Exhibit 13.3
Management's Discussion and Analysis
Results of Operations for 1995, 1996, and 1997
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Microsoft develops, manufactures, licenses, sells, and supports a wide range of
software products, including scalable operating systems for information
appliances, personal computers (PCs), and servers; server applications for
client/server environments; business and consumer productivity applications;
software development tools; and Internet and intranet software and technologies.
The Company has recently expanded its interactive content efforts, including
entertainment and information software programs, MSN, The Microsoft Network
online service, Internet-based services, and alliances with companies involved
with other forms of digital interactivity. Microsoft also sells personal
computer input devices and books, and researches and develops advanced
technologies for future software products.
Revenue
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The Company's revenue grew 46% in the fiscal year ended June 30, 1996 and 31% in
fiscal 1997. Revenue growth was particularly strong in 1996 due to the retail
introduction of the Microsoft Windows 95 operating system. 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 and organization
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. During 1996 and 1997, an
increased percentage of products and programs became subject to ratable revenue
recognition, such as Windows operating systems, Office 97, maintenance, and
other subscription models. (See accompanying notes.)
Product groups. Microsoft has a Platforms Product Group and an Applications &
Content Product Group.
Platforms Product Group revenue was $2.36 billion, $4.11 billion, and $5.97
billion in 1995, 1996, and 1997. Platform revenue is primarily from licenses of
PC operating systems, business systems with client/server architectures, and
software development tools.
The Company's principal desktop platform products in 1996 and 1997 were its 32-
bit operating systems, Microsoft Windows 95 and Microsoft Windows NT
Workstation. Released in August 1995, Windows 95 was a successor to MS-DOS and
Microsoft Windows 3.x operating systems. Windows NT Workstation version 4.0 was
released in fiscal 1997. Desktop operating systems increasingly contributed to
revenue as shipments of new PCs preinstalled with such systems increased rapidly
during the three-year period. Additionally, increased penetration of higher
value 32-bit operating systems led to growth in 1996 and 1997. In 1996, retail
license sales of Windows 95 were a major factor in the Platforms revenue
increase, reflecting the typical sales pattern for major operating system
upgrades. Also in 1996, a portion of Windows operating system revenue became
subject to ratable recognition.
Business systems products offer an enterprise-wide distributed client/server
environment based on the Microsoft Windows NT Server operating system and the
server applications in the Microsoft BackOffice family of products. Revenue
from these products increased strongly in 1995, 1996, and 1997 due to greater
corporate demand, particularly for intranet solutions.
Revenue 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 programming system to
develop software for Windows 95 and Windows NT operating systems and the
Internet.
Applications & Content Product Group revenue was $3.58 billion, $4.56 billion,
and $5.39 billion in 1995, 1996, and 1997. Applications and Content revenue
includes primarily licenses of desktop and consumer productivity applications,
interactive media programs, and PC input devices. Microsoft Office for Windows
95 was released in fiscal 1996 and Microsoft Office 97 was released in fiscal
1997. Applications and Content revenue grew 27% in 1996 and 18% in 1997. The
lower growth rate in 1997 was due to the expected impact of saturation of
desktop applications, the continued shift in mix toward corporate licenses from
packaged products, and the ratable revenue recognition model for Office 97.
Absolute increases in desktop applications revenue during the three-year period
were led by Microsoft Office. The primary programs in Microsoft Office are
Microsoft Word word processor, Microsoft Excel spreadsheet, and Microsoft
PowerPoint presentation graphics program. Various versions of Office, which
are available for the 32-bit version of Windows, the 16-bit version of Windows,
and Macintosh operating systems, also include Microsoft Access database
management program, Microsoft Outlook desktop information manager, or other
programs. Revenue from stand-alone versions of Microsoft Excel, Microsoft Word,
and Microsoft PowerPoint continued to decrease as the sales mix shifted to
integrated product suites. Microsoft Project scheduling and project management
program revenue increased during the three-year period.
Microsoft offers a broad range of interactive media products, which also showed
moderate growth. Products include CD-ROM multimedia reference titles and
programs for home and small office productivity, children's creativity, and
entertainment. In addition to The Microsoft Network, recently introduced online
Internet services include travel information and reservations, local event
information, and new-car buying.
The Company also markets input devices. Mouse and gaming device sales increased
while keyboard revenue was steady during the three-year period.
Sales channels. The Company distributes its products primarily through OEM
licenses, corporate and organizational licenses, and retail packaged products.
OEM channel revenue represents 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 and organization licenses and
packaged products in these channels are primarily to distributors and resellers.
OEM channel revenue was $1.65 billion in 1995, $2.50 billion in 1996, and $3.48
billion in 1997. The primary source of OEM revenue is the licensing of desktop
operating systems, and OEM revenue is highly dependent on PC shipment volume.
Licensing programs 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. U.S. and Canadian channel
revenue was $1.88 billion, $2.68 billion, and $3.41 billion in 1995, 1996, and
1997. Revenue in Europe was $1.49 billion, $2.02 billion, and $2.54 billion in
1995, 1996, and 1997. 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 licensing programs. Other International
channel revenue was $924 million in 1995, $1.47 billion in 1996, and $1.93
billion in 1997. Growth rates were higher in the Other International channel
due to customers accepting newly localized products, particularly in Japan, and
penetration in emerging markets.
The Company's operating results are affected by foreign exchange rates.
Approximately 37%, 34%, and 32% of the Company's revenue was collected in
foreign currencies during 1995, 1996, and 1997. Since a portion of local
currency revenue is hedged and much of the Company's international manufacturing
costs and operating expenses are also incurred in local currencies, the impact
of exchange rates is partially mitigated.
Operating Expenses
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Cost of revenue. As a percentage of revenue, cost of revenue was 14.8% in 1995,
13.7% in 1996, and 9.6% in 1997. The decrease was due to the shifts in mix to
CD-ROMs (which carry lower cost of goods than disks), licenses to OEMs and
corporations, and higher-margin Windows NT Server and other BackOffice server
products.
Research and development. Microsoft invested heavily in the future by funding
research and development (R&D). Expense increases of 67% in 1996 and 34% in
1997 resulted primarily from development staff headcount growth and higher
levels of third-party development costs in many areas, including continued
development efforts for Windows
desktop operating systems, Office, BackOffice, and Internet and intranet
technologies. R&D costs also increased for development tools, consumer systems,
and interactive media initiatives such as MSN 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 expanded
product-specific marketing programs, particularly for Windows 95 during 1996.
Sales and marketing costs as a percentage of revenue decreased, particularly in
1997, reflecting moderate headcount growth. Also in 1997, Microsoft brand
advertising and product support expenses declined.
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 and Income Taxes
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Interest income increased primarily as a result of a larger investment portfolio
generated by cash from operations. Other expenses increased due to recognition
of Microsoft's share of joint venture activities, 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. The effective income tax rate was 33% in 1995 and 35% in 1996 and 1997.
Net Income
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Net income as a percent of revenue increased in 1996 and 1997 due to the lower
relative cost of revenue, sales and marketing expenses, and general and
administrative expenses, partially offset by investments in research and
development and joint ventures.
Financial Condition
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Microsoft's cash and short-term investment portfolio totaled $8.97 billion at
June 30, 1997. The portfolio is diversified among security types, industries,
and individual issuers. Microsoft's investments are generally liquid and
investment grade. The portfolio is invested predominantly in U.S. dollar
denominated securities, but also includes foreign currency positions in
anticipation of continued international expansion. The portfolio is primarily
invested in short-term securities to minimize interest rate risk and facilitate
rapid deployment in the event of immediate cash needs.
During 1996, Microsoft and National Broadcasting Company (NBC) established two
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.
During 1997, Microsoft invested $1.0 billion in Comcast Corporation, a cable
television and diversified telecommunications company. Comcast Special Class A
common stock of $500 million and convertible preferred stock of $500 million are
included in equity investments on the balance sheet.
Microsoft has no material long-term debt and has $70 million of standby
multicurrency lines of credit to support foreign currency hedging and cash
management. Stockholders' equity at June 30, 1997 was $10.78 billion.
Microsoft will continue to invest in sales, marketing, and product support
infrastructure. Additionally, research and development activities will include
investments in existing and advanced areas of technology, including using cash
to acquire technology and to fund ventures and other strategic opportunities.
Additions to property and equipment will continue, including new facilities and
computer systems for research and development, sales and marketing, support, and
administrative staff. Commitments for constructing new buildings were $300
million on June 30, 1997.
Cash will also be used to repurchase common stock to provide shares for employee
stock option and purchase plans. Despite recent increases in stock repurchases,
the buyback program has not kept pace with employee stock option grants or
exercises. Beginning in fiscal 1990, Microsoft has repurchased 154 million
common shares for $6.2 billion while 363 million shares were issued under the
Company's employee stock option and purchase plans. The market value of all
outstanding stock options was $30.2 billion as of June 30, 1997. Microsoft
enhances its repurchase program by selling put warrants. During December 1996,
Microsoft issued 12.5 million shares of 2.75% convertible preferred stock. Net
proceeds of $980 million were used to repurchase common shares.
Management believes existing cash and short-term investments together with funds
generated from operations will be sufficient to meet operating requirements for
the next 12 months. Microsoft's cash and short-term investments are available
for strategic investments, mergers and acquisitions, other potential large-scale
cash needs that may arise, and to fund an increased stock buyback program over
historical levels to reduce the dilutive impact of the Company's employee stock
option and purchase programs.
Microsoft has not paid cash dividends on its common stock. The preferred stock
pays $2.196 per annum per share.
Outlook: Issues and Uncertainties
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Microsoft does not provide forecasts of future financial performance. While
Microsoft 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 and competition. Rapid change, uncertainty due to
new and emerging technologies, and fierce competition characterize the PC
software industry. The pace of change has recently accelerated due to the
Internet and new programming languages, such as Java.
Future initiatives. The Company is expanding its efforts to provide and support
mission-critical systems to large enterprises. Scalability of BackOffice server
and application products, manageability of Windows- and Office-based systems,
and Internet and intranet integration are also major focus areas. Additionally,
Microsoft is committed to providing technologies, operating systems, and
interactive content for the future convergence of PCs, televisions, and the
Internet. Future revenue from these initiatives may not duplicate historical
revenue growth rates.
PC growth rates. The underlying PC unit growth rate, which may decrease in the
future, directly impacts software revenue growth.
Product ship schedules. Shipments of new versions of major products such as
Windows 95 have generally had positive impacts on revenue growth rates. The
Company does not currently expect that individual products to be released in
1998 will repeat the financial performance of Windows 95. Also, delays in new-
product releases can cause operational inefficiencies that impact manufacturing
and distribution logistics, independent software vendor (ISV) and OEM
relationships, and telephone support staffing.
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.
Prices. Future product prices may decrease from historical levels, depending on
competitive market and cost factors. European and Far Eastern software prices
vary by country and are generally higher than in the United States to cover
localization costs and higher costs of distribution. Increased global license
agreements, European monetary unification, or other factors could erode such
price uplifts in the future.
Earnings process. An increasingly higher percentage of the Company's revenue is
subject to ratable recognition. Subsequent product support and delivery of
unspecified enhancements require the applicable portion of revenue for certain
products to be recognized over the product's life cycle. This policy may be
required for future products, depending on specific license terms and
conditions. Also, maintenance and other subscription programs may continue to
increase in popularity, particularly with corporations and other large
organizations.
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 and organization
license programs is lower than average revenue per unit from retail versions
shipped through the finished goods channels. Unit sales under 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 revenue was achieved
through the OEM channel during 1996 and 1997.
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. Revenue from integrated
suites may continue to increase as a percentage of total revenue.
Cost of revenue. Although cost of revenue as a percentage of revenue decreased
in 1996 and 1997, it varies with channel mix and product mix within channels.
The trend of declining cost of revenue as a percentage of revenue is unlikely to
continue in 1998.
Pay and participation model. Microsoft employees currently receive salaries,
incentive bonuses, other fringe benefits, and stock options. New government
regulations, poor stock price performance, 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 1995, 1996, and 1997, the pretax
expense would have been approximately $310 million, $450 million, and $620
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 revenue is not anticipated for a number of years. Management
expects total spending for research and development in 1998 to increase over
spending in 1997.
Sales and marketing and support investments. The Company's plans for 1998
include accelerated 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.
Interest rate sensitivity. The Company's cash and short-term investment
portfolio is subject to interest rate risk. An abrupt increase in interest
rates would decrease the market value of the Company's fixed income securities.
For example, a 200 basis point increase in short-term treasury security yields
would reduce the carrying value of the portfolio at June 30, 1997 by $200
million.
Intellectual property rights. Microsoft diligently defends its intellectual
property rights, but unlicensed copying of software represents a loss of revenue
to the Company. While this adversely affects U.S. revenue, 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 revenue positively.
Future growth rate. The revenue growth rate in 1998 may not approach the level
attained in 1997, particularly when compared to the second half of 1997. As
discussed above, operating expenses are expected to increase in 1998. Because
of the fixed nature of a significant portion of such expenses, coupled with the
possibility of slower revenue growth, operating margins in 1998 may decrease
from those in 1997.
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.