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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, 2001
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from _____ to ____
______________________________
Commission File Number 0-14278
MICROSOFT CORPORATION
Washington 91-1144442
(State of incorporation) (I.R.S. ID)
One Microsoft Way, Redmond, Washington 98052-6399
(425) 882-8080
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [_]
The aggregate market value of common stock held by non-affiliates of the
registrant as of September 10, 2001 was $258,033,100,664.
The number of shares outstanding of the registrant's common stock as of
September 10, 2001 was 5,401,944,951.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement dated September 10, 2001 to be
delivered to shareholders in connection with the Annual Meeting of Shareholders
to be held November 7, 2001 are incorporated by reference into Part III.
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MICROSOFT CORPORATION
FORM 10-K
For The Fiscal Year Ended June 30, 2001
INDEX
Part I
Item 1. Business................................................................................. 1
Item 2. Properties............................................................................... 12
Item 3. Legal Proceedings........................................................................ 12
Item 4. Submission of Matters to a Vote of Security Holders...................................... 13
Executive Officers of the Registrant..................................................... 13
Part II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters..................... 16
Item 6. Selected Financial Data.................................................................. 17
Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition.... 18
Item 7a. Quantitative and Qualitative Disclosures about Market Risk............................... 25
Item 8. Financial Statements and Supplementary Data.............................................. 27
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures.... 47
Part III
Item 10. Directors of the Registrant.............................................................. 47
Item 11. Executive Compensation................................................................... 47
Item 12. Security Ownership of Certain Beneficial Owners and Management........................... 47
Item 13. Certain Relationships and Related Transactions........................................... 47
Part IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K......................... 48
Signatures............................................................................... 49
PART I
Item 1. Business
General
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Microsoft Corporation (the "Company" or "Microsoft") was founded as a
partnership in 1975 and incorporated in 1981. Microsoft develops, manufactures,
licenses, and supports a wide range of software products for a multitude of
computing devices. Microsoft(R) software includes scalable operating systems
for servers, personal computers (PCs), and intelligent devices; server
applications for client/server environments; knowledge worker productivity
applications; and software development tools. The Company's online efforts
include the MSN(R) network of Internet products and services and alliances with
companies involved with broadband access and various forms of digital
interactivity. Microsoft also licenses consumer software programs; sells
hardware devices; provides consulting services; trains and certifies system
integrators and developers; and researches and develops advanced technologies
for future software products.
Microsoft's business strategy emphasizes the development of a broad line of
software products for information technology (IT) professionals, knowledge
workers, developers, and consumers, marketed through multiple channels of
distribution. The Company is structured around the following core groups: the
Business Groups; the Worldwide Sales, Marketing, and Services Group; Microsoft
Research; and the Operations Group.
The Company's product segments, which are based on the Business Groups, are
Desktop and Enterprise Software and Services, Consumer Software, Services, and
Devices, Consumer Commerce Investments, and Other. The Desktop and Enterprise
Software and Services segment includes the Platforms Group and the Productivity
and Business Services Group. The Platforms Group has responsibility for
continuing to evolve the Windows platform. In addition, the division includes
the .NET Enterprise Server Group, the Developer Tools Division, and the Windows
Digital Media Division. The Productivity and Business Services Group drives
Microsoft's broad vision for productivity and business process applications and
services. This group includes the Office Division, the Emerging Technologies
Group, the Business Tools Division, and the Business Applications Group, which
includes bCentral(TM) and Microsoft Great Plains(R).
The Consumer Software, Services, and Devices segment contains the MSN Business
Group; the Personal Services Business Group; and the Home and Retail Division.
MSN Business Group runs the network programming, business development, and
worldwide sales and marketing for MSN and Microsoft's other services efforts,
including MSN eShop, the MSNBC venture, Slate(R), and MSNTV. The Personal
Services Group (PSG) focuses on making it easier for consumers and businesses to
connect online and to deliver software as a service on a variety of devices. PSG
encompasses Microsoft's Personal .NET initiative, the Services Platform
Division, the Mobility Group, the MSN Internet Access, Consumer Devices Group,
and the User Interface Platform Division. The Home and Retail Division develops
and markets learning and entertainment software and the future Xbox game
console.
The Consumer Commerce Investment segment includes Expedia, Inc., the
HomeAdvisor(TM) online real estate service, and the MSN CarPoint(R) online
automotive service.
For financial reporting, revenue from Microsoft Press(R) and Hardware is
included in the Other segment.
The Worldwide Sales, Marketing, and Services Group integrates the activities of
Microsoft's sales and service partners with the needs of Microsoft customers
around the world. In addition, the group includes Microsoft Product Support
Services, the Network Solutions Group, the Enterprise Partner Group, the Central
Marketing Organization, and all three of Microsoft's major business-sales
regions worldwide.
Microsoft Research works on devising innovative solutions to computer science
problems, such as making computers easier to use, designing software for the
next generation of hardware, improving the software design process, and
investigating the mathematical underpinnings of computer science.
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The Operations Group is responsible for managing business operations and overall
business planning. This includes corporate functions such as finance,
administration, human resources, and information technology.
Products
Microsoft has four product segments: Desktop and Enterprise Software and
Services; Consumer Software, Services, and Devices; Consumer Commerce
Investments; and Other. See Notes to Financial Statements for financial
information regarding segment reporting.
Desktop and Enterprise Software and Services
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Desktop and Enterprise Software and Services includes Desktop Applications;
Desktop Platforms; and Enterprise Software and Services. For segment reporting
purposes, Desktop Applications includes revenue from Microsoft Office, Microsoft
Project, Microsoft Visio(R), Microsoft Great Plains, bCentral; and client access
licenses for Windows NT(R) Server and Windows 2000 Server, Exchange, and
BackOffice(R). Desktop Platforms includes revenue from Windows 2000
Professional, Windows NT Workstation, Windows Millennium Edition, Windows 98,
and other desktop operating systems. Enterprise Software and Services includes
Enterprise Platforms, Server Applications, Developer Tools and Services, and
Enterprise Services.
Desktop Applications
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Microsoft Office. Microsoft Office is a suite of software programs featuring
seamless integration of the most commonly used desktop applications. Microsoft
Office is based upon a document-centric concept, with common commands and
extensive use of cross-application capabilities. Microsoft Office is available
in several versions, with certain combinations of products, and available for
the Windows and Macintosh operating systems. Microsoft Office XP helps users
complete common business tasks, including word processing, electronic mail (e-
mail), presentations, and data management, with features like smart tags, task
panes, integrated e-mail, document recovery, and send for review. Products
offered in the various versions include the word processor Microsoft Word,
Microsoft Excel spreadsheet, Microsoft Outlook(R) personal information
management and communication client, Microsoft PowerPoint(R) presentation
graphics program, Microsoft Access database management application, and others.
Microsoft Word is a word-processing program designed to create documents such as
reports, letters, business plans, and more. Microsoft Excel creates data-rich
spreadsheets for universal viewing on the Internet and for collaboration, allows
users to analyze data with charts, and incorporates Microsoft PivotTable(R)
views and graphs. Microsoft Outlook personal information management and
communication client provides a single, integrated solution for organizing and
managing digital communication tools such as e-mail and instant messaging, along
with day-to-day information, including calendars, contacts, task lists, and
notes. Microsoft PowerPoint presentation graphics program is a complete set of
tools for creating professional presentations. Microsoft Access database
management application allows for easy access and retrieval of information and
includes pre-packaged solutions to create databases quickly. Microsoft
FrontPage(R) is a Web site creation and management tool for Web sites on the
Internet or intranets. Microsoft Publisher business desktop publishing is a
program for creating professional-looking marketing and business materials.
Other Desktop Application Products. The Company also offers other stand-alone
desktop application products. Microsoft Project is a project management program
for scheduling, organizing, and analyzing tasks, deadlines, and resources.
Microsoft Visio is a diagramming program that helps people visualize and
communicate ideas, information, and systems. Most of the applications included
in the various software program suites are also licensed separately.
Microsoft Great Plains. Microsoft Great Plains offers a range of integrated
business and accounting products, including Dynamics, Solomon, and eEnterprise,
which deliver broad and deep functionality. Dynamics provides Internet-ready
accounting and business management capabilities for small- to mid-sized
companies. Solomon offers a full range of e-business and accounting
applications for small- to mid-sized companies. eEnterprise supports mid-sized
to larger companies by providing a collaborative environment for information
management and sharing.
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bCentral. Microsoft's small businesses portal, bCentral, allows companies to
leverage the Internet to drive their business forward. Microsoft bCentral Site
Manager is a Web site management and hosting service which empowers small
businesses to easily create and manage their own Web sites, while allowing for
higher-end editing in Microsoft FrontPage. Microsoft bCentral LinkExchange(TM)
provides services to small businesses and Web site owners to increase their
online traffic and sales with free advertising banner ads on their site in
exchange for placing ads on other network sites.
Client Access Licenses. A client access license gives a client computer the
legal right to access a computer running a Microsoft server product and the
services supported by the server.
Desktop Platforms
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Windows XP. Windows XP is the next major version of the Windows operating
system and is scheduled for widespread availability in October 2001. Windows XP
extends the personal computing experience by uniting PCs, devices, and services,
and brings the solid foundation of Windows 2000 to home PC users, enhancing
reliability, security, and performance. Windows XP Home Edition is designed for
individuals or families at home and includes experiences for digital media, home
networking, and communications. Windows XP Professional is for businesses of
all sizes and for people who demand the most out of their computing experience.
Windows XP Professional adds remote access, security, performance,
manageability, and multilingual features to help users improve productivity and
connectivity.
Windows 2000 Professional. The successor to Windows NT Workstation, Windows
2000 Professional operating system combines features to create a mainstream
operating system for desktop and notebook computing in all organizations.
Windows 2000 Professional contains the enhanced business features of Windows 98
such as Plug and Play, easy-to-use user interface, and power management and
integrates the strengths of Windows NT Workstation including standards-based
security, manageability, and reliability.
Windows NT Workstation. A fully integrated, multitasking 32-bit PC operating
system, Windows NT Workstation provides security, robustness, and portability.
Windows NT Workstation combines the Windows 98 operating system interface and
usability features with the reliability and security of Windows NT for the
business environment.
Windows Millennium Edition. Windows Millennium Edition (Me) operating system is
designed specifically for home users to manage digital photos and music, work
with video, create a home network, and communicate with other consumers.
Windows 98. The successor to Windows 95, Windows 98 is a personal computer
operating system that provides a Web-oriented user interface and better system
performance along with easier system diagnostics and maintenance. Windows 98
supports graphics, sound, and multimedia technologies and provides the ability
to easily add and remove peripheral devices and support for Universal Serial Bus
(USB).
Enterprise Software and Services
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Windows 2000 Server, Advanced Server, and Datacenter Server. Windows 2000
Server family builds on the Windows NT technology, integrating standards-based
directory, Web, application, communications, file and print services with high
reliability, efficient management, and support for networking hardware to
provide the foundation for integrating with the Internet. Windows 2000 Server
is a multipurpose network operating system for businesses of all sizes. Windows
2000 Advanced Server operating system is ideal for e-commerce and line-of-
business applications and provides enhanced performance and scalability through
symmetric multiprocessing (SMP) and extended memory support. Windows Datacenter
Server operating system is built for large-scale line-of-business and enterprise
backend usage and supports server consolidation and enhanced scalability.
Windows NT Server. Windows NT Server is an operating system foundation for both
server applications and file and print sharing, with network management
features, administration tools, security, and high availability. Windows NT
Server provides a scalable platform for business critical applications and
databases, connectivity, system management, and e-mail servers. The operating
system integrates Web services such as Microsoft Internet Information Server, a
service used to manage intranet and Internet functionality, and Microsoft
FrontPage Web site creation and management tool. Windows NT Server,
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Terminal Server Edition, an extension to the Windows NT Server, offers the
application support of the Windows operating system platform with the centrally
managed environment of the mainframe with terminal. Windows NT Server Enterprise
Edition provides the means for building and deploying large-scale distributed
applications for large and mission-critical servers featuring comprehensive
clustering for scalability and availability.
Microsoft .NET Enterprise Servers. Microsoft .NET Enterprise Servers include
Microsoft SQL Server(TM), Exchange Server, Application Center, BizTalk(TM)
Server, Commerce Server, Content Management Server, Host Integration Server,
Internet Security and Acceleration Server, Mobile Information Server, and
SharePoint(TM) Portal Server. SQL Server is a fully Web-enabled database and
data analysis product, providing core support for Extensible Markup Language
(XML) and the ability to query across the Internet and beyond the firewall.
Exchange Server is a messaging and collaboration server which provides e-mail,
group scheduling, task management, and document routing capabilities.
Application Center is Microsoft's deployment and management tool for high-
availability Web applications built on the Microsoft Windows 2000 operating
system. BizTalk Server enables companies to rapidly build and deploy integrated
business processes within their organizations and with partners. Commerce
Server provides a comprehensive set of features for building scalable, user-
centric, business-to-consumer, and business-to-business e-commerce sites.
Content Management Server is the enterprise Web content management system that
enables companies to quickly and efficiently build, deploy, and maintain highly
dynamic Internet, intranet, and extranet Web sites. Host Integration Server
extends Microsoft Windows to other systems by providing application, data, and
network integration. Internet Security and Acceleration Server provides secure,
fast, and manageable Internet connectivity. It integrates an extensible,
multilayer enterprise firewall and a scalable high-performance Web cache.
Mobile Information Server mobile-enables the enterprise, extending the reach of
Microsoft .NET Enterprise applications, enterprise data, and intranet content to
the mobile user. SharePoint Portal Server extends the capabilities of Microsoft
Windows and Microsoft Office by offering knowledge workers a powerful new way to
easily organize, find, and share information. It combines the ability to easily
create corporate Web portals with document management, content searching, and
team collaboration features.
Other Servers. Designed for the branch office, department, and medium-sized
business, BackOffice Server provides a wide range of infrastructure and
application services including directory, networking, Web application, database,
messaging and collaboration, Internet proxy and firewall, host integration, and
Windows desktop management. Proxy Server is an extensible firewall and Web
cache server that provides Internet security while improving network response
time and efficiency. Site Server is the powerful intranet server, optimized for
Microsoft Windows NT Server with Internet Information Server, for publishing and
finding information easier and faster. Site Server Commerce is a comprehensive
Internet commerce server that organizations can use to build and monitor dynamic
and cost-effective business sites that take full advantage of the Web. Small
Business Server is the flexible network solution designed to help small
businesses with up to 50 computers. SNA Server provides connectivity to host
data and applications. Systems Management Server helps centrally manage the
distributed environment with integrated features, including hardware inventory,
software inventory and metering, software distribution and installation, and
remote troubleshooting tools.
Developer Tools and Services. Software development tools and computer languages
allow software developers to write programs in a particular computer language
and translate programs into a binary machine-readable set of commands that
activate and instruct various hardware devices. The Company develops and
markets a number of software development environments and language compilers.
Microsoft Visual C++(R) is the Company's development system for Windows-based
application development. The Microsoft Visual Basic(R) development system
provides easy access to a wide variety of data sources by integrating the
Microsoft Access database engine and the ability to take advantage of
investments in commercial applications. The Microsoft Visual InterDev(R)
development system includes integrated, team-based development tools for
building Web-based applications based on HTML, Script, and components written in
any language. Microsoft Visual J++ development system for Java contains a high
productivity Integrated Development Environment and a collection of integrated
components to create, test, tune, and deploy Java code on multiple platforms.
Microsoft Visual Studio(R) development system for Windows-based development is a
suite of developer tools enabling developers to build components and
applications
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using Visual Basic, Visual C++, Microsoft Visual FoxPro(R) database development
system, Visual InterDev, and Visual J++. Developers can subscribe to the
Microsoft Developer Network (MSDN(R)) information service and receive periodic
updates via CD-ROMs, magazines, and several online information services. In
addition, Microsoft receives certification fees through the Microsoft Certified
Professional (MCP) program, a program that provides credentials for those who
have demonstrated in-depth knowledge of at least one Microsoft product.
Enterprise Services. Microsoft Enterprise Services assist organizations with
every stage of technology planning, building, deployment, and support.
Specializing in real-life IT solutions for the enterprise, Microsoft offers a
full range of consulting services for advance technology requirements, including
custom solutions services, enterprise application planning, architecture and
design services, and proof-of-concept services. The Company provides product
support services aligned to the customer segments, partner segments, and
communities. Support offerings include the Alliance program, tailored for large
enterprises running mission-critical applications on Microsoft platforms; the
Premier program for enterprises; the Authorized Premier Support for all types of
businesses who work jointly with Microsoft and Microsoft Gold Certified
Partners; the Professional program for IT professionals, developers, and OEMs;
and the Personal program for home users, which provides free online self-help
resources and paid assisted phone support.
Consumer Software, Services, and Devices
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Consumer Software, Services, and Devices includes MSN Internet access, MSN
network services, PC and online games, Xbox, learning and productivity software,
mobility and embedded systems.
MSN Internet Access. MSN Internet access is a Web-based online service. MSN
provides easy and inexpensive access for users to a wide range of graphically
rich online content. MSN Internet access includes MSN Explorer, the Internet
software from Microsoft that makes it easier to get more from the Web. MSN
Internet access subscribers can access their account from multiple sources,
including a computer, television, Internet appliances, and Personal Data
Assistants.
MSN Network Services. MSN network service provides services on the Internet,
encompassing MSN properties such as Homepage and Search, as well as other
services. MSN Hotmail(R) is the world's leading free Web-based e-mail service.
MSN Messenger Service is a free Internet messaging service that enables users to
see when others are online and exchange instant messages with them. CNBC on MSN
Money, located exclusively on MSN, is a complete online personal financial
service that combines the award-winning finance tools and content from Microsoft
with exclusive investment news and analysis from CNBC. MSN Music provides
consumers with one place online to find old favorites, as well as discover new
music, and delivers a high quality listening experience. MSN eShop is a one-
stop online shopping resource.
PC and Online Games. The Company offers a line of entertainment products from
classic software games to online games, simulations, sport products, and
strategy games. Microsoft Flight Simulator is a popular aircraft flight
simulation product. Other games include Combat Flight Simulator, Age of
Empires(R), MechWarrior(TM), Microsoft Links(R), and other sports and action
titles. Zone.com is a gaming community on the Internet allowing multiplayer
gaming competitions of Microsoft's popular CD-ROM games and classic card, board,
and puzzle games.
Xbox. Microsoft Xbox(TM), scheduled for North America release in November 2001,
is Microsoft's future-generation video game console system that delivers high
quality graphics and audio gameplay experiences and will ultimately enable new
online gaming scenarios.
Learning and Productivity Software. Learning titles include Microsoft
Encarta(R) multimedia encyclopedia and Microsoft Bookshelf(R) CD-ROM reference
library. The Encarta family of products includes a multimedia encyclopedia
database with interactive information, an interactive world atlas with three-
dimensional maps, a world English dictionary, and an online version with monthly
updates. Microsoft Bookshelf is a multimedia reference library that gives users
fast, easy access to reference resources. Titles for children include My
Personal Tutor, a comprehensive, grade-based learning suite with TutorAssist
learning technology that identifies a child's specific learning needs and offers
instruction, and a series of
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products based on the popular children's book and television series,
Scholastic's The Magic School Bus(R). Microsoft's productivity offerings include
Microsoft Works, an integrated software program that contains basic word
processing, spreadsheet, and database capabilities that allows the easy exchange
of information from one tool to another. Microsoft Money offers leading tools
and resources to conduct a wide range of financial activities. The Works Suite
provides a comprehensive collection of software, including Microsoft Works,
Microsoft Word, Microsoft Money, Microsoft Encarta encyclopedia, Microsoft
Picture It!(R) Publishing, and Microsoft Streets & Trips.
Mobility and Embedded Systems. Microsoft develops a number of software
platforms for mobile computing form factors. Products such as Pocket PC,
Microsoft Mobile Explorer, and Microsoft Smartphone platform (currently
codenamed Stinger) are designed to enable a variety of mobile scenarios.
Microsoft's embedded offerings include two embedded operating systems, Microsoft
Windows CE and Microsoft Windows NT Embedded, as well as device specific
solutions. Microsoft Windows CE, a robust real-time embedded operating system,
is targeted at small footprint, mobile 32-bit devices. Microsoft Windows NT
Embedded, based on the desktop and server versions of Microsoft's operating
systems, is targeted at higher-end embedded products and devices. Both embedded
operating systems offer integrated tool sets to enable embedded system
developers to quickly create sophisticated embedded device and application
solutions. Microsoft Mobile Explorer enables secure mobile access to corporate
or personal e-mail, corporate networks, and the Internet when connected to a
wireless network. Microsoft Mobile Information Server is a scalable and
reliable mobile applications server that provides enterprise customers and
mobile operators with a rich platform for extending .NET Enterprise application
and securely delivering real-time, wireless data to mobile devices.
Consumer Commerce Investments
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Consumer Commerce Investments include Expedia, Inc., the HomeAdvisor online real
estate service, and the CarPoint online automotive service.
Expedia, Inc. Expedia, Inc. operates Expedia.com, a leading online travel
service in the United States with localized versions in Canada, Germany, and the
United Kingdom. Expedia.com provides air, car, and hotel booking, vacation
package and cruise offerings, destination information, and mapping. On July 16,
2001, USA Networks, Inc. (USA) announced an agreement to acquire a controlling
interest in Expedia through the purchase of up to 37.5 million shares,
approximately 75% of the current outstanding shares. If holders of more than
37.5 million Expedia shares elect to sell their shares to USA, there will be a
pro rata reduction among all electing shareholders. Microsoft has agreed to
transfer all of its 33.7 million shares and warrants, subject to pro-ration. It
is expected that the transaction will close by December 31, 2001.
HomeAdvisor online real estate service. The HomeAdvisor online real estate
service is a complete guide to the home-buying process and provides
comprehensive tools for finding homes and loans on the Internet. HomeAdvisor
provides users with the information and knowledge needed to take control of the
home-buying process. This includes customized search features, worksheets and
calculators, and editorial content and home-buying advice.
CarPoint online automotive service. The CarPoint online automotive service is
the leading online automotive marketplace, visited by more than 7 million
consumers each month. With details on more than 10,000 car models and 100,000
used vehicles, users can research and compare cars of virtually every make and
model, identify local dealers, and receive instructions for post-purchase
service and maintenance.
Other
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Hardware. The Company develops and markets several PC input devices including
the Microsoft IntelliMouse(R) family of hand-held pointing devices that
facilitate using the PC. The Company also markets several types of keyboards
including the Microsoft Natural(R) Keyboard, an ergonomically designed keyboard.
Microsoft sells various Microsoft SideWinder(R) game controllers and force
feedback joysticks with realistic performance technology to use with PC games.
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Microsoft Press. Microsoft Press offers comprehensive learning and training
resources to help new users, power users, and professionals get the most from
Microsoft technology through books, CDs, self-paced training kits, and videos
that are created to accommodate different learning styles and preferences.
Microsoft Press books are authored by professional and technical writers, both
by Microsoft employees and independent authors.
Equity Investments
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The Company has entered into joint venture arrangements to take advantage of
creative talent and content from other organizations. Microsoft owns 50 percent
of MSNBC Cable L.L.C., a 24-hour cable news and information channel, and 50
percent of MSNBC Interactive News L.L.C., an interactive online news service.
National Broadcasting Company (NBC) owns the remaining 50 percent of these two
joint ventures. Microsoft owns 49 percent of Avanade Inc., a joint venture with
Accenture Ltd, which offers solutions and services based on Windows 2000.
Product Development
The software industry is characterized by rapid technological change, which
requires constant attention to computing technology trends, and shifting
consumer demand, and rapid product innovation. The pace of change is
accelerating as the computing needs of our customers move beyond the PC toward
intelligent devices and appliances.
Most of the Company's software products are developed internally. The Company
also purchases technology, licenses intellectual property rights, and oversees
third-party development and localization of certain products. Internal
development enables Microsoft to maintain closer technical control over its
products and gives the Company the freedom to designate which modifications and
enhancements are most important and when they should be implemented. The
Company has created a substantial body of proprietary development tools and has
evolved development methodologies for creating and enhancing its products.
These tools and methodologies are also designed to simplify a product's
portability among different operating systems, microprocessors, or computing
devices. Product documentation is generally created internally.
The Company believes that a crucial factor in the success of a new product is
getting it to market quickly to respond to new user needs or advances in
intelligent devices, PCs, servers, and the Internet, without compromising
product quality. The Company strives to become informed at the earliest
possible time about changing usage patterns and hardware advances that may
affect software design. Before releasing new software platforms, Microsoft
provides to software vendors a range of development, training, testing
resources, and guidelines for developing applications.
To best serve the needs of users around the world, Microsoft "localizes" many of
its products to reflect local languages and conventions and to improve the
quality and usability of the product in international markets. Localizing a
product might require modifying the user interface, altering dialog boxes, and
translating text. In Japanese versions, for example, all user messages and
documentation are in Japanese with monetary references in the Japanese yen.
Various Microsoft products have been localized into more than 30 languages.
During fiscal years 1999, 2000, and 2001, the Company spent $2.97 billion, $3.77
billion, and $4.38 billion, respectively, on product research and development
activities excluding funding of joint venture activity. Those amounts
represented 15.0%, 16.4%, and 17.3%, respectively, of revenue in each of those
years. The Company is committed to continue high expenditures for research and
product development.
Microsoft .NET is Microsoft's platform for XML Web services. XML Web services
allow applications to communicate and share data over the Internet, regardless
of operating system or programming language. The Microsoft .NET platform
includes a comprehensive family of products, built on XML and Internet industry
standards, which provide for each aspect of developing, managing, using, and
experiencing XML Web services. There are five areas where Microsoft is building
the .NET platform today: Tools, Servers, XML Web Services, Clients, and .NET
Experiences. In the Tools area, Visual Studio .NET and the
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Microsoft .NET framework supply a complete solution for developers to build,
deploy, and run XML Web services. They maximize the performance, reliability,
and security of XML Web services. The .NET Enterprise Servers, including the
Windows 2000 Server family, make up Microsoft .NET's server infrastructure for
deploying, managing, and orchestrating XML Web services. Designed with mission-
critical performance in mind, they provide enterprises with the agility they
need to integrate their systems, applications, and partners through XML Web
services, and the flexibility to adapt to changing business requirements.
In addition to developers creating XML Web services, Microsoft is creating a
core set of building block services that perform routine tasks and act as the
backbone for developers to build upon. The first set of XML Web services being
built, codenamed "HailStorm", is a group of user-centric services oriented
around people, rather than specific devices, networks, or applications.
HailStorm is based upon the Microsoft Passport user authentication system. With
HailStorm, users receive relevant information, as they need it, delivered to the
devices they are using, and based on preferences they have established.
Clients are PCs, laptops, workstations, phones, handheld computers, Tablet PCs,
game consoles, and other smart devices. These smart clients and devices use
software that supports XML Web services, which enable users to access their data
regardless of the location, type, and number of clients used. Smart clients and
devices leverage XML Web services to create .NET experiences that allow users to
access information across the Internet and from stand-alone applications in an
integrated way. Some of the products that Microsoft is transitioning into .NET
experiences are Office, MSN, bCentral, and Visual Studio .NET.
Manufacturing
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Microsoft contracts out most of its manufacturing activity to third parties.
Outside manufacturers produce various retail software packaged products and
hardware. There are other custom manufacturers Microsoft could use in the event
outsourced manufacturing becomes unavailable from current vendors.
The Company's CD-ROM manufacturing facilities are located in Puerto Rico. The
Company has multiple sources for raw materials, supplies, and components and is
often able to acquire component parts and materials on a volume discount basis.
Quality control tests are performed on purchased parts, CD-ROMs, and other
products.
Operations
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Microsoft manages all product fulfillment, licensing, and logistics services.
The Company has regional operations centers in Ireland, Singapore, and the
Greater Seattle area. The regional centers support all operations activities,
including information processing, vendor management, logistics, and related
supporting functions by geographical regions. The regional center in Dublin,
Ireland supports the European, African, and Middle East regions, the center in
Singapore supports the Asia Pacific region, and the center in the Greater
Seattle area supports North and South America. Microsoft Licensing Incorporated
(MSLI), a wholly-owned subsidiary in Reno, Nevada, manages the Company's
original equipment manufacturer (OEM) and certain organizational licensing
operations.
Marketing and Distribution
--------------------------------------------------------------------------------
The Company's sales and marketing group seeks to build long-term relationships
with customers of Microsoft. The OEM sales group includes the sales force that
works with original equipment manufacturers that preinstall Microsoft software
on their PCs. In addition to the OEM channel, Microsoft has three major
geographic sales and marketing organizations: the South Pacific and Americas;
Europe, Middle East, and Africa; and Asia.
8
Finished Goods Channels
--------------------------------------------------------------------------------
Distributors and Resellers. The Company licenses and sells its products in the
finished goods channels primarily to and through independent non-exclusive
distributors and resellers. Distributors and resellers include Ingram Micro,
Tech Data, Software Spectrum, Corporate Software & Technology, SOFTBANK,
Software House International, ASAP Software Express, and Tech Pacific Group.
Microsoft has a network of field sales representatives and field support
personnel who solicit orders from distributors and resellers and provide product
training and sales support.
Enterprise Accounts. The Microsoft Select program offers flexible software
acquisition, licensing, and maintenance options specially customized to meet the
needs of large multinational organizations. Targeted audiences include
technology specialists and influential end users in large enterprises.
Marketing efforts and fulfillment are generally coordinated with large account
resellers. The Microsoft Open program is a licensing program that is targeted
for small- and medium-sized organizations. It is available through the reseller
channel and offers discounts based on initial purchase volumes. The Microsoft
Enterprise Agreement program is a licensing program designed to provide a
flexible licensing and service solution tailored to customers making a long-term
licensing commitment. The agreements are designed to increase customer
satisfaction by simplifying license administration, payment terms, and the
contract process.
Certified Partners. Microsoft Certified Partners are independent companies that
offer their clients leading-edge technology through consulting, deployment,
remote and on-site maintenance, helpdesk support, packaged software
applications, hosting services, training, and more. Microsoft Certified
Partners encompass a broad range of expertise and vendor affiliations and have
experience ranging from networking, e-commerce, collaboration, business
intelligence, and other leading edge disciplines.
International Sales Sites. The Company has established marketing and/or support
subsidiaries in more than 80 countries. Product is generally delivered by the
Company's owned or outsourced manufacturing operations, which are located in the
geographical region in which the product was sold. By organizing
geographically, the Company is able to provide service to international channel
customers and access to Microsoft professionals located in the same region to
serve their specific needs. Subsidiaries have the responsibility for selling
products to customers, managing licensing programs, and providing support to all
types of customers based in international countries.
The Company's international operations, both OEM and finished goods, are subject
to certain risks common to foreign operations in general, such as governmental
regulations, import restrictions, and foreign exchange rate fluctuations.
Microsoft hedges a portion of its foreign exchange risk.
OEM Channel
--------------------------------------------------------------------------------
Microsoft operating systems are licensed primarily to OEMs under agreements that
grant the OEMs the right to distribute copies of the Company's products with
their computing devices, principally PCs. The Company also markets and licenses
certain server operating systems, desktop applications, hardware devices, and
consumer software programs to OEMs under similar arrangements. In almost all
cases, the products are distributed under Microsoft trademarks. The Company has
OEM agreements covering one or more of its products with virtually all of the
major PC OEMs, including Acer, Actebis, Compaq, Dell, eMachines, Fujitsu,
Fujitsu Siemens Computers, Gateway, Hewlett-Packard, IBM, Micron, NEC, Samsung,
Sony, and Toshiba. A substantial amount of OEM business is also conducted with
system builders, which are low-volume customized PC vendors.
Advertising
--------------------------------------------------------------------------------
The Company works closely with large advertising and direct marketing firms.
Advertising, direct marketing, worldwide packaging, and marketing materials are
targeted to various end-user segments. The Company uses broad consumer media
(television, radio, the Internet, and business publications) and trade
publications. Microsoft has programs under which qualifying resellers and OEMs
are reimbursed for certain advertising expenditures.
9
Customers
--------------------------------------------------------------------------------
The Company's customers include consumers, small- and medium-sized
organizations, enterprises, educational institutions, ISPs, application
developers, and OEMs. Most consumers of Microsoft products are individuals in
businesses, government agencies, educational institutions, and at home. The
consumers and organizations obtain Microsoft products primarily through
resellers and OEMs, which include certain Microsoft products with their
computing hardware. The Notes to Financial Statements (see Item 8) quantify
customers that represent more than 10% of the Company's revenue. The Company's
practice is to ship its products promptly upon receipt of purchase orders from
its customers and, consequently, backlog is not significant.
Competition
--------------------------------------------------------------------------------
The software business is intensely competitive and subject to rapid
technological change. As the company pursues its largest strategic initiative,
Microsoft .NET, the Company could experience more intense competition during the
transition from the traditional core businesses to its new products based on the
.NET platform. The Company continues to face movements from PC-based
applications to server-based applications or Web-based application hosting
services, from proprietary software to open source software, and from PCs to
Internet-based devices. A number of Microsoft's most significant competitors,
including IBM, Sun Microsystems, Oracle, and AOL Time Warner, are collaborating
with one another on various initiatives directed at competing with Microsoft.
These initiatives relate in part to efforts to move software from individual PCs
to centrally managed servers, which would present significant challenges to the
Company's historical business model. Other competitive collaborative efforts
include the development of new platform technologies that are intended to
replicate much of the value of Microsoft Windows operating systems. New
computing form factors, including non-PC information devices, are gaining
popularity and competing with PCs running Microsoft's software products.
Microsoft faces formidable competition in these new areas and in all areas of
its current business activity, including competition from many companies much
larger than Microsoft. The rapid pace of technological change, particularly in
the area of Internet platforms and services, continually creates new
opportunities for existing competitors and start-ups and can quickly render
existing technologies less valuable. The Company also faces relentless
competition from software pirates who unlawfully copy and distribute Microsoft's
copyrighted software products, depriving the Company of large amounts of revenue
on an annual basis.
The Company's competitive position may be adversely affected by one or more of
the following factors in the future, particularly in view of the fast pace of
technological change in the computing industry.
Desktop and Enterprise Software and Services
--------------------------------------------
The Company's competitors include many software application vendors, such as IBM
(Lotus), Oracle, Apple (Filemaker, Inc.), Sun Microsystems, Corel, Qualcomm, and
local application developers in Europe and Asia. IBM and Corel have large
installed bases with their spreadsheet and word processor products,
respectively, and both have aggressive pricing strategies. Also, IBM and Apple
preinstall certain of their application software products on various models of
their PCs, competing directly with Microsoft's desktop application software.
Sun Microsystems' Star Office is also very aggressive with its pricing, offering
a free download from the Web or nominal charge for a CD. Additionally, Web-
based application hosting services provide an alternative to PC-based
applications such as Microsoft Office.
Microsoft's operating system products face substantial competition from a wide
variety of companies. Competitors such as IBM, Apple Computer, Sun
Microsystems, and others are vertically integrated in both software development
and hardware manufacturing and have developed operating systems that they
preinstall on their own computers. Many of these operating system software
products are also licensed to third-party OEMs for preinstallation on their
computers. Microsoft's operating system products compete with UNIX-based
operating systems from a wide range of companies, including IBM, Hewlett-
Packard, Sun
10
Microsystems, and others. Variants of UNIX run on a wide variety of computer
platforms and have gained increasing acceptance as desktop operating systems.
With increased attention toward open source software, the Linux operating system
has gained increasing acceptance as well. Several computer manufacturers
preinstall Linux on PC servers and many leading software developers have written
applications that run on Linux. Microsoft Windows operating systems are also
threatened by alternative platforms such as those based on Internet browsing
software and Java technology promoted by AOL Time Warner and Sun Microsystems.
The Company competes in the business of providing enterprise-wide computing
solutions with several competitors who enjoy a larger share of sales and larger
installed bases. Many companies offer operating system software for mainframes
and midrange computers, including IBM, Hewlett-Packard, and Sun Microsystems.
Since legacy business systems are typically support-intensive, these competitors
also offer substantial support services. Software developers that provide
competing server applications for PC-based distributed client/server
environments include Oracle, IBM, Computer Associates, Sybase, and Informix.
There are also several software vendors who offer connectivity servers. As
mentioned above, there are numerous companies and organizations that offer
Internet and intranet server software, which compete against the Company's
business systems. Additionally, IBM has a large installed base of Lotus Notes
and cc:Mail, both of which compete with the Company's collaboration and e-mail
products.
The Company's developer products compete against offerings from Borland,
Macromedia, Oracle, Sun Microsystems, Sybase, Symantec, and other companies.
Consumer Software, Services, and Devices
----------------------------------------
Microsoft's online services network, MSN, faces formidable competition from AOL
Time Warner (including its CompuServe unit), Yahoo!, and a vast array of Web
sites and portals that offer content of all types and e-mail, instant messaging,
calendaring, chat, and search and shopping services, among other things. In
addition, the ease of entry into Internet services has allowed numerous Web-
based service companies to build significant businesses in areas such as e-mail,
electronic commerce, Web search engines, directories, and information of
numerous types. Competitors include AOL Time Warner, Yahoo!, Excite, Lycos,
Infoseek, AltaVista, and many others. The Company's MSNBC joint ventures face
considerable competition from other 24-hour cable and Internet news
organizations such as CNN, CNN Headline News, and Fox News Network. MSNBC also
competes with traditional news media such as newspapers, magazines, and
broadcast TV.
The Company's Consumer Group continues to see consolidation across the various
entertainment and productivity segments in which Microsoft competes.
Competitors include Vivendi (Havas), Intuit, Electronic Arts, The Learning
Company, Infogrammes, and Logitech. Still other competitors own branded
content, such as Disney and LucasArts.
Additionally, PC-based games and the Company's future Xbox compete and will
compete head-to-head against games created for proprietary systems such as the
Nintendo GameCube and the Sony PlayStation. Game developers like Electronic
Arts, Namco, Midway, Activision, Konami, THQ, to name a few, are both partners
and competitors in the games software development segment.
Microsoft faces many competitors in the Mobile Devices space, including Palm,
Symbian, Nokia, and Openwave. The embedded operating system market is highly
fragmented with many competitive offerings. Key competitors include Wind River
and versions of embeddable Linux from commercial Linux vendors such as Red Hat,
Lineo, and Monta Vista. The largest competitor remains in-house operating
systems developed by device manufacturers. However, this is changing as more
device builders opt for commercial offerings as connectivity and richer features
are required in devices.
11
Consumer Commerce Investments
-----------------------------
In the United States, Expedia, Inc. competes with traditional travel
distribution channels and online travel services such as Travelocity.com, Hotel
Reservations Network, Priceline.com, CheapTickets.com, Biztravel.com,
Worldres.com, and Trip.com. Expedia also competes with supplier-owned sites
such as United.com, Delta.com, and Marriott.com. In addition, two new
competitors owned by various airlines, Orbitz and Hotwire, emerged in fiscal
year 2001. Internationally, Expedia competes with a different set of
participants in each market. Microsoft faces many competitors in the online
real estate service space, including AOL's House and Home channel and Homestore.
The Company also faces many competitors in the online automotive service space,
including Autobytel, CarsDirect, AOL autos, and Yahoo! autos.
Other
-----
PC input devices face substantial competition from computer manufacturers, since
computers are typically sold with a keyboard and mouse, and other manufacturers
of these devices. Microsoft Press competes in the retail book and eLearning
markets with publishers that also create content on Microsoft technologies. A
few of the retail competitors are Pearson, WROX, Sybex, and Wiley. The major
eLearning competitors are Smartforce and NetG.
Employees
--------------------------------------------------------------------------------
As of June 30, 2001, the Company employed approximately 47,600 people on a full-
time basis, 33,000 in the United States and 14,600 internationally. Of the
total, 19,400 were in product research and development, 22,500 in sales,
marketing, and support, 1,900 in manufacturing and distribution, and 3,800 in
finance and administration. Microsoft's success is highly dependent on its
ability to attract and retain qualified employees. Competition for employees is
intense in the software industry. To date, the Company believes it has been
successful in its efforts to recruit qualified employees, but there is no
assurance that it will continue to be as successful in the future. None of the
Company's employees is subject to collective bargaining agreements. The Company
believes relations with its employees are excellent.
Item 2. Properties
The Company's corporate offices consist of approximately 7.9 million square feet
of office building space located in King County, Washington. The Company is
constructing three buildings with approximately 720,000 square feet of space
that will be occupied in the Fall of 2001. The Company owns 4.8 million square
feet of corporate campus space situated on slightly more than 300 acres of land
and leases approximately 3.1 million square feet around the Puget Sound region.
To accommodate expansion needs the Company has an option to purchase 150 acres
of land in Issaquah, Washington, which can accommodate 2.95 million square feet
of additional office space.
The Company leases many sites domestically totaling approximately 3.0 million
square feet of office building space. This includes the recent acquisition of
the Great Plains facilities which totaled 425,000 square feet.
The Company leases many sites internationally totaling approximately 4.1 million
square feet. The Company's European operations center and localization division
leases a 382,000 square-foot campus in Dublin, Ireland. The Company leases a
45,000 square-foot disk duplication facility in Humacao, Puerto Rico and leases
a 36,000 square-foot facility in Singapore for its Asia Pacific operations
center. The Company has office building space leased in the following
locations: Tokyo, Japan 343,000 square feet; Unterschleissheim, Germany 253,000
square feet; United Kingdom campus 242,000 square feet; Les Ulis, France 229,000
square feet; and Beijing, China 115,000 square feet.
The Company's facilities are fully used for current operations of all segments
and suitable additional space is available to accommodate expansion needs.
Item 3. Legal Proceedings
See Notes to Financial Statements-Contingencies (Item 8) for information
regarding legal proceedings.
12
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 2001.
Executive Officers of the Registrant
The executive officers of Microsoft as of September 10, 2001 were as follows:
Name Age Position with the Company
William H. Gates, III 45 Chairman of the Board; Chief Software Architect
Steven A. Ballmer 45 Chief Executive Officer
Richard E. Belluzzo 47 President; Chief Operating Officer
James E. Allchin 49 Group Vice President, Platforms
Orlando Ayala 45 Group Vice President, Worldwide Sales, Marketing, and Services
Robert J. (Robbie) Bach 39 Senior Vice President, Games
Douglas J. Burgum 45 Senior Vice President, Business Solutions; President, Great Plains Division
David W. Cole 39 Senior Vice President, Services Platform Division
John G. Connors 42 Senior Vice President; Chief Financial Officer
Jean-Philippe Courtois 41 Senior Vice President; President, Microsoft Europe, Middle East, and Africa
Jon Stephan DeVaan 40 Senior Vice President, TV Division
Richard P. Emerson 39 Senior Vice President, Corporate Development and Strategy
Paul Flessner 42 Senior Vice President, .NET Enterprise Servers
Kevin R. Johnson 40 Senior Vice President, U.S. Sales, Marketing, and Services
Robert L. Muglia 41 Group Vice President, Personal Services Group
Craig J. Mundie 52 Senior Vice President; Chief Technical Officer, Advanced Strategies and Policy
William H. Neukom 59 Executive Vice President, Law and Corporate Affairs; Secretary
Jeffrey S. Raikes 43 Group Vice President, Productivity and Business Services
Richard F. Rashid 49 Senior Vice President, Research
Steven J. Sinofsky 36 Senior Vice President, Office
Brian Valentine 41 Senior Vice President, Windows
David Vaskevitch 48 Senior Vice President; Chief Technical Officer, Business Platform
Deborah N. Willingham 45 Senior Vice President, Human Resources
Mr. Gates co-founded Microsoft in 1975 and served as its Chief Executive Officer
from the time the original partnership was incorporated in 1981 until January
2000, when he resigned as Chief Executive Officer and assumed the position of
Chief Software Architect. Mr. Gates has served as Chairman of the Board since
the Company's incorporation.
Mr. Ballmer was named Chief Executive Officer and a director of the Company in
January 2000. He had been President from July 1998 to February 2001.
Previously, he had served as Executive Vice President, Sales and Support since
February 1992. He was Senior Vice President, Systems Software from 1989 to
1992. From 1984 until 1989, Mr. Ballmer served as Vice President, Systems
Software. He joined Microsoft in 1980.
Mr. Belluzzo was named President and Chief Operating Officer in February 2001.
He had been Group Vice President, Personal Services and Devices since August
2000. He joined Microsoft as Group Vice President, Consumer and Commerce in
September 1999. Mr. Belluzzo had been Chairman of the Board
13
and Chief Executive Officer, Silicon Graphics, Inc. since January 1998. Prior to
his employment at Silicon Graphics, Inc., Mr. Belluzzo was employed by the
Hewlett-Packard Company for 22 years, serving since 1995 as Executive Vice
President and General Manager of the computer organization.
Mr. Allchin was named Group Vice President, Platforms in December 1999. He had
been Senior Vice President, Platforms since March 1999. He was previously
Senior Vice President, Personal and Business Systems since February 1996, Senior
Vice President, Business Systems Division since November 1994, and had been Vice
President, Business Systems Division since July 1991. Mr. Allchin joined
Microsoft in 1991.
Mr. Ayala was named Group Vice President, Worldwide Sales, Marketing, and
Services in August 2000. He had been Senior Vice President, South Pacific and
Americas since February 1998, and before holding that position, was Vice
President of the developing markets of Africa, India, the Mediterranean and
Middle East, Latin America, Southeast Asia and the South Pacific. He joined
Microsoft in May 1991 as Senior Director of the Latin America Region.
Mr. Bach was named Senior Vice President, Games in March 2000. He had been Vice
President, Home and Retail since March 1999. Before holding that position, he
had been Vice President, Learning, Entertainment and Productivity since 1996.
Mr. Bach joined Microsoft in 1988.
Mr. Burgum joined the Company upon Microsoft's acquisition of Great Plains
Software, Inc. in April 2001. Mr. Burgum became Great Plains' first outside
investor in March 1983. He was named President of Great Plains in 1984 and
subsequently named Chairman and Chief Executive Officer.
Mr. Cole was named Senior Vice President, Services Platform Division in August
2000. He had been Senior Vice President, Consumer Services since December 1999.
Before holding that position, he had been Vice President, Consumer Windows since
March 1999. Previously, he was Vice President, Web Client and Consumer
Experience and Vice President, Internet Client and Collaboration. Mr. Cole
joined Microsoft in 1986.
Mr. Connors was named Senior Vice President and Chief Financial Officer in
December 1999. He had been Vice President, Enterprise since March 1999. Mr.
Connors had been Vice President, Information Technology, and Chief Information
Officer since July 1996. He joined Microsoft in January 1989.
Mr. Courtois was named Senior Vice President and President, Microsoft Europe,
Middle East, and Africa in July 2000. He had been Vice President, Customer
Marketing since July 1998. Before holding that position, he had been Vice
President of Microsoft Europe since 1997 and General Manager for Microsoft
France since 1994. Mr. Courtois joined Microsoft in 1984.
Mr. DeVaan was named Senior Vice President, TV Division in December 1999. He
had been Senior Vice President, Consumer and Commerce since September 1999. Mr.
DeVaan had been Vice President, Consumer and Commerce since March 1999. He had
been Vice President, Desktop Applications since 1995. Mr. DeVaan joined
Microsoft in 1985.
Mr. Emerson joined Microsoft in November 2000 as Senior Vice President,
Corporate Development and Strategy. Prior to joining Microsoft, he was Managing
Director and co-head of Technology and Telecommunications Advisory Services at
international investment bank Lazard Freres & Co. LLC. He spent 12 years in San
Francisco and New York with Lazard and Morgan Stanley, specializing in advising
clients in the technology and telecommunications sectors on mergers,
acquisitions, and strategic partnerships.
Mr. Flessner was named Senior Vice President, .NET Enterprise Servers in
December 1999. He had been Vice President, Database and Data Access. Since
joining the Company, Mr. Flessner's primary responsibilities have been the
development of Microsoft's database business. He assumed responsibility for the
engineering of Microsoft SQL Server in 1995. He joined Microsoft in 1994.
Mr. Johnson was named Senior Vice President, U.S. Sales, Marketing, and Services
in August 2001. He had been Vice President, U.S. Sales, Marketing and Services.
Mr. Johnson was named Vice President, Product Support Services in July 1998. He
joined Microsoft in 1992.
14
Mr. Muglia was named Group Vice President, Personal Services Group in August
2000. He had been Group Vice President, Business Productivity since December
1999. He was named Senior Vice President, Business Productivity in March 1999
and was named Senior Vice President, Applications and Tools in February 1998.
He had been Vice President, Server Applications since 1997 and was Vice
President, Developer Tools since 1995. He joined Microsoft in January 1988.
Mr. Mundie was named Senior Vice President and Chief Technical Officer, Advanced
Strategies and Policy in August 2001. He was named Senior Vice President,
Consumer Platforms in February 1996. He was named Senior Vice President,
Consumer Systems in May 1995 and had been Vice President, Advanced Consumer
Technology since July 1993. He joined Microsoft as General Manager, Advanced
Consumer Technology in December 1992.
Mr. Neukom was named Executive Vice President, Law and Corporate Affairs in
October 1999. He had been Senior Vice President, Law and Corporate Affairs
since February 1994. He joined Microsoft in 1985 as Vice President, Law and
Corporate Affairs.
Mr. Raikes was named Group Vice President, Productivity and Business Services in
August 2000. He had been Group Vice President, Sales and Support since July
1998. Before holding that position, he had been Group Vice President, Sales and
Marketing since July 1996. He was named Senior Vice President, Microsoft North
America in January 1992 and had been Vice President, Office Systems since 1990.
Mr. Raikes joined Microsoft in 1981.
Mr. Rashid was named Senior Vice President, Research in May 2000. He had been
Vice President, Research since July 1994. He joined Microsoft in September
1991.
Mr. Sinofsky was named Senior Vice President, Office in December 1999. 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. He joined Microsoft in July 1989.
Mr. Valentine was named Senior Vice President, Windows in December 1999. He had
been Vice President, Business and Enterprise since March 1999. He had been Vice
President, Windows since December 1998. Before managing the Windows group, Mr.
Valentine managed the server applications division and had been responsible for
the Exchange product unit. He joined Microsoft in 1987.
Mr. Vaskevitch was named Senior Vice President and Chief Technical Officer,
Business Platform in August 2001. He was named Senior Vice President, Business
Applications in March 2000. He had been Senior Vice President, Developer since
December 1999. Before holding that position, he had been Vice President,
Distributed Applications Platform. He joined Microsoft in 1986.
Ms. Willingham was named Senior Vice President, Human Resources in February
2001. She had been Vice President, Human Resources since April 2000. Ms.
Willingham had been Vice President, Business and Enterprise Division Marketing
and was responsible for Windows operating system client and server marketing
strategy and training, as well as for providing centralized marketing services
for the Consumer Windows Marketing and Streaming Media Marketing teams. She
joined Microsoft in 1993.
15
PART II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters
The Company's common stock is traded on The Nasdaq Stock Market under the symbol
MSFT. On July 31, 2001, there were 112,001 registered holders of record of the
Company's common stock. The Company has not paid cash dividends on its common
stock. The high and low common stock prices per share were as follows:
Quarter Ended
---------------------------------------------------------------------------------------------------------
Sept. 30 Dec. 31 Mar. 31 June 30 Year
---------------------------------------------------------------------------------------------------------
2000
Common stock price per share:
High $100.75 $119.94 $118.63 $96.50 $119.94
Low 81.63 84.38 88.13 60.38 60.38
---------------------------------------------------------------------------------------------------------
2001
Common stock price per share:
High $ 82.00 $ 70.88 $ 64.69 $73.68 $ 82.00
Low 60.31 41.50 43.38 51.94 41.50
---------------------------------------------------------------------------------------------------------
On April 11, 2001, the Company closed the acquisition of substantially all of
the assets of iCommunicate Holding, Inc., a Delaware corporation
("iCommunicate"). Promptly thereafter, the Company issued an aggregate of
272,093 of its common shares to iCommunicate, which were subsequently
distributed to iCommunicate's eleven shareholders in the liquidation of
iCommunicate. All of the shares issued in this transaction were issued in a
non-public offering pursuant to an exemption from the registration requirements
of the Securities Act of 1933, as amended (the "1933 Act"), under Section 4(2)
of the 1933 Act.
On May 4, 2001, the Company issued an aggregate of 926,077 of its common shares
pursuant to the merger of a subsidiary of the Company with Ensemble Studios
Corporation, a Delaware corporation ("Ensemble"), owned by 45 shareholders. All
of the shares issued in this transaction were issued in a non-public offering
pursuant to an exemption from the registration requirements of the 1933 Act,
under Section 4(2) of the 1933 Act.
The above described sales were made without general solicitation or advertising.
The Company has filed a Registration Statement on Form S-3 covering the resale
of such securities issued pursuant to such acquisitions. All net proceeds from
the sale of such securities will go to the selling shareholders who offer and
sell their shares. The Company has not received and will not receive any
proceeds from the sale of these common shares other than the assets and certain
liabilities of iCommunicate and in connection with the merger with Ensemble.
16
Item 6. Selected Financial Data
Financial Highlights
(In millions, except earnings per share)
--------------------------------------------------------------------------------------------------------------
Year Ended June 30 1997 1998 1999 2000 2001(1)
--------------------------------------------------------------------------------------------------------------
Revenue $11,936 $15,262 $19,747 $22,956 $25,296
Income before accounting change 3,454 4,490 7,785 9,421 7,721
Net income 3,454 4,490 7,785 9,421 7,346
Diluted earnings per share before
accounting change 0.66 0.84 1.42 1.70 1.38
Diluted earnings per share 0.66 0.84 1.42 1.70 1.32
Cash and short-term investments 8,966 13,927 17,236 23,798 31,600
Total assets 14,387 22,357 38,625 52,150 59,257
Stockholders' equity 10,777 16,627 28,438 41,368 47,289
--------------------------------------------------------------------------------------------------------------
(1) Fiscal year 2001 includes an unfavorable cumulative effect of accounting
change of $375 million or $0.06 per diluted share and $3.92 billion (pre-
tax) in impairments of certain investments, primarily cable and
telecommunication investments.
17
Item 7. Management's Discussion and Analysis of Results of Operations and
Financial Condition
Results of Operations for 1999, 2000, and 2001
--------------------------------------------------------------------------------
Microsoft develops, manufactures, licenses, and supports a wide range of
software products for a multitude of computing devices. Microsoft software
includes scalable operating systems for servers, personal computers (PCs), and
intelligent devices; server applications for client/server environments;
knowledge worker productivity applications; and software development tools. The
Company's online efforts include the MSN network of Internet products and
services and alliances with companies involved with broadband access and various
forms of digital interactivity. Microsoft also licenses consumer software
programs; sells hardware devices; provides consulting services; trains and
certifies system integrators and developers; and researches and develops
advanced technologies for future software products.
Management's Discussion and Analysis contains statements that are forward-
looking. These statements are based on current expectations and assumptions
that are subject to risks and uncertainties. Actual results could differ
materially because of factors discussed below under "Issues and Uncertainties."
Revenue
--------------------------------------------------------------------------------
The Company's revenue growth rate was 29% in fiscal 1999, 16% in fiscal 2000,
and 10% in fiscal 2001. Revenue growth in fiscal 2001 was driven primarily by
licensing of Microsoft Windows 2000 Professional, Microsoft SQL Server, and the
other .NET Enterprise Servers. Consumer Software, Services, and Devices revenue
also grew strongly. Partially offsetting those items was flat revenue growth
from Windows Millennium Edition (Windows Me) and Windows 98 operating systems,
reflecting the slowdown in consumer PC shipments and a higher mix of Windows
2000 Professional and Windows NT Workstation. Revenue growth in fiscal 2000 was
driven by strong licensing of Microsoft Windows NT Workstation, Windows 2000
Professional, Windows NT Server, Windows 2000 Server, Microsoft Office 2000, and
SQL Server. Consumer Software, Services, and Devices revenue also grew
strongly. Partially offsetting those items was slower growth from Windows
operating systems sold through the original equipment manufacturer (OEM) channel
due to slow demand for business PCs throughout a significant portion of fiscal
2000. Revenue growth in fiscal 1999 reflected the continued adoption of Windows
operating systems and Microsoft Office. In addition, the Company's estimate for
future product returns was reduced by $250 million in fiscal 1999.
In fiscal 1999, Microsoft made two changes related to the ratable recognition of
revenue for a portion of its revenue for certain products. American Institute
of Certified Public Accountants (AICPA) Statement of Position (SOP) 98-9,
Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions, requires companies to use the average sales price of each
undelivered element of software arrangements to unbundle revenue. Prior
authoritative accounting guidance allowed a comparison of the total price
differential between a licensed product sold through different channels of
distribution to derive the value of undelivered elements offered to customers
acquiring product from one channel but not the other. Upon adoption of this new
rule in the fourth quarter of fiscal 1999, the percentages of the total
arrangement treated as unearned decreased. This change reduced the amount of
Microsoft Windows and Microsoft Office sales treated as unearned and increased
the amount of revenue recognized upon shipment. Additionally, as part of the
Company's long range planning process and a review of product shipment cycles,
it was determined that the life cycle of Windows should be extended from two
years to three years.
Product Revenue
Microsoft has four segments: Desktop and Enterprise Software and Services;
Consumer Software, Services, and Devices; Consumer Commerce Investments; and
Other. The Management Discussion and Analysis presentation of revenue differs
from that reported under the Company's Segment Information appearing in the
Notes to Financial Statements because reconciling items are allocated to those
segments.
18
Desktop and Enterprise Software and Services
Desktop and Enterprise Software and Services revenue was $17.84 billion, $20.40
billion, and $22.41 billion in 1999, 2000, and 2001. Desktop and Enterprise
Software and Services includes Desktop Applications; Desktop Platforms; and
Enterprise Software and Services.
Desktop Applications revenue was $7.77 billion, $9.30 billion, and $9.54 billion
in 1999, 2000, and 2001. Desktop Applications includes revenue from Microsoft
Office; Microsoft Project; Visio; client access licenses (CALs) for Windows NT
Server and Windows 2000 Server, Exchange, and BackOffice; Microsoft Great
Plains; and bCentral. In fiscal 2001, revenue from client access licenses
increased 14% reflecting strong licensing growth of Windows NT Server and
Windows 2000 Server CALs. Office revenue growth was flat during the year. In
fiscal 2000 and 1999, revenue growth from Microsoft Office integrated suites,
including the Premium, Professional, Small Business, and Standard Editions were
very solid.
Desktop Platforms revenue was $6.74 billion, $7.02 billion, and $8.04 billion in
1999, 2000, and 2001. Desktop Platforms includes revenue from Windows 2000
Professional, Windows NT Workstation, Windows Me, Windows 98, and other desktop
operating systems. Fiscal 2001 revenue growth reflected the strong adoption of
Windows 2000 Professional, partially offset by flat revenue growth from Windows
Me and Windows 98 operating systems, reflecting the slowdown in consumer PC
shipments and a higher mix of Windows 2000 Professional and Windows NT
Workstation. In fiscal 2000, Desktop Platforms revenue growth was modest due to
soft demand for business PCs during most of the year; a slowdown in shipments in
anticipation of the post mid-year availability of Windows 2000 operating
systems; and, as expected, a longer business migration cycle for the newest
Windows operating system offerings. In fiscal 1999, Windows units licensed
through the OEM channel, particularly Windows NT Workstation, increased strongly
over the prior year. Organizational licensing of Windows NT Workstation and
Windows 98 also contributed to the growth.
Enterprise Software and Services revenue was $3.33 billion, $4.08 billion, and
$4.83 billion in 1999, 2000, and 2001. Enterprise Software and Services
includes Enterprise Platforms, Server Applications, Developer Tools and
Services, and Enterprise Services. As a result of the continued adoption of
Microsoft's .NET Enterprise Server offerings in fiscal 2001, Server Applications
revenue increased 31% versus the prior year. Enterprise Services revenue,
representing consulting and product support services, was up 34% compared to
fiscal 2000. Enterprise Platforms, which includes Windows 2000 Server and
Windows NT Server operating systems, increased 10% while revenue from Developer
Tools and Services was flat with the prior year. In fiscal 2000, Enterprise
Platforms revenue growth was particularly strong led by increased adoption by
customers of Windows NT Server and Windows 2000 Server. Revenue from Server
Applications grew strongly, largely due to the strong success of SQL Server 7.0.
Software Developer Tools and Services revenue declined, due to increased suite
licensing versus stand-alone licenses, and the lack of a release upgrade of the
Visual Studio development system. In fiscal 1999, the revenue growth rate for
Windows NT Server was healthy. Revenue from Server Applications grew strongly,
reflecting, in part, the release of SQL Server 7.0. The Visual Studio 6.0
development system drove healthy Developer Tools and Services revenue growth.
Consulting services revenue rose substantially.
Consumer Software, Services, and Devices
Consumer Software, Services, and Devices revenue was $1.19 billion, $1.63
billion, and $1.95 billion in 1999, 2000, and 2001. Consumer Software,
Services, and Devices includes MSN Internet access; MSN network service; WebTV
Internet access and services; PC and online games; learning and productivity
software; mobile and wireless devices; and embedded systems. In fiscal 2001,
revenue from MSN network services grew strongly in light of the decline in the
online advertising market. MSN Internet access revenue also grew solidly as a
result of an increased subscriber base, partially offset by a decline in the
average revenue per subscriber due to a larger mix of subscribers contracted
under rebate programs. Revenue from embedded systems grew strongly from the
prior year, while learning and productivity software revenue and PC and online
games revenue declined, reflecting softness in the overall consumer market. In
fiscal 2000, online revenue growth was very strong and reflected higher
subscriber totals, offset by lower net prices for Internet access subscriptions
compared to the prior year. Additionally, strong sell-through of entertainment
software produced robust revenue growth. In fiscal 1999, online advertising
revenue rose substantially and Internet access revenue increased moderately.
19
Consumer Commerce Investments
Consumer Commerce Investments revenue was $62 million, $182 million, and $299
million in 1999, 2000, and 2001. Consumer Commerce Investments include Expedia,
Inc., the HomeAdvisor online real estate service, and the CarPoint online
automotive service. Acquisitions of Travelscape.com and VacationSpot.com by
Expedia, Inc., and increased product offerings from Expedia led to the strong
revenue growth in fiscal 2001. The increased overall reach of all properties
led to the strong revenue growth in fiscal 2000 and 1999.
On July 16, 2001, USA Networks, Inc. (USA) announced an agreement to acquire a
controlling interest in Expedia through the purchase of up to 37.5 million
shares, approximately 75% of the current outstanding shares. If holders of more
than 37.5 million Expedia shares elect to sell their shares to USA, there will
be a pro rata reduction among all electing shareholders. Microsoft has agreed
to transfer all of its 33.7 million shares and warrants, subject to pro-ration.
It is expected that the transaction will close by December 31, 2001.
Other
Other revenue was $653 million, $754 million, and $630 million in 1999, 2000,
and 2001. Other primarily includes Hardware and Microsoft Press. Lower sales
of gaming devices and other hardware peripherals as a result of weakness in the
consumer market caused the decline in revenue in fiscal 2001. Continued success
of the Company's new hardware device offerings led to the revenue growth in
fiscal 2000. Revenue from hardware devices and Microsoft Press was relatively
flat in fiscal 1999.
Distribution Channels
Microsoft distributes its products primarily through OEM licenses,
organizational licenses, online services and products, and retail packaged
products. OEM channel revenue represents license fees from original equipment
manufacturers who preinstall Microsoft products, primarily on PCs. Microsoft
has three major geographic sales and marketing regions: the South Pacific and
Americas Region; the Europe, Middle East, and Africa Region; and the Asia
Region. Sales of organizational licenses and packaged products via these
channels are primarily to and through distributors and resellers.
OEM revenue was $6.40 billion in 1999, $7.01 billion in 2000, and $7.86 billion
in 2001. Although total licenses were impacted by a slowdown in PC shipments in
fiscal 2001, the mix of the higher priced Windows 2000 Professional and Windows
NT Workstation in the OEM channel increased substantially resulting in higher
average revenue per license. The relatively low growth rate in fiscal 2000 was
due to lower business PC shipment growth, especially as a result of the soft
demand for business PCs and component shortages for part of the year. These
issues combined with post mid-year availability of Windows 2000 Professional
resulted in lower revenue growth. Average earned revenue per license also
declined compared to the prior year, due in part to a mix shift to the lower-
priced Windows 98 operating system reflecting the softness in demand for
business PCs and lower prices on operating systems licensed through certain OEM
channel sectors. In fiscal 1999, PC shipment growth coupled with an increased
penetration of higher value 32-bit operating systems drove the OEM revenue
increases.
South Pacific and Americas Region revenue was $7.25 billion, $8.33 billion, and
$9.52 billion in 1999, 2000, and 2001. In fiscal 2001, revenue growth,
principally in the United States, was led by strong licensing of Windows 2000
Professional and the family of .NET Enterprise Servers, particularly SQL Server
2000 and Exchange 2000 Server. Revenue from Enterprise services and MSN
subscription and services grew strongly. In fiscal 2000, Office 2000 integrated
suites, Windows 2000 Server, online revenue, and SQL Server sales were the
primary drivers of the revenue growth. Strong retail sales of hardware devices
and consumer software also contributed to the growth over the prior year.
Revenue growth was particularly strong in Latin America and Australia, moderate
in Canada, and modest in the United States. In fiscal 1999, server
applications, Windows NT Server, Windows NT Workstation, and Microsoft Office
all exhibited solid year-over-year growth rates. Organizational licensing
activity was strong. Revenue growth was solid in the United States and moderate
in Latin America and the South Pacific.
Europe, Middle East, and Africa Region revenue was $4.33 billion, $5.02 billion,
and $4.86 billion in 1999, 2000, and 2001. In fiscal 2001, weakening local
currencies negatively impacted translated revenue compared to the prior year.
Revenue in the region would have increased 6% if foreign exchange rates were
constant with those of the prior year. Revenue from Windows 2000 Professional
and the .NET Enterprise Server family of products was very healthy. In fiscal
2000, retail sales of Windows operating systems and Office licensing produced
moderate growth in the region. Growth from SQL Server licensing, new
20
hardware device offerings, and entertainment software was especially strong.
Revenue growth, measured in constant dollars, was very healthy in Germany and
Italy, robust in the Middle East, and low in the United Kingdom. In fiscal 1999,
all major products grew strongly over the prior year. Revenue growth was solid
in the United Kingdom, Germany, and France, and was particularly high in Sweden,
the Netherlands, and Spain.
Asia Region revenue was $1.78 billion in 1999, $2.60 billion in 2000, and $3.06
billion in 2001. In fiscal 2001, the region's growth rate reflected strong
revenue from localized versions of Microsoft Office 2000 and Microsoft Office
XP, especially the Office Personal suite. The growth was also attributable to
Windows 2000 Professional and .NET Server applications licensing. Revenue
growth was particularly strong in Korea and the greater China region, resulting
from advantageous economic conditions as well as successful anti-piracy efforts.
In fiscal 2000, the region's growth rate reflected strong performance resulting
from improved local economic conditions. Revenue growth was also influenced by
robust growth of localized versions of Microsoft Office 2000, especially the
Office Personal Edition sold in Japan, Windows platform and server licensing,
and strong adoption of SQL Server. Revenue grew strongly in nearly all
countries in the Asia region. In fiscal 1999, Japan, Taiwan, China, Hong Kong,
and Southeast Asia had moderate revenue growth, while revenue grew very strongly
in Korea.
The Company's operating results are affected by foreign exchange rates.
Approximately 29%, 30%, and 27% of the Company's revenue was collected in
foreign currencies during 1999, 2000, and 2001. 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
--------------------------------------------------------------------------------
Cost of Revenue
Cost of revenue as a percent of revenue was 14.3% in 1999, 13.1% in 2000, and
13.7% in 2001. In fiscal 2001, higher support and service costs associated with
the MSN Internet access and MSN network services were partially offset by the
lower relative costs associated with organizational licensing and the drop in
the mix of packaged product versus the prior year. Cost of revenue in fiscal
2000 reflected lower costs associated with WebTV Networks' operations, partially
offset by the growth in hardware peripherals costs. Cost of revenue as a
percentage of revenue decreased in fiscal 1999 primarily due to the trend in mix
shift to OEM and organizational licenses. Additionally, cost of revenue in 1999
was positively impacted by a reduction in estimates of obsolete inventory and
other manufacturing costs of $67 million.
Research and Development
Microsoft continued to invest heavily in the future by funding research and
development (R&D). In fiscal 2001, the increase in R&D expense was the result
of higher headcount-related costs and investments in new product initiatives.
The increase in fiscal 2000 was driven primarily by higher headcount-related
costs. The increase in fiscal 1999 reflected higher development headcount-
related costs offset by lower infrastructure and third-party development costs.
Sales and Marketing
In fiscal 2001, sales and marketing expenses as a percentage of revenue
increased due to higher relative headcount-related costs, higher marketing and
sales expenses associated with MSN, the Microsoft Agility advertising campaign,
and other new sales initiatives. In fiscal 2000, sales and marketing expenses
as a percentage of revenue increased due to higher relative marketing costs
associated with new product releases and online marketing. In fiscal 1999,
sales and marketing expense as a percentage of revenue decreased due to lower
relative sales expenses and lower relative marketing costs.
General and Administrative
In fiscal 2001, general and administrative costs decreased due to a charge
related to the settlement of the lawsuit with Caldera, Inc. recorded in fiscal
2000. Excluding this charge, general and administrative expenses in fiscal 2001
increased from the prior year due to higher headcount-related costs and legal
fees. For fiscal 2000, besides the settlement of the lawsuit, general and
administrative expenses also reflected increased legal fees and certain employee
stock option-related expenses. The increase in fiscal year 1999 was
attributable to higher legal fees, settlement costs, and headcount-related costs
necessary to support the Company's expanding operations.
21
Non-operating Items, Investment Income/(Loss), and Income Taxes
--------------------------------------------------------------------------------
Losses on equity investees and other incorporates Microsoft's share of income or
loss from the MSNBC entities, Avanade, Wireless Knowledge, StarBand
Communications, and other investments accounted for using the equity method.
The increase in losses on equity investees and other in fiscal 2001 reflects an
increase in the number of such investments during the year. In fiscal 2000 and
1999, losses on equity investees decreased reflecting smaller losses from the
MSNBC entities.
In fiscal 2001, the Company reported an investment loss of $36 million, a
decrease in investment income of $3.36 billion versus fiscal 2000. Net
recognized losses were $2.22 billion in fiscal 2001, reflecting $4.80 billion in
impairments of certain investments, primarily in the cable and telecommunication
industries, and $592 million of net losses attributable to derivative
instruments. These losses were partially offset by higher net gains from the
sales of investments, including a gain from Microsoft's investment in Titus
Communications (which was merged with Jupiter Telecommunications) and the
closing of the sale of Transpoint to CheckFree Holdings Corp. Interest and
dividend income increased $591 million from the prior year, reflecting a larger
investment portfolio. In fiscal years 2000 and 1999, investment income
increased primarily as a result of a larger investment portfolio generated by
cash from operations coupled with realized gains from the sale of securities.
The effective tax rate for fiscal 2001 was 33%. The effective tax rate for
fiscal 2000 was 34%. Excluding the impact of the gain on the sale of Softimage,
Inc., the effective tax rate for fiscal 1999 was 35%.
Accounting Change
--------------------------------------------------------------------------------
Effective July 1, 2000, Microsoft adopted Statement of Financial Accounting
Standards (SFAS) 133, Accounting for Derivative Instruments and Hedging
Activities, which establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts and for hedging activities. All derivatives, whether designated in
hedging relationships or not, are required to be recorded on the balance sheet
at fair value. If the derivative is designated as a fair value hedge, the
changes in the fair value of the derivative and the hedged item are recognized
in earnings. If the derivative is designated as a cash flow hedge, changes in
the fair value of the derivative are recorded in other comprehensive income
(OCI) and are recognized in the income statement when the hedged item affects
earnings.
The adoption of SFAS 133 resulted in a cumulative pre-tax reduction to income of
$560 million ($375 million after-tax) and a cumulative pre-tax reduction to OCI
of $112 million ($75 million after-tax). The reduction to income was mostly
attributable to a loss of approximately $300 million reclassified from OCI for
the time value of options and a loss of approximately $250 million reclassified
from OCI for derivatives not designated as hedging instruments. The reduction
to OCI was mostly attributable to losses of approximately $670 million on cash
flow hedges offset by the reclassifications out of OCI of the approximately $300
million loss for the time value of options and the approximately $250 million
loss for derivative instruments not designated as hedging instruments.
Financial Condition
--------------------------------------------------------------------------------
The Company's cash and short-term investment portfolio totaled $31.60 billion at
June 30, 2001. The portfolio consists primarily of fixed-income securities,
diversified among 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 order to diversify financial risk. The portfolio is
primarily invested in short-term securities to minimize interest rate risk and
facilitate rapid deployment for immediate cash needs.
Cash flow from operations was $13.42 billion in fiscal 2001, an increase of
$2.00 billion from the prior year. The increase was primarily attributable to
the growth in revenue and other changes in working capital, partially offset by
the decrease in the stock option income tax benefit, reflecting decreased stock
option exercises by employees. Cash used for financing was $5.59 billion in
fiscal 2001, an increase of $3.39 billion from the prior year. The increase
primarily reflects the repurchase of put warrants in fiscal 2001, compared to
the sale of put warrants in the prior fiscal year, as well as an increase in
common stock repurchased. All outstanding put warrants were either retired or
exercised during fiscal 2001. During fiscal
22
2001, the Company repurchased 89.0 million shares. Cash used for investing was
$8.73 billion in fiscal 2001, a decrease of $658 million from the prior year.
In fiscal 2000, cash flow from operations was $11.43 billion, a decrease of $720
million from the prior year, reflecting working capital changes partially offset
by the increase in the stock option income tax benefit. Cash used for financing
was $2.19 billion in fiscal 2000, an increase of $1.33 billion from the prior
year, reflecting an increase in common stock repurchased versus the prior year.
During fiscal 2000, the Company repurchased 55.2 million shares. Cash used for
investing was $9.39 billion in fiscal 2000, a decrease of $808 million from the
prior year. In fiscal 1999, cash flow from operations was $12.15 billion, an
increase of $3.78 billion from the prior year, reflecting the growth in revenue
and the increase in the stock option income tax benefit. Cash used for
financing was $862 million in fiscal 1999, a decrease of $137 million from the
prior year. During fiscal 1999, the Company repurchased 44.9 million shares.
Cash used for investing was $10.20 billion in fiscal 1999, an increase of $3.00
billion from the prior year, reflecting the growth in the investment portfolio.
Microsoft has no material long-term debt. Stockholders' equity at June 30, 2001
was $47.29 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. Additions to property
and equipment will continue, including new facilities and computer systems for
R&D, sales and marketing, support, and administrative staff. Commitments for
constructing new buildings were $181 million on June 30, 2001. Cash will also
be used for strategic opportunities.
In addition, cash will be used to repurchase common stock to provide shares for
employee stock option and purchase plans. Since fiscal 1990, Microsoft has
repurchased 854 million common shares while 2.12 billion shares were issued
under the Company's employee stock option and purchase plans. The market value
of all outstanding stock options was $66 billion as of June 30, 2001. During
December 1996, Microsoft issued 12.5 million shares of 2.75% convertible
exchangeable preferred stock. The Company's convertible preferred stock matured
on December 15, 1999. Each preferred share was converted into 1.1273 common
shares.
Management believes existing cash and short-term investments together with funds
generated from operations should be sufficient to meet operating requirements.
The Company's cash and short-term investments are available for strategic
investments, mergers and acquisitions, and other potential large-scale needs and
to fund the share repurchase program. Microsoft has not paid cash dividends on
its common stock.
Recently Issued Accounting Standards
--------------------------------------------------------------------------------
In June 2001, the Financial Accounting Standards Board issued SFAS 141, Business
Combinations, and SFAS 142, Goodwill and Other Intangible Assets. SFAS 141
requires business combinations initiated after June 30, 2001 to be accounted for
using the purchase method of accounting. It also specifies the types of
acquired intangible assets that are required to be recognized and reported
separately from goodwill. SFAS 142 will require that goodwill and certain
intangibles no longer be amortized, but instead tested for impairment at least
annually. SFAS 142 is required to be applied starting with fiscal years
beginning after December 15, 2001, with early application permitted in certain
circumstances. The Company plans to early adopt SFAS 142 in fiscal 2002 and
does not expect any impairment of goodwill upon adoption. Goodwill amortization
was approximately $300 million in fiscal 2001 and approximately $225 million in
fiscal 2000.
Issues and Uncertainties
--------------------------------------------------------------------------------
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 software industry, which means that Microsoft's
market position is always at risk. Microsoft's ability to maintain its current
market share may depend upon the Company's ability to satisfy customer
requirements, enhance existing products, develop and introduce new products and
achieve market acceptance of such products. This process grows more challenging
as the pace of change continues to accelerate. Open source
23
software, new computing devices, new microprocessor architectures, the Internet,
and Web-based computing models are among the competitive challenges the Company
must meet. If Microsoft does not successfully identify new product opportunities
and develop and bring new products to market in a timely and cost-efficient
manner, the Company's business growth will suffer and demand for its products
will decrease.
Future Initiatives
The Company plans to continue to make significant investments in software
research and development including Microsoft .NET, "HailStorm", Xbox, wireless
technologies, digital devices, television, and small business. It is
anticipated that these investments in research and development will increase
over historical spending levels. Significant revenue from these product
opportunities may not be achieved for a number of years, if at all.
PC Growth Rates
The nature of the PC marketplace is changing in ways that may reduce Microsoft's
software sales and revenue growth. Overall market demand for PCs can
significantly impact Microsoft's revenue growth. Recently, manufacturers have
sought to reach more consumers by developing and producing lower cost PCs - PCs
that come without pre-installed software or contain software with reduced
functionality. In addition to the influx of low-cost PCs, a market for handheld
computing and communication devices has developed. While these devices are not
as powerful or versatile as PCs, they threaten to erode sales growth in the
market for PCs with pre-installed software. This may affect Microsoft's revenue
growth because manufacturers may choose not to install Microsoft software in
these low-cost PCs or consumers may purchase alternative intelligent devices
that do not use Microsoft software. These lower-priced devices require
Microsoft to provide lower-priced software with a subset of the original
functionality. As a result, the Company may generate less revenue from the sale
of software produced for these devices than from the sale of software for PCs.
Product Development
The software industry is inherently complex. New products and product
enhancements can require long development and testing periods. Significant
delays in new product releases or significant problems in creating new products
could damage Microsoft's business. The Company anticipates that Windows XP and
Xbox will be released in fiscal 2002. Delays in either product may adversely
affect revenue and net income.
Prices
The competitive factors described above may require Microsoft to lower product
prices to meet competition, reducing the Company's revenue and net income.
Earnings Process
An increasingly higher percentage of the Company's revenue is subject to ratable
recognition, which impacts the timing of revenue and earnings recognition.
Ratable revenue recognition may be required for additional products, depending
on specific license terms and conditions. Also, maintenance and new
subscription programs are increasing in popularity.
Employee Compensation
Microsoft employees currently receive salaries, incentive bonuses, other
benefits, and stock options. New government regulations, poor stock price
performance, or other factors could diminish the value of the option program to
current and prospective employees and require the Company to pay higher salaries
and other cash compensation.
International Operations
Microsoft develops and sells products throughout the world. The prices of the
Company's products in countries outside of the United States are generally
higher than the Company's prices in the United States because of the cost
incurred in localizing software for non-U.S. markets. The costs of producing
and selling the Company's products in these countries are also higher. Pressure
to globalize Microsoft's pricing structure might require that the Company reduce
the sales price of its software in other countries, even though the costs of the
software continue to be higher than in the United States. Unfavorable changes
in software "piracy" trade protection laws, policies and measures, and other
regulatory requirements affecting trade and investment; unexpected changes in
regulatory requirements for software; social, political, labor, or economic
conditions in a specific country or region; difficulties in staffing and
managing foreign
24
operations; and potential adverse foreign tax consequences; among other factors,
could also have an impact on the Company's business and results of operations
outside of the United States.
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.
Litigation
Litigation regarding intellectual property rights, patents, and copyrights
occurs in the software industry. In addition, there are government regulation
and investigation risks along with other general corporate legal risks. The
Company is a defendant in a lawsuit filed by the Antitrust Division of the U.S.
Department of Justice and a group of eighteen state Attorneys General alleging
violations of the Sherman Act and various state antitrust laws. After the
trial, the District Court entered Findings of Fact and Conclusions of Law
stating that Microsoft had violated Sections 1 and 2 of the Sherman Act and
various state antitrust laws. A Judgment was entered on June 7, 2000 ordering,
among other things, the breakup of Microsoft into two companies. The Judgment
was stayed pending an appeal. On June 28, 2001, the U.S. Court of Appeals for
the District of Columbia Circuit affirmed in part, reversed in part, and vacated
the Judgment in its entirety and remanded the case to the District Court for a
new trial on one Section 1 claim and for entry of a new judgment consistent with
its ruling. In its ruling, the Court of Appeals substantially narrowed the
bases of liability found by the District Court, but affirmed some of the
District Court's conclusions that Microsoft had violated Section 2. On
September 6, 2001, the plaintiffs announced that on remand they will not ask the
Court to break Microsoft up, that they will seek imposition of conduct remedies,
and that they will not retry the one Section 1 claim returned to the District
Court by the Court of Appeals. On August 7, 2001, Microsoft petitioned the
Supreme Court for a writ of certiorari to review the appellate court's ruling
concerning its disqualification of the District Court judge. Microsoft may
petition the Supreme Court to review other aspects of the appellate court's
decision after final judgment is entered. In response to the Court of Appeal's
decision, Microsoft has modified the terms of its agreements with computer
manufacturers to permit them to remove Internet Explorer icons from Windows when
the manufacturer wants to promote an alternative browser, and modifying other
provisions of the agreements. While the Company cannot predict with certainty
the final outcome of this matter, its resolution may result in additional
changes to the Company's business practices and could affect how the Company
develops and markets new products and services. In addition, while the Court of
Appeals ruling vacated the remedies portion of the Judgment in its entirety, it
is possible the District Court could enter a new judgment providing for certain
remedies that would have a material adverse effect on the Company if the Company
cannot obtain relief from such provisions on appeal.
A large number of antitrust class action lawsuits have been initiated against
Microsoft. These cases allege that Microsoft has competed unfairly and
unlawfully monopolized alleged markets for operating systems and certain
software applications and seek to recover alleged overcharges that the
complaints contend Microsoft charged for these products. Although Microsoft
believes the claims are without merit and is vigorously defending the cases, the
Company cannot predict with certainty the outcome of these lawsuits.
Future Growth Rate
The revenue growth rate in 2002 may not approach the level attained in prior
years. Because of the fixed nature of a significant portion of operating
expenses, coupled with the possibility of slower revenue growth, operating
margins in 2002 may decrease from those in 2001. In addition, with the
anticipated introduction of Xbox in fiscal 2002, cost of revenue as a percentage
of revenue may increase versus prior years.
Item 7a. Quantitative and Qualitative Disclosures about Market Risk
The Company is exposed to foreign currency, interest rate, and securities price
risks. A portion of these risks is hedged, but fluctuations could impact the
Company's results of operations and financial position.
25
The Company hedges the exposure of accounts receivable and a portion of
anticipated revenue to foreign currency fluctuations, primarily with option
contracts. The Company monitors its foreign currency exposures daily to maximize
the overall effectiveness of its foreign currency hedge positions. Principal
currencies hedged include the Euro, Japanese yen, British pound, and Canadian
dollar. Fixed income securities are subject to interest rate risk. The portfolio
is diversified and consists primarily of investment grade securities to minimize
credit risk. The Company routinely uses options to hedge its exposure to
interest rate risk in the event of a catastrophic increase in interest rates.
Many securities held in the Company's equity and other investments portfolio are
subject to price risk. The Company uses options to hedge its price risk on
certain highly volatile equity securities.
The Company uses a value-at-risk (VAR) model to estimate and quantify its market
risks. The VAR model is not intended to represent actual losses in fair value,
but is used as a risk estimation and management tool. Assumptions applied to
the VAR model at June 30, 2000 and June 30, 2001 include the following: normal
market conditions; Monte Carlo modeling with 10,000 simulated market price
paths; a 97.5% confidence interval; and a 20-day estimated loss in fair value
for each market risk category. Accordingly, 97.5% of the time the estimated 20-
day loss in fair value would be nominal for foreign currency denominated
investments and accounts receivable at June 30, 2000 and June 30, 2001, and
would not exceed $211 million and $363 million at June 30, 2000 and June 30,
2001 for interest-sensitive investments or $1.02 billion and $520 million at
June 30, 2000 and June 30, 2001 for equity securities.
26
Item 8. Financial Statements and Supplementary Data
Income Statements
(In millions, except earnings per share)
---------------------------------------------------------------------------------------------------------------
Year Ended June 30 1999 2000 2001
---------------------------------------------------------------------------------------------------------------
Revenue $19,747 $22,956 $25,296
Operating expenses:
Cost of revenue 2,814 3,002 3,455
Research and development 2,970 3,772 4,379
Sales and marketing 3,238 4,126 4,885
General and administrative 715 1,050 857
---------------------------------------------------------------------------------------------------------------
Total operating expenses 9,737 11,950 13,576
---------------------------------------------------------------------------------------------------------------
Operating income 10,010 11,006 11,720
Losses on equity investees and other (70) (57) (159)
Investment income/(loss) 1,951 3,326 (36)
---------------------------------------------------------------------------------------------------------------
Income before income taxes 11,891 14,275 11,525
Provision for income taxes 4,106 4,854 3,804
---------------------------------------------------------------------------------------------------------------
Income before accounting change 7,785 9,421 7,721
Cumulative effect of accounting change (net of income
taxes of $185) -- -- (375)
---------------------------------------------------------------------------------------------------------------
Net income $ 7,785 $ 9,421 $ 7,346
---------------------------------------------------------------------------------------------------------------
Basic earnings per share:
Before accounting change $ 1.54 $ 1.81 $ 1.45
Cumulative effect of accounting change -- -- (0.07)
---------------------------------------------------------------------------------------------------------------
$ 1.54 $ 1.81 $ 1.38
---------------------------------------------------------------------------------------------------------------
Diluted earnings per share:
Before accounting change $ 1.42 $ 1.70 $ 1.38
Cumulative effect of accounting change -- -- (0.06)
---------------------------------------------------------------------------------------------------------------
$ 1.42 $ 1.70 $ 1.32
---------------------------------------------------------------------------------------------------------------
Weighted average shares outstanding:
Basic 5,028 5,189 5,341
---------------------------------------------------------------------------------------------------------------
Diluted 5,482 5,536 5,574
---------------------------------------------------------------------------------------------------------------
See accompanying notes.
27
Balance Sheets
(In millions)
-------------------------------------------------------------------------------------------------------
June 30 2000 2001
-------------------------------------------------------------------------------------------------------
Assets
Current assets:
Cash and equivalents $ 4,846 $ 3,922
Short-term investments 18,952 27,678
-------------------------------------------------------------------------------------------------------
Total cash and short-term investments 23,798 31,600
Accounts receivable 3,250 3,671
Deferred income taxes 1,708 1,949
Other 1,552 2,417
-------------------------------------------------------------------------------------------------------
Total current assets 30,308 39,637
Property and equipment, net 1,903 2,309
Equity and other investments 17,726 14,141
Other assets 2,213 3,170
-------------------------------------------------------------------------------------------------------
Total assets $52,150 $59,257
-------------------------------------------------------------------------------------------------------
Liabilities and stockholders' equity
Current liabilities:
Accounts payable $ 1,083 $ 1,188
Accrued compensation 557 742
Income taxes 585 1,468
Unearned revenue 4,816 5,614
Other 2,714 2,120
-------------------------------------------------------------------------------------------------------
Total current liabilities 9,755 11,132
-------------------------------------------------------------------------------------------------------
Deferred income taxes 1,027 836
-------------------------------------------------------------------------------------------------------
Commitments and contingencies
Stockholders' equity:
Common stock and paid-in capital--shares authorized 12,000;
shares issued and outstanding 5,283 and 5,383 23,195 28,390
Retained earnings, including accumulated other
comprehensive income of $1,527 and $587 18,173 18,899
-------------------------------------------------------------------------------------------------------
Total stockholders' equity 41,368 47,289
-------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $52,150 $59,257
-------------------------------------------------------------------------------------------------------
See accompanying notes.
28
Cash Flows Statements
(In millions)
---------------------------------------------------------------------------------------------------------
Year Ended June 30 1999 2000 2001
---------------------------------------------------------------------------------------------------------
Operations
Net income $ 7,785 $ 9,421 $ 7,346
Cumulative effect of accounting change, net of tax -- -- 375
Depreciation, amortization, and other noncash items 926 1,250 1,536
Net recognized (gains)/losses on investments (803) (1,732) 2,221
Stock option income tax benefits 3,107 5,535 2,066
Deferred income taxes (650) (425) (420)
Unearned revenue 5,877 6,177 6,970
Recognition of unearned revenue (4,526) (5,600) (6,369)
Accounts receivable (687) (944) (418)
Other current assets (235) (775) (482)
Other long-term assets (117) (864) (330)
Other current liabilities 1,469 (617) 927
---------------------------------------------------------------------------------------------------------
Net cash from operations 12,146 11,426 13,422
---------------------------------------------------------------------------------------------------------
Financing
Common stock issued 1,350 2,245 1,620
Common stock repurchased (2,950) (4,896) (6,074)
Sales/(repurchases) of put warrants 766 472 (1,367)
Preferred stock dividends (28) (13) --
Other, net -- -- 235
---------------------------------------------------------------------------------------------------------
Net cash used for financing (862) (2,192) (5,586)
---------------------------------------------------------------------------------------------------------
Investing
Additions to property and equipment (583) (879) (1,103)
Purchases of investments (34,686) (42,290) (66,346)
Maturities of investments 4,063 4,025 5,867
Sales of investments 21,006 29,752 52,848
---------------------------------------------------------------------------------------------------------
Net cash used for investing (10,200) (9,392) (8,734)
---------------------------------------------------------------------------------------------------------
Net change in cash and equivalents 1,084 (158) (898)
Effect of exchange rates on cash and equivalents 52 29 (26)
Cash and equivalents, beginning of year 3,839 4,975 4,846
---------------------------------------------------------------------------------------------------------
Cash and equivalents, end of year $ 4,975 $ 4,846 $ 3,922
---------------------------------------------------------------------------------------------------------
See accompanying notes.
29
Stockholders' Equity Statements
(In millions)
------------------------------------------------------------------------------------------------------
Year Ended June 30 1999 2000 2001
------------------------------------------------------------------------------------------------------
Convertible preferred stock
Balance, beginning of year $ 980 $ 980 $ --
Conversion of preferred to common stock -- (980) --
------------------------------------------------------------------------------------------------------
Balance, end of year 980 -- --
------------------------------------------------------------------------------------------------------
Common stock and paid-in capital
Balance, beginning of year 8,025 13,844 23,195
Common stock issued 2,338 3,554 5,154
Common stock repurchased (64) (210) (394)
Sales/(repurchases) of put warrants 766 472 (1,367)
Stock option income tax benefits 3,107 5,535 2,066
Other, net (328) -- (264)
------------------------------------------------------------------------------------------------------
Balance, end of year 13,844 23,195 28,390
------------------------------------------------------------------------------------------------------
Retained earnings
Balance, beginning of year 7,622 13,614 18,173
------------------------------------------------------------------------------------------------------
Net income 7,785 9,421 7,346
Other comprehensive income:
Cumulative effect of accounting change -- -- (75)
Net gains on derivative instruments -- -- 634
Net unrealized investment gains/(losses) 1,052 (283) (1,460)
Translation adjustments and other 69 23 (39)
------------------------------------------------------------------------------------------------------
Comprehensive income 8,906 9,161 6,406
Preferred stock dividends (28) (13) --
Immaterial pooling of interests -- 97 --
Common stock repurchased (2,886) (4,686) (5,680)
------------------------------------------------------------------------------------------------------
Balance, end of year 13,614 18,173 18,899
------------------------------------------------------------------------------------------------------
Total stockholders' equity $28,438 $41,368 $47,289
------------------------------------------------------------------------------------------------------
See accompanying notes.
30
Notes to Financial Statements
Accounting Policies
Accounting Principles
The financial statements and accompanying notes are prepared in accordance with
generally accepted accounting principles in the United States.
Principles of Consolidation
The financial statements include the accounts of Microsoft and its subsidiaries.
Intercompany transactions and balances have been eliminated. Equity investments
in which Microsoft owns at least 20% of the voting securities are accounted for
using the equity method, except for investments in which the Company is not able
to exercise significant influence over the investee, in which case, the cost
method of accounting is used. Issuances of shares by a subsidiary are accounted
for as capital transactions.
Estimates 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 provisions for returns, concessions and bad
debts; and the length of product life cycles and buildings' lives. Actual
results may differ from these estimates.
Foreign Currencies
Assets and liabilities recorded in foreign currencies are translated at the
exchange rate on the balance sheet date. Translation adjustments resulting from
this process are charged or credited to other comprehensive income. Revenue and
expenses are translated at average rates of exchange prevailing during the year.
Revenue Recognition
Revenue from products licensed to original equipment manufacturers is recorded
when OEMs ship licensed products while revenue from certain license programs is
recorded when the software has been delivered and the customer is invoiced.
Revenue from packaged product sales to and through distributors and resellers is
recorded when related products are shipped. Maintenance and subscription
revenue is recognized ratably over the contract period. Revenue attributable to
undelivered elements, including technical support and Internet browser
technologies, is based on the average sales price of those elements and is
recognized ratably on a straight-line basis over the product's life cycle. When
the revenue recognition criteria required for distributor and reseller
arrangements are not met, revenue is recognized as payments are received. Costs
related to insignificant obligations, which include telephone support for
certain products, are accrued. Provisions are recorded for returns,
concessions, and bad debts.
Cost of Revenue
Cost of revenue includes direct costs to produce and distribute product and
direct costs to provide online services, consulting, product support, and
training and certification of system integrators.
Research and Development
Research and development costs are expensed as incurred. Statement of Financial
Accounting Standards (SFAS) 86, Accounting for the Costs of Computer Software to
Be Sold, Leased, or Otherwise Marketed, does not materially affect the Company.
Advertising Costs
Advertising costs are expensed as incurred. Advertising expense was $804
million in 1999, $1.23 billion in 2000, and $1.36 billion in 2001.
Income Taxes
Income tax expense includes U.S. and international income taxes, plus the
provision for U.S. taxes on undistributed earnings of international
subsidiaries. Certain items of income and expense are not reported in tax
returns and financial statements in the same year. The tax effect of this
difference is reported as deferred income taxes.
Financial Instruments
The Company considers all liquid interest-earning investments with a maturity of
three months or less at the date of purchase to be cash equivalents. Short-term
investments generally mature between three months and six years from the
purchase date. All cash and short-term investments are classified as available
for sale and are recorded at market value using the specific identification
method; unrealized gains and losses are reflected in other comprehensive income
(OCI).
31
Equity and other investments include debt and equity instruments. Debt
securities and publicly traded equity securities are classified as available for
sale and are recorded at market using the specific identification method.
Unrealized gains and losses (excluding other-than-temporary losses) are
reflected in other comprehensive income. All other investments, excluding those
accounted for using the equity method, are recorded at cost.
Microsoft lends certain fixed income and equity securities to enhance investment
income. Collateral and/or security interest is determined based upon the
underlying security and the creditworthiness of the borrower. The fair value of
collateral that Microsoft is permitted to sell or repledge was $499 million at
June 30, 2001. There was no collateral that Microsoft was permitted to sell or
repledge at June 30, 2000.
Investments are considered to be impaired when a decline in fair value is judged
to be other-than-temporary. The Company employs a systematic methodology that
considers available evidence in evaluating potential impairment of its
investments. In the event that the cost of an investment exceeds its fair
value, the Company evaluates, among other factors, the duration and extent to
which the fair value is less than cost; 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 the Company's
intent and ability to hold the investment. Once a decline in fair value is
determined to be other-than-temporary, an impairment charge is recorded and a
new cost basis in the investment is established. In 2001, the Company
recognized $4.80 billion in impairments of certain investments, primarily in the
cable and telecommunication industries.
The Company uses derivative instruments to manage exposures to foreign currency,
security price, and interest rate risks. The Company's objectives for holding
derivatives are to minimize these risks using the most effective methods to
eliminate or reduce the impact of these exposures.
Foreign Currency Risk
---------------------
Certain forecasted transactions and assets are exposed to foreign currency risk.
The Company monitors its foreign currency exposures daily to maximize the
overall effectiveness of its foreign currency hedge positions. Principal
currencies hedged include the Euro, Japanese yen, British pound, and Canadian
dollar. Options used to hedge a portion of forecasted international revenue for
up to three years in the future are designated as cash flow hedging instruments.
Options and forwards not designated as hedging instruments under SFAS 133 are
also used to hedge the impact of the variability in exchange rates on accounts
receivable and collections denominated in certain foreign currencies.
Securities Price Risk
---------------------
Strategic equity investments are subject to market price risk. From time to
time, the Company uses and designates options to hedge fair values and cash
flows on certain equity securities. The security, or forecasted sale thereof,
selected for hedging is determined by market conditions, up-front costs, and
other relevant factors. Once established, the hedges are not dynamically
managed or traded, and are generally not removed until maturity.
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. The Company routinely uses options, not designated as
hedging instruments, to hedge its exposure to interest rate risk in the event of
a catastrophic increase in interest rates.
Other Derivatives
-----------------
In addition, the Company 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.
For options designated either as fair value or cash flow hedges, changes in the
time value are excluded from the assessment of hedge effectiveness.
32
Property 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 shorter of
the estimated life of the software or three years.
Intangible Assets
Goodwill and other intangible assets are amortized using the straight-line
method over their estimated period of benefit, ranging from three to seven
years. The Company periodically evaluates the recoverability of intangible
assets and takes into account events or circumstances that warrant revised
estimates of useful lives or that indicate that an impairment exists.
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) 141, Business Combinations, and SFAS 142,
Goodwill and Other Intangible Assets. SFAS 141 requires business combinations
initiated after June 30, 2001 to be accounted for using the purchase method of
accounting. It also specifies the types of acquired intangible assets that are
required to be recognized and reported separately from goodwill. SFAS 142 will
require that goodwill and certain intangibles no longer be amortized, but
instead tested for impairment at least annually. SFAS 142 is required to be
applied starting with fiscal years beginning after December 15, 2001, with early
application permitted in certain circumstances. The Company plans to early
adopt SFAS 142 in fiscal 2002 and does not expect any impairment of goodwill
upon adoption. Goodwill amortization was approximately $300 million in fiscal
2001 and approximately $225 million in fiscal 2000.
Reclassifications
Certain reclassifications have been made for consistent presentation.
Accounting Change
Effective July 1, 2000, the Company adopted SFAS 133, Accounting for Derivative
Instruments and Hedging Activities, which establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts and for hedging activities. All derivatives,
whether designated in hedging relationships or not, are required to be recorded
on the balance sheet at fair value. If the derivative is designated as a fair
value hedge, the changes in the fair value of the derivative and of the hedged
item attributable to the hedged risk are recognized in earnings. If the
derivative is designated as a cash flow hedge, the effective portions of changes
in the fair value of the derivative are recorded in other comprehensive income
and are recognized in the income statement when the hedged item affects
earnings. Ineffective portions of changes in the fair value of cash flow hedges
are recognized in earnings.
The adoption of SFAS 133 on July 1, 2000, resulted in a cumulative pre-tax
reduction to income of $560 million ($375 million after-tax) and a cumulative
pre-tax reduction to OCI of $112 million ($75 million after-tax). The reduction
to income was mostly attributable to a loss of approximately $300 million
reclassified from OCI for the time value of options and a loss of approximately
$250 million reclassified from OCI for derivatives not designated as hedging
instruments. The reduction to OCI was mostly attributable to losses of
approximately $670 million on cash flow hedges offset by reclassifications out
of OCI of the approximately $300 million loss for the time value of options and
the approximately $250 million loss for derivative instruments not designated as
hedging instruments. The net derivative losses included in OCI as of July 1,
2000 were reclassified into earnings during the twelve months ended June 30,
2001.
The change in accounting from the adoption of SFAS 133 did not materially affect
net income in 2001.
Unearned Revenue
A portion of Microsoft's revenue is earned ratably over the product life cycle
or, in the case of subscriptions, over the period of the license agreement.
End users receive certain elements of the Company's products over a period of
time. These elements include items such as browser technologies and technical
support. Consequently, Microsoft's earned revenue reflects the recognition of
the fair value of these elements over the product's life cycle. Upon adoption
of American Institute of Certified Public Accountants (AICPA) Statement of
Position (SOP) 98-9, Modification of SOP 97-2, With Respect to
33
Certain Transactions, during the fourth quarter of fiscal 1999, the Company was
required to change the methodology of attributing the fair value to undelivered
elements. The percentages of undelivered elements in relation to the total
arrangement decreased, reducing the amount of Windows and Office revenue treated
as unearned, and increasing the amount of revenue recognized upon shipment. The
percentage of revenue recognized ratably decreased from a range of 20% to 35% to
a range of approximately 15% to 25% of Windows desktop operating systems. For
desktop applications, the percentage decreased from approximately 20% to a range
of approximately 10% to 20%. The ranges depend on the terms and conditions of
the license and prices of the elements. In addition, in the fourth quarter of
fiscal 1999, the Company extended the life cycle of Windows from two to three
years based upon management's review of product shipment cycles. Product life
cycles are currently estimated at 18 months for desktop applications. The
Company also sells subscriptions to certain products via maintenance and certain
organizational license agreements.
At June 30, 2000 and 2001, Desktop Applications unearned revenue was $1.84
billion and $2.19 billion. Desktop Platforms unearned revenue was $2.34 billion
and $2.59 billion. Enterprise Software and Services unearned revenue was $433
million and $413 million. Unearned revenue associated with Consumer Software,
Services, and Devices, and Other was $200 million and $427 million at June 30,
2000 and 2001.
Cash and Short-Term Investments
---------------------------------------------------------------
In Millions / June 30 2000 2001
---------------------------------------------------------------
Cash and equivalents:
Cash $ 849 $ 1,145
Commercial paper 1,986 894
Certificates of deposit 1,017 286
U.S. government and agency securities 729 400
Corporate notes and bonds 265 1,130
Municipal securities -- 67
---------------------------------------------------------------
Cash and equivalents 4,846 3,922
---------------------------------------------------------------
Short-term investments:
Commercial paper 612 638
U.S. government and agency securities 7,104 7,322
Corporate notes and bonds 9,473 17,321
Municipal securities 1,113 1,703
Certificates of deposit 650 694
---------------------------------------------------------------
Short-term investments 18,952 27,678
---------------------------------------------------------------
Cash and short-term investments $23,798 $31,600
===============================================================
As of June 30, 2000 and 2001, cost approximated market for all classifications
of cash and short-term investments. Realized gains and (losses) from cash and
short-term investments were $150 million and $(131) million in 1999, $80 million
and $(226) million in 2000, and $541 million and $(369) million in 2001.
Property and Equipment
----------------------------------------------------------------
In Millions / June 30 2000 2001
----------------------------------------------------------------
Land $ 176 $ 185
Buildings 1,387 1,584
Computer equipment and software 1,909 2,431
Other 842 1,075
----------------------------------------------------------------
Property and equipment--at cost 4,314 5,275
Accumulated depreciation (2,411) (2,966)
----------------------------------------------------------------
Property and equipment--net $ 1,903 $ 2,309
================================================================
During 1999, 2000, and 2001, depreciation expense, of which the majority related
to computer equipment, was $483 million, $668 million, and $764 million.
34
Equity and Other Investments
Cost Unrealized Unrealized Recorded
In Millions / June 30, 2000 Basis Gains Losses Basis
---------------------------------------------------------------------------------------------------------------
Debt securities recorded at market, maturing:
Within one year $ 498 $ 27 $ -- $ 525
Between 2 and 10 years 388 11 (3) 396
Between 10 and 15 years 775 14 (93) 696
Beyond 15 years 4,745 -- (933) 3,812
---------------------------------------------------------------------------------------------------------------
Debt securities recorded at market 6,406 52 (1,029) 5,429
---------------------------------------------------------------------------------------------------------------
Common stock and warrants 5,815 5,655 (1,697) 9,773
Preferred stock 2,319 -- -- 2,319
Other investments 205 -- -- 205
---------------------------------------------------------------------------------------------------------------
Equity and other investments $14,745 $5,707 $(2,726) $17,726
===============================================================================================================
Cost Unrealized Unrealized Recorded
In Millions / June 30, 2001 Basis Gains Losses Basis
---------------------------------------------------------------------------------------------------------------
Debt securities recorded at market, maturing:
Within one year $ 500 $ -- $ -- $ 500
Between 2 and 10 years 643 12 (3) 652
Between 10 and 15 years 513 -- (9) 504
Beyond 15 years 4,754 -- (829) 3,925
---------------------------------------------------------------------------------------------------------------
Debt securities recorded at market 6,410 12 (841) 5,581
---------------------------------------------------------------------------------------------------------------
Common stock and warrants 5,555 2,030 (285) 7,300
Preferred stock 881 -- -- 881
Other investments 379 -- -- 379
---------------------------------------------------------------------------------------------------------------
Equity and other investments $13,225 $2,042 $(1,126) $14,141
===============================================================================================================
Debt securities include corporate and government notes and bonds and derivative
securities. Debt securities maturing beyond 15 years are composed entirely of
AT&T 5% convertible preferred debt with a contractual maturity of 30 years. The
debt is convertible into AT&T common stock on or after December 1, 2000, or may
be redeemed by AT&T upon satisfaction of certain conditions on or after June 1,
2002. Equity securities that are restricted for more than one year or not
publicly traded are recorded at cost. At June 30, 2000 and 2001, the estimated
fair value of these investments in excess of their recorded basis was $2.70
billion and $161 million, based on publicly available market information or
other estimates determined by management. Realized gains and (losses) from
equity and other investments (excluding impairments discussed previously) were
$786 million and $(2) million in 1999, $1.94 billion and $(10) million in 2000,
and $3.03 billion and $(23) million in 2001.
Derivatives
For the twelve months ended June 30, 2001, investment income included a net
unrealized loss of $592 million, comprised of a $214 million gain for changes in
the time value of options for fair value hedges, $211 million loss for changes
in the time value of options for cash flow hedges, and $595 million loss for
changes in the fair value of derivative instruments not designated as hedging
instruments.
Derivative gains and losses included in OCI are reclassified into earnings at
the time forecasted revenue or the sale of an equity investment is recognized.
During the twelve months ended June 30, 2001, $214 million of derivative gains
were reclassified to revenue and $416 million of derivative losses were
reclassified to investment income/(loss). The derivative losses reclassified to
investment income/(loss) were offset by gains on the item being hedged. The
Company estimates that $144 million of net derivative gains included in other
comprehensive income will be reclassified into earnings within the next twelve
months.
35
For instruments designated as hedges, hedge ineffectiveness, determined in
accordance with SFAS 133, had no impact on earnings for the twelve months ended
June 30, 2001. No fair value hedges or cash flow hedges were derecognized or
discontinued for the twelve months ended June 30, 2001.
Investment Income/(Loss)
The components of investment income/(loss) are as follows:
In Millions / Year Ended June 30 1999 2000 2001
----------------------------------------------------------------------------------------------------
Dividends $ 118 $ 363 $ 377
Interest 1,030 1,231 1,808
Net recognized gains/(losses) on investments 803 1,732 (2,221)
----------------------------------------------------------------------------------------------------
Investment income/(loss) $ 1,951 $ 3,326 $ (36)
====================================================================================================
Income Taxes
The provision for income taxes consisted of:
In Millions / Year Ended June 30 1999 2000 2001
----------------------------------------------------------------------------------------------------
Current taxes:
U.S. and state $ 4,027 $ 4,744 $ 3,243
International 281 535 514
----------------------------------------------------------------------------------------------------
Current taxes 4,308 5,279 3,757
Deferred taxes (202) (425) 47
----------------------------------------------------------------------------------------------------
Provision for income taxes $ 4,106 $ 4,854 $ 3,804
====================================================================================================
U.S. and international components of income before income taxes were:
In Millions / Year Ended June 30 1999 2000 2001
----------------------------------------------------------------------------------------------------
U.S. $10,649 $11,860 $ 9,189
International 1,242 2,415 2,336
----------------------------------------------------------------------------------------------------
Income before income taxes $11,891 $14,275 $11,525
====================================================================================================
In 1999, the effective tax rate was 35.0%, excluding the impact of the gain on
the sale of Softimage, Inc. In 2000, the effective tax rate was 34.0%, and
included the effect of a 2.5% reduction from the U.S. statutory rate for tax
credits and a 1.5% increase for other items. In 2001, the effective tax rate
was 33.0%, and included the effect of a 3.1% reduction from the U.S. statutory
rate for tax credits and a 1.1% increase for other items. The components of the
differences between the U.S. statutory tax rate and the Company's effective tax
rate in 1999 were not significant.
Deferred income taxes were:
----------------------------------------------------------------------------------------------------
In Millions / June 30 2000 2001
----------------------------------------------------------------------------------------------------
Deferred income tax assets:
Revenue items $ 1,320 $ 1,469
Expense items 2,122 1,761
----------------------------------------------------------------------------------------------------
Deferred income tax assets 3,442 3,230
----------------------------------------------------------------------------------------------------
Deferred income tax liabilities:
Unrealized gain on investments (874) (395)
International earnings (1,766) (1,667)
Other (121) (55)
----------------------------------------------------------------------------------------------------
Deferred income tax liabilities $(2,761) $(2,117)
====================================================================================================
During fiscal 2001, the U.S. Tax Court issued an adverse ruling which is being
appealed to the 9th Circuit Court of Appeals for taxes assessed in 1990 and
1991. Income taxes, except for 1990 and 1991 assessments, have been settled
with the Internal Revenue Service (IRS) for all years through 1994. The IRS is
examining the Company's
36
1995 and 1996 U.S. income tax returns. Management believes any adjustments which
may be required will not be material to the financial statements. Income taxes
paid were $874 million in 1999, $800 million in 2000, and $1.3 billion in 2001.
Convertible Preferred Stock
During 1996, Microsoft issued 12.5 million shares of 2.75% convertible
exchangeable principal-protected preferred stock. The Company's convertible
preferred stock matured on December 15, 1999. Each preferred share was
converted into 1.1273 common shares.
Common Stock
Shares of common stock outstanding were as follows:
In Millions / Year Ended June 30 1999 2000 2001
-------------------------------------------------------------------
Balance, beginning of year 4,940 5,109 5,283
Issued 213 229 189
Repurchased (44) (55) (89)
-------------------------------------------------------------------
Balance, end of year 5,109 5,283 5,383
===================================================================
Repurchase Program
The Company repurchases its common shares in the open market to provide shares
for issuance to employees under stock option and stock purchase plans. During
1998, the Company executed two forward settlement structured repurchase
agreements with an independent third party totaling 42 million shares of stock
and paid cash for a portion of the purchase price. In 1999, the Company settled
the agreements by returning 28 million shares of stock, based upon the stock
price on the date of settlement. The timing and method of settlement were at
the discretion of the Company. The differential between the cash paid and the
price of Microsoft common stock on the date of the agreement was originally
reflected in common stock and paid-in capital. In 2001, the Company entered
into a structured stock repurchase transaction giving it the right to acquire
5.1 million of its shares (2.55 million shares in October 2001 and 2.55 million
shares in June 2002) in exchange for an up-front net payment of $264 million.
Put Warrants
To enhance its stock repurchase program, Microsoft sold put warrants to
independent third parties. These put warrants entitled the holders to sell
shares of Microsoft common stock to the Company on certain dates at specified
prices. In the third quarter of fiscal 2001, the Company issued 2.8 million
shares to settle a portion of the outstanding put warrants. During fiscal 2001,
all the remaining outstanding put warrants were either retired or exercised.
37
Other Comprehensive Income
The changes in the components of other comprehensive income were as follows:
In Millions / Year Ended June 30 1999 2000 2001
-----------------------------------------------------------------------------------------------------------------------------
Cumulative effect of accounting change, net of tax effect of $(37) $ -- $ -- $ (75)
-----------------------------------------------------------------------------------------------------------------------------
Net gain on derivative instruments:
Unrealized gains, net of tax effect of $246 -- -- 499
Reclassification adjustment for losses included in
net income, net of tax effect of $67 -- -- 135
-----------------------------------------------------------------------------------------------------------------------------
Net gain on derivative instruments -- -- 634
-----------------------------------------------------------------------------------------------------------------------------
Net unrealized investment gains/(losses):
Unrealized holding gains/(losses), net of tax effect of $772 in 1999,
$248 in 2000, and $(351) in 2001 1,432 531 (1,200)
Reclassification adjustment for gains included in
net income, net of tax effect of $(205) in 1999,
$(420) in 2000, and $(128) in 2001 (380) (814) (260)
-----------------------------------------------------------------------------------------------------------------------------
Net unrealized investment gains/(losses) 1,052 (283) (1,460)
-----------------------------------------------------------------------------------------------------------------------------
Translation adjustments and other 69 23 (39)
-----------------------------------------------------------------------------------------------------------------------------
Other comprehensive income/(loss) $1,121 $(260) $ (940)
=============================================================================================================================
The components of accumulated other comprehensive were:
In Millions / June 30 2000 2001
----------------------------------------------------------------------------------------------------------
Net gains on derivative instruments $ -- $ 177
Net unrealized investment gains 1,676 598
Translation adjustments and other (149) (188)
----------------------------------------------------------------------------------------------------------
Accumulated other comprehensive income $1,527 $ 587
==========================================================================================================
Employee Stock and Savings Plans
Employee Stock Purchase Plan
The Company has an employee stock purchase plan for all eligible employees.
Under the plan, shares of the Company's common stock may 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 may purchase shares having a value
not exceeding 10% of their gross compensation during an offering period. During
1999, 2000, and 2001, employees purchased 2.7 million, 2.5 million, and 5.7
million shares at average prices of $52.59, $72.38, and $36.87 per share. At
June 30, 2001, 62.7 million shares were reserved for future issuance.
Savings Plan
The Company has a savings plan, which qualifies under Section 401(k) of the
Internal Revenue Code. Participating employees may contribute up to 15% of
their pretax salary, but not more than statutory limits. The Company
contributes fifty cents for each dollar a participant contributes, with a
maximum contribution of 3% of a participant's earnings. Matching contributions
were $49 million, $65 million, and $86 million in 1999, 2000, and 2001.
Stock Option Plans
The Company has stock option plans for directors, officers, and employees, which
provide for nonqualified and incentive stock options. Options granted prior to
1995 generally vest over four and one-half years and expire 10 years from the
date of grant. Options granted between 1995 and 2000 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 after 10 years. Options granted during 2001vest over four and
one-half years and expire 10 years from the date of grant. At June 30, 2001,
options for 331 million shares were vested and 550 million shares were available
for future grants under the plans.
38
Stock options outstanding were as follows:
In Millions, Except Per Share Amounts
Price per Share
------------------------------
Weighted
Shares Range Average
-------------------------------------------------------------------------
Balance, June 30, 1998 893 $ 0.56 - $ 43.63 $11.94
Granted 78 45.59 - 83.28 54.62
Exercised (175) 0.56 - 53.63 6.29
Canceled (30) 4.25 - 74.28 21.06
----
Balance, June 30, 1999 766 0.56 - 83.28 23.87
Granted 304 65.56 - 119.13 79.87
Exercised (198) 0.56 - 82.94 9.54
Canceled (40) 4.63 - 116.56 36.50
----
Balance, June 30, 2000 832 0.56 - 119.13 41.23
Granted 224 41.50 - 80.00 60.84
Exercised (123) 0.59 - 85.81 11.13
Canceled (35) 13.83 - 119.13 63.57
----
Balance, June 30, 2001 898 0.56 - 119.13 49.54
=========================================================================
For various price ranges, weighted average characteristics of outstanding stock
options at June 30, 2001 were as follows:
In Millions, Except Per Share Amounts
Outstanding Options Exercisable Options
------------------------------------------------------------------------------
Range of Remaining Weighted Weighted
Exercise Prices Shares Life (Years) Average Price Shares Average Price
----------------------------------------------------------------------------------------------
$0.56- $5.97 73 1.6 $ 4.75 67 $ 4.71
5.98- 13.62 75 1.3 11.01 72 11.02
13.63- 29.80 110 3.0 15.06 92 14.92
29.81- 43.62 84 3.6 32.20 52 32.08
43.63- 60.00 191 7.8 55.82 25 53.17
60.01- 83.28 210 6.1 68.28 11 69.20
83.29- 119.13 155 5.5 89.91 12 87.39
==============================================================================================
39
The Company follows Accounting Principles Board Opinion 25, Accounting for Stock
Issued to Employees, to account for stock option and employee stock purchase
plans. An alternative method of accounting for stock options is SFAS 123,
Accounting for Stock-Based Compensation. Under SFAS 123, employee stock options
are valued at grant date using the Black-Scholes valuation model, and this
compensation cost is recognized ratably over the vesting period. Had
compensation cost for the Company's stock option and employee stock purchase
plans been determined as prescribed by SFAS 123, pro forma income statements for
1999, 2000, and 2001 would have been as follows:
In Millions, Except Per Share Amounts
Year Ended June 30 1999 2000 2001
------------------------------------------------------------------------------------------------------------------
Reported Pro Forma Reported Pro Forma Reported Pro Forma
--------------------------------------------------------------------
Revenue $19,747 $19,747 $22,956 $22,956 $25,296 $25,296
Operating expenses:
Cost of revenue 2,814 3,013 3,002 3,277 3,455 3,775
Research and development 2,970 3,479 3,772 4,814 4,379 6,106
Sales and marketing 3,238 3,445 4,126 4,468 4,885 5,888
General and administrative 715 841 1,050 1,284 857 1,184
------------------------------------------------------------------------------------------------------------------
Total operating expenses 9,737 10,778 11,950 13,843 13,576 16,953
------------------------------------------------------------------------------------------------------------------
Operating income 10,010 8,969 11,006 9,113 11,720 8,343
Losses on equity investees and other (70) (70) (57) (57) (159) (159)
Investment income/(loss) 1,951 1,951 3,326 3,326 (36) (36)
------------------------------------------------------------------------------------------------------------------
Income before income taxes 11,891 10,850 14,275 12,382 11,525 8,148
Provision for income taxes 4,106 3,741 4,854 4,210 3,804 2,689
------------------------------------------------------------------------------------------------------------------
Income before accounting change 7,785 7,109 9,421 8,172 7,721 5,459
Cumulative effect of accounting change -- -- -- -- (375) (375)
==================================================================================================================
Net income $ 7,785 $ 7,109 $ 9,421 $ 8,172 $ 7,346 $ 5,084
==================================================================================================================
Basic earnings per share $ 1.54 $ 1.41 $ 1.81 $ 1.57 $ 1.38 $ 0.95
==================================================================================================================
Diluted earnings per share $ 1.42 $ 1.30 $ 1.70 $ 1.48 $ 1.32 $ 0.91
==================================================================================================================
The weighted average Black-Scholes value of options granted under the stock
option plans during 1999, 2000, and 2001 was $20.90, $36.67, and $29.31. Value
was estimated using a weighted average expected life of 5.0 years in 1999, 6.2
years in 2000, and 6.4 years in 2001, no dividends, volatility of .32 in 1999,
.33 in 2000, and .39 in 2001, and risk-free interest rates of 4.9%, 6.2%, and
5.3% in 1999, 2000, and 2001.
40
Earnings Per Share
Basic earnings per share is computed on the basis of the weighted average number
of common shares outstanding. Diluted earnings per share is computed on the
basis of the weighted average number of common shares outstanding plus the
effect of outstanding preferred shares using the "if-converted" method, assumed
net-share settlement of common stock structured repurchases, outstanding put
warrants using the "reverse treasury stock" method, and outstanding stock
options using the "treasury stock" method.
The components of basic and diluted earnings per share were as follows:
In Millions, Except Per Share Amounts
------------------------------------------------------------------------------------------
Year Ended June 30 1999 2000 2001
------------------------------------------------------------------------------------------
Income before accounting change $7,785 $9,421 $7,721
Preferred stock dividends 28 13 --
------------------------------------------------------------------------------------------
Net income available for common shareholders $7,757 $9,408 $7,721
==========================================================================================
Weighted average outstanding shares of common stock 5,028 5,189 5,341
Dilutive effect of:
Common stock under structured repurchases 13 -- --
Put warrants -- 2 21
Preferred stock 16 7 --
Employee stock options 425 338 212
------------------------------------------------------------------------------------------
Common stock and common stock equivalents 5,482 5,536 5,574
==========================================================================================
Earnings per share before accounting change:
Basic $ 1.54 $ 1.81 $ 1.45
==========================================================================================
Diluted $ 1.42 $ 1.70 $ 1.38
==========================================================================================
Operational Transactions
In November 1998, Microsoft acquired LinkExchange, Inc., a leading provider of
online marketing services to Web site owners and small- and medium-sized
businesses. Microsoft paid $265 million in stock.
In November 1999, Expedia, Inc. completed an initial public offering of its
common stock. Expedia, which is majority-owned by Microsoft, is a leading
provider of branded online travel services for leisure and small business
travelers. Expedia's financial results and financial condition are consolidated
with the operations of Microsoft.
In January 2000, the Company merged with Visio Corporation in a transaction that
was accounted for as a pooling of interests. Microsoft issued 14 million shares
in the exchange for the outstanding stock of Visio. Visio's assets and
liabilities, which were nominal, are included with those of Microsoft as of the
merger. Operating results for Visio from periods prior to the merger were not
material to the combined results of the two companies. Accordingly, the
financial statements for such periods have not been restated.
In July 2000, the Company acquired an interest in Telewest Communications plc
for approximately $2.6 billion in stock. Telewest is a leading broadband cable
communications operator in the United Kingdom.
In April 2001, the Company acquired Great Plains Software, Inc. for
approximately $1.1 billion in stock. Great Plains is a leading supplier of mid-
market business applications. The acquisition was accounted for by the purchase
method and operating results for Great Plains subsequent to the date of
acquisition are included with those of Microsoft. The pro forma impact of Great
Plains' operating results prior to the date of acquisition was not material.
Commitments
The Company has operating leases for most U.S. and international sales and
support offices and certain equipment. Rental expense for operating leases was
$135 million, $201 million, and $281 million in 1999, 2000, and 2001. Future
minimum rental commitments under noncancellable leases, in millions of dollars,
are: 2002, $218; 2003, $210; 2004, $185; 2005, $162; 2006, $140; and thereafter,
$430. Microsoft has committed $181 million for constructing new buildings and
$46 million for the manufacturing of products. In addition, the Company has
guaranteed $420 million in debt of its equity investees.
41
Contingencies
On January 23, 2001, Microsoft and Sun Microsystems, Inc. ("Sun") entered into a
Settlement Agreement. Under the terms of the public agreement, the parties
agreed to a dismissal with prejudice of all pending claims in the suit brought
by Sun against Microsoft on October 7, 1997 in the U.S. District Court for the
Northern District of California. Sun also granted to Microsoft a non-exclusive
license to continue distribution of certain Sun technology for a seven year
period. Microsoft further agreed to pay Sun $20 million.
The Company is a defendant in U.S. v. Microsoft, a lawsuit filed by the
Antitrust Division of the U.S. Department of Justice (DOJ) and a group of
eighteen state Attorneys General alleging violations of the Sherman Act and
various state antitrust laws. After the trial, the District Court entered
Findings of Fact and Conclusions of Law stating that Microsoft had violated
Sections 1 and 2 of the Sherman Act and various state antitrust laws. A
Judgment was entered on June 7, 2000 ordering, among other things, the breakup
of Microsoft into two companies. The Judgment was stayed pending an appeal. On
June 28, 2001, the U.S. Court of Appeals for the District of Columbia Circuit
affirmed in part, reversed in part, and vacated the Judgment in its entirety and
remanded the case to the District Court for a new trial on one Section 1 claim
and for entry of a new judgment consistent with its ruling. In its ruling, the
Court of Appeals substantially narrowed the bases of liability found by the
District Court, but affirmed some of the District Court's conclusions that
Microsoft had violated Section 2. On September 6, 2001, the plaintiffs
announced that on remand they will not ask the Court to break Microsoft up, that
they will seek imposition of conduct remedies, and that they will not retry the
one Section 1 claim returned to the District Court by the Court of Appeals. On
August 7, 2001, Microsoft petitioned the Supreme Court for a writ of certiorari
to review the appellate court's ruling concerning its disqualification of the
District Court judge. Microsoft may petition the Supreme Court to review other
aspects of the appellate court's decision after final judgment is entered.
In other ongoing investigations, the DOJ and several state Attorneys General
have requested information from Microsoft concerning various issues. In
addition, the European Commission has instituted proceedings in which it alleges
that Microsoft has failed to disclose information that Microsoft competitors
claim they need to interoperate fully with Windows 2000 clients and servers and
has engaged in discriminatory licensing of such technology. The remedies sought,
though not fully defined, include mandatory disclosure of Microsoft Windows
operating system technology and imposition of fines. Microsoft denies the
European Commission's allegations and intends to contest the proceedings
vigorously.
A large number of overcharge class action lawsuits have been initiated against
Microsoft. These cases allege that Microsoft has competed unfairly and
unlawfully monopolized alleged markets for operating systems and certain
software applications and seek to recover alleged overcharges that the
complaints contend Microsoft charged for these products. Microsoft believes the
claims are without merit and is vigorously defending the cases. To date,
Microsoft has won dismissals of all claims for damages by indirect purchasers
under Federal law and in 15 separate state court proceedings. Claims on behalf
of foreign purchasers have also been dismissed. Plaintiffs have appealed most
of these rulings. While no trials or other proceedings have been held
concerning any liability issues, courts in several states have ruled that these
cases may proceed as class actions, while one court has denied class
certification status to the claims in that state proceeding.
Two purported class action employment discrimination cases are pending against
Microsoft, Donaldson v. Microsoft, a class case consolidating three separately
filed class action complaints filed in October 2000 and February 2001 in Federal
court in Seattle, Washington, and Jackson v. Microsoft, an amendment to an
existing case alleging class claims filed on January 3, 2001 in Federal court in
Washington, D.C. Microsoft's motion to transfer the Jackson case to Federal
court in Seattle was granted on May 3, 2001. The Donaldson plaintiffs purport
to represent a nationwide class of current and former African American and
female Microsoft employees and seek injunctive relief, an unspecified amount of
compensatory and punitive damages, and attorneys' fees. The Jackson plaintiffs
purport to represent a nationwide class of current and former African American
Microsoft employees and seeks injunctive relief, $5 billion in compensatory and
punitive damages, and attorneys' fees. Both cases allege that Microsoft's
compensation, evaluation, and promotion policies are discriminatory with respect
to the plaintiffs in violation of Title VII of the 1964 Civil Rights Act and 42
U.S.C. (S) 1981. Microsoft denies the allegations and is vigorously defending
both cases.
42
The Securities and Exchange Commission is conducting a non-public investigation
into the Company's accounting reserve practices. Microsoft is also subject to
various legal proceedings and claims that arise in the ordinary course of
business.
Management currently believes that resolving these matters will not have a
material adverse impact on the Company's financial position or its results of
operations.
Segment Information
In Millions / Year Ended June 30
Desktop and Consumer
Enterprise Software,
Software and Services, and Consumer Commerce Reconciling
Services Devices Investments Other Amounts Consolidated
------------------------------------------------------------------------------------------------------------------------------
1999
Revenue $17,810 $ 1,148 $ 62 $593 $ 134 $19,747
==============================================================================================================================
2000
Revenue $20,410 $ 1,654 $ 182 $691 $ 19 $22,956
Operating income/(loss) 13,210 (1,090) (60) 86 (1,140) 11,006
==============================================================================================================================
2001
Revenue $22,720 $ 1,961 $ 522 $652 $ (559) $25,296
Operating income/(loss) 14,261 (1,666) (222) 97 (750) 11,720
==============================================================================================================================
Desktop and Enterprise Software and Services Revenue:
In Millions / Year Ended June 30 1999 2000 2001
--------------------------------------------------------------------------------------------------------
Desktop Applications $ 7,590 $ 9,013 $ 9,580
Desktop Platforms 6,932 7,383 8,265
--------------------------------------------------------------------------------------------------------
Desktop Software 14,522 16,396 17,845
Enterprise Software and Services 3,288 4,014 4,875
--------------------------------------------------------------------------------------------------------
Total Desktop and Enterprise Software and Services $17,810 $20,410 $22,720
========================================================================================================
In 2001, Microsoft changed the composition of its segments to reflect the
internal reorganization around Microsoft .NET, the Company's vision for the
next-generation of Internet-based products and services. Except for 1999
operating income/(loss), prior year disclosures have been restated for
consistent presentation. It is not practicable to discern operating income for
1999 for the current segments due to previous internal reorganizations.
Microsoft has four segments: Desktop and Enterprise Software and Services;
Consumer Software, Services, and Devices; Consumer Commerce Investments; and
Other. Desktop and Enterprise Software and Services operating segment includes
Desktop Applications, Desktop Platforms, and Enterprise Software and Services.
Desktop Applications include Microsoft Office; Project; Visio; client access
licenses for Windows 2000 Server, Windows NT Server, Exchange, and BackOffice;
Microsoft Great Plains; and bCentral. Desktop Platforms include Windows 2000
Professional, Windows NT Workstation, Windows Millennium Edition (Windows Me),
Windows 98, and other desktop operating systems. Enterprise Software and
Services includes Windows NT Server and Windows 2000 Server operating systems,
SQL Server and client access licenses, Exchange Server, developer tools,
consulting services, product support services, and training and certification.
Consumer Software, Services, and Devices operating segment includes MSN Internet
access, MSN network services, WebTV Internet access and services, gaming,
learning and productivity software, mobile and wireless devices, and embedded
systems. Consumer Commerce Investments operating segment includes Expedia,
Inc., the HomeAdvisor online real estate service, and the CarPoint online
automotive service. Other includes Hardware and Press.
Segment information is presented in accordance with SFAS 131, Disclosures about
Segments of an Enterprise and Related Information. This standard is based on a
management approach, which requires segmentation based upon the Company's
internal organization and disclosure of revenue and operating income based upon
internal accounting methods. The Company's financial reporting systems present
various data for management to run the business, including internal profit and
loss statements (P&Ls) prepared on a basis not consistent with generally
accepted accounting principles. Assets are not allocated to segments for
internal reporting purposes.
43
Reconciling items for revenue include certain elements of unearned revenue and
the treatment of certain channel inventory amounts and estimates. In addition
to the reconciling items for revenue, reconciling items for operating
income/(loss) include general and administrative expenses ($1,050 million in
2000 and $857 million in 2001), certain research expenses ($141 million in 2000
and $154 million in 2001), and other corporate level adjustments. The internal
P&Ls use accelerated methods of depreciation and amortization. Additionally,
losses on equity investees and minority interest are classified in operating
income for internal reporting presentations.
Revenue attributable to U.S. operations includes shipments to customers in the
United States, licensing to OEMs and certain multinational organizations, and
exports of finished goods, primarily to Asia, Latin America, and Canada.
Revenue from U.S. operations totaled $13.7 billion, $15.7 billion, and $17.8
billion in 1999, 2000, and 2001. Revenue from outside the United States,
excluding licensing to OEMs and certain multinational organizations and U.S.
exports, totaled $6.0 billion, $7.3 billion, and $7.5 billion in 1999, 2000, and
2001. A single customer accounted for approximately 11%, 9%, and 8% of revenue
in 1999, 2000, and 2001.
Long-lived assets totaled $1.8 billion and $2.2 billion in the United States in
2000 and 2001 and $126 million and $154 million in other countries in 2000 and
2001.
Subsequent Event
On July 16, 2001, USA Networks, Inc. (USA) announced an agreement to acquire a
controlling interest in Expedia, Inc. through the purchase of up to 37.5 million
shares, approximately 75% of the current outstanding shares. If holders of more
than 37.5 million Expedia shares elect to sell their shares to USA, there will
be a pro rata reduction among all of those electing shareholders. Microsoft has
agreed to transfer all of its 33.7 million shares and warrants, subject to pro-
ration. It is expected that the transaction will close by December 31, 2001.
44
Quarterly Information
(In millions, except per share amounts) (Unaudited)
Quarter Ended
---------------------------------------------------------------------------------------------------------
Sept. 30 Dec. 31 Mar. 31 June 30 Year
---------------------------------------------------------------------------------------------------------
1999
Revenue $4,193 $5,195 $4,595 $5,764 $19,747
Gross profit 3,544 4,407 3,887 5,095 16,933
Net income 1,683 1,983 1,917 2,202 7,785
Basic earnings per share 0.34 0.40 0.38 0.43 1.54
Diluted earnings per share 0.31 0.36 0.35 0.40 1.42
------------------------------------------------------------------------------------------------------
2000
Revenue $5,384 $6,112 $5,656 $5,804 $22,956
Gross profit 4,672 5,356 4,904 5,022 19,954
Net income 2,191 2,436 2,385 2,409 9,421
Basic earnings per share 0.43 0.47 0.46 0.46 1.81
Diluted earnings per share 0.40 0.44 0.43 0.44 1.70
------------------------------------------------------------------------------------------------------
2001
Revenue (1) $5,766 $6,550 $6,403 $6,577 $25,296
Gross profit 4,941 5,686 5,504 5,710 21,841
Net income (2)(3) 2,206 2,624 2,451 65 7,346
Basic earnings per share (2)(3) 0.42 0.49 0.46 0.01 1.38
Diluted earnings per share (2)(3) 0.40 0.47 0.44 0.01 1.32
---------------------------------------------------------------------------------------------------------
(1) For the first three quarters of 2001, revenue and cost of revenue have
been reclassified to report Expedia merchant revenue on a net basis,
which represents the amount charged to the customer less the amount
paid to the supplier.
(2) First quarter of 2001 includes an unfavorable cumulative effect of
accounting change of $375 million or $0.07 per basic share and $0.06
per diluted share.
(3) Fourth quarter of 2001 includes $3.92 billion (pre-tax) in impairments
of certain investments, primarily cable and telecommunication
investments.
45
Independent Auditors' Report
--------------------------------------------------------------------------------
To the Board of Directors and Stockholders of Microsoft Corporation:
We have audited the accompanying consolidated balance sheets of Microsoft
Corporation and subsidiaries as of June 30, 2000 and 2001, and the related
consolidated statements of income, cash flows, and stockholders' equity for each
of the three years in the period ended June 30, 2001. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Microsoft Corporation and
subsidiaries as of June 30, 2000 and 2001, and the results of their operations
and their cash flows for each of the three years in the period ended June 30,
2001 in conformity with accounting principles generally accepted in the United
States of America.
As discussed in the notes to the financial statements, the Company was required
to adopt Statement of Financial Accounting Standards No. 133, Accounting for
Derivative Instruments and Hedging Activities, effective July 1, 2000.
Deloitte & Touche LLP
Seattle, Washington
July 19, 2001 (September 6, 2001 as to the second paragraph of Contingencies
note)
46
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosures
None.
PART III
Item 10. Directors of the Registrant
Information with respect to Directors may be found under the caption "Election
of Directors and Management Information" of the Company's Proxy Statement dated
September 10, 2001, for the Annual Meeting of Shareholders to be held November
7, 2001 (the "Proxy Statement"). Such information is incorporated herein by
reference.
Item 11. Executive Compensation
The information in the Proxy Statement set forth under the captions "Information
Regarding Executive Officer Compensation" and "Information Regarding the Board
and its Committees" is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information set forth under the caption "Information Regarding Beneficial
Ownership of Principal Shareholders, Directors, and Management" of the Proxy
Statement is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
The information set forth under the captions "Certain Relationships and Related
Transactions" and "Indebtedness of Executive Officers" of the Proxy Statement is
incorporated herein by reference.
47
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) Financial Statements and Schedules
The financial statements are set forth under Item 8 of this report on
Form 10-K.
Financial statement schedules have been omitted since they are either
not required, not applicable, or the information is otherwise included.
(b) Reports on Form 8-K
The Company filed no reports on Form 8-K during the quarter ended June
30, 2001.
(c) Exhibit Listing
Exhibit Number Description
-------------- -----------
3.1 Restated Articles of Incorporation of Microsoft
Corporation (1)
3.2 Bylaws of Microsoft Corporation
10.1 Microsoft Corporation 1991 Stock Option Plan (2)
10.2 Microsoft Corporation 1981 Stock Option Plan (3)
10.3 Microsoft Corporation 1999 Stock Option Plan for Non-
Employee Directors (4)
10.4 Microsoft Corporation Stock Option Plan for Consultants
and Advisors (5)
10.5 Microsoft Corporation 1997 Employee Stock Purchase Plan
10.6 Microsoft Corporation Savings Plus Plan (6)
10.7 Trust Agreement dated June 1, 1993 between Microsoft
Corporation and First Interstate Bank of Washington (7)
10.8 Form of Indemnification Agreement (7)
21. Subsidiaries of Registrant
23. Independent Auditors' Consent
_____________________________
(1) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year
Ended June 30, 1999.
(2) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year
Ended June 30, 1997.
(3) Incorporated by reference to Registration Statement 33-37623 on Form S-8.
(4) Incorporated by reference to Registration Statement 333-91755 on Form S-8.
(5) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year
Ended June 30, 1994.
(6) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year
Ended June 30, 2000.
(7) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year
Ended June 30, 1993.
48
Signatures
Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned; thereunto duly authorized, in the City of Redmond,
State of Washington, on September 17, 2001.
MICROSOFT CORPORATION
By /s/ John G. Connors
-------------------------------------------
John G. Connors
Senior Vice President; Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of Registrant and in
the capacities indicated on September 17, 2001.
Signature Title
/s/ William H. Gates, III
-------------------------------------- Chairman of the Board of Directors
William H. Gates, III and Chief Software Architect
/s/ Steven A. Ballmer
--------------------------------------
Steven A. Ballmar Chief Executive Officer
/s/ James I. Cash, Jr.
--------------------------------------
James I. Cash, Jr. Director
/s/ Raymond V. Gilmartin
--------------------------------------
Raymond V. Gilmartin Director
/s/ Ann McLaughlin Korologos
--------------------------------------
Ann McLaughlin Korologos Director
/s/ David F. Marquardt
--------------------------------------
David F. Marquardt Director
/s/ Wm. G. Reed, Jr.
--------------------------------------
Wm. G. Reed, Jr. Director
/s/ Jon A. Shirley
--------------------------------------
Jon A. Shirley Director
/s/ John G. Connors
--------------------------------------
John G. Connors Senior Vice President; Chief Financial Officer
(Principal Financial and Accounting Officer)
49