Financial Update
Financial Analyst Meeting 2004
July 29, 2004

JOHN CONNORS: Thanks very much. We've had, hopefully, a good day today. You've been able to cover an awful lot of material. You've been able to see a lot of what we have planned in the future, and the extensive, innovative pipeline we have.

What I thought I would do is give you sort of a financial perspective on how we viewed the year, and then the look-forward next year and a couple of years out. And Steve will close with what are the prospects for Microsoft and how do you measure success.

The starting point for us is to look at how have we performed over the last couple years against a peer set of companies. We've selected a number of companies, many of which you follow, many of which are comparables for us. When we look at how we've performed over the last couple of years, we feel very, very good about both our absolute performance and our relative performance. And you can look at this chart, and you can say Microsoft has done a remarkably good job by shareholders over the last couple of years. The only company that's outperformed us in terms of operating income growth on a CAGR basis is SAP. You can see we have Sony down growing 13 percent. Being the good guys we are, we took their reported GAAP operating income and adjusted for their restructuring. So, on an adjusted basis, they're up 13 percent. If we didn't adjust for their restructuring, they'd have a CAGR of minus 24 percent. But being the good guys we are, we adjusted according to the way they would want you to see it.

But net-net, we have had a heck of a good run the last couple of years. More importantly, we've had a great run while investing very, very heavily for the long term and investing very heavily in customer, partner, and employee satisfaction. If you look at the aggregate level of investment we've made in operating expenses and costs of goods sold, it is a tremendous amount of money over that four-year period. Particularly notable is what we've spent in our large franchise businesses. But also if you look across the other businesses, we've invested very, very heavily. In terms of MSN, you can see that we've invested $8 billion. About $3 billion of that is in the cost of goods sold area. The rest is in the operating expenses lines. In terms of home and entertainment, $12 billion—$7 billion of that runs through COGS, and $5 billion of it is in the operating expense categories.

So when we think about our performance from a financial perspective over the last couple of years, and the fact we've been able to invest for the long term, we feel quite good.

If you think about fiscal year '04, we feel like it was a terrific year. At the start of the year we had pretty good prospects, and throughout the year we were able to deliver better than we expected in nearly every single business, in nearly every single quarter.

There are a couple of big highlights. One of the most obvious is just the level of growth in revenue, where we grew about $4.6 billion in absolute dollars year over year. When we talk to people internally, we like to remind them about the context of how big is $4.6 billion. That's a couple of Yahoos, more than one eBay—a pretty darn good year.

Secondly, we had $9 billion in GAAP operating income—and that's after paying for $5.7 billion in equity compensation and a couple billion in legal settlements. So, despite those large hits to the P&L, we still had $9 billion in GAAP operating income.

If you look at the transition we made as a company in fiscal year '04 on the equity compensation front, we feel very good about how we're positioned, both for shareholders and how we're positioned for employees. That was an important milestone for the company and sets employees up for the long term, and sets shareholders up for the long term.

We also solved a large number of legal issues during the year, many of which had been outstanding for a long period of time. We still have a number of significant legal issues in front of us. But the overwhelming majority of the legal issues that would impact our near-term financial prospects we feel like we've cleared.

We've also put together and announced our plan for distributing $75 billion to shareholders over the next four years. That has been something that this audience had asked about more than once. Many people in the audience provided us great input, great insight, and we think we came up with a good plan, and I'll talk a little bit more about that. But it was another big milestone in this terrific year.

We're also making progress on our big bets. I'll show you in a couple of charts today why we think we're making big progress and how much more progress we think we'll make. Using an analogy of oil well drilling, a few folks in the audience have more than once said, how many of these investments do you guys think are dry holes? Well, if you look at the progress we made in '04, and you look at our optimism for '05 and beyond, I think you're going to conclude we've got pretty good geologists here at Old Mister Microsoft, and you'll see how we think we'll do and the progress we've made this year.

We've made great progress on the people front, which Steve will talk about a little bit more. And at the end of the day, all the intellectual property, all the market value we create, is a function of the people coming in and out of the buildings at Microsoft worldwide. And we're in better shape now than we were at the start of the year, and we were in better shape at the start of the year than we were at the previous start. So we've made good progress there.

And finally, you've probably been able to discern from today, and from all the research you've done about us, that the innovative pipeline we have in shape and in place is broad and extensive, and we probably have enough content to fill multiple analysts’ days. We choose to do it in one long day, and I think you get a great sense of just how much product and just how much technology there is in the pipeline for future years.

A good place to start in terms of measuring how are we doing on the big bets we've made is to look at the last couple of years of performance for each of our business segments. This is the GAAP operating income improvement, or decrement, year over year '03 to '04. And there are a couple of adjustments I think that are important to make because of their one-time nature in this fiscal year. That is the option transfer program as well as a couple of legal settlements that were significant in fiscal year '04.

If you look at the fiscal year '04 performance, even before the option transfer program, we had pretty decent results in terms of improvement year over year. If you then step back and adjust for that one-time event called the option transfer program and the Sun legal settlement that was impactful to the client and server and tools P&L, we had a heck of a good year. If you look at client, you can see on an adjusted basis up over a billion dollars in terms of operating income growth. Server and tools up about $850 million. If you look at information worker, over a billion dollars of improvement in operating results. If you look at the MBS, Microsoft Business Services, business, up $81 million. If you look at MED, up over $100 million. If you look at MSN, a terrific, terrific performance, up $832 million relative to '03. And then, finally, home and entertainment, up $117 million. So those bets are beginning to pay off, while we still continue to grow our largest businesses that we've had in place for a number of years.

I think it's also important for people to step back and think about how are we doing in terms of new products or new versions of products. One way we look at our business is what new billed revenue are we getting with existing products versus new products. This chart gives you an illustration of how to think about the innovation we've been investing in for a number of years. If you look at the bottom, the orange, that's the billed revenue by fiscal year for those products that were in place prior to fiscal year '00, that is, products that had shipped prior to fiscal year '00. The green are those products that succeeded products that existed, i.e., the successor versions of franchises we had in place. We've done a very good job over the last four years in what has been mostly a very difficult selling environment, replacing existing franchises with new versions of products. More importantly, though, is the percentage and the growth we're getting on products that did not exist in fiscal year '00. You can see that the percentage growth is very good, and the percentage of our absolute billed revenue is quite good.

And for us to continue to grow, we have to do a couple of things. First of all, we have to continue to invest for the long term with respect to R&D, and we have to be willing to make big bets. Secondly, we've got to be very successful with our current selling and marketing efforts, and expand the way people think about using our technology. And, finally, we've got to be looking at those areas where we can acquire or get new ideas into markets we're not in. In the last couple of years we've done a good job on all three fronts, and the representation of this chart shows how much new and how much existing product we're replacing as we move to new versions. Innovation really does matter in our business, and we've had a good run the last three or four years.

I want to talk just a little bit about fiscal year '05. And the thing about Microsoft that has been somewhat difficult is every year seems to have tough comparables. That is, the only time you don't have tough comparables is when you go into the ditch. And we haven't gone into the ditch in any meaningful way in the history of the company. So '04 was a terrific year. And we think '05 will be a great year, and it's another year of tough comparables. It may be tougher than a couple of prior years. Those who have followed us for a long time have heard that before, but '05 will have tough comparables for a few reasons.

First of all, we will have the upgrade advantage revenue we've recognized in '04 not recur in '05. That's just over a billion dollars. There's no revenue left to recognize from upgrade advantage. Secondly, we've had strong results when we translate non-U.S.–dollar sales into U.S. currency. And in fiscal year '04, we've had a foreign exchange benefit of just over $1 billion. Our expectation is little to no benefit in fiscal year '05. If we get some, that's great, but our forecast doesn't assume much.

The third key factor is PC shipments. The PC market is very healthy; '04 was a very, very good year. Our estimate is that PC unit growth worldwide was about 13 percent on a very large base, and we expect very healthy growth in fiscal year '05 of 7 to 9 percent. But we lose a few points of growth there because of lower relative growth rates on a large absolute base.

The server business should be very good in fiscal year '05, as it was very good in fiscal year '04. Server shipments were up about 16 percent in our fiscal year '04. We think the range for '05 is a very healthy 13 to 15 percent—down marginally, but again, no uptick from server shipments, in our view.

We have another couple of factors that are somewhat unique because of business decisions we made or where we are in our product cycle. The first is that MSN Internet access revenue will continue to decline as our narrowband subscriber base declines. That's a trend we've seen for the last 18 months. It's a trend we expect to continue. We'll see very healthy growth in advertising transactions and all other forms of revenue from MSN, but we will have a bit of a drag on absolute growth in revenue from that Internet access subscriber decline.

We also expect modest revenue growth in home and entertainment, and we expect some decline in Xbox as a result of price reductions. As Brian described, we're very well positioned relative to a year ago. We're very optimistic, but we do anticipate those price declines to affect revenue.

We are making very good progress on costs. We had the transition with equity compensation and the option transfer program in fiscal year '04. In our fiscal year '05 results, we expect all forms of stock-based compensation to be down about $3.2 billion. Secondly, our '05 forecast does not include the $2 billion in legal settlements we had in '04. Hopefully, we're not going to see those kinds of substantial legal settlements in '05, and the forecast does not include anything like what we saw in '04.

Finally, the remainder of our expenses are essentially flat year over year. We've been hard at work on a broad range of ways to run the company better, some difficult trade-offs we've asked people to make in discretionary costs, in marketing. But we are going to add a significant number of employees. We are going to add significant areas of investment, but we will be able to hold other operating expenses generally flat year over year.

A key point in '05 is operating profit growth in every single business. And then, finally, we feel good about the direction we expect for unearned revenue for fiscal year '05. We said in our earnings call last week that we expected unearned revenue to probably end the year right around $8.6 billion. That's something that can move around quite a bit. But basically we expect a positive trend on unearned revenue from the end of fiscal year '04.

The underlying growth in our annuity business should be a bit higher than the growth rate of unearned in total, because we still will see a drag in fiscal year '05 from product unearned. Our underlying annuity growth rate looks pretty darn good, pretty darn healthy, and unearned trends are good, exiting '05. And we should start to see the more normal seasonal trends in unearned now that we've gotten all the way through our unearned earn-back from the Licensing 6.0 program.

FY '05 should be a good year. Hopefully it can be a great year. It would be tough to describe it as a terrific year, in terms of the percentage growth we've seen in '04, but we're going to work hard to have a great year.

When you think about the '05 guidance, there are a couple of key things that we look at. First of all, we have in '05 and in '04 five Fortune 1,000 companies. We have three Fortune 500 companies in terms of revenue. All of those Fortune 1,000 revenue companies will grow, as will our other two businesses. We expect, as we described in the earnings call, to have a revenue growth range of somewhere between 4 and 5 percent. We're going to see very, very strong operating income growth in fiscal year '05, as a result of our work on costs and lower legal and compensation expenses.

Beginning with fiscal year '05, we don't feel that we need to forecast equity compensation expenses separately from any other. The second quarter we'll have a bit of an unusual quarter in '04 comparables, because of the options transfer program. But, otherwise, once we get through the second quarter we have a more normalized comparison, and our GAAP numbers are our GAAP numbers.

Investment income is going to decline by a fairly sizable amount, as we described in the earnings call. I'll talk a little bit about some of the factors that drive that, but we would expect now to have about a billion dollars in operating income, an EPS of $1.05 to $1.08. Great year. Hopefully we can make it a terrific year.

I wanted to speak just a little bit about our business segment performance for FY '05 and beyond. We do expect every single business to improve its operating profile in fiscal year '05. Every single business should improve. A couple of those businesses that made over a billion dollars in adjusted operating income growth from '03 to '04—holy Toledo, that's a lot of comparable growth to get, and you shouldn't expect a similar growth in the '05 time frame—but every single business should grow.

I think more importantly is to think about the big bets we've made over the last couple of years and when will we get those big bets to profitability. As a company, we don't want to say, hey, we're committed to making a certain business profitable by a certain quarter in a certain year, because in the long run that would be foolish for shareholders, to have us chase making a number in a quarter if we were giving up making big share gains or big profit gains for a multiyear period. But we are very focused on removing the term "emerging" from our businesses that currently don't make a profit. If you look at a couple of our businesses, MBS and MED, I think they have a good chance of removing the term "emerging" from a descriptor in the fiscal year '06 time frame. It could be a little bit longer, could be maybe shorter, but '06 is a general time frame when it's probable based on the projection we could get there. It might be '07, but we could probably get there. With home and entertainment, it's probably more around a fiscal year '07 time frame. But in terms of their ability to get to profitability, we do think there's a reasonable time frame, and they're on the trajectory to get there.

As a company, we're only going to forecast and give you one year of firm guidance, but we're working hard to make those things get to profitability, but most importantly have them in a position to generate profits for many years to come. But getting rid of the "emerging" terminology is a goal that each of those groups has.

Let me talk just a little bit about the cash distribution plan. We feel very good about the plan we came up with. A number of folks have given us input on, you would have preferred more of this, less of that. But in general I think we feel like we struck a good balance for a number of constituencies, and we left the company in a position to have the flexibility it needs for future issues, future considerations, and future ideas.

It is going to be, at least according to our calculation, the largest payout of any company in history. Perhaps Exxon will beat us, if oil prices stay where they're at, but according to today it looks like the largest payout in corporate history.

You should understand that this plan reflects the current strength the company has, but, more importantly, the optimism we have for the future. And hopefully you see that optimism coming through today. But we've got a lot of reason to think the company can deliver great return to shareholders in the future, and we have a good position today, having resolved a number of legal issues.

The plan does give us the ability to repurchase a billion shares at current prices over that four-year period. We're not going to forecast how many shares we're going to buy every quarter. We will have to have a very relatively large-scale program. But we'll report what we buy. And the SEC has a very good rule that when companies announce buyback plans they now have to report quarterly what they're doing against them. We'll report that quarterly, and we'll try to be opportunistic when the time is appropriate, but we will be focused on increasing the amount of buyback that that commitment reflects, and reducing the dilutive effect of all things in the future, which that plan allows us to do.

We do have to gain approval from many of the representatives in this room and other shareholders on the special dividend. There are really a couple of things I think that are important when you think about that special dividend. First of all, technically it wasn't really clear that we had to get shareholder approval to amend our employee stock option and stock award plans. But the board, our legal team, Bill and Steve, thought it was very important from a good governance perspective that we get shareholder approval for such a change.

The only thing we're going to ask is that employees be kept economically whole -- not enhanced -- kept economically whole, and we adjust the options in terms of units and stock awards in term of units to reflect the price of the dividend being taken out of the stock on an X dividend date. We feel very good about the plan, and we feel very good about the general feedback we've gotten.

Let me talk just a little bit about investment income and also the way we really think you should think about our cash and our treasury versus our operating business going forward. We've had pretty darn good results over the last couple of years, which the next chart will show, in managing your money. In terms of the way we think about the '04 to '05 comparables for investment income, there's just a dramatic change in the absolute size of the portfolio and its composition. We moved about $40 billion over the last quarter and early this year into a highly liquid position, relative to the way the portfolio was allocated throughout '04 and fiscal year '03. As we move that, we had some pretty significant gains, because of the heavy investments we had in fixed income and the market-to-market position we had in that. But we also had to close out a wide variety of derivatives used to hedge the risk in that portfolio.

As we think about fiscal year '05, we do have dividends and interest, and we do have net recognized gains that would be expected in that forecast. We don't expect significant gains in that portfolio in '05, but there is some expectation that as we manage the portfolio and third parties manage, there could be some. We don't forecast impairments or derivatives, because impairments are very difficult to forecast, and derivatives are almost impossible to forecast on anything more than about a one-week or two-week basis. But basically we expect to have about a billion dollars in investment income versus the $3.2 billion we had in fiscal year '04.

When you think about the way we've managed the portfolio over the last couple of years, we feel like we've done a pretty good job on an absolute and relative basis managing that portfolio. We also have had a very substantial amount of investment of your money that we had to manage. When you think about the company going forward in terms of fiscal year '05, we expect to get pretty modest yields, post-dividend payment, because of the fact that we don't see a lot of return in the fixed-income portfolio, and we don't see a lot of opportunities in the equity portfolio for the fiscal year '05 time frame.

Throughout the first part of the year, we'll have a significant amount of money in highly liquid, almost yielding nothing compared to what you've seen in the last couple of years.

When we think about managing that portfolio going forward, we're very, very focused on preserving the value of the investments that we have and the principal that we manage. If you think about the company going forward in the fiscal year '05 time frame, the operating results are really what are going to drive Microsoft, not the cash. The cash is the cash, and has cash-like yields. When you think about the allocation of the portfolio, we do have today, as of June 30, over $70 billion. In terms of our normal investment portfolio, you can see the allocation that we have, which is about 65 percent liquid. And you can then see the strategic equity portfolio, which has about $8.5 billion. That hasn't changed much in terms of composition year over year, and you shouldn't expect much change.

The chart in the lower left shows you how we moved the money over the course of the last couple of years. We had pretty good success in emerging markets. We had pretty good success in high yield. And we had very good success in fixed income. As things moved to a higher interest rate environment and we've moved to a liquid position, you'll see the investment income reflect more of those modest yields, as well as the fact that a lot of that money will be paid out in fiscal year '05, around midyear, assuming we get shareholder approval.

I want to spend just a couple of minutes talking about acquisitions. First of all, you've all heard the news about one discussion we had, and it was a bit unique. And our strategy with respect to acquisitions has not fundamentally changed. That is, we generally look at two things: How do we add value to customers, and how do we do it in a way that builds shareholder value for the long term? When you think about what we've done over the last four years, we have been relatively active. We've acquired about 46 companies, for right around $5 billion. When you look at the profile of what we buy versus the consideration, you can see from this chart the overwhelming majority of the number of deals we've done are to buy IP or people or the combination of both. The consideration per deal is a bit lower, but the absolute number is driven around IP and people. That will likely continue in the future.

Secondly, how do we buy new SKUs for existing Microsoft customers? That is, adjacencies to what we do today.

The third key category has been to acquire channels or customers.

And then finally, enter into a new business or accelerate innovation. This profile will likely stay very similar in '05, and we don't feel that we need to buy companies to grow, but we will look at opportunities, and we will continue to be an active acquirer -- mostly smaller companies, but each group will be looking at how can they add customer value and how can they build shareholder value. Our current innovation pipeline is pretty full, but there are opportunities that each group has that each group pursues.

There are a couple of key risk factors I think I want to mention before I close on what are our strengths. First of all, noncommercial software continues to be a risk. I think you probably heard from Kevin Johnson at midday today that we've got a pretty firm handle on that risk, and we've got a pretty firm plan. But noncommercial software and its impact on our pricing and share is a risk.

Secondly, we're diversified now into a broad range of things, and PC and server demand continues to be very important, but there are other factors that drive the company's results that are risk factors. IT spend is generally independent of PC and server shipments. The online advertising market is one that Microsoft and several other companies are really beginning to monetize as the shift in advertising accelerates. That would have an impact if it were adverse.

Finally, consumer demand. We have a broad range of consumer products and devices we sell today, and consumer demand is important to the company's overall health and the company's overall growth.

And finally, legal risks. We put a significant number of the legal risks behind us, but in an IP patent world, and in the litigious world that we live in, there are always risks on the legal front.

In terms of strengths, and I think Steve will really have a great way to frame this, there are really five key things I look at. First of all, the pipeline is full, and the pipeline is growing. We've never had this breadth and depth of product innovation to sell. Secondly, the long-term focus the company has had has served everybody very well: employees, partners, and shareholders. Our ability to take and stick to big bets differentiates Microsoft from many other companies. The third thing is people. You'll hear more on this from Steve, but the leadership team, the management depth, and the technology depth, is very, very deep. The fourth thing is the industry we're in. Businesses, consumers, and government entities are going to use more software every year in the future than they use today. It's good to be in an industry where people use more. Hopefully the pricing will work out, hopefully our share will work out, but people will use more software.

And then finally, diversification. We have expanded the company's footprint and gotten into a number of new businesses in a period when people retrenched. You can start to see that that's paying off. If we execute well, if we develop great products and we sell great products, the diversification is going to be even more of a strength a year from now, two years from now, five years from now, 10 years from now.

With that, I'd just like to say thank you very much, and we'll close with Steve Ballmer.

(Applause.)

END

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