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.

Summary



                                   Three Months Ended                       Six Months Ended
(In millions, except per share        December 31,        Percentage          December 31,       Percentage
amounts and percentages)            2008         2007       Change          2008        2007       Change
Revenue                          $    16,629   $ 16,367            2 %    $  31,690   $ 30,129            5 %
Operating income                 $     5,939   $  6,453           (8 )%   $  11,938   $ 12,302           (3 )%
Diluted earnings per share       $      0.47   $   0.50           (6 )%   $    0.94   $   0.95           (1 )%

Three months ended December 31, 2008 compared with three months ended December 31, 2007

Revenue growth was driven primarily by increased SQL Server and Windows Server revenue and increased Xbox 360 platform revenue, substantially offset by decreased revenue from Windows operating systems as a result of PC market weakness and a continued shift to lower priced netbook PCs. Revenue growth included a favorable impact from foreign currency exchange rates of $222 million or one percentage point.

Operating income decreased primarily reflecting increased headcount-related expenses and increased cost of revenue, partially offset by increased revenue. Headcount-related expenses increased 12%, 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 $364 million or 10%, reflecting increased online costs, including traffic acquisition and people costs, and increased Xbox 360 platform costs.

Diluted earnings per share declined primarily reflecting decreased other income (expense), partially offset by a decrease in provision for income taxes and share repurchases. Other income (expense) decreased reflecting increased net losses on derivatives and foreign currency remeasurements. Provision for income taxes decreased reflecting a decline in the recurring effective tax rate primarily as a result of foreign earnings taxed at lower rates.

Six months ended December 31, 2008 compared with six months ended December 31, 2007

Revenue growth was driven primarily by increased SQL Server and Windows Server revenue and increased licensing of the 2007 Microsoft Office system, partially offset by decreased revenue from Windows operating systems as a result of PC market weakness and a continued shift to lower priced netbook PCs. Foreign currency exchange rates accounted for a $660 million or two percentage point increase in revenue.

Operating income decreased primarily reflecting increased headcount-related expenses and cost of revenue, partially offset by increased revenue. Headcount-related expenses increased 17%, 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 $537 million or 9%, reflecting increased online costs, including traffic acquisition, data center and equipment, and people costs, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 platform costs.

Diluted earnings per share declined primarily reflecting decreased other income (expense), partially offset by a decrease in provision for income taxes and share repurchases. Other income (expense) decreased reflecting increased net losses on derivatives and foreign currency remeasurements. Provision for income taxes decreased reflecting a decline in the recurring effective tax rate primarily as a result of foreign earnings taxed at lower rates.

Outlook

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 six months to further deteriorate. Given this, we are focused on executing in the areas we can control by continuing to provide high value products at the lowest total cost of ownership while managing our expenses.

On January 22, 2009, we announced a resource management program which includes a reduction in operating expenses, employee headcount, and capital expenditures. We plan to eliminate up to 5,000 jobs in research and development, marketing, sales, finance, legal, human resources, and IT, including 1,400 jobs this month. The net headcount in these functions is expected to decline by 2,000 to 3,000 over the next 18 months. Merit increases will be eliminated for employees in fiscal year 2010. Operating expenses will be reduced by cutting travel expenditures, reducing spending on vendors and contingent staff, reducing marketing spending, and scaling back capital expenditures. These initiatives will reduce our annual operating expense run rate by approximately $1.5 billion.

These plans are being finalized, and the costs of implementation and employee severance will be included in our third quarter results of operations.

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                      Six Months Ended
                                         December 31,         Percentage        December 31,         Percentage
(In millions, except percentages)      2008         2007        Change        2008         2007        Change
Revenue                             $    3,982    $   4,334         (8)%   $    8,200   $    8,473         (3)%
Operating income                    $    2,946    $   3,386        (13)%   $    6,219   $    6,778         (8)%

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 is directly impacted by 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"), including the impact from lower cost netbook PCs which are sold with a lower cost version of Windows, 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.

Three months ended December 31, 2008 compared with three months ended December 31, 2007

Client revenue decreased primarily as a result of PC market weakness and a continued shift to lower priced netbook PCs. OEM revenue decreased $465 million or 12% while OEM license units decreased 1%. The decline in OEM revenue reflects an 11 percentage point decrease in the OEM premium mix to 64%, primarily driven by growth of licenses related to sales of netbook PCs, as well as changes in the geographic and product mixes. Revenue from commercial and retail licensing of Windows operating systems increased $113 million or 19%. Based on our estimates, total worldwide PC shipments from all sources was approximately flat, driven by increased demand in emerging markets, offset by decreased demand in mature markets.

Client operating income decreased primarily reflecting decreased revenue and increased sales and marketing expenses. Sales and marketing expenses increased $80 million or 19%, primarily reflecting increased advertising and marketing campaigns.

Six months ended December 31, 2008 compared with six months ended December 31, 2007

Client revenue decreased primarily as a result of PC market weakness and a continued shift to lower priced netbook PCs. OEM revenue decreased $510 million or 7% while OEM license units increased 3%. The decline in OEM revenue reflects a seven percentage point decrease in the OEM premium mix to 68%, primarily driven by growth of licenses related to sales of netbook PCs, as well as changes in the geographic and product mixes. Revenue from commercial and retail licensing of Windows operating systems increased $238 million or 20%. Based on our estimates, total worldwide PC shipments from all sources increased 4% to 7%, driven by increased demand in emerging markets, partially offset by decreased demand in mature markets.

Client operating income decreased primarily reflecting decreased revenue and increased sales and marketing and research and development expenses. Sales and marketing expenses increased $203 million or 29%, primarily reflecting increased advertising and marketing campaigns. Research and development expenses increased $72 million or 15% as a result of increased headcount-related expenses.

Server and Tools



                                      Three Months Ended                      Six Months Ended
                                         December 31,         Percentage        December 31,         Percentage
(In millions, except percentages)      2008         2007        Change        2008         2007        Change
Revenue                             $    3,743    $   3,261          15%   $    7,149   $    6,143          16%
Operating income                    $    1,489    $   1,154          29%   $    2,635   $    2,092          26%

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.

Three months ended December 31, 2008 compared with three months ended December 31, 2007

Server and Tools revenue increased reflecting growth in product and services revenue and included a favorable impact from foreign currency exchange rates of $82 million or three percentage points. Server and server application revenue (including CAL revenue) and developer tools revenue

increased $378 million or 15%, primarily driven by growth in SQL Server and Windows Server revenue. This growth reflects recognition of deferred revenue from previously signed agreements and 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 $104 million or 16%, primarily due to revenue from annuity support agreements.

Server and Tools operating income increased primarily due to growth in high-margin product revenue, partially offset by increased research and development expenses. Research and development expenses increased $82 million or 18%, primarily driven by increased headcount-related expenses.

Six months ended December 31, 2008 compared with six months ended December 31, 2007

Server and Tools revenue increased reflecting growth in product and services revenue and included a favorable impact from foreign currency exchange rates of $211 million or three percentage points. Server and server application revenue (including CAL revenue) and developer tools revenue increased $790 million or 16%, primarily driven by growth in SQL Server and Windows Server revenue. This growth reflects recognition of deferred revenue from previously signed agreements and adoption of the Windows Platform and applications with the recent product releases as described above. Consulting and Premier and Professional product support services revenue increased $216 million or 17%, primarily due to revenue from annuity support agreements.

Server and Tools operating income increased primarily due to growth in high-margin product revenue, partially offset by increased research and development expenses and cost of revenue. Research and development expenses increased $177 million or 20%, primarily driven by increased headcount-related expenses. Cost of revenue increased $165 million or 14%, reflecting the growth in consulting and support services.

Online Services Business

Online Services Business ("OSB") consists of an online 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 advertiser and publisher tools. Revenue is also generated through subscriptions and transactions generated from online paid services, digital marketing and advertising agency services, and from MSN narrowband Internet access subscribers. During the first quarter of fiscal year 2008, 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 six months ended December 31, 2008 included six months of aQuantive results whereas amounts during the six months ended December 31, 2007 included aQuantive results only from the acquisition date through the end of the period.

Three months ended December 31, 2008 compared with three months ended December 31, 2007

OSB revenue was flat as a result of increased online advertising revenue, offset by decreased access and other OSB revenue. Online advertising revenue increased $43 million or 7%, to $664

million. This increase reflected growth in our search and display business. Access revenue decreased $19 million or 28%, to $48 million, reflecting continued migration of subscribers to broadband or other competitively-priced service providers.

OSB operating loss increased due to increased cost of revenue and research and development expenses. Cost of revenue increased $137 million or 28%, primarily driven by increased online costs, including traffic acquisition costs and data center and equipment costs. Research and development expenses increased $87 million or 32%, primarily due to increased headcount-related expenses.

Six months ended December 31, 2008 compared with six months ended December 31, 2007

OSB revenue increased as a result of increased online advertising revenue and agency revenue, partially offset by decreased access revenue. Online advertising revenue increased $111 million or 10%, to $1.2 billion. This increase reflected growth in our search and display business. Agency revenue, which is solely derived from aQuantive, was $191 million during the six months ended December 31, 2008 and $154 million during the six months ended December 31, 2007. Access revenue decreased $39 million or 28%, to $98 million, reflecting continued migration of subscribers to broadband or other competitively-priced service providers.

OSB operating loss increased due to increased cost of revenue and research and development expenses, partially offset by increased revenue. Cost of revenue increased $320 million or 37%, primarily driven by increased online costs, including traffic acquisition costs, data center and equipment costs, people costs, and agency expenses. Research and development expenses increased $141 million or 25%, primarily due to increased headcount-related expenses.

Microsoft Business Division



                                      Three Months Ended                    Six Months Ended
                                         December 31,        Percentage       December 31,       Percentage
(In millions, except percentages)      2008         2007       Change        2008       2007       Change
Revenue                             $    4,876    $  4,815          1%    $    9,825   $ 8,932          10%
Operating income                    $    3,140    $  3,185         (1)%   $    6,442   $ 5,879          10%

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.

Three months ended December 31, 2008 compared with three months ended December 31, 2007

MBD revenue growth increased reflecting increased business revenue, partially offset by decreased consumer revenue and included a favorable impact from foreign currency exchange rates of

$167 million or four percentage points. Business revenue increased $285 million or 7%, primarily reflecting growth in volume licensing agreement revenue and included a 7% decrease in Microsoft Dynamics customer billings. The growth in volume licensing agreement revenue primarily reflects recognition of deferred revenue from previously signed agreements. Consumer revenue decreased $224 million or 23%, primarily as a result of decreased licensing of the 2007 Microsoft Office system through our OEM channel.

MBD operating income decreased reflecting increased research and development expenses and cost of revenue, partially offset by increased revenue. Research and development expenses increased $54 million or 15%, primarily driven by an increase in headcount-related expenses associated with the April 2008 acquisition of Fast Search & Transfer ASA ("FAST"). Cost of revenue increased $46 million or 20%, primarily driven by FAST.

Six months ended December 31, 2008 compared with six months ended December 31, 2007

MBD revenue increased reflecting growth in our business revenue and consumer revenue and included a favorable impact from foreign currency exchange rates of $380 million or four percentage points. Business revenue increased $828 million or 12%, primarily reflecting growth in volume licensing agreement revenue partially offset by a 2% decrease in Microsoft Dynamics customer billings. The growth in volume licensing agreement revenue primarily reflects the recognition of deferred revenue from previously signed agreements. Consumer revenue increased $65 million or 4%, reflecting increased licensing of the 2007 Microsoft Office system from retail packaged product sales, partially offset by decreased licensing of 2007 Microsoft Office system through our OEM channel.

MBD operating income increased reflecting increased revenue, partially offset by increased cost of revenue and research and development expenses. Cost of revenue increased $110 million or 25%, primarily driven by FAST. Research and development expenses increased $110 million or 15%, primarily driven by an increase in headcount-related expenses associated with FAST.

Entertainment and Devices Division



                                      Three Months Ended                    Six Months Ended
                                         December 31,        Percentage       December 31,       Percentage
(In millions, except percentages)      2008         2007       Change        2008       2007       Change
Revenue                             $    3,183    $  3,076          3%    $    4,997   $ 5,024         (1)%
Operating income                    $      151    $    375        (60)%   $      329   $   560        (41)%

Entertainment and Devices Division ("EDD") offerings include the Xbox 360 platform (which includes the Microsoft Xbox 360 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.

Three months ended December 31, 2008 compared with three months ended December 31, 2007

EDD revenue increased primarily due to increased Xbox 360 platform and PC game revenue and other EDD product revenue, partially offset by decreased Zune platform revenue. Xbox 360 platform and PC game revenue increased $135 million . . .