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

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Quarterly Report



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.


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, 2013 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 devices that integrate 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 identify and address 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 generate future growth.

We invest research and development resources in new products and services in these areas. 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 of 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


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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.

Windows 8 reflects this shift. Launched in October 2012, Windows 8 was designed to unite the light, thin, and convenient aspects of a tablet with the power of a PC. The Windows 8 operating system includes the Windows Store, which offers a large and growing number of applications from Microsoft and partners for both business and consumer customers. The general availability of Windows 8.1, which will enable new hardware and further the integration with other Microsoft services, started on October 17, 2013.

Going forward, our strategy will focus on creating a family of devices and services for individuals and businesses that empower people around the globe at home, at work, and on the go, for the activities they value most. This strategy will require investment in datacenters and other infrastructure to support our services, and will bring continued competition with Apple, Google, and other well-established and emerging competitors. We believe our history of powering devices such as Windows PCs and Xbox, as well as our experience delivering high-value experiences through Office and other applications, will position us for future success.

Services for the enterprise

Today, businesses face important opportunities and challenges. Enterprises are asked to deploy technology that drives business strategy forward. They decide what solutions will make employees more productive, collaborative, and satisfied, or connect with customers in new and compelling ways. 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 Office, Exchange, SharePoint, Lync, Yammer, Microsoft Dynamics, 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.

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 premise, 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. These hybrid capabilities allow customers to fully harness the power of the cloud so they can achieve greater 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, gesture, and speech.

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


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

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 high-value experiences 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

The market for software, devices, and cloud-based services is dynamic and highly competitive. Some of our traditional businesses such as the Windows operating system are in a period of transition. Our competitors are developing new devices and deploy competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud and in some cases the user's choice of which suite of cloud-based services to use. The Windows ecosystem must continue to evolve and adapt, over an extended time, in pace with this changing environment. To support our strategy of offering a family of devices and services designed to empower our customers for the activities they value most, we announced a change in our organizational structure in July 2013. Through this realignment our goal is to become more nimble, collaborative, communicative, motivated, and decisive. Even if we achieve these benefits, the investments we are making in devices and infrastructure to support our cloud-based services will increase our operating costs and may decrease our operating margins.

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, 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.

Aggregate demand for our software, services, and hardware is correlated to global macroeconomic factors, which remain dynamic. See a discussion of these factors and other risks under Risk Factors (Part II, Item 1A of this Form 10-Q).

Unearned Revenue

Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions within Corporate and Other below regarding:

revenue deferred on pre-sales of Windows 8.1 to original equipment manufacturers ("OEMs") and retailers before general availability ("Windows
8.1 Pre-Sales");

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 OEMs and retailers before general availability (collectively, the "Windows Deferral"); and

revenue deferred on sales of the previous 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 (collectively, the "Office Deferral").

If our customers elect to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable.

Reportable Segments

The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. Segment information appearing in Note 16 - Segment Information of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) is also presented on this basis. All differences between our internal management reporting basis and accounting principles generally accepted in the U.S. ("U.S. GAAP"), along with certain corporate-level and other activity, are included in Corporate and Other. Operating expenses are not allocated to our segments.


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During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result of these changes, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, we have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance during the current fiscal year. Our reportable segments are described below.

Devices and Consumer ("D&C")

Our D&C segments develop and market products and services designed to entertain and connect people, increase personal productivity, help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. Our D&C segments are:

D&C Licensing, comprising: Windows, including all OEM licensing ("Windows OEM") and other non-volume licensing and academic volume licensing of the Windows operating system and related software (collectively, "Consumer Windows"); non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers ("Consumer Office"); Windows Phone, including related patent licensing; and certain other patent licensing revenue;

D&C Hardware, comprising: the Xbox 360 gaming and entertainment console and accessories, second-party and third-party video games, and Xbox LIVE subscriptions ("Xbox Platform"); Surface; and Microsoft PC accessories; and

D&C Other, comprising: Resale, including Windows Store, Xbox LIVE transactions, and the Windows Phone Marketplace; search advertising; display advertising; Subscription, comprising Office 365 ("O365") Home Premium; Studios, comprising first-party video games; our retail stores; and certain other consumer products and services not included in the categories above.


Our Commercial segments develop and market software and services designed to increase individual, team, and organization productivity and efficiency, and to simplify everyday tasks through seamless operations across the user's hardware and software. Our Commercial segments are:

Commercial Licensing, comprising: server products, including Windows Server, Microsoft SQL Server, Visual Studio, and System Center; Windows Embedded; volume licensing of the Windows operating system, excluding academic ("Commercial Windows"); Microsoft Office for business, including Office, Exchange, SharePoint, and Lync ("Commercial Office"); Client Access Licenses, which provide access rights to certain server products ("CAL"); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype; and

Commercial Other, comprising: Enterprise Services, including Premier product support services and Microsoft Consulting Services; Cloud Services, comprising O365, excluding O365 Home Premium ("Commercial O365"), other Microsoft Office online offerings, Dynamics CRM Online, and Windows Azure; and certain other commercial products and online services not included in the categories above.

                         SUMMARY RESULTS OF OPERATIONS


(In millions, except percentages and per share               Three Months Ended        Percentage
amounts)                                                          September 30,            Change
------------------------------------------------------------------------------------------------- -

                                                           2013            2012

Revenue                                              $   18,529      $   16,008               16%
Operating income                                     $    6,334      $    5,308               19%
Diluted earnings per share                           $     0.62      $     0.53               17%
------------------------------------------------------------------------------------------------- -

Revenue increased, mainly due to higher Commercial Licensing, D&C Hardware, and Commercial Other revenue. Revenue was also impacted by the timing of revenue deferrals.


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Operating income increased, reflecting higher revenue and lower general and administrative expenses, offset in part by higher cost of revenue, sales and marketing expenses, and research and development expenses. Key changes in cost of revenue and operating expenses were:

Cost of revenue increased $946 million or 23%, primarily due to Surface product costs, as well as higher datacenter and headcount-related expenses.

Sales and marketing expenses increased $359 million or 12%, due mainly to increased advertising of Windows Phone 8 and Surface and higher headcount-related expenses, as well as due to higher fees paid to third-party enterprise software advisors.

Research and development expenses increased $307 million or 12%, due mainly to higher capitalization of certain costs in the prior year.

General and administrative expenses decreased $117 million or 10%, primarily due to lower legal charges.

                         SEGMENT RESULTS OF OPERATIONS

Devices and Consumer

                                                 Three Months Ended       Percentage
      (In millions, except percentages)               September 30,           Change
      ------------------------------------------------------------------------------ -

                                                2013           2012

      Licensing                           $    4,343     $    4,678             (7)%
      Hardware                                 1,485          1,084              37%
      Other                                    1,635          1,400              17%
      ---------------------------------------------- -   - -------- -
      Total revenue                       $    7,463     $    7,162               4%
                                          - -------- -   - -------- -
      Gross Margin

      Licensing                           $    3,925     $    4,103             (4)%
      Hardware                                   206            448            (54)%
      Other                                      352            362             (3)%
      ---------------------------------------------- -   - -------- -
      Total gross margin                  $    4,483     $    4,913             (9)%
                                          - -------- -   - -------- -

Devices and Consumer revenue increased $301 million or 4%, reflecting continued adoption of the Windows platform, including customer adoption of new Windows-enabled devices. Devices and Consumer gross margin declined $430 million or 9%, due mainly to our preparation for new product launches.

D&C Licensing

D&C Licensing revenue decreased $335 million or 7%, due mainly to lower revenue from licenses of Windows OEM and Consumer Office, offset in part by increased Windows Phone revenue. Windows OEM revenue declined $237 million or 7%, reflecting a 22% decrease in OEM non-Pro revenue, offset in part by a 6% increase in OEM Pro revenue. Consumer Office revenue declined $217 million or 23%. These decreases resulted primarily from the impact on revenue of a decline in consumer demand. In the case of Consumer Office, the decline was also influenced by the transition of customers to O365 Home Premium, offset by increased levels of Office attached to devices shipped. Windows Phone revenue increased $102 million, including an increase in patent licensing revenue.

D&C Licensing gross margin decreased $178 million or 4%, due to decreased revenue, offset in part by a $157 million or 27% decrease in cost of revenue. D&C Licensing cost of revenue decreased, due mainly to lower traffic acquisition costs.

D&C Hardware

D&C Hardware revenue increased $401 million or 37%, due primarily to Surface revenue of $400 million. The general availability of Surface RT and Surface Pro started October 26, 2012 and February 9, 2013, respectively.

D&C Hardware gross margin decreased $242 million or 54%, due to a $643 million or 101% increase in cost of revenue, offset in part by higher revenue. D&C Hardware cost of revenue increased, primarily due to $645 million higher Surface cost of revenue. Surface product costs increased with higher volumes sold, while other costs grew as we ready inventory lines for the Surface 2 launch and the holiday sales cycle.


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D&C Other

D&C Other revenue increased $235 million or 17%, due mainly to higher advertising revenue, which increased $106 million or 13%. Search advertising revenue growth was offset in part by a decline in display advertising revenue. Search advertising revenue increased 47%, due primarily to increased revenue per search resulting from ongoing improvements in ad products and higher search volume, offset in part by lower display advertising revenue, which was down 31%, due mainly to a decline in advertising revenue. D&C Other revenue also increased $129 million or 21%, primarily due to higher volumes of content resold through our online platforms.

D&C Other gross margin decreased slightly, due to a $245 million or 24% increase in cost of revenue, substantially offset by higher revenue. D&C Other cost of revenue increased, due mainly to a $99 million or 20% increase in advertising cost of revenue, reflecting increased investment in online infrastructure and higher traffic acquisition costs. D&C Other cost of revenue also increased, due mainly to royalty costs on higher volumes of resale transactions.


                                                  Three Months Ended      Percentage
     (In millions, except percentages)                 September 30,          Change
     ------------------------------------------------------------------------------- -

                                                2013            2012

     Licensing                           $     9,594     $     8,945              7%
     Other                                     1,603           1,248             28%
     ----------------------------------------------- -   - --------- -
     Total revenue                       $    11,197     $    10,193             10%
                                         - --------- -   - --------- -
     Gross Margin

     Licensing                           $     8,801     $     8,183              8%
     Other                                       275             105            162%
     ----------------------------------------------- -   - --------- -
     Total gross margin                  $     9,076     $     8,288             10%
                                         - --------- -   - --------- -

Commercial revenue increased $1.0 billion or 10%, reflecting growth in our traditional businesses as well as adoption by customers of our cloud services. Commercial gross margin increased $788 million or 10%, in line with revenue growth.

Commercial Licensing

Commercial Licensing revenue increased $649 million or 7%, due primarily to increased revenue from our server, CAL, and Office licenses offset in part by the transition of customers to Commercial O365. Annuity revenue grew 8% driven by growth in revenue from volume licensing with Software Assurance. Non-annuity revenue grew 4% driven by increased sales of Office and SQL Server.

Commercial Licensing gross margin increased $618 million or 8%, due to higher revenue, offset in part by a $31 million or 4% increase in cost of revenue.

Commercial Other

Commercial Other revenue increased $355 million or 28%, due to higher Cloud Services revenue and Enterprise Services revenue. Cloud Services revenue grew $261 million or 103%, due mainly to higher revenue from Commercial O365. Enterprise Services revenue grew $93 million or 9%, due to growth in both Premier product support and consulting services.

Commercial Other gross margin increased $170 million or 162%, due to higher revenue, offset in part by a $185 million or 16% increase in cost of revenue. The increase in cost of revenue was due mainly to higher datacenter expenses, reflecting investment in online operations infrastructure, and increased headcount-related expenses due to higher headcount.

                                     PART I

                                     Item 2

Corporate and Other

                                                 Three Months Ended        Percentage
     (In millions, except percentages)                September 30,            Change
     -------------------------------------------------------------------------------- -

                                               2013            2012

     Revenue                             $     (131 )    $   (1,347 )             90%
     Gross margin                        $     (144 )    $   (1,361 )             89%
     -------------------------------------------------------------------------------- -

Corporate and Other revenue comprises certain revenue deferrals, including those related to product and service upgrade offers and pre-sales of new products to OEMs prior to general availability.

Corporate and Other revenue increased $1.2 billion or 90%, primarily due to the . . .

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