EXHIBIT 13.4
MICROSOFT CORPORATION
FINANCIAL STATEMENTS
Income Statements for the three years ended June 30, 1998
Cash Flows Statements for the three years ended June 30, 1998
Balance Sheets as of June 30, 1997 and 1998
Stockholders' Equity Statements for the three years ended June 30, 1998
Notes to Financial Statements
Independent Auditors' Report
1
INCOME STATEMENTS
(In millions, except earnings per share)
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Year Ended June 30 1996 1997 1998
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Revenue $8,671 $11,358 $14,484
Operating expenses:
Cost of revenue 1,188 1,085 1,197
Research and development 1,432 1,925 2,502
Acquired in-process technology -- -- 296
Sales and marketing 2,657 2,856 3,412
General and administrative 316 362 433
Other expenses 19 259 230
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Total operating expenses 5,612 6,487 8,070
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Operating income 3,059 4,871 6,414
Interest income 320 443 703
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Income before income taxes 3,379 5,314 7,117
Provision for income taxes 1,184 1,860 2,627
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Net income 2,195 3,454 4,490
Preferred stock dividends -- 15 28
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Net income available for common shareholders $2,195 $ 3,439 $ 4,462
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Earnings per share (1):
Basic $ 0.93 $ 1.44 $ 1.83
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Diluted $ 0.86 $ 1.32 $ 1.67
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(1) Earnings per share have been restated to reflect a two-for-one stock split
in February 1998.
See accompanying notes.
2
CASH FLOWS STATEMENTS
(In millions)
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Year Ended June 30 1996 1997 1998
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Operations
Net income $ 2,195 $ 3,454 $ 4,490
Depreciation and amortization 480 557 1,024
Write-off of acquired in-process technology -- -- 296
Unearned revenue 983 1,601 3,268
Recognition of unearned revenue from prior periods (477) (743) (1,798)
Other current liabilities 584 321 208
Accounts receivable (71) (336) (520)
Other current assets 25 (165) (88)
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Net cash from operations 3,719 4,689 6,880
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Financing
Common stock issued 504 744 959
Common stock repurchased (1,385) (3,101) (2,468)
Put warrant proceeds 124 95 538
Preferred stock issued -- 980 --
Preferred stock dividends -- (15) (28)
Stock option income tax benefits 352 796 1,553
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Net cash from (used for) financing (405) (501) 554
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Investments
Additions to property and equipment (494) (499) (656)
Cash portion of WebTV purchase price -- -- (190)
Equity investments and other (625) (1,669) (1,598)
Short-term investments (1,551) (921) (4,828)
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Net cash used for investments (2,670) (3,089) (7,272)
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Net change in cash and equivalents 644 1,099 162
Effect of exchange rates on cash and equivalents (5) 6 (29)
Cash and equivalents, beginning of year 1,962 2,601 3,706
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Cash and equivalents, end of year 2,601 3,706 3,839
Short-term investments 4,339 5,260 10,088
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Cash and short-term investments $ 6,940 $ 8,966 $13,927
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See accompanying notes.
3
BALANCE SHEETS
(In millions)
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June 30 1997 1998
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ASSETS
Current assets:
Cash and short-term investments $ 8,966 $13,927
Accounts receivable 980 1,460
Other 427 502
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Total current assets 10,373 15,889
Property and equipment 1,465 1,505
Equity investments 2,346 4,703
Other assets 203 260
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Total assets $14,387 $22,357
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LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 721 $ 759
Accrued compensation 336 359
Income taxes payable 466 915
Unearned revenue 1,418 2,888
Other 669 809
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Total current liabilities 3,610 5,730
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Commitments and contingencies
Stockholders' equity:
Convertible preferred stock--shares authorized 100;
shares issued and outstanding 13 980 980
Common stock and paid-in capital--shares authorized 8,000;
shares issued and outstanding 2,408 and 2,470 4,509 8,025
Retained earnings 5,288 7,622
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Total stockholders' equity 10,777 16,627
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Total liabilities and stockholders' equity $14,387 $22,357
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See accompanying notes.
4
STOCKHOLDERS' EQUITY STATEMENTS
(In millions)
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Year Ended June 30 1996 1997 1998
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CONVERTIBLE PREFERRED STOCK
Balance, beginning of year -- -- $ 980
Convertible preferred stock issued -- $ 980 --
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Balance, end of year -- 980 980
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COMMON STOCK AND PAID-IN CAPITAL
Balance, beginning of year $ 2,005 2,924 4,509
Common stock issued 504 744 1,262
Common stock repurchased (41) (91) (165)
Structured repurchases price differential -- -- 328
Proceeds from sale of put warrants 124 95 538
Reclassification of put warrant obligation (20) 45 --
Stock option income tax benefits 352 792 1,553
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Balance, end of year 2,924 4,509 8,025
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RETAINED EARNINGS
Balance, beginning of year 3,328 3,984 5,288
Net income 2,195 3,454 4,490
Preferred stock dividends -- (15) (28)
Common stock repurchased (1,344) (3,010) (2,631)
Reclassification of put warrant obligation (210) 590 --
Net unrealized investment gains and other 15 285 503
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Balance, end of year 3,984 5,288 7,622
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Total stockholders' equity $ 6,908 $10,777 $16,627
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See accompanying notes.
5
NOTES TO FINANCIAL STATEMENTS
ACCOUNTING POLICIES
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PRINCIPLES OF CONSOLIDATION. The financial statements include the accounts of
Microsoft and its subsidiaries. Significant intercompany transactions and
balances have been eliminated. Investments in 50% owned joint ventures are
accounted for using the equity method; the Company's share of joint ventures'
activities is reflected in other expenses.
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 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 equity.
Revenue, costs, and expenses are translated at average rates of exchange
prevailing during the year. Gains and losses on foreign currency transactions
are included in other expenses.
REVENUE RECOGNITION. Revenue is recognized when earned. The Company's revenue
recognition policies are in compliance with American Institute of Certified
Public Accountants Statements of Position 97-2 and 98-4, Software Revenue
Recognition. Revenue from products licensed to original equipment manufacturers
is recorded when OEMs ship licensed products while revenue from organization
license programs is recorded when the software has been delivered and the
customer is invoiced. Revenue from packaged product sales to distributors and
resellers is recorded when related products are shipped. Maintenance and
subscription revenue is recognized ratably over the contract period. Revenue
attributable to significant support (technical support and unspecified
enhancements such as service packs and Internet browser updates) is based on the
price charged or derived value of the undelivered elements and is recognized
ratably on a straight-line basis over the product's life cycle. Costs related
to insignificant obligations, which include telephone support for certain
products, are accrued. Provisions are recorded for returns and bad debts.
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.
TELEPHONE SUPPORT. Telephone support costs are included in sales and marketing.
INCOME TAXES. Income tax expense includes U.S. and international income taxes,
plus an accrual 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. Tax credits are accounted for
as a reduction of tax expense in the year in which the credits reduce taxes
payable.
STOCK SPLIT. In February 1998, outstanding shares of common stock were split
two-for-one. All share and per share amounts have been restated.
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 five years from the purchase date. All cash and short-term
investments are classified as available for sale and are recorded at market.
Cost approximates market for all classifications of cash and short-term
investments; realized and unrealized gains and losses were not material.
Publicly tradeable equity securities are recorded at market; unrealized gains
and losses are reflected in stockholders' equity. The pretax unrealized gain
was $1.4 billion at June 30, 1998.
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 30 years.
RECLASSIFICATIONS. Certain reclassifications have been made for consistent
presentation.
6
UNEARNED REVENUE
Microsoft believes that Internet technologies are integral to its products and
has committed to integrating these technologies, such as its browser software,
Microsoft Internet Explorer, into existing products at no additional cost to its
customers. Given this strategy and other commitments such as telephone support,
Internet-based technical support, and unspecified product enhancements,
Microsoft recognizes approximately 20% of Windows operating systems OEM revenue
and approximately 35% of retail versions revenue over the product life cycles,
currently estimated at two years. The unearned portion of revenue from Windows
operating systems was $860 million and $1.19 billion at June 30, 1997 and 1998.
Since Office 97 is also tightly integrated with the Internet, and in the view of
subsequent delivery of new Internet technologies, enhancements, and other
support, a ratable revenue recognition policy was implemented for Office 97.
Approximately 20% of Office 97 revenue is recognized ratably over the estimated
18-month product life cycle. Unearned revenue associated with Office 97 totaled
$300 million and $770 million at June 30, 1997 and 1998.
Unearned revenue also includes maintenance and other subscription contracts,
including organization license agreements.
FINANCIAL RISKS
The Company's investment portfolio is diversified and consists primarily of
short-term investment grade securities. Interest rate fluctuations impact the
carrying value of the portfolio. While no hedge was in place on June 30, 1998,
the Company routinely hedges the portfolio in case of a catastrophic increase in
interest rates. At June 30, 1997 and 1998, approximately 31% and 40% of
accounts receivable represented amounts due from ten customers. One customer
accounted for approximately 13%, 12%, and 8% of revenue in 1996, 1997, and 1998.
Finished goods sales to international customers in Europe, Japan, and Australia
are primarily billed in local currencies. Payment cycles are relatively short,
generally less than 90 days. European manufacturing costs and international
selling, distribution, and support costs are generally disbursed in local
currencies. Local currency cash balances in excess of short-term operating
needs are generally converted into U.S. dollar cash and short-term investments
on receipt. Therefore, foreign exchange rate fluctuations generally do not
create a risk of material balance sheet gains or losses. As a result,
Microsoft's hedging activities for balance sheet exposures have been minimal.
Foreign exchange rates affect the translated results of operations of the
Company's foreign subsidiaries. The Company hedges a percentage of planned
international revenue with purchased options. The notional amount of the
options outstanding at June 30, 1998 was $2.1 billion. At June 30, 1998, the
fair value and premiums paid for the options were not material.
CASH AND SHORT-TERM INVESTMENTS
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June 30 1997 1998
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Cash and equivalents:
Cash $ 246 $ 195
Commercial paper 1,660 2,771
Money market preferreds 946 454
Certificates of deposit 854 419
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Cash and equivalents 3,706 3,839
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Short-term investments:
Commercial paper 261 868
Municipal securities 571 1,361
Corporate notes and bonds 1,907 3,998
U.S. government and agency securities 1,513 3,511
Certificates of deposit 1,008 350
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Short-term investments 5,260 10,088
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Cash and short-term investments $8,966 $13,927
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7
PROPERTY AND EQUIPMENT
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June 30 1997 1998
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Land $ 183 $ 183
Buildings 1,027 1,259
Computer equipment 1,064 1,182
Other 503 428
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Property and equipment--at cost 2,777 3,052
Accumulated depreciation (1,312) (1,547)
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Property and equipment--net $ 1,465 $ 1,505
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During 1997 and 1998, depreciation expense, of which the majority related to
computer equipment, was $353 million and $528 million; disposals were
immaterial.
INCOME TAXES
The provision for income taxes consisted of:
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Year Ended June 30 1996 1997 1998
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Current taxes:
U.S. and state $1,139 $1,710 $2,518
International 285 412 526
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Current taxes 1,424 2,122 3,044
Deferred taxes (240) (262) (417)
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Provision for income taxes $1,184 $1,860 $2,627
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U.S. and international components of income before income taxes were:
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Year Ended June 30 1996 1997 1998
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U.S. $2,356 $3,775 $5,072
International 1,023 1,539 2,045
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Income before income taxes $3,379 $5,314 $7,117
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The effective income tax rate was 35.0% in 1996 and 1997. The effective tax
rate increased to 36.9% in 1998 due to the nondeductible write-off of WebTV in-
process technologies.
Income taxes payable were:
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June 30 1997 1998
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Deferred income tax assets:
Revenue items $ 474 $ 713
Expense items 505 613
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Deferred income tax assets 979 1,326
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Deferred income tax liabilities:
Unrealized gain on investments (479)
International earnings (465) (373)
Other (4) (26)
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Deferred income tax liabilities (469) (878)
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Current income tax liabilities (976) (1,363)
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Income taxes payable $(466) $ (915)
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Income taxes have been settled with the Internal Revenue Service (IRS) for all
years through 1989. The IRS has assessed taxes for 1990 and 1991 which the
Company is contesting in Tax Court. The IRS is examining the Company's U.S.
income tax returns for 1992 through 1994. Management believes any related
adjustments that might be required will not be material to the financial
statements. Income taxes paid were $758 million in 1996, $1.1 billion in 1997,
and $1.1 billion in 1998.
CONVERTIBLE PREFERRED STOCK
8
During 1996, Microsoft issued 12.5 million shares of 2.75% convertible
exchangeable principal-protected preferred stock. Dividends are payable
quarterly in arrears. Preferred shareholders have preference over common
stockholders in dividends and liquidation rights. In December 1999, each
preferred share is convertible into common shares or an equivalent amount of
cash determined by a formula that provides a floor price of $79.875 and a cap of
$102.24 per preferred share. Net proceeds of $980 million were used to
repurchase common shares.
COMMON STOCK
ISSUED AND OUTSTANDING Shares of common stock outstanding were as follows:
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Year Ended June 30 1996 1997 1998
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Balance, beginning of year 2,352 2,388 2,408
Issued 88 94 101
Repurchased (52) (74) (39)
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Balance, end of year 2,388 2,408 2,470
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REPURCHASE PROGRAM The Company repurchases its common stock in the open market
to provide shares for issuing to employees under stock option and stock purchase
plans. The Company's Board of Directors authorized continuation of this program
in 1999.
In addition, under structured repurchases with an independent third-party, the
Company executed two forward purchases totaling 21 million shares of stock.
Under these arrangements, a portion of the purchase price will be paid in the
next five or six years and determined based upon the price of Microsoft common
stock at that time. The timing and method of payment (net share or cash) is at
the discretion of the Company. The differential between the cash paid and the
price of Microsoft common stock on the two dates of agreement is reflected in
common stock and paid-in capital.
PUT WARRANTS
To enhance its stock repurchase program, the Company sells put warrants to
independent third-parties. These put warrants entitle the holders to sell
shares of Microsoft common stock to the Company on certain dates at specified
prices. On June 30, 1998, 60 million warrants were outstanding. The
outstanding put warrants at June 30, 1998 expire between November 1998 and June
2000 and have strike prices ranging from $72 to $77 per share. The outstanding
put warrants permit a net-share settlement at the Company's option and do not
result in a put warrant liability on the balance sheet.
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 1996, 1997, and 1998, employees purchased 3.6
million, 2.8 million, and 2.2 million shares at average prices of $18.86,
$29.82, and $54.42 per share. At June 30, 1998, 36.8 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 defer up to
15% of 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 $15 million, $28 million, and $39 million in 1996, 1997, and 1998.
STOCK OPTION PLANS The Company has stock option plans for directors, officers,
and employees, which provide for nonqualified and incentive stock options. The
option exercise price is the fair market value at the date of grant. Options
granted prior to 1995 generally vest over four and one-half years and expire 10
years from the date of grant. Options granted during and after 1995 generally
vest over four and one-half years and expire seven years from the date of grant,
while certain options vest over seven and one-half years and expire after 10
years. At June 30, 1998, options for 222 million shares were vested and 523
million shares were available for future grants under the plans.
Stock options outstanding were as follows:
Price per Share
--------------------------------
Weighted
Shares Range Average
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Balance, June 30, 1995 456 $ 0.39 - $20.79 $ 7.28
9
Granted 114 20.05 - 29.47 22.50
Exercised (80) 0.39 - 22.63 5.38
Canceled (14) 1.30 - 27.72 13.93
---
Balance, June 30, 1996 476 0.55 - 29.47 11.04
Granted 110 27.66 - 59.60 29.15
Exercised (90) 0.55 - 29.47 6.64
Canceled (18) 8.50 - 48.57 19.42
---
Balance, June 30, 1997 478 1.12 - 59.60 15.72
GRANTED 69 33.12 - 87.25 62.56
EXERCISED (88) 1.12 - 62.47 9.27
CANCELED (13) 1.32 - 83.88 29.37
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BALANCE, JUNE 30, 1998 446 1.12 - 87.25 23.87
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For various price ranges, weighted average characteristics of outstanding stock
options at June 30, 1998 were as follows:
Outstanding options Exercisable options
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Range of Shares Remaining Weighted average Shares Weighted average
exercise prices life (years) price price
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$1.12-$8.50 85 2.7 $ 5.06 84 $ 5.07
8.51-11.94 100 4.4 10.47 83 10.19
11.95-27.25 97 4.9 21.62 38 21.14
27.26-59.60 100 5.6 29.81 17 28.99
59.61-87.25 64 6.5 64.00 -- --
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The Company follows Accounting Principles Board Opinion 25, Accounting for Stock
Issued to Employees, to account for stock option and employee stock purchase
plans. No compensation cost is recognized because the option exercise price is
equal to the market price of the underlying stock on the date of grant.
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 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 based
on the Black-Scholes value at the grant dates for awards as prescribed by SFAS
123, pro forma income statements for 1996, 1997, and 1998 would have been as
follows:
Year Ended June 30 1996 1997 1998
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Reported Pro forma Reported Pro forma REPORTED PRO FORMA
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Revenue $8,671 $8,671 $11,358 $11,358 $14,484 $14,484
Operating expenses:
Cost of revenue 1,188 1,204 1,085 1,107 1,197 1,227
Research and development 1,432 1,655 1,925 2,230 2,502 2,924
Acquired in-process technology -- -- -- -- 296 296
Sales and marketing 2,657 2,823 2,856 3,082 3,412 3,725
General and administrative 316 362 362 424 433 520
Other expenses 19 19 259 259 230 230
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Total operating expenses 5,612 6,063 6,487 7,102 8,070 8,922
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Operating income 3,059 2,608 4,871 4,256 6,414 5,562
Interest income 320 320 443 443 703 703
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Income before income taxes 3,379 2,928 5,314 4,699 7,117 6,265
Provision for income taxes 1,184 1,026 1,860 1,646 2,627 2,325
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Net income 2,195 1,902 3,454 3,053 4,490 3,940
Preferred stock dividends -- -- 15 15 28 28
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Net income available for common shareholders $2,195 $1,902 $ 3,439 $ 3,038 $ 4,462 $ 3,912
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Diluted earnings per share $ 0.86 $ 0.74 $ 1.32 $ 1.16 $ 1.67 $ 1.47
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10
The pro forma disclosures in the previous table include the amortization of the
fair value of all options vested during 1996, 1997, and 1998, regardless of the
grant date. If only options granted after 1996 were valued, as prescribed by
SFAS 123, pro forma net income would have been $2,073 million, $3,179 million,
and $4,019 million, and earnings per share would have been $0.81, $1.21, and
$1.50 for 1996, 1997, and 1998.
The weighted average Black-Scholes value of options granted under the stock
option plans during 1996, 1997, and 1998 was $8.86, $11.72, and $23.62. Value
was estimated using an expected life of five years, no dividends, volatility of
.32 in 1998 and .30 in prior years, and risk-free interest rates of 6.0%, 6.5%,
and 5.7% in 1996, 1997, and 1998.
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, and outstanding
stock options using the "treasury stock" method.
The components of basic and diluted earnings per share were as follows:
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Year Ended June 30 1996 1997 1998
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Net income $2,195 $3,454 $4,490
Preferred stock dividends -- 15 28
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Net income available for common shareholders $2,195 $3,439 $4,462
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Average outstanding shares of common stock 2,368 2,391 2,432
Dilutive effect of:
Common stock under structured repurchases -- -- 3
Preferred stock -- 13 17
Employee stock options 193 218 229
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Common stock and common stock equivalents 2,561 2,622 2,681
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Earnings per share:
Basic $ 0.93 $ 1.44 $ 1.83
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Diluted $ 0.86 $ 1.32 $ 1.67
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ACQUISITION
In August 1997, Microsoft acquired WebTV Networks, Inc., an online service that
enables consumers to experience the Internet through their televisions via set-
top terminals based on proprietary technologies. A director of the Company
owned 10% of WebTV. Microsoft paid $425 million in stock and cash for WebTV.
The Company recorded an in-process technologies write-off of $296 million in the
first quarter of 1998.
SUBSEQUENT SALE
In August 1998, the Company sold a wholly-owned subsidiary, Softimage, Inc. to
Avid Technology, Inc. A pretax gain of $160 million will be recognized in the
first quarter of 1999. As part of a transitional service agreement, Microsoft
agreed to make certain development tools and management systems available to
Avid for use in the Softimage business.
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
$92 million, $92 million, and $95 million in 1996, 1997, and 1998. Future
minimum rental commitments under noncancelable leases, in millions of dollars,
are: 1999, $85; 2000, $72; 2001, $52; 2002, $25; 2003, $17; and thereafter, $17.
In connection with the Company's communications infrastructure and the operation
of online services, Microsoft has certain communication usage commitments.
Future related minimum commitments, in millions of dollars, are: 1999, $184;
2000, $100; and
11
2001, $30. Also, Microsoft has committed to certain volumes of outsourced
telephone support and manufacturing of packaged product and has committed $420
million for constructing new buildings.
During 1996, Microsoft and National Broadcasting Company (NBC) established two
MSNBC joint ventures: a 24-hour cable news and information channel and an
interactive online news service. Microsoft agreed to pay $220 million over a
five-year period for its interest in the cable venture, to pay one-half of
operational funding of both joint ventures for a multiyear period, and to
guarantee a portion of MSNBC debt.
CONTINGENCIES
On October 7, 1997, Sun Microsystems, Inc. brought suit against Microsoft in the
U.S. District Court for the Northern District of California. Sun's Complaint
alleges several claims against Microsoft, all related to the parties'
relationship under a March 11, 1996 Technology License and Distribution
Agreement (Agreement) concerning certain Java programming language technology.
The Complaint seeks: a preliminary and permanent injunction against Microsoft
distributing certain products with the Java Compatibility logo, and against
distributing Internet Explorer 4.0 unless certain alleged obligations are met;
an order compelling Microsoft to perform certain alleged obligations; an
accounting; termination of the Agreement; and an award of damages, including
compensatory, exemplary and punitive damages, and liquidated damages of $35
million for the alleged source code disclosure.
On March 24, 1998, the court entered an order enjoining Microsoft from using the
Java Compatibility logo on Internet Explorer 4.0 and the Microsoft Software
Developers Kit for Java 2.0. Microsoft has taken steps to fully comply with the
order.
On May 12, 1998, Sun filed companion motions seeking a preliminary injunction
based on allegations of copyright infringement and unfair competition. Sun
requested an order enjoining Microsoft from distributing any Java-based
technology in any operating system, browser, or developers tools, including
Windows 98, Internet Explorer 4.0 software, and the Visual J++(TM) 6.0
development system for Java, unless and until Microsoft includes with each such
product an implementation of the Java run-time environment that passes Sun's
compatibility test suite or an operable implementation of Sun's current Java
run-time environment. The hearing for these motions is set for September 4,
1998.
On October 20, 1997, the Antitrust Division of the U.S. Department of Justice
(DOJ) filed a Petition for An Order To Show Cause in United States District
Court for the District of Columbia. In its petition, the DOJ contends that
Microsoft has violated a 1994 consent decree by including Internet Explorer
technology in Windows 95, and by preventing OEMs from removing Internet Explorer
functionality from versions of Windows 95 the OEMs are licensed to install on
computer systems they sell.
On December 11, 1997, the district court entered two orders. In the first
order, Judge Thomas Penfield Jackson denied the DOJ's contempt petition, and
dismissed the DOJ's request for relief concerning Microsoft's non-disclosure
agreements because the DOJ had failed to present evidence that the agreements
had interfered with any DOJ investigation. In addition, however, the court
ruled that there were disputed issues of fact regarding Microsoft's violation of
the consent decree, and concluded that the DOJ was likely to prevail on its
claim that a violation had occurred. The court entered a preliminary injunction
sua sponte requiring Microsoft not to condition the licensing of Windows 95 or
- ----------
any successor desktop operating system on a computer manufacturer also licensing
any Microsoft browser software, including Internet Explorer 3.0 or 4.0. In the
second order, the court appointed Harvard Law Professor Lawrence Lessig as a
special master, to whom the court delegated the authority to conduct discovery,
take evidence, and make proposed findings of fact and conclusions of law on all
issues in the case by May 31, 1998.
Microsoft immediately appealed the preliminary injunction to the District of
Columbia Circuit Court of Appeals. On May 5, 1998, Microsoft also sought a stay
of the District Court's injunction insofar as it applied to Windows 98. On May
12, 1998, the Court of Appeals granted Microsoft's request for a stay. The
Court of Appeals issued an opinion on Microsoft's appeal on June 23, 1998. It
unanimously reversed the trial court, both as to the entry of the injunction and
the reference to the special master. The opinion both cited procedural errors
in the issuance of the injunction and errors of substantive law in the
interpretation of the consent decree. The court remanded the case to Judge
Jackson for further proceedings consistent with the Court's opinion. There has
been no further action in that case since the Court of Appeals' decision.
Although the Court of Appeals could have reversed the district court solely on
procedural grounds, it chose to address at length the central issue in both the
consent decree case and in the new Sherman Act case brought by the DOJ and 20
state Attorneys General: whether Microsoft is unlawfully "tying" a "separate
product" known as Microsoft Internet Explorer to the Windows operating system.
Two members of the Court rejected the DOJ's main argument that Internet Explorer
constitutes a separate product because Microsoft treats it separately in some
circumstances. (One judge dissented in part from the reasoning in this part of
the opinion.) The Court's discussion of antitrust tying law, although made in
the context of the consent decree case, clearly provides guidance on many of the
issues raised in the new Sherman Act case.
On May 18, 1998, the DOJ and a group of 20 state Attorneys General filed two
antitrust cases against Microsoft in the U.S. District Court for the District of
Columbia. The DOJ complaint alleges violations of Sections 1 and 2 of the
Sherman Act. The DOJ complaint seeks declaratory relief as to the violations it
asserts and preliminary and permanent injunctive relief regarding: the inclusion
of Internet browsing software (or other software products) as part of Windows;
the terms of agreements regarding non-Microsoft Internet browsing software (or
other software products); taking or threatening "action adverse" in consequence
of a person's failure to license or distribute Microsoft Internet browsing
software (or other software product) or distributing competing
12
products or cooperating with the government; and restrictions on the screens,
boot-up sequence, or functions of Microsoft's operating system products. The
state Attorneys General allege largely the same claims, and various pendent
state claims. The states seek declaratory relief, and preliminary and permanent
injunctive relief similar to that sought by the DOJ, together with statutory
penalties under the state law claims. The foregoing description is qualified in
its entirety by reference to the full text of the complaints and other papers on
file in those actions, case numbers 98-1232 and 98-1233.
On May 22, 1998, Judge Jackson consolidated the two actions. Hearings for the
plaintiffs' motion for a preliminary injunction, Microsoft's motion for summary
judgment, and a trial on the merits are scheduled to begin in September 1998.
Microsoft believes that the claims are without merit and intends to defend
against them vigorously. In other ongoing investigations, the DOJ and several
state Attorneys General have requested information from Microsoft concerning
various issues.
Caldera, Inc. filed a lawsuit against Microsoft in July 1996. It alleges
Sherman Act violations relating to Microsoft licensing practices of MS-DOS and
Windows in the late 80's and early 90's--essentially the same complaints that
resulted in the 1994 consent decree. Caldera claims to own the rights of
Novell, Inc. and Digital Research Inc. relating to DR-DOS and Novell DOS
products. It also asserts a claim that Windows 95 is a technological tie of
Windows and MS-DOS. Fact discovery is scheduled to end in October 1998, and
trial is scheduled for June 1999. Microsoft is vigorously defending the case.
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.
GEOGRAPHIC INFORMATION
Year Ended June 30 1996 1997 1998
- -------------------------------------------------------------------------
REVENUE
U.S. operations $ 6,739 $ 8,877 $11,331
European operations 2,215 2,770 3,719
Other international operations 1,267 1,757 1,776
Eliminations (1,550) (2,046) (2,342)
- -------------------------------------------------------------------------
Total revenue $ 8,671 $11,358 $14,484
- -------------------------------------------------------------------------
OPERATING INCOME
U.S. operations $ 2,118 $ 3,474 $ 4,591
European operations 649 1,013 1,470
Other international operations 297 469 423
Eliminations (5) (85) (70)
- -------------------------------------------------------------------------
Total operating income $ 3,059 $ 4,871 $ 6,414
- -------------------------------------------------------------------------
IDENTIFIABLE ASSETS
U.S. operations $ 8,193 $11,630 $18,294
European operations 2,280 3,395 5,052
Other international operations 1,042 705 1,113
Eliminations (1,422) (1,343) (2,102)
- -------------------------------------------------------------------------
Total identifiable assets $10,093 $14,387 $22,357
- -------------------------------------------------------------------------
Intercompany sales between geographic areas are accounted for at prices
representative of unaffiliated party transactions. "U.S. operations" include
shipments to customers in the United States, licensing to OEMs, and exports of
finished goods directly to international customers, primarily in Asia, South
America, and Canada. Exports and international OEM transactions are primarily
in U.S. dollars and totaled $2.1 billion, $2.3 billion, and $2.9 billion in
1996, 1997, and 1998.
"Other international operations" primarily include subsidiaries in Japan,
Canada, Australia, and Brazil. International revenue, which includes European
operations, other international operations, exports, and OEM distribution, was
56%, 56%, and 53% of total revenue in 1996, 1997, and 1998. Most international
identifiable assets are U.S. dollar denominated investment securities.
13
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
We have audited the accompanying balance sheets of Microsoft Corporation and
subsidiaries as of June 30, 1997 and 1998, and the related statements of income,
cash flows, and stockholders' equity for each of the three years ended June 30,
1998. 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 generally accepted auditing
standards. 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 financial statements present fairly, in all material
respects, the financial position of Microsoft Corporation and subsidiaries as of
June 30, 1997 and 1998, and the results of their operations and their cash flows
for each of the three years ended June 30, 1998 in conformity with generally
accepted accounting principles.
/s/ DELOITTE & TOUCHE LLP
DELOITTE & TOUCHE LLP
Seattle, Washington
July 16, 1998
(August 3, 1998 as to Subsequent Sale Note)
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