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ROBBIE BACH: Good afternoon. I want to talk a little bit today about where we are in the consumer space and the work we're doing with consumers, and then focus in on entertainment, in particular with Xbox and IPTV.

So if you think about the work we've been doing in the entertainment space and in the consumer space, we've gone back about the last three years, and really tried to develop a focus on seven scenarios, and you can see those scenarios pictured here. Whether you're at the PC in a mobile scenario, whether you're working on TV and stereo or playing on a TV and stereo, each of these scenarios needs to fit in and work well together.

And what we've done is allocated our resources and our development investments and really tried to invest to make sure we do a great job in each of these scenarios. So if we take a look at that in a slightly different way in the consumer space, across the scenarios, you can see the work we've done at the platform level, whether that's with Media Center, Windows Mobile things that Pieter just showed, Microsoft TV and Xbox that I'm going to talk about, or just Windows XP itself; we really do have platforms that play in all of these scenarios. And form the foundation on which the other parts of Microsoft as well as other companies can build their solutions.

Of course, going to the next level, you have the software layer, where we have software tools and applications that provide solutions for consumers, whether that's the Windows Media Player, Microsoft games and the games we do in the Games Studio, Microsoft Office, Microsoft Money, and a host of other consumer applications, as well as applications that come from third parties that build on top of our platform.

The way we think about this from a consumer level, services is increasingly an important part of this picture. Consumers are now understanding the idea that it's not just about the devices they have or even the software that they buy for those devices, but it's about the services that run on top of them. So again, in each of the categories, whether it's MSN Music, or Encarta, or the work we do in Search, or the work we've done in Xbox Live, we have service plays designed or we're investing heavily to build a complete solution.

And of course, we don't think that solution is complete without the partners to go along with it. In particular, in the consumer space, it's very important that we don't think we can do everything ourselves. We have to do a lot of work to help create an integrated environment, but we need great support from partners, and I could have made this list of partners three or four times as long in each of these categories, but I wanted to pick some that you'd recognize, so that you could see the work we're doing in the partner space.

And then finally, there's a set of underlying technology and plumbing that goes along in all these scenarios that's incredibly important. And we continue to invest both internally and with standards bodies externally to make sure that those technologies are done well and are used by other people to create a good solution. In the consumer space, you don't have that IT director. You don't have somebody who can make it work, and a real challenge in each of these scenarios is working over time, and continuing to invest to make sure there is a great end-to-end solution for consumers — and I think you've seen us make a lot of progress in many of these scenarios, you're going to see increased investment across our businesses in making this happen.

Now I'm going to spend some time today focusing in particular on Xbox 360 and what we're doing in the Xbox space. And this is certainly a place where the company's done what I just said. Four or five years ago, we started making big investments in this scenario, we decided that video games was key to our success in the home; we've been continuing that investment over time, and now with Xbox 360 we see the opportunity to bring that investment to fruition. In designing Xbox 360, we decided that there were really four things that were absolutely critical for us to focus on.

The first of those, which you see here on the screen, was industrial design. I haven't met anybody who thought our first version of Xbox was pretty; it didn't win any design awards; it was kind of big and bulky. And Xbox 360 really is designed to put us at the cutting edge of that industrial design work, and the feedback we've gotten relative to our competitors is that we're now in a place where people say, wow, that could have been done by Sony, or that could have been done by Apple; you guys have really figured out how to make progress in that space,

A second trend in the market that we wanted to take advantage of was the ability to customize, to personalize your Xbox. In fact, most people in our target audience customize and personalize everything. They customize their car, they tattoo their bodies, they customize their hair; everything is specific to them. And so with Xbox 360 we want to enable them to do the same thing, and so we have just one example of the customization we do here is custom faceplates, where you can buy your own faceplate, you'll be able to create your own faceplate, publishers of games will create faceplates that people can use on their box; if you're a big Madden fan, I'm sure the Electronic Arts will produce a Madden faceplate for people to take advantage of. That's the kind of customization, just a sample, of what we're doing in the product.

The third area we wanted to focus on was connectivity. Xbox 360 is fundamentally an online console, and if you think about it, that's the place where we have a huge leap and a huge advantage in the marketplace. Xbox Live has been very successful; our primary competitor Sony does not have an answer to that and hasn't talked about an answer for the future, and it is gaining customer momentum and helping our platform succeed. It is about building community and Xbox 360 is going to help make that happen.

And the final design point was around the television itself. Over the next 10 years, there is a revolution that's going to take place in television, moving to 16-by-9 screens and moving to high-definition format. And Xbox 360 is going to be a driving application for people to get high-definition television. Every Xbox 360 game will play on a regular TV, but they will all also support high-definition TV, and once you see a game in high definition, you never want to go back.

So that's the basic overriding trends and design points we have, you might say, so what's the strategy? Well, in fact, the strategy starts with today's Xbox itself, and we really have tried to be a thought leader in this generation. All right, if you think the console itself: we sold about 22 million consoles to date worldwide, we innovated there with the first hard disk in a console, we innovated with very high-end graphics in a very powerful system, and in fact, that innovation has led us to success. This holiday season we outsold PlayStation 2 in North America. That's a big milestone for us. So there's thought leadership there. In Xbox Live, clearly thought leadership. The first console sold to take a crack at making online gaming a real success, we have a subscription service with over 2 million subscribers; that's faster to 2 million than any other subscription service in the equivalent space — faster than HBO, faster than AOL, faster than TiVo — and double what we had last year at this time, which was about a million subscribers. That continues to grow and form a great foundation for our future.

And finally, that foundation is based on great games, and “Halo 2” was and is an amazing game. In one day, we sold in the United States $125 million worth of “Halo 2.” That's more than any other entertainment property has ever done in a single day, and I'm not just talking about video games; I include movies, I include music, any entertainment property. So that's the kind of IP we're building, to build our foundation.

So Xbox has been a big investment and continues to be a big investment, has built a great solid foundation, and the next step in that foundation is to go from thought leadership to market leadership with Xbox 360. And really what that means is we have to take that core audience that we've built with Xbox and figure out how to captivate that into a mass audience, so that we can be the market leader. And there's really four things we're focused on there.

The first is making sure we have the most powerful platform. We now know a lot of the specifics around Sony's next-generation box PS3, and we know that from a sheer power perspective, our hardware and their hardware are going to be about the same. They're going to be a little faster in a few areas, we're going to be a little faster in a few areas; the net result from a hardware perspective is going to be kind of a toss-up. But our platform has secret sauce that they don't have. We have a great software environment in Xbox 360 that's going to enable game developers to produce great games easily and produce new experiences for our gamers. And we also, as I said before, have our online platform, Xbox Live, in place and continuing to grow. The combination of hardware, software and Xbox Live service means we're going to have the best platform, and that's a key for making sure we have the best games. And that is the other thing that's really critical: We need to have great game lineup, we need to have great games coming from a wide variety of publishers, and our publisher support this generation is going to be wider and deeper than it was last generation, not only in North America and Europe, but also in Japan. And I'll talk about—I'll actually give you a chance to see one of our upcoming games—just give you a little sense of the direction we're going on.

I talked about Xbox Live being critical; with Xbox 360, we take that to the next step. We started with Voice in Xbox; Xbox 360, we'll do video chats, we'll do something called spectator mode, so that you can watch other people play games. Take that to its logical conclusion, a few years from now there's a “Halo” tournament around the world and 100,000 people enter that tournament, and then tens of thousands of people come to watch the finals, and sponsors decide they want to sponsor the final. That's not only an incredibly cool end-user gamer consumer experience, it's also a new revenue opportunity and a new advertising opportunity for our partners.

Finally, it's important for us to be more than just a game console. Certainly we have to be the world's best game console, we know that, but our consumers are looking for Xbox 360 to integrate into the broader consumer experience in the home. In particular, in our case, we think Media Center is very important to us, and Xbox 360, every Xbox 360 will be what's called a Media Center Extender, and that means if you have content on your Media Center in the home and you have a network, you'll be able to play that content on your Xbox on the TV that the Xbox is connected to, which gives you the ability to distribute your music, your photos, your video, throughout the home. You'll also be able to take a camera, a digital camera, a digital music player, plug it into an Xbox 360, see your photos, play your music.

So the combination of those elements, we think, gives us the opportunity to be the market leader in this next generation, and that's absolutely our goal. And we also know that it gives us the opportunity to make money doing it, and to bring the return to our investment in Xbox back to Microsoft. And as we said last year, our plan for the entire home and entertainment division is to be profitable in fiscal year '07. We continue on that plan and continue on that track.

So just to make sure everybody's clear, Xbox 360 is here, we will have a Christmas holiday launch in North America, in Japan and in Europe. That will be the first time any game console is launched in all three territories at the same time. We know we're going to have a great games lineup; we've been working very closely with third parties for almost 18 months now, producing a lot of games. We have over 160 games in development; we're targeting, well, probably around 15 games at launch, something like that, 25 to 40 by the end of the holiday from all the people you'd expect.

So what I'd like to do now is actually show you one of our games, “Project Gotham Racing 3,”; it's a game done by Microsoft, published by Microsoft, done by Bizarre Creations from the UK. And what you're going to see here is all produced in engine in the game, so this is what people are going to experience when they play “Project Gotham Racing.” Let's roll that video.

(Video segment.)

ROBBIE BACH: So that gives you some idea of the type of content we're going to be able to bring. You put that in high definition, you put it across the lineup of games we have, and we believe we have the product to make us the leader in this space in the next generation. So that's the first example in this consumer space of really an end-to-end solution that I talked about earlier, the platform, the software, the service, and the underlying technology to make for a great story and for a great consumer experience.

I want to talk about a second one, which is Microsoft TV, and Microsoft TV again is a place where the company has been investing for quite a while. It's a place where we see a real opportunity in the future and we're really going to the next cutting edge. Many of you know we have a product called Foundation Edition, which is primarily designed to work with the cable industry and their existing hardware and new hardware they're coming out with. Our current version of this is called Foundation Edition 1.7. Comcast is our biggest customer in North America; we have a 5 million subscriber deal with them. We also have a lot of business actually in Latin America, where we're the leading digital set-top box software provider. This is a product that we'll continue to invest in and continue to work with the cable industry as they make the migration over to the digital world.

But in some ways where the new cutting-edge work is happening, is in what's called IPTV, Internet Protocol Television. And IPTV Edition is our product that's entering in that space, and I want to talk a little bit about what that means and then we'll take a moment to show it to you. Basically what IPTV Edition enables you to do, regardless of whether you're a cable provider or a telco or any net operator, you can take live media, on-demand media, across an IP network and put it into the home on a high-definition television, and you can do multiple streams of that content without having to have multiple tuners in the set-top box. You really can produce an amazing TV experience. You get better TV just in basics, and then you get a better-connected TV and a better platform.

And I want to point out from a Microsoft perspective what's very cool about this is not only is this a new product and a new business for us to sell, but it also is fundamentally based on our other technologies. This product sells SQL Server, it sells Commerce Server, it sells the rest of our backbone into these operators, and really helps broaden our business.

So IPTV for us is another example of a new opportunity, a chance for us to take the investment we've been making and grow it and produce something new and very exciting.

So what I want to do now is I want to bring out Chris Wimmer, who's going to take you through a demo of IPTV. Chris?

CHRIS WIMMER: Thank you, Robbie.

So I'll switch over to the video experience, and one of the first things that we want to point out is that even though it's TV delivered over a broadband connection, it still has to be a great television experience. And so what we're delivering over here is high- definition TV over that broadband connection, which is really becoming increasingly popular in homes and certainly Xbox 360 will drive HDTV, and IPTV will be able to deliver HDTV.

Now, when we talk about IPTV, we also think it's going to be a better TV experience. Something as simple as instant channel changing, as fast as I can click the remote control, I can flip through and surf through all of those channels. And one of the things that we found, working closely with cable operators, is really with the architecture that they have, that broadcast-oriented architecture, they're never going to be able to deliver instant channel changing. It's really the power of taking advantage of that two-way broadband connection and software to enable something that really helps deliver that great experience.

Now, Robbie touched a little bit upon this picture-in-picture technology that we've also added to IPTV; and by itself picture in picture is not unique, but what we are doing is eliminating the need for multiple hardware tuners in the box, so we're focusing on the cost reduction of the set-top boxes to make the overall IPTV solution more cost effective for operators.

And we can build that into the guide experience as well, and there's a very rich animation, we're really taking advantage of Moore's Law and the greater processing power and speed that these boxes have with IP set-top boxes.

But when we talk about picture-in-picture, let's take it to another level, and I'll show you a prototype we've put together in association with Major League Baseball to show how the content can really start to play in new ways with IPTV.

So here's watching a baseball game on TV today, but with IPTV in the future you'll be able to watch four games at once. We're essentially delivering four video streams down to the box, and I can actually toggle back and forth between those games. Now, that doesn't have to be baseball games, it can be four news programs, it can be four kids programs, it can be multiple video angles if you wanted to; it's really up to the operator, companies like SBC and others, to work with the content providers to package content in new and exciting ways like four video streams being played at once.

Certainly in our demos we've done even more video streams, but there comes a point in terms of usability that consumers can only watch so many games at once.

Then we talk about video on-demand is certainly an area where we felt was an integral piece to IPTV, because you can really expand the number of programming choices that you have with IPTV.

And when I have thousands of programs, you need an effective way to sort through all that information, and then I can also go into movies, I'm going to pick on that's an HD movie, and I can rent that program and just start up right away, and now I have full control over that program, just as if it was a DVD in my DVD player. So I can fast forward at multiple speeds, I can pause, play, rewind; I have a lot of ability to control that program. And then I have that same level of control when I have DVR. So these boxes will most likely have a hard drive in it; it certainly depends upon the operator whether they want to have a hard drive in that box or not.

And I can also play programming through here, quickly navigate to get to that information, and again I have full control over it.

So these are some of the ways where we're innovating with IPTV to create that better TV experience through IPTV.

ROBBIE BACH: Thanks a lot, Chris, that's great.

So that gives you some idea of the types of experience we're trying to deliver in what I talked about as the digital lifestyle in the home.

Now one of the other exciting things about IPTV is that we're actually making a lot of progress in the marketplace. We actually have four commercial agreements signed with SBC, Verizon, SwissCom and British Telecom. We also have numerous others, as you see here, Bell Canada, BellSouth, Telecom Italia, Deutsche Telecom and Reliance Infocom. As companies that are in what's called our early adopter program, they're doing tests and test evaluations of our systems.

When you look at that, that represents a very large percentage, a very meaningful percentage of the capable lines in the world that can deliver this type of service. And in particular with the telco companies, you're seeing an excitement in their business and a need in their business to drive forward in this area and be able to deliver not just voice, not just data, but also video and television content.

I'll also point out that we have a very good relationship with Alcatel, which is a partner with us and will be delivering the same technology to the second- and third-tier telco providers, which when you actually look on a global basis is a very large market, and another great opportunity for us to continue to grow in this business.

So overall we think this business is positioned as a breakout business over the next three or four years. And it's going to take time; we have to go through trials with each of these guys, and you have to roll out in test markets and then roll out into the broader marketplace, but all the right things are in place. The broadband technology is getting into place, we have motivated partners that are excited about the technology, we have good foundations. It's a software-based technology, something Microsoft knows how to do very, very well. And we think we really can deliver something exciting for the future.

And so between the combinations of what we show with Xbox 360 and what we're showing here with IPTV and the work we've done on Foundation Edition, we think the Home and Entertainment division business, as well as the broader Microsoft approach in the consumer space, is actually in a very good space.

So let me talk just finally about competition and what it means to compete and how we are thinking. And I get the question from people pretty regularly, so how do you compete with Sony, how do you compete with Apple, what are you going to do to be successful against those companies?

And there's really two aspects to it. The first of those is we have to go compete in the spaces where they're successful. This is, to be completely obvious, why we got into the Xbox business. That was a successful business for Sony. We needed to go compete in that business to be successful in a place where they were doing well, and it's also, as I said earlier, one of our key scenarios.

Likewise in the music space, that's both a key scenario and a place where Apple's been successful. So we're going to need to do more to be more effective in that music space and compete with them successfully.

But that's only one part of what we have to do. That's sort of the head-to-head competition, if you will. The other part we have to do, to me, goes back to where I started with the key scenarios. We have to be able to prove that we can deliver in all the key scenarios, end-to-end, both ourselves, and with partners, and create an ecosystem that works very well for everyone. We have to be able to deliver integrated solutions. I talked about the work we're doing between Media Center and Xbox 360; that's the type of integrated solution the consumer expects where when you put two products that are designed to work together and plug them in, they just work and the right thing happens.

We need to bet on the next-generation scenarios. We can go fight yesterday's battle, or we can go look to the future and look at the ways the digital lifestyle is starting to permeate homes and really try and take advantage of it. It's what we're doing with Xbox Live, it's what we're doing with IPTV; we think that's the direction to go in the future.

We also know it's not just about great hardware, it's about great hardware, great software, and great services. Sometimes we're going to produce that hardware ourselves, like we do with Xbox, sometimes we're going to do that with partners; Peter showed a bunch of very cool partner devices where in the mobile space we really are getting momentum behind the devices as well as our software and services.

The combination of these three things together is what's going to make us unique, and is what other people can't match. Sony isn't the power in software, they're not a power in services, and they're going to have a hard time competing with us on that turf.

And finally I think it's important to deliver choice with partners. I think it's in some ways ironic when you look at the comparisons in consumer space, I think Apple and Sony aren't very partner oriented. They're very monolithic oriented with an Apple solution and a Sony solution. And our approach is to provide a lot of the technology, provide the platform, enable the ecosystem, and yes we want to make money when we do that. But we know that the best way for us to make money is to make sure our partners in the ecosystem make money as well. Because consumers do want choice, they do want variety, and our challenge and our job is to deliver that choice and variety while we deliver a great integrated experience, and I'm very confident that we can do that.

So when you think about the work we've been doing in the consumer space, I go back. I've been at the company now 17 years, and I worked in the Office business when we were 20 percent market share to Lotus and WordPerfect's 80 percent market share in word processing and spreadsheets. And I lived through what I'll call the digital business revolution where we came to really change and be a part of the change that happened in business when digital technology really took hold and started driving change. And Microsoft and our partners benefited tremendously from our willingness to bet on that investment and to make that investment pay off in the future.

My proposition for you today is that we're doing exactly the same thing in the consumer space. A digital revolution is happening in the consumer space, it's started, and we are investing, and we're going to invest to make that pay off for us and for our partners, to really drive us to success over the next five years.

Thanks very much.

END

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