Home and Entertainment
2003 Financial Analyst Meeting
July 24, 2003

ROBBIE BACH: Good afternoon, everybody. I'm going to talk today briefly about our consumer strategy as a whole across the company and then spend the vast majority of my time talking about the Home and Entertainment Division and what we're accomplishing there.

So if you think about our consumer strategy, it really starts with Windows®, not surprisingly. Windows is the technology, and the product, that enables us to deliver all of the consumer scenarios we're focused on, whether that's things like productivity, communications, browsing, digital image editing, playing games or whatever it is. It forms the foundation for pursuing those activities.

In addition, it's also the thing in the home that physically is in the center of the picture, because it is the thing that is going to manage your Internet connections and provide the infrastructure for a home network and provide the foundation for a set of connected devices to enable you to have all of these exciting experiences.

And that brings me to the second part of the strategy, which is really focused on the devices, where we have devices—everything from a stopwatch to a PC, a mobile phone, Tablet PC, Xbox®—that are running some form of Windows operating system or Windows technology. To connect those scenarios to the people who need to engage in them, whether they're in the bedroom, outside the home, at work, in the living room, wherever they are—being connected to what we can do really makes all of this possible.

And then, finally, are the services and applications that run on those devices and rely on Windows as the foundation for the work they do. On the application side, you have productivity tools like Office, education tools like Encarta®, PC games, Age of Empires®, those types of things. In the services area, you have Xbox Live™, MSN®, Windows Update and other services.

All of those things together, running on the foundation that Windows built, running on a connected network, and provided by Microsoft or by third parties, forms the whole of what we think is possible for consumers in the home—and connecting that with what they do at work.

So that gives you a little bit of the foundation of what we're trying to accomplish across the company in consumer. Now, I want to talk a little bit about the Home and Entertainment Division itself. Just as a refresh, there are three parts to the Home and Entertainment Division: the games part, which does Xbox and PC games; the Home and Retail Division, which does consumer apps, Macintosh applications, consumer hardware, as well as being responsible for retail sales for all of Microsoft's products, including Office and Windows, and any other products that we actually sell at retail.

And then, the third aspect of Home and Entertainment is Microsoft® TV, which is where we're building the TV platform for network operators. And all of these things work together to help deliver on that consumer strategy we talked about.

In the home and retail space, fiscal year '03 was very successful for us. On the hardware side, we gained share in mice and keyboards—particularly effective with our wireless products and with a mouse-keyboard bundle that has really delivered a wireless solution for people on the desktop. We also successfully entered the home networking market. We think that's a market that can both be profitable for us financially, but that is also important to us strategically as we build that connected home environment that I talked about earlier.

On the Mac, great work—working with Apple to drive Mac office sales, promotional work, and other work to make this a very successful year for us. And in the rest of the consumer software business—Money, Encarta, our digital imaging products—we gained share and actually grew in a year, and which the market as a whole, probably declined a few points. So all in all, fiscal year '03 was a very good year for the home retail business.

As you look to the coming year's priorities, a lot of what we're focused on is on Windows excitement and creating excitement and potential for people in using their Windows PC. Certainly, the Office 2003 launch will be a big part of what this group focuses on this year, because launching that product successfully at retail leads to a sense of buzz in the marketplace and really encourages people, from the ground up, to move towards new versions of that product.

Obviously, we continue to have a good PC games business, and we have some big new releases this year, and we will be launching some new Macintosh applications as well, based on the acquisition of Connectix. So this is a good year for home and retail, with some nice challenges for fiscal year '04.

Microsoft TV, in fiscal year '03, also was a year of building momentum and really laying the foundation for what I think is a very positive future. During the year, we launched our Microsoft TV IPG product, which is our Interactive Programming Guide, as well as Foundation Edition, which is the platform for network operators to build applications on top of. We signed nine deals, five in Latin America, four in the U.S., including a deal with Comcast and Time/Warner, for trials and, hopefully, ultimately, rollouts of that technology.

So that's a big step forward for us in making progress in this marketplace. We've already deployed, in Latin America, 70,000 units of the programming guide, and I think you'll see more of that in the coming year. Finally, in the '03 accomplishments, we've done a lot of work with Cable Labs, which is the industry consortium that drives standardization technology, to incorporate .NET into their O-CAP standard.

That sounds like a little bit of a small point, but it is an important sign that we're making progress and working with network operators in a positive way.

As we look to fiscal year '04, it's really about executing on the momentum that we've built today. We want to get Foundation Edition into trials and then into deployment. We want to keep growing the IPG business to get more deployments there. We're also working on some IP TV technology that we think is pretty exciting, in particular, in Europe and Asia. Most of the rest of the work in Microsoft TV has been North American-based. So this presents us with some new opportunities, and there's some foundation technology work we're working on to make that happen.

And finally, we'll continue on the standards effort, both with standards bodies in the U.S. and around the world, to incorporating our technology and making it work well for the cable operators.

When you go to Xbox— this year was a pivotal year for us, and a year in which we made a tremendous amount of progress in the marketplace. As you heard on the conference call last week, we've shipped to date 9.4 million consoles worldwide. Our market share is up to about 25 percent in almost every market, with the exception of Japan, which I'll talk about in a moment.

We launched Xbox Live successfully. It's now the largest paid gaming service in the world—500,000 paid subscribers thus far—with a lot of positive momentum around that service. On the games side, we're ahead of any console at this stage in its life, in terms of selling games. Our attach rate is higher than any console has achieved at this point in its life. Our first party group that produces Microsoft titles is now building a series of franchises that we think will build our portfolio for the future, which is critical to the long-term success of Xbox.

And equally critical, we've gotten great support from third parties, and I'll talk a little bit about that in a minute. But third parties really are doing a great job driving the platform and freeing up our first party group to focus on platform innovations rather than trying to have a title in every category. So it gives us a little bit more flexibility in what we're doing.

As we think about our priorities for the coming year, it's really about expanding content, community and competition, because we're now in a phase of the market where things are getting beyond the core gamers, and we're into the broad base market. So really, the group is focused on making sure we have great games that excite people, regardless of the demographic.

By the end of this holiday, we'll have about 400 titles. You can see there some of the key franchises; we're actually going to show you two of those today. XSN Sports is a new concept we've come up with in sports to add the types of online capabilities that enable you to create tournaments, create ladders, create communities in your sports leagues just as you would with a rec league locally, and put your team together with friends, have tournaments, have a season, and really create an ongoing sense of community that will drive people to the live service and keep them there for the long term.

And Music Mixer is actually an example of something that fits into that consumer strategy that I talked about earlier, because this enables you, from Xbox, to access your music and digital photos from a PC on the network and play them and manipulate them locally on Xbox. And this is the first step we've taken in integrating the things we're doing in the home with what we're doing in Xbox, and I think you'll see more of that going forward.

Xbox Live is in a very strong position. It's a clear differentiator for us relative to Sony. I think you're going to see some nice updates to the service with new capabilities, particularly around community. We'll have 50 games by this holiday and 100 by this time next year, and we're seeing very strong critical mass from our publishers in terms of their excitement about doing this.

But we think we will double the subscriber base this year. So by 12 months from now, a million paid subscribers on Xbox Live, which is well ahead of what we thought when we got started, but it certainly is consistent with the excitement and momentum we've seen.

I'm going to talk about cost reduction later, but I did want to just reiterate our guidance on forecast—14.5 to 16 million cumulative shipments by the end of the fiscal year, which puts us in position for a nice growth year this year, and continuing to make progress in the marketplace.

I thought I would also spend a little bit of time talking about the things driving our business. Our count per volume certainly is critical. And what you're seeing in the marketplace now is a virtual cycle around Xbox. We had a very successful holiday, much more successful this past year than anybody expected. And what that's done is it's encouraged more developers and publishers to bring more titles to Xbox and move them from other platforms.

As they bring more of those titles, consumers get more excited about Xbox, and we sell more consoles. And you get in this cycle where more consoles lead to more titles, which lead to more consoles, and we're seeing that driving our popularity. We see it in the data; we see it in the purchase intent for what we're doing.

Pricing also is an interesting topic—one that certainly drives the business model. Our reference price in the U.S.—the price today in the U.S.—is $179. Sony is priced—they have one SKU at $179 and another SKU at $199. In our business, the sales continue to do well. We'll see how pricing evolves. Certainly, our strategy will be to be competitive, and we will see how Sony decides that they want to evolve their pricing strategy, and we will be there, as we have demonstrated over the last few years, competitive in the marketplace, making sure consumers are getting a great value with Xbox.

When you look at cost reduction, this is really a continuous process in three parts. First, there are the things we do in the box that are just day in and day out—working with vendors to drive cost out of the system at the component level, and that's something we've been doing since the beginning and continue to do. Second are things we do inside Xbox architecturally, which you would call major changes in the chip structure or chip size, other types of things in the Box, to reduce cost. It doesn't change the performance of the Box any, but it does lower our cost.

And we do those in increments, and we try to time those increments so they come into production in time for the big push for the holiday so that we get the maximum benefit we can in the P&L. And in the third area, which is a recent area of focus, is driving down our operations costs overall. Because when you think about P&L, it doesn't matter whether you're the cost out of the box or out of the distribution or out of IT or out of whatever it is in the system. We want to drive that cost lower so we have more flexibility on pricing and can drive more demand.

And so, you're going to see us do a lot of work with our suppliers in shipping and a whole set of other operations capabilities so that we have a world class, end-to-end, efficient supply chain. That's really where a lot of focus is going in today.

On the games attach rate side, we're getting great titles from our studio; I'll talk about that in a moment. We're very excited about what we're seeing for this holiday, and I'd say the next 12 months is the strongest lineup we've ever had, and I think the strongest lineup in the industry. So I'm very excited about those games. And a lot of that's based on our third-party support, where we're seeing, actually, more exclusive titles coming to the platform in addition to cross-platform titles coming to the platform that just look and play better on Xbox. And that has differentiated us and enabled us to drive the extra share in volume that we have.

Certainly, if you look at our P&L, and look at the business, it does vary by territory. I gave the share numbers earlier of about 25 percent in all the major markets. There are several markets where we have higher share than that. Australia, Canada and the UK are all over 30 percent now, and so that's really good progress for us, and we'll continue to try to move the average up as well.

Japan is the one outlier where our share is pretty steady at four or five percent. We're doing a lot of work in Japan to fundamentally rebuild that business. We obviously haven't been as successful there as we would have liked out of the gate. We hired Peter Moore from Sega, who is now running Europe and Japan, working for me. And he is there. In fact, he is there today, working with a team, building relationships with partners, putting the foundation in place for long-term success.

And the way you should think about Japan for us is, this is something were committed to long term—you probably won't see the numbers change a lot in the short term—but that we're committed to long term, and we're going to be successful in that marketplace, and we're taking the steps necessary to enable us to do that.

From a competitive perspective, obviously, Sony is the primary competition here. They've done very well in the market. They started with about a year to two-year head start on us, depending on which market you look at. I'm actually very pleased with the progress we've made against Sony to date. There's obviously more for us to do. We think things like Xbox Live and our game lineup are the principal things that are going to drive us to more success, because they clearly differentiate Xbox from what you can get on a PS2. And we plan and hope to continue to make progress in that competition.

Finally, on the console cycle side, I just wanted to point out that we're sort of in the part of the cycle—the console cycle kind of goes in these bell curve cycles for hardware and software, hardware slightly ahead of the software curve. And we're now sort of right at the peak of those two curves, where hardware sales are kind of at their max for the cycle and software is getting to its max in the cycle.

The exciting thing about that for us is it means that things right now are about the games. It's not about the design or the box; it's not about the features of the box, because people know that. It's been in the market for a long time. Now, it's about the games you're producing and the excitement you're generating with those games. And as I'll talk in a minute, we're very excited about the portfolio of games we have coming forward.

One of the big things in that portfolio is making sure we broaden our audience. Xbox has done exceptionally well with what you would call a more dedicated gaming audience. And we are now, given our size and scale in the market, broadening out to reach more consumers. So what you see here are titles from a variety of publishers—Electronic Arts, Atari, THQ, Sega, Konami. These are titles that reach into the broad audience.

The first three or four are movie franchises that people know, and it's an easy purchase for people to make at retail. The next three or four are games that are probably designed for a younger audience—so Finding Nemo, SpongeBob SquarePants, Grabbed by the Ghoulies, which was from Rare—it was a company we acquired last year. Sonic Heroes is a young person's audience.

Then there's Music Mixer and Dance Dance Revolution, which are what I call alternative entertainment products. They're not really games. I mean, Dance Dance is sort of a game, but it's a dancing game, and Music Mixer gives you the abilities to manipulate music and photos, do karaoke—there's a set of other things. It is entertainment; it's just not traditional video game entertainment. And that reaches to a broader audience and a broader demographic.

I talked a little about XSN today. That's a key initiative for us, and we'll kick off with a launch of NFL Fever in a couple of weeks. The other title I want to talk about is Project Gotham Racing® 2. PGR™ 1 sold well over a million units as a launch title for Xbox. And we think Project Gotham Racing 2, which will support Xbox Live, will be an even bigger title.

And so, I'm going to invite Scott Lee out to give you a little tour of Project Gotham Racing 2.

Scott.

SCOTT LEE: Thanks, Robbie. Project Gotham Racing 2, or PGR 2, as I call it. PGR 1 was the best-selling racing title on Xbox. It outsold the competition by almost four to one. So we're going to jump in today to give you a little tour around the lap of Florence, Italy, in an Enzo Ferrari. This is a 660 horsepower car—$750,000 if you're lucky enough to be invited to buy one. It's free with Project Gotham Racing 2.

If you look at the cities here, we're going to cross nearby the Pontivechio in Florence. It's just a gorgeous city. You can see the lighting effects there. The developer, Bizarre Creations, out of Liverpool, England, has had a lot more time to get familiar with Xbox and what it can do, so the graphics have improved greatly on here. And you can see if I go through here, I'm racking up what we call kudos points.

And what makes this game unique is that it rewards you not only for how fast you drive, but for how you drive fast. It's something that my wife probably wouldn't reward me for, but anyway. Here's a little crash into the nearby Duomo there, and there's the Doors of Paradise. If you've ever been to Florence—that's what it looks like.

There's Antonio's Pharmacia there on the right. If I go through here, the hard drive is actually recording my first lap here, and as I come around, you'll see in a minute there will be what we call a ghost car. And that ghost car—ooh, ouch, look at the damage—and that ghost car gets recorded and actually gets uploaded to Xbox Live servers so that everyone in the world can race against me, whether they're a single player or not.

So that ghost will get uploaded; I can race against it. I'll also be able to play against base players on Xbox Live. We'll have downloadable content, new cities and cars that people can download. Look for this title to come out in November. This holiday, we expect some great things from it.

Thanks, Robbie.

ROBBIE BACH: So that's Project Gotham Racing 2—we think it will be one of the leading titles for us this holiday. I also want to talk a little bit about the fact that in addition to broadening the audience, we're still paying attention and focused on our core gaming audience. And the set of titles here—if you looked at any list of critically acclaimed titles, these titles would all appear on them. And we're very excited about this.

I'm only going to highlight a few of them. Star Wars: Knights of the Old Republic is a title from LucasArts that shipped last week. In its first week, it sold 250,000 units. That's a four-day record for Xbox. This is a role-playing game. It's the first role-playing game we've had on the platform that's with a big franchise associated with it. And we think this is going to drive a lot of volume going through the holidays. It's getting game ratings over 90 percent, which happens in a very, very, very small number of titles.

Other things I'd point to: Rainbow Six, Tom Clancy—again, a big franchise. That will be exclusive on Xbox this holiday. Ninja Gaiden, Soul Caliber II from Japanese developers Namco and Tecmo. And then, three titles at the bottom from Microsoft: Counter-Strike, which will ship for this holiday; Fable, which we'll ship in the spring. And then, my own personal favorite—and my son's personal favorite—Halo 2. So with that, I'm going to show you a recording of the demo that we did at D3 for Halo 2. This is a title that we'll ship this spring. The first version of Halo™ has sold over 3 million units, all at full price. It is probably the most-anticipated console title this year, on any platform, and you're going to get to see an early of it. Here's Halo 2.

(Video segment.)

So that's Halo 2, probably our feature title for the year.

If you look across all of our businesses, whether it's in home and retail, Microsoft TV, or in Xbox, we feel like we're making a lot of progress on the product side, on the marketing side, and in the market itself. And I think fiscal year '04 will be another example of that continuing.

Thanks very much.

END

Due to the varying sound quality and subject matter of tapes, the information in this transcript may contain inaccuracies.