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EXHIBIT 13.3
MANAGEMENT'S DISCUSSION AND ANALYSIS
RESULTS OF OPERATIONS FOR 1994, 1995, AND 1996
Microsoft develops, manufactures, licenses, sells, and supports a wide range of
software products, including operating systems for personal computers (PCs) and
servers, server applications for client/server environments, business and
consumer productivity applications, interactive media programs, and Internet
platform and development tools. Microsoft also offers online services, sells
personal computer books and input devices, and researches and develops advanced
technology software products.
NET REVENUES
The Company's net revenues grew 28% in the fiscal year ended June 30, 1995 and
46% in fiscal year 1996. Software license volume increases have been the
principal factor in Microsoft's revenue growth. The average selling price per
license has decreased, primarily because of general shifts in the sales mix from
retail packaged products to licensing programs, from new products to product
upgrades, and from stand-alone desktop applications to integrated product
suites. Average revenue per license from original equipment manufacturer (OEM)
licenses and corporate license programs, such as Microsoft Select, is lower than
average revenue per license from retail versions. Likewise, product upgrades
have lower prices than new products. Also, prices of integrated suites, such as
Microsoft Office, are less than the sum of the prices for the individual
programs included in these suites when such programs are licensed separately.
PRODUCT GROUPS. Microsoft has a Platforms Product Group and an Applications and
Content Product Group.
Platforms Product Group revenues were $1.83 billion, $2.36 billion, and $4.11
billion in 1994, 1995, and 1996.
The Company's principal desktop operating system product in 1996 was Microsoft
Windows 95. Released in August 1995, Windows 95 was a successor to MS-DOS(R) and
Microsoft Windows 3.X operating systems. Windows 95, and before its release,
MS-DOS and Windows 3.X, were preinstalled on PCs by most OEMs. Desktop operating
systems increasingly contributed to revenues as new PCs preinstalled with such
systems increased rapidly during the three-year period. Additionally, retail
sales of Windows 95 were a major factor in the platforms revenue increase in
1996, reflecting the typical sales pattern for operating systems upgrades.
Business systems products offer an enterprise-wide distributed client/server
environment based on the Microsoft Windows NT operating system and the server
applications in the Microsoft BackOffice family of products. Revenues from these
products increased strongly in 1994, 1995, and 1996 due to greater corporate
demand for Windows NT Workstation and Windows NT Server.
During 1996, Microsoft implemented its policy of offering customers the latest
Internet technology at no additional cost. Given this strategy, and because
Internet browsers are a fundamental and integral part of Windows-based operating
systems, ratable revenue recognition is required for a portion of all
Windows-based operating system license fees, including those licensed through
retail and OEM channels. Unearned revenues as of June 30, 1996 on the
accompanying balance sheet include $425 million for future support commitments,
Internet browser updates, and other unspecified enhancements to Windows-based
operating systems that will be recognized ratably over the products' life
cycles.
Revenues from developer products increased steadily in all three years, as more
independent software vendors, corporate developers, and solutions developers
licensed tools such as the Microsoft Visual Basic(R) programming system to
develop software for Windows 95, Windows NT, and the Internet.
Applications and Content Product Group revenues were $2.82 billion, $3.58
billion, and $4.56 billion in 1994, 1995, and 1996.
Increases in desktop applications revenues were led by strong sales of 16-bit
and 32-bit versions of Microsoft Office. The Microsoft Office Standard product
includes the Microsoft Excel spreadsheet; Microsoft Word, a word-
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processing program; and the Microsoft PowerPoint presentation graphics program.
The Microsoft Office for Windows 95 (32-bit) version also includes the Microsoft
Schedule+ calendar and scheduling program. Microsoft Office Professional version
includes all of the above plus the Microsoft Access database management system.
Sales of stand-alone versions of Microsoft Excel and Microsoft Word continued to
decrease as the sales mix shifted to integrated product suites. Sales of
Microsoft Project and Microsoft Works also increased during the three-year
period.
Microsoft licenses a broad range of consumer software products, which also
showed continued growth. Products include CD-ROM multimedia reference titles and
programs for home and small office productivity, children's creativity, and
entertainment.
The Company also markets input devices. Mouse and keyboard sales increased
during the three-year period, while the joystick's initial introduction
increased revenues in 1996.
SALES CHANNELS. The Company distributes its products primarily through OEM
licenses, corporate licenses, and retail packaged products. OEM channel revenues
are license fees from original equipment manufacturers. Microsoft has three
major geographic sales and marketing organizations: the United States and
Canada, Europe, and elsewhere in the world (Other International). Sales of
corporate licenses and packaged products in these channels are primarily to
distributors and resellers.
OEM channel revenues were $1.18 billion in 1994, $1.65 billion in 1995, and
$2.50 billion in 1996. The primary source of OEM revenues is the licensing of
desktop operating systems. As such, OEM channel revenues are highly dependent on
PC shipment volume.
Corporate licenses continued to grow in popularity across all geographic areas
during the three-year period. Packaged product volume increased in 1996 due to
the release of retail upgrade versions of Windows 95 and 32-bit desktop
applications. U.S. and Canadian channel revenues were $1.58 billion, $1.88
billion, and $2.68 billion in 1994, 1995, and 1996. Revenues in Europe were
$1.36 billion, $1.49 billion, and $2.02 billion in 1994, 1995, and 1996. Growth
rates have been lower in Europe than in other geographic areas due to general
economic slowness, higher existing market shares, and a more dramatic shift to
corporate licensing programs. Other International channel revenues were $532
million in 1994, $924 million in 1995, and $1.47 billion in 1996. Growth rates
continue to be strong due to customers accepting newly localized products,
particularly in Japan, and early entrance into emerging markets.
The Company's operating results are affected by foreign exchange rates.
Approximately 40%, 37%, and 38% of the Company's revenues were collected in
foreign currencies during 1994, 1995, and 1996. Since much of the Company's
international manufacturing costs and operating expenses are also incurred in
local currencies, the impact of exchange rates on net income is less than on
revenues.
OPERATING EXPENSES
COST OF REVENUES. As a percentage of revenues, cost of revenues was 16.4% in
1994, 14.8% in 1995, and 13.7% in 1996. The percentage decreased due to a
greater proportion of licenses to OEMs and corporations, a higher proportion of
CD-ROM versions, and manufacturing efficiencies. These factors were offset
somewhat by increased sales of lower-margin products such as integrated suites
and retail upgrades.
RESEARCH AND DEVELOPMENT. Microsoft invested heavily in the future by funding
research and development (R&D). Expense increases of 41% in 1995 and 67% in 1996
resulted primarily from development staff headcount growth and higher levels of
third-party development costs in many areas, including development efforts for
Windows 95 in 1995 and Windows NT and the Internet in 1996. R&D costs also
increased for business systems, consumer systems, desktop applications, and
interactive media products such as The Microsoft Network and other online
services.
SALES AND MARKETING. The increase in the absolute dollar amount of sales and
marketing expenses in the three-year period was due primarily to increased
product-specific marketing programs, particularly for Windows 95 during 1996.
Also, expenses increased due to higher levels of Microsoft brand advertising and
product support.
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GENERAL AND ADMINISTRATIVE. Increases in general and administrative expenses
were primarily attributable to growth in the number of people and computer
systems necessary to support overall increases in the scope of the Company's
operations.
NONOPERATING ITEMS
Interest income increased primarily as a result of a larger investment portfolio
generated by cash from operations. Other expenses increased in 1996 due to
recognition of Microsoft's share of joint venture operational expenses,
including DreamWorks Interactive and the MSNBC entities. During 1995, Microsoft
paid a $46 million breakup fee to Intuit Inc. in connection with the termination
of a planned merger. During 1994, the Company recorded a net pretax charge of
$90 million, reflecting the patent litigation settlement with Stac Electronics.
PROVISION FOR INCOME TAXES
The effective tax rate was 33.5% in 1994, 33.0% in 1995, and 35.0% in 1996. The
1996 increase was primarily attributable to the research and experimental credit
expiring in the United States.
NET INCOME
Net income as a percent of revenues increased in 1996 due to the lower relative
cost of revenues, sales and marketing expenses, general and administrative
expenses, and nonoperating expenses, offset by higher relative research and
development expenses and the higher tax rate. The net income percentage
decreased in 1995 due to increased relative research and development, sales and
marketing, and general and administrative expenses, offset by the lower relative
cost of revenues and the higher relative net nonoperating income.
FINANCIAL CONDITION
The Company's cash and short-term investments equaled $6.94 billion at June 30,
1996. The portfolio is diversified among security types, industries, and
individual issuers. The Company's investments are generally investment grade and
liquid. The portfolio is invested predominantly in U.S. dollar denominated
securities, but also includes foreign currency positions in anticipation of
continued international expansion. The Company's portfolio is primarily invested
in short-term securities to minimize interest rate risk and facilitate rapid
deployment in the event of immediate cash needs.
Microsoft has no material long-term debt. The Company has $70 million of standby
multicurrency lines of credit that support foreign currency hedging and
international cash management.
Stockholders' equity at June 30, 1996 exceeded $6.9 billion.
Cash generated from operations has been sufficient historically to fund the
Company's investment in research and development activities and facilities
expansion. As the Company grows, investments will continue in research and
development in existing and advanced areas of technology. The Company's cash
will also be used to acquire technology and to fund ventures and other strategic
opportunities. Additions to property, plant, and equipment are expected to
continue, including facilities and computer systems for research and
development, sales and marketing, product support, and administrative staff. On
June 30, 1996, commitments for constructing new buildings approximated $293
million.
Employees exercising stock options provides additional cash. These proceeds have
funded the Company's open market stock repurchase program through which
Microsoft provides shares for stock option and stock purchase plans. This
program will continue in 1997.
To enhance its stock repurchase program, Microsoft sold equity put warrants to
independent third parties. These put warrants entitle the holders to sell shares
of Microsoft common stock to the Company on certain dates at specified prices.
A subsidiary of Tele-Communications, Inc. (TCI) owns a 20% minority interest in
The Microsoft Network. TCI contributed $125 million of TCI common stock, and
Microsoft contributed the business assets of this online service.
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During 1996, Microsoft and National Broadcasting Company (NBC) established two
MSNBC joint ventures: a 24-hour cable news and information channel, and an
interactive online news service. Microsoft agreed to pay $220 million over a
five-year period for its interest in the cable venture and to pay one-half of
operational funding of both joint ventures for a multiyear period.
Management believes existing cash and short-term investments together with funds
generated from operations will be sufficient to meet operating requirements in
1997. The Company's cash and short-term investments are also managed to be
available for strategic investment opportunities or other potential large-scale
cash needs that may arise in pursuing the Company's long-term strategies.
Microsoft shareholders have also authorized issuing up to 100 million shares of
preferred stock, which may be used for any proper corporate purpose.
OUTLOOK: ISSUES AND UNCERTAINTIES
Microsoft does not provide forecasts of future financial performance. While
Microsoft's management is optimistic about the Company's long-term prospects,
the following issues and uncertainties, among others, should be considered in
evaluating its growth outlook.
RAPID TECHNOLOGICAL CHANGE. The PC software industry is characterized by rapid
change and uncertainty due to new and emerging technologies. The pace of change
has recently accelerated due to the Internet, online services, networking, and
new programming languages, such as Java.
PC GROWTH RATES. The underlying PC unit growth rate, which may increase at a
slower rate in the future, impacts software revenue growth.
CUSTOMER ACCEPTANCE. While the Company performs extensive usability and beta
testing of new products, user acceptance and corporate penetration rates
ultimately dictate the success of development and marketing efforts.
PRODUCT SHIP SCHEDULES. Delays in new-product releases impact revenue growth
rates and can cause operational inefficiencies that impact manufacturing and
distribution logistics, independent software vendor (ISV) and OEM relationships,
and telephone support staffing.
PRICES. Future prices the Company can obtain for its products may decrease from
historical levels, depending on competitive market or cost factors. European and
Far Eastern software prices are generally higher than in the United States to
cover localization costs and higher costs of distribution. Such price uplifts
could erode in the future.
EARNINGS PROCESS. An increasingly higher percentage of the Company's revenues is
earned after the initial shipment or licensing of the software product.
Microsoft also offers product support, Internet browsers and add-ons, and other
unspecified enhancements, so the applicable portion of revenues is recognized
over the product's life cycle. This policy may be required for future products
such as Microsoft Office 97, depending on specific license terms and conditions.
SATURATION. Product upgrades, which enable users to upgrade from earlier
versions of the Company's products or from competitors' products, have lower
prices and margins than new products. As the desktop applications market has
become saturated, the sales mix has shifted from standard products to upgrade
products. This trend is likely to continue.
CORPORATE LICENSES. Average revenue per unit from corporate license programs is
lower than average revenue per unit from retail versions shipped through the
finished goods channels. Unit sales under corporate licensing programs may
continue to increase.
CHANNEL MIX. Average revenue per license is lower from OEM licenses than from
retail versions, reflecting the relatively lower direct costs of operations in
the OEM channel. An increasingly higher percentage of revenues was achieved
through the OEM channel during 1995 and 1996.
INTEGRATED SUITES. The price of integrated suites, such as Microsoft Office, is
less than the sum of the prices for the individual programs included in these
suites when such programs are licensed separately. Revenues from integrated
suites may continue to increase as a percentage of total revenues.
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COST OF REVENUES. Although cost of revenues as a percentage of net revenues
decreased in 1995 and 1996, it varies with channel mix and product mix within
channels. Such mix factors may increase cost of revenues as a percentage of
revenues in 1997.
PAY AND PARTICIPATION MODEL. Microsoft employees currently receive salaries,
incentive bonuses, other fringe benefits, and stock options. New government
regulations, low stock prices, or other factors could diminish the value of the
option program and force the Company into more of a cash compensation model. Had
the Company paid employees in cash the grant date Black-Scholes value of options
vested in 1994, 1995, and 1996, the pretax expense would have been approximately
$360 million, $410 million, and $570 million.
LONG-TERM RESEARCH AND DEVELOPMENT INVESTMENT CYCLE. Developing and localizing
software is expensive and the investment in product development often involves a
long payback cycle. The Company plans to continue significant investments in
software research and development and related product opportunities from which
significant revenues are not anticipated for a number of years. Management
expects total spending for research and development in 1997 to increase over
spending in 1996.
SALES AND MARKETING AND SUPPORT INVESTMENTS. The Company's plans for 1997
include continued investments in its sales and marketing and support groups.
FOREIGN EXCHANGE. A large percentage of the Company's sales, costs of
manufacturing, and marketing is transacted in local currencies. As a result, the
Company's international results of operations are subject to foreign exchange
rate fluctuations.
INTELLECTUAL PROPERTY RIGHTS. Microsoft diligently defends its intellectual
property rights, but unlicensed copying of software represents a loss of
revenues to the Company. While this adversely affects U.S. revenues, revenue
loss is even more significant outside of the United States, particularly in
countries where laws are less protective of intellectual property rights.
Throughout the world, Microsoft actively educates consumers on the benefits of
licensing genuine products and educates lawmakers on the advantages of a
business climate where intellectual property rights are protected. However,
continued efforts may not affect revenues positively.
FUTURE GROWTH RATE. The revenue growth rate in the first two quarters of 1997
may not approach the level attained in 1996, which was high due to Windows 95
upgrades. As discussed above, operating expenses are expected to increase in
1997. Because of the fixed nature of a significant portion of such expenses,
coupled with the possibility of slower revenue growth, operating margins in 1997
may decrease from those in 1996.
LITIGATION. Litigation regarding intellectual property rights, patents, and
copyrights occurs in the PC software industry. In addition, there are government
regulation and investigation risks along with other general corporate legal
risks.