Financial Update
2003 Financial Analyst Meeting
July 24, 2003

ANNOUNCER: Ladies and gentlemen, please welcome Chief Financial Officer John Connors.

JOHN CONNORS: Okay, well, thanks very much, and I hope we're getting down to the end of the day before we have some cocktails and dinner. The first thing I would like you to note in your online distribution is the forward-looking statement slide here in terms of what it is we are presenting; please do take note of it.

To start, what I'd like to do is introduce some of the senior-level people we've promoted from within or hired from outside of Microsoft as part of the broad transformation the company is going through. I think the people in this room are clearly familiar with how rapidly the company has grown and, even more importantly, how rapidly we've diversified into a number of new businesses. We initiated a process a little more than a year ago to really scale up the level of financial leadership and the roles that the finance organization plays both in the center of the company as well as in the seven business groups, and in our large-scale operations centers and large-scale marketing services group.

I'd like to have, if Alain Peracca is here, have him stand up. Alain is the client CFO—joined us from Hewlett Packard. Secondly, Marc Chardon is the Information Worker CFO. He's been with Microsoft for a number of years. Thirdly, Peter Klein, who's been with us a couple of years, he's the CFO for Server and Tools. Next I'd like to introduce Ken Mueller, who joined us in the last six months as the CFO for Business Solutions. Bruce Jaffe is the CFO for MSN®. He is not here today. He is on a vacation and will be back at the end of the summer. Bryan Lee is here. He's been with us a couple of years—joined us from Sony. He is the Home and Entertainment CFO. David Rinn, who I believe I saw earlier in the lobby, has been with Microsoft for about nine years as the CFO for the Mobile and Embedded Devices division. Alain Crozier is the CFO for our Sales, Marketing, and Services group and has been with the company since 1994. Eileen Johnston, who's been with us about six years, is the CFO for the Operations and Technology Group, which includes our large-scale centralized operations centers around the world.

Robert Uhlaner is the vice president and head of our Corporate Strategy, Planning, and Analysis Group. He joined us in February from McKenzie. Scott Di Valerio is the corporate controller who has replaced Scott Boggs, who's out on a sabbatical. Scott joined us from Disney in April. And then finally, two longtime Microsoft leaders in the financial organization who I think many of you have met, Mike Boyle, who is in charge of our tax organization and internal audit, and Brent Callinicos, who is in charge of our Treasury group.

I'd like to introduce the new leaders, and I think a number of you got to see them at lunch. You'll see them at cocktails, see them at dinner, and then as shareholders and analysts visit us over the years, this is the group that will be largely responsible for working with you with each of our respective businesses.

I'd like to just take a quick look back before we start talking about fiscal year '03. We feel like we have been on a pretty darn good run as a company. Our results have been good on an absolute basis and we think our results have been quite great on a relative basis.

If you look back to July's financial analyst meeting of '00, you can see the disproportionate representation of technology companies in the Top 10 market cap lists. If you go to last year's financial analyst meeting, things begin to shift pretty dramatically back to the companies that produced the largest profits and the largest cash flow, and you can see now that the world economy and market valuation are really to the companies and those industries with the largest absolute cash, largest absolute profit base. As of yesterday we were Number One. I checked just before coming up and we were still about $4.5, $5 billion ahead of GE. That can change any day between us, GE, and Pfizer. But we feel like we have had some very good results in what it has been a pretty darn challenging environment generally and for technology companies specifically.

When we look back on fiscal year '03, it's important to put in context '03 with '02. If you look at the absolute revenue results and growth results on a GAAP basis for both of those fiscal years, we've done a good job for shareholders.

I think it's important to note, though, for a couple of businesses we had a transition effect in '03 that muted '02's results a little bit and does have an impact on '04. If you look at the '03 results in total, I think the first thing to note and something we are quite proud of is the fact that each of our businesses did report double-digit revenue growth in the fiscal year with respect to revenue.

If you look at the Information Worker and the Server business, you have to look at '03 in the context of '02. '02 results were a little bit muted as we began the shift to Licensing 6.0, and that transition date that was July 15th a year ago. And '03 results are higher than they otherwise would have been from a GAAP perspective absent that transition.

But nonetheless, in each of our businesses we feel like we had a pretty darn good year. And if you look at the two years back to back of double-digit revenue growth, it has been a good run for the company.

If you look at the income statement, we also had a good year. On an absolute basis I think it was very strong; on a relative basis, pretty darn phenomenal.

A couple of things to note in terms of this chart: All the numbers are GAAP except head count, and there's a couple of adjustments that you'll have to make mentally, but those of you that follow us closely would have already made or are familiar with.

In fiscal year '02 the operating income was impacted by a $600 million accrual for legal settlements. Fiscal year '03 included about a billion dollars for legal settlement accruals.

If you take those out of both years, that growth year over year of 13 percent is pretty phenomenal, and the absolute amount of profit growth is tremendous. Part of that is Licensing 6.0, part of that is FX, part of that is the transition to Windows® XP Professional, and part of that is just very good execution on a diversified front.

I think the most important thing to think about with respect to Microsoft is we did have a very strong year in a year that we were investing quite heavily. We also ended the year in a position of enviable financial strength. In terms of the balance sheet, our assets are strong. In terms of overall shareholders equity, we showed very strong percentage growth and very good absolute growth.

I think the key thing to think about with Microsoft is we are in a position to continue the momentum we've had for the last couple of years as we enter FY04 from a balance sheet perspective.

A year ago we told you that we were going to make some significant investments. We had a slide that said this was a breakaway year with a serious of breakthrough investments. We were sacrificing short-term profitability for investments in a number of categories. This chart lays out for you the top-level things we told you we would do in fiscal year '03 from an investment perspective, and then it's a little bit of a scorecard of what did we actually do.

Across the board in each business, we feel like we had significant activity to build the company for the long term. In addition, we did make a number—or close on or integrate a number—of significant acquisitions. We purchased an integrated Navision, and you've heard about that today. We purchased PlaceWare. We purchased Vicinity. We purchased Rare.

In terms of each of the business groups, we feel like we had good dollars spent for momentum for the long term.

Most importantly, when you think about how did the company perform in its traditional businesses that you're familiar with, that we've been in for some time, as well as the new businesses that we've entered over the last couple of years, revenue growth was strong, and we also feel like the P&L profile of each of these businesses has shown improvement.

Obviously the Client and Information Worker segments continue to be very strong segments no matter how you measure it. The Server and Tools segment continues to be one of the most important growth engines for us, and we really did have a very, very good year both in revenue as well as segment performance.

But in addition to that, each of our new businesses—Business Solutions, the Mobile and Embedded Devices division, the MSN division, as well as Home and Entertainment—showed an improving P&L profile from a segment perspective relative to '02. That's despite the fact that we had significant investments in each of those.

You have heard particularly from Robbie Bach and Yusuf Mehdi the work that is underway in each of those groups to really improve the profile as we go forward. We are not going to do anything that is intended to improve a single quarter or intended to improve just a single year, but we are hard at work on the fundamental economics, both fixed costs and variable costs that can help us grow those businesses for the long term in a profile that shareholders like.

At the Financial Analysts Meeting in the summer of 2000, we talked about the business shift that we thought we would be undergoing with respect to the nature of the way people bought software from us. Part of that shift was a function of the move to online and the move to new businesses such as Home and Entertainment, and part of that shift was in anticipation of moving more of our business to a subscription model or multiyear annuity model for those customers that buy organizational licenses.

In the summer of 2000 for the Analysts Meeting, we showed you what we had shipped in that year of reporting. We made a projection for fiscal year '03 in terms of what would that mix shift look like. We thought we would have a mix of 37 percent outright purchase. We thought we would have a percentage of 26 percent that is royalties. And finally we thought we would have a mixed percentage of about 37 percent that was subscription and online.

As we close this fiscal year and hold this meeting this summer, we wanted to update you on how did those projections come out. We actually had a purchase percentage in '03 of 31. We had a royalty percentage of 32. And finally a subscription and online of 37. You can see the breakdown below of the components of the subscription and online.

Our royalty business probably grew and was a bit stronger than we thought going into that fiscal year '01. A couple of the emerging businesses probably did not have quite the growth over that three-year period we might have forecasted, but the shift to subscription and annuity was largely consistent with what we anticipated in that summer of 2000.

It is likely that we'll continue to see a mixed shift in our organizational licensing business to the annuity program that we launched. I'll talk a little bit about Software Assurance. You've heard a lot about customer values from Jim Allchin, from Jeff Raikes, from Eric Rudder, from Doug Burgum, from Orlando Ayala, but each of those talked a little bit about what we're doing to ensure that the subscription and multiyear programs we're introducing for customers have value that is compelling.

We're seeing a remarkable increase in unearned revenue over the course of the last couple of years. The increase we saw in the period for the fiscal year ended June 30th of '02 was a phenomenal increase of 38 percent. Despite that increase, we did see strong growth in fiscal year '03, up nearly 16 percent. The largest percentage of that growth obviously occurred in the first quarter of this fiscal year as the deadline for transition to Licensing 6.0 expired, but we were pleased with the results throughout the rest of this fiscal year and, in particular, the strong close to business in the fourth quarter, and in particular with large enterprises and government institutions around the world. But we do feel that we are on a path where our model moves consistently for organizations to a multiyear model.

Let's talk now a little bit about fiscal year '04, and we've gotten lots of feedback from participants here as well as shareholders that aren't here in person about the growth in '04 versus the growth in '03.

The most important thing to put in your mind for context is, adjusting for legal settlement, that operating income growth in '03 is roughly $1.7 billion. If you think about the absolute amount of growth in '03, there's just no way we're going to put up those kind of numbers year after year, and '04 presents a particularly unique set of tough comparables.

There's a couple of key things that each of you really do have to think about when modeling us for the long term. '04 comparables are tough, first because of the remarkable shift we've seen in the percentages of licenses we sell—either to customers directly with organizational agreements or indirect through OEMs—that are Windows XP Professional. There simply isn't the runway of license growth left because we've seen such dramatic increase over the last 18 months.

Secondly, the FX benefits we've seen, particularly in the last half of fiscal year '03, may or may not transpire. We were quite surprised at the dollar decline from a magnitude perspective from the period of March through June. The dollar strengthened a little bit relative to that remarkable run-up, but the quantum effect of the FX shift relative to what we expected is probably something we won't see as dramatically for the full course of '04.

Thirdly, the transition to a major new licensing program depressed '02 from a GAAP-reported results perspective a little bit. It lifts '03 and makes the '04 comp difficult, so we won't have that anomalous effect in '04 that we saw in '03.

I do want to highlight a couple of key macro-assumptions as well as Microsoft-specific assumptions that are important for the full year. We do anticipate positive unit growth in both PCs as well as server sales in the segment of hardware we compete in.

Secondly, we're assuming that the worldwide economy remains roughly at current levels; that is, that it isn't super strong worldwide, but we don't see a big contraction from where we are. We don't expect phenomenal growth to impact our results but we do not expect any decline from where economic activity is today.

All of our results for '04, as we described in the earnings call a couple weeks ago—a week ago rather—include the adoption of FAS 123 effective July 1st of this fiscal year. It does not include any impact from the option transfer program we describe in the July 8th announcement to employees and the public about our new compensation program.

We assume FX rates for the year, specifically for the most important currencies with respect to volume—the U.K. pound, the Euro, and the yen—to stay at about where they are today. If things move positively, that might help a little; if they move down, that could hurt.

In terms of the full year, we do think we are going to put up pretty darn good absolute growth against very tough comparables. And finally, we do expect to see, if we're successful with our internal plan, improvement in the profiles of our emerging businesses with respect to margins or their P&L profile. The rate of improvement varies considerably, but we do expect to see some improvement in each.

Let me now talk a little about each of the segments from a revenue perspective and the total for the company. We've already described for you at the earnings call what we expected the range of increase to be with respect to our business, and as always we highly recommend people take the lower end of our range in terms of guidance, in terms of what you would expect, and how you would expect us to perform for the money you manage or the universe of companies you follow.

We do expect both Client and Information Worker to show good growth relative to very large balances.

We talked at the July earnings call about the modest impact we expect in '04 from an adjustment in the lives on our product unearned. That's about 400 million of growth for those two segments in total. Two thirds of it goes to Client, a third of it goes to IW and there is no comparable benefit from the prior year.

The Server and Tools business we expect to grow in the 8 to 12 percent range. We'll have to work hard to grow against that large absolute base, but I think we've got a pretty good plan going into '04. Business Solutions has an aggressive plan—24 to 32 percent growth—and as we compare '04 to '03, we have a full year of results of Navision included in the '03, so the apples-to-apples comparison is difficult.

Burgum's organization, Ayala's organization and our worldwide channel partners will have to do a very good job to reach this aggressive growth range, particularly if you contrast that against any other business application seller, regardless of the segment they're selling into.

MSN we expect, as we described, to be down in the 4 to 7 percent range in terms of GAAP net revenue. That's largely a function of a decline in our paid subscriber base as we see people move from narrow band to broadband. We anticipated that would happen more rapidly in '03 than we've seen but we do think it's a trend that will happen, and that impacts the revenue number. Advertising growth will continue to be strong and the profile of the subscribers is actually better in '04 than '03, but we will see an absolute decline in those paid subscriber numbers.

Home and Entertainment has the difficult issue of a full-year comparable across every business, and then some of the pricing action that was discussed or announced in the spring. We are very, very confident, in part because of the strong position we've gotten to with the Xbox® in both the European market and the U.S.

The Home and Entertainment results also face the impact of a relatively tepid PC market for games and consumer software, regardless of the company, but we do expect positive growth.

The Mobile and Embedded Devices division will show very strong growth, we expect, on a relatively small base of revenue relative to Microsoft. All in, we expect that growth in revenue to be 6 to 9 percent. That includes the impact of the product unearned I described against a tough set of comparables.

In terms of operating income, we still expect the operating income to come in at $11.3 to $11.6 billion. That includes the adoption of FAS 123 beginning July 1st. We talked about that at the analyst meeting. That's about $3.9 billion.

If you compare to the prior year, we'll show operating income on a GAAP basis was $13.2 billion. Adjusting for equity compensation in that '03 period, you would get down to 9.2 of operating income, as reported under GAAP. For apples-to-apples you've we've got to add a billion to '03 so you get a base of 10.2 for comparables against what we expect to be 11.3 to 11.6. That's decent growth on a GAAP-reported basis, just about 6.5 percent if you adjust for the product unearned—good absolute growth against tough comparables.

We wanted to give you some visibility into what we expect with respect to PC unit shipments for '04. There are probably some final modifications to what the '03 PC unit shipment rates are, but we wanted to give you our view, consistent with what we talked about at the July earnings call, and then a little bit of breakdown of what we expect or what we think happened in '03 from a geographic perspective.

We do expect in '04 to see positive unit growth rates with respect to PC unit shipments in every geography of the world except Japan. We expect Japan to end up at mid-single-digit decline.

Consistent with fiscal year '03, by far the fastest-growing market in the world is APAC and greater China, and that's the region of the world where the number of units that we collect for PC shipping has a very low rate with respect to the Windows penetration. So the fastest-growing market in '04 will again be the market where we don't sell licensed copies of Windows.

We do expect the growth rate to be about 5.5 percent or thereabouts against 3 percent for fiscal year '03. We do expect the business market to grow a little bit more than the consumer market, but those numbers should come close to converging towards the end of the year.

In terms of server shipments, we wanted to describe for you our view of the unit year-over-year growth percentages over the last couple of years as well as the market segment share percentages. And I use the term market segment share percentages simply because we participate in one part of the market, but there is an awful lot of money that gets spent outside of the segment that we compete in.

If you look at the unit year-over-year growth percentages, we do expect fiscal year '04 to improve in total, with growth rates of about 8.5 percent—8.2 percent against a fiscal year '03 growth rate of about 6.5 percent.

Again, we expect the Windows and the Linux environment to be the only environments that grow in fiscal year '04. We anticipate that we'll pick up a little bit more share in this segment, that Linux grows faster in terms of share gain, and that the rest of the folks competing against the Microsoft® Windows platform and the Linux platform continue to decline.

I want to now just talk about fiscal year '04 investments in a little bit of a summarized view. You've heard from each of the respective business leaders as well as Orlando about some of the key investments that are being made in fiscal year '04. A year ago we said we anticipated we would have $1.3 billion of incremental investment for initiatives specific to '03. In fiscal year '04 we have a specific set of initiatives, many of which were outlined. We anticipate that the incremental investment for '04 is somewhere in the magnitude of a billion dollars, depending on timing, depending on the finalization of certain programs.

There's four areas that I would point out specifically. We do have a significant investment in Software Assurance for organizational customers. And I've got a chart that describes that very briefly.

Secondly, we do have a significant set of initiatives in the commercial software initiative—how does Microsoft successfully sell value and reach customers and grow against noncommercial software.

Thirdly, we've had a lot of success with our global advertising campaign and our brand advertising, and you should expect to see a very concerted effort in this fiscal year on a coordinated global advertising campaign really emphasizing the key brands, those brands that have built tremendous value for shareholders over the last 20 years.

And finally, as we've talked about, we have a significant investment in the academic and public sector in fiscal year '04 across both large geographies and small geographies.

When you think about the Software Assurance program, you should look at the chart on the right (the pie) in terms of what it is we're fundamentally trying to do in fiscal year '04 with this program, in addition to the great product lineup we've got.

We're really trying to drive the customer value proposition with individual products but also with the programs we attach in terms of maintenance and multiyear annuity. We've listened very carefully to customers over the course of the last 15 to 18 months as we've launched the Licensing 6.0 program, and we have a program enhancement with respect to Software Assurance that is really focused on how do we ensure that customer satisfaction with the program increases, and that the attach of Software Assurance is a function of people being pleased and valuing the program.

There's really three key things: How do we provide more assistance—how do we give people more technical help from TechNet, from Web support and from telephonic support from PSS, particularly for enterprise customers? How do we make things easier to manage from a budget perspective and easier to forecast? And finally, what are some broader value propositions we can present to large, midsize organizational customers, such that Software Assurance continues to gain traction in FY04 and beyond?

A couple of key things are broader training programs and home-use programs for those customers that enroll. So we've put a lot of effort, a lot of thinking, a lot of feedback from customers into the program, and we've got today about 1,100 customers trialing it, so we think we have a pretty good program in place.

In terms of each of our businesses for fiscal year '04, we do anticipate and have a goal that we continue to improve each of the businesses, particularly our emerging businesses. We've got very tough comparables with respect to Client and IW and very high bars in terms of those segments' profitability performance.

Across each of our other businesses, if we execute well, if we're successful from a revenue perspective, if we're successful from an execution perspective, we do anticipate that we'll see continuing improvement in the profitability profile. If we're not successful on revenue or if we don't execute well, some of these businesses will not improve their P&L profile. We are anticipating that each of them do improve in FY04.

Over the course of the last year, we've tried a new format when we meet with shareholders and meet with analysts, and that is to take those questions we're getting most commonly and to scale them down to a couple of the key questions that we're hearing from the majority of people. So I want to address a couple of those.

The first is: What is the impact of the new compensation program and shift to FAS 123? You'll have the opportunity to hear from Steve. You'll also have the opportunity to talk to various leaders about how is the program being received in their group, but I just wanted to summarize some of the key principles and effects.

First of all, we do feel that the stock awards provide a lot more predictable value to employees, and that's come through relatively loud and clear in the feedback since the program's been announced.

Secondly, given their inherent value, we will grant fewer units of stock awards than we would have of stock options.

The third key thing, we do feel that this program, as articulated, both from a stock award perspective for our broad-based employee population, as well as a performance incentive award program for senior-level people, does have a very strong long-term alignment of employee and shareholder interest. The stock awards, as well as the performance program, vest over time, and the performance program has characteristics that if we do well with customers we will do well with respect to the performance program. If we do well with customers, the odds and probabilities are we're going to do well with shareholders over the long term.

Finally, a portion of top management awards are really performance-based, meaning folks have upside to their comp at risk if we don't achieve performance targets. We have seen—and it's maybe a little too early and it's perhaps therefore anecdotal—we have seen instances since we announced the program that we closed offers to potential employees as a result of the program. People look at that program and they say, "It's certain. I like it. I'm going to close the offer you've given me."

We did have, as one of the key principles of the program, the ability both to retain great talent but also to attract great talent. We've probably had as good a period of attracting great talent as I can ever remember in the time I've been here, and we want that to continue. The program should help us do that.

A second big question we get is FY04 unearned revenue growth: What will FY04 unearned revenue growth end at? We didn't provide any guidance with respect to the full year and we're not going to provide any guidance with respect to the full year today.

There's a number of key drivers in terms of how will the unearned revenue balance end the year. We anticipate it'll tick down in the September quarter, as previously guided. For the full year, there's a couple of key things that'll drive how that balance ends. How do we do with the new annuity licensing agreements, both new EAs and SA? How do we do particularly in midsize accounts as we move more and more of that business to EA?

Secondly, how will we do with respect to the Software Assurance attach? How will we do in EA renewals? How many incremental products do we add to EAs as they renew, particularly those EAs that were primarily desktop? As we renew them, are we successful getting incremental server product attach and incremental Client Access License attach? Do we get more desktops covered as we move forward with existing or new agreements? And then, finally, and probably most significantly, what does IT spend look like for fiscal year '04? Do we see a rebound from what we've seen over the last couple of years, or do companies stay more focused on cost containment than new investment?

If you look at the product pipeline, if you look at what's been presented today, if you look at our customer value initiatives, Software Assurance initiatives, we're well positioned relative to competition and we think we have a compelling lineup. How much will that IT budget increase worldwide is probably question Number One.

The next big question that we get asked relatively frequently is: "What are your plans for getting cash back to shareholders?" I want to reiterate we did announce and execute on our first dividend in January. Secondly, we have repurchased about $24 billion worth of stock over the last four years and the next chart will show you a breakdown.

How and when we return cash to shareholders is based on a number of factors. First of all, what is the business model risk as a function of legal risk? We have a number of legal issues outstanding: the EU, the Sun antitrust litigation. Twelve of the states' class-action cases are still open. And obviously in the industry we're in, there's always going to be an unpredictable set of additional IP issues.

But the biggest factor to think about in any distribution of cash or any change in our announced policy is: What is the business model risk to unresolved legal issues? A lot of people have written or have inquired, "Well, this can't cost you more than X, Y, or Z for this legal settlement." That's unknown. But the larger unknown is: What is the business model risk to unresolved legal matters of significant consequence?

So I want to talk a little bit about the deployment of cash and how do we manage the cash on behalf of these very large shareholders in this room, as well as two very large shareholders who are in the room just on the other side of the hall.

The first thing is to give your view of the share repurchase and what we've done over the course of the last four years and what we've done life to date. As you can see, we have repurchased about $24 billion worth of stock in the four-year period. Life to date we've repurchased about $35 billion, 2.3 billion shares, against options exercised of 5.3. The dividend is not inconsequential at $857 million, and we do have a large portfolio we manage.

I want to take a couple of minutes now to walk you through the nature of the portfolio and how we manage it and how have we done. When we think about the portfolio, there's two distinct ways that the portfolio is sorted. There's the Treasury-managed portfolio that would be analogous to a set of fund managers that is about $53.5 billion, and there's a strategic portfolio that are investments largely driven by business decisions and long-term business direction.

In terms of the balance sheet classification, the majority of these investments show up above current assets in cash and short-term investments. Of that total, it's about $49 billion. That's a classification, that's a function of, "Are they held for resale within a 12-month period?"

Then there's the Treasury portfolio portion that's in the strategic equity that's part of the equity, another 13.7, that's about $4.5 billion, and then the current balance for strategic investment is about $9 billion; a total of about $63 billion as of June 30th.

If we do a simple math calculation on our GAAP-published financial results, both the income statement and the balance sheet, many people come to a calculation that says, "Okay, you folks have reported investment income in '01, '02, and '03 of these numbers. Your cash and short-term investment balances in each of these years as of year-end are $31.6, $38.7, and $49 billion. Equity and other investments ended the years at 14.4, 14.2, and 13.7."

So let's just do a simple average. Let's take those cash and short-term investments, the equity in other investments, do a simple average that says you know you've had $43.7 available on average in '01, $49.4 in '02, and $57.8 in '03. If I calculate that as the base against the investment income you've earned, I see you've lost about .1 percent in '01, you've lost about .6 percent in '02, and you've gained about 2.7 percent in '03. That would be a simple calculation one would make from the P&L and the balance sheet.

However, it's not quite that simple. When you look at the way that we manage the portfolio versus the way we report under GAAP, it's very difficult to do the calculation. And under GAAP we have taken more than $10 billion in other than temporary impairments over the course of the last three years.

We wanted to give you a view in terms of that Treasury portfolio, how has it performed, and where is the money invested. As I mentioned, we have as of June 30th about $53.5 billion in that Treasury portfolio. The overwhelming majority of that is in fixed income, about 70 percent; there's about 10 percent in equities and about 20 percent in cash. We do want to have a significant cash balance available at any given time for opportunistic investments and necessary disbursements that require a cash fund on balance.

In terms of that fixed-income portfolio, you can see how it's allocated as of June 30th. We go through this portfolio with much rigor monthly and with our finance committee in a lot of detail every quarter.

In terms of the portfolio management, about 75 percent of it is managed internally and about 25 percent is externally. Particularly external are those things that require a lot of specific insights and a lot of back-office support: mortgage-backed securities, international equities, things that require a lot of credit work.

Based on our total portfolio return—and we follow AMIR in terms of portfolio calculations and returns—over the course of '01 we had about 9.1 percent return. That's realized and unrealized gains and losses, i.e., market to market, plus accrued dividends, plus accrued interest for that full period. In '02 it was about 5.4 percent. In '03 it was about 7.5 percent.

So in terms of that large portfolio balance, our absolute economic performance has been pretty decent over the last three years, and you can't really get the sense for the economic return from just the GAAP-reported numbers.

If you go through our shareholders equity statement, there is something called "other comprehensive income" that does help to give you a sense of what's the market-to-market of the portfolio, but it's very difficult to get from GAAP to the portfolio return.

In terms of the strategic portfolio, we have had fairly significant impairments over the course of the last three years, but I would tell you that this program was started in 1989, and life to date we're up about 1 percent in terms of total portfolio return. This gives you an allocation of what's included in that portfolio as of June 30th. It is business-led investment, and it also is investments in sectors that have a high degree of synergy with our current partners or future partners with respect to what business initiatives are we driving forward.

You can see that the majority of those today are public versus private, and you can see that as of today the majority of that in terms of investment is cable and satellite, with cable being by far the single biggest stake.

In terms of how we performed, we have had fairly significant impairments, but the absolute portfolio management returns—measured similar to how you would measure your returns for fund managers—have been much better than a simple calculation from GAAP.

A big question is future deployment of cash, and you'll get an opportunity to talk to the management team, the leadership team, which really give three alternatives. You can do a dividend program, you can do a large buy-back program, or a combination. The senior leadership team, with respect to Bill and Steve and the board, regularly discuss, regularly evaluate. It's clear that current U.S. tax laws recently enacted make dividends more comparable to buy-back in terms of total returns, and the board regularly evaluates the number of programs.

The thing I really want to reiterate is we don't have anything to announce today. You'll have an opportunity to provide lots of input, but until we have our legal issues resolved to see our way clear of the business model impacts and those that we can foresee, those we couldn't foresee, there really isn't anything the company is going to move forward on, on the scale many of you have suggested.

There is a great country-western song by a guy named Jim Beck. He wrote it in 1950 and there have been several renditions, including probably the most famous by Willie Nelson. And the famous lyrics in it are: "If you've got the money, honey, I've got the time." And we would ask that people be a little bit patient as we work through the litigation and the business model impact.

We're managing the money conservatively. We've got a very hard eye for avoiding investments that subject these shareholders, as well as other large shareholders, to impairments. But until we see our way through that there wouldn't be any big program to announce.

I want to reiterate the risk factors that are very important for those people managing money. First of all, the economic environment. We've talked about the fact that we do not anticipate the economy improve radically worldwide but we also don't expect it to decline measurably.

Secondly, Linux and noncommercial software: We've shown you what we think the Linux share gains will be for '04. If Linux gains more share, that's an impact to us. If Linux gains share on the desktop, that's an impact to us. If we execute well, we mitigate the risk.

Growing the new billings off of that large base. If you go back to the chart we distributed online and you go to '01 to the end of '03, we've built a very large contract base with respect to our annuity contracts. How we continue to grow that relative to that large balance is a significant challenge that I think the team is up to, but from a shareholder perspective, that's a risk.

Continued legal risk. I think you all are aware of the issues we face. We try to be very, very clear about the legal risks, both in earnings calls and in the communication. And I highly recommend, if you're not a regular reader of the 10-K and the 10-Q, you read them in great detail.

And finally, we do have to execute on multiple fronts. We've diversified very, very rapidly and we've got to execute well on more fronts than the company has ever had to execute on in the past.

In terms of strengths, we exit this year with a lot of momentum. We told you a year ago that we thought if we make these investments, we'll end the year a stronger company than we entered it. And I think, being objective, being fair and balanced, I would say we end this year with more momentum than we started at the beginning of the year.

If you look across each of our businesses, there are certainly things we could improve, there are certainly risks; but I think in each of these businesses we're in a better competitive position than we were when we started. So we've got a lot of momentum.

We've strengthened the depth and breadth of our leadership team broadly across all categories. The Finance team is one example, but I think you'll hear from Steve about some of the significant hires we've made elsewhere. If you look at the acquisitions we've done, the management we've hired from other places, we've got a stronger and deeper leadership team than we had at the start of the year.

We've got a great financial position. Our balance sheet allows us to have a level of security and shareholders to have a level of security that's probably unmatched, certainly in our industry. So our financial position is very solid for the long term.

And finally, we've got a very focused set of initiatives on customer value and we're adding a lot of customers in every single segment. If you go through each of those businesses and say, "Does Microsoft have plans to add more customers?" I think the answer is yes. Did we add more customers in FY03 than we had at the beginning of the year? The answer is yes. To the extent we can make customers have a higher degree of satisfaction and happiness with our products and offerings over the long haul, shareholders will be pleased and returns will be good.

With that, I'd just like to say thanks very much. I think we've got time for a break, and Steve's up next. 'Appreciate it.

END

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