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MSFT > SEC Filings for MSFT > Form 10-Q on 24-Jan-2013All Recent SEC Filings

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Form 10-Q for MICROSOFT CORP


24-Jan-2013

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, 2012 and our financial statements and accompanying Notes to Financial Statements in this Form 10-Q.

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, by offering an array of services, including cloud-based services to consumers and businesses, by designing and selling hardware that integrates with our cloud-based services, and by delivering relevant online advertising to a global 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 that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to anticipate the changing demands of customers, industry trends, and competitive forces.

Key Opportunities and Investments

We invest research and development resources in new products and services in the areas where we see significant opportunities to drive future growth. As we look forward, the capabilities and accessibility of PCs, tablets, phones, televisions, and other devices powered by rich software platforms and applications continue to grow. With this trend, we believe the full potential of software will be seen and felt in how people use these devices and the associated services at work and in their personal lives.

Devices with End-User Services

We work with an ecosystem of partners to deliver a broad spectrum of Windows devices. In some cases, we build our own devices, as we have chosen to do with Xbox and Surface. In all our work with partners and on our own devices, we focus on delivering seamless services and experiences across devices. As consumer services and hardware advance, we expect they will continue to better complement one another, connecting the devices people use daily to unique communications, productivity, and entertainment services from Microsoft and our partners and developers around the world.


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Windows 8 reflects this shift. Launched in October 2012 on a variety of state-of-the-art hardware, Windows 8 is built to take advantage of our consumer cloud services. Windows 8 is made for both personal and professional use and unites the light, thin, and convenient aspects of a tablet with the power of a PC. For example, Xbox Music, Video, Games, and SmartGlass applications make it possible to select and experience entertainment across a range of devices by simplifying and increasing the accessibility of those experiences. SkyDrive, our cloud storage solution, connects content across all of a user's devices. Bing's search technologies in Windows 8 are designed to help users get more done. Skype has a new Windows 8 application and connects directly to the new Office.

The new Office is designed for Windows 8 and takes advantage of new mobile form factors with touch and pen capabilities. It unlocks new experiences for reading, note taking, meetings, and communications and brings social experiences directly into productivity and collaboration scenarios. The combination of a Windows 8 tablet with OneNote and SkyDrive will transform how to take notes, annotate documents, and share information.

Services for the Enterprise

Today, businesses face important opportunities and challenges. Enterprise IT departments are asked to deploy technology that drives business strategy forward. They decide what solutions will make employees more productive, collaborative, and satisfied. They work to unlock business insights from a world of data. At the same time, they must manage and secure corporate information that employees access across a growing number of personal and corporate devices.

To address these opportunities, businesses look to our world-class business applications like Microsoft Dynamics, Office, Exchange, SharePoint, Lync, and our business intelligence solutions. They rely on our technology to manage employee corporate identity and to protect their corporate data. And, increasingly, businesses of all sizes are looking to Microsoft to realize the benefits of the cloud.

Helping businesses move to the cloud is one of our largest opportunities. Cloud-based solutions provide customers with software, services, and content over the Internet by way of shared computing resources located in centralized data centers. 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 improving the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. Because of the improved economics, the cloud offers unique levels of elasticity and agility that enable new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers.

Unique to Microsoft, we continue to design and deliver cloud solutions that allow our customers to use both the cloud and their on-premise assets however best suits their own needs. For example, a company can choose to deploy Office or Microsoft Dynamics on premises, as a cloud service, or a combination of both. With Windows Server 2012, Windows Azure, and System Center infrastructure, businesses can deploy applications in their own datacenter, a partner's datacenter, or in Microsoft's datacenter with common security, management, and administration across all environments, with the flexibility and scale they desire. Our business customers tell us these hybrid capabilities are critical to harnessing the power of the cloud so they can reach new levels of efficiency and tap new areas of growth.

Our Future Opportunity

There are several distinct areas of technology that we are focused on driving forward. Our goal is to lead the industry in these areas over the long term, which we expect will translate to sustained growth well into the future. We are investing significant resources in:

Developing new form factors that have increasingly natural ways to use them, including touch, gestures, and speech.

Making technology more intuitive and able to act on our behalf, instead of at our command, with machine learning.

Building and running cloud services in ways that unleash new experiences and opportunities for businesses and individuals.


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Firmly establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market.

Delivering new scenarios with improvements in how people learn, work, play, and interact with one another.

We believe the breadth of our devices and services portfolio, our large, global partner and customer base, and the growing Windows ecosystem position us to be a leader in these areas.

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 may be developed 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 hire 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.

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.

Unearned Revenue

Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions below regarding revenue deferred on: sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price (the "Windows Upgrade Offer") and pre-sales of Windows 8 to original equipment manufacturers ("OEMs") and retailers before general availability ("Windows 8 Pre-Sales") (collectively, the "Windows Deferral"); sales of the current version of the Microsoft Office system with a guarantee to be upgraded to the new Office at minimal or no cost (the "Office Upgrade Offer") and pre-sales of the new Office to OEMs and retailers before general availability ("Office Pre-Sales") (collectively, the "Office Deferral"); and on sales of video games with the right to receive specified software upgrades/enhancements (the "Video Game Deferral").

                             RESULTS OF OPERATIONS

Summary



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

                                        2012          2011                          2012          2011

Revenue                            $  21,456     $  20,885              3%     $  37,464     $  38,257             (2)%
Operating income                   $   7,771     $   7,994            (3)%     $  13,079     $  15,197            (14)%
Diluted earnings per share         $    0.76     $    0.78            (3)%     $    1.28     $    1.46            (12)%
----------------------------------------------------------------------------------------------------------------------- -


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

Revenue increased, primarily due to the launch of Windows 8 and Surface on October 26, 2012, and strong sales of Server and Tools products and services, offset in part by lower Entertainment and Devices revenue. During the three months ended December 31, 2012, we recognized a net $622 million of revenue related to the Windows Deferral, and we deferred a net $788 million of revenue related to the Office Deferral and $380 million of revenue related to the Video Game Deferral.

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

Sales and marketing expenses increased $547 million or 15%, primarily reflecting advertising of Windows 8 and Surface.

Research and development expenses increased $157 million or 7%, due mainly to higher headcount-related expenses, primarily related to the Entertainment and Devices Division.

Six months ended December 31, 2012 compared with six months ended December 31, 2011

Revenue decreased, primarily due to the deferral of certain Office, Windows, and video game revenue and lower Entertainment and Devices revenue, offset in part by strong sales of Server and Tools products and services and the launch of Windows 8 and Surface. During the six months ended December 31, 2012, we deferred $977 million of revenue related to the Office Deferral, a net $545 million of revenue related to the Windows Deferral, and $380 million of revenue related to the Video Game Deferral.

Operating income decreased, reflecting lower revenue and increased cost of revenue and operating expenses. Key changes in cost of revenue and operating expenses were:

Sales and marketing expenses increased $592 million or 9%, primarily reflecting advertising of Windows 8 and Surface.

Cost of revenue increased $445 million or 5%, reflecting payments made to Nokia related to joint strategic initiatives, higher headcount-related expenses, primarily related to Server and Tools, and increased product costs associated with Surface, offset in part by lower volumes of Xbox 360 consoles sold.

Research and development expenses increased $288 million or 6%, due mainly to higher headcount-related expenses, primarily related to the Entertainment and Devices Division.

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.

Windows Division



                                          Three Months Ended       Percentage          Six Months Ended       Percentage
(In millions, except percentages)               December 31,           Change              December 31,           Change
------------------------------------------------------------------------------------------------------------------------ -

                                           2012         2011                          2012         2011

Revenue                              $    5,881     $  4,741              24%     $  9,125     $  9,615             (5)%
Operating income                     $    3,296     $  2,880              14%     $  4,950     $  6,161            (20)%
------------------------------------------------------------------------------------------------------------------------ -

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 seamless operations across the user's hardware and software. Windows Division offerings consist of the Windows operating system, software, and services, Surface, and Microsoft PC hardware products. The general availability of Surface, Windows 8, and Windows 8 and Windows RT devices started on October 26, 2012.


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Excluding the impact of the Windows Deferral, approximately 65% of total Windows Division revenue comes from Windows operating system software purchased by OEMs, which they pre-install on equipment they sell. The remaining Windows Division revenue is generated by commercial and retail sales of Windows, Surface, PC hardware products, and online advertising.

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

Windows Division revenue increased from the prior year, due in part to the recognition of a net $622 million of revenue related to Windows Deferral, as well as due to sales of Surface and Windows 8 upgrades. OEM revenue grew 17%, reflecting the net Windows Deferral recognition and increased demand in our distribution channels, offset in part by a decline in the x86 PC market.

Windows Division operating income increased, primarily due to revenue growth, offset in part by higher sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $420 million or 49%, reflecting advertising costs associated with the launch of Windows 8 and Surface. Cost of revenue increased $293 million or 58%, including product costs associated with Surface and Windows 8 and Windows 8 upgrade support costs.

Six months ended December 31, 2012 compared with six months ended December 31, 2011

Windows Division revenue decreased from the prior year, due in part to the deferral of a net $545 million of revenue related to the Windows Upgrade Offer, as well as due to a decline in the x86 PC market and continued higher relative growth in emerging markets, where average selling prices are lower than developed markets. The revenue decrease was offset in part by sales of Surface and Windows 8 upgrades.

Windows Division operating income decreased, due mainly to lower revenue and higher sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $368 million or 24%, reflecting advertising costs associated with the launch of Windows 8 and Surface. Cost of revenue increased $292 million or 30%, including product costs associated with Surface and Windows 8 and Windows 8 upgrade support costs.

Server and Tools



                                         Three Months Ended       Percentage          Six Months Ended       Percentage
(In millions, except percentages)              December 31,           Change              December 31,           Change
----------------------------------------------------------------------------------------------------------------------- -

                                          2012         2011                          2012         2011

Revenue                             $    5,186     $  4,737               9%     $  9,739     $  8,953               9%
Operating income                    $    2,121     $  1,950               9%     $  3,858     $  3,503              10%
----------------------------------------------------------------------------------------------------------------------- -

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 80% of Server and Tools revenue comes from product revenue, including purchases through volume licensing programs, licenses sold to OEMs, and retail packaged product, while the remainder comes from Enterprise Services.

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

Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $347 million or 9%, driven primarily by growth in SQL Server, Windows Server, and System Center, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $102 million or 10%, due to growth in both Premier product support and consulting services.

Server and Tools operating income increased, primarily due to revenue growth, offset in part by higher cost of revenue and sales and marketing expenses. Cost of revenue increased $163 million or 17%, primarily reflecting higher headcount-related expenses. Sales and marketing expenses grew $76 million or 7%, reflecting increased fees paid to third-party enterprise software advisors and corporate sales and marketing activities.


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Six months ended December 31, 2012 compared with six months ended December 31, 2011

Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $560 million or 8%, driven primarily by growth in SQL Server, System Center, and Windows Server, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $226 million or 12%, due to growth in both Premier product support and consulting services.

Server and Tools operating income increased, primarily due to revenue growth, offset in part by higher cost of revenue and sales and marketing expenses. Cost of revenue increased $273 million or 15%, primarily reflecting higher headcount-related expenses. Sales and marketing expenses grew $124 million or 6%, reflecting increased fees paid to third-party enterprise software advisors and corporate sales and marketing activities.

Online Services Division



                                         Three Months Ended        Percentage           Six Months Ended        Percentage
(In millions, except percentages)              December 31,            Change               December 31,            Change
-------------------------------------------------------------------------------------------------------------------------- -

                                         2012          2011                           2012          2011

Revenue                             $     869       $   784               11%     $  1,566      $  1,425               10%
Operating loss                      $    (283 )     $  (459 )             38%     $   (647 )    $   (973 )             34%
-------------------------------------------------------------------------------------------------------------------------- -

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

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

Online advertising revenue grew $109 million or 15% to $823 million, reflecting continued growth in search advertising revenue, offset in part by decreased display advertising revenue. Search revenue grew, primarily due to increased revenue per search. According to third-party sources, Bing organic U.S. market share for the month of December 2012 was approximately 16%, and grew 120 basis points year over year. Bing-powered U.S. market share, including Yahoo! properties, was approximately 26% for the month of December 2012, down 90 basis points year over year.

OSD's operating loss was reduced by higher revenue and lower cost of revenue and sales and marketing expenses. Cost of revenue decreased $72 million, driven by lower traffic acquisition costs and Yahoo! reimbursement costs. Sales and marketing expenses decreased $31 million or 16%, due mainly to decreased advertising and corporate marketing activities.

Six months ended December 31, 2012 compared with six months ended December 31, 2011

Online advertising revenue grew $193 million or 15% to $1.5 billion, reflecting continued growth in search advertising revenue, offset in part by decreased display advertising revenue. Search revenue grew, primarily due to increased revenue per search.

OSD's operating loss was reduced by higher revenue and lower cost of revenue and sales and marketing expenses, offset in part by higher research and development expenses. Cost of revenue decreased $163 million, driven by lower traffic acquisition costs and Yahoo! reimbursement costs. Sales and marketing expenses decreased $71 million or 19%, due mainly to decreased advertising and corporate marketing activities. Research and development expenses increased $47 million or 8%, primarily reflecting higher headcount-related expenses.

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