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Financial Analyst Meeting 2005
July 28, 2005

COLLEEN HEALY: Hello. I'm delighted to be able to facilitate questions and answers with you for Bill, Steve and Chris. We're going to do this a couple ways. One is we've already received some questions over the COMNET that I will include. And then we'll favor the live questions from the audience.

The IR team is in the aisles. They've got those fancy paddles. They will walk to you with a microphone. If you kindly state your name and firm and your question, we'll field your question.

Okay, great. Who wants to start? Paddle 3, please?

QUESTION: Thanks, hi, Rick Sherlund at Goldman Sachs.

Bill, we heard from Steve about premium services, I guess premium products. And we also heard about services, and I think those are two different things. I wonder if we could just get maybe you to expand a little bit and get your views as well on what kinds of opportunities you think there are for the company. I don't know if you want to quantify it, or maybe just directionally, if you can expand a little bit and give a sense of where you're headed there.

BILL GATES: I think one good historical example for us is what we did with Windows Home versus Windows Pro, where we were able to have a product that was attractively priced for OEMs and for the consumer market?, and a rich product that was a significant increase in the OEM license fee that went into the business market at large. And we drove a lot of profitability as the mix of Pro became a substantial part of the OEM mix.

We've had that to a very limited degree with Media Center and Tablet Edition. As those two things are catching on and becoming mainstream in the market, depending on how we do the SKU assortment, the capabilities associated with those will not be in the lowest price SKUs. We're still talking about exactly how that rolls out. We have some more enterprise-oriented features that we can do some SKU work around.

And you could say the whole family is getting bigger, if you think of Windows CE being the lowest cost offering, Starter Edition which is very targeted as being the next notch up from that, Windows Home is the next notch up from that. We'll also be adding some richness here in the slightly increased price area.

Another one that I want to make sure comes through very strongly is the idea that the value that we've got on the server with our Office product line, particularly SharePoint, Exchange, all of those things, that—we expect—and it's our goal that we can make that kind of a common sense thing. In the same way that you buy Office on the client, that you do spreadsheets, presentations, documents that way, we think that what we've got with SharePoint—the work flow rights management, document lifecycle—all those capabilities eventually will become common sense so that businesses will build their business applications, and all their information—visualization and sharing activities—around that. What that would derive is some CAL-type revenue; that is, because you want every desktop to have full access to those server capabilities, one of our premium CAL, you know, say there be an Office premium CAL-type offering, that would become very high volume if we achieve that, versus what that looks like today.

Even in spaces like mobile we're looking at, is the offering more for the consumer-oriented user of that phone versus the more Office-oriented user of that phone? Is there a distinction there where we can do essentially what we've been doing for the broad volume market, and then get some value out of what we'll do, new things in that Office type user. So you see it really in many parts of our product strategy. And emerging element are things like FrontBridge.

STEVE BALLMER: Just one thing I want to be clear on that I'm not sure I was clear just from some discussion at lunch. It's premium value at a premium price. We're of course going to keep the current product set around, and we're going to have to prove to our customers that they want the premium value, because we're going to continue to deliver great value in the products that we have. We have to continue to enhance and upgrade that value to drive upgrades, etc. So really the question is we have to prove to the customers superior value at a somewhat higher price.

BILL GATES: That's right. Yeah, if you take the innovation we have available, some substantial portion of that goes into the base product to keep it very high market share, something that people want to upgrade to. But we feel we have enough innovation to take pieces of it like we did with Windows Professional.

Just to finish on this, there are some things that are pretty novel altogether, like what we've done with this FrontBridge, where you filter people's IP stream and they just don't have not only the server and software costs, they just don't have the personnel costs. So it's taking expertise and making that available. And we're going to work that from both ends. We're going to work it from the consumer end with more storage and premium offers there; and we're going to go after an area that I think has been underestimated, which is software services for businesses that we're just edging into, but we see gigantic potential over a five-year timeframe.

COLLEEN HEALY: Great. Panel number one, please?

QUESTION: Charles DiBona of Sanford Bernstein.

Sort of an organizational question around R&D, so I don't know which of you two would like to address it, but with something that Steve mentioned at lunch about going to sort of more frequent maybe less Big Bang-type releases in Windows, and also with sort of the—a lot of technology sort of cropping up in a bunch of the different business units at once—something like voice over IP which is in Xbox, on the desktop, in the server side—how is that impacting the sort of way you run your R&D department, and how do you coordinate these sort of diverse efforts along the same lines without layering on too much bureaucracy and possibly slowing your ability to bring these things to market in a coordinated way, and maybe even alienating developers, who can be somewhat mercurial about these things?

BILL GATES: Well, I'll start off on this. The developers like seeing their products in the marketplace, and so if you can take the upper layers, say of Windows, and have a more regular release cycle for those things, then you just get feedback back more rapidly, you understand what's going on, you get some of the support for new scenarios, new hardware, done in a somewhat better fashion. Windows is one of the places we're doing that layering.

With MSN we've always had a fairly rapid release cycle. I think Messenger—of all the products that get released out to the Web, you've seen faster innovation in MSN Messenger than anyone else's equivalent or any type of online thing. So that has been very fruitful for us as MSN Messenger is driven to number one market share.

STEVE BALLMER: In terms of the development issues, you're right to note that we have in a variety of ways technologies that impact a number of our different business groups. Sometimes we let the group sort of drive ahead, pursuing their own independent vision, and then try to link. We're doing some good work in that area now. Bill and I were in a meeting this week on how we make some of our communications assets work together more seamlessly.

Sometimes we decide we really have to get one thing done right at the start, because to get to critical mass we can't have multiple approaches in the marketplace. So there's not a magic one-size-fits-all answer in some of these things. Sometimes we get some skunk work stuff bottoms up, which is great. Sometimes we have to make some top-down decisions on how to move forward.

We have done—let's just take VOIP—it's a great example. We've done some great work integrating voice and video into MSN Messenger. That's proceeding kind of posthaste. At the same time, what we're doing with Office Communicator, Live Meeting, pushing forward—in that case we're going to get I think a lot of synergy. And it all builds on the same sort of basic technology, code technology for encoding the voice and doing all of that. That's kind of a platform-level functionality for us.

So we have to be able to be nimble, but not—you know, if you try to be too nimble, too many little broken pieces, you don't get critical mass, and the advantage I think we have versus the small guys is when we decide it's important to get critical mass, we can. And, when it's important to just let a few flowers bloom, we can allow—certainly our people love the flexibility that we can provide them in that regard as well.

COLLEEN HEALY: Let me take a question off the COMNET that was previously submitted. The question is the CEO—that's you, I guess, Steve—is much more confident about growth prospects for the anchor businesses than are outsiders. What specific drivers of growth are outsiders missing?

STEVE BALLMER: I think probably folks are missing a couple things. Number one, certainly while people understand the market is growing, I still think there is almost an unwillingness among some outside who accept the market can continue to grow, albeit it some of that growth is coming—hardware market growth is coming in high piracy countries, to me in some senses that represents sort of a double-pumped growth opportunity for the future.

We have essentially very little revenue relative to PC market in China. That's all upside opportunity, and I do think unlicensed PCs, piracy in emerging markets, is probably fairly substantial—substantially underestimated for the long run. We have challenges to capture, but it's underestimated.

Number two, I think people assume in all of these areas we do have high volume and high share. We sell an awful lot of Office licenses, but relative to the number of PCs that get sold, or, sorry, that are in the installed base, we still have upside. Relative to the server market, we still have market share upside. I think there is more upside probably potential we see than others see. Probably the biggest though is in this area that Bill was describing a minute ago, and I described in the morning, which is really in this notion of I think what I called anchor business portfolio expansion, bringing higher-end offerings, whether it's Small Business Server Premium or what we've done with Windows Pro, or some of the things we're talking about with Office premium CALs. There are literally billions of dollars over the next several years—three, four, five years—billions of dollars of I think growth people don't think about and anticipate.

It's kind of funny, you see us in the press announcing new products and new technologies and doing acquisitions, and until we're actually monetizing, I'm not sure if people pay those things as much attention as we are, as we're trying to bootstrap up the new revenue and profit stream.

You take all of that at least in those anchor businesses, plus what we can do with services in the way that Bill described with FrontBridge, and I think you have pretty robust growth opportunities for the next several years.

COLLEEN HEALY: Great, thank you.

Number two, please.

QUESTION: Michael Cohen, Pacific American Securities.

Sony, IBM and Toshiba are partnered on a new microprocessor code-named “Cell,” which is to be out next year. And I was wondering if you could give us some of your thoughts on the potential for competition against Xbox and Media Center. And I was also wondering if you see it as purely competitive or if you also see it as an opportunity for additional software development in the digital media area?

BILL GATES: Well, you've got to give Sony a lot of credit, because they've taken what's an evolution of microprocessor architecture, which is to have an integer unit, along with some pipeline floating point, and they've given it this name, “Cell.” If you look at the processor that we have down inside the Xbox, we also have a pretty unbelievable floating point capability. We have a lot more integer capability than they do. Depending on your algorithm, they may have more floating point than we do, not a dramatic amount, but more if you fit a very pipelined approach that they use.

This idea of special execution units has been around for a long time, and as you're getting lots of silicon, you have to think, okay, which applications can use those special side execution units, could Microsoft Office use those? In most cases the answer is no. Could general applications use it? And most of the things you think about in terms of that type of pipelining or codec-type things that just brute-force through the normal processor makes that work very well.

So over the next, oh, 18 months, the thing to do is to go to people who are doing software development for the PlayStation 3 and for Xbox 360 and get a sense from them which tools let you be most creative, which tools are letting you connect up to your customers in the new way, which tools give you the best graphics algorithms, graphics capabilities, and you'll get a sense of that.

Our view is basically we've got a Ferrari, they've got a Ferrari. Our Ferrari is leaving the starting line substantially before their Ferrari is, and in most races that's a very nice thing. We tried it the other way last time and although we have some bragging points, when you get to the bottom line of total market share units sold, that early start was very advantageous for them in that previous round. Many of the new things play to our strengths.

I don't see that in terms of the broader market, I don't see a “Cell”-like architecture being applicable to the PC space. I mean, Apple certainly looked at that, chose not to get involved in it, in fact, chose to move to the Intel architecture. That current design doesn't have relevance for the 99 percent of the software that you run on a PC.

COLLEEN HEALY: Number three.

QUESTION: Jason Maynard, CSFB.

I wanted to follow up on Bill's comment about the large opportunity for software services for business. And if you look at sort of the traditional model of selling business software into, say, SMBs, I mean, it's been a graveyard of companies that have tried to actually scale that business. Ironically, like the ADPs and the Paychex have made a lot of money selling, in essence, outsourced business services.

So does it make more sense to maybe look at this sort of SMB business service market a lot more radically versus sort of the traditional put-software-in-a-box mode that, say, Business Solutions is trying and a lot of other companies are trying as they move downstream?

BILL GATES: Well, yeah, I'll start, but you should add a bit.

What it does is it makes sense to architect all the software we do so we can deliver it to run on a server on-premise for people who want to run it that way or partners who want to run it that way, and in a form that we can host it so we sell it kind of on a monthly basis.

We've had a phenomenal success with a product called Small Business Server. It's aimed exactly at that market, it's something that you install locally and run on a server, and so I wouldn't say there's any graveyard there. We are making, between our Windows client revenue, and Office revenue, Small Business Server and other things, we are doing quite well in small business.

The whole play in applications, I'd say, is that independent of architecture we think there will be higher market share; that is, the top three players in doing SMB applications will have substantially higher market share as a group than those top three do today. And so as you get that consolidation, because the technology gets cheaper, particularly connection to Office with the rich visualization things I talked about, means one-stop shopping there is very attractive, we think we can gain share. And share gives you scale; scale gives you profit.

STEVE BALLMER: There are really kind of three tiers to that SMB market. There are businesses that don't have and probably never will have a server, in which case the real play is all service.

There's a group of people that will probably never have more than one server, and for them we want to give them the server and most everything else comes as a service.

And then there are guys who have an IT staff of five to 10 people, will put in some servers, and then you get a FrontBridge level of what I'd call more outcast services rather than moving the whole thing out, and we want to be able to deliver appropriately for sort of all scales of complexity in that SMB business.

COLLEEN HEALY: Great. Number four, please.

QUESTION: Hi. It's Adam Holt from JP Morgan.

In an earlier presentation I believe Jeff noted that in all aspects Office 2003 has been more successful than XP. As you look at your obviously enormous installed base, how do you think about and if possible quantify what you think the opportunity is for “12”? And somewhat strangely, did the success of 2003 at all change your thinking about the trajectory of “12”?

STEVE BALLMER: Well, there are hundreds of millions of Office users in the world, and the key with the new release is really not only how quickly can we sell, but how quickly can we sell and get deployed the new releases, and it's really on that second dimension, how quickly can we not only sell but get deployed new releases that, as Jeff highlighted, Office 2003 is really a shining star.

We know we still have work to do to make it easier to deploy new software, and we've got a lot of work going on, not really so much even in Office as in Windows to make the management and distribution of software in larger companies and in the consumer market simpler.

And certainly because of our belief in our ability, whether it's through services or through other technologies to improve that process, we think there is a chance to, shall I say, increase the velocity of Microsoft Office over time.

We have believed that; we continue to believe that; we will believe that. “Office 12” wasn't sort of guided by that fundamental fact; it was guided by its own independent sort of innovative perspective. But at the same time, it is part of the reason why we believe there's sort of, if we do it right, even more growth prospects out of this.

We did, I've got to say, one of the most fun things I've had a chance to do; Bill and I were both at our sales meeting last week, and we had a chance to show some of our folks just about a smidgen of what we've got coming in “Office 12.” And I've got to say I think we're going to get a lot of excitement not just from our own people but from customers as we bring that product to market, and so if we can take some of the friction of deployment out, it ought to bode well for the possibilities for some velocity.

COLLEEN HEALY: We likely have time for maybe just a couple more questions.

Number one, please?

QUESTION: Mike Kwatinetz from Azure Capital

Steve, you've always loved a good jihad, and I was looking at the slides and I noticed $29 billion in advertising in 2008. You seem to be making some progress, good progress versus Google. How are you thinking of what you want of that 29 billion and when do you think you can pass Google in terms of the efforts that you have? And then finally, how are you going to promote it once you do? Because there's a certain slowness in people switching.

STEVE BALLMER: Number one, what do we want? More than anybody else has. (Laughter.) No, I mean, seriously, come on, you might think it's a funny answer but if you don't set the big, bold goal, the big ambition to be number one, you never get to be there. And it may take us a few years, it may take us a few more years, it might take us a few less years.

In a sense, it matters a lot; in a sense, it doesn't matter at all, because we're going to keep coming and coming and coming and coming and coming. I don't know when it will be, I'm not going to make that prediction, but I will tell you we are going to invest: we'll invest in R&D, we'll invest in sales and marketing, we'll invest in advertising, we'll do what it takes to keep coming and coming and coming and coming on this front.

I love the stuff Blake had a chance to show you. That should help, but we'll keep coming and more and more and more, and all of the tenacity and all of the passion and all of the drive and all particularly of the innovation we can bring to bear we'll bring to bear.

I got asked earlier today, you know, somebody said, well, gee, can you lead from the front, can you come from behind. We've had both experiences. I remember the days when people said, you would never, Microsoft, really learn how to sell enterprise software, and now we're the number one seller of enterprise software. In that case, we were kind of born from behind, because the IBM mainframe was there before our company was there. But in this case, okay, we have to come from behind, but we are a dog — not an old dog, but we're a dog that learns new tricks; we're a dog that's not afraid to change itself, reinvent itself. We will have a very significant advertising business, we are committed to being number one in Internet services, search included, number one in Internet advertising, and to have that be a very big, strong business for the company.

And to the point Chris made at the end, if that takes even more investment, we'll give it even more investment, because we think that will be in the long-term interest of our shareholders, and if that means—at least I was watching his slide carefully, the yellow line has got to be below the green line, because I think that's what investment mode looks like on Chris's slide, that is where revenue growth exceeds operating income growth, so be it. It's an attractive opportunity and we're not going to let anything stand in our way. We'll put the best of our best on that problem.

COLLEEN HEALY: Number three, please.

QUESTION: Thanks. It's Jamie Friedman at Fulcrum.

The question for Bill, and then maybe a follow-up for Chris. When can we expect some of the push technology in Exchange Server out to a mobile client? And then assuming that's coming, Chris, as you get more, say, mobile functionality in the server, how do you deal with the classification of those revenues?

Thanks.

STEVE BALLMER: The always-up-to-date push e-mail stuff comes with the Exchange release that we're making in the fall. It's September, October-type timeframe. And with Windows Mobile 5 devices, which are shipping now. So we're on the cusp, so to speak.

Do you want to comment about the revenue recognition? I'll leave that one to Chris.

CHRIS LIDDELL: Can you ask the question again, please?

QUESTION: Yes, it's just, the question is, as you have more functionality shared across the seven segments, and this is particularly with regards to mobile, as you have more mobile functionality in this example onto the server, how do you deal with the classification of revenue between the server segment and the mobile segment?

STEVE BALLMER: We have no separate SKU. You buy an Exchange Client Access License, or something that includes an Exchange Client Access License, you get the mobile connectivity as part of that price. So, in a sense, it's clean. There's no revenue allocation across the two segments. All the Exchange revenue goes into our server area, and COWs, the COWs, do have a split between Information Worker and Server. And all the royalty licensees that we pick up from licensing Windows Mobile to people who make handsets, that all goes into MED.

COLLEEN HEALY: Number two, please.

DREW BROSSEAU: Hi, it's Drew Brosseau from SG Cowan. I have a philosophical question about your financial performance, which is, do you have specific goals for the three-to-five-year growth in margin performance for the company, or do you think of that simply as the result of how you perform across the various businesses? And in the absence of a specific set of goals that are stated to the market, how do you convince the investors in this room that they should want to invest in Microsoft? That seems to have been an issue with the stock, that people seem to just not care that much.

BILL GATES: Every share we have is owned by someone at a non-zero price.

STEVE BALLMER: We have a longer-range outlook that we do once a year. We do have that outlook. The outlook is not a fad document, and it's not rocket science. There are so many things that can happen. How quickly are we going to catch Google in search? I don't know the answer to that, because I don't know what they're doing. We can't anticipate all the dynamics. There are a lot of issues. So, given some real externals as opposed to internal long-range forecasts, we've never found that to be very helpful, still don't find it to be very helpful. We try to be fairly transparent. More transparent, I would say, today about where we see financial opportunities, not just innovation opportunity, and share opportunity, but financial opportunity than we've been. I tried to put that in the context of a growing industry as Chris did. You asked me, is there a substantive amount of operating income upside on top of the $18 billion or $17 billion with stock options included over the next five years, is it there, can we get it? Yes, it's there. It's there. It's there. Will it come like this? Will it come like this? Will it come like this? Will it be like that? Having a dialogue every minute of every day with the folks in this room about whether we're 1 cent off of the long-term thing we talked about, that's not a very helpful dialogue. We have big ambitions, big goals, not only about innovation and not only about market share, but about growth.

In my staff meeting, I'll tell you, most of what we talk about is competition, innovation and growth, competition, innovation and growth. And we do have big, bold internal goals. We want to surface for you at least the big, bold opportunities that lead us to be excited and set those big, bold goals for ourselves.

COLLEEN HEALY: Our last question, number two, please.

LAURA LEDERMAN: Yes, Laura Lederman, William Blair. Speaking of big, bold opportunities, can you talk a little bit about the opportunity in IPTV, over what period of time do you think that's real, how big can that be, what are your advantages over the competition, et cetera, et cetera.

BILL GATES: IPTV is a great example of something that Microsoft started investing in a long time ago, having the vision that this kind of infrastructure would be possible, and that we wanted to get out front creating products, creating intellectual property and having a lead into that marketplace. We're very excited that the cost of these networks has gotten to the point where the network operating, particularly telcos at this point, but as we said, the cable companies, we think, will join in on this, because they'll want to have the next-generation video platform, as well, that they're making those investments.

You saw in the case of the SBC deal a very large commitment from SBC to Microsoft, so it gives you a sense that if they bet their future on the billions they're putting in, having a software partner that stands behind that and having the very best software becomes a big part of the business plan there.

As Robbie mentioned, we actually get revenue from those deals that doesn't even show up in the HED type P&L , because as they license in the infrastructure pieces, we grow our relationship with those telcos. Our share relative to UNIX broadly has never been as high as it is in many other industry sectors. That's a benefit that comes over into those other areas.

There are services—what you're seeing us do now is provide infrastructure, and that can be a good, profitable business for us as it rolls out around the world. It also gives us an opportunity, not a guarantee, that we can provide some services on top of that, things like Windows Terminal Server connecting up to those people, or some of the MSN services. So we'll compete for that at a separate level, but the strength of that relationship should be of some benefit there.

It can be a good, profitable business. I think of it, this opportunity, a little bit like I do the Mobile and Embedded Devices business. Drive the volume up, and then you get something that doesn't have a lot of cost structure, other than R&D, and so it can deliver good profits.

STEVE BALLMER: It all depends on units, but over the next several years it should be, assuming we can drive the units, hundreds of millions to billion, hundreds of millions to low billions profit, if we can drive the units. The key is to start getting the units driven, and I think the SBC and Verizon situations are both particularly important. They're both driving the leading edge. I have rarely worked on anything as mission-critical to our customers as IPTV is to Verizon and SBC. And we've got our feet to the fire; they've got their feet to the fire. Alcatel is a good partner, Motorola, we've got a number of good partners in these fields.

We're driving hard. We've got an aggressive schedule. These are aggressive, but we're working hard, we're going to make those schedules. And when we get in market in a broader way with both of those companies here in the very near future, then we get to start to see how successful we are with them attracting customers to this next-generation, potentially, video service. I'm bullish on that. The SBC and Verizon folks are bullish on that. We find the same at British Telecom, Bell Canada, and some of the other really important partners that we have.

COLLEEN HEALY: Great. Steve, Bill, Chris, thank you so much.

BILL GATES: Thanks, everybody.

END

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