Turning Innovation into Market Leadership
Financial Analyst Meeting 2004
July 29, 2004

ANNOUNCER: Ladies and gentlemen, please welcome Corporate Vice President and Chief Financial Officer of the Home and Entertainment Division, Bryan Lee.

BRYAN LEE: It's a very exciting opportunity to tell you about the things we have going on in the Home and Entertainment Group. To do that, I thought I'd take a minute and set a little bit of context about how we fit into Microsoft's overall consumer vision, how we work with other groups to make sure that you have a good context for that.

I'll start by making sure that you understand we have an organization called a Consumer Leadership team that's focused on setting the direction for our consumer strategy cross-group, up from and it's co-chaired by Robbie Bach, our senior VP of our Home & Entertainment Group, and Will Poole, our senior VP of the Windows Client Group. And what they do is they make sure that we focus on scenarios cross-group and that we focus our innovation and how those scenarios can best satisfy customer needs.

To do that, they have a framework that's not surprising, and you've probably seen something like this before, that flows from the software platform. We believe that Windows is the software platform for the consumer space, for all the evolution in that, much like it is for the enterprise space.

But the key here is to ensure that there's a rich environment of connection—connectivity and also the ability for personalization. So we and other partners build devices that fit across this and take the Windows infrastructure and allow for connectivity, relationships and personalization.

So across here you'll see a lot of devices that have already been discussed today. You'll see Smartphones, you'll see Pocket PCs, you'll see media devices. A lot of those are made by partners—Dell, Creative Labs, Rio, Samsung. You'll also see an Xbox made by Microsoft. But again the whole notion is that they're better scenarios through the integration of the innovation and we really satisfy customers' needs.

On top of that, where they really come to life are through the applications, the services that sit on top of them. So here we've highlighted some applications primarily that Microsoft makes. To put all the applications obviously that our partners make we'd need a lot more slide room. But the notion here is that they follow the entire spectrum of things that help people get more things done, productivity, stay connected and have more fun. And those three overarching themes are what the organization has found through our own research, through confirmation with our partners, through listening to customers. This is really what people want. They want things that make their life better around productivity, around staying in touch and around having more fun.

So if you talk about Home & Entertainment, we actually have pieces that fit into all of this puzzle. They fit into all these bubbles and the notion again is that they work very well with both our internal partners here at Microsoft and external partners.

So with that very quick backdrop, let me talk a bit about what the Home & Entertainment Group is. There are three central pillars to our business. The first one and the one that people focus on a lot is our game space. This is where you'll see our Xbox business. You'll also see our gaming for Windows business. You'll see the peripherals that we produce, and you'll see our Xbox Live business sitting here.

Beside that, we have our Home & Retail space, and there are four product lines or lines of service to think about here. We produce the consumer-facing software for the company. We also produce hardware: keyboards, mice. We also take our products and provide them for the Mac platform. And then the fourth is that we are the retail touch point for the organization, so for Windows and Office in the retail environment we're servicing those accounts and making those things happen.

And the third pillar is Microsoft TV, and what Microsoft TV does is provide the platform for all of our network solution, to take digitized TV and really harvest the benefit from that.

Let me talk about games and talk first about the magnitude of the games market, because there's a lot of anecdotal information about it being big and being growing, and I just want to give you a few numbers to anchor it.

So today around the world there are 100 million homes that have video game consoles in them. The past year in the United States alone it was $10 billion spent on the video game industry. That number represents a 60 percent increase from the same number six years ago.

If you think about those, I think about them both in a nominal basis and on a trajectory basis. So take the 10 billion, and we'll use some loose math, that's about the same as the U.S. box office receipts. It's also about the same number as the U.S. music revenue.

So in terms of nominal and scale, what you're seeing is video games are rising to be an entertainment icon that's on par with a lot of other parts of the more established entertainment medium.

But when you think about that trajectory, box office receipts are relatively flat over the six-year period I referenced earlier, music revenues unfortunately for a lot of our partners have been dropping, but we're on a 60 percent growth path. And when you think about what can happen in the future, there are actually a lot of reasons why that trajectory can continue. So I said there are 100 million consoles out in homes, but then in the United States, for example, only about 35 percent of the homes actually have a video game console. And when you move to the established markets outside the United States, that number drops to about 25 percent.

We also will talk a lot about online gaming as a great growth opportunity for the business, but today its revenues are relatively small compared to the packaged good revenues.

And when you think about the distribution channel and that it still is fundamentally a packaged good channel and it hasn't yet had technology and innovation lead to online distribution and different ways to really break the market free, if you think about those things there's huge opportunity for growth. There's no reason we can't get console penetration to 50, 60, 70 percent. There's no reason online shouldn't be a big part of the revenue pie going forward. There's no reason that we can't come up with new distribution opportunities that augment the existing model much like DVD augments box office receipts. And then you layer on that the enormous opportunity of emerging markets like China and India, the industry is ripe for a lot of growth. So we're going to come back and talk about the details of the gaming business but before we do that let's go into a little bit more in Home & Retail and Microsoft TV.

Now, I outlined before what consists of Home & Retail. Let's do a little snapshot of the state of the business. This fiscal year has been another solid year. In terms of our retail performance, Office 2003 actually is one of the most successful Office retail launches in the history of the company. Our Mac product for 2004 is the most successful product we've had in 10 years. Our keyboard business continues to be strong and grows on a consecutive year basis. And our mice business in most every emerging market we're either Number One or Number Two in terms of market position. And in our consumer software we've seen a lot of growth both at a macro level and our individual level in digital imaging. So this business is a nice, healthy, solid business.

As we look forward, they're going to keep it that way. We're going to keep producing, going to keep executing against those things.

But there's also innovation. This group has been pushing wireless, so you'll see a lot of wireless innovation coming from here. You'll also push design. We have a new line of mice, our Starck mice that have a very innovative design. And then you'll also see very interesting technologies of biometrics for fingerprint reading, so a very interesting business, very solid with a lot of interesting innovation ahead.

Now, our Microsoft TV business has had a great year and has really been at a point of transition. There are really two main product lines here. Again, the notion is that building a software platform that allows network operators, both cable companies and telcos, to provide digital television, to provide VOD, digital recoding, interactive programming guides, as Bill alluded to earlier, customized advertising. So if you think about the scope of the market and the growth opportunities, they're certainly rather large here.

But on a very tangible basis this year with our Foundation Edition product we've already announced a very large deal with Comcast that will involve deployment of 5 million units. That business is really up and running. And as we think about IP TV and the opportunity growth there and just the general momentum in the industry, we actually see that as a tremendous place to grow, because obviously it's got those great one-way capabilities but now you've got two-way, a broad pipe going both ways, which opens a variety of scenarios.

And you can see the list of deals that we've consummated, and you've also probably been following the industry and seeing just the general capital outlay. SBC, by way of example, has made a large statement about capital outlay in its infrastructure to support initiatives just like this one.

So we're very excited about this part of the business.

But if you really want to talk about the momentum in the Home & Entertainment business you have to talk about the Xbox. So the Xbox right now in its evolution of the business model and the ecosystem is that it's a great sweet spot, where the console install base is large, where great games are being developed, where developers have harnessed all the power capable, and now you layer on innovation. You layer on the fact that Xbox Live has both got consumer traction and it's opened up new ways for developers to communicate with gamers.

So the numbers here do speak for themselves, but I'll highlight them some. We have sold 15.5 million consoles through the end of the fiscal year. That's what we told you last year, and we hit the number. But the important thing here is the momentum. To take a look, in the United States we now have a third of the market. A year ago we had 23 percent; that's a 10-point increase. In Europe we've also seen an increase in our market share. And we're looking to tell you this time next year that we will have sold in excess of 20 million consoles, another great hurdle and another great growth opportunity in the space.

But it's the software that really tells a lot of the story about the health of the ecosystem. The attach rate, the number of games sold divided by the number of consoles, continues to be a real bellwether of the health of the industry, and this is a place where we lead. Our 6.9 ratio in the United States is the highest ever of any console at this point in its life cycle. We've got strong third-party support in terms of quantity of games, as you can see, 425 games available, 100 of which are Live-enabled, and then you can see for the quarter just ended the enormous growth in units shipped on the Xbox platform. The other great part of this story is Xbox Live and on this one we actually do have to take a second and crow. When we were developing Xbox Live, we went to a bunch of people in the industry and we said we've got an idea, we're going to build a subscription service that's broadband-only. Everybody thought we were crazy. But we said, no, in order for developers to be able to realize their potential, in order for consumers to have their appetites satisfied, the only way to do it was broadband and this was before broadband was as pervasive as it is now. But we made that bet. So how did we do? Well, we have a million subscribers today. Now, we told you last year we'd have a million subscribers, so you might say, great, that's fine. So think about it differently. Let's compare it for a second to other entertainment platforms. Let's look at HBO, AOL, TiVo, all great brand names, good businesses, have hit the million consumer subscriber threshold. It took all of them five years. We did it in a third of the time. So we're very excited to see the big innovation bet we made in this space pay off.

And we're actually even more excited looking forward with two great content assets coming to bear that we haven't had before. Electronic Arts is bringing its content to Xbox Live, and consumers can't wait. And when you combine that with Halo 2, a hugely anticipated title, we think this number is going to continue to rise. So we've given you guidance that we think we'll have 1.5 million subscribers at the end of next fiscal year, so that's a 50-percent increase in our business.

I mentioned Halo 2. This is without a doubt the most anticipated title in the gaming industry. It's the sequel to Halo, probably by a lot of accounts the best video game ever created. Halo has sold over 4 million units so far. The title comes to market November 9, and consumers are clamoring for it; they just can't wait. And so to tease them just a little bit, we've created a trailer, and this trailer is actually, if you've been to some movies lately, you might have seen it. It's at the head of a lot of movies like Spiderman, I, Robot, Catwoman, a lot of great things that are out in the industry. So let's take a look. (Video segment.)

So not only are we excited about Halo as a property to take to gamers, but we're incredibly excited about how it typifies the integration and innovation that we really stand for.

The team at Bungee, which developed Halo, is pushing the platform beyond anything we could ever imagine. They're pushing for every ounce of power; they're pushing for everything they can do creatively; and they're doing the same with our Xbox Live service. They're going to redefine even further what gaming looks like.

Now, as we talk aboutHalo 2, we're certainly very proud of it but don't be confused, it's not the only AAA title in our lineup. We've got the hot titles coming. You can see the list, you can see Doom, you can see Madden, they're all there. And when you look at the titles and the support we have from key publishers, Tecmo, Activision, Ubisoft, Electronic Arts, Lucas Arts, Midway, Sega, we've got the AAA titles to deliver. Combine that with the rest of the Microsoft Game Studio portfolio, which includes Forza Motorsports, Fable, this is the platform for AAA hits this year.

But it's also about diversity. So not everyone likes those kinds of games. You'll see Spiderman on here, you'll see Spongebob Squarepants, Zoo Tycoon. The idea is to bring a wealth of content that really satisfies consumers.

And it's not just about the breadth, it's about the quality. obviously. We had the pleasure of actually being honored very well at the last Electronic Expo, E3, which is our major trade show, in May. The E3 game critics awarded prizes for best in show effectively and the Xbox play received seven awards. This was more than any other platform. And Microsoft Game Studios specifically was very honored to take best video game console, best action game, and best role-playing game.

So the games are here; the games are great. We've been saying they're great for a while. You really see it this year. There's no time the portfolio has looked better.

But let's talk about the assets we've created, what are we doing with all this. We think we've created some very firm assets that really set the company up for success this generation and in future generations. We are the Number Two install base. That's a big thing. We shipped our first console two and a half years ago.

We've established a consumer brand that resonates with entertainment and excitement. We've established franchises, which benefit this generation and again will set us up for success going forward. We've established strong third-party relationships, our attach rate the highest in history, the breadth of our content. All those things prove we've entered the market; we don't have to prove that anymore.

When you add to that the innovations, which you've already seen, Xbox Live is redefining what gaming is about. We are the undisputed leader in online.

Now think about the initiative we've announced with XNA and how we want to take tools, how we want to take our focus there and help improve the ecosystem, take the costs out, allow the developers to focus much more in the creativity instead of the costs.

We're very happy with what we've created, but when I showed this slide to some of the guys back at the Xbox team before I came here, there was one thing they were very dissatisfied with. They were very dissatisfied with seeing the Number Two. There are a lot of people right now who are focused—laser focused—on being Number One, being Number One through innovation. They want to push innovation harder, faster, and farther than anyone in the video game business has ever seen before. And quite frankly they're going to push it harder, faster, and farther than Sony has ever seen it handed to them before as well.

The next console cycle will be a major inflection point in the industry. Console cycles thus far have been primarily defined by the power of the hardware, and hardware is going to grow, no doubt about that, but future cycles are going to be defined by something else. They're going to be defined by the power of the software that sits on top of that. It's truly going to redefine what interactive gaming means.

Thus far, interactive gaming has meant an immersive experience—being taken to places you've never been before, seeing characters, experiences you've never seen before; that will continue, that is first and foremost. But interactivity also means how do I interact with my friends, how do I interact with my other media, how do I interact with my PC and how do I interact with that multitude of devices that sit around my home or I take with me?

The company that can define those scenarios and execute on them will win the next console cycle. That company will either be Microsoft or it will be Sony.

So we think we've proven we can play; our goal now is to prove that we can lead.

Thank you very much.

(Applause.)

END

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