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MSFT > SEC Filings for MSFT > Form 10-Q on 19-Apr-2012All Recent SEC Filings

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Form 10-Q for MICROSOFT CORP


19-Apr-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Note About Forward-Looking Statements

Certain statements in this report, 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. Forward-looking statements may appear throughout this report, including without limitation, the following sections: "Management's Discussion and Analysis," and "Risk Factors." These forward-looking statements generally are identified by the words "believe," "project," "expect," "anticipate," "estimate," "intend," "strategy," "future," "opportunity," "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" (Part II, Item 1A of this Form 10-Q). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise.

OVERVIEW

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 Annual Report on Form 10-K for the year ended June 30, 2011 and our financial statements and accompanying Notes to Financial Statements.

Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. We create technology that transforms the way people work, play, and communicate across a wide range of computing devices.

We generate revenue by developing, licensing, and supporting a wide range of software products and services, by designing and selling hardware, and by delivering relevant online advertising to a global customer audience. Our most significant expenses are related to compensating employees, designing, manufacturing, marketing and selling our products and services, and income taxes.

Industry Trends

Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas which can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad set of research and technology innovations that seek to anticipate the changing demands of customers, industry trends, and competitive forces.

Key Opportunities and Investments

Based on our assessment of key technology trends and our broad focus on long-term research and development of new products and services, we see significant opportunities to drive future growth.

Smart connected devices

The price per unit of processing, storage, and networks continues to decline while at the same time devices increase in capability. As a result, the capabilities and accessibility of PCs, mobile, and other devices powered by rich software platforms and applications continue to grow. At the same time, the information and services people use increasingly span multiple devices. User experiences will be transformed by the adoption of cloud computing when brought together with the richness of smart, connected devices. Microsoft is delivering experiences that seamlessly connect PCs and mobile and other devices through the cloud. We are devoting significant resources to consumer cloud offerings like Bing, Windows Live, and Xbox LIVE. Our software and hardware platform investments can be seen in products like Kinect, Windows, Windows Azure, Windows Phone, Windows Server, and Xbox.


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Cloud computing transforming the data center and information technology

Cloud-based solutions provide customers with software, services and content over the Internet by way of shared computing resources located in centralized data centers. Computing is undergoing a long-term shift from client/server to the cloud, a shift similar in importance and impact to the transition from mainframe to client/server. The shift to the cloud is driven by three important economies of scale: larger data centers can deploy computational resources at significantly lower cost per unit than smaller ones; larger data centers can coordinate and aggregate diverse customer, geographic, and application demand patterns which can improve the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. As a result of the improved economics, the cloud offers unique levels of elasticity and agility that will enable new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus more on innovation while leaving non-differentiating activities to reliable and cost-effective providers. For many businesses, the first step in achieving cloud economics is the adoption of virtualization in their data center. We are devoting significant resources to developing cloud infrastructure, platforms, and applications including offerings such as Microsoft Dynamics Online, Microsoft SQL Azure, Office 365, Windows Azure, Windows Intune, and Windows Server.

Entertainment

The evolution of hardware, software, services, and the cloud are enhancing the delivery and quality of unified entertainment experiences across many devices. These rich media experiences include games, movies, music, television, and social interactions with family, friends, and colleagues. At Microsoft, our approach is to simplify and increase the accessibility of these entertainment experiences to broaden market penetration of our software and services. We invest significant resources to develop or partner to develop hardware, software, and content that is used in products and services such as Windows Phone, Xbox, Xbox LIVE, and Skype.

Search

Over the last two decades, web content and social connections have increased dramatically as people spend more time online, while discoverability and accessibility has been transforming from direct navigation and document links. There is significant opportunity to deliver differentiated products that helps users make better decisions and complete tasks more simply when using PC, mobile, and other devices. Our approach is to use machine learning to try to understand user intent, and differentiate our product by focusing on the integration of visual, social, and other elements which simplifies people's interaction with the Internet. We invest significant resources in Bing, SharePoint, Windows, Windows Phone, and Xbox LIVE.

Communications and productivity

Personal and business productivity has been transformed by the ubiquity of computing and software tools. Over the last decade, Microsoft redefined software productivity beyond the rich Office client on the PC. Productivity scenarios now encompass unified communications, business intelligence, collaboration, content management, and relationship management, which are increasingly powered by server-side applications. These server applications can be hosted by the customer, a partner, or by Microsoft in the cloud. There are significant opportunities to provide productivity and communication scenarios across PCs, mobile devices, and other devices that connect to services. We invest significant resources in Dynamics, Exchange, Lync, Skype, Office, Office 365, SharePoint, Windows Live, and Windows Phone.

Economic Conditions, Challenges and Risks

As discussed above, our industry is dynamic and highly competitive. We must anticipate changes in technology and business models. Our model for growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we develop and market.

At Microsoft, we prioritize our investments among the highest long-term growth opportunities. These investments require significant resources and are multi-year in nature. The products and services we bring to market can be built internally, brought to market as part of a partnership or alliance, or through acquisition.

Our success is highly dependent on our ability to attract and retain qualified employees. We rely on hiring from a mix of university and industry talent worldwide. Microsoft competes for talented individuals worldwide by offering broad customer reach, scale in resources, and competitive compensation.


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Demand for our software, services, and hardware has a strong correlation to global macroeconomic factors. The current macroeconomic factors remain dynamic. See a discussion of these factors and other risks under Risk Factors (Part II, Item 1A. of this Form 10-Q).

Seasonality

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 approximately 40% of its yearly segment revenue in our second fiscal quarter. In addition, quarterly revenue may be impacted by the deferral of revenue. See the discussions below regarding sales of earlier versions of the Microsoft Office system with a guarantee to be upgraded to the newest version of the Microsoft Office system at minimal or no cost (the "Office Deferral").

                             RESULTS OF OPERATIONS

Summary



(In millions, except
percentages and per share               Three Months Ended      Percentage             Nine Months Ended       Percentage
amounts)                                         March 31,          Change                     March 31,           Change
------------------------------------------------------------------------------------------------------------------------- -

                                       2012           2011                           2012           2011

Revenue                          $   17,407     $   16,428              6%     $   55,664     $   52,576               6%
Operating income                 $    6,374     $    5,709             12%     $   21,571     $   20,990               3%
Diluted earnings per share       $     0.60     $     0.61            (2)%     $     2.05     $     2.01               2%
------------------------------------------------------------------------------------------------------------------------- -

Three months ended March 31, 2012 compared with three months ended March 31, 2011

Revenue increased primarily due to strong sales of Server and Tools products and services and the 2010 Microsoft Office system, offset in part by a decline in Xbox 360 entertainment platform sales. Revenue for the three months ended March 31, 2012 also included Skype revenue.

Operating income increased 12%, primarily reflecting an increase in revenue, offset in part by higher research and development expenses. Research and development expenses increased $248 million or 11%, due mainly to higher headcount-related expenses. Headcount-related expenses increased across the company reflecting a 4% increase in headcount from March 31, 2011 and changes in our employee compensation program.

Diluted earnings per share were $0.60. Prior year net income and diluted earnings per share reflected a partial settlement with the U.S. Internal Revenue Service ("I.R.S.") and higher other income. The partial settlement with the I.R.S. added $461 million to prior year net income and $0.05 to diluted earnings per share.

Nine months ended March 31, 2012 compared with nine months ended March 31, 2011

Revenue increased primarily due to strong sales of Server and Tools products and services and the 2010 Microsoft Office system. Revenue for the nine months ended March 31, 2012 also included Skype revenue from the date of acquisition.

Operating income increased reflecting increased revenue, offset in part by higher operating expenses. Key changes in operating expenses were:

Cost of revenue increased $1.5 billion or 13%, reflecting higher costs associated with providing Server and Tools products and services, higher Xbox royalty costs, and changes in the mix of products and services sold.

Research and development expenses increased $567 million or 9%, due mainly to higher headcount-related expenses.

General and administrative expenses increased $390 million or 13%, due mainly to higher headcount-related expenses and Puerto Rican excise taxes.


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Headcount-related expenses increased across the company reflecting a 4% increase in headcount from March 31, 2011 and changes in our employee compensation program.

Diluted earnings per share were $2.05. Prior year net income and diluted earnings per share reflected a partial settlement with the I.R.S. and higher other income. The partial settlement with the I.R.S. added $461 million to prior year net income and $0.05 to diluted earnings per share.

SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)

The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the U.S. ("U.S. GAAP") and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 17 - Segment Information of the Notes to Financial Statements (Part I, Item I of this Form 10-Q) is presented on a basis consistent with our current internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division.

Windows & Windows Live Division



                                           Three Months Ended       Percentage             Nine Months Ended      Percentage
(In millions, except percentages)                   March 31,           Change                     March 31,          Change
---------------------------------------------------------------------------------------------------------------------------- -

                                          2012           2011                            2012           2011

Revenue                             $    4,624     $    4,447               4%     $   14,228     $   14,290              0%
Operating income                    $    2,952     $    2,792               6%     $    9,063     $    9,303            (3)%
---------------------------------------------------------------------------------------------------------------------------- -

Windows & Windows Live Division ("Windows Division") develops and markets PC operating systems, related software and online services, and PC hardware products. This collection of software, hardware, and services is designed to simplify everyday tasks through efficient browsing capabilities and seamless operations across the user's hardware and software. Windows Division offerings consist of multiple editions of the Windows operating system, software and services through Windows Live, and Microsoft PC hardware products.

Windows Division revenue is largely correlated to the PC market worldwide, as approximately 75% of total Windows Division revenue comes from Windows operating system software purchased by original equipment manufacturers ("OEMs") which they pre-install on equipment they sell. The remaining approximately 25% of Windows Division revenue is generated by commercial and retail sales of Windows and PC hardware products and online advertising from Windows Live.

Three months ended March 31, 2012 compared with three months ended March 31, 2011

Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 8% and sales of PCs to consumers were flat. Excluding a decline in sales of netbooks, we estimate that sales of PCs to consumers grew approximately 6%. Taken together, the total PC market increased an estimated 2% to 4%. Windows Division revenue was positively impacted by a higher rate of Windows licensed on PCs shipped and growth in sales to businesses.

Windows Division operating income increased primarily due to revenue growth, offset in part by higher research and development expenses, which grew due mainly to an increase in headcount-related costs and product development costs associated with the next version of the Windows operating system.

Nine months ended March 31, 2012 compared with nine months ended March 31, 2011

Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 5% and sales of PCs to consumers decreased 1%. Excluding a decline in sales of netbooks, we estimate that sales of PCs to consumers grew approximately 6%. Taken together, the total PC market increased an estimated 0% to 2%. Windows Division revenue was negatively impacted by higher growth in emerging markets, where average selling prices are lower, relative to developed markets, partially offset by a higher rate of Windows licensed on PCs shipped and growth in sales to businesses.


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Windows Division operating income decreased due primarily to higher research and development expenses associated with the next version of the Windows operating system.

Server and Tools



                                           Three Months Ended       Percentage             Nine Months Ended       Percentage
(In millions, except percentages)                   March 31,           Change                     March 31,           Change
----------------------------------------------------------------------------------------------------------------------------- -

                                          2012           2011                            2012           2011

Revenue                             $    4,572     $    4,007              14%     $   13,594     $   12,156              12%
Operating income                    $    1,738     $    1,352              29%     $    5,336     $    4,604              16%
----------------------------------------------------------------------------------------------------------------------------- -

Server and Tools develops and markets technology and related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Visual Studio, System Center products, Windows Embedded device platforms, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training, and certification. Approximately 50% of Server and Tools revenue comes primarily from multi-year volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes from Enterprise Services.

Three months ended March 31, 2012 compared with three months ended March 31, 2011

Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $396 million or 12%, driven primarily by growth in SQL Server, Windows Server, and System Center, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew in both Premier product support and consulting services.

Server and Tools operating income increased primarily due to revenue growth, offset in part by higher costs of providing products and services.

Nine months ended March 31, 2012 compared with nine months ended March 31, 2011

Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $980 million or 10%, driven primarily by growth in SQL Server, Windows Server, and System Center, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew in both Premier product support and consulting services.

Server and Tools operating income increased primarily due to revenue growth, offset in part by higher costs of providing products and services.

Online Services Division



                                          Three Months Ended        Percentage              Nine Months Ended        Percentage
(In millions, except percentages)                  March 31,            Change                      March 31,            Change
------------------------------------------------------------------------------------------------------------------------------- -

                                         2012           2011                             2012            2011

Revenue                             $     707      $     667                6%     $    2,132      $    1,927               11%
Operating loss                      $    (479 )    $    (776 )             38%     $   (1,449 )    $   (1,912 )             24%
------------------------------------------------------------------------------------------------------------------------------- -

Online Services Division ("OSD") develops and markets information and content designed to help people simplify tasks and make more informed decisions online, and that help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising. Search and display advertising accounts for nearly all of OSD's annual revenue.


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Three months ended March 31, 2012 compared with three months ended March 31, 2011

Online advertising revenue grew $51 million or 9% to $639 million, reflecting continued growth in search advertising revenue, offset in part by decreased display advertising revenue. As of March 31, 2012, according to third-party sources, Bing organic U.S. market share grew over 10% from March 31, 2011 to approximately 15%. Bing-powered U.S. market share, including Yahoo! properties was approximately 26% at both March 31, 2012 and 2011.

OSD operating loss decreased due to higher revenue and lower cost of revenue and sales and marketing expenses.

Nine months ended March 31, 2012 compared with nine months ended March 31, 2011

Online advertising revenue grew $232 million or 14% to $1.9 billion, reflecting continued growth in search advertising revenue, offset in part by decreased display advertising revenue. As of March 31, 2012, according to third-party sources, Bing organic U.S. market share grew over 10% from March 31, 2011 to approximately 15%. Bing-powered U.S. market share, including Yahoo! properties was approximately 26% at both March 31, 2012 and 2011.

OSD operating loss decreased due primarily to higher revenue and lower sales and marketing expenses.

Microsoft Business Division



                                           Three Months Ended       Percentage             Nine Months Ended       Percentage
(In millions, except percentages)                   March 31,           Change                     March 31,           Change
----------------------------------------------------------------------------------------------------------------------------- -

                                          2012           2011                            2012           2011
Revenue                             $    5,814     $    5,329               9%     $   17,700     $   16,641               6%
Operating income                    $    3,770     $    3,313              14%     $   11,619     $   10,896               7%
----------------------------------------------------------------------------------------------------------------------------- -

Microsoft Business Division ("MBD") develops and markets software and online services designed to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (comprising mainly Office, SharePoint, Exchange, Lync, and Office 365), which generates over 90% of MBD revenue, and Microsoft Dynamics business solutions. We evaluate MBD 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 March 31, 2012 compared with three months ended March 31, 2011

MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system. Business revenue increased $469 million or 11%, primarily reflecting growth in multi-year volume licensing revenue, licensing of the 2010 Microsoft Office system to transactional business customers, and an 11% increase in Microsoft Dynamics revenue. Consumer revenue increased $16 million or 2% due mainly to increased sales of the 2010 Microsoft Office system.

MBD revenue for the three months ended March 31, 2012 included a favorable foreign currency impact of $121 million.

MBD operating income increased primarily due to revenue growth. An increase in cost of revenue, which resulted primarily from higher online operation and support costs, was nearly offset by a decrease in sales and marketing expenses, which resulted primarily from lower headcount-related costs.

Nine months ended March 31, 2012 compared with nine months ended March 31, 2011

MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system. Business revenue increased $1.2 billion or 9%, primarily reflecting growth in multi-year volume licensing revenue, licensing of the 2010 Microsoft . . .

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