other online channels. MSN delivers Internet accesschannels, and the Microsoft Online Services platform, which includes offerings for businesses such as cloud-hosted Exchange, SharePoint, and Office Communications. OSB provides various premium services to consumers and tools to consumers. MSN also delivers online e-mailbusinesses, such as email and messaging communication services and information servicestools such as online search, advertising, and premium content. Home and Entertainment operatesEDD offers the Xbox Live service which allows customers to participate in the gaming experience online with other subscribers online. Microsoft Business Solutions operatessubscribers. We also offer the Microsoft Small Business Center portal which is delivered online. This portal provides tools and expertise for small-business owners to build, market, and manage their businesses online. Other services delivered online include Microsoft Developer Networks subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling our products and solutions.
CUSTOMERS
Our customers include individual consumers, small and medium-sized organizations, enterprises, governmental institutions, educational institutions, Internet Service Providers,service providers, application developers, and OEMs. Consumers and small- and medium-sized organizations obtain our products primarily through resellers and OEMs. SalesNo sales to Dell and its subsidiaries in the aggregatean individual customer accounted for approximately 11%more than 10% of fiscal year 2006 and 10% in each of fiscal year 2005 and 20042009, 2008, or 2007 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.
EXECUTIVE OFFICERS OF THE REGISTRANT
Our executive officers as of August 25, 2006July 29, 2009 were as follows:
Name | Age | Position with the Company | ||
| ||||
Steven A. Ballmer | Chief Executive Officer | |||
Robert J. (Robbie) Bach | President, | |||
Lisa E. Brummel | Senior Vice President, Human Resources | |||
| 45 | |||
Christopher P. Liddell | Senior Vice President and Chief Financial Officer | |||
| President, | |||
Robert L. Muglia | 49 | President, Server and Tools Business | ||
Craig J. Mundie | 60 | Chief Research and Strategy Officer | ||
Raymond E. Ozzie | 53 | Chief Software Architect | ||
Steven Sinofsky | 43 | President, Windows Division | ||
Bradford L. Smith | Senior Vice | |||
| 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.
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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. HeMr. Ballmer 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 since 1997, and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined Microsoft in 1988.
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Ms. Brummel was named Senior Vice President, Human Resources in December 2005. She had been Corporate Vice President, Human Resources since AprilMay 2005. From 1995May 2000 to AprilMay 2005, she had been Corporate Vice President of the Home & Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of 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.
Mr. JohnsonElop was named Co-President,President, Microsoft Platforms and ServicesBusiness Division in SeptemberJanuary 2008. Prior to joining the Company, Mr. Elop served as Chief Operating Officer of Juniper Networks, Inc. from January 2007 to January 2008. From December 2005 to December 2006, he served as President of Worldwide Field Operations at Adobe Systems Inc. Mr. Elop joined Adobe following the 2005 acquisition of Macromedia Inc., where he was President and Chief Executive Officer from January 2005 to December 2005. He had been GroupDuring his almost eight-year tenure at Macromedia, Mr. Elop held many senior positions, including Chief Operating Officer, Executive Vice President of Worldwide Sales, MarketingField Operations and Services 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.General Manager of Macromedia’s eBusiness division.
Mr. Liddell was named Senior Vice President and Chief Financial Officer of the Company in May 2005. Mr. Liddell served as Senior Vice President and Chief Financial Officer of International Paper Company sincefrom March 2003 through April 2005, and prior to becoming Chief Financial Officer, he held the positions of 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.
Dr. Lu joined Microsoft in January 2009 as President, Online Services Division. Prior to joining the Company, Dr. Lu was a senior executive at Yahoo!, Inc. for 10 years. His roles included serving as Executive Vice President of Engineering for Yahoo!’s Search and Advertising Technology Group and Vice President of Engineering.
Mr. RaikesMuglia was named President, MicrosoftServer and Tools Business Division in September 2005.January 2009. He had been GroupSenior Vice President, Information WorkerServer and Tools Business since June 2004.October 2005. Before holding that position, he had beena number of leadership positions at Microsoft, including Senior Vice President, Enterprise Storage Division since November 2001, Group Vice President, Productivity and BusinessPersonal Services Group since August 2000, and Group Vice President, SalesBusiness Productivity since December 1999, Senior Vice President, Business Productivity since March 1999, Senior Vice President, Applications and SupportTools since July 1998.February 1998, and Corporate Vice President, Server Applications since 1997. Mr. RaikesMuglia joined Microsoft in 1981.1988.
Mr. Mundie was named Chief Research and Strategy Officer in June 2006. He had been Senior Vice President and Chief Technical Officer, Advanced Strategies and Policy since August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. Mr. Mundie joined Microsoft in 1992.
Mr. Ozzie was named Chief Software Architect in June 2006. He had been Chief Technical Officer from April 2005 to June 2006. He assumed that role in April 2005 after Microsoft acquired Groove Networks, a collaboration software company he formed in 1997.
Mr. Sinofsky was named President, Windows Division in July 2009. He served as Senior Vice President of the Windows and Windows Live Engineering Group since December 2006 and Senior Vice President, Office from December 1999 to December 2006. He had been Vice President, Office since December 1998. Mr. Sinofsky joined the Office team in 1994, increasing his responsibility with each subsequent release of the desktop suite. Mr. Sinofsky joined Microsoft in 1989.
Mr. Smith was appointednamed 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. HeMr. Smith joined Microsoft in 1993.
Mr. Turner was appointednamed Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President of Wal-Mart Stores, Inc. and President and Chief Executive Officer of the Sam’s Club division of Wal-Mart Stores, Inc.division. 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.
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EMPLOYEES
As of June 30, 2006,2009, we employed approximately 71,00093,000 people on a full-time basis, 44,00056,000 in the United States and 27,00037,000 internationally. Of the total, 28,00036,000 were in product research and development, 21,00026,000 in sales and marketing, 13,00017,000 in product support and consulting services, 2,0005,000 in manufacturing and distribution, and 7,0009,000 in general and administration. Our success is highly dependent on our ability to attract and retain qualified employees. None of our employees are subject to collective bargaining agreements.
AVAILABLE INFORMATION
Our Company Internet address is www.microsoft.com. ThereAt our Investor Relations Web site, www.microsoft.com/msft, we make available free of charge oura variety of information for investors. Our goal is to maintain the Investor Relations Web site as a portal through which investors can easily find or navigate to pertinent information about us, including:
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 suchthat material with or furnish it to the Securities and Exchange Commission (“SEC”).
Our SEC reports can be accessed through theInvestor Central site, an interactive and easily navigable source of information including our business strategies, financial results, and key performance indicators.
Announcements of investor relations sectionconferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of these events are also available.
Press releases on quarterly earnings, product and service announcements, legal developments, and international news.
Corporate governance information including our Web site. articles, bylaws, governance guidelines, committee charters, codes of conduct and ethics, and other governance-related policies.
Other news and announcements that we may post from time to time that investors might find useful or interesting.
Opportunities to sign up for email alerts and RSS feeds to have information pushed in real time.
The information found on our Web site is not part of this or any other report we file with or furnish to the SEC.
Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock.
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 developeddevelop and distributed.distribute. 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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certainCertain “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 exampleSome of open source software is the Linux operating system. Whilethese firms may build upon Microsoft ideas that we believeprovide to them free or at low royalties in connection with 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.interoperability initiatives. 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, andsales, revenue, and operating margins may consequently decline.
Another development is the software-as-a-service business model byunder which companies provide content, and software in the form of applications, data, and related services, over the Internet. Providers useInternet in exchange for revenues primarily from advertising or subscription-based revenue models. Recent advancessubscriptions. An example of an advertising-funded business model is Internet search, where providing a robust
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alternative is particularly important and challenging due to the scale effects enjoyed by a single market dominant competitor. 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.competing software plus services strategies including the Windows Azure Platform, our hosted computing platform designed to facilitate the rapid, flexible and scalable development of cloud-based services. It is uncertain whether these strategies will provebe successful.
An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A competing vertically-integrated model, in which a single firm controls both the software and hardware elements of a product, has been successful with certain consumer products such as personal computers, mobile phones, and digital music players. We also offer vertically-integrated hardware and software products; however, efforts to compete with the vertically integrated model may increase our cost of sales and reduce our operating margins.
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. WhileAlthough we believe the breadth of our businesses and product portfolio offers benefits to our customers that areis a competitive advantage, our competitors that are focused on a narrower product linelines 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 channellow and the non-commercial software model described above have reduced barriers to entry even further.products, once developed, can be distributed broadly and quickly at relatively low cost. Open source software vendors are devoting considerable efforts to developing software that mimics the features and functionality of our products.products, in some cases on the basis of technical specifications for Microsoft technologies that we make available at little or no cost. In response to competitive factors,competition, 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 adequately protect our intellectual property rights against piracy, infringement ofrights. Protecting our patents by third parties, or declining legal protection for intellectual property. We defend ourglobal intellectual property rights and combatcombating unlicensed copying and use of software and other 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 thispiracy adversely affects U.S. revenue, the impact on revenue from outside the United StatesU.S. 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 toTo resolve these claims we 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 suchcustomers. Such agreements or take such actions, ourmay cause operating margins may decline as a result.to decline. 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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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. WhileAlthough we license certain portions of our source code for various software programsapplication and operating systemssystem source code 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 protectionThis 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 also could also increase certainthe security 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. WhileAlthough this is an industry-wide problem that affects computers across all platforms, it affects our products in particular because hackers tend
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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 security vulnerabilities through:
engineering even more secure products, products;
enhancing security and reliability options and settings when we deliver products, and providing guidance to helpfeatures in our products;
helping 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 improveattacks;
improving the deployment of software updates to address security vulnerabilities discovered after our products are released. We are also vulnerabilities;
investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed. We advisedeployed; and
providing 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 and 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. WhileAlthough 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.withstand all legal challenges.
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 close 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 allegedto assert claims of 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 regulatoryvarious constraints on our Windows operating system businesses, includingbusinesses. These constraints include limits on certain contracting practices, requiredmandated disclosure of certain software program interfaces limits on Microsoft’s abilityand protocols, and rights for computer manufacturers to ensurelimit the visibility of certain Windows features in new PCs, and required licensing of certain communications protocols. While wePCs. We believe we currently are in full compliance with the Decree and Judgment,these rules. However, if we fail to comply with them, in the future additional restrictions could be imposed on us that would adversely affect our business.
The European Commission closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. In March 2004, the European Commission determined that we mustordered us to 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 proprietary Windows communications protocols supported in Windows. Microsoft has appealed both determinationstheir own products. The Commission’s impact on product design may limit our ability to European courts. As a resultinnovate in Windows or other products in the future, diminish the developer appeal of the Commission decision, we have incurredWindows platform, and will (absent a reversal of this ruling) continue to incur duplicativeincrease our product 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 related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of Microsoft’sour own products which could result in a reduction indecreased sales of our products. Pending resolution of Microsoft’s appeal, there will remain uncertainty about the legal principles that govern
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 governmentGovernment regulatory effortsactions and court decisions such as these may hinder or delay our ability to provide thesethe benefits of our software to consumers and businesses, thereby reducing the attractiveness of our products and the revenues that come from them. Moreover, there always remains the risk of new legal action,New actions could be initiated at any time, either by these or other governments or private claimants, including with respect to productsnew versions of Windows or features that haven’t been scrutinized or been the subject of objections in the past.other Microsoft products. The outcome of such legal actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including:
We may have to designchoose between withdrawing products from certain geographies to avoid fines or developdesigning and developing alternative versions of those products for specific geographical markets to removecomply with government rulings, which may entail a delay in a product release and removing functionality that customers want or limit visibility of certain functionality, resulting in reduced customer benefits or additional costs and delays in the release of product lines or specific product versions.on which developers rely.
We may be required to make available licenses to our software may cause confusionproprietary technologies on terms that harmsdo not reflect their fair market value or do not protect our reputation, including among consumers and with third-party software and Web site developers who rely on the functionality removed from these alternative versions.associated intellectual property.
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Part I
Item 1A
Our software and services online offerings are subject to government regulation of the Internet domestically and internationally in many areas, such asincluding user privacy, telecommunications, 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 conductingstop doing the alleged 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 and leaders 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. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution.
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. Our increasing focus on software plus services also presents new and complex development issues. Significant delays in new product or service releases or significant problems in creating new products or services could adversely affect our revenue.
We make significant investments in new products and services that may not be profitable. Our growth depends on our ability to innovate by offering new, and adding value to our existing, software and service offerings. We have made and will continue to make significant investments in research, development, and marketing for new products, services, and technologies, including the Windows Vista,PC operating system, the 2007 Microsoft Office system, Xbox 360, MSNLive Search, Windows Server, Zune, Windows Live, the Windows Azure Services platform, and Windows Live.other software plus services offerings. Investments in new technology are inherently speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. SignificantIf customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software products or upgrades, unfavorably impacting revenue. We may not achieve 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.
Part I
Item 1A
DeclinesAdverse economic conditions may harm our business. Unfavorable changes in demand for software could occur.economic conditions, including inflation, recession, or other changes in economic conditions, may result in lower information technology spending and adversely affect our revenue. If overall market demand for PCs, servers, and other computing devices declines, significantly, or consumer or corporatebusiness spending for suchthose products declines, our revenue will be adversely affected. In addition,Our product distribution system also relies on an extensive partner network. The impact of economic conditions on our revenue wouldpartners, such as the bankruptcy of a major distributor, could result in sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, reserves for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be unfavorably impacted if customers reduce their purchasesexacerbated by unusual events that have affected global financial markets. If global credit and equity markets experience prolonged periods 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,decline, our revenue and operating margins couldinvestment portfolio may be adversely affected.impacted and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely impact our financial results.
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 thethese 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. WhileAlthough 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, or cash flows, 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 aA material adverse impact on our financial position, and the results of operations, or cash flows also could occur for the period in which the effect of an unfavorable final outcome becomes probable and reasonably estimable.
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Part I
Item 1A
We may have additional tax liabilities. We are subject to income taxes in both the United States and numerousmany 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 regularly 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 theThe results of an audit or litigation could have a material effect on our income tax provision, net incomefinancial position, results of operations, or cash flows in the period or periods for which that determination is mademade. In addition, there have been proposals to reform U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. We earn a substantial portion of our income in foreign countries. Although we cannot predict whether or in what form this proposed legislation will pass, if enacted it could result.have a material adverse impact on our tax expense and cash flow.
WeOur vertically-integrated hardware and software products may be at risk of having insufficient supplies of certain Xbox 360 componentsexperience quality or console inventory.supply problems Some components of. Our hardware products such as the Xbox 360 console are obtainedhighly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or effectively address such issues through design, testing, or warranty repairs. We obtain some components of our hardware devices from a single supplier and others may be subject to an industry-wide supply shortage.sole suppliers. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be unable to obtain timely replacement supplies, on a timely basis, resulting in reduced console and game sales. Components are ordered based on forecasted console demand so we may experienceEither component shortages for the Xbox 360 or alternatively, excess consoleor obsolete inventory that may require us to record charges to cost of revenue. Xbox 360 consoles will beare assembled in Asia; disruptions in the supply chain may result in console shortages that would affect our revenues and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer.
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
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; unexpectedinvestment, including the Foreign Corrupt Practices Act and local laws prohibiting corrupt payments; and changes in regulatory requirements for software;software. Emerging markets are a significant focus of our international growth strategy. The developing nature of these markets presents a number of risks. Deterioration of social, political, labor, or economic conditions in a specific country or region;region and difficulties in staffing and managing foreign operations. Whileoperations may also adversely affect our operations or financial results. Although 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 or geo-political conditions may disrupt our business. We are a highly automated business and aA disruption or failure of our systems or operations in the event of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, and providing services.services, or performing other mission-critical functions. 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 affectharm our ability to conduct normal business operations and asour operating results. Abrupt political change, terrorist activity, and armed conflict pose a result,risk of general economic disruption in affected countries, which may increase our future operating results could be adversely affected.costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers.
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Part I
Item 1A, 1B, 2, 3, 4
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 theour 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 factorsevents could adversely affectharm 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 significantlarge amounts of personally identifiable information as we offer a large array of products and services to our customers.information. 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 and services also enable our customers to store and process personal data. Perceptions that our products or services do not adequately protect the privacy of personal information could inhibit sales of our products.
Other risks thatWe may affectexperience outages and disruptions of our business.online services if we fail to maintain an adequate operations infrastructure. Other factors that may affectOur increasing user traffic and complexity of our performance may include:
Part I current and potential users, subscribers, and advertisers, harming our operating results and financial condition.
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 20062009 that remain unresolved.
Our corporate offices consist of approximately 11.015 million square feet of office building space located in King County, Washington: 8.5ten million square feet of owned space that is situated on approximately 500 acres of land we own inat our corporate campus in Redmond, Washington and approximately 2.5five million square feet of space we lease. We own approximately 533,000two million square feet of office buildingand datacenter space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately 2.7four million square feet of office buildingand datacenter space.
We occupy many sites internationally, totaling approximately 6.9two million square feet that is leasedowned and approximately 883,000nine million square feet that is owned. These facilitiesleased. Facilities that we own include our European Operations Center that leases a 187,000 square foot campus in Dublin, Ireland,Ireland; the India Development Center in Hyderabad, India; and a 56,000 square footfacility in Reading, UK. The largest leased office spaces include the following locations: Beijing and Shanghai, China; Bangalore, India; Dublin, Ireland; Tokyo, Japan; Mississauga, Canada; Taipei, Taiwan; Seoul, Korea; Sydney, Australia; and Milan, Italy. In addition to the above locations, we have a disk duplication and digital distribution facility in Humacao, Puerto Rico, and a 159,000 square foot facility in Singapore for our Asia Pacific Operations Center and Regional headquarters. Leased office building space includes the following locations: Tokyo, Japan 408,000 square feet; Unterschleissheim, Germany 381,000 square feet; Les Ulis, France 262,000 square feet; Reading, England 241,000 square feet;headquarters, and Mississauga, 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”the “Research and Development” section above.
Our facilities are fully used for current operations of all segments, and suitable additional space isspaces are 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 ana development agreement with the City of Redmond under which we may currently develop an additional 2.2approximately 1.6 million square feet of additional facilities at our corporate campus in Redmond, Washington. In addition, we own 63 acres of undeveloped land in Issaquah, Washington, that can accommodate approximately one million square feet of office space.
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 17 – Contingencies in “Item 8.of the Notes to Financial Statements and Supplementary Data”(Part II, Item 8) for information regarding other legal proceedings in which we are involved.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of fiscal year 2006.2009.
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Part II
Item 5
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded on Thethe NASDAQ Stock Market under the symbol MSFT. On August 18, 2006,July 27, 2009, there were 148,993142,468 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows:
Quarter Ended | Sep. 30 | Dec. 31 | Mar. 31 | June 30 | Year | Sep. 30 | Dec. 31 | Mar. 31 | June 30 | Year | ||||||||||||||||||||
Fiscal year 2005 | ||||||||||||||||||||||||||||||
Fiscal year 2009 | ||||||||||||||||||||||||||||||
Common stock price per share: | ||||||||||||||||||||||||||||||
High | $ | 29.00 | $ | 29.98 | $ | 26.84 | $ | 26.07 | $ | 29.98 | $ | 28.50 | $ | 27.47 | $ | 21.00 | $ | 24.34 | $ | 28.50 | ||||||||||
Low | 26.88 | 26.53 | 23.92 | 24.12 | 23.92 | $ | 23.50 | $ | 17.50 | $ | 14.87 | $ | 18.18 | $ | 14.87 | |||||||||||||||
Fiscal year 2006 | ||||||||||||||||||||||||||||||
Fiscal year 2008 | ||||||||||||||||||||||||||||||
Common stock price per share: | ||||||||||||||||||||||||||||||
High | $ | 27.76 | $ | 28.16 | $ | 28.15 | $ | 27.74 | $ | 28.16 | $ | 31.84 | $ | 37.50 | $ | 35.96 | $ | 32.10 | $ | 37.50 | ||||||||||
Low | 24.65 | 24.30 | 26.28 | 21.51 | 21.51 | $ | 27.51 | $ | 29.29 | $ | 26.87 | $ | 27.11 | $ | 26.87 |
DIVIDENDS AND SHARE REPURCHASES
See Note 1218 – Stockholders’ Equity of the Notes to Financial Statements (Item(Part II, Item 8) for information regarding dividends approved by our Board of Directors in fiscal years 2006 and 2005.
On July 20, 2006, we announced the completion of the 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:share repurchases.
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 announced 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 shares 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 repurchase additional shares in an amount up to $36.2 billion through June 30, 2011.
ITEM 6. SELECTED FINANCIAL DATA
FINANCIAL HIGHLIGHTS
(In millions, except per share data) | |||||||||||||||||||||||||||||||
Fiscal Year Ended June 30 | 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||||||||||||||
Fiscal Year Ended June 30, | 2009 | 2008 | 2007 | 2006 | 2005 | ||||||||||||||||||||||||||
Revenue | $ | 44,282 | $ | 39,788 | $ | 36,835 | $ | 32,187 | $ | 28,365 | $ | 58,437 | $ | 60,420 | $ | 51,122 | $ | 44,282 | $ | 39,788 | |||||||||||
Operating income | 16,472 | 14,561 | 9,034 | 9,545 | 8,272 | $ | 20,363 | $ | 22,271 | $ | 18,438 | $ | 16,380 | $ | 14,576 | ||||||||||||||||
Net income | 12,599 | 12,254 | 8,168 | 7,531 | 5,355 | $ | 14,569 | $ | 17,681 | $ | 14,065 | $ | 12,599 | $ | 12,254 | ||||||||||||||||
Diluted earnings per share | $ | 1.20 | $ | 1.12 | $ | 0.75 | $ | 0.69 | $ | 0.48 | $ | 1.62 | $ | 1.87 | $ | 1.42 | $ | 1.20 | $ | 1.12 | |||||||||||
Cash dividends declared per share | $ | 0.35 | $ | 3.40 | $ | 0.16 | $ | 0.08 | $ | – | $ | 0.52 | $ | 0.44 | $ | 0.40 | $ | 0.35 | $ | 3.40 | |||||||||||
Cash and short-term investments | 34,161 | 37,751 | 60,592 | 49,048 | 38,652 | ||||||||||||||||||||||||||
Cash and cash equivalents and short-term investments | $ | 31,447 | $ | 23,662 | $ | 23,411 | $ | 34,161 | $ | 37,751 | |||||||||||||||||||||
Total assets | 69,597 | 70,815 | 94,368 | 81,732 | 69,910 | $ | 77,888 | $ | 72,793 | $ | 63,171 | $ | 69,597 | $ | 70,815 | ||||||||||||||||
Long-term obligations | 7,051 | 5,823 | 4,574 | 2,846 | 2,722 | $ | 11,296 | (a) | $ | 6,621 | $ | 8,320 | $ | 7,051 | $ | 5,823 | |||||||||||||||
Stockholders’ equity | 40,104 | 48,115 | 74,825 | 64,912 | 54,842 | $ | 39,558 | $ | 36,286 | $ | 31,097 | $ | 40,104 | $ | 48,115 |
(a) | Includes $3.75 billion of debt securities issued in May 2009. See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8). |
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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, 2005,2009, 2008, AND 20042007
OVERVIEWOverview
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft 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,generate revenue by developing, manufacturing, licensing, and supportsupporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for personal computers, servers, PCs, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; andhigh-performance computing applications; software development tools.tools; and video games. We provide consulting and product support services, and we train and certify computer system integrators and developers. We also design and sell hardware, including the Xbox 360 video game console, the Zune digital music and games, PC games,entertainment device, and PC peripherals. Online communicationofferings and information services are delivered through Bing, Windows Live, Office Live, our MSN portals and channels, aroundand the world.Microsoft Online Services platform, which includes offerings for businesses, such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on Bing through our proprietary adCenter platform.
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 HomeEntertainment and Entertainment segmentDevices Division is particularly subject to seasonalityseasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, Homethe Entertainment and EntertainmentDevices Division has generated overapproximately 40% of its yearlyannual segment revenues in our second fiscal quarter. We believeIn fiscal year 2007, our revenue was highest in the seasonalitythird quarter due to the recognition of $1.7 billion of revenue previously deferred from the Express Upgrade to Windows Vista and Microsoft Office Technology Guarantee programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system. The technology guarantee programs provided customers who purchased current products with free or discounted rights to Windows Vista and the 2007 Microsoft Office system when those products became available to consumers.
The unfavorable global economic environment adversely affected our business in fiscal year 2009 as consumers and businesses cut back on spending, which reduced PC shipments and IT investments. But because we offer a wide range of products that enable companies to improve productivity and reduce costs, and because we have a strong pipeline of products, including new versions of Windows and Office planned for release in fiscal year 2010, we believe that Microsoft is likelywell-positioned to continueweather the economic downturn. As the global economy improves, this will create new opportunities to increase revenue. To further help weather the economic downturn, in fiscal year 2009 we made important adjustments to our cost structure and streamlined internal business processes.
Technological innovation is the future.
Wefoundation of our long-term growth and we intend to sustain the long-term growth ofmaintain our businesses through technological innovation,commitment to investment in research and development, engineering excellence, and a commitment to delivering high-quality products and services to customers and partners. Recognizing that one of our primary challengesbusiness objectives 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 increasingremain focused on selling our focus onproducts in emerging markets and reducing the amount of unlicensed software used in those markets. In addition, we
We also continue to develop innovative software applications and solutions that we believe will enhance theinformation worker 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 growth in the growthface 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 – thesoftware that is easiest to deploy and manage, and that is most secure – with the lowest total cost of ownership.
WeIn addition, we continue to invest in research and development in existing and new lines of business, including cloud computing, search, online solutions, business solutions, mobile computing, communication, entertainment,
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Part II
Item 7
and othersother areas that we believe may contribute to our long-term growth. We also invest in research and developdevelopment of 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 laidThis long-term focus on investment in research and development has enabled us to lay a foundation for long-termfuture growth by delivering innovative products, creating opportunities for partners, and improving customer satisfaction with key audiences, putting some of our most significant legal cases behind us, and improving our internal business processes.satisfaction. Our focus in fiscal year 20072010 is buildingto build on this foundation and executingto continue to execute well in key areas including continuing to innovatethrough ongoing innovation on our integrated software platform, by responding effectively to customer and partner needs, and continuing to focusby focusing internally on product excellence, business efficacy, and accountability across the company.
Key market opportunities include:
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Worldwide macroeconomic factors have a strong correlation to business and consumer demand for our software, services, games and Internet service offerings. We expect a broad continuation in the economic conditions and demand in fiscal year 2007 as compared to fiscal year 2006.
As open source software development and distribution evolves, we continue to seek to differentiate our products from competing products that are based on open 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, 2005,2009, 2008, and 20042007
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | |||||||||||||||||||||
(In millions, except percentages and per share amounts) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | |||||||||||||||||||||
Revenue | $ | 44,282 | $ | 39,788 | $ | 36,835 | 11% | 8% | $ | 58,437 | $ | 60,420 | $ | 51,122 | (3)% | 18% | ||||||||||
Operating income | $ | 16,472 | $ | 14,561 | $ | 9,034 | 13% | 61% | $ | 20,363 | $ | 22,271 | $ | 18,438 | (9)% | 21% | ||||||||||
Diluted earnings per share | $ | 1.62 | $ | 1.87 | $ | 1.42 | (13)% | 32% |
Our revenue growth forFiscal year 2009 compared with fiscal year 2006 was2008
Revenue declined across most segments primarily driven primarily by growth in SQL Server following the launch of SQL Server 2005weakness in the second quarter, Windows Serverglobal PC market and other server applications, increased Xbox revenue resulting from the Xbox 360 launch in the second quarter, growth in licensing of 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.unfavorable economic environment. Foreign currency exchange rates did not haveaccounted for a significant impact on consolidated$486 million or operating segment revenue duringone percentage point increase in revenue. Primary factors contributing to the fiscal year.decline include the following:
Revenue growth for fiscal year 2005 was driven by growth in licensing offrom Windows Server operating systems declined reflecting PC market weakness, especially PCs sold to businesses, 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 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 earnedthe OEM premium mix.
Revenue from our Entertainment and Devices Division decreased across most lines of business including Xbox 360 platform and PC game 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 year 2005 when the contract period expired. Fiscal year 2004 revenue growth waswhich declined primarily driven by the growth in licensing of Windows client operating systems through OEMs, Windows Server operating systems, Office and other server applications as a result of growth in PCdecreased revenue per console due to price reductions during the past 12 months, partially offset by increased console sales and Xbox Live revenue.
The above declines were partially offset by increased server and server hardware shipments. The worldwide PC shipment growth rateapplication revenue, reflecting recognition of deferred revenue from all sources was estimated at 13%previously signed agreements and continued adoption of the Windows server shipment was estimated at 18% in fiscal year 2004 as compared to fiscal year 2003. The net impact of foreign exchange rates on revenue was positive in fiscal year 2004 due to a relative strengthening of most foreign currencies versus the U.S. dollar. This resulted in approximately $1.10 billion growth in total revenue.Server Platform and applications through SQL Server, Enterprise CAL Suites, and System Center products.
Operating income for fiscal year 2006 increaseddecreased primarily reflecting thedecreased revenue. Operating expenses were flat with decreased general and administrative and sales and marketing expenses offset by increased headcount-related expenses, cost of revenue, increase and a $991 million decrease inemployee severance charges.
General and administrative expenses decreased $1.4 billion or 28%, primarily due to decreased costs for legal settlements and contingencies. We incurred $283 million of legal contingencies. These changescharges during the twelve months ended June 30, 2009 as compared to $1.8 billion during the twelve months ended June 30, 2008. The prior year costs were partially offset by a $1.62 billion increase in cost of revenue primarily related to Xbox 360the European Commission fine of $1.4 billion (€899 million).
Sales and marketing expenses decreased $381 million or 3%, primarily driven by the resource management program. As part of that program, we reduced marketing and advertising expenses.
Headcount-related expenses, excluding $330 million of employee severance charges, increased 7%, driven by a $1.26 billion2% increase in salesheadcount during the past 12 months 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 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 $733headcount.
Cost of revenue increased $557 million or 30%5%, primarily 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 Serveronline costs, including online traffic acquisition, data center and Tools, Clientequipment, and Information Worker, which have higher gross margins as compared to other segments; and a reduction in legalheadcount-related costs, associated with major litigation. In addition, strong sales of 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 increaseddecreased Xbox 360 platform costs.
In January 2009, we announced and implemented a resource management program to reduce discretionary operating expenses, employee headcount, and capital expenditures. As part 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 tothis program, we announced the $2.53 billion of charges related to the settlement of Sun
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Microsystems litigation
elimination of up to 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010. During the fine imposed bytwelve months ended June 30, 2009, we recorded employee severance charges of $330 million for the European Commissionexpected reduction in fiscal year 2004. This effect wasemployee headcount.
Diluted earnings per share declined primarily reflecting decreased net income, partially offset by legal expenses of $2.08 billion related to settlementsshare repurchases during the past 12 months. We repurchased 318 million shares during the twelve months ended June 30, 2009.
Fiscal year 2008 compared with IBM, Novell, Gateway, and end-user class action plaintiffs to resolve antitrust issues and other matters. In fiscal year 2004, the operating income decline2007
Revenue growth was causeddriven primarily by $2.53increased licensing of the 2007 Microsoft Office system, increased Xbox 360 platform sales, increased revenue associated with Windows Server and SQL Server, and increased licensing of Windows Vista. Foreign currency exchange rates accounted for a $1.6 billion or three percentage point increase in revenue during fiscal year 2008.
Operating income increased primarily reflecting increased revenue, partially offset by increased headcount-related expenses, increased costs for legal settlements and legal contingencies, and increased cost of revenue. Headcount-related expenses increased 12%, reflecting an increase in headcount during fiscal year 2008. We incurred $1.8 billion of legal charges and $2.21 billion of stock-based compensation expenseduring fiscal year 2008 primarily related to the European Commission fine of $1.4 billion (€899 million) as compared with $511 million of legal charges during fiscal year 2007. Cost of revenue increased $905 million or 8%, reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the growth in our employee stock option transfer program, mainlyconsulting services, partially 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 indecreased Xbox 360 costs. The decreased Xbox 360 costs reflect the second quarter of fiscal year 2004 in which employees could elect to transfer all of their vested and unvested stock options with a 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 resulted in additional stock-based compensation expense of $2.21$1.1 billion in the second 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 upcoming launches of Windows 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%charge in fiscal year 2007 as comparedrelated to fiscal year 2006. We do not expect a significant impact from year-over-year foreign currency exchange ratesthe expansion of our Xbox 360 warranty, partially offset by increased Xbox 360 product costs reflecting growth in unit console sales.
The diluted earnings per share growth was impacted by the $1.1 billion Xbox 360 charge in fiscal year 2007.2007 and share repurchases during fiscal year 2008.
We expectFiscal Year 2010 Outlook
Global macroeconomic factors have a strong correlation to demand for our operating income growth ratesoftware, services, hardware, and online offerings. While we see the potential for improvement in calendar year 2010, we are unable to lagpredict the actual timing. In the meantime, we are positive about our revenue growth raterelative market position and our product delivery plans. In addition, we remain focused on executing in the first halfareas we can control by continuing to provide high value products at the lowest total cost of fiscal year 2007 due to an increasing mix of Xbox 360 console revenue and related costs, coupled with significant investments in preparation for the launches ofownership while managing our flagship products. We expect this trend to reverse in the second half of the fiscal year when we expect operating income to grow faster than revenue.expenses.
SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)
Our 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 2007; the seven segments 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/income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the United States (“U.S. Generally Accepted Accounting Principles (“GAAP”) and include certain reconciling items attributable to each of the segments. The segmentSegment information appearing in Note 1822 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8) is presented on a basis consistent with the Company’sour current internal management reporting, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131,Disclosures about Segments of an Enterprise and Related Information. Certain corporate level expenses havecorporate-level activity has been excluded from our segment operating results and areis analyzed separately. Fiscal years 2005 and 2004Prior period amounts have been restated for certain internal reorganizations andrecast to conform to the fiscal year 2006 presentation.way we internally managed and monitored performance at the segment level during the current period.
Client
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | ||||||||||||||||
Revenue | $ | 13,209 | $ | 12,151 | $ | 11,556 | 9% | 5% | $ | 14,712 | $ | 16,865 | $ | 14,911 | (13)% | 13% | ||||||||||
Operating income | $ | 10,203 | $ | 9,464 | $ | 8,740 | 8% | 8% | $ | 10,856 | $ | 13,105 | $ | 11,424 | (17)% | 15% |
Client offerings consist of premium and standard edition Windows operating systems. Premium editions are those that include additional functionality and are sold at a price above our standard editions. Premium editions include Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, Windows Vista Enterprise,
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Client consists of premium edition operating systems, including
Windows XP Professional, Windows XP Media Center, Edition, Tablet PC Edition, and other standard Windows operating systems, including Windows XP Home. Premium offerings areTablet PC. Standard editions include Windows operating systems sold at a premium aboveVista Home Basic and Windows XP Home. Client revenue growth correlates with theis directly impacted by growth of PC purchases of PCs from OEMsoriginal equipment manufacturers (“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 license units from increased PC unit shipments, partially offset by a $118 million or 6% decrease in revenue from 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 primarily by changes in the mix of OEM Premium Mix,Windows premium edition operating systems licensed as a percentage of total OEM Windows operating systems licensed (“OEM premium mix”). Additional differences in growth rates result from the impact from lower cost netbook PCs, which are sold with a lower cost version of Windows, changes in the geographicalgeographic mix, and changes in the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders.
Fiscal year 2009 compared with fiscal year 2008
Client revenue decreased primarily as a result of PC market weakness, especially PCs sold to businesses. OEM revenue decreased $2.3 billion or 16% while OEM license units declined 2%. The decline in OEM revenue reflects a 10 percentage point decline in the OEM premium mix to 64%. Based on our estimates, total worldwide PC shipments from all sources experienced a decline of approximately 1% to growth of approximately 2%, driven by changes in demand in emerging and developed markets.
Client operating income decreased primarily reflecting decreased revenue and increased sales and marketing expenses. Sales and marketing expenses increased $122 million or 7%, primarily reflecting increased advertising and marketing.
Fiscal year 2008 compared with fiscal year 2007
Client revenue increased reflecting growth in licensing of Windows Vista. By the end of fiscal year 20052008, more than 180 million Windows Vista licenses had been sold (approximately 130 million were sold during fiscal year 2008) and millions of enterprise seats had been deployed. OEM revenue increased $1.8 billion or 14%, driven by 12%16% 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 revenueunits. 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 earnedincreased $202 million or 9%, primarily from Upgrade Advantage declined by $99 millionEnterprise Agreements and anti-piracy efforts in emerging markets. During fiscal year 2005 contributing2008, the OEM premium mix increased seven percentage points to the decrease74%, reflecting strong demand for Windows Vista Home Premium. We estimate total worldwide PC shipments from all sources grew approximately 12% to 14%, driven by demand in commercialboth emerging and retail licensing revenue.mature markets.
Client operating income increased in fiscal year 2006 reflecting the increase in OEMincreased revenue, partially offset by a $224 million increase inincreased 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 year 2005 primarily due to an increase in OEM revenue and a $444 million decrease in stock-based compensation expense. These factors were partially offset by an increase in salescost of revenue. Sales and marketing expenses increased $106 million or 7%, primarily reflecting increased expenses associated with “Start Something,” a globally launched advertising campaign, marketing for security initiatives,our corporate sales force. Cost of revenue increased $116 million or 14%, primarily driven by Windows Vista product costs.
Other
The segment information discussed above is presented the way we internally managed and an increasemonitored performance at the business group level in salaryfiscal years 2009, 2008, and benefits for new2007. Effective July 1, 2009, we reorganized the Windows Live operations from Online Services Business to Client to better align our strategies and existing headcount. The additional headcount for research and development was primarily devoted to the continued development of Windows Vista.focus in those areas.
Server and Tools
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | ||||||||||||||||
Revenue | $ | 11,467 | $ | 9,938 | $ | 8,590 | 15% | 16% | $ | 14,126 | $ | 13,102 | $ | 11,104 | 8% | 18% | ||||||||||
Operating income | $ | 4,323 | $ | 3,291 | $ | 1,474 | 31% | 123% | $ | 5,327 | $ | 4,539 | $ | 3,571 | 17% | 27% |
Server and Tools consistslicenses products, applications, tools, content, and services that are designed to make information technology professionals and developers more productive and efficient. Server and Tools offerings consist of server software licenses and client access licenses (“CAL”) for Windows Server, Microsoft SQL Server, Exchange Server and other server products. ItWe also includesoffer developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting 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 usescan be run on-site, in a partner-hosted environment, or in a Microsoft-
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hosted environment. We use multiple channels for licensing, including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. TheWe sell licenses are sold both as one-time licenses and as multi-year volume licenses. Server and Tools uses product innovation and partnerships
Fiscal year 2009 compared with information technology professionals to drive the adoption and sales growth of its products.fiscal year 2008
Server and Tools revenue increased during fiscal year 2006 mainlyreflecting growth in both product and services revenue. Server and server application revenue (including CAL) and developer tools revenue increased $809 million or 8%, primarily driven by growth in SQL Server, Enterprise CAL Suites, and System Center revenue. This growth reflects recognition of deferred revenue from previously signed agreements and continued adoption of the Windows Server Platform and Core CAL. SQL Server 2005applications. Consulting 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$215 million or 15%8%, 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 productfrom annuity support services revenue increased $241 million or 19% compared to the previous year.agreements. Foreign currency exchange rate changesrates accounted for $284a $140 million or threeone 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%point 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, revenue.
Server and Tools operating income increased primarily due to growth in product revenue, partially offset by increased research and development expenses and cost of revenue. Research and development expenses increased $168 million or 9%, primarily driven by increased headcount-related expenses. Cost of revenue increased $84 million or 3%, reflecting the growth in support, online, and consulting services.
Fiscal year 2008 compared with fiscal year 2007
Server and Tools revenue increased reflecting growth in product and services revenue and included a $1.07favorable impact from foreign currency exchange rates of $464 million or four percentage points. Server and server application revenue (including CAL revenue) and developer tools revenue increased $1.4 billion decreaseor 16%, primarily driven by growth in stock-based compensation expense.volume licensing of Windows Server and SQL Server products. This increase wasgrowth reflects broad adoption of the Windows Platform and applications with the releases of Windows Server 2008 and Visual Studio 2008 during fiscal year 2008. Consulting and Premier product support services revenue increased $593 million or 29%, primarily due to higher demand for consulting and support services by corporate enterprises.
Server and Tools operating income increased primarily due to growth in product revenue, partially offset by increased sales and marketing expenses, cost of revenue, and research and development expenses. Sales and marketing expenses increased $458 million or 13%, due to higher expenses associated with our corporate sales force. Cost of revenue increased $404 million or 19%, reflecting the growth in Consulting and Premier product support services. Research and development expenses increased $177 million or 10%, primarily driven by increased headcount-related expenses. Headcount-related expenses increased 6%, driven by an increase in sales and marketing costs and headcount-related costs as a result of increased headcount and an increase in salaries and benefits for existing headcount.from the prior year-end.
Information WorkerOnline Services Business
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | |||||||||||||||||||
Revenue | $ | 11,756 | $ | 11,169 | $ | 10,748 | 5% | 4% | $ | 3,088 | $ | 3,214 | $ | 2,434 | (4)% | 32% | |||||||||||||
Operating income | $ | 8,285 | $ | 8,025 | $ | 7,458 | 3% | 8% | |||||||||||||||||||||
Operating loss | $ | (2,253 | ) | $ | (1,222 | ) | $ | (604 | ) | (84)% | (102)% |
Information Worker primarilyOnline Services Business (“OSB”) consists of the Microsoft Office system of programs, servers, solutions,an online advertising platform with offerings for both publishers and services designed to increaseadvertisers, 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 areascommunications services, such as enterprise content management, collaboration, unified communications,email and business intelligence.
Information Workerinstant messaging, online information offerings, such as Bing, and the MSN portals and channels around the world. We earn revenue increased inprimarily from online advertising, including search, display, email, messaging services, and advertiser and publisher tools. Revenue is also generated through subscriptions and transactions generated from online paid services digital marketing and advertising agency services, and from MSN narrowband Internet access subscribers (“Access”). During the first quarter of fiscal year 2006 primarily reflecting2008, we completed our acquisition of aQuantive, Inc. (“aQuantive”), a $521 million or 5% increase in volume licensing, retail packaged products, and preinstalled versionsdigital marketing business. aQuantive was consolidated into our results 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, and pre-installed versions of Office in Japan, a $91 million or 6% increase in OEM revenue, andoperations starting August 10, 2007, the 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 three percentage points of the revenue growth for fiscal year 2005, offset by a $663 million decline in Upgrade Advantage earned revenue.acquisition date.
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 an increase in headcount and an increase in salaries and benefits for existing headcount.
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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% |
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 related 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,Fiscal year 2009 compared 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 in fiscal year 2006 driven by new users for Microsoft CRM and existing Dynamics ERP customers purchasing functionality and user licenses. The increase in Microsoft Business Solutions2008
OSB 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 in fiscal year 2006 reflecting the increase in revenue accompanied by a $56 million decrease in sales and marketing expensedecreased primarily as a result of decreased net SMS&P spending.online advertising and access revenue. Online advertising revenue decreased $73 million or 3%, to $2.3 billion, reflecting a decrease in display advertising, partially offset by an increase in search advertising. Access revenue decreased $72 million or 28%, reflecting continued migration of subscribers to broadband or other competitively-priced service providers. Foreign currency exchange rates accounted for a $28 million or one percentage point decrease in revenue.
OSB operating loss increased due to increased cost of revenue and research and development expenses, and decreased revenue. Cost of revenue increased $692 million or 36%, primarily driven by increased online traffic acquisition, data center and equipment, and headcount-related costs. Research and development expenses increased $149 million or 13%, primarily due to increased headcount-related expenses.
Fiscal year 2008 compared with fiscal year 2007
OSB revenue increased driven by increased online advertising revenue and the inclusion of aQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased $550 million or 31%, to $2.3 billion. This increase reflects growth in our existing online advertising business and includes aQuantive online advertising revenue of $161 million. Agency revenue, which is solely derived from aQuantive, was $345 million during fiscal year 2008. Access revenue decreased $98 million or 28%, to $256 million, reflecting migration of subscribers to broadband or other competitively-priced service providers.
OSB operating loss increased driven by increased cost of revenue and other operating expenses, partially offset by increased revenue. Cost of revenue increased $796 million or 71%, primarily driven by increased data center and equipment costs, online content expenses, and aQuantive-related expenses. Sales and marketing expenses increased $311 million or 37%, primarily due to increased amortization of customer-related intangible assets of $94 million, increased headcount-related expenses, and increased marketing costs. Research and development expenses increased $177 million or 17%, and general and administrative expenses increased $114 million or 178%, primarily reflecting increased headcount-related expenses and merger and acquisition-related expenses. Headcount-related costsexpenses increased 3% reflecting both a 10%24%, driven by an increase in headcount from the prior year-end.
Other
The segment information discussed above is presented the way we internally managed 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 declinedmonitored performance at the business group level in fiscal year 2005 primarily due to a $175 million decline in stock-based compensation expense, an increase in product revenue,years 2009, 2008, and a decline 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% |
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.2007. Effective July 1, 2005, functions related2009, we reorganized the Windows Live operations from OSB to MapPoint previously reportedClient to better align our strategies and focus in Mobilethose areas.
On July 29, 2009, we announced that we entered into a 10-year agreement with Yahoo! Inc. (“Yahoo”). Under terms of the agreement, Microsoft will provide the exclusive algorithmic and Embeddedpaid search platform for Yahoo websites. We believe this agreementwill allow us over time to improve the effectiveness and increase the value of our search offering through greater scale in search queries and an expanded and more competitive search and advertising marketplace. The transaction is subject to regulatory review. Both parties anticipate entering into more detailed definitive agreements prior to closing the transaction which is expected in calendar year 2010. See Note 24 – Subsequent Event of the Notes to Financial Statements (Part II, Item 8).
Microsoft Business Division
(In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | ||||||||
Revenue | $ | 18,894 | $ | 18,929 | $ | 16,476 | –% | 15% | |||||
Operating income | $ | 12,141 | $ | 12,369 | $ | 10,838 | (2)% | 14% |
Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office system
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Devices were moved
offerings, which generate over 90% of MBD revenue, depends on our ability to MSN. Mobileadd value to the core Office product set and Embedded Devicesto continue to expand our product offerings in other information worker areas such as content management, enterprise search, collaboration, unified communications, and MSN operatingbusiness intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. We evaluate our results forbased upon the prior periods have been restated for this reorganization. We announcednature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue.
Fiscal year 2009 compared with fiscal year 2006, Windows Live™,2008
MBD revenue was flat reflecting decreased consumer revenue offset by increased business revenue, and included a setfavorable impact from foreign currency exchange rates of Internet services and software designed to improve the users’ connected experience, including Windows Live™ Local and Windows Live Messenger.
MSN$378 million or two percentage points. Consumer revenue decreased in fiscal year 2006 primarily reflecting a $195$525 million or 28% decline in access revenue, partially offset by a $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 display advertising for portals, channels, email, and messaging services, which was partially offset by a decline in search revenue due to the transition to adCenter. In fiscal year 2005, MSN revenue increased reflecting $193 million or 16% growth in advertising revenue14%, primarily as a result of industryPC market weakness, a shift to lower-priced products, and marketpricing promotions on the 2007 Microsoft Office system. Business revenue increased $490 million or 3%, primarily reflecting growth and continued growth of MSN display advertisingin volume licensing agreement revenue and $84 million or 88%included a 7% decrease in Microsoft Dynamics customer billings. The growth in subscriptionvolume licensing agreement revenue primarily reflects recognition of deferred revenue from previously signed agreements.
MBD operating income decreased reflecting increased cost of revenue and transaction services revenue. These increases wereresearch and development expenses, partially offset by the search claritydecreased sales and marketing expenses. Cost of revenue increased $135 million or 14% primarily driven by expenses associated with Fast Search & Transfer ASA (“FAST”) which we acquired in advertising program, the impactApril 2008, as well as online services infrastructure costs. Research and development expenses increased $119 million or 8%, primarily driven by an increase in headcount-related expenses associated with FAST. Sales and marketing expenses decreased $90 million or 2%, primarily driven by a decrease in corporate marketing activities and headcount-related costs associated with our corporate sales force.
Fiscal year 2008 compared with fiscal year 2007
MBD revenue increased reflecting growth in licensing of the homepage redesign,2007 Microsoft Office system and included a declinefavorable impact from foreign currency exchange rates of $219$724 million or 24%four percentage points. Business revenue increased $2.6 billion or 21%, primarily as a result of growth in accessvolume licensing agreement revenue driven byand strong transactional license sales to businesses. The increase in business revenue also included a 21% increase in Microsoft Dynamics customer billings. Consumer revenue decreased $131 million or 3%, reflecting the continued migrationconsumer launch of Internet Access subscribers to broadband or other competitively priced Internet service providers.
MSN operating income decreasedthe 2007 Microsoft Office system in fiscal year 2006 due to a $230 million or 39% increase2007.
MBD operating income increased reflecting growth in research and development costs, a $126 million or 22% increase inrevenue, partially offset by increased sales and marketing expenses, research and development expenses, and cost of revenue. Sales and marketing expenses increased $446 million or 13%, reflecting increased expenses associated with our corporate sales force. Research and development expenses increased $229 million or 18%, primarily driven by an increase in headcount-related expenses and a $67$35 million in-process research and development expense related to the acquisition of FAST. Cost of revenue increased $214 million or 9%27%, primarily driven by an increase in cost of revenue as we continueonline services infrastructure costs and product costs related to invest in MSN adCenter, Windows Live, and other new platforms.retail packaged product sales. Headcount-related costsexpenses increased 25% reflecting a 44%10%, driven by an 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 withfrom 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.prior year-end.
MobileEntertainment and Embedded Devices Division
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | |||||||||||||||||||
Revenue | $ | 377 | $ | 262 | $ | 193 | 44% | 36% | $ | 7,753 | $ | 8,206 | $ | 6,139 | (6)% | 34% | |||||||||||||
Operating income (loss) | $ | 2 | $ | (65 | ) | $ | (237 | ) | * | 73% | $ | 169 | $ | 497 | $ | (1,898 | ) | (66)% | * |
* |
|
Entertainment and Devices Division (“EDD”) offerings include the Xbox 360 platform (which includes the Microsoft Xbox 360 video game console system, Xbox 360 video games, Xbox Live, and Xbox 360 accessories), the Zune
Mobile and Embedded Devices includes Windows Mobile software, Windows Embedded operating systems, and Windows Automotive. These 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 managing 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 OEMs and mobile operators. Effective July 1, 2005, functions related to MapPoint previously reported in Mobile and Embedded Devices were moved to MSN. Mobile and Embedded Devices and MSN operating results for the prior periods have been restated for this reorganization.
Mobile and Embedded 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
digital music and entertainment platform, PC software games, online games and services, Mediaroom (our Internet protocol television software), the Microsoft Surface computing platform, mobile and embedded device platforms, and other devices. EDD leads the development efforts for phone-enabled devices,our line of consumer software and increased growth in shipmentshardware products including application software for standalone PDAs. In fiscal year 2005, revenueApple’s Macintosh computers and Microsoft PC hardware products, and is responsible 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 inall retail sales and marketing expense. This improvement wasfor Microsoft Office and Windows operating systems.
Fiscal year 2009 compared with fiscal year 2008
EDD revenue decreased across most lines of business. Revenue from our non-gaming business decreased $292 million or 12%, primarily reflecting decreased Zune and PC hardware product revenue. Xbox 360 platform and PC game revenue decreased $161 million or 3%, primarily as a result of decreased revenue per Xbox 360 console due to price reductions during the past 12 months, 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 increased in fiscal year 2006 primarily due to the launch of the Xbox 360 console partially offset by a decline in first partysales and increased Xbox game sales primarily resulting from the significant impact of Halo 2 in fiscal year 2005.Live revenue. We sold approximately 5shipped 11.2 million Xbox 360 consoles during fiscal year 2006. The revenue growth was also attributable to $1402009, compared with 8.7 million Xbox 360 consoles during fiscal year 2008. Foreign currency exchange rates accounted for a $74 million or 15% growth from our other product lines,one percentage point decrease in revenue.
EDD operating income decreased primarily due to decreased revenue and increased research and development expenses, partially offset by decreased cost of revenue. Research and development expenses increased $252 million or 16%, primarily reflecting increased headcount-related expenses associated with the Windows Mobile device platform, driven by recent acquisitions. Cost of revenue decreased $326 million or 7%, primarily due to decreased Xbox 360 platform costs.
Fiscal year 2008 compared with fiscal year 2007
EDD revenue increased primarily due to increased Xbox 360 platform sales. Xbox 360 platform and PC game revenue increased $1.7 billion or 41% as a result of an increase in PC gamesincreased Xbox 360 console sales, video game sales led by Halo 3, Xbox Live revenue, and Xbox 360 accessory sales. We shipped 8.7 million Xbox 360 consoles during fiscal year 2008, compared with 6.6 million Xbox 360 consoles during fiscal year 2007.
EDD operating income increased primarily due to significant new game releases, especially “Ageincreased revenue and decreased cost of Empires III”revenue, partially offset by increased research and development expenses and sales and marketing expenses. Cost of revenue decreased $684 million or 13%, and an increase in MSTV revenue due to deploymentsreflecting the impact of the $1.1 billion Xbox 360 charge in fiscal year 2006. Revenue increased in fiscal year 20052007 (which primarily duerelated to significant new product launches, which resulted 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 year 2005. Revenue from consumer hardware and software, PC games, and TV platforms declined $50 million or 5% compared to fiscal year 2004 due to lower PC games software sales.
Home and Entertainment operating loss increased in fiscal year 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,warranty expansion), partially offset by the revenue growth. Our fiscal year 2006 operating loss increased dueXbox 360 product costs related to increased unit console sales. Research and development expenses increased $242 million or 18%, primarily reflecting increased headcount-related expenses and costs related to the significant impactacquisition of Halo 2 in fiscal year 2005.Danger, including a $24 million in-process research and development expense. Sales and marketing expenses increased $89 million or 7%, primarily reflecting increased headcount-related expenses and increased bad debt expense. Headcount-related costsexpenses 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 year 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 offset22%, driven by an increase in costs associated with Xbox 360 console development and related launch efforts.
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headcount from the prior year-end.
Corporate-Level Activity
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | |||||||||||||||||||||
Corporate-level expenses | $ | 5,026 | $ | 5,910 | $ | 6,871 | (15 | )% | (14 | )% | |||||||||||||||||||||
Corporate-level activity | $ | (5,877 | ) | $ | (7,017 | ) | $ | (4,893 | ) | 16% | (43)% |
Certain corporate-level expenses areactivity is not allocated to our segments. Those results include expenses primarily include corporate operations related tosuch as 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.contingencies, and employee severance.
Fiscal year 2009 compared with fiscal year 2008
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, 20062009, primarily reflecting both a 23% increase in headcountdecreased general and an increase in salariesadministrative and benefits for existing headcount,sales and marketing expenses, partially offset by a decrease in stock-based compensation.
Corporate-levelemployee severance charges of $330 million. General and administrative expenses decreased in fiscal year 2005,$1.4 billion or 28%, primarily as a result of a $736 million reduction in stock-based compensation expense anddue to decreased costs for legal settlements and legal contingencies. In fiscal year 2005, we recognized $2.31 billion inWe incurred $283 million of legal charges as compared to $2.53 billion in fiscal year 2004 which included a $1.92 billion charge for a settlement withduring 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:twelve months ended
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 growthJune 30, 2009 as compared to $1.8 billion during the twelve months ended June 30, 2008. The prior year costs were primarily related to the European Commission fine of $1.4 billion (€899 million). Sales and marketing expenses decreased $412 million or 30%, reflecting the resource management program implemented 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 inJanuary 2009.
Fiscal year 2008 compared with fiscal year 2007 as
Corporate-level expenses increased, reflecting increased costs for legal settlements and legal contingencies and a result13% increase in headcount-related expenses. We incurred $1.8 billion of continued ramp up of adCenter. We expect revenue from narrowband Internet Access to continue to decline inlegal charges during fiscal year 2007.
Microsoft Business Division We expect Microsoft Business Division revenue2008 primarily related to grow inthe European Commission fine of $1.4 billion (€899 million) as compared with $511 million of legal charges during fiscal year 2007. We feel that our customers’ continued preference to purchase annuity contracts indicates enthusiasm forThe increase in headcount-related expenses reflects an increase in headcount from the 2007 Microsoft Office system. We also expect continued demand for our Dynamics products, building on the fiscal 2006 momentum.prior year-end.
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 pace of development in growth areas such as business intelligence, security, management and unified communications (including acquisitions); and increased costs to execute on our online services strategy. While these investments will translate into increased operating expenses in fiscal year 2007, we believe they will help lay the groundwork for future growth and profitability.
Operating ExpensesOPERATING EXPENSES
Cost of Revenue
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | |||||||||||||||||||
Cost of revenue | $ | 7,650 | $ | 6,031 | $ | 6,596 | 27% | (9)% | $ | 12,155 | $ | 11,598 | $ | 10,693 | 5% | 8% | |||||||||||||
As a percent of revenue | 17% | 15% | 18% | 2ppt | (3)ppt | 21 | % | 19 | % | 21 | % | 2ppt | (2)ppt |
Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs related to product support service centers and product distribution centers, costs incurred to drive traffic to our website and/or acquire online advertising space (“traffic acquisition costs”), costs incurred to support and maintain Internet-based products and services, andwarranty costs, inventory valuation adjustments, costs associated with the delivery of consulting services. services, and the amortization of capitalized research and development costs associated with software products that have reached technological feasibility.
Fiscal year 2009 compared with fiscal year 2008
Cost of revenue increased during the twelve months ended June 30, 2009, primarily reflecting increased online costs, including traffic acquisition, data center and equipment, and headcount costs, partially offset by decreased Xbox 360 platform costs.
Fiscal year 2008 compared with fiscal year 2007
Cost of revenue increased reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 costs. Xbox 360 costs decreased because of the $1.1 billion charge in fiscal year 2006 increased mainly due2007 (which primarily related to a $1.64 billion increase in Home and Entertainment as a resultthe expansion of an increase in the number of total Xbox consoles sold and higherour Xbox 360 unit costs. Cost of revenue in fiscal year 2005 decreased due to a $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 a $169 million reduction in other product costs mainly due to Xbox consoles cost efficiency,warranty coverage), partially offset by increased Xbox 360 product costs, reflecting growth in product support and consulting services costs.unit console sales.
Research and Development
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | |||||||||||||||||||
Research and development | $ | 6,584 | $ | 6,097 | $ | 7,735 | 8% | (21)% | $ | 9,010 | $ | 8,164 | $ | 7,121 | 10% | 15% | |||||||||||||
As a percent of revenue | 15% | 15% | 21% | –ppt | (6)ppt | 15 | % | 14 | % | 14 | % | 1ppt | –ppt |
Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related costsexpenses 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. content, and in-process research and development.
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Fiscal year 2009 compared with fiscal year 2008
Research and development costsexpenses increased during the twelve months ended June 30, 2009, primarily reflecting a 13% increase in headcount-related costs.
Fiscal year 2008 compared with fiscal year 2006 primarily due to2007
Research and development expenses increased reflecting increased headcount-related expenses, increased product 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 in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Ourin-process research and development expenses decreased inrelated to acquisitions during fiscal year 2005 due to a $1.88 billion decrease2008. Headcount-related expenses increased 12%, reflecting an increase in stock-based compensation expense. This expense decline was partially offset by increased headcount and product development costs associated withfrom the Xbox 360 console and related games, SQL Server 2005, Windows Vista, and product development in Mobile and Embedded Devices.prior year-end.
Sales and Marketing
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | |||||||||||||||||||
Sales and marketing | $ | 9,818 | $ | 8,563 | $ | 8,195 | 15% | 4% | $ | 12,879 | $ | 13,260 | $ | 11,541 | (3)% | 15% | |||||||||||||
As a percent of revenue | 22% | 22% | 22% | –ppt | –ppt | 22 | % | 22 | % | 23 | % | –ppt | (1)ppt |
Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related costsexpenses associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs.
Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For the twelve months ended June 30, 2009, $509 million of losses were reported as other income (expense). For the twelve months ended June 30, 2008 and 2007, $221 million and $86 million of gains, respectively, were previously recorded as a component of sales and marketing expense and have been recast as other income (expense).
Fiscal year 2009 compared with fiscal year 2008
Sales and marketing expenses decreased, primarily driven by the resource management program implemented in January 2009.
Fiscal year 2008 compared with fiscal year 2007
Sales and marketing expenses increased, during fiscal year 2006 primarily due toreflecting increased headcount-related costs, investments in partnerexpenses and increased corporate marketing and product launch-related spending.advertising campaigns. Headcount-related costsexpenses increased 13% during fiscal year 2006 reflecting both a 20%14%, driven by an increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense.
For fiscal year 2005, sales and marketing expense increased slightly due to $470 million higher headcount-related costs from increased headcount and general salary increases; higher sales and marketing costs driven by product planning, reseller marketing, and advertising campaign costs mainly related to launch of the“Start Something” campaign; launch of “Halo 2”; and launch arrangements for Xbox 360. The increase was offset mainly by a $660 million decrease in stock-based compensation expense. prior year-end.
General and Administrative
(In millions, except percentages) | 2006 | 2005 | 2004 | Percent versus 2005 | Percent versus 2004 | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | |||||||||||||||||||
General and administrative | $ | 3,758 | $ | 4,536 | $ | 5,275 | 17% | 14% | $ | 3,700 | $ | 5,127 | $ | 3,329 | (28)% | 54% | |||||||||||||
As a percent of revenue | 8% | 11% | 14% | (3)ppt | (3)ppt | 6 | % | 8 | % | 7 | % | (2)ppt | 1ppt |
General and administrative costs include payroll, employee benefits, stock-based compensation expense and other headcount-related costsexpenses associated with finance, legal, facilities, certain human resources and other administrative headcount, and legal and other administrative fees.
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Fiscal year 2009 compared with fiscal year 2008
General and administrative costsexpenses decreased in fiscal year 2006 primarily reflecting decreased costs for legal settlements and legal contingencies. We incurred $1.32legal charges of $283 million in current year, as compared with $1.8 billion induring fiscal year 2008. The fiscal year 2008 legal costs were primarily related to the European Commission fine of $1.4 billion (€899 million).
Fiscal year 2008 compared with fiscal year 2007
General and administrative expenses increased reflecting increased costs for legal settlements and legal contingencies, increased consulting and professional fees, and increased headcount-related expenses. We incurred $1.8 billion of legal charges during fiscal year 20062008, primarily related to the European Commission fine, as compared to $2.31 billion inwith $511 million of legal charges incurred during fiscal year 2005.2007. Headcount-related costsexpenses increased 7% during, reflecting an increase in headcount from the prior year-end.
Employee Severance
In January 2009, we announced and implemented a resource management program to reduce discretionary operating expenses, employee headcount, and capital expenditures. As part of this program, we announced the elimination of up to 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010. During the current year, we recorded employee severance charges of $330 million for the expected reduction in employee headcount.
Other Income (Expense)
The components of other income (expense) were as follows:
(In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 | Percentage Change 2008 Versus 2007 | |||||||||||
Dividends and interest | $ | 706 | $ | 888 | $ | 1,319 | ||||||||||
Net recognized gains (losses) on investments | (125 | ) | 346 | 650 | ||||||||||||
Net gains (losses) on derivatives | (558 | ) | 226 | (358 | ) | |||||||||||
Net gains (losses) on foreign currency remeasurements | (509 | ) | 226 | 56 | ||||||||||||
Other | (56 | ) | (143 | ) | (4 | ) | ||||||||||
Total | $ | (542 | ) | $ | 1,543 | $ | 1,663 | (135)% | (7)% | |||||||
Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For the twelve months ended June 30, 2006 reflecting both an 18% increase in headcount2009, $509 million of losses were reported as other income (expense). For the twelve months ended June 30, 2008 and an increase in salaries2007, $221 million and benefits for existing headcount, partially offset by$86 million of gains, respectively, were previously recorded as a decrease in stock-based compensation expense. Generalcomponent of sales and administrative costs decreased in fiscal year 2005 primarily reflecting decreased stock-based compensationmarketing expense and decreased costs for legal settlements and legal contingencies. In fiscal year 2005, we recognized $277 million of stock-based compensation expensehave been recast as compared to $664 million in 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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Investment Income and Other
The components of investmentother income and other were as follows:
(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.(expense).
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.investments, including market declines subsequent to the period end. If the cost of an investment exceeds its fair value, among other factors, we evaluate general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and
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sector performance, changes in technology, and operational and financing cash flow factors, and rating agency actions.factors. Once a decline in fair value is determined to be other than temporary,other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established.
We lend certain fixed-income and equity securities to enhanceincrease investment income.returns. 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. Cash collateral is recorded as an asset with a corresponding liability.
We use derivative instruments to manage exposuresrisks related to foreign currencies, equity prices, interest rates, equity prices, and foreign currency marketscredit; to enhance investment returns; and to facilitate portfolio diversification. NetGains and losses onfrom changes in fair values of derivatives werethat are not designated 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 year 2006, we experienced lower net losses on derivatives as compared to fiscal year 2005 primarily due to nethedges are recognized in other income (expense). These are generally offset by unrealized gains on non-designated equity derivatives in the current fiscal year as compared to netand losses in the prior
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fiscal year and higher net gains on commodity positionsunderlying securities 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 revenuesinvestment portfolio 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 component of other comprehensive income. Commodity derivatives are
Fiscal year 2009 compared with fiscal year 2008
Dividends and interest income decreased primarily reflecting lower interest rates on our fixed-income investments. Net recognized losses on investments increased primarily due to higher other-than-temporary impairments that were partially offset by gains on sales of certain equity investments held forin our strategic investments portfolio. Other-than-temporary impairments were $862 million during the purposetwelve months ended June 30, 2009, as compared with $312 million during the twelve months ended June 30, 2008 and increased primarily due to declines in equity values as a result of portfolio diversification.deterioration in equity markets. Net losses related to foreign currency contracts relateon derivatives increased 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
Net derivative losses in fiscal year 2005 were primarily relateddue to losses on equity, derivatives,commodity, and 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 includedcurrent period 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 unrealizedcompared with gains in the underlying assets which are included in other comprehensive income.prior period. Net losses on derivatives also includedforeign currency remeasurements increased due to the strengthening of the U.S. dollar, particularly in the first half of the current fiscal year.
Fiscal year 2008 compared with fiscal year 2007
Dividends and interest income decreased reflecting lower interest rates on our fixed-income investments and a reduction in the average balance of interest-bearing investments owned. Net recognized gains related to commodity positions used to provide portfolio diversification. Gains on commodity positions were $46investments, which include other-than-temporary impairments of $312 million during fiscal year 2005.
Derivative losses were $2682008 and $25 million induring fiscal year 20042007, decreased primarily due to declines in equity values as a result of the recent stock market decline. Net gains on derivatives increased primarily due to higher net losses in time valuegains on foreign exchange contracts used to hedge anticipated foreign currency revenues.equity, commodity, and interest rate derivatives.
In the second quarter ofIncome Taxes
Fiscal year 2009 compared with fiscal year 2006, we entered into an agreement with NBC Universal, Inc. (“NBC”) that restructured our joint venture relationships for MSNBC Cable L.L.C. (“CJV”)2008
Our effective tax rates in fiscal years 2009 and MSNBC Interactive News, L.L.C. (“IJV”). As2008 were 27% and 26%, respectively. While the fiscal year 2009 rate reflects a result, we divested 32%higher mix of CJV for $331 million and NBC acquiredforeign earnings taxed at lower rates, the right, exercisable inrate increased from the following two years,prior year because the fiscal year 2008 rate reflects the resolution of tax positions relating 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 ofInternal Revenue Service (“IRS”) settling 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 the above transactions.
Income Taxes
Our effective tax rate for fiscal year 2006 was 31% as compared to 26% for fiscal year 2005. During fiscal year 2006, we recorded a tax benefit of $108 million from the resolution of state audits. The increased rate in fiscal year 2006 resulted primarily from2000-2003 examination, partially offset by the European Commission fine of€281 million ($351 million) which iswas not tax deductible,deductible. As a result of the settlement and a lower ratethe impact on subsequent years, we paid the IRS approximately $4.1 billion during fiscal year 2009.
Fiscal year 2008 compared with fiscal year 2007
Our effective tax rates in fiscal year 2005 as a result of reversal of $776 million of previously accrued taxes upon settling an Internal Revenue Service examination for2008 and 2007 were 26% and 30%, respectively. The fiscal year 1997 – 1999 and a tax benefit of $179 million generated by2008 rate was lower due to the decision to repatriate foreign subsidiary earnings under a temporary incentive provided by the American Jobs Creation Act of 2004. Our effective tax rate for fiscal year 2004 was 33%.items noted above.
Financial ConditionFINANCIAL CONDITION
Cash, andcash equivalents, and short-term investments totaled $34.16 billion and $37.75$31.4 billion as of June 30, 2006,2009, compared with $23.7 billion as of June 30, 2008. Equity and 2005, respectively. This investment portfolio consistsother investments were $4.9 billion as of June 30, 2009, compared with $6.6 billion as of June 30, 2008. Our investments consist 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 positionsforeign-denominated securities in order to diversify financial risk. The portfolio isWe invest primarily invested in short-term securities to facilitate rapid deploymentliquidity and for immediate cash needs. Equity and other investments were $9.23 billion and $11.00 billion as of June 30, 2006, and 2005, respectively.capital preservation. 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$22.8 billion at June 30, 2006.2009. Our retained deficit is not expected to impactaffect our future ability to operate, or pay dividends, or repay our debt given our continuing profitability and strong cash and financial position.
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In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, U.S. treasuries, and agency securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and certain agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio.
A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. Such controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.
While we own certain mortgage- and asset-backed fixed-income securities, our portfolio as of June 30, 2009 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of the mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association.
Debt
Short-term Debt
In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Pursuant to the authorization, we established a commercial paper program providing for the issuance and sale of up to $2.0 billion in short-term commercial paper. As of June 30, 2009, $2.0 billion of the commercial paper was issued and outstanding with a weighted average interest rate, including issuance costs, of 0.20% and maturities of 22 to 119 days.
In September 2008, we also entered into a $2.0 billion six-month senior unsecured credit facility, principally to support the commercial paper program. In November 2008, we replaced the six-month credit facility with a $2.0 billion 364-day credit facility. This credit facility expires on November 6, 2009. In March 2009, we entered into an additional credit facility. This $1.0 billion 364-day credit facility expires on March 12, 2010. As of June 30, 2009, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against these credit facilities during the year ended June 30, 2009.
Long-term Debt
In November 2008, we filed a shelf registration statement with the U.S. Securities and Exchange Commission that allows us to issue debt securities from time to time pursuant to the September 2008 authorization for debt financings of up to $6.0 billion. In May 2009, we issued $3.75 billion of debt securities under that registration statement as follows: $2.0 billion aggregate principal amount of 2.95% notes due 2014, $1.0 billion aggregate principal amount of 4.20% notes due 2019, and $750 million aggregate principal amount of 5.20% notes due 2039 (collectively “the Notes”). Interest on the Notes will be payable semi-annually on June 1 and December 1 of each year, commencing on December 1, 2009, to holders of record on the preceding May 15 and November 15. The Notes are senior unsecured obligations and will rank equally with our other unsecured and unsubordinated debt outstanding.
We intend to use the net proceeds from sales of the debt securities for general corporate purposes, which may include funding for working capital, capital expenditures, repurchases of our capital stock, and acquisitions.
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Unearned Revenue
Unearned revenue from volumeis comprised of the following items:
Volume Licensing Programs
Represents customer billings for multi-year licensing programs represents customer billings,arrangements, paid either upfront or annually at the beginning of each billing coverage period, thatwhich 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
Undelivered Elements
Represents the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis and free post-delivery telephone support. This revenue deferral is applicable for Windows XP and prior versions shipped as retail packaged products, products licensed to OEMs, and perpetual licenses for current products under our Open and Select volume licensing programs. 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 cyclecycle. Product life cycles are currently estimated at three and one-half years for Windows operating systems. Undelivered elements include $276 million of deferred revenue related to the related product. Windows 7 Upgrade Option program. The program, which started June 26, 2009, allows customers who purchase PCs from participating computer makers or retailers with certain versions of Windows Vista to receive an upgrade to the corresponding version of Windows 7 at minimal or no cost. In addition, purchasers of retail packaged Windows Vista may also qualify for a free or discounted upgrade to the equivalent Windows 7 product with participating retailers in participating markets when the product becomes generally available.
Other unearned revenue includes
Represents payments for post-delivery support and consulting services TV Platform,to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Business Solutions, advertising,Dynamics business solutions products, Xbox Live subscriptions, Mediaroom, and subscriptionsother offerings 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, 2006, increased $1.74 billion from June 30, 2005, reflecting additions to unearned revenue from multi-year licensing that outpaced recognitions by $1.66 billion, a $53 million decrease in 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, 2006:2009:
(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 | |
(In millions) | Recognition of Unearned Revenue | |
Three months ended: | ||
September 30, 2009 | $ 4,740 | |
December 31, 2009 | 4,120 | |
March 31, 2010 | 2,743 | |
June 30, 2010 | 1,400 | |
Thereafter | 1,281 | |
Total | $14,284 | |
Cash Flows
Fiscal year 2009 compared with fiscal year 2008
Cash flow from operations for fiscal year 2006 decreased 13% to $14.40$2.6 billion primarily due to increased paymentspayment of approximately $4.1 billion to fund a $987 million increasethe IRS 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 byconnection with 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 decreasesettlement of $20.52 billion from the previous year driven by a $32.57 billion reduction in cash dividend payments.2000-2003 audit examination. This impact was partially offset by an $11.15 billion increase in common stock repurchases. Net cash from investing was $8.00 billion inthe fiscal year 2006, a decrease2008 payment of $7.02the $1.4 billion from fiscal year 2005 driven primarily by an $8.93 billion decrease in cash from combined purchase, sales, and maturities of investments and a $766 million increase in additions to property and equipment. These factors were partially offset by $3.12 billion of cash proceeds from our securities lending program.
(€899 million) European Commission fine. Cash flow from operationsused for fiscal year 2005 increased 14% to $16.61financing decreased $5.5 billion primarily due to an increase in cash receipts from customers driven by our 8% revenue growth combined with a 12% increase in unearned revenue. 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 in 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 $41.08 billion in fiscal year 2005, driven by $36.11$5.7 billion of net cash dividends paidproceeds from issuance of short-term and long-term debt 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 $4.67 billion in cash used for share repurchases compared to the previous year, reflecting 312 million shares repurchased in fiscal year 2005, an increase of 188.5 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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year 2009. Financing activities also included a $3.2 billion decrease in common stock repurchased, which was offset by a $2.9 billion decline in common stock issued. Cash used for investing increased $11.2 billion due to a $15.9 billion rise in purchases of investments along with a $1.7 billion decrease in cash from investment sales and maturities. These impacts were partially offset by a $7.2 billion decrease in cash paid for acquisition of companies, including the purchase of aQuantive in fiscal year 2008.
Fiscal year 2008 compared with fiscal year 2007
Cash flow from operations for fiscal year 2004 decreased $1.17increased $3.8 billion due to $14.63 billion. The decrease primarily reflects the combinedan increase in cash outflows of $2.56 billion related to the Sun Microsystems settlement and the European Commission fine partially offset by increased cash receiptsreceived from customers driven by 18% revenue growth, partially offset by the rise in revenue billings.$1.4 billion (€899 million) payment of the European Commission fine. Cash used for financing was $2.36decreased $11.6 billion in fiscal year 2004,primarily due to a $15.0 billion decrease of $2.86 billion from the previous year. The decrease reflects that we did not repurchasein common stock in the fourth quarter of fiscal year 2004 combined with a $628 million increase primarily from stock issuances related to employee stock options exercises,repurchases, partially offset by an $872 million increasea $3.3 billion decrease in cash dividends paid. We repurchased 123.7 million sharesproceeds from the issuance of common stock under our share repurchase program in fiscal year 2004.stock. Cash used for investing was $3.34$4.6 billion infor fiscal year 2004, a decrease2008 as compared with cash provided of $3.88$6.1 billion fromfor fiscal year 2003.2007. This decrease was primarily due to a $6.9 billion increase in cash paid for acquisition of companies, reflecting the purchase of aQuantive in the first quarter of fiscal year 2008, a $918 million increase in purchases of property and equipment, and a $3.1 billion decrease in cash from combined investment purchases, sales, and maturities.
We have no material long-term debt. Stockholders’ equity at June 30, 2006,2009, was $40.10$39.6 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, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $234$621 million on June 30, 2006.2009. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling $276$475 million, $299$398 million, and $331$325 million, in fiscal year 2006, 2005years 2009, 2008, and 2004,2007, respectively. We have issued residual value guarantees in connection with various operating leases. These guarantees 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, 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 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.Share Repurchases
On July 20, 2006,September 22, 2008, we announced the completion of the two repurchase program initiallyprograms approved by our Board of Directors on July 20, 2004during the first quarter of fiscal year 2007 to buy back up to $30$40.0 billion inof 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,September 22, 2008, we also announced that our Board of Directors authorizedapproved a new share repurchase programs, comprised of a $20program authorizing up to $40.0 billion tender offer which was completed on August 17, 2006, and an additional $20 billion ongoingin share repurchase programrepurchases with an expiration date of September 30, 2013. We repurchased 318 million shares for $8.2 billion during the fiscal year ended June 30, 2009; 101 million shares were repurchased for $2.7 billion under the repurchase program approved by our Board of Directors during the first quarter of fiscal year 2007 and 217 million shares were repurchased for $5.5 billion under the repurchase program approved by our Board of Directors during the first quarter of fiscal year 2009. As of June 30, 2011. Under the tender offer, we repurchased2009, approximately 155 million shares of our common stock, or approximately 1.5%$34.5 billion remained of the common shares outstanding, for approximately $3.8$40.0 billion at a price per share of $24.75. On August 18, 2006, we announced that the authorization for the ongoing shareapproved repurchase amount. All repurchases were made using cash resources. The repurchase program previously announced on July 20, 2006, had been increased by approximately $16.2 billion. As a result,may be suspended or discontinued at any time without notice.
Dividends
During fiscal years 2009 and 2008, our Board of Directors declared the company is authorized to repurchase additional shares in an amount up to $36.2 billion through June 30, 2011.following dividends:
Declaration Date | Per Share Dividend | Record Date | Total Amount | Payment Date | ||||
(in millions) | ||||||||
(Fiscal year 2009) | ||||||||
September 19, 2008 | $0.13 | November 20, 2008 | $1,157 | December 11, 2008 | ||||
December 10, 2008 | $0.13 | February 19, 2009 | $1,155 | March 12, 2009 | ||||
March 9, 2009 | $0.13 | May 21, 2009 | $1,158 | June 18, 2009 | ||||
June 10, 2009 | $0.13 | August 20, 2009 | $1,158 | September 10, 2009 | ||||
(Fiscal year 2008) | ||||||||
September 12, 2007 | $0.11 | November 15, 2007 | $1,034 | December 13, 2007 | ||||
December 19, 2007 | $0.11 | February 21, 2008 | $1,023 | March 13, 2008 | ||||
March 17, 2008 | $0.11 | May 15, 2008 | $1,020 | June 12, 2008 | ||||
June 11, 2008 | $0.11 | August 21, 2008 | $ 998 | September 11, 2008 |
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We believe existing cash, cash equivalents, and short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements, regular quarterly dividends, debt repayment schedules, and planned share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and cash equivalents, 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 amountsize to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products.products and certain other matters. We evaluate estimated losses for suchthese indemnifications under SFAS No. 5,Accounting for Contingencies, as interpreted by FASBFinancial Accounting Standards Board Interpretation No. (“FIN”) No. 45,Guarantor’s Accounting and Disclosure Requirements for Guarantees, Includingincluding Indirect Guarantees of Indebtedness of Others. We consider such factors such 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 materialsignificant costs as a result of suchthese obligations and have not accrued any material liabilities related to suchthese indemnifications in our financial statements.
Contractual Obligations
The following table summarizes our outstanding contractual obligations as of June 30, 2006:2009. We expect to fund these commitments with existing cash and cash equivalents, short-term investments and cash flows from operations.
(In millions) | |||||||||||||||||||||||||
Payments due by period | Payments Due by Period | ||||||||||||||||||||||||
Fiscal Years | 2007 | 2008-2010 | 2011-2013 | 2014 and thereafter | Total | 2010 | 2011-2013 | 2014-2016 | 2017 and Thereafter | Total | |||||||||||||||
Long-term debt | $ | – | $ | – | $ | – | $ | – | $ | – | |||||||||||||||
Construction commitments(2)(4) | 234 | – | – | – | 234 | ||||||||||||||||||||
Long-term debt:(a) | |||||||||||||||||||||||||
Principal payments | $ – | $ – | $2,000 | $1,750 | $ 3,750 | ||||||||||||||||||||
Interest payments | 145 | 420 | 302 | 1,023 | 1,890 | ||||||||||||||||||||
Construction commitments(b) | 621 | – | – | – | 621 | ||||||||||||||||||||
Lease obligations: | |||||||||||||||||||||||||
Capital leases | – | – | – | – | – | 3 | 9 | 1 | – | 13 | |||||||||||||||
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 | ||||||||||||||||||||
Operating leases(c) | 457 | 931 | 520 | 477 | 2,385 | ||||||||||||||||||||
Purchase commitments(d) | 3,289 | 382 | 1 | – | 3,672 | ||||||||||||||||||||
Other long-term liabilities(e) | – | 110 | 4 | 2 | 116 | ||||||||||||||||||||
Total contractual obligations | $ | 2,707 | $ | 511 | $ | 159 | $ | 41 | $ | 3,418 | $4,515 | $1,852 | $2,828 | $3,252 | $12,447 | ||||||||||
See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8) |
(b) | These amounts represent commitments for the construction of buildings. |
(c) | These amounts represent undiscounted future minimum rental commitments under noncancellable leases. |
(d) | These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as construction commitments above. |
(e) | We have excluded |
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Item 7
RECENTLY ISSUED ACCOUNTING STANDARDS
Recently Adopted Accounting Pronouncements
On April 1, 2009, we adopted the Financial Accounting Standards Board (“FASB”) Staff Positions (“FSP”) FAS 157-4, FSP FAS 115-2 and FAS 124-2, and FSP FAS 107-1 and APB 28-1. These FSPs are intended to provide additional application guidance and enhance disclosures about fair value measurements and impairments of securities. FSP FAS 157-4 clarifies the objective and method of fair value measurement even when there has been a significant decrease in market activity for the asset being measured. FSP FAS 115-2 and FAS 124-2 establishes a new model for measuring other-than-temporary impairments for debt securities, including establishing criteria for when to recognize a write-down through earnings versus other comprehensive income. FSP FAS 107-1 and APB 28-1 expands the fair value disclosures required for all financial instruments within the scope of SFAS No. 107,Disclosures about Fair Value of Financial Instruments, to interim periods. Adoption of these FSPs did not have a significant impact on our accounting for financial instruments but did expand our associated disclosures.
On January 1, 2009, we adopted SFAS No. 161,Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133. SFAS No. 161 requires additional disclosures about the Company’s objectives in using derivative instruments and hedging activities, the method of accounting for such instruments under SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities, and its related interpretations, and tabular disclosures of the effects of such instruments and related hedged items on our financial position, financial performance, and cash flows. See Note 5 – Derivatives of the Notes to Financial Statements (Part II, Item 8).
On July 1, 2008, we adopted SFAS No. 157,Fair Value Measurements, for all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. See Note 4 – Investments of the Notes to Financial Statements (Part II, Item 8).
SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115, became effective for us on July 1, 2008. SFAS No. 159 gives us the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis with the difference between the carrying value before election of the fair value option and the fair value recorded upon election as an adjustment to beginning retained deficit. As of June 30, 2009, we had not elected the fair value option for any eligible financial asset or liability.
Recent Accounting Pronouncements Not Yet Adopted
In November 2005,June 2009, the FASB issued Staff Position (“FSP”) FAS123(R)-3,Transition Election to Accounting for the Tax Effects of Share-Based Payment Awards.This FSP requires an entity to follow either the transition guidance for the additional-paid-in-capital pool as prescribed in SFAS No. 123(R),167,Share-Based PaymentAmendments to FASB Interpretation No. 46(R), orwhich is effective for us beginning July 1, 2010. This Statement amends FIN 46(R),Consolidation of Variable Interest Entities an interpretation of ARB No. 51, to require revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over such entities, and additional disclosures for variable interests. We believe 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 one-time election to adopt the transition method described in this FSP. An entity may take up to one year from the later of its initial adoption of SFAS No. 123(R) or the effective date of this FSP to evaluate its available transition alternatives and make its one-time election. We elected to adopt the transition method as described in the FSP as of July 1, 2005. This method change didpronouncement will not have ana material impact on our financial statements.
In June 2006,February 2008, the FASB issued FIN No. 48,FSP FAS 157-2,Accounting for Uncertainty in Income Taxes – an interpretationEffective Date of FASB Statement No. 109,157,which clarifiesdelays the accountingeffective date of SFAS No. 157 for uncertaintyus to July 1, 2009, for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in income taxes recognized in an enterprise’sthe financial statements in accordance with FASB Statement No. 109,Accounting for Income Taxes.The interpretation prescribeson a recognition threshold and measurement attribute for the 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 for us beginning July 1, 2007.recurring basis (at least annually). We are assessing the potential impact thatbelieve the adoption of FINthe delayed items of SFAS No. 48157 will not have a material impact on our financial statements.
In December 2007, the FASB issued SFAS No. 141(R),Business Combinations, which replaces SFAS No. 141. The statement retains the fundamental requirements in SFAS No. 141 that the acquisition method of accounting (previously referred to as the purchase method of accounting) be used for all business combinations, but requires a number of changes, including changes in the way assets and liabilities are recognized as a result of business combinations. It also requires the capitalization of in-process research and development at fair value and requires the expensing of acquisition-related costs as incurred. In April 2009, the FASB issued FSP FAS 141(R)-1 which amends SFAS No. 141(R) by establishing a model to account for certain pre-acquisition contingencies. Under the FSP, an
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Item 7
In June 2006,acquirer is required to recognize at fair value an asset acquired or a liability assumed in a business combination that arises from a contingency if the FASB ratifiedacquisition-date fair value of that asset or liability can be determined during the Emerging Issues Task Force (“EITF”) consensus on EITF Issuemeasurement period. If the acquisition-date fair value cannot be determined, then the acquirer should follow the recognition criteria in SFAS No. 06-2, “5,Accounting for Sabbatical Leave Contingencies,and Other Similar Benefits Pursuant toFASB Interpretation No. 14,Reasonable Estimation of the Amount of a Loss – an interpretation of FASB Statement No. 435.”. EITF IssueSFAS No. 06-2 requires companies141(R) and FSP FAS 141(R)-1 are effective for us beginning July 1, 2009, and will apply prospectively to accruebusiness combinations completed on or after that date. The impact of the costsadoption of compensated absences underSFAS No. 141(R) and FSP FAS 141(R)-1 will depend on the nature of acquisitions completed after the date of adoption.
In December 2007, the FASB issued SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51, which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a sabbaticalcomponent of equity separate from the parent’s equity, and purchases or similar benefit arrangement oversales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the requisite service period. EITF Issuenoncontrolling interest will be included in net income and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in net income. SFAS No. 06-2160 is effective for us beginning July 1, 2007. The cumulative effect2009, and will apply prospectively, except for the presentation and disclosure requirements, which will apply retrospectively. We believe the adoption of the application of this consensusSFAS No. 160 will not have a material impact on prior period results should be recognized through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. Elective retrospective application is also permitted. We are currently evaluating theour financial impact of this guidance and the method of adoption that will be used.statements.
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, accounting for stock-based compensation, and accounting for stock-based compensation.product warranties.
Revenue Recognition
We account for the licensing of software in accordance with American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2,Software Revenue 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”) of fair value exists for those elements. Customers receive certain
A portion of the revenue related to Windows XP is recorded as unearned due to undelivered elements of our products over a period of time. These elements includeincluding, 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,basis. The amount of revenue allocated to undelivered elements is based on the VSOE of fair value of whichfor those elements using the residual method or relative fair value method. Unearned revenue due to undelivered elements is recognized ratably on a straight-line basis over the product’srelated products’ life cycles. Revenue related to Windows Vista is not subject to a similar deferral because there are no significant undelivered elements. However, Windows Vista revenue is subject to deferral as a result of the Windows 7 Upgrade Option program which started June 26, 2009. The program allows customers who purchase PCs from participating computer makers or retailers with certain versions of Windows Vista to receive an upgrade to the corresponding version of Windows 7 at minimal or no cost. In addition, purchasers of retail packaged Windows Vista may also qualify for a free or discounted upgrade to the equivalent Windows 7 product with participating retailers in participating markets when the product becomes generally available. Accordingly, estimated life cycle. revenue related to the undelivered Windows 7 product is deferred until the product is delivered.
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.
Impairment of Investment Securities
SFAS No. 115,Accounting for Certain Investments in Debt and Equity Securities, Staff Accounting Bulletin No. 111, and SEC SAB 59,FSP FAS 115-2 and FAS 124-2,Accounting for Noncurrent Marketable Equity SecuritiesRecognition and Presentation of Other-Than-Temporary Impairments, provide guidance
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Item 7
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, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. 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, and operational and financing cash flow factors, and rating agency actions.factors. Once a decline in fair value is determined to be other-than-temporary,other than temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.
Goodwill
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 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and/orand goodwill impairment for each reporting unit. We allocate goodwill to reporting units based on the reporting unit expected to 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.
Part II Research and Development Costs
Item 7
We account for research and development costs in accordance with severalapplicable 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. SFAS No. 86 specifies that costs incurred internally in researching and developing a computer software product should be charged to expense 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 after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. Costs incurred after technological feasibilityThe amortization of these costs is established have not been material,included in cost of revenue over the estimated life of the products.
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Legal and accordingly, we have expensed all research and development costs when incurred.Other Contingencies
The outcomes of legal proceedings and claims brought 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. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our results of operations, financial position, or our results of operations.cash flows.
Income Taxes
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. Accruals for uncertain tax positions are provided for in accordance with the requirements of FIN No. 48,Accounting for Uncertainty in Income Taxes – An interpretation of FASB Statement No. 109. Under FIN No. 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN No. 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations 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.
Stock-Based Compensation
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-basedstock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the vestingrequisite service period. Determining the fair value of share-basedstock-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of share-basedstock-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 could be materially impacted.
Product Warranties
We account for product warranties in accordance with SFAS No. 5,Accounting for Contingencies. We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, over the life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary.
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Part II
Item 7
Statement of Management’s Responsibility for Financial Statements
Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America.
The Company designs and 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, an independent auditors,registered public accounting firm, 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 accordance with the standards of the Public Company Accounting Oversight Board (United States).
The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent auditorsregistered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee.
Steven A. Ballmer Chief Executive Officer |
Christopher P. Liddell Senior Vice President, Finance and Administration; Chief Financial Officer |
Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer |
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Part II
Item 7A
ITEM 7A. QUANTITATIVEQUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
RISKS
We are exposed to economic risk from foreign currency exchange rates, interest rate, fixed-income,rates, credit risk, equity prices, and commodity price risks.prices. A portion of these risks is hedged, but fluctuations couldthey may impact our results of operations cash flows and financial position. We hedge a portion of anticipated revenuecondition.
Foreign Currency. Certain forecasted transactions, assets, and accounts receivable exposureliabilities are exposed to foreign currency fluctuations, primarily with option contracts.risk. We monitor our foreign currency exposures daily and use hedges where practicable to offset the risks and maximize the overalleconomic effectiveness of our foreign currency hedge positions. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Fixed-income securities are subject primarily to interest rate risk. The
Interest Rate. Our fixed-income portfolio is diversified across credit sectors and structuredmaturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to minimize credit risk. Securities held in ourachieve economic returns that correlate to certain global and domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed securities.
Equity. Our equity portfolio consists of global, developed, and other investments portfolioemerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and are generally not hedged. However, wereturn to correlate with these indices.
Commodity. We use optionsbroad-based commodity exposures to hedge our priceenhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global commodity indices and expect their economic risk on certain equity securities that are held primarily for strategic purposes. Commodity derivatives held for the purpose of portfolio diversification are subjectand return to commodity price risk.correlate with these indices.
VALUE-AT-RISK
We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR 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 VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP, but is used as a risk estimation and management tool. The model used for currencies, equities, and commodities is geometric Brownian motion, which allows incorporationdistribution of optionality with regard to these risk exposures. For interest rate risk, exposures such as key rate durations and spread durations are used in calculations that reflect the principle that fixed-income security prices revert to maturity value over time.
VaR is calculated by computing the exposures of each holding’s market value to a range of over 1,000 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 accountis computed based on the weighted historical volatilities of the differentand correlations among foreign currency exchange rates, andinterest rates, equity prices, and the weighted historical correlations among the different rates and prices. commodity prices, assuming normal market conditions.
The VaR is then calculated as the total loss that will not be exceeded at the 97.5 percentile confidence 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 equity 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 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 factor-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 the specified holding period can exceed the reported VaR by significant amounts and can also accumulate over a longer time horizon than the specified holding period used in the VaR analysis. VaR 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.
VaR numbers are shown separately for interest rate, currency rate, equity price, and commodity price risks. These VaR numbers include the underlying portfolio positions and related hedges. We use historical data to estimate VaR. Given the reliance on historical data, VaR 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 VaR is that the distribution of past changes in market risk factors may not produce accurate predictions of future market risk.
Part II
Item 7A
The following table sets forth the one-day VaR for substantially all of our positions as of June 30, 20062009 and 2005,2008 and for the fiscal year ended June 30, 2006:2009:
(In millions) | |||||||||||||||
Year ended June 30, 2006 | |||||||||||||||
Risk Categories | 2006 | 2005 | Average | High | Low | ||||||||||
Interest rates | $ | 66 | $ | 88 | $ | 82 | $ | 127 | $ | 62 | |||||
Currency rates | 91 | 52 | 33 | 91 | 11 | ||||||||||
Equity prices | 88 | 164 | 116 | 168 | 84 | ||||||||||
Commodity prices | 12 | 14 | 15 | 18 | 12 | ||||||||||
(In millions) | ||||||||||
Year Ended June 30, 2009 | ||||||||||
Risk Categories | June 30, 2009 | June 30, 2008 | Average | High | Low | |||||
Foreign currency | $ 68 | $100 | $53 | $ 99 | $20 | |||||
Interest rate | 42 | 34 | 28 | 43 | 17 | |||||
Equity | 157 | 45 | 98 | 158 | 45 | |||||
Commodity | 16 | 7 | 10 | 16 | 6 | |||||
Total one-day VaR for the combined risk categories was $158$211 million at June 30, 20062009 and $195$123 million at June 30, 2005.2008. The total VaR is 38%25% less at June 30, 20062009, and 39%34% less at June 30, 20052008, than the sum of the separate risk categories in the above table due to the diversification benefit of the combination of risks.overall portfolio.
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Item 8
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INCOME STATEMENTS
(In millions, except per share amounts) | |||||||||||||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||||||||||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||||||||||||||||
Revenue | $ | 44,282 | $ | 39,788 | $ | 36,835 | $ | 58,437 | $ | 60,420 | $ | 51,122 | |||||||||||
Operating expenses: | |||||||||||||||||||||||
Cost of revenue | 7,650 | 6,031 | 6,596 | 12,155 | 11,598 | 10,693 | |||||||||||||||||
Research and development | 6,584 | 6,097 | 7,735 | 9,010 | 8,164 | 7,121 | |||||||||||||||||
Sales and marketing | 9,818 | 8,563 | 8,195 | 12,879 | 13,260 | 11,541 | |||||||||||||||||
General and administrative | 3,758 | 4,536 | 5,275 | 3,700 | 5,127 | 3,329 | |||||||||||||||||
Employee severance | 330 | – | – | ||||||||||||||||||||
Total operating expenses | 27,810 | 25,227 | 27,801 | 38,074 | 38,149 | 32,684 | |||||||||||||||||
Operating income | 16,472 | 14,561 | 9,034 | 20,363 | 22,271 | 18,438 | |||||||||||||||||
Investment income and other | 1,790 | 2,067 | 3,162 | ||||||||||||||||||||
Other income (expense) | (542 | ) | 1,543 | 1,663 | |||||||||||||||||||
Income before income taxes | 18,262 | 16,628 | 12,196 | 19,821 | 23,814 | 20,101 | |||||||||||||||||
Provision for income taxes | 5,663 | 4,374 | 4,028 | 5,252 | 6,133 | 6,036 | |||||||||||||||||
Net income | $ | 12,599 | $ | 12,254 | $ | 8,168 | $ | 14,569 | $ | 17,681 | $ | 14,065 | |||||||||||
Earnings per share: | |||||||||||||||||||||||
Basic | $ | 1.21 | $ | 1.13 | $ | 0.76 | $ | 1.63 | $ | 1.90 | $ | 1.44 | |||||||||||
Diluted | $ | 1.20 | $ | 1.12 | $ | 0.75 | $ | 1.62 | $ | 1.87 | $ | 1.42 | |||||||||||
Weighted average shares outstanding: | |||||||||||||||||||||||
Basic | 10,438 | 10,839 | 10,803 | 8,945 | 9,328 | 9,742 | |||||||||||||||||
Diluted | 10,531 | 10,906 | 10,894 | 8,996 | 9,470 | 9,886 | |||||||||||||||||
Cash dividends declared per common share | $ | 0.35 | $ | 3.40 | $ | 0.16 | $ | 0.52 | $ | 0.44 | $ | 0.40 |
See accompanying notes.
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Part II
Item 8
BALANCE SHEETS
(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 | ||||||
(In millions) | ||||||||
June 30, | 2009 | 2008 | ||||||
Assets | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 6,076 | $ | 10,339 | ||||
Short-term investments (including securities pledged as collateral of$1,540 and $2,491) | 25,371 | 13,323 | ||||||
Total cash, cash equivalents, and short-term investments | 31,447 | 23,662 | ||||||
Accounts receivable, net of allowance for doubtful accounts of$451 and $153 | 11,192 | 13,589 | ||||||
Inventories | 717 | 985 | ||||||
Deferred income taxes | 2,213 | 2,017 | ||||||
Other | 3,711 | 2,989 | ||||||
Total current assets | 49,280 | 43,242 | ||||||
Property and equipment, net of accumulated depreciation of$7,547 and $6,302 | 7,535 | 6,242 | ||||||
Equity and other investments | 4,933 | 6,588 | ||||||
Goodwill | 12,503 | 12,108 | ||||||
Intangible assets, net | 1,759 | 1,973 | ||||||
Deferred income taxes | 279 | 949 | ||||||
Other long-term assets | 1,599 | 1,691 | ||||||
Total assets | $ | 77,888 | $ | 72,793 | ||||
Liabilities and stockholders’ equity | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 3,324 | $ | 4,034 | ||||
Short-term debt | 2,000 | – | ||||||
Accrued compensation | 3,156 | 2,934 | ||||||
Income taxes | 725 | 3,248 | ||||||
Short-term unearned revenue | 13,003 | 13,397 | ||||||
Securities lending payable | 1,684 | 2,614 | ||||||
Other | 3,142 | 3,659 | ||||||
Total current liabilities | 27,034 | 29,886 | ||||||
Long-term debt | 3,746 | – | ||||||
Long-term unearned revenue | 1,281 | 1,900 | ||||||
Other long-term liabilities | 6,269 | 4,721 | ||||||
Commitments and contingencies | ||||||||
Stockholders’ equity: | ||||||||
Common stock and paid-in capital – shares authorized 24,000; outstanding8,908 and 9,151 | 62,382 | 62,849 | ||||||
Retained deficit, including accumulated other comprehensive income of$969 and $1,140 | (22,824 | ) | (26,563 | ) | ||||
Total stockholders’ equity | 39,558 | 36,286 | ||||||
Total liabilities and stockholders’ equity | $ | 77,888 | $ | 72,793 | ||||
See accompanying notes.
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(In millions) | ||||||||||||||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | |||||||||||||||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | |||||||||||||||||||||
Operations | ||||||||||||||||||||||||
Net income | $ | 12,599 | $ | 12,254 | $ | 8,168 | $ | 14,569 | $ | 17,681 | $ | 14,065 | ||||||||||||
Adjustments to reconcile net income to net cash from operations: | ||||||||||||||||||||||||
Depreciation, amortization, and other noncash items | 903 | 855 | 1,186 | 2,562 | 2,056 | 1,440 | ||||||||||||||||||
Stock-based compensation | 1,715 | 2,448 | 5,734 | 1,708 | 1,479 | 1,550 | ||||||||||||||||||
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 | ) | – | – | ||||||||||||||||||||
Net recognized losses (gains) on investments and derivatives | 683 | (572 | ) | (292 | ) | |||||||||||||||||||
Excess tax benefits from stock-based compensation | (52 | ) | (120 | ) | (77 | ) | ||||||||||||||||||
Deferred income taxes | 219 | (179 | ) | (1,479 | ) | 762 | 935 | 421 | ||||||||||||||||
Unearned revenue | 16,453 | 13,831 | 11,777 | |||||||||||||||||||||
Deferral of unearned revenue | 24,409 | 24,532 | 21,032 | |||||||||||||||||||||
Recognition of unearned revenue | (14,729 | ) | (12,919 | ) | (12,527 | ) | (25,426 | ) | (21,944 | ) | (19,382 | ) | ||||||||||||
Changes in operating assets and liabilities: | ||||||||||||||||||||||||
Accounts receivable | (2,071 | ) | (1,243 | ) | (687 | ) | 2,215 | (1,569 | ) | (1,764 | ) | |||||||||||||
Other current assets | (1,405 | ) | (245 | ) | 478 | (422 | ) | 153 | 232 | |||||||||||||||
Other long-term assets | (49 | ) | 21 | 34 | (273 | ) | (98 | ) | (435 | ) | ||||||||||||||
Other current liabilities | (145 | ) | 396 | 1,529 | (3,371 | ) | (748 | ) | (552 | ) | ||||||||||||||
Other long-term liabilities | 1,273 | 1,245 | 609 | 1,673 | (173 | ) | 1,558 | |||||||||||||||||
Net cash from operations | 14,404 | 16,605 | 14,626 | 19,037 | 21,612 | 17,796 | ||||||||||||||||||
Financing | ||||||||||||||||||||||||
Short-term borrowings, maturities of 90 days or less, net | 1,178 | – | – | |||||||||||||||||||||
Proceeds from issuance of debt, maturities longer than 90 days | 4,796 | – | – | |||||||||||||||||||||
Repayments of debt, maturities longer than 90 days | (228 | ) | – | – | ||||||||||||||||||||
Common stock issued | 2,101 | 3,109 | 2,748 | 579 | 3,494 | 6,782 | ||||||||||||||||||
Common stock repurchased | (19,207 | ) | (8,057 | ) | (3,383 | ) | (9,353 | ) | (12,533 | ) | (27,575 | ) | ||||||||||||
Common stock cash dividends | (3,545 | ) | (36,112 | ) | (1,729 | ) | (4,468 | ) | (4,015 | ) | (3,805 | ) | ||||||||||||
Excess tax benefits from stock-based payment arrangements | 89 | – | – | |||||||||||||||||||||
Excess tax benefits from stock-based compensation | 52 | 120 | 77 | |||||||||||||||||||||
Other | – | (18 | ) | – | (19 | ) | – | (23 | ) | |||||||||||||||
Net cash used in financing | (20,562 | ) | (41,078 | ) | (2,364 | ) | (7,463 | ) | (12,934 | ) | (24,544 | ) | ||||||||||||
Investing | ||||||||||||||||||||||||
Additions to property and equipment | (1,578 | ) | (812 | ) | (1,109 | ) | (3,119 | ) | (3,182 | ) | (2,264 | ) | ||||||||||||
Acquisition of companies, net of cash acquired | (649 | ) | (207 | ) | (4 | ) | (868 | ) | (8,053 | ) | (1,150 | ) | ||||||||||||
Purchases of investments | (51,117 | ) | (68,045 | ) | (95,005 | ) | (36,850 | ) | (20,954 | ) | (36,308 | ) | ||||||||||||
Maturities of investments | 3,877 | 29,153 | 5,561 | 6,191 | 2,597 | 4,736 | ||||||||||||||||||
Sales of investments | 54,353 | 54,938 | 87,215 | 19,806 | 25,132 | 41,451 | ||||||||||||||||||
Net proceeds from securities lending | 3,117 | – | – | |||||||||||||||||||||
Securities lending payable | (930 | ) | (127 | ) | (376 | ) | ||||||||||||||||||
Net cash from (used in) investing | 8,003 | 15,027 | (3,342 | ) | (15,770 | ) | (4,587 | ) | 6,089 | |||||||||||||||
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 | |||||||||||||||||||||
Effect of exchange rates on cash and cash equivalents | (67 | ) | 137 | 56 | ||||||||||||||||||||
Cash and equivalents, end of period | $ | 6,714 | $ | 4,851 | $ | 14,304 | ||||||||||||||||||
Net change in cash and cash equivalents | (4,263 | ) | 4,228 | (603 | ) | |||||||||||||||||||
Cash and cash equivalents, beginning of period | 10,339 | 6,111 | 6,714 | |||||||||||||||||||||
Cash and cash equivalents, end of period | $ | 6,076 | $ | 10,339 | $ | 6,111 | ||||||||||||||||||
See accompanying notes.
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STOCKHOLDERS’ EQUITY STATEMENTS
(In millions) | ||||||||||||||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | |||||||||||||||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | |||||||||||||||||||||
Common stock and paid-in capital | ||||||||||||||||||||||||
Balance, beginning of period | $ | 60,413 | $ | 56,396 | $ | 49,234 | $ | 62,849 | $ | 60,557 | $ | 59,005 | ||||||||||||
Common stock issued | 1,939 | 3,223 | 2,815 | 567 | 3,504 | 6,783 | ||||||||||||||||||
Common stock repurchased | (4,447 | ) | (1,737 | ) | (416 | ) | (2,611 | ) | (3,022 | ) | (6,162 | ) | ||||||||||||
Stock-based compensation expense | 1,715 | 2,448 | 5,734 | 1,708 | 1,479 | 1,550 | ||||||||||||||||||
Stock option income tax benefits/(deficiencies) | (617 | ) | 89 | (989 | ) | |||||||||||||||||||
Stock-based compensation income tax benefits (deficiencies) | (128 | ) | 253 | (661 | ) | |||||||||||||||||||
Other, net | 2 | (6 | ) | 18 | (3 | ) | 78 | 42 | ||||||||||||||||
Balance, end of period | 59,005 | 60,413 | 56,396 | 62,382 | 62,849 | 60,557 | ||||||||||||||||||
Retained earnings (deficit) | ||||||||||||||||||||||||
Retained deficit | ||||||||||||||||||||||||
Balance, beginning of period | (12,298 | ) | 18,429 | 15,678 | (26,563 | ) | (29,460 | ) | (18,901 | ) | ||||||||||||||
Cumulative effect of a change in accounting principle – adoption of FIN 48 | – | (395 | ) | – | ||||||||||||||||||||
Cumulative effect of a change in accounting principle – adoption of | – | (17 | ) | – | ||||||||||||||||||||
Net income | 12,599 | 12,254 | 8,168 | 14,569 | 17,681 | 14,065 | ||||||||||||||||||
Other comprehensive income: | ||||||||||||||||||||||||
Net gains/(losses) on derivative instruments | 76 | (58 | ) | 101 | ||||||||||||||||||||
Net unrealized investments gains/(losses) | (282 | ) | 371 | (873 | ) | |||||||||||||||||||
Net unrealized gains on derivatives | 302 | 18 | 14 | |||||||||||||||||||||
Net unrealized gains (losses) on investments | (233 | ) | (653 | ) | 326 | |||||||||||||||||||
Translation adjustments and other | 9 | (6 | ) | 51 | (240 | ) | 121 | 85 | ||||||||||||||||
Comprehensive income | 12,402 | 12,561 | 7,447 | 14,398 | 17,167 | 14,490 | ||||||||||||||||||
Common stock cash dividends | (3,594 | ) | (36,968 | ) | (1,729 | ) | (4,620 | ) | (4,084 | ) | (3,837 | ) | ||||||||||||
Common stock repurchased | (15,411 | ) | (6,320 | ) | (2,967 | ) | (6,039 | ) | (9,774 | ) | (21,212 | ) | ||||||||||||
Balance, end of period | (18,901 | ) | (12,298 | ) | 18,429 | (22,824 | ) | (26,563 | ) | (29,460 | ) | |||||||||||||
Total stockholders’ equity | $ | 40,104 | $ | 48,115 | $ | 74,825 | $ | 39,558 | $ | 36,286 | $ | 31,097 | ||||||||||||
See accompanying notes.
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NOTE 1 ACCOUNTING POLICIES
ACCOUNTING PRINCIPLESAccounting 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. Intercompany transactions and balances have been eliminated. Equity investments in which we exercise significant influence but do not control and are not the primary beneficiary are accounted for using the equity method. Investments in which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost 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, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between 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 creditedrecorded to Other Comprehensive Income (“OCI”).
Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. Prior period amounts have been recast to conform to the current period presentation. See Note 3 – Other Income (Expense).
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 (“OEM”OEMs”), and perpetual licenses for current products under our Open and Select volume licensing programs generally is recognized as products are shipped, with ashipped. A portion of the revenue related to Windows XP is 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 vendor-specific objective evidence of fair value for those elements using the residual method. Under the residual method the totalor relative 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.method. Unearned revenue due to undelivered elements is recognized
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ratably on a straight-line basis over the related product’sproducts’ life cycle.cycles. Revenue related to Windows Vista is not subject to a similar deferral because there are no significant undelivered elements. However, Windows Vista revenue is subject to deferral as a result of the Windows 7 Upgrade Option program which started June 26, 2009. The program allows customers who purchase PCs from participating computer makers or retailers with certain versions of Windows Vista to receive an upgrade to the corresponding version of Windows 7 at minimal or no cost. In addition, purchasers of retail packaged Windows Vista may also qualify for a free or discounted upgrade to the equivalent Windows 7 product with participating retailers in participating markets when the product becomes generally available. Accordingly, estimated revenue related to the undelivered Windows 7 product is deferred until the product is delivered.
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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arrangements include rights to receive future versions of software product on a when-and-if-available basis under Open and Select volume licensing programs (Software Assurance)(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, Xbox Live, and Microsoft Developer Network subscriptions are also accounted for as subscriptions.
Revenue related to our Xbox 360 game console, is recognized upon shipment of the product to retailers. Revenue related to games published by us, and other hardware components is generally recognized when those games have been deliveredownership is transferred to the retailers. Revenue related to games published by third parties for use on the Xbox 360 platform is recognized when games are manufactured forby the game publishers. OnlineDisplay 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. RevenueConsulting revenue for fixed pricefixed-price services arrangements is recognized based on percentageas services are provided.
Revenue generally is recognized net of completion.any taxes collected from customers and subsequently remitted to governmental authorities.
CostsCost of Revenue
Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs related to insignificantproduct support service centers and product distribution centers, costs incurred to drive traffic to our website and/or acquire online advertising space (“traffic acquisitions costs”), costs incurred to support and maintain Internet-based products and services, warranty costs, inventory valuation adjustments, costs associated with the delivery of consulting services, and the amortization of capitalized research and development costs associated with software products that have reached technological feasibility. Capitalized research and development costs are amortized over the estimated lives of the products.
Product Warranty
We provide for the estimated costs of fulfilling our obligations which include telephone support for developer tools software, PC games, computerunder hardware and Xbox, are accrued whensoftware warranties at the time the related revenue is recognized. Provisions are recorded forFor hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated returns, concessions,life of the software.
Research and bad debts.
RESEARCH AND DEVELOPMENTDevelopment
Research and development expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costsexpenses associated with product development. We have determinedResearch and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, the amortization of purchased software code and services content, and in-process research and development. Such costs related to software development are included in research and development expense until
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the point that technological feasibility is reached, which for our software products, is reachedgenerally shortly before the products are released to manufacturing. Costs incurred afterOnce technological feasibility is established have not been material,reached, such costs are capitalized and accordingly, we have expensed all researchamortized to cost of revenue over the estimated lives of the products.
Sales and development costs when incurred.
SALES AND MARKETINGMarketing
Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costsexpenses associated with sales and marketing personnel, and the costs of advertising, promotions, tradeshows, seminars, and other marketing-related programs. Advertising costs are expensed as incurred. Advertising expense was $1.23$1.4 billion, $1.2 billion, and $1.3 billion in fiscal year 2006, $995 millionyears 2009, 2008, and 2007, respectively.
Employee Severance
We record employee severance when a specific plan has been approved by management, the plan has been communicated to employees, and it is unlikely that significant changes will be made to the plan.
Stock-Based Compensation
We account for stock-based compensation in fiscal year 2005,accordance with SFAS No. 123(R),Share-Based Payment. Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and $904 million in fiscal year 2004.is recognized as expense over the applicable vesting period of the stock award (generally four to five years) using the straight-line method.
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 expenseexpenses 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. The fair value of these investments approximates their carrying value. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short termshort-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 saleavailable-for-sale and realized gains and losses are recorded at market value using the specific identification method; unrealized gains and losses (excludingmethod. Changes in market value, excluding other-than-temporary impairments)impairments, are reflected in OCI.
Equity and other investments mayclassified as long-term include both debt and equity instruments. Debt securities and publicly tradedpublicly-traded equity securities are classified as available for saleavailable-for-sale and realized gains and losses are recorded at market using the specific identification method. Unrealized gains and losses (excludingChanges in market value, excluding other-than-temporary impairments)impairments, are reflected in OCI. AllCommon and preferred stock and other investments excluding those accountedthat are restricted for more than one year or are not publicly traded are recorded at cost or using the equity method, are recorded at cost.method.
We lend certain fixed-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 isinterests received (securities pledged as collateral) are determined based upon the underlying security lent and the creditworthiness of the borrower. Cash collateral 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, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to
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sell, the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. 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, and operational and financing cash flow factors, and rating agency actions.factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established.
We use derivative instruments to manage exposures to foreign currency, equity price, interest rate and credit 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 lossSee Note 5 – Derivatives.
Our current financial liabilities, including our short-term debt, have fair values that approximate their carrying values. Our long-term financial liabilities consist of long-term debt which is recognized in earnings in the period of change together with the offsetting loss or gainrecorded 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 hedgesbalance sheet at issuance price less unamortized discount.
Allowance for accounting purposes are recognized in earnings.
Foreign Currency Risk. Certain assets, liabilities, and forecasted transactions are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Options are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging 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 and to manage other foreign currency exposures.
Equities Price Risk. Equity 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. Certain options, futures and swap contracts, not designated as hedging instruments under SFAS No. 133, are 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.
Other Derivatives. Swap contracts, not designated as hedging instruments under SFAS No. 133, are used to manage exposures to credit 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 Be Announced” 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. All derivative instruments not designated as hedging instruments are recorded at fair value, with changes in value recognized in earnings during the period of change.
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ALLOWANCE FOR DOUBTFUL ACCOUNTSDoubtful Accounts
The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts 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 was 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 | |||||||||
2004 | $ | 242 | $ | 44 | $ | (120 | ) | $ | 166 | ||||
2005 | 166 | 48 | (43 | ) | 171 | ||||||||
2006 | 171 | 40 | (69 | ) | $ | 142 |
(In millions) | 2009 | 2008 | 2007 | |||||||||
Year Ended June 30, | ||||||||||||
Balance, beginning of period | $ | 153 | $ | 117 | $ | 142 | ||||||
Charged to costs and other | 360 | 88 | 64 | |||||||||
Write-offs | (62 | ) | (52 | ) | (89 | ) | ||||||
Balance, end of period | $ | 451 | $ | 153 | $ | 117 | ||||||
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.basis through a charge to cost of revenue.
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.years.
GOODWILLGoodwill
Goodwill is tested for impairment on an annual basis as of July 1, and between annual tests if indicators of potential impairment exist, using a fair-value-based approach. NoDuring the second quarter of fiscal year 2009, we changed the date of our annual impairment of goodwill has been identified during any oftest from July 1 to May 1. The change was made to more closely align the periods presented.impairment testing date with our long-range planning and forecasting process. We believe the change in our annual impairment testing date did not delay, accelerate, or avoid an impairment charge. We have determined that this change in accounting principle is preferable under the circumstances and does not result in adjustments to our financial statements when applied retrospectively. See Note 10 – Goodwill.
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INTANGIBLE ASSETS Part II
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Intangible Assets
Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to ten10 years. We evaluate the recoverability of intangible assets periodically and takeby taking into account events or circumstances that may warrant revised estimates of useful lives or that may indicate that impairment exists.the asset may be impaired. All of our intangible assets are subject to amortization. No material impairments of intangible assets have been identified during any of the periods presented.
NOTE 2 UNEARNED REVENUESubsequent Events
Unearned revenue is comprisedWe evaluated events occurring between the end of our most recent fiscal year and July 29, 2009, the date the financial statements were issued.
Recently Issued Accounting Standards
Recently Adopted Accounting Pronouncements
On April 1, 2009, we adopted the Financial Accounting Standards Board (“FASB”) Staff Positions (“FSP”) FAS 157-4, FSP FAS 115-2 and FAS 124-2, and FSP FAS 107-1 and APB 28-1. These FSPs are intended to provide additional application guidance and enhance disclosures about fair value measurements and impairments of securities. FSP FAS 157-4 clarifies the objective and method of fair value measurement even when there has been a significant decrease in market activity for the asset being measured. FSP FAS 115-2 and FAS 124-2 establishes a new model for measuring other-than-temporary impairments for debt securities, including establishing criteria for when to recognize a write-down through earnings versus other comprehensive income. FSP FAS 107-1 and APB 28-1 expands the fair value disclosures required for all financial instruments within the scope of SFAS No. 107,Disclosures about Fair Value of Financial Instruments, to interim periods. Adoption of these FSPs did not have a significant impact on our accounting for financial instruments but did expand our associated disclosures.
On January 1, 2009, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 161,Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133. SFAS No. 161 requires additional disclosures about the Company’s objectives in using derivative instruments and hedging activities, the method of accounting for such instruments under SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities, and its related interpretations, and tabular disclosures of the following items:
Volume licensing programseffects of such instruments and related hedged items on our financial position, financial performance, and cash flows. See Note 5 – 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.Derivatives.
Undelivered elementsOn July 1, 2008, we adopted SFAS No. 157,Fair Value Measurements, for all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. See Note 4 – Represents free post-delivery telephone supportInvestments.
SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115, became effective for us on July 1, 2008. SFAS No. 159 gives us the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis with the difference between the carrying value before election of the fair value option and the rightfair value recorded upon election as an adjustment to receive unspecified upgrades/enhancementsbeginning retained deficit. As of Microsoft Internet ExplorerJune 30, 2009, we had not elected the fair value option for any eligible financial asset or liability.
Recent Accounting Pronouncements Not Yet Adopted
In June 2009, the FASB issued SFAS No. 167,Amendments to FASB Interpretation No. 46(R), which is effective for us beginning July 1, 2010. This Statement amends Financial Accounting Standards Board Interpretation (“FIN”) No. 46(R),Consolidation of Variable Interest Entities an interpretation of ARB No. 51, to require revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over such entities, and additional disclosures for variable interests. We believe the adoption of this pronouncement will not have a material impact on a when-and-if-available basis. The amount recorded as unearned is based onour financial statements.
In February 2008, the sales priceFASB issued FSP FAS 157-2,Effective Date of those elements when sold separatelyFASB Statement No. 157,which delays the effective date of SFAS No. 157 for us to July 1, 2009, for all nonfinancial assets 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 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 one-half years for Windows operating systems and two years for desktop applications.nonfinancial liabilities, except
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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 enhancement billings, Xbox Live and other billings that are accounted for as subscriptions, and other agreements where Microsoft is committed to the delivery of future enhancements, products, or services, including the TV platform.
The components of unearned revenue were as follows:
(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 | 2006 | 2005 | ||||
Client | $ | 2,850 | $ | 2,687 | ||
Server and Tools | 3,792 | 3,048 | ||||
Information Worker | 3,609 | 2,814 | ||||
Other segments | 651 | 618 | ||||
Unearned revenue | $ | 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
for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). We believe the adoption of the delayed items of SFAS No. 157 will not have a material impact on our financial statements.
In December 2007, the FASB issued SFAS No. 141(R),Business Combinations, which replaces SFAS No. 141. The statement retains the fundamental requirements in SFAS No. 141 that the acquisition method of accounting (previously referred to as the purchase method of accounting) be used for all business combinations, but requires a number of changes, including changes in the way assets and liabilities are recognized as a result of business combinations. It also requires the capitalization of in-process research and development at fair value and requires the expensing of acquisition-related costs as incurred. In April 2009, the FASB issued FSP FAS 141(R)-1 which amends SFAS No. 141(R) by establishing a model to account for certain pre-acquisition contingencies. Under the FSP, an acquirer is required to recognize at fair value an asset acquired or a liability assumed in a business combination that arises from a contingency if the acquisition-date fair value of that asset or liability can be determined during the measurement period. If the acquisition-date fair value cannot be determined, then the acquirer should follow the recognition criteria in SFAS No. 5,Accounting for Contingencies,and FASB Interpretation No. 14,Reasonable Estimation of the Amount of a Loss – an interpretation of FASB Statement No. 5.SFAS No. 141(R) and FSP FAS 141(R)-1 are effective for us beginning July 1, 2009, and will apply prospectively to business combinations completed on or after that date. The impact of the adoption of SFAS No. 141(R) and FSP FAS 141(R)-1 will depend on the nature of acquisitions completed after the date of adoption.
In December 2007, the FASB issued SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51, which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be included in net income and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with continuous unrealized lossesany gain or loss recognized in net income. SFAS No. 160 is effective for less thanus beginning July 1, 2009, and greater than 12 monthswill apply prospectively, except for the presentation and their related fair values weredisclosure requirements, which will apply retrospectively. We believe the adoption of SFAS No. 160 will not have a material impact on our financial statements.
NOTE 2 EARNINGS PER SHARE
Basic earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted earnings per share are 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 | ) |
(In millions, except earnings per share) | |||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||
Net income available for common shareholders (A) | $ | 14,569 | $ | 17,681 | $ | 14,065 | |||
Weighted average outstanding shares of common stock (B) | 8,945 | 9,328 | 9,742 | ||||||
Dilutive effect of stock-based awards | 51 | 142 | 144 | ||||||
Common stock and common stock equivalents (C) | 8,996 | 9,470 | 9,886 | ||||||
Earnings per share: | |||||||||
Basic (A/B) | $ | 1.63 | $ | 1.90 | $ | 1.44 | |||
Diluted (A/C) | $ | 1.62 | $ | 1.87 | $ | 1.42 | |||
For the years ended June 30, 2009, 2008, and 2007, 342 million, 91 million, and 199 million shares, respectively, were attributable to outstanding stock-based awards and were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive.
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NOTE 3 OTHER INCOME (EXPENSE)
The components of other income (expense) were as follows:
(In millions) | ||||||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | |||||||||
Dividends and interest | $ | 706 | $ | 888 | $ | 1,319 | ||||||
Net recognized gains (losses) on investments | (125 | ) | 346 | 650 | ||||||||
Net gains (losses) on derivatives | (558 | ) | 226 | (358 | ) | |||||||
Net gains (losses) on foreign currency remeasurements | (509 | ) | 226 | 56 | ||||||||
Other | (56 | ) | (143 | ) | (4 | ) | ||||||
Total | $ | (542 | ) | $ | 1,543 | $ | 1,663 | |||||
Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For fiscal year 2009, $509 million of losses were reported as other income (expense). For fiscal years 2008 and 2007, $221 million and $86 million of gains, respectively, were previously recorded as a component of sales and marketing expense and have been recast as other income (expense).
Net recognized gains (losses) on investments included other-than-temporary impairments of $862 million, $312 million, and $25 million in fiscal years 2009, 2008, and 2007, respectively. Realized gains and losses from sales of available-for-sale securities (excluding other-than-temporary impairments) were $1.6 billion and $897 million, respectively, in fiscal year 2009, $751 million and $93 million, respectively, in fiscal year 2008, and $851 million and $176 million, respectively, in fiscal year 2007.
NOTE 4 INVESTMENTS
Investment Components, Including Associated Derivatives
(In millions) | Cost Basis | Unrealized Gains | Unrealized Losses | Recorded Basis | Cash and Cash | Short-term Investments | Equity and Other | |||||||||
June 30, 2009 | ||||||||||||||||
Cash | $ 2,064 | $ – | $ – | $2,064 | $ 2,064 | $ – | $ – | |||||||||
Mutual funds | 1,007 | – | (25 | ) | 982 | 900 | 82 | – | ||||||||
Commercial paper | 2,601 | – | – | 2,601 | 400 | 2,201 | – | |||||||||
Certificates of deposit | 555 | – | – | 555 | 275 | 280 | – | |||||||||
U.S. Government and Agency securities | 13,450 | 21 | (5 | ) | 13,466 | 2,369 | 11,097 | – | ||||||||
Foreign government bonds | 3,450 | 71 | (4 | ) | 3,517 | – | 3,517 | – | ||||||||
Mortgage-backed securities | 3,353 | 81 | (16 | ) | 3,418 | – | 3,418 | – | ||||||||
Corporate notes and bonds | 4,361 | 287 | (52 | ) | 4,596 | – | 4,596 | – | ||||||||
Municipal securities | 255 | 2 | (1 | ) | 256 | 68 | 188 | – | ||||||||
Common and preferred stock | 4,015 | 627 | (182 | ) | 4,460 | – | – | 4,460 | ||||||||
Other investments | 465 | – | – | 465 | – | (8 | ) | 473 | ||||||||
Total | $35,576 | $1,089 | $(285) | $36,380 | $6,076 | $25,371 | $4,933 | |||||||||
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(In millions) | Cost Basis | Unrealized Gains | Unrealized Losses | Recorded Basis | Cash and Cash Equivalents | Short-term Investments | Equity and Other Investments | |||||||||||||||
June 30, 2008 | ||||||||||||||||||||||
Cash | $ | 3,274 | $ | – | $ | – | $ | 3,274 | $ | 3,274 | $ | – | $ | – | ||||||||
Mutual funds | 1,044 | 15 | (8 | ) | 1,051 | 835 | 136 | 80 | ||||||||||||||
Commercial paper | 787 | – | – | 787 | 787 | – | – | |||||||||||||||
Certificates of deposit | 1,580 | – | – | 1,580 | 1,373 | 207 | – | |||||||||||||||
U.S. Government and Agency securities | 4,200 | 37 | (4 | ) | 4,233 | 1,839 | 2,318 | 76 | ||||||||||||||
Foreign government bonds | 3,466 | 15 | (62 | ) | 3,419 | – | 3,419 | – | ||||||||||||||
Mortgage-backed securities | 3,628 | 31 | (25 | ) | 3,634 | – | 3,634 | – | ||||||||||||||
Corporate notes and bonds | 5,013 | 91 | (39 | ) | 5,065 | 2,122 | 2,943 | – | ||||||||||||||
Municipal securities | 761 | 4 | (4 | ) | 761 | 109 | 652 | – | ||||||||||||||
Common and preferred stock | 4,815 | 1,224 | (113 | ) | 5,926 | – | – | 5,926 | ||||||||||||||
Other investments | 520 | – | – | 520 | – | 14 | 506 | |||||||||||||||
Total | $ | 29,088 | $ | 1,417 | $ | (255 | ) | $ | 30,250 | $ | 10,339 | $ | 13,323 | $ | 6,588 | |||||||
Unrealized Losses on Investments
Investments with continuous unrealized losses for less than 12 months and 12 months or greater 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 | Total Fair Value | Unrealized Losses | |||||||||||||||
June 30, 2009 | |||||||||||||||||||||
Mutual funds | $ | 3 | $ | (1 | ) | $ | 77 | $ | (24 | ) | $ | 80 | $ | (25 | ) | ||||||
U.S. Government and Agency securities | 4,033 | (5 | ) | – | – | 4,033 | (5 | ) | |||||||||||||
Foreign government bonds | 1,444 | (3 | ) | 669 | (1 | ) | 2,113 | (4 | ) | ||||||||||||
Mortgage-backed securities | 503 | (16 | ) | – | – | 503 | (16 | ) | |||||||||||||
Corporate notes and bonds | 713 | (10 | ) | 504 | (42 | ) | 1,217 | (52 | ) | ||||||||||||
Municipal securities | 16 | (1 | ) | – | – | 16 | (1 | ) | |||||||||||||
Common and preferred stock | 1,154 | (135 | ) | 120 | (47 | ) | 1,274 | (182 | ) | ||||||||||||
Total | $ | 7,866 | $ | (171 | ) | $ | 1,370 | $ | (114 | ) | $ | 9,236 | $ | (285 | ) | ||||||
Less than 12 Months | 12 Months or Greater | Total | |||||||||||||||||||
(In millions) | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | Total Fair Value | Unrealized Losses | |||||||||||||||
June 30, 2008 | |||||||||||||||||||||
Mutual funds | $ | 123 | $ | (7 | ) | $ | 12 | $ | (1 | ) | $ | 135 | $ | (8 | ) | ||||||
U.S. Government and Agency securities | 342 | (4 | ) | – | – | 342 | (4 | ) | |||||||||||||
Foreign government bonds | 2,241 | (62 | ) | – | – | 2,241 | (62 | ) | |||||||||||||
Mortgage-backed securities | 1,078 | (25 | ) | – | – | 1,078 | (25 | ) | |||||||||||||
Corporate notes and bonds | 807 | (26 | ) | 925 | (13 | ) | 1,732 | (39 | ) | ||||||||||||
Municipal securities | 176 | (3 | ) | 193 | (1 | ) | 369 | (4 | ) | ||||||||||||
Common and preferred stock | 598 | (106 | ) | 28 | (7 | ) | 626 | (113 | ) | ||||||||||||
Total | $ | 5,365 | $ | (233 | ) | $ | 1,158 | $ | (22 | ) | $ | 6,523 | $ | (255 | ) | ||||||
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At June 30, 20062009, unrealized losses of $243$285 million consisted of: $196$79 million related to investment grade fixed-income securities, $12$24 million related to investments in high yield and emerging market fixed-income securities, $2$110 million related to domestic equity securities, and $33$72 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 international equities are due to market price movements. At June 30, 20052008, unrealized losses of $258$255 million consisted of: $112$121 million related to investment grade fixed-income securities, $13$21 million related to investments in high yield and emerging market fixed incomefixed-income securities, $90$99 million related to domestic equity securities, and $43$14 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 international equities are due to market price movements. Management does not believe any unrealized losses represent an other-than-temporary impairmentimpairments based on our evaluation of available evidence as of June 30, 2006.2009.
CommonAt June 30, 2009, the recorded basis and estimated fair value of common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost.was $204 million. At June 30, 20062008, the recorded basis and estimated fair value of these investments was $41 million, and their estimated fair value was $41$289 million. At June 30, 2005 the recorded basis of these investments was $1.05 billion, and their estimated fair value was $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:Debt Investment Maturities
(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 sales of available-for-sale securities (excluding other-than-temporary impairments) were $1.11 billion and $(531) million in fiscal year 2006, $1.38 billion and $(376) million in fiscal year 2005, and $2.16 billion and $(518) million in fiscal year 2004.
(In millions) | Cost Basis | Estimated Fair Value | ||
Due in one year or less | $ 8,487 | $ 6,750 | ||
Due after one year through five years | 9,796 | 10,071 | ||
Due after five years through ten years | 1,212 | 1,248 | ||
Due after ten years | 2,759 | 2,819 | ||
Total | $22,254 | $20,888 | ||
NOTE 5 DERIVATIVES
ForWe use derivative instruments designatedto manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as hedges,effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge ineffectiveness, determined in accordance withaccounting treatment under SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities, did.
Foreign Currency
Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Options and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of June 30, 2009, the total notional amount of such foreign exchange contracts was $7.2 billion. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments. As of June 30, 2009, the total notional amount of these foreign exchange contracts sold was $3.5 billion. Certain options and forwards not have a significant impactdesignated as hedging instruments are also used to manage the variability in exchange rates on earningsaccounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of June 30, 2009, the total notional amounts of these foreign exchange contracts purchased and sold were $3.2 billion and $3.6 billion, respectively.
Equity
Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price
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risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2009, the total notional amounts of designated and non-designated equity contracts purchased and sold were immaterial.
Interest Rate
Securities held in our fixed-income portfolio are subject to different interest rate risks based on their various maturities. The average maturity of the fixed-income portfolio is managed to achieve economic returns which correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of June 30, 2009, the total notional amount of fixed-interest rate contracts purchased and sold were $2.7 billion and $456 million, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed securities. These meet the definition of a derivative instrument under SFAS No. 133 in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of June 30, 2009, the total notional derivative amount of mortgage contracts purchased was $1.3 billion.
Credit
Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and facilitate portfolio diversification. We use credit default swaps as they are a low cost way of managing exposure to individual credit risks or groups of credit risks while continuing to improve liquidity. As of June 30, 2009, the total notional amounts of credit contracts purchased and sold were immaterial.
Commodity
We use broad-based commodity exposures to enhance portfolio returns and facilitate portfolio diversification. We use swap and futures contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they are low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of June 30, 2009, the total notional amounts of commodity contracts purchased and sold were $543 million and $33 million, respectively.
Credit-Risk-Related Contingent Features
Certain of our counterparty agreements for fiscal years 2006, 2005,derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, collateral will be required for posting, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2009, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral is required to be posted.
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Gross Fair Values of Derivative Instruments (Excluding FIN No. 39(a) Netting)
June 30, 2009 | ||||||||||||||||||
(In millions) | Foreign Exchange Contracts | Equity Contracts | Interest Rate Contracts | Credit Contracts | Commodity Contracts | Total Derivatives | ||||||||||||
Assets | ||||||||||||||||||
Derivatives not designated as hedginginstruments | ||||||||||||||||||
Short-term investments | $ 9 | $78 | $ 44 | $ 21 | $ 2 | $ 154 | ||||||||||||
Other current assets | 48 | – | – | – | – | 48 | ||||||||||||
Total | $ 57 | $78 | $ 44 | $ 21 | $ 2 | $ 202 | ||||||||||||
Derivatives designated as hedging instruments | ||||||||||||||||||
Short-term investments | $ 12 | $ – | $ – | $ – | $ – | $ 12 | ||||||||||||
Other current assets | 417 | – | – | – | – | 417 | ||||||||||||
Equity and other investments | – | 2 | – | – | – | 2 | ||||||||||||
Total | $ 429 | $ 2 | $ – | $ – | $ – | $ 431 | ||||||||||||
Total assets(b) | $ 486 | $80 | $ 44 | $ 21 | $ 2 | $ 633 | ||||||||||||
Liabilities | ||||||||||||||||||
Derivatives not designated as hedginginstruments | ||||||||||||||||||
Other current liabilities | $(183 | ) | $ (3 | ) | $(20 | ) | $(62 | ) | $(6 | ) | $(274 | ) | ||||||
Derivatives designated as hedginginstruments | ||||||||||||||||||
Other current liabilities | $ (75 | ) | $ – | $ – | $ – | $ – | $ (75 | ) | ||||||||||
Total liabilities(b) | $(258 | ) | $ (3 | ) | $(20 | ) | $(62 | ) | $(6 | ) | $(349 | ) | ||||||
(a) | FIN No. 39, Offsetting of Amounts Related to Certain Contracts – an interpretation of APB No. 10 and FASB Statement No. 105, permits the netting of derivative assets and derivative liabilities when a legally enforceable master netting agreement exists. These amounts include fair value adjustments related to our own credit risk and counterparty credit risk. |
(b) | See Note 6 – Fair Value Measurements. |
Fair-Value Hedges
For a derivative instrument designated as a fair-value hedge, the gain (loss) is recognized in earnings in the period of change together with the offsetting loss or 2004. During fiscal year 2006, $217 million in gainsgain on fair valuethe hedged item attributed to the risk being hedged. For options designated as fair-value hedges, from changes in the time value and $399 million in losses on cash flow hedges from changes in time value wereare excluded from the assessment of hedge effectiveness and includedare recognized in investment income and other. earnings.
During fiscal year 2005, $79 million2009, we recognized in other income (expense) the following gains (losses) on fair value hedged derivatives and their related hedged items:
(In millions) | Foreign Exchange Contracts | Equity Contracts | ||||
Derivatives | $121 | $191 | ||||
Hedged items | (120 | ) | (211 | ) | ||
Total | $ 1 | $ (20 | ) | |||
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Cash-Flow Hedges
For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain (loss) is initially reported as a component of other comprehensive income (“OCI”) and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash-flow hedges, from changes in the time value and $116 million in losses on cash flow hedges from changes in time value wereare excluded from the assessment of hedge effectiveness and includedare recognized in investment income and other. During fiscal year 2004, $31 million in gainsearnings. Gains (losses) on fair value hedges from changes in time value and $325 million in losses on cash flow hedges from changes in time value werederivatives representing either hedge components excluded from the assessment of effectiveness or hedge effectiveness and includedineffectiveness are recognized 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.earnings. During fiscal year 2006, $166 million of derivative2009, we recognized the following gains were reclassified(losses) related to revenue and $23 million in derivative gains were reclassified to investment income and other. During fiscal year 2005, $57 million of derivative gains were reclassified to revenue and $33 million in derivative gains were reclassified to investment income and other. During fiscal year 2004, $14 million of derivative gains were reclassified to revenue and no derivative gains or losses were reclassified to investment income and other.foreign exchange contracts:
(In millions) | ||||
Effective portion: | ||||
Gain recognized in OCI, net of tax effect of$472 | $ | 876 | ||
Gain reclassified from accumulated OCI into revenue | $ | 884 | ||
Amount excluded from effectiveness assessment and ineffective portion: | ||||
Loss recognized in other income (expense) | $ | (314 | ) | |
We estimate that $133$528 million of net derivative gains included in OCI will be reclassified into earnings within the next 12 months. No significant amounts of gains or losses(losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2009.
Non-Designated Derivatives
Gains (losses) from changes in fair values of derivatives that are not designated as hedges are recognized in other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying securities and are recorded as a component of OCI. The amounts recognized during fiscal year 2009 were as follows:
(In millions) | ||||
Foreign exchange contracts | $ | (234 | ) | |
Equity contracts | (131 | ) | ||
Interest-rate contracts | 5 | |||
Credit contracts | (18 | ) | ||
Commodity contracts | (126 | ) | ||
Total | $ | (504 | ) | |
Gains (losses) for foreign exchange, equity, interest rate, credit, and commodity contracts presented in other income statement line items were immaterial for fiscal years 2006, 2005,year 2009 and 2004.have been excluded from the table above.
NOTE 6 FAIR VALUE MEASUREMENTS
SFAS No. 157 defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities should include consideration of non-performance risk, including our own credit risk.
In addition to defining fair value, SFAS No. 157 expands the disclosure requirements around fair value and establishes a fair value hierarchy for valuation inputs. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market. Each fair value measurement is
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reported in one of the three levels, which is determined by the lowest level input that is significant to the fair value measurement in its entirety. These levels are:
Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets.
Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques.
The following section describes the valuation methodologies we use to measure financial assets and liabilities at fair value.
Investments Other Than Derivatives
Investments other than derivatives primarily include U.S. Government and Agency securities, foreign government bonds, mortgage-backed securities, commercial paper, corporate notes and bonds, and common and preferred stock.
In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This pricing methodology applies to our Level 1 investments, such as domestic and international equities, U.S. treasuries, exchange-traded mutual funds, and agency securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. These investments are included in Level 2 and consist primarily of corporate notes and bonds, foreign government bonds, mortgage-backed securities, commercial paper, and certain agency securities. Our Level 3 assets primarily include investments in certain corporate bonds. We value the Level 3 corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant to the fair values of the investments.
Derivatives
In general, and where applicable, we use quoted prices in an active market for identical derivative assets and liabilities that are traded on exchanges. These derivative assets and liabilities are included in Level 1. The fair values for the derivative assets and liabilities included in Level 2 are estimated using industry standard valuation models, such as the Black-Scholes model. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot prices for currencies and commodities. Level 2 derivative assets and liabilities primarily include certain over-the-counter options, futures, and swap contracts. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions to determine fair value. These derivative assets and liabilities are included in Level 3 and primarily represent derivatives for foreign equities.
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Assets and Liabilities Measured at Fair Value on a Recurring Basis
The following table presents our assets and liabilities at June 30, 2009, which are measured at fair value on a recurring basis:
(In millions) | |||||||||||||
Level 1 | Level 2 | Level 3 | Gross Fair Value | FIN No. 39 Netting(a) | Net Fair Value | ||||||||
Assets | |||||||||||||
Mutual funds | $ 982 | $ – | $ – | $ 982 | $ – | $ 982 | |||||||
Commercial paper | – | 2,601 | – | 2,601 | – | 2,601 | |||||||
Certificates of deposit | – | 555 | – | 555 | – | 555 | |||||||
U.S. Government and Agency securities | 7,134 | 6,105 | – | 13,239 | – | 13,239 | |||||||
Foreign government bonds | 501 | 3,022 | – | 3,523 | – | 3,523 | |||||||
Mortgage-backed securities | – | 3,593 | – | 3,593 | – | 3,593 | |||||||
Corporate notes and bonds | – | 4,073 | 253 | 4,326 | – | 4,326 | |||||||
Municipal securities | – | 256 | – | 256 | – | 256 | |||||||
Common and preferred stock | 4,218 | 28 | 5 | 4,251 | – | 4,251 | |||||||
Derivatives | 5 | 623 | 5 | 633 | (235 | ) | 398 | ||||||
Total | $12,840 | $20,856 | $263 | $33,959 | $(235 | ) | $33,724 | ||||||
Liabilities | |||||||||||||
Derivatives | $ 5 | $ 344 | $ – | $ 349 | $(231 | ) | $ 118 | ||||||
(a) | FIN No. 39, Offsetting of Amounts Related to Certain Contracts – an interpretation of APB No. 10 and FASB Statement No. 105, permits the netting of derivative assets and derivative liabilities when a legally enforceable master netting agreement exists. These amounts include fair value adjustments related to our own credit risk and counterparty credit risk. |
Changes in Level 3 Instruments Measured at Fair Value on a Recurring Basis
The majority of our Level 3 instruments consist of investment securities classified as available-for-sale with changes in fair value included in other comprehensive income. The following table presents the changes in Level 3 instruments measured on a recurring basis for the year ended June 30, 2009:
(In millions) | ||||||||||||
Corporate Notes and Bonds | Common and Preferred Stock | Derivative Assets | Total | |||||||||
Balance, beginning of period | $138 | $ 8 | $ 71 | $217 | ||||||||
Total realized and unrealized gains (losses): | ||||||||||||
Included in other income (expense) | (6 | ) | (6 | ) | 51 | 39 | ||||||
Included in other comprehensive income | 111 | – | – | 111 | ||||||||
Purchases, issuances, and settlements | – | 5 | (119 | ) | (114 | ) | ||||||
Transfers in (out) | 10 | (2 | ) | 2 | 10 | |||||||
Balance, end of period | $253 | $ 5 | $ 5 | $263 | ||||||||
Change in unrealized gains (losses) included in other income (expense) related to assets held as of June 30, 2009 | $ (7 | ) | $ (5 | ) | $ 4 | $ (8 | ) | |||||
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Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis. These assets are recognized at fair value when they are deemed to be other-than-temporarily impaired. At June 30, 2009, the fair value of the common and preferred stock that we held that was required to be measured at fair value on a non-recurring basis was $164 million. This fair value was determined using models with significant unobservable inputs.
In accordance with the provisions of Accounting Principles Board Opinion No. 18,The Equity Method of Accounting for Investments in Common Stock, we review the carrying values of our investments when events and circumstances warrant, and we consider all available evidence in evaluating when declines in fair value are other than temporary. The fair values of our investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other than temporary. During the fiscal year ended June 30, 2009, impairment charges of $86 million were recognized for certain investments measured at fair value on a nonrecurring basis as the decline in their respective fair values below their cost was determined to be other than temporary in all instances.
NOTE 7 INVENTORIES
The components of inventories were as follows:
(In millions) | ||||||
June 30 | 2006 | 2005 | ||||
Finished goods | $ | 1,013 | $ | 422 | ||
Raw materials and work in process | 465 | 69 | ||||
Inventories | $ | 1,478 | $ | 491 | ||
(In millions) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
June 30, | 2009 | 2008 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Raw materials | $170 | $417 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Work in process | 45 | 31 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Finished goods | 502 | 537 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Total | $717 | $985 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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June 30, | 2009 | 2008 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Land | $ 526 | $ 518 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Buildings and improvements | 5,886 | 4,302 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Leasehold improvements | 1,938 | 1,728 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Computer equipment and software | 4,989 | 4,475 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Furniture and equipment | 1,743 | 1,521 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Total, at | 15,082 | 12,544 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Accumulated depreciation | (7,547 | ) | (6,302 | ) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 7,535 | $ 6,242 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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 generally range from two to 10 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.
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During fiscal years 2009, 2008, and 2007, depreciation expense was $1.7 billion, $1.4 billion, and $1.2 billion, respectively. The majority of depreciation expense in all years related to computer equipment.
NOTE 9 ACQUISITIONS
We acquired nine entities during fiscal year 2009 for total consideration of $925 million, substantially all of which was paid in cash. All of the entities have been consolidated into our results of operations since their respective acquisition dates. The purchase price allocations for these acquisitions are preliminary for up to 12 months after the acquisition dates and are subject to revision as more detailed analyses are completed and additional information about the fair values of assets and liabilities becomes available. Any change in the estimated fair value of the net assets of the acquired companies within this timeframe will change the amount of the purchase price allocable to goodwill. Pro forma results of operations have not been presented because the effects of these acquisitions, individually and in the aggregate, were not material to our consolidated results of operations.
NOTE 10 GOODWILL
Changes in the carrying amount of goodwill for fiscal years 2009 and 2008 by segment were as follows:
(In millions) | ||||||||||||||||
Balance as of June 30, 2007 | Acquisitions | Purchase Accounting Adjustments and Other | Balance as of June 30, 2008 | Acquisitions | Purchase Accounting Adjustments and Other | Balance as of June 30, 2009 | ||||||||||
Client | $ 77 | $ 77 | $ (1 | ) | $ 153 | $ 1 | $ (77 | ) | $ 77 | |||||||
Server and Tools | 580 | 90 | 68 | 738 | 233 | 67 | 1,038 | |||||||||
Online Services Business | 552 | 5,775 | (53 | ) | 6,274 | 447 | (64 | ) | 6,657 | |||||||
Microsoft Business Division | 3,132 | 1,073 | (14 | ) | 4,191 | _ | (264 | ) | 3,927 | |||||||
Entertainment and Devices Division | 419 | 354 | (21 | ) | 752 | 58 | (6 | ) | 804 | |||||||
Total | $4,760 | $7,369 | $(21 | ) | $12,108 | $739 | $(344 | ) | $12,503 | |||||||
None of the amounts recorded as goodwill are expected to be deductible for tax purposes. The purchase price allocations for all of the acquisitions are preliminary for up to 12 months after the acquisition date and are subject to revision as more detailed analyses are completed and additional information about fair value of the assets and liabilities become available. Any change in the fair value of the net assets of the acquired company within this timeframe will change the amount of the purchase price allocable to goodwill. Changes in goodwill amounts resulting from foreign currency translations are included in “purchase accounting adjustments and other” in the above table.
We test goodwill for impairment annually at the reporting unit level using a fair value approach, in accordance with the provisions of SFAS No. 142,Goodwill and Other Intangible Assets. During the second quarter of fiscal year 2009, we changed the date of our annual impairment test from July 1 to May 1. The change was made to more closely align the impairment testing date with our long-range planning and forecasting process. We believe the change in our annual impairment testing date did not delay, accelerate, or avoid an impairment charge. We have determined that this change in accounting principle is preferable under the circumstances and does not result in adjustments to our financial statements when applied retrospectively. During fiscal year 2009, the annual impairment test was performed as of July 1, 2008 and was performed again as of May 1, 2009.
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NOTE 11 INTANGIBLE ASSETS
The components of intangible assets, all of which are finite-lived, were as follows:
(In millions) | ||||||||||||||
June 30, | 2009 | 2008 | ||||||||||||
Gross Carrying Amount | Accumulated Amortization | Net Carrying Amount | Gross Carrying Amount | Accumulated Amortization | Net Carrying Amount | |||||||||
Contract-based | $1,087 | $ (855 | ) | $ 232 | $1,074 | $ (796 | ) | $ 278 | ||||||
Technology-based | 2,033 | (1,090 | ) | 943 | 1,677 | (672 | ) | 1,005 | ||||||
Marketing-related | 188 | (97 | ) | 91 | 171 | (65 | ) | 106 | ||||||
Customer-related | 732 | (239 | ) | 493 | 708 | (124 | ) | 584 | ||||||
Total | $4,040 | $(2,281 | ) | $1,759 | $3,630 | $(1,657 | ) | $1,973 | ||||||
During fiscal year 2009 and 2008, we recorded additions to intangible assets of $354 million and $1.6 billion, respectively. We estimate that we have no significant residual value related to our intangible assets.
The components of intangible assets acquired during fiscal years 2009 and 2008 were as follows:
(In millions) | ||||||||
Year Ended June 30, | 2009 | 2008 | ||||||
Amount | Weighted Average Life | Amount | Weighted Average Life | |||||
Contract-based | $ 26 | 4 years | $ 91 | 6 years | ||||
Technology-based | 293 | 4 years | 787 | 4 years | ||||
Marketing-related | 7 | 5 years | 116 | 5 years | ||||
Customer-related | 28 | 2 years | 589 | 6 years | ||||
Total | $354 | $1,583 | ||||||
Acquired intangibles generally are amortized on a straight-line basis over their weighted average lives. Intangible assets amortization expense was $591 million for fiscal year 2009, $472 million for fiscal year 2008, and $236 million for fiscal year 2007. The following table outlines the estimated future amortization expense related to intangible assets as of June 30, 2009:
(In millions) | ||
Year Ended June 30, | Amount | |
2010 | $ 562 | |
2011 | 511 | |
2012 | 455 | |
2013 | 191 | |
2014 and thereafter | 40 | |
Total | $1,759 | |
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NOTE 12 DEBT
Short-term Debt
In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Pursuant to the authorization, we established a commercial paper program providing for the issuance and sale of up to $2.0 billion in short-term commercial paper. As of June 30, 2009, $2.0 billion of the commercial paper was issued and outstanding with a weighted average interest rate, including issuance costs, of 0.20% and maturities of 22 to 119 days. The estimated fair value of this commercial paper approximates its carrying value.
In September 2008, we also entered into a $2.0 billion six-month senior unsecured credit facility, principally to support the commercial paper program. In November 2008, we replaced the six-month credit facility with a $2.0 billion 364-day credit facility. This credit facility expires on November 6, 2009. In March 2009, we entered into an additional credit facility. This $1.0 billion 364-day credit facility expires on March 12, 2010. As of June 30, 2009, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against these credit facilities during the year ended June 30, 2009.
Long-term Debt
In November 2008, we filed a shelf registration statement with the U.S. Securities and Exchange Commission that allows us to issue debt securities from time to time pursuant to the September 2008 authorization for debt financings of up to $6.0 billion. In May 2009, we issued $3.75 billion of debt securities under that registration statement (“Notes”). Interest on the Notes will be payable semi-annually on June 1 and December 1 of each year, commencing on December 1, 2009, to holders of record on the preceding May 15 and November 15. The Notes are senior unsecured obligations and will rank equally with our other unsecured and unsubordinated debt outstanding.
The components of long-term debt as of June 30, 2009 were as follows:
(In millions) | ||||
2.95% Notes due on June 1, 2014 | $ | 2,000 | ||
4.20% Notes due on June 1, 2019 | 1,000 | |||
5.20% Notes due on June 1, 2039 | 750 | |||
Unamortized debt discount | (4 | ) | ||
Total | $ | 3,746 | ||
Maturities of long-term debt for the next five years are as follows:
(In millions) | |||
Year Ended June 30, | Amount | ||
2010 | $ | – | |
2011 | – | ||
2012 | – | ||
2013 | – | ||
2014 | 2,000 | ||
Thereafter | 1,750 | ||
Total | $ | 3,750 |
As of June 30, 2009, the total carrying value and estimated fair value of our long-term debt were $3.75 billion and $3.74 billion, respectively. The estimate of fair value is based on quoted prices for our publicly-traded debt as of June 30, 2009. The effective interest yields of the Notes due in 2014, 2019, and 2039 were 3.00%, 4.29%, and 5.22%, respectively, at June 30, 2009.
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NOTE 13 INCOME TAXES
The components of the provision for income taxes were as follows:
(In millions) | |||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||
Current taxes: | |||||||||
U.S. Federal | $3,159 | $4,357 | $4,593 | ||||||
U.S. State and Local | 192 | 256 | 154 | ||||||
International | 1,139 | 1,007 | 957 | ||||||
Current taxes | 4,490 | 5,620 | 5,704 | ||||||
Deferred taxes | 762 | 513 | 332 | ||||||
Provision for income taxes | $5,252 | $6,133 | $6,036 | ||||||
U.S. and international components of income before income taxes were as follows:
|
| ||||||||
(In millions) | |||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||
U.S. | $ 5,529 | $12,682 | $12,902 | ||||||
International | 14,292 | 11,132 | 7,199 | ||||||
Income before income taxes | $19,821 | $23,814 | $20,101 | ||||||
The items accounting for the difference between income taxes computed at the federal statutory rate and the
| |||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||
Federal statutory rate | 35.0 | % | 35.0 | % | 35.0 | % | |||
Effect of: | |||||||||
Foreign earnings taxed at lower rates | (9.3 | )% | (7.0 | )% | (5.1 | )% | |||
Internal Revenue Service settlement | – | % | (5.8 | )% | – | % | |||
European Commission fine | – | % | 2.1 | % | – | % | |||
Other reconciling items, net | 0.8 | % | 1.5 | % | 0.1 | % | |||
Effective rate | 26.5 | % | 25.8 | % | 30.0 | % | |||
In general, other reconciling items consist of interest, U.S. state income taxes, domestic production deductions, and research credits. In fiscal years 2009 and 2008, there were no individually significant other reconciling items. Other reconciling items in fiscal year 2007 included the impact of a $195 million reduction resulting from various changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit assessments.
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The components of the deferred income tax assets and liabilities were as follows:
(In millions) | ||||||||
June 30, | 2009 | 2008 | ||||||
Deferred income tax assets: | ||||||||
Stock-based compensation expense | $ | 2,004 | $ | 2,225 | ||||
Other expense items | 1,595 | 1,933 | ||||||
Unearned revenue | 743 | 928 | ||||||
Impaired investments | 236 | 331 | ||||||
Other revenue items | 120 | 91 | ||||||
Deferred income tax assets | $ | 4,698 | $ | 5,508 | ||||
Deferred income tax liabilities: | ||||||||
International earnings | $ | (1,191 | ) | $ | (1,300 | ) | ||
Unrealized gain on investments | (516 | ) | (513 | ) | ||||
Other | (499 | ) | (729 | ) | ||||
Deferred income tax liabilities | (2,206 | ) | (2,542 | ) | ||||
Net deferred income tax assets | $ | 2,492 | $ | 2,966 | ||||
Reported as: | ||||||||
Current deferred income tax assets | $ | 2,213 | $ | 2,017 | ||||
Long-term deferred income tax assets | 279 | 949 | ||||||
Net deferred income tax assets | $ | 2,492 | $ | 2,966 | ||||
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 the taxes are actually paid or recovered.
We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $18.0 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the United States. The unrecognized deferred tax liability associated with these temporary differences is approximately $5.4 billion.
Income taxes paid were $6.6 billion in fiscal year 2009, $5.4 billion in fiscal year 2008, and $5.2 billion in fiscal year 2007.
Uncertain Tax Positions
As of June 30, 2009, we had $5.4 billion of unrecognized tax benefits of which $4.4 billion, if recognized, would affect our effective tax rate. As of June 30, 2008, we had $3.2 billion of unrecognized tax benefits of which $2.3 billion, if recognized, would affect our effective tax rate.
Interest and penalties related to unrecognized tax benefits are included in income tax expense. Such interest totaled $230 million in fiscal year 2009 and $121 million in fiscal year 2008. As of June 30, 2009 and 2008, we had accrued interest related to uncertain tax positions of $554 million and $324 million, respectively, net of federal income tax benefits, on our balance sheets.
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The aggregate changes in the balance of unrecognized tax benefits were as follows:
(In millions) | ||||||||
Year Ended June 30, | 2009 | 2008 | ||||||
Balance, beginning of year | $ | 3,195 | $ | 7,076 | ||||
Decreases related to settlements | (82 | ) | (4,787 | ) | ||||
Increases for tax positions related to the current year | 2,203 | 934 | ||||||
Increases for tax positions related to prior years | 239 | 66 | ||||||
Decreases for tax positions related to prior years | (132 | ) | (80 | ) | ||||
Reductions due to lapsed statute of limitations | (20 | ) | (14 | ) | ||||
Balance, end of year | $ | 5,403 | $ | 3,195 | ||||
During fiscal year 2008, we reached a settlement with the Internal Revenue Service (“IRS”) on its 2000-2003 examination. As a result, we reduced our unrecognized tax benefits by $4.8 billion and recognized a tax provision reduction of $1.2 billion. As a result of the 2000-2003 settlement and the related impact on subsequent years, we paid the IRS approximately $4.1 billion during fiscal year 2009.
We are under audit by the IRS for the tax years 2004-2006. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months as we do not believe the examination will be concluded within the next 12 months.
We are subject to income tax in many jurisdictions outside the United States, none of which are individually material to our financial position, cash flows, or results of operations.
NOTE 14 UNEARNED REVENUE
Unearned revenue is comprised of the following items:
Volume licensing programs
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.
Undelivered elements
Represents the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis and free post-delivery telephone support. This revenue deferral is applicable for Windows XP and prior versions shipped as retail packaged products, products licensed to OEMs, and perpetual licenses for current products under our Open and Select volume licensing programs. 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. Product life cycles are currently estimated at three and one-half years for Windows operating systems. Undelivered elements include $276 million of deferred revenue related to the Windows 7 Upgrade Option program.
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 Dynamics business solutions products, Xbox Live subscriptions, Mediaroom, and other offerings 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.
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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.
Part II
Item 8
NOTE 9 INTANGIBLE ASSETS
The components of finite-lived intangible assets
The components of unearned revenue were as follows:
(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 | ||||||
During 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 as follows:
(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 | |
Part II
Item 8
NOTE 10 INCOME TAXES
The components of the provision for income taxes were as follows:
(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 as follows:
(In millions) | |||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||
U.S. | $ | 11,404 | $ | 9,806 | $ | 8,088 | |||
International | 6,858 | 6,822 | 4,108 | ||||||
Income before income taxes | $ | 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 | % | |||
The 2006 other reconciling items includes the impact of the $351 million non-deductible European Commission fine. The 2005 other reconciling items include a $179 million repatriation tax benefit under the American Jobs Creation Act of 2004. The 2004 other reconciling items include the $208 million benefit from the resolution of an issue remanded by the Ninth Circuit Court of Appeals and the impact of the $605 million 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 are actually paid or recovered.
We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $505 million resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the United States. The amount of unrecognized 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 repatriate foreign subsidiary earnings by providing an elective 85% dividends received deduction for certain dividends from controlled foreign corporations. Under these provisions, 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. deferred tax liabilities on these unremitted foreign subsidiary earnings in 2005. The dividend was paid in June 2006.
Income taxes paid were $4.8 billion in fiscal year 2006, $4.3 billion in fiscal year 2005, and $2.5 billion in 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
Part II
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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 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 | ||
(In millions) | ||||||
June 30, | 2009 | 2008 | ||||
Volume licensing programs | $ | 11,350 | $ | 12,232 | ||
Undelivered elements | 1,083 | 1,396 | ||||
Other | 1,851 | 1,669 | ||||
Total | $ | 14,284 | $ | 15,297 | ||
Unearned revenue by segment was as follows:
(In millions) | ||||||
June 30, | 2009 | 2008 | ||||
Client | $ | 2,345 | $ | 2,738 | ||
Server and Tools | 4,732 | 5,007 | ||||
Microsoft Business Division | 6,508 | 7,101 | ||||
Other segments | 699 | 451 | ||||
Total | $ | 14,284 | $ | 15,297 | ||
NOTE 12 STOCKHOLDERS’ EQUITY15 OTHER LONG-TERM LIABILITIES
Shares
(In millions) | ||||||
June 30, | 2009 | 2008 | ||||
Tax contingencies and other tax liabilities | $ | 5,515 | $ | 3,812 | ||
Legal contingencies | 407 | 530 | ||||
Product warranty | 132 | 278 | ||||
Other | 215 | 101 | ||||
Total | $ | 6,269 | $ | 4,721 | ||
NOTE 16 COMMITMENTS AND GUARANTEES
We have committed $621 million for constructing new buildings as of common stock outstandingJune 30, 2009.
We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for operating leases was $475 million, $398 million, and $325 million, in fiscal years 2009, 2008, and 2007, respectively. Future minimum rental commitments under noncancellable operating leases in place as of June 30, 2009 are as follows:
(In millions) | |||
Year Ended June 30, | Amount | ||
2010 | $ | 457 | |
2011 | 370 | ||
2012 | 309 | ||
2013 | 252 | ||
2014 and thereafter | 997 | ||
$ | 2,385 | ||
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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 and certain other matters. We evaluate estimated losses for these indemnifications under SFAS No. 5,Accounting for Contingencies, as interpreted by FIN 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 significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements.
Product Warranty
The changes in our aggregate product warranty liabilities, which are included in other current liabilities and other long term-liabilities on our balance sheets, were as follows:
(In millions) | |||||||||||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||||||||||
Year Ended June 30, | 2009 | 2008 | |||||||||||||||
Balance, beginning of year | 10,710 | 10,862 | 10,771 | $ | 692 | $ | 850 | ||||||||||
Issued | 106 | 160 | 215 | ||||||||||||||
Repurchased | (754 | ) | (312 | ) | (124 | ) | |||||||||||
Accruals for warranties issued | 161 | 365 | |||||||||||||||
Adjustments to pre-existing warranties | – | 36 | |||||||||||||||
Settlements of warranty claims | (511 | ) | (559 | ) | |||||||||||||
Balance, end of year | 10,062 | 10,710 | 10,862 | $ | 342 | $ | 692 | ||||||||||
NOTE 17 CONTINGENCIES
Government Competition Law Matters
In March 2004, the European Commission issued a competition law decision that, among other things, ordered us to license certain Windows server protocol technology to our competitors. In March 2007, the European Commission issued a statement of objections claiming that the pricing terms we proposed for licensing the technology as required by the March 2004 decision were “not reasonable.” Following additional steps we took to address these concerns, the Commission announced on October 22, 2007 that we were in compliance with the March 2004 decision and that no further penalty should accrue after that date. On February 27, 2008, the Commission issued a fine of $1.4 billion (€899 million) relating to the period prior to October 22, 2007. In May 2008, we filed an application with the European Court of First Instance to annul the February 2008 fine. We paid the $1.4 billion (€899 million) fine in June 2008.
In January 2008, the Commission opened a competition law investigation relating to the inclusion of various capabilities in our Windows operating system software, including Web browsing software. The investigation was precipitated by a complaint filed with the Commission by Opera Software ASA, a firm that offers Web browsing software. On January 15, 2009, the European Commission issued a statement of objections expressing the Commission’s preliminary view that the inclusion of Internet Explorer in Windows since 1996 has violated European competition law. According to the statement of objections, other browsers are foreclosed from competing because Windows includes Internet Explorer. We filed our written response to the statement of objections in late April 2009. The European Commission will not make a final determination until after it assesses our response and considers submissions from others, a process that is now underway. The statement of objections seeks to impose a remedy that is different than the remedy imposed in the earlier proceeding concerning Windows Media Player. While computer users and OEMs are already free to run any Web browsing software on Windows, the Commission is considering ordering other changes to further promote the prospects of competing browser software. This may include ordering creation of a “ballot screen” from which computer users could choose from among a variety of browsers. The statement of objections also seeks to impose a significant fine based on worldwide sales of Windows operating systems. In January 2008, the Commission opened an additional competition law investigation that relates primarily to interoperability with respect to our Microsoft Office family of products. This investigation resulted from complaints filed with the Commission by a trade association of Microsoft’s competitors. On July 20, 2006,24, 2009 we announcedsubmitted a proposal to the completion ofCommission to resolve the $30 billion Microsoft common stock repurchase program approved by our Board of Directors on July 20, 2004. The repurchases were made using our cash resources. Our Board of Directors had previously approvedinvestigation concerning Internet Explorer. Under this proposal, European consumers who use Internet Explorer as their default browser would be shown a program to repurchase shares of our common stock. Under these repurchase plans, we have made“ballot screen” from which they could, if they wished, easily install competing browsers from the following share repurchases:Web. We also submitted a proposal regarding means
(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 | ||||||
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In fiscal year 2006, our Board of Directors declared the 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 |
of promoting greater interoperability between non-Microsoft products and our Windows and Office families of products. We made this proposal following extensive discussions with the Commission. In a statement issued on July 24, 2009, the Commission stated it welcomes our proposals. We understand the Commission will now consider them, which will likely entail seeking input from a range of industry participants.
We are subject to a Consent Decree and Final Judgment (“Final Judgments”) that resolved lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions. The Final Judgments imposed various constraints on our Windows operating system businesses. Originally, the Final Judgments were scheduled to expire in November 2007. In 2006, we voluntarily agreed to extend certain elements of the Final Judgments to November 2009. The U.S. Department of Justice and other states advised the Court that they would not seek any extension of the Final Judgments to which they are party. In January 2008, the court issued a decision granting the states’ motion to extend these additional provisions of the Final Judgments until November 2009. On April 16, 2009, we agreed with the Department of Justice and the states, respectively, to extend the Final Judgments to May 2011, and submitted to the U.S. District Court for the District of Columbia joint motions for this extension. In April 2009, the Court entered an order approving the extension.
In fiscal yearother ongoing investigations, various foreign governments and several state attorneys general have requested information from us concerning competition, privacy, and security issues.
Antitrust, 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, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under federal law and in 15 states. Courts refused to certify classes in two additional states. We have reached agreements to settle all claims that have been made to date in 19 states and the District of Columbia.
Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers.
The settlements in all states except Arizona have received final court approval. Cases in Canada have not been settled. We estimate the total cost to resolve all of the overcharge class action cases will range between $1.8 billion and $2.0 billion. The actual cost depends on factors such as the claim rate, the quantity and mix of products for which claims are 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. At June 30, 2009, we have recorded a liability related to these claims of approximately $800 million, which reflects our estimated exposure of $1.8 billion less payments made to date of approximately $1.0 billion mostly for vouchers, legal fees, and administrative expenses.
Other Antitrust Litigation and Claims
In November 2004, Novell, Inc. filed a complaint in U.S. District Court, asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. This case was transferred to Maryland. In June 2005, the trial court granted our Boardmotion to dismiss four of Directors declarednine claims of the following dividends:complaint. Both parties appealed, and in October 2007, the court of appeals affirmed the decision of the trial court, and remanded the case to that court for further proceedings. Fact discovery has closed and summary judgment motions are expected to be filed in the fall.
Patent and Intellectual Property Claims
In 2003 we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents (although this action began before the merger of Alcatel and Lucent in 2006, for simplicity we refer to the post-merger entity of Alcatel-Lucent). In April 2008, a jury returned a verdict in Alcatel-Lucent’s favor in a trial on a consolidated group of one video and three user interface patents. The jury concluded that we had infringed two user interface patents and awarded $367 million in damages. In June 2008, the trial judge increased the amount of damages to $512 million to include $145 million of interest. We have appealed that award to the Federal Circuit. In December 2008, we entered into a settlement agreement resolving all other litigation
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 |
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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The components of accumulated other comprehensive income were as follows:
(In millions) | |||||||||
Year Ended June 30 | 2006 | 2005 | 2004 | ||||||
Net gains on derivative instruments | $ | 103 | $ | 27 | $ | 85 | |||
Net unrealized investment gains | 1,062 | 1,344 | 973 | ||||||
Translation adjustments and other | 64 | 55 | 61 | ||||||
Accumulated other comprehensive income | $ | 1,229 | $ | 1,426 | $ | 1,119 | |||
pending between Microsoft and Alcatel-Lucent, leaving approximately $500 million remaining in dispute. In April 2009, the U.S. Patent and Trademark Office, after a reexamination of the remaining patent in dispute, determined that the patent was invalid and Alcatel-Lucent has appealed that ruling.
In October 2003, Uniloc USA Inc., a subsidiary of a Singapore-based security technology company, filed a patent infringement suit in U.S. District Court in Rhode Island, claiming that product activation technology in Windows XP and certain other Microsoft programs violated a Uniloc patent. After we obtained a favorable summary judgment that we did not infringe any of the claims of this patent, the court of appeals vacated the trial court decision and remanded the case for trial. In April 2009, the jury returned a $388 million verdict against us, including a finding of willful infringement. We are seeking to overturn this verdict via post-trial motions and, if necessary, will appeal, based on evidence that our product activation technology does not infringe the patent, that the patent is invalid, and that the damages were unsupported. With pre-judgment interest, approximately $500 million is in dispute.
In March 2007, i4i Limited Partnership, based in Canada, sued Microsoft in U.S. District Court in the Eastern District of Texas, claiming that certain custom XML technology in Word 2003 and 2007 infringed i4i’s patent. In May 2009, a jury returned a verdict against us, finding damages of $200 million and that we willfully infringed the patent. Our defense of inequitable conduct has not yet been ruled upon, and we are also seeking to overturn the verdict via post-trial motions and, if necessary, via appeal. With pre-judgment interest, approximately $240 million is in dispute.
There are over 50 other patent infringement cases pending against Microsoft, 10 of which are set for trial in fiscal year 2010.
Other
We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial position, our results of operations, or 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, 2009, we had accrued aggregate liabilities of approximately $800 million in other current liabilities and approximately $400 million 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 that we estimate could be up to $2.2 billion in aggregate beyond recorded amounts. The foregoing amount does not include the January 15, 2009 European Commission statement of objections, the outcome and range of which is not reasonably estimable. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our financial position, results of operations, and cash flows for the period in which the effects become reasonably estimable.
NOTE 14 EMPLOYEE STOCK AND SAVINGS PLANS18 STOCKHOLDERS’ EQUITY
Effective July 1, 2005, we adopted SFAS No. 123(R),Share-Based Payment,using the modified prospective application transition method. Because the fair value recognition provisionsShares Outstanding
Shares of SFAS No. 123, Stock-Based Compensation, and SFAS 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 benefitscommon stock outstanding 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 |
(In millions) | |||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||
Balance, beginning of year | 9,151 | 9,380 | 10,062 | ||||||
Issued | 75 | 173 | 289 | ||||||
Repurchased | (318 | ) | (402 | ) | (971 | ) | |||
Balance, end of year | 8,908 | 9,151 | 9,380 | ||||||
Employee Stock Purchase Plan. We have an employee stock purchase plan for all eligible employees. Compensation expense forShare Repurchases
On September 22, 2008, we announced the employee stock purchase plan is recognized in accordance with SFAS No. 123(R). The administrative committee undercompletion of the plantwo repurchase programs approved by our Board of Directors during the first quarter of fiscal year 2007 to buy back up to $40.0 billion of Microsoft common stock. On September 22, 2008, we also announced that our Board of Directors 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.new share repurchase program
Under the plan in effect previous to fiscal year 2005, shares of our common stock could be purchased at six 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 could purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal year 2004 employees purchased 16.7 million shares at average prices of $22.74 per share.
Savings Plan. We have a savings plan in the United States that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 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 $178 million, $154 million, and $141 million in fiscal years 2006, 2005, and 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 Plans. We have stock plans for directors and for officers, employees, consultants, and advisors. At
authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. As of June 30, 2006, an aggregate2009, approximately $34.5 billion remained of 812 millionthe $40.0 billion approved repurchase amount. All repurchases were made using cash resources. The repurchase program may be suspended or discontinued at any time without prior notice.
We repurchased the following shares were authorized for future grant under ourof common 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)above-described repurchase plans:
(In millions) | ||||||||||||
Year Ended June 30, | 2009(a) | 2008(b) | 2007(c) | |||||||||
Shares | Amount | Shares | Amount | Shares | Amount | |||||||
First quarter | 223 | $5,966 | 81 | $ 2,348 | 285 | $ 6,965 | ||||||
Second quarter | 95 | 2,234 | 120 | 4,081 | 205 | 6,037 | ||||||
Third quarter | – | – | 30 | 1,020 | 238 | 6,744 | ||||||
Fourth quarter | – | – | 171 | 4,975 | 243 | 7,367 | ||||||
Total | 318 | $8,200 | 402 | $12,424 | 971 | $27,113 | ||||||
(a) | Of the 318 million shares of common stock repurchased in fiscal year 2009, 101 million shares were repurchased for $2.7 billion under the repurchase plan approved by our Board of Directors during the first quarter of fiscal year 2007. The remaining shares were repurchased under the repurchase plan approved by our Board of Directors on September 22, 2008. |
(b) | All shares repurchased in fiscal year 2008 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2006. |
(c) | Of the 971 million shares of common stock repurchased in fiscal year 2007, 155 million shares were repurchased for $3.8 billion under our tender offer in the first quarter of fiscal year 2007. The remaining shares were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2006. |
Dividends
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 allowed2009, our Board of Directors to adjust eligible options, unvested stock awards, and shared performance stock awards to maintain their pre-dividend value afterdeclared 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. following dividends:
Declaration Date | Dividend Per Share | Record Date | Total Amount (in millions) | Payment Date | |||||
September 19, 2008 | $0.13 | November 20, 2008 | $1,157 | December 11, 2008 | |||||
December 10, 2008 | $0.13 | February 19, 2009 | $1,155 | March 12, 2009 | |||||
March 9, 2009 | $0.13 | May 21, 2009 | $1,158 | June 18, 2009 | |||||
June 10, 2009 | $0.13 | August 20, 2009 | $1,158 | (a) | September 10, 2009 |
(a) | The dividend declared on June 10, 2009 will be paid after the filing date of this report on Form 10-K and was included in other current liabilities as of June 30, 2009. |
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 byfiscal year 2008, our Board of Directors on July 20, 2004 to buy back up to $30 billion in Microsoft common stock.declared the following dividends:
Declaration Date | Dividend Per Share | Record Date | Total Amount (in millions) | Payment Date | |||||
September 12, 2007 | $0.11 | November 15, 2007 | $1,034 | December 13, 2007 | |||||
December 19, 2007 | $0.11 | February 21, 2008 | $1,023 | March 13, 2008 | |||||
March 17, 2008 | $0.11 | May 15, 2008 | $1,020 | June 12, 2008 | |||||
June 11, 2008 | $0.11 | August 21, 2008 | $ 998 | (a) | September 11, 2008 |
(a) | The dividend declared on June 11, 2008 was included in other current liabilities as of June 30, 2008. |
Other
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 wasOn July 1, 2003 through June 30, 2006 (January 1, 2004 through June 30, 20062007, we adopted the provisions of FIN No. 48,Accounting for certain executive officers). Following the endUncertainty in Income Taxes – an interpretation 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 coveredFASB Statement No. 109, which provides a three-year period, SPSAs issued in fiscal year 2005financial statement recognition threshold and 2006 were given only to newly hired and promoted employees eligible to receive SPSAs.
The Company will grant SPSAs for fiscal 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.
PAGE |
Part II
Item 8
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 aremeasurement attribute for a tax position taken or expected to be taken in a tax return. Upon adoption, we 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$395 million charge to our directorsbeginning retained deficit as a cumulative effect of a change in accounting principle.
On July 1, 2007, we adopted Emerging Issues Task Force Issue No. 06-2 (“EITF 06-2”),Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43. EITF 06-2 requires companies to accrue the costs of compensated absences under our non-employee director stock plan. Nonqualified and incentive stock options were granteda sabbatical or similar benefit arrangement over the requisite service period. Upon adoption, we recognized a $17 million charge to our officers and employees under our employee stock plans. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven years from the datebeginning retained deficit as a cumulative effect 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 after 2001 vest over four and one-half years and expire ten years from the date of grant. Approximately 2.9 million stock options were granteda change in conjunction with business acquisitions during fiscal year 2006. No stock options were granted during the year 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.accounting principle.
During fiscal year 2004, we completed an employee stock option transfer program whereby employees could elect to transfer all of their 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 year 2004. As of June 30, 2006, 237 million options transferred 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 have expiration dates extending through December 2006.
Part II NOTE 19 OTHER COMPREHENSIVE INCOME
Item 8
Employee stock options outstandingThe activity in other comprehensive income and related income tax effects were as follows:
Shares (in millions) | Weighted Average Exercise Price | Weighted Average Remaining Contractual Term (years) | Aggregate (in millions) | ||||||||
Balance, July 1, 2005 | 864 | $ | 27.41 | ||||||||
Granted | 3 | 23.54 | |||||||||
Exercised | (76 | ) | 20.59 | ||||||||
Canceled | (33 | ) | 32.13 | ||||||||
Forfeited | (8 | ) | 23.01 | ||||||||
Balance, June 30, 2006 | 750 | $ | 27.92 | 4.16 | $ | 452 | |||||
Exercisable, June 30, 2006 | 673 | $ | 28.55 | 3.93 | $ | 343 |
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 exercise prices presented. These options have an exercise price range of $0 to $150.93 and 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 to be recognized over a weighted average period of approximately one year.
During fiscal years 2006, 2005, and 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 15 EARNINGS PER SHARE
Basic earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted earnings per share are as follows:
(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 | |||
Part II
Item 8
For the years ended June 30, 2006, 2005, and 2004, 649 million, 854 million, and 1.2 billion shares, respectively, were attributable to outstanding stock options and were excluded from the calculation of diluted earnings per share because the exercise 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, 2006, 1.2 million shared performance stock awards, out of the 36.6 million targeted amount outstanding, have been excluded from the calculation of diluted earnings per share because the number of shares ultimately issued is contingent on our performance against metrics established for the performance period, as discussed in Note 14 – Employee Stock and Savings Plans.
(In millions) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Net unrealized gains on derivatives: | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Unrealized gains, net of tax effects of$472, $46, and $66 | $ 876 | $ 86 | $123 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Reclassification adjustment for gains included in net income, net of tax effects of$(309), $(36), and $(59) | (574 | ) | (68 | ) | (109 | ) | |||||||||||||||||||||||||||||||||||||||||||||||||||
Net unrealized gains on derivatives | 302 | 18 | 14 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Net unrealized gains (losses) on investments: | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Unrealized gains (losses), net of tax effects of$(142), $(234), and $393 | (263 | ) | (435 | ) | 730 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
Reclassification adjustment for losses (gains) included in net income, net of tax effects of$16, $(117), and $(217) | 30 | (218 | ) | (404 | ) | ||||||||||||||||||||||||||||||||||||||||||||||||||||
Net unrealized gains (losses) on investments | (233 | ) | (653 | ) | 326 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
Translation adjustments and other | (240 | ) | 121 | 85 | |||||||||||||||||||||||||||||||||||||||||||||||||||||
Other comprehensive income (loss) | $(171 | ) | $(514 | ) | $425 | ||||||||||||||||||||||||||||||||||||||||||||||||||||
The components of accumulated other comprehensive income were as follows:
|
| ||||||||||||||||||||||||||||||||||||||||||||||||||||||||
(In millions) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Net unrealized gains on derivatives | $437 | $ 135 | $ 117 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Net unrealized gains on investments | 502 | 735 | 1,388 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Translation adjustments and other | 30 | 270 | 149 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Accumulated other comprehensive income | $969 | $1,140 | $1,654 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
NOTE
Stock-based compensation expense and
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||
(In | 2009 | 2008 | 2007 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Year Ended June 30, | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Total stock-based compensation expense | $1,708 | $1,479 | $1,550 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 598 | $ 518 | $ 542 |
PAGE | 73 |
Part II
Item 8
Employee Stock Purchase Plan
We have an employee stock purchase plan for all eligible employees. Compensation expense for the employee stock purchase plan is recognized in accordance with SFAS No. 123(R). Shares of our common stock may 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. Employees purchased the following shares:
(Shares in millions) | 2009 | 2008 | 2007 | ||||||
Year Ended June 30, | |||||||||
Shares purchased | 24 | 18 | 17 | ||||||
Average price per share | $ | 20.13 | $ | 26.78 | $ | 25.36 |
At June 30, 2009, 83 million shares were reserved for future issuance.
Savings Plan
We have a savings plan in the United States that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 50% of their 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 $262 million, $238 million, and $218 million in fiscal years 2009, 2008, and 2007, respectively, and were expensed as contributed. 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.
Stock Plans
We have stock plans for directors and for officers, employees, consultants, and advisors. At June 30, 2009, an aggregate of 714 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. We issue new shares to satisfy stock option exercises.
Stock Awards
Stock awards (“SAs”) are grants that entitle the holder to shares of Microsoft common stock as the award vests. Our SAs generally vest over a five-year period.
Shared Performance Stock Awards
Shared performance stock awards (“SPSAs”) are a form of SA in which the number of shares ultimately received depends on our business performance against specified performance targets.
The Company granted SPSAs for fiscal years 2009, 2008, and 2007 with performance periods of July 1, 2008 through June 30, 2009, July 1, 2007 through June 30, 2008, and July 1, 2006 through June 30, 2007, respectively. At the end of each performance period, the number of shares of stock subject to the award is determined by multiplying the target award by a percentage ranging from 0% to 150%. The percentage is based on performance metrics for the performance period, as determined by the Compensation Committee of the Board of Directors in its sole discretion. An additional number of shares, approximately 12.2% of the total target SPSAs, are available as additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each award vest following the end of the performance period, and an additional one-quarter of the shares vest on each of the following three anniversaries of the grant date. Following the end of the fiscal year 2008 and 2007 performance periods, the Compensation Committee of the Board of Directors determined that the number of shares of SPSAs to be issued were 18 million and 11 million respectively, based on the actual performance against metrics established for the performance period. The number of shares of SPSAs to be issued for the fiscal year 2009 performance period will be determined in the first quarter of fiscal year 2010.
PAGE | 74 |
Part II
Item 8
Executive Officer Incentive Plan
In fiscal year 2009, the Compensation Committee approved a new Executive Officer Incentive Plan (“EOIP”) for executive officers of the Company. The EOIP replaced the annual cash bonus opportunity and equity award plans for executive officers. Under the EOIP, the Compensation Committee makes awards of performance-based compensation for specified performance periods. For fiscal year 2009, executive officers were eligible to receive annual awards comprised of cash and SAs from an incentive pool funded based on the achievement of operating income targets. Following approval of the awards for fiscal year 2009, 20% of the award will be paid to the executive officers in cash, and the remaining 80% will be converted into an SA for shares of Microsoft common stock. The SA portion of the award will vest one-quarter immediately after the award is approved following fiscal year 2009, and one-quarter on August 31 of each of the following three years.
The Company will grant awards to the executive officers in September 2009 based on the performance period of July 1, 2008 through June 30, 2009, from an incentive pool equal to 0.35% of the Company’s fiscal year 2009 operating income. Each executive officer will receive a fixed percentage of the pool ranging between 0 and 150% of a target based on an assessment of the executive officer’s performance during fiscal year 2009. The number of shares subject to the SA portion of the award will be determined by dividing the value of the award by the closing price of Microsoft common stock on August 31, 2009.
Activity for All Stock Plans
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 EOIP are amortized over their applicable vesting period (generally four to 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:
2009 | 2008 | 2007 | |||||||
Year Ended June 30, | |||||||||
Dividends per share (quarterly amounts) | $ | 0.11 - $0.13 | $ | 0.10 - $0.11 | $ | 0.09 - $0.10 | |||
Interest rates range | 1.4% - 3.6% | 2.5% - 4.9% | 4.3% -5.3% |
During fiscal year 2009, the following activity occurred under our existing plans:
Shares (In millions) | Weighted Average Grant-Date Fair Value | |||||
Stock awards: | ||||||
Nonvested balance, beginning of year | 153 | $ | 26.12 | |||
Granted | 91 | $ | 24.95 | |||
Vested | (43 | ) | $ | 25.56 | ||
Forfeited | (10 | ) | $ | 26.08 | ||
Nonvested balance, end of year | 191 | $ | 25.69 | |||
Shared performance stock awards: | ||||||
Nonvested balance, beginning of year | 36 | $ | 26.14 | |||
Granted | 10 | $ | 25.93 | |||
Vested | (18 | ) | $ | 25.07 | ||
Forfeited | – | – | ||||
Nonvested balance, end of year | 28 | $ | 26.79 | |||
As of June 30, 2009, there was $3.8 billion and $551 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 3.5 years and 2.5 years, respectively.
PAGE | 75 |
Part II
Item 8
During fiscal year 2008 and 2007, the following activity occurred under our plans:
(In millions, except fair values) | 2008 | 2007 | ||||
Stock awards granted | 71 | 57 | ||||
Weighted average grant-date fair value | $ | 27.83 | $ | 25.15 | ||
Shared performance stock awards granted | 19 | 11 | ||||
Weighted average grant-date fair value | $ | 27.82 | $ | 25.18 |
Stock Options
In fiscal year 2004, we began granting employees SAs 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 until 2004 when we began granting directors SAs. Nonqualified and incentive stock options were granted to certain officers and employees under our employee stock 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 10 years from the date of grant. Options granted after 2001 vest over four and one-half years and expire 10 years from the date of grant. We granted one million, 10 million, and two million stock options, respectively, in conjunction with business acquisitions during fiscal years 2009, 2008, and 2007.
Employee stock options outstanding were as follows:
Shares (In millions) | Weighted Average Exercise Price | Weighted Average Remaining Contractual Term (Years) | Aggregate Intrinsic Value (In millions) | ||||||
Balance, July 1, 2008 | 364 | $28.12 | |||||||
Granted | 1 | $ 2.14 | |||||||
Exercised | (6 | ) | $22.44 | ||||||
Canceled | (28 | ) | $30.31 | ||||||
Forfeited | (1 | ) | $10.50 | ||||||
Balance, June 30, 2009 | 330 | $27.99 | 1.99 | $318 | |||||
Exercisable, June 30, 2009 | 327 | $27.99 | 1.98 | $271 |
Options outstanding as of June 30, 2009 include approximately eight 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 exercise price. These options have an exercise price range of $0.01 to $150.93 and a weighted average exercise price of $9.50.
During fiscal years 2009, 2008, and 2007, the following activity occurred under our plans:
(In millions) | 2009 | 2008 | 2007 | ||||||
Total intrinsic value of stock options exercised | $ | 48 | $ | 1,042 | $ | 818 | |||
Total fair value of stock awards vested | $ | 1,126 | $ | 804 | $ | 566 | |||
Total fair value of shared performance stock awards vested | $ | 450 | $ | 336 | $ | 292 |
Cash received and income tax benefits from stock option exercises were $88 million and $12 million, respectively, for fiscal year 2009.
PAGE | 76 |
Part II
Item 8
NOTE 21 EMPLOYEE SEVERANCE
In January 2009, we announced and implemented a resource management program to reduce discretionary operating expenses, employee headcount, and capital expenditures. As part of this program, we announced the elimination of up to 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010.
During the fiscal year ended June 30, 2009, we recorded charges of $330 million for the expected reduction in employee headcount which was recorded as corporate-level activity. During the year we had a net reduction of approximately 4,400 positions under the resource management program.
The changes in our employee severance liabilities were as follows:
(In millions) | ||||
Year Ended June 30, 2009 | ||||
Balance, beginning of period | $ | – | ||
Employee severance charges | 330 | |||
Cash payments | (203 | ) | ||
Balance, end of period | $ | 127 | ||
NOTE 22 SEGMENT INFORMATION AND GEOGRAPHIC DATA
Segment revenue and operating income (loss) was as follows:
(In millions) | |||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||
Revenue: | |||||||||
Client | $ | 14,414 | $ | 16,472 | $ | 14,779 | |||
Server and Tools | 14,135 | 13,121 | 11,117 | ||||||
Online Services Business | 3,088 | 3,190 | 2,434 | ||||||
Microsoft Business Division | 18,902 | 18,935 | 16,478 | ||||||
Entertainment and Devices Division | 7,753 | 8,213 | 6,136 | ||||||
Unallocated and other | 145 | 489 | 178 | ||||||
Consolidated | $ | 58,437 | $ | 60,420 | $ | 51,122 | |||
(In millions) | ||||||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | |||||||||
Operating Income (Loss): | ||||||||||||
Client | $ | 10,435 | $ | 12,566 | $ | 11,295 | ||||||
Server and Tools | 5,047 | 4,170 | 3,520 | |||||||||
Online Services Business | (2,391 | ) | (1,304 | ) | (617 | ) | ||||||
Microsoft Business Division | 11,940 | 12,169 | 10,757 | |||||||||
Entertainment and Devices Division | 5 | 325 | (1,945 | ) | ||||||||
Reconciling amounts | (4,673 | ) | (5,655 | ) | (4,572 | ) | ||||||
Consolidated | $ | 20,363 | $ | 22,271 | $ | 18,438 | ||||||
PAGE | 77 |
Part II
Item 8
SFAS No. 131,Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information about operating segments. This standard requires segmentation based on our internal organization and reporting of revenue and operating income (loss) based upon internal accounting methods. Our financial reporting systems present various data for management to operate the business, including internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segments are designed to allocate resources internally and provide a framework to determine management responsibility. Amounts for prior periods have been recast to conform to the current management view. Operating segments are defined as components of an 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 in assessing performance. Our chief operating decision maker is our Chief Executive Officer. Our five segments are Client; Server and Tools; Online Services Business; Microsoft Business Division; and Entertainment and Devices Division.
The types of products and services provided by each segment are summarized below:
Client– Windows Vista, including Home Basic, Home Premium, Ultimate, Business, Enterprise and Starter Edition; Windows XP, including Professional, Home, Media Center, and Tablet PC Edition; and other standard Windows operating systems.
Server and Tools – Windows Server operating system; Microsoft SQL Server; Visual Studio; Silverlight; System Center products; Forefront security products; Biz Talk Server; Microsoft Consulting Services; Premier product support services; and other products and services.
Online Services Business – Bing; Microsoft adCenter/adExpert; Microsoft Media Network (MMN); MSN portals, channels, and mobile services; Windows Live suite of applications and mobile services; Atlas online tools for advertisers and publishers; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, and MSN Software Services); and Razorfish media agency services.
Microsoft Business Division – Microsoft Office; Microsoft Office Project; Microsoft Office Visio; Microsoft Office SharePoint Server; FAST ESP; Microsoft Exchange Server; Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communications Server; Microsoft Office Communicator; Microsoft Tellme Service; Microsoft Dynamics ERP products including AX, NAV, GP, SL, Retail Management System, and Point of Sale; Microsoft Dynamics CRM; and Microsoft Dynamics CRM Online.
Entertainment and Devices Division – Xbox 360 console and games; Xbox Live; Zune; Mediaroom; numerous consumer software and hardware products (such as mice and keyboards); Windows Mobile software and services platform; Windows Embedded device operating system; Windows Automotive; and the Microsoft Surface computing platform.
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 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.
Assets 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 and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.
Reconciling amounts include adjustments to conform with U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, 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.
PAGE | 78 |
Part II
Item 8
Significant reconciling items were as follows:
(In millions) | |||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||
Summary of reconciling amounts: | |||||||||
Corporate-level activity(a) | $(5,877 | ) | $(7,017 | ) | $(4,893 | ) | |||
Stock-based compensation expense | 936 | 950 | 123 | ||||||
Revenue reconciling amounts | 280 | 385 | 120 | ||||||
Other | (12 | ) | 27 | 78 | |||||
Total | $(4,673 | ) | $(5,655 | ) | $(4,572 | ) | |||
(a) Corporate-level activity excludes stock-based compensation expense and revenue reconciling amounts presented separately in those line items. |
| ||||||||
No sales to an individual customer accounted for more than 10% of fiscal year 2009, 2008, or 2007 revenue.
Revenue, classified by the major geographic areas in which our customers are located, was as follows:
| |||||||||
(In millions) | |||||||||
Year Ended June 30, | 2009 | 2008 | 2007 | ||||||
United States(a) | $33,052 | $35,928 | $31,346 | ||||||
Other countries | 25,385 | 24,492 | 19,776 | ||||||
Total | $58,437 | $60,420 | $51,122 | ||||||
(a) Includes shipments to customers in the United States and licensing to certain OEMs and multinational organizations.
Long-lived assets, excluding financial instruments and deferred taxes, classified by the location of the controlling statutory company, were as follows:
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(In millions) | |||||||||
Year Ended June 30, | 2009 | 2008 | |||||||
United States | $19,362 | $19,129 | |||||||
Other countries | 2,435 | 1,194 | |||||||
Total | $21,797 | $20,323 | |||||||
PAGE | 79 |
Part II
Item 8
NOTE 23 QUARTERLY INFORMATION (Unaudited)
(In millions, except per share amounts) | ||||||||||||||||||
Quarter Ended | Sep. 30 | Dec. 31 | Mar. 31 | June 30 | Total | |||||||||||||
Fiscal year 2009 | ||||||||||||||||||
Revenue | $ | 15,061 | $ | 16,629 | $ | 13,648 | $ | 13,099 | (a) | $ | 58,437 | |||||||
Gross profit | 12,213 | 12,722 | 10,834 | 10,513 | 46,282 | |||||||||||||
Net income | 4,373 | 4,174 | 2,977 | (b) | 3,045 | (b) | 14,569 | |||||||||||
Basic earnings per share | 0.48 | 0.47 | 0.33 | 0.34 | 1.63 | |||||||||||||
Diluted earnings per share | 0.48 | 0.47 | 0.33 | 0.34 | 1.62 | |||||||||||||
Fiscal year 2008 | ||||||||||||||||||
Revenue | $ | 13,762 | $ | 16,367 | $ | 14,454 | $ | 15,837 | $ | 60,420 | ||||||||
Gross profit | 11,087 | 12,824 | 11,940 | 12,971 | 48,822 | |||||||||||||
Net income | 4,289 | 4,707 | (c) | 4,388 | (d) | 4,297 | 17,681 | |||||||||||
Basic earnings per share | 0.46 | 0.50 | 0.47 | 0.46 | 1.90 | |||||||||||||
Diluted earnings per share | 0.45 | 0.50 | 0.47 | 0.46 | 1.87 | |||||||||||||
Fiscal year 2007 | ||||||||||||||||||
Revenue | $ | 10,811 | $ | 12,542 | (e) | $ | 14,398 | (f) | $ | 13,371 | $ | 51,122 | ||||||
Gross profit | 9,115 | 8,922 | 12,258 | 10,134 | (h) | 40,429 | ||||||||||||
Net income | 3,478 | 2,626 | 4,926 | (g) | 3,035 | 14,065 | ||||||||||||
Basic earnings per share | 0.35 | 0.27 | 0.51 | 0.32 | 1.44 | |||||||||||||
Diluted earnings per share | 0.35 | 0.26 | 0.50 | 0.31 | 1.42 |
(a) |
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(b) | Includes employee severance of $290 million and $40 million (pre-tax) in the |
(c) | Includes charges of $237 million (pre-tax) related to various legal matters. |