Certain statements in Management's Discussion and Analysis ("MD&A"), other than purely historical information, including estimates, projections, statements relating to our business plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words "believe," "project," "expect," "anticipate," "estimate," "intend," "strategy," "plan," "may," "should," "will," "would," "will be," "will continue," "will likely result," and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled "Risk Factors" (refer to Part II, Item 1A). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise.

The following MD&A is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial statements ("Notes").

We develop, manufacture, license, and support a wide range of software products for many computing devices. Our software products include operating systems for servers, PCs, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; and software development tools. We provide consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, the Zune digital music and entertainment device, PC games, and PC peripherals. Online communication and information services are delivered through our MSN portals, channels around the world, and through our search products.

Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated over 40% of its yearly segment revenues in our second fiscal quarter. In fiscal year 2007, our revenue was highest in the third quarter due to the recognition of $1.7 billion of revenue previously deferred from the Express Upgrade to Windows Vista and Microsoft Office Technology Guarantee programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system. The technology guarantee programs provided customers who purchased current products with free or discounted rights to Windows Vista and the 2007 Microsoft Office system when those products became available to consumers. We believe the seasonality of revenue is likely to continue in the future consistent with our experience prior to fiscal year 2007.

All growth and percentage comparisons refer to the three or six months ended December 31, 2007, as compared with the three or six months ended December 31, 2006, unless otherwise noted.

Summary



                                    Three months ended                         Six months ended
(In millions, except per share         December 31,          Percentage          December 31,         Percentage
amounts and percentages)             2007          2006        Change          2007         2006        Change
Revenue                           $    16,367    $ 12,542            30 %    $  30,129    $ 23,353            29 %
Operating income                  $     6,481    $  3,472            87 %    $  12,399    $  7,946            56 %
Diluted earnings per share        $      0.50    $   0.26            92 %    $    0.95    $   0.61            56 %

For the three and six months ended December 31, 2007, revenue growth was impacted by the deferral of revenue during the first half of fiscal year 2007 from the Express Upgrade to Windows Vista and Microsoft Office Technology Guarantee programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system. Revenue growth for the three months ended December 31, 2007 was driven primarily by licensing of Windows Vista and the 2007 Microsoft Office system, which were made available to consumers in January 2007, and increased revenue associated with Windows Server and SQL Server. Revenue growth for the six months ended December 31, 2007 was driven primarily by licensing of Windows Vista and the 2007 Microsoft Office system, increased Xbox console and game sales, and increased revenue associated with Windows Server and SQL Server. Revenue from licensing of Windows Vista and the 2007 Microsoft Office system reflects growth in our OEM channel and growth from volume licensing. Foreign currency exchange rates accounted for a $410 million or three percentage point increase in revenue during the three months and a $615 million or three percentage point increase during the six months ended December 31, 2007.

Operating income growth for the three months ended December 31, 2007 was driven primarily by the increased revenue, partially offset by increased headcount-related expenses, increased sales and marketing expenses, and increased costs for legal settlements and legal contingencies. During the quarter, we incurred $237 million in legal charges as compared with $111 million in legal charges during the three months ended December 31, 2006. Operating income growth for the six months ended December 31, 2007 was driven primarily by the increased revenue, partially offset by increased cost of revenue, increased headcount-related expenses, and increased sales and marketing expenses. Total headcount-related expenses increased 13% during the three months and 10% during the six months ended December 31, 2007, driven by a 12% increase in headcount over the past twelve months and an increase in salaries and benefits for existing headcount, partially offset by decreased stock-based compensation expense.

Worldwide macroeconomic factors have a strong correlation to business and consumer demand for our software, services, games, and Internet service offerings. While we are monitoring the changing economic conditions, we continue to expect double-digit revenue growth. We estimate worldwide PC shipments will grow 11% to 13%. We expect a continued favorable impact from changes in year-over-year foreign currency exchange rates in fiscal year 2008. We expect our operating income growth rate to continue to exceed our revenue growth rate in fiscal year 2008.

SEGMENT PRODUCT REVENUE/OPERATING INCOME/(LOSS)

Revenue and operating income/(loss) amounts in this section are presented on a basis consistent with U.S. GAAP and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 9 - Segment Information is presented on a basis consistent with our current internal management reporting, in accordance with Statement of Financial Accounting Standards ("SFAS") No. 131, Disclosures about Segments of an Enterprise and Related Information. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. Prior period amounts have been recast to conform to the way we internally manage and monitor performance at the segment level in fiscal year 2008.

Client



                                Three months ended                           Six months ended
                                   December 31,                                December 31,
(In millions, except                                      Percentage                                 Percentage
percentages)                     2007          2006         Change           2007         2006         Change
Revenue                       $    4,335     $  2,586             68 %    $    8,473     $ 5,893             44 %
Operating income              $    3,358     $  1,838             83 %    $    6,727     $ 4,485             50 %

Client offerings consist of premium edition and standard Windows operating systems. Premium offerings are those that include additional functionality and are sold at a price above our standard versions. Premium offerings include Windows XP Professional, XP Media Center Edition, XP Tablet PC Edition, Vista Business, Vista Home Premium, Vista Ultimate, and Vista Enterprise. Standard Windows operating systems include Windows XP Home and Windows Vista Home Basic. Client revenue growth correlates with the growth of purchases of PCs from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for approximately 80% of total Client revenue. The differences between unit growth rates and revenue growth rates from year to year are affected by changes in the mix of OEM Windows operating systems licensed with premium edition operating systems as a percentage of total OEM Windows operating systems licensed ("OEM premium mix"), changes in the geographical mix, and changes in the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders.

Client revenue increased during the three and six months ended December 31, 2007, primarily reflecting licensing of Windows Vista. During the second quarter of fiscal year 2007, we deferred approximately $1.1 billion of revenue and during the first half of fiscal year 2007, we deferred approximately $1.2 billion of revenue pending the January 2007 release of Windows Vista to consumers. During the three months ended December 31, 2007, OEM revenue increased $1.7 billion or 80% driven by 18% growth in OEM license units. During the six months ended December 31, 2007, OEM revenue increased $2.4 billion or 48%, driven by 19% growth in OEM license units. Revenue from commercial and retail licensing of Windows operating systems increased $92 million or 18% during the three months and $218 million or 21% during the six months ended December 31, 2007, primarily due to strong sales from Enterprise Agreements and anti-piracy efforts in Russia, China, and other emerging markets. The OEM premium mix increased eight percentage points to 75% compared with the second quarter of last year and 12 percentage points to 75% compared to the first half of last year, driven by increased consumer premium mix. Based on our estimates, total worldwide PC shipments from all sources grew 14% to 16% from the second quarter of the previous year and 13% to 15% from the first half of the previous year driven by demand in both emerging and mature markets.

Client operating income increased during the three and six months ended December 31, 2007, reflecting the increased revenue, partially offset by increased cost of revenue and increased sales and marketing expenses. Cost of revenue increased $89 million or 54% during the three months and $193 million or 70% during the six months ended December 31, 2007, driven by Windows Vista product costs. Sales and marketing expenses increased $78 million or 22% during the three months and $157 million or 27% during the six months ended December 31, 2007, primarily reflecting increased headcount-related expenses associated with our corporate sales force. Headcount-related expenses increased 38% during the three months and 4% during the six months ended December 31, 2007.

For the remainder of fiscal year 2008, we expect continued strength in OEM revenue growth, in line with strength in the PC market. We expect PC shipments to grow 11% to 13% for fiscal year 2008. We believe that PC unit growth rates will be higher in the consumer segment than in the business segment and higher in emerging markets than in mature markets.

Server and Tools



                              Three months ended                            Six months ended
                                 December 31,                                 December 31,
(In millions, except                                    Percentage                                  Percentage
percentages)                  2007          2006          Change            2007         2006         Change
Revenue                    $    3,278     $   2,843             15 %     $    6,178     $ 5,339             16 %
Operating income           $    1,172     $     981             19 %     $    2,132     $ 1,751             22 %

Server and Tools offerings consist of server software licenses and client access licenses ("CAL") for Windows Server, Microsoft SQL Server, and other server products. It also includes developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. Server and Tools concentrates on licensing products, applications, tools, content, and services that make information technology professionals and developers more productive and efficient. We use multiple channels for licensing, including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. We sell licenses both as one-time licenses and as multi-year volume licenses.

Server and Tools revenue increased during the three and six months ended December 31, 2007, reflecting growth in both product and services revenue. Server and server application revenue (including CAL revenue) and developer tools, training, and certificate revenue increased $289 million or 12% during the three months and $551 million or 13% during the six months ended December 31, 2007, primarily driven by growth in new and recurring volume licensing of Windows Server and SQL Server products and reflects broad adoption of the Windows Platform and applications. Consulting, Premier and Professional product support services revenue increased $146 million or 28% during the three months and $288 million or 30% during the six months ended December 31, 2007, primarily due to higher demand for consulting and support services in corporate enterprises. Foreign currency exchange rates accounted for a $111 million or four percentage point increase in revenue for the three months and $177 million or four percentage point increase in revenue for the six months ended December 31, 2007.

Server and Tools operating income increased for the three and six months ended December 31, 2007, primarily reflecting the increased revenue, partially offset by increased sales and marketing expenses and cost of revenue for services. Sales and marketing expenses increased $102 million or 12% during the three months and $235 million or 15% during the six months ended December 31, 2007, primarily reflecting increased headcount-related expenses associated with our corporate sales force. Cost of revenue increased $93 million or 18% during the three months and $169 million or 16% during the six months ended December 31, 2007, reflecting the growth in services provided. Headcount-related expenses increased 9% during the three months and 6% during the six months ended December 31, 2007, driven by an 11% increase in headcount over the past twelve months and an increase in salaries and benefits for existing headcount, partially offset by decreased stock-based compensation expense.

For the remainder of fiscal year 2008, we expect continued growth in both product and services revenue. We expect product revenue growth from platform adoption through new and renewal volume licensing growth coupled with our new product offerings.

Online Services Business




(In millions,               Three months ended                                  Six months ended
except                         December 31,               Percentage              December 31,              Percentage
percentages)              2007              2006            Change             2007            2006           Change
Revenue                 $     863        $      625               38 %      $    1,534          1,161               32 %
Operating loss          $    (245 )      $     (118 )           (108 )%     $     (510 )         (236 )           (116 )%

Online Services Business ("OSB") provides personal communications services, such as e-mail and instant messaging, online information offerings, such as Live Search, and the MSN portals and channels around the

world. OSB also provides a variety of online services such as MSN Internet Access and MSN Premium Web Services. We earn revenue primarily from online advertising, including search, home page, email, and messaging services, from consumers and partners through subscriptions and transactions generated from online paid services, and from MSN narrowband Internet access subscribers. We continue to launch new online initiatives and expect to do so in the future. During the first quarter of fiscal year 2008, we launched a new release of Windows Live Search, and during the second quarter of fiscal year 2008, we launched the Windows Live suite of applications and services.

During the first quarter of fiscal year 2008, we completed our acquisition of aQuantive, Inc. ("aQuantive"), a digital marketing business which we expect will play a key role in the future development of our advertising business. aQuantive earns revenue from online advertising and from digital marketing and advertising agency services. We believe the acquisition will help us build and support next-generation advertiser and publisher solutions in environments such as cross-media planning, video-on-demand, and internet protocol television. aQuantive was consolidated into our results of operations starting August 10, 2007, the acquisition date.

OSB revenue increased during the three and six months ended December 31, 2007 driven primarily by increased online advertising revenue and the inclusion of aQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased $170 million or 38% to $623 million during the three months and $286 million or 35% to $1.1 billion during the six months ended December 31, 2007. This increase reflects growth in our existing online advertising business and includes aQuantive online advertising revenue of $52 million during the three months and $81 million during the six months ended December 31, 2007. Agency revenue, which is solely derived from aQuantive, was $102 million during the three months and $153 million during the six months ended December 31, 2007. Access revenue was $67 million for the three months and $137 million for the six months ended December 31, 2007, reflecting decreases of 26% and 29%, respectively. As of December 31, 2007, we had approximately 427 million Windows Live IDs compared with 352 million as of the same period last year.

OSB operating loss increased during the three and six months ended December 31, 2007 driven primarily by increased cost of revenue and increased sales and marketing expenses, partially offset by the increased revenue. OSB operating loss for the quarter ended December 31, 2007 included $46 million of amortization of intangible assets acquired from aQuantive, and OSB operating loss for the six months ended December 31, 2007 includes $76 million of intangible assets amortization and a $24 million in-process research and development write-off. Cost of revenue increased $218 million or 82% during the three months and $369 million or 73% during the six months ended December 31, 2007 primarily driven by increased data center costs, online content expenses, and aQuantive-related expenses. Sales and marketing expenses increased $92 million or 43% during the three months and $161 million or 43% during the six months ended December 31, 2007, primarily due to increased marketing costs and amortization of customer-related intangible assets. Headcount-related expenses increased 23% during the three months and 15% during the six months ended December 31, 2007, driven by a 22% increase in headcount over the past twelve months and an increase in salaries and benefits for existing headcount.

For the remainder of fiscal year 2008, we expect continued growth in online advertising revenue as the portals, channels, and communications services continue to expand globally and the overall Internet advertising market continues to expand. Online advertising revenue is expected to benefit from our acquisition of aQuantive while revenue from narrowband Internet Access is expected to continue to decline. For the remainder of fiscal year 2008, we expect operating expenses to increase as we continue to invest in our long-term strategy. We believe these investments will lay the groundwork for future growth.

Microsoft Business Division



                                          Three months ended                              Six months ended
                                             December 31,             Percentage            December 31,            Percentage
(In millions, except percentages)         2007           2006           Change            2007          2006          Change
Revenue                                $    4,811      $   3,513              37 %     $    8,922      $ 6,941              29 %
Operating income                       $    3,185      $   2,152              48 %     $    5,879      $ 4,391              34 %

Microsoft Business Division ("MBD") offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office system offerings, which generate over 90% of MBD revenue, depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as enterprise content management, collaboration, unified communications, and business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. We evaluate our results based upon the nature of the end user in two primary parts: business revenue which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue.

MBD revenue increased during the three and six months ended December 31, 2007, primarily reflecting licensing of the 2007 Microsoft Office system and the fiscal year 2007 second quarter revenue deferral of approximately $500 million as a result of the Microsoft Office Technology Guarantee program. Business revenue increased $706 million or 23% during the three months and $1.4 billion or 24% during the six months ended December 31, 2007, primarily as a result of growth in volume licensing agreement revenue and strong transactional license sales to businesses. The increase in business revenue also included a 26% increase in Microsoft Dynamics customer billings during the three months and a 24% increase during the six months ended December 31, 2007. Consumer revenue increased $592 million or 153% during the three months and $620 million or 53% during the six months ended December 31, 2007, primarily reflecting the technology guarantee deferral of approximately $500 million discussed above. Foreign currency exchange rates accounted for a $170 million or five percentage point increase in revenue during the three months and a $263 million or four percentage point increase in revenue during the six months ended December 31, 2007.

MBD operating income increased for the three and six months ended December 31, 2007, reflecting the increased revenue, partially offset by increased sales and marketing expenses, cost of revenue, and research and development expenses. Sales and marketing expenses increased $159 million or 19% during the three months and $312 million or 20% during the six months ended December 31, 2007, primarily reflecting increased headcount-related expenses associated with our corporate sales force. Cost of revenue increased $47 million or 26% during the three months and $97 million or 28% during the six months ended December 31, 2007, primarily driven by an increase in online costs reflecting the April 2007 acquisition of Tellme Networks. Research and development expenses increased $52 million or 17% during the three months and $74 million or 12% during the six months ended December 31, 2007, primarily reflecting increased headcount-related expenses. Headcount-related expenses increased 9% during the three months and 4% during the six months ended December 31, 2007, driven by a 6% increase in headcount over the past twelve months and an increase in salaries and benefits for existing headcount, partially offset by decreased stock-based compensation expense.

For the remainder of fiscal year 2008, we expect revenue to continue to increase over the prior year due to the strong performance of the 2007 Microsoft Office system. We continue to develop plans to grow revenue in new areas such as unified communications and through our existing portfolio of Microsoft Dynamics products.

Entertainment and Devices Division



                               Three months ended                              Six months ended
                                  December 31,                                   December 31,
(In millions, except                                       Percentage                                    Percentage
percentages)                   2007          2006            Change            2007         2006           Change
Revenue                     $    3,060     $   2,969                3 %     $    4,989     $ 3,980               25 %
Operating income/(loss)     $      357     $    (302 )              *       $      524     $  (423 )              *

The Entertainment and Devices Division ("EDD") products include the Xbox 360 platform (which includes the Microsoft Xbox video game console system, Xbox 360 video games, Xbox Live, and Xbox 360 accessories), PC games, consumer software . . .