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 nine months ended March 31, 2008, as compared with the three or nine months ended March 31, 2007, unless otherwise noted.

Proposed Acquisition of Yahoo! Inc.

On January 31, 2008, we made a proposal to the Yahoo! Inc. ("Yahoo") board of directors to acquire all the outstanding shares of Yahoo common stock for consideration of $31 per Yahoo share, representing a total value of approximately $44.6 billion at the time of the offer. Our proposal would allow the Yahoo shareholders to elect to receive cash or 0.9509 of a share of Microsoft common stock for each of their shares of Yahoo common stock, subject to proration so that in the aggregate, one-half of the outstanding shares of Yahoo common stock would be exchanged for shares of Microsoft common stock and the other half would be exchanged for cash. On February 11, 2008, the Yahoo board of directors stated publicly that our offer undervalued the company and was not in the best interests of its shareholders. There are no assurances that any acquisition will be completed.

Summary



                                   Three Months Ended                       Nine Months Ended
(In millions, except per share         March 31,          Percentage            March 31,         Percentage
amounts and percentages)            2008         2007       Change           2008        2007       Change
Revenue                          $    14,454   $ 14,398           -  %    $   44,583   $ 37,751           18 %
Operating income                 $     4,409   $  6,589          (33 )%   $   16,808   $ 14,535           16 %
Diluted earnings per share       $      0.47   $   0.50           (6 )%   $     1.41   $   1.11           27 %

Revenue growth for the three months ended March 31, 2008 was driven primarily by increased Xbox platform sales, increased Windows Server and SQL Server revenue, and increased online advertising revenue, offset by decreased licensing revenue from Windows Vista and the 2007 Microsoft Office system. During the three months ended March 31, 2007, we recognized approximately $1.7 billion of revenue deferred during the first half of fiscal year 2007 related to 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 nine months ended March 31, 2008 was driven primarily by licensing of the 2007 Microsoft Office system, increased Xbox platform sales, increased revenue associated with Windows Server and SQL Server, and increased licensing of Windows Vista. Foreign currency exchange rates accounted for a $403 million or three percentage point increase in revenue during the three months and a $1.0 billion or three percentage point increase during the nine months ended March 31, 2008.

Operating income declined during the three months ended March 31, 2008, driven primarily by increased costs for legal settlements and legal contingencies, increased headcount-related expenses, and increased cost of revenue (data center and online costs, costs associated with the growth in consulting services, and Xbox 360 product costs reflecting increased Xbox 360 console sales, partially offset by decreased Xbox 360 manufacturing costs per console). Operating income growth for the nine months ended March 31, 2008 was primarily driven by the increased revenue, partially offset by increased costs for legal settlements and legal contingencies, increased cost of revenue (reflecting the items noted above and increased Windows Vista product costs), and increased headcount-related expenses. We incurred $1.5 billion of legal charges during the three months and $1.8 billion during the nine months ended March 31, 2008, primarily related to the European Commission fine of €899 million as compared with $296 million of legal charges during the three months and $494 million during the nine months ended March 31, 2007, primarily related to antitrust and unfair competition consumer class actions and intellectual property claims. Total headcount-related expenses increased 14% during the three months and 11% during the nine months ended March 31, 2008, driven by a 13% increase in headcount over the past 12 months and an increase in salaries and benefits for existing headcount.

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

SEGMENT PRODUCT REVENUE/OPERATING INCOME/(LOSS)

Revenue and operating income/(loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the United States of America ("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 during the current period.

Client



                                      Three Months Ended                       Nine Months Ended
                                          March 31,          Percentage            March 31,         Percentage
(In millions, except percentages)      2008         2007       Change           2008        2007       Change
Revenue                             $    4,025    $  5,274          (24 )%   $   12,498   $ 11,167           12 %
Operating income                    $    3,097    $  4,204          (26 )%   $    9,824   $  8,689           13 %

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, Windows XP Media Center Edition, Windows XP Tablet PC Edition, Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, and Windows 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 decreased during the three months ended March 31, 2008, primarily reflecting revenue of approximately $1.2 billion recognized during the third quarter of the prior fiscal year upon the January 2007 release of Windows Vista to consumers. The amount had been deferred during the first half of fiscal year 2007 as a result of the Express Upgrade to Windows Vista Technology Guarantee program. Client revenue increased during the nine months ended March 31, 2008, primarily reflecting licensing of Windows Vista. During the three months ended March 31, 2008, OEM revenue decreased $1.1 billion or 25%, primarily reflecting revenue recognized during the third quarter of fiscal year 2007 related to the technology guarantee program, partially offset by a 5% increase in OEM license units. During the nine months ended March 31, 2008, OEM revenue increased $1.3 billion or 14%, driven by 14% growth in OEM license units. Revenue from commercial and retail licensing of Windows operating systems decreased $146 million or 18% during the three months ended March 31, 2008, primarily reflecting revenue recognized during the third quarter of the prior year related to the January 2007 consumer launch of Windows Vista. Revenue from commercial and retail licensing of Windows operating systems increased $71 million or 4% during the nine months ended March 31, 2008, primarily due to sales from Enterprise Agreements and anti-piracy efforts in emerging markets. The OEM premium mix increased five percentage points to 76% compared with the third quarter of last year and nine percentage points to 75% compared with the first nine months of last year, driven by increased consumer premium mix. Based on our estimates, total worldwide PC shipments from all sources grew 8% to 10% from the third quarter of the previous year and 12% to 14% from the first nine months of the previous year driven by demand in both emerging and mature markets.

Client operating income decreased during the three months ended March 31, 2008, reflecting the decreased revenue, partially offset by decreased sales and marketing expenses and decreased cost of revenue. Client operating income increased during the nine months ended March 31, 2008, reflecting the increased revenue, partially offset by increased cost of revenue. Sales and marketing expenses decreased $111 million or 21% during the three months, driven by decreased global advertising. Cost of revenue decreased $31 million or 11% during the three months, reflecting higher support services related to commercial and retail licensing during the third quarter of the prior fiscal year for the Windows Vista launch, and increased $162 million or 30% during the nine months, driven by Windows Vista product costs. Headcount-related expenses decreased 7% during the three months and were flat during the nine months ended March 31, 2008, driven by a 2% decrease in headcount over the past 12 months and decreased stock-based compensation expense.

For the fourth quarter of fiscal year 2008, we expect PC market growth will exceed OEM revenue growth. 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                       Nine Months Ended
                                           March 31,          Percentage           March 31,         Percentage
(In millions, except percentages)      2008         2007        Change          2008        2007       Change
Revenue                             $    3,255    $   2,748           18 %   $    9,433    $ 8,087           17 %
Operating income                    $    1,092    $     911           20 %   $    3,220    $ 2,656           21 %

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 nine months ended March 31, 2008, reflecting growth in both product and services revenue. Server and server application revenue (including CAL revenue) and developer tools, training, and certificate revenue increased $381 million or 17% during the three months and $932 million or 14% during the nine months ended March 31, 2008, primarily driven by growth in new and recurring volume licensing of Windows Server and SQL Server products, reflecting broad adoption of the Windows Platform and applications. Consulting and Premier and Professional product support services revenue increased $126 million or 24% during the three months and $414 million or 28% during the nine months ended March 31, 2008, primarily due to higher demand for consulting and support services in corporate enterprises. Foreign currency exchange rates accounted for a $120 million or four percentage point increase in revenue for the three months and $296 million or four percentage point increase in revenue for the nine months ended March 31, 2008.

Server and Tools operating income increased for the three and nine months ended March 31, 2008, primarily reflecting the increased revenue, partially offset by increased sales and marketing expenses, cost of revenue for services, and research and development expenses. Sales and marketing expenses increased $165 million or 20% during the three months and $397 million or 16% during the nine months ended March 31, 2008, primarily reflecting increased headcount-related expenses associated with our corporate sales force. Cost of revenue increased $92 million or 17% during the three months and $261 million or 16% during the nine months ended March 31, 2008, reflecting the growth in services provided. Research and development expenses increased $71 million or 17% during the three months and $136 million or 11% during the nine months ended March 31, 2008, primarily driven by increased headcount-related expenses. Headcount-related expenses increased 8%

during the three months and 7% during the nine months ended March 31, 2008, driven by a 10% increase in headcount over the past 12 months and an increase in salaries and benefits for existing headcount, partially offset by decreased stock-based compensation expense.

For the fourth quarter 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

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 fiscal year 2008, we launched a new release of Windows Live Search and 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 nine months ended March 31, 2008, driven primarily by increased online advertising revenue and the inclusion of aQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased $175 million or 39% to $619 million during the three months and $460 million or 36% to $1.7 billion during the nine months ended March 31, 2008. This increase reflects growth in our existing online advertising business and includes aQuantive online advertising revenue of $47 million during the three months and $128 million during the nine months ended March 31, 2008. Agency revenue, which is solely derived from aQuantive, was $97 million during the three months and $251 million during the nine months ended March 31, 2008. Access revenue was $60 million for the three months and $197 million for the nine months ended March 31, 2008, reflecting decreases of 29% for both periods. As of March 31, 2008, we had 448 million Windows Live IDs compared with 380 million as of the same period last year.

OSB operating loss increased during the three and nine months ended March 31, 2008, driven primarily by increased cost of revenue and increased sales and marketing expenses, partially offset by increased revenue. Cost of revenue increased $176 million or 61% during the three months and $545 million or 68% during the nine months ended March 31, 2008, primarily driven by increased data center costs, online content expenses, and aQuantive-related expenses. Sales and marketing expenses increased $69 million or 33% during the three months and $231 million or 39% during the nine months ended March 31, 2008, primarily due to increased marketing costs and amortization of customer-related intangible assets. OSB operating loss for the three months ended March 31, 2008 included $46 million of amortization of intangible assets acquired from aQuantive, and OSB operating loss for the nine months ended March 31, 2008 included $122 million of intangible assets amortization

and a $24 million in-process research and development write-off.
Headcount-related expenses increased 27% during the three months and 19% during the nine months ended March 31, 2008, driven by a 26% increase in headcount over the past 12 months and an increase in salaries and benefits for existing headcount, partially offset by decreased stock-based compensation expense.

For the fourth quarter of fiscal year 2008, online advertising revenue is expected to benefit from our acquisition of aQuantive, while revenue from narrowband Internet Access is expected to continue to decline. We also 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                               Nine Months Ended
                                               March 31,              Percentage               March 31,              Percentage
(In millions, except percentages)         2008           2007           Change             2008           2007          Change
Revenue                                $    4,745      $   4,827              (2 )%     $   13,668      $ 11,768              16 %
Operating income                       $    3,138      $   3,399              (8 )%     $    9,017      $  7,794              16 %

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 decreased during the three months ended March 31, 2008, primarily reflecting revenue of approximately $500 million recognized during the third quarter of the prior fiscal year upon the January 2007 release of the 2007 Microsoft Office system to consumers. The amount had been deferred during the first half of fiscal year 2007, as a result of the Microsoft Office Technology Guarantee program. MBD revenue increased during the nine months ended March 31, 2008, primarily reflecting licensing of the 2007 Microsoft Office system. Business revenue increased $555 million or 17% during the three months and $1.9 billion or 21% during the nine months ended March 31, 2008, 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 13% increase in Microsoft Dynamics customer billings during the three months and a 20% increase during the nine months ended March 31, 2008. Consumer revenue decreased $636 million or 39% primarily reflecting revenue of approximately $500 million recognized during the third quarter related to the 2007 Microsoft Office Technology Guarantee program and remained flat during the nine months ended March 31, 2008, primarily reflecting the consumer launch of the 2007 Microsoft Office system in the prior fiscal year. Foreign currency exchange rates accounted for a $194 million or four percentage point increase in revenue during the three months and a $458 million or four percentage point increase in revenue during the nine months ended March 31, 2008.

MBD operating income decreased for the three months ended March 31, 2008, reflecting the decreased revenue, increased sales and marketing expenses, research and development expenses, and cost of revenue. MBD operating income increased for the nine months ended March 31, 2008, 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 $72 million or 8% during the three months and $386 million or 16% during

the nine months ended March 31, 2008, primarily reflecting increased . . .