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 Management's Discussion and Analysis ("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 generate revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for personal computers, servers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and video games. We provide consulting and product support services, and we train and certify computer system integrators and developers. We also design and sell hardware including the Xbox 360 video game console, the Zune digital music and entertainment device, and peripherals. Online offerings and information are delivered through Live Search, Windows Live, Office Live, our MSN portals and channels, and the Microsoft Online Services platform which includes offerings for businesses such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on Live Search through our proprietary adCenter® platform.

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.

All growth and percentage comparisons refer to the three months ended September 30, 2008, as compared with the three months ended September 30, 2007, unless otherwise noted.

Summary



                                                            Three Months Ended
                                                              September 30,        Percentage
(In millions, except per share amounts and percentages)      2008         2007       Change
Revenue                                                   $    15,061   $ 13,762            9 %
Operating income                                          $     5,999   $  5,849            3 %
Diluted earnings per share                                $      0.48   $   0.45            7 %

Revenue growth was driven primarily by increased licensing of the 2007 Microsoft Office system and increased revenue associated with Windows Server and SQL Server. Foreign currency exchange rates accounted for a $439 million or three percentage point increase in revenue during the three months ended September 30, 2008.

Operating income increased primarily reflecting increased revenue, partially offset by increased headcount-related expenses and increased cost of revenue. Headcount-related expenses increased 22%, reflecting a 14% increase in headcount during the past 12 months and an increase in salaries and benefits for existing headcount. Cost of revenue increased $173 million or 6%, reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 manufacturing costs.

Diluted earnings per share growth was impacted favorably by share repurchases.

Demand for our software, services, hardware, and online offerings are correlated with global macroeconomic factors. For the remainder of fiscal year 2009, we expect the economic conditions experienced during the first quarter to broadly continue. We are monitoring economic conditions and have three major areas of focus: continuing to provide high value products at the lowest total cost of ownership, increasing focus on our expense management, and prioritizing our investment dollars in key strategic opportunities to enable us to manage our business for the long term.

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 15 - 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 managed and monitored performance at the segment level during the current period.

Client



                                             Three Months Ended
                                               September 30,        Percentage
       (In millions, except percentages)      2008         2007       Change
       Revenue                             $    4,218    $  4,139            2 %
       Operating income                    $    3,267    $  3,388           (4 )%

Client offerings consist of premium and standard edition Windows operating systems. Premium editions are those that include additional functionality and are sold at a price above our standard editions. Premium editions include Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, Windows Vista

Enterprise, Windows XP Professional, Windows XP Media Center Edition, and Windows XP Tablet PC Edition. Standard editions include Windows Vista Home Basic and Windows XP Home. Client revenue growth generally correlates with the growth of PC purchases from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 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 geographic 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 reflecting growth in licensing of Windows Vista. Revenue from commercial and retail licensing of Windows operating systems increased $125 million or 22%. OEM revenue decreased $46 million or 1% while OEM license units increased 8%. The decline in OEM revenue reflected the four percentage point decrease in the OEM premium mix to 71% as well as changes in the geographic and product mixes. Based on our estimates, total worldwide PC shipments from all sources grew 10% to 12%, driven by demand in both emerging and mature markets.

Client operating income decreased reflecting increased sales and marketing expenses, research and development expenses, and cost of revenue, partially offset by increased revenue. Sales and marketing expenses increased $123 million or 43%, primarily reflecting increased advertising and marketing campaigns. Research and development expenses increased $45 million or 20% as a result of increased headcount-related expenses. Cost of revenue increased $31 million or 14%, primarily driven by product and services costs.

For the remainder of fiscal year 2009, we expect PC shipments will grow between 8% and 12%. Within the overall PC market, we expect current trends to continue.

Server and Tools



                                              Three Months ended
                                                September 30,        Percentage
        (In millions, except percentages)      2008         2007       Change
        Revenue                             $    3,406    $  2,900           17 %
        Operating income                    $    1,151    $    959           20 %

Server and Tools concentrates on licensing products, applications, tools, content, and services that are designed to make information technology professionals and developers more productive and efficient. Server and Tools offerings consist of server software licenses and client access licenses ("CAL") for Windows Server, Microsoft SQL Server, and other server products. We also offer developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. Server products can be run on-site, in a hosted environment, or in a Web-based environment. 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 reflecting growth in product and services revenue and included a favorable impact from foreign currency exchange rates of $130 million or four percentage points. Server and server application revenue (including CAL revenue) and developer tools revenue increased $395 million or 17%, primarily driven by growth in volume licensing of Windows Server and SQL Server products. This growth reflects continued broad adoption of the Windows Platform and applications with the releases of Windows Server 2008 during the second half of fiscal year 2008 and the release of SQL Server 2008 during the first quarter of fiscal year 2009. Consulting and Premier and Professional product support services revenue increased $111 million or 19%, primarily due to higher demand for consulting and support services by corporate enterprises.

Server and Tools operating income increased, primarily due to growth in high-margin product revenue, partially offset by increased cost of revenue, research and development expenses, and sales and marketing expenses. Cost of revenue increased $119 million or 20%, reflecting the growth in consulting and Premier and Professional product support services delivered. Research and development expenses increased $93 million or 22%, primarily driven by increased headcount-related expenses. Sales and marketing expenses increased $83 million or 10%, due to higher expenses associated with our corporate sales force.

For the remainder of fiscal year 2009, we expect continued growth in both product and services revenue driven by strong adoption of our product portfolio and the recognition of deferred revenue from previously signed agreements.

Online Services Business

Online Services Business ("OSB") consists of an on-line advertising platform with offerings for both publishers and advertisers, personal communications services such as email and instant messaging, online information offerings such as Live Search, and the MSN portals and channels around the world. We earn revenue primarily from online advertising, including search, display, and email and messaging services. Revenue is also generated through subscriptions and transactions generated from online paid services, from advertiser and publisher tools, digital marketing and advertising agency services, and from MSN narrowband Internet access subscribers. During the three months ended September 30, 2007, we completed our acquisition of aQuantive, Inc. ("aQuantive"), a digital marketing business. aQuantive was consolidated into our results of operations starting August 10, 2007, the acquisition date. Amounts during the three months ended September 30, 2008 included three months of aQuantive results whereas amounts during the three months ended September 30, 2007 included aQuantive results only from the acquisition date through the end of the quarter.

OSB revenue increased as a result of increased online advertising revenue and incremental aQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased $72 million or 15%, to $557 million. This increase reflected growth in our existing online advertising business. Agency revenue, which is solely derived from aQuantive, was $98 million during the three months ended September 30, 2008 and $51 million during the three months ended September 30, 2007. Access revenue decreased $20 million or 29%, to $50 million, reflecting continued migration of subscribers to broadband or other competitively-priced service providers.

OSB operating loss increased due to increased cost of revenue, sales and marketing expenses, and research and development expenses, partially offset by increased revenue. Cost of revenue increased $183 million or 47%, primarily driven by increased data center and equipment costs, online content expenses, and agency expenses. Sales and marketing expenses increased $54 million or 23%, and research and development expenses increased $54 million or 19%, primarily due to increased headcount-related expenses.

For the remainder of fiscal year 2009, we expect revenue to increase over the prior year as a result of investments we have made. We also expect operating expenses to increase as we continue to invest in our long-term strategy.

Microsoft Business Division



                                              Three Months Ended
                                                September 30,        Percentage
        (In millions, except percentages)      2008         2007       Change
        Revenue                             $    4,949    $  4,117           20 %
        Operating income                    $    3,311    $  2,700           23 %

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 reflecting growth in licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of $214 million or five percentage points. Business revenue increased $544 million or 16%, 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 10% increase in Microsoft Dynamics customer billings. Consumer revenue increased $288 million or 36%, reflecting increased sales primarily due to promotional pricing programs for the 2007 Microsoft Office system.

MBD operating income increased reflecting growth in revenue, partially offset by increased sales and marketing expenses, cost of revenue, and research and development expenses. Sales and marketing expenses increased $90 million or 11%, reflecting increased expenses associated with our corporate sales force. Cost of revenue increased $64 million or 30%, driven by an increase in consulting service expenses associated with the April 2008 acquisition of Fast Search & Transfer ASA ("FAST"), and online services infrastructure costs. Research and development expenses increased $56 million or 16%, primarily driven by an increase in headcount-related expenses associated with the FAST acquisition.

For the remainder of fiscal year 2009, we expect revenue to continue to increase over the prior year as sales of the 2007 Microsoft Office system continue to grow.

Entertainment and Devices Division



                                             Three Months Ended
                                               September 30,        Percentage
       (In millions, except percentages)      2008         2007       Change
       Revenue                             $    1,814    $  1,929           (6 )%
       Operating income                    $      178    $    167            7 %

Entertainment and Devices Division ("EDD") offerings include the Xbox 360 platform (which includes the Microsoft Xbox video game console system, Xbox 360 video games, Xbox Live, and Xbox 360 accessories), the Zune digital music and entertainment platform, PC software games, online games and services, Mediaroom (our Internet protocol television software), the Surface computing platform, mobile and embedded device platforms,

and other devices. EDD leads the development efforts for our line of consumer software and hardware products including application software for Apple's Macintosh computers and Microsoft PC hardware products, and is responsible for all retail sales and marketing for Microsoft Office and the Windows operating systems.

EDD revenue decreased primarily due to decreased Xbox platform and PC game revenue, partially offset by increases across other EDD product revenue. Xbox 360 platform and PC game revenue decreased $331 million or 22%, primarily as a result of the $330 million of incremental revenue from the launch of Halo 3 in the first quarter of fiscal year 2008 and decreased revenue per Xbox 360 console as a result of price reductions during the past 12 months. We shipped 2.2 million Xbox 360 consoles during the first quarter of fiscal year 2009, compared with 1.8 million Xbox 360 consoles during the first quarter of fiscal year 2008. Other EDD product revenue increased $216 million or 51%, led by increased sales of application software for Apple's Macintosh computers, the Zune digital music and entertainment platform, and mobile and embedded device platforms.

EDD operating income increased primarily due to decreased cost of revenue and sales and marketing expenses, partially offset by increased research and development expenses and decreased revenue. Cost of revenue decreased $251 million or 21%, primarily driven by decreased Xbox 360 manufacturing costs. Sales and marketing expenses decreased $27 million or 10%, reflecting a decrease in product advertising and bad debt expenses. Research and development expenses increased $145 million or 46%, primarily reflecting increased headcount-related expenses associated with the Windows Mobile device platform, driven by recent acquisitions.

For the remainder of fiscal year 2009, we expect revenue to be flat or to decrease relative to the prior fiscal year due to year-over-year variations in launches, volumes, mix, and prices across our portfolio of products and services. We expect sustained profitability for fiscal year 2009.

Corporate-Level Activity

Certain corporate-level activity is not allocated to our segments. Those results include expenses such as broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, and legal settlements and contingencies. Corporate-level expenses increased, primarily reflecting an increase in headcount-related expenses and partner payments.

OPERATING EXPENSES

Cost of Revenue



                                            Three Months Ended
                                               September 30,          Percentage
      (In millions, except percentages)      2008          2007         Change
      Cost of revenue                     $    2,848      $ 2,675              6 %
      As a percent of revenue                     19 %         19 %            -  ppt

Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, warranty costs, inventory valuation adjustments, costs associated with the delivery of consulting services, and the amortization of capitalized research and development

costs associated with software products that have reached technological feasibility. Cost of revenue increased reflecting increased data center and equipment costs, online content expenses, and costs associated with growth in our consulting services, partially offset by decreased Xbox 360 manufacturing costs.

Research and Development



                                            Three Months Ended
                                               September 30,          Percentage
      (In millions, except percentages)      2008          2007         Change
      Research and development            $    2,283      $ 1,837             24 %
      As a percent of revenue                     15 %         13 %            2  ppt

Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, the amortization of purchased software code and services content, and in-process research and development. The increase in research and development expenses was primarily driven by a 24% increase in headcount-related expenses.

Sales and Marketing



                                            Three Months Ended
                                               September 30,          Percentage
      (In millions, except percentages)      2008          2007         Change
      Sales and marketing                 $    3,044      $ 2,683             13 %
      As a percent of revenue                     20 %         19 %            1  ppt

Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased primarily as a result of a 19% increase in headcount-related expenses and increased corporate marketing and advertising campaigns.

Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures and as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For the three months ended September 30, 2008, $179 million of losses were reported as other income (expense). For the three months ended September 30, 2007, $69 million of gains were previously recorded as a component of sales and marketing expense and have been recast as other income (expense).

General and Administrative



                                            Three Months Ended
                                               September 30,           Percentage
     (In millions, except percentages)     2008            2007          Change
     General and administrative          $     887       $     718             24 %
     As a percent of revenue                     6 %             5 %            1  ppt

General and administrative costs include payroll, employee benefits, stock-based compensation expense and other headcount-related expenses associated with . . .