Microsoft Corporation

Financial Highlights

Fourth Quarter 2003

(All growth percentages are comparisons
to the comparable quarter of fiscal year 2002)

Revenue

Revenue for the fourth quarter of fiscal year 2003 was $8.07 billion, an increase of 11% over the fourth quarter of fiscal year 2002. The revenue growth was driven primarily by multi-year licensing for Information Worker and Server Platforms products along with 25% growth in MSN revenue.

Product Revenue

Microsoft’s seven segments are: Client; Server Platforms; Information Worker; Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment.

Client includes revenue from Windows XP, Windows 2000, other standard Windows operating systems, Tablet PC, Windows Media Center Edition, and classic operating systems licensed for embedded systems (operating system software for use in devices other than PCs). Client revenue was $2.53 billion in the fourth quarter, increasing 4% compared to $2.43 billion in the fourth quarter of the prior year. The quarterly revenue growth was driven by a 2 percentage point increase to 62% of the mix of the higher priced Windows Professional operating systems, the majority of which was in the OEM channel. Windows Professional revenue growth for the fourth quarter of fiscal 2003 was $201 million or 14% compared to the prior year fourth quarter, offset by a decline in other Windows operating systems.

Server Platforms consists of server software licenses and client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other servers. It also includes developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft consulting services. Total Server Platforms revenue grew 17% to $1.93 billion in the fourth quarter, driven by an increase in Windows-based server shipments and growth in SQL Server and Exchange revenue. Server revenue, including CALs, grew $251 million or 21% from the prior year’s fourth quarter as a result of increased new and recurring multi-year licensing agreements. Consulting and Premier product support services increased $33 million or 14% compared to the prior year’s fourth quarter. Revenue from developer tools, training, certification, Microsoft Press and other services declined $1 million.

Information Worker consists of Microsoft Office, Microsoft Project, Visio, other information worker products, SharePoint Portal Server CALs, and professional product support services. Revenue from Information Worker was $2.35 billion in the fourth quarter of fiscal 2003, increasing 8% from the prior year’s fourth quarter. The growth in revenue was due to a $102 million or 5% increase in Office suites revenue associated with new and recurring multi-year licensing agreements and a $75 million or 32% increase in revenue from the combined total of Project, Visio, and other standalone applications.

Business Solutions includes Microsoft Great Plains; Navision; and bCentral. Business Solutions revenue for the fourth quarter was $179 million compared to $86 million in the prior year’s fourth quarter. The acquisition of Navision at the beginning of the fiscal year combined with the increase customer demand for Navision products accounted for $86 million of the increase.

MSN includes MSN Subscription and MSN Network services. MSN revenue totaled $559 million in the fourth quarter compared to $447 million in the prior year’s fourth quarter. MSN Network services revenue grew $80 million or 48% as a result of growth in paid search and strong general advertising sales across all geographic regions. The remainder of the quarterly growth was attributed to MSN Subscription revenue.

Mobile and Embedded Devices includes Pocket PC, SmartPhones, Handheld PC, other Mobility, Windows embedded device operating systems, and MapPoint. Fourth quarter revenue totaled $44 million, compared to $36 million in the prior year’s fourth quarter. The increase in revenue was driven by increased Pocket PC shipments and MapPoint licensing. Prior year revenue for Mobile and Embedded Devices has been restated to reflect the reorganizations of MapPoint from Information Worker and Windows embedded device operating systems from Client to Mobile and Embedded Devices.

Home and Entertainment includes the Xbox video game system; PC games; consumer software and hardware; and TV platform. Home and Entertainment revenue was $483 million in the fourth quarter of fiscal 2003, increasing 8% from $448 million in the prior year’s fourth quarter. Xbox revenue increased $32 million or 13% from the prior year’s fourth quarter, primarily as a result of higher sales of Xbox games. Revenue from consumer hardware and software and PC games increased 1% compared to a year ago.

Distribution Channels

Microsoft distributes its products primarily through OEM licenses, organizational licenses, online services and products, and retail packaged products. These distribution channels are aligned geographically with the exception of OEM customers, which are generally managed centrally.

The Company’s three major geographic sales and marketing organizations are the Americas Region, the Europe, Middle East, and Africa Region (EMEA), and the Japan and Asia-Pacific Region. For fiscal year 2003, Microsoft reorganized the alignment of countries located in the South Pacific to be included as part of the Japan and Asia-Pacific region. Prior year geographic revenue has been adjusted to conform to the current presentation. Sales of organizational licenses and retail packaged products via these channels are primarily to and through distributors and resellers.

OEM channel revenue represents license fees from original equipment manufacturers who pre-install Microsoft products, primarily on PCs. OEM revenue for the fourth quarter was $2.49 billion, up 6% from $2.34 billion in the comparable quarter of fiscal 2002. The OEM revenue growth reflects a 5% increase in reported licenses, a 25% increase in Windows Professional revenue due to an increase in the mix of the higher priced Windows Professional licenses, and 18% and 37% revenue growth for Office and Server products, respectively.

Americas Region revenue in the fourth quarter was $2.99 billion, an increase of 3% compared to $2.91 billion in the prior year’s fourth quarter. The Americas region revenue growth was primarily the result of 22% growth in MSN revenue and 25% growth in Business Solutions revenue. Revenue from Server Platforms increased 3%; however, Client and Information Worker revenue declined 4% and 7%, respectively.

Europe, Middle East, and Africa Region revenue was $1.75 billion, increasing 43% from the $1.22 billion reported in the fourth quarter of the prior year. The revenue growth was aided by favorable foreign exchange rates compared to the prior year’s fourth quarter exchange rates. Had foreign exchange rates been constant with those of the fourth quarter of 2002, revenue in the region would have increased 27% instead of increasing 43%, excluding any effects of hedging gains and losses. Including the favorable foreign exchange rates, revenue growth in Information Worker and Server Platforms increased 39% and 37%, respectively. The acquisition of Navision in the first quarter of 2003 also led to a $70 million increase in fourth quarter revenue in the region for Business Solutions compared to the prior year’s fourth quarter.

Japan and Asia-Pacific Region revenue increased 7% to $835 million from $780 million in the fourth quarter of the prior year. The region’s revenue increase reflected a 42% increase in Home and Entertainment sales, primarily Xbox gaming consoles, and a 16% increase in Server Platforms revenue. Client and Information Worker revenue were flat with the prior year’s fourth quarter. Had foreign exchange rates been constant with those of the fourth quarter of 2002, revenue in the region would have decreased 0.2% instead of increasing 7%, excluding any effects of hedging gains and losses.

Translated international revenue is affected by foreign exchange rates. The net impact of foreign exchange rates on revenue was positive in the fourth quarter compared to a year ago, primarily due to a stronger Euro and Japanese yen versus the U.S. dollar. Had the rates from the prior year’s comparable quarter been in effect in the fourth quarter of fiscal 2003, translated international revenue billed in local currencies would have been approximately $255 million lower. Certain manufacturing, selling, distribution, and support costs are disbursed in local currencies, and a portion of international revenue is hedged, thus offsetting a portion of the translation exposure.

Operating Expenses

Cost of revenue was $1.24 billion, or 15.4% of revenue, in the fourth quarter, compared to $1.37 billion, or 18.9% of revenue, in the fourth quarter of the prior year. The decrease in absolute dollars, as well as percentage of revenue, resulted primarily from a 43% decrease in Home & Entertainment costs, due to fewer Xbox console units and lower costs of producing the Xbox console, partially offset by a 24% increase in program costs for Client, Information Worker, and Server Platforms.

Research and development expenses in the fourth quarter of fiscal 2003 were $1.34 billion, 16.6% of revenue, an increase of 13% in absolute dollar terms over the fourth quarter of the prior year. The increase was primarily due to a $117 million or 15% increase in headcount-related costs and a $14 million or 56% increase in localization costs, primarily related to the upcoming launch of Office System 2003, and $21 million or 13% increase in third party product development costs, testing equipment, and lab expenses.

Sales and marketing expenses were $2.10 billion in the fourth quarter, or 26.1% of revenue, compared to $1.54 billion in the fourth quarter of the prior year, or 21.3% of revenue. Sales and marketing costs increased in absolute dollars due to a 30% increase in marketing spending, including spending related to the Realizing Potential initiative, Windows Server System product launches, and the upcoming launch of Office System 2003, $38 million related to the integration of our Small/Medium and the Business Solutions sales forces, and $84 million of headcount-related expenses primarily associated with the additions to the Enterprise and Small/Medium sales forces as well as additional sales bonuses commensurate with the growth in revenue.

General and administrative costs were $1.19 billion in the fourth quarter compared to $284 million in the comparable quarter of the prior year. General and administrative costs in the fourth quarter included $750 million charge for the AOL Time Warner settlement and $46 million additional administrative costs associated with the settlement of the class action lawsuits.

Non-operating Items, Investment Income, and Income Taxes

Losses on equity investees and other incorporates Microsoft’s share of income or loss from equity method investments and income or loss attributable to minority interests. Losses on equity investees and other increased to $15 million in the fourth quarter of fiscal 2003, from $14 million in the comparable quarter of fiscal 2002.

The components of investment income are as follows:

The effective tax rate for the fourth quarter is 33%. The effective tax rate for fiscal 2002 was 32%.

Unearned Revenue

A portion of Microsoft’s revenue from Enterprise Agreements, Software Assurance, Upgrade Advantage and other volume licensing programs is recorded as unearned revenue at the time of billing and recognized ratably over the billing coverage period. Also, revenue attributable to undelivered elements, including technical support and Internet browser technologies, is based on a range of average sales prices of those elements when sold separately, and is recognized ratably on a straight-line basis over the product’s life cycle. Product life cycles, determined to be the time period between when a product is released and when a new product in the same product family is expected to be released, are currently estimated at three and a half years for Windows operating systems and two years for desktop applications (primarily Office). The percentage of revenue recorded as unearned and recognized ratably for undelivered elements ranges from approximately 15% to 25% for Windows XP Home, approximately 5% to 15% for Windows XP Professional, and approximately 5% to 15% for desktop applications, depending on the terms and conditions of the license and prices of the elements.

The components of unearned revenue were as follows:

Unearned revenue as of June 30, 2003 increased $483 million from March 31, 2003 reflecting a sequential increase in new and recurring multi-year licensing agreements partially offset by recognition of unearned revenue from multi-year licensing in prior periods. Of the $9.02 billion of unearned revenue at June 30, 2003, $2.65 billion is expected to be recognized in the first quarter of fiscal 2004, $2.05 billion in the second quarter of fiscal 2004, $1.53 billion in the third quarter of fiscal 2004, $1.00 billion in the fourth quarter of fiscal 2004, and $1.79 billion thereafter.

Financial Condition

Cash and short-term investments totaled $49.05 billion as of June 30, 2003. Cash flow from operations for the fourth quarter of fiscal 2003 was $2.69 billion, compared to $3.43 billion in the comparable quarter of the prior year. The decrease reflects a cash payment for the legal settlement with AOL Time Warner in the fourth quarter of fiscal 2003, an 18% decline in cash flow from accounts receivables, partially offset by an increase in new and recurring multi-year contract billings. Cash used for financing was $483 million in the fourth quarter of fiscal 2003, compared to $3.84 billion in the comparable quarter of the prior year. This decrease in cash used from the prior year reflected a $2.91 billion decrease in cash used for stock repurchases, and a $445 million increase of common stock issuances primarily for employee stock option programs. The Company repurchased 48.1 million shares of common stock under its share repurchase program in the fourth quarter, compared to 179.0 million shares repurchased in the prior year. Cash used for investing was $90 million in the fourth quarter, a decrease of $1.61 billion from the prior year reflecting lower investing activity in the fourth quarter of fiscal 2003.

Employee Stock Options (ESOs)

The Company encourages broad-based employee ownership of Microsoft stock and has had an ESO program in which the majority of employees have been eligible to participate. At June 30, 2003, 1.55 billion vested and unvested options were outstanding, compared to 10.77 billion common shares outstanding.

For the year ended June 30, 2003, Microsoft followed Accounting Principles Board Opinion (APB) 25, Accounting for Stock Issued to Employees, to account for ESOs, which generally does not require income statement recognition of options granted at the market price on the date of issuance. FICA and Medicare payroll taxes associated with stock option exercises are recorded as an expense. Other events such as the accelerated vesting of options can also trigger recording an expense. These costs were reflected in each operating expense line item in the income statement. Under SFAS 123, Accounting for Stock-Based Compensation, employee stock options are valued at grant date using the Black-Scholes valuation model, and this compensation cost is recognized ratably over the vesting period. Had compensation cost for our stock option and employee stock purchase plans been determined as prescribed by SFAS 123, pro forma income statements for fiscal years 2002 and 2003 would have been as follows:

ALTERNATIVE PRESENTATION OF ACCOUNTING FOR ESOS UNDER SFAS 123

(In millions, except earnings per share)(Unaudited)

In July 2003, the Company announced that it would adopt the fair value recognition provisions of SFAS 123 on July 1, 2003 (fiscal year 2004) and restate prior periods to reflect the compensation cost that would have been recognized had the recognition provisions of SFAS 123 been applied to all awards granted to employees after July 1, 1995.

Microsoft, Great Plains, Windows, Xbox, Visio, Windows NT, BackOffice, bCentral, Visual Studio, MSN, HomeAdvisor, CarPoint, and Microsoft Press are either registered trademarks or trademarks of Microsoft Corporation or Great Plains in the United States and/or other countries. The names of actual companies and products mentioned herein may be the trademarks of their respective owners.

For More Information:

Curt Anderson, Senior Director, Investor Relations, (425) 706-3703