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ANNOUNCER: Please welcome Senior Vice President and Chief Financial Officer for Microsoft, Chris Liddell. (Applause.)

CHRIS LIDDELL: Thanks and good afternoon.

You're just about to now enter a different zone, and that is the demo-free zone part of the day. So I thought about demoing some of the cool new software we're doing inside finance, and where we're trialing some of our own software, but I thought that's probably not what you want to hear from me. What you want to hear from me is about the investor concerns that you have that you've been feeding back to me in the year that I've been here as CFO.

So what I'm going to do is as follows: I talked last year about the framework as I see the company and the virtuous circle between our growth and driving that, how we generate cash and how much we give back to shareholders, and how we use cash to invest inside the company to drive even further growth, and our virtuous circle has certainly been a fabulous business model for 30 years.

And what I'd like to do is—I've spent the last year talking to a number of you, I've met a number of you on several occasions, and you've given me feedback about the issues that you have. And I cluster those into seven major groups, and what I want to do is address each of those seven over the next 30 minutes.

The first one is growth rate in our core businesses: What can you expect in terms of the growth rate, are these single-digit businesses or are these double-digit businesses, and what can you expect going forward, how are we driving growth rate inside the core businesses? The second, what's our strategy to win online? Thirdly, when can you expect to see profitability inside our entertainment division? Fourth, in particular, return on cash: What sort of cash expectations can we have in terms of generating cash, and what can you expect from us in terms of returning cash to shareholders? Fifth, our overall margin structure; a number of people looking at the margin structure of the company wanting to understand what's driving it at the moment and going forward. Sixth, our investment discipline: How do we think about investments? We're obviously making some big bets—you've heard about some of those today—what's the thinking behind it, particularly from the financial perspective and the way that we look at driving investments inside the company? And seventh, last but not least, communications: How do we best communicate with you in particular about some of our strategic thinking?

I'm going to work through each of those seven in turn. I'm going to some extent recap what you've heard from other people as it falls inside their area, and as it falls more naturally inside my area I'll talk specifically to it with some new material.

But before I do that, what I want to do is what we commit to you each year to do, which is give you our report card, how did we come out of fiscal year '06 in terms of what I told you you could expect when I stood up here a year ago.

So what I've done is summarize in this case in our old seven segments section how we did in terms of actual results relative to the guidance that we gave you a year ago. I'm going to run through those quickly. Our client business, a very good year, close to double-digit revenue growth, relative to expectations of 5 to 6 percent; very happy with the progress we made, in particular in things like Media Center growth, which grew almost 500 percent. So a very good year in particular pre-launch.

Server and Tools, just another fabulous year, Bob talked about it, 16 consecutive quarters now of double-digit growth. That business just continues to perform extremely well.

Information Worker met expectations, 5 percent, inside the range. It was affected by a shift from license to annuity, which was a good foreshadowing for future years, and was still able to make the guidance that we gave you, which was extremely good in the year before our launch.

Business Solutions, particularly happy with the next two results, Business Solutions outperformed our guidance, and more particularly hit profitability for the year. And we talked to you about the expectations that you could have for profitability for that business. It was profitable in the year. We expect it to continue to be profitable in this case inside a larger segment.

A very similar situation in MED, our mobile business grew faster than expectations, was profitable for the year. We expect it to continue to be profitable inside a larger segment.

MSN fell slightly short of expectations for two reasons in particular: firstly, the monetization that we got over the Overture platform, and that was lower in particular in the first half of the year, and that encouraged us to ramp up our efforts in terms of transferring to our own platform, adCenter, but that was the right strategic decision that hurt us from a financial point of view in terms of the monetization that we get off that platform as it ramps up.

And lastly, H&E, an extremely good year, obviously very, very critical year in terms of launching Xbox 360, which got great market development, and we had a 36 percent revenue growth; not as high as the aggressive expectations that we set, but are very happy and very satisfied with where it got to by the end of the year.

How does that all ramp up for the company? In terms of total revenue we're basically right in the middle of the range that we gave you, 11 percent for the company compared to the guidance that we gave you of 10 to 12.

We didn't hit the operating income guidance that we gave you, mainly because of some of the investment decisions that we made during the course of the year, which I'll talk to you about later in the presentation, but we were still able to hit our earnings per share guidance basically on the lower tax rate and a more aggressive buyback. So the leaders that we were able to pull out, other than operating income, allowed us to hit our earnings per share guidance, even though we didn't hit operating income.

So let me talk about each of those seven issues that I hear from you continuously and talk a little bit about our thinking about that.

Firstly, let's start with the growth rate in our core businesses. When I think about our core businesses, I'm thinking about our client business, Server and Tools, and MBD. And just to put it in context, those three businesses have grown by $10 billion collectively over the last three years. But probably more significantly, they've grown at 11 percent compound annual growth rate.

So these are three businesses which—I know I hear the word mature—but they are collectively growing by an enormous amount in absolute dollars and collectively growing at double-digits.

We've given you guidance last week for next year that we expect them to grow at 10 or 11 percent, so to continue at double-digit performance, obviously helped by the Windows Vista and Office launch in the back half of the year.

If I go out longer term and talk to some of the things that you've heard from people today, what we are expecting and what we've seen in terms of opportunity is not only the core growth from those businesses, but also the additional opportunities that you heard about from Kevin—from Kevin Johnson, from Bob, and from Jeff. In particular, in the client area our ability to attract people to premium SKUs gives us an opportunity to get any greater revenue growth—commercial and retail—which has been a drag on the system, our ability to sell into the embedded base the Vista operating system, and the efforts we have in emerging markets and our Genuine Windows program.

In Server and Tools, Bob talked to you about with a market size of over $50 billion where we are relatively lowly represented at the moment and hence have a huge market opportunity; in particular growing in security, Web and high-performance computing—areas where Linux has traditionally been strong—continuing to drive revenue in areas which have been very successful over the last few years, and SQL and Visual Studio, and then starting to invest in some of the emerging businesses as we've seen them: management, security, and BI.

On the MBD side we see the opportunity to not only drive core growth there around the IW productivity software, but also start to make significant inroads over the next few years in the ERP, business application, BI, CRM, Exchange, unified communications, and services—areas where, as you heard from Jeff, have a collective market size or market opportunity of $100 billion, and when you add that in the Server and Tools opportunity we're talking about, and contrast it with a total size for this, we still see these businesses having huge latent growth, against which we are investing, and is the reason why we are investing the way we are, which I'll come back to in one of the later slides.

You've heard from Kevin and Ray in particular, and Jeff and Robbie to some extent in their businesses, about our strategy to win online. The takeaway here is that it is a very broad-based strategy. I've listed 10 components where we are investing in content, communications, Windows Live services, and so forth. The approach we are taking is broad-based and long-term, and we are investing to get what we believe will be a winning position over the long term.

The third area you wanted to hear about was entertainment profitability. I think this is the chart that Robbie showed you that is a very good summary of how we see the businesses. There are different moving pieces inside of the business, but the productivity area is already profitable. We believe it will continue to be more profitable going forward. Mobile and Embedded hit profitability this year, as I talked about, for the first time, will be profitable going forward. The Entertainment Division—part of the division we see as in an investment phase—and gaming will go from a large loss to a smaller loss in fiscal year '07 to profitability in fiscal year '08. And some collection of all of those will be profitability, we believe, by fiscal year '08.

To return to some of the more financial issues, and what you wanted to hear about that, the first thing you want to hear about is cash, what our cash flow philosophy is, and what we have done in terms of return on cash. The first thing is, I was obviously delighted last week to talk about the $30 billion program we commenced two years ago, and said would be a four-year program. We completed that in half the time we originally had talked about, so we completed it in two years, and more particularly, as you can see from the shape of the graph, we accelerated during the course of the program. So, we carried out just over $22 billion in buyback in the last year, in the year since I stood up in front of you, which was, if you like, three times the original rate envisaged. So, we completed that $30 billion buyback in half the time we originally committed to, and then we introduced a new buyback.

I talked about this on the earnings call last week. We have up there at the moment a $20 billion tender. The offer period started the day after earnings, which was last Friday, July 21, runs through August 17. We offered in a range of $22.50 to $24.75. It's carried out through what's called a modified Dutch auction, which means we receive bids in from investors at different price points, we collect all those bids together, and set a clearing price that allows us to buy $20 billion back. So, that's being carried out as we talk. Assuming it's successful inside the range, that would result in about an 8 percent reduction in share count.

If I could just put the tender in perspective for you, $20 billion obviously 8 percent, relatively large for us, it's about five times bigger than any other tender that's ever been carried out. So, to put it in perspective relative to the capital markets, the biggest one ever seen before was around $4 billion. So, this is unprecedented in terms of size, in terms of commitment from our point of view, to return $20 billion over, in this case, 20 days.

The second part of the buyback program was an ongoing buyback of $20 billion. In this case, it's simply an authorization, not a commitment. We will look to take opportunities over that five-year period into the market when we believe it's the right thing to do, in total $40 billion.

And when I look at that, I want to just reflect on what's the business model that allows us to return such large amounts of cash to shareholders. And one of the things that sort of sits behind our accounts that we don't talk a lot about is the amount of money that we put into CAPEX and acquisition. Now, we've ramped up both of those numbers quite considerably over the last few years. This is fiscal year '06, so this is the last fiscal year we had, and all of our free cash flow on a GAAP basis, we spent about 11 percent on CAPEX last year, and about 5 percent on acquisitions. So, all of the rest of the balance was available for dividends or returns to shareholders. I just contrast that with a couple of other types of companies, firstly, our technology competitors, so it's a reasonable like for like, and we've just taken nine companies here, and we spend about half what they do in order to generate the growth that we are looking for, we spend about half what they do in terms of CAPEX and acquisitions. Part of the reason why we spend less than them is, we spend so much on Ramp; that that, to some extent, is our form of capital, and that's expensed for us, so it's before the free cash flow numbers that you see. So, a large part of the way we think about capital is before we generate free cash flow for shareholders.

Relatively to large non-tech companies, which tend to invest in physical capital to a much greater extent, they spend between three and four times what we do on acquisitions and CAPEX from a cash flow point of view. That allows us to have a large amount of cash flow, which builds up over periods, and then we return it in relatively large amounts. To put it in perspective, over the last five years, and this is using collective numbers rather than a single period, we've generated $76 billion free cash flow from our operation, we've spent $7 billion of that on CAPEX and acquisitions, so it's a slightly lower proportion than last year, given we ramped it up last year, less than 10 percent. And in terms of what returned to shareholders, we returned $86 billion. So, $86 billion returned to shareholders, $7 billion reinvested in the company.

So, we have, firstly, generated more—returned more than we have generated. And, second, we have returned much more to shareholders than we have reinvested in the business. So, from my perspective, do we have the right balance of investing in the company's growth versus return to shareholders, absolutely. If you add the $86 billion that we have paid back to the $20 billion tender, assuming that goes ahead as planned, that's more than $100 billion over five years.

Next issue, margin structure. After three years, no one asks too much about our margin structure because it was improving. It declined in fiscal year '06, and based on the guidance we gave you last week, it will go down again next year. So, why is that, and what's driving the inherent margin structure, and how do I think about that going forward?

First thing to note is, there are changes going on around aligned business. There's two big changes. This is the first of them—the first is that our mix of COGs, cost of goods sold, and our OPEX is changing. And that's because we are growing in COGs-heavy businesses like Xbox, online services, consulting and support, and some of the launch costs associated with full package producting for next year. So, we're seeing a shift in the operating expense, and I know that is making it progressively difficult to follow the company and predict exactly what the operating income structure is going to look like.

The second impact is probably more significant, and that's where we're growing. So, if I look at our five segments going forward, and split them into their underlying operating margins and their growth rates, and then compare that to the Microsoft average, you see we have two businesses which had a higher operating margin than the average, but are growing at less than the average, and you've got three businesses which have operating margins which are either negative or less than average, and two of the three are growing faster than average. This is simply because of the business mix change because we are growing. Not surprisingly, businesses which are less mature tend to grow faster and have lower margins; that's the nature of the curve that Craig talked to you. Just by virtue of the underlying growth in the businesses which we are pushing hard, we get a change in the margin structure.

So, if I just apply that revenue growth rate—and these are all public figures we've given out, to the margin structure—and don't change the margin structure at all for next year, I get the following result. So, I apply fiscal year '06 margins to fiscal year '07 growth rates, and you can see that our average margin next year is going to go down by 30 to 38 percent, and you can do that calculation based on what we've done. The more important thing from our point of view, in the way that we think about driving the company, is not trying to maximize 40 or 38, that's two things, that's making the pie as big as we possibly can, we want to grow those businesses that have a lower margin structure, even if it takes our average down, if we create economic value, it's the right thing to do; and, secondly, look at the underlying margin structure inside each of the businesses, because that's more important than what the average is based on their different growth rates.

And if I address each of those in turn, as I dig down a level and look at the underlying margin structure of all of our five businesses, go back three years, and then talk about what might affect them over the next couple of years, firstly, Client, MBD, and Server and Tools, our core businesses, margin structure is generally speaking gone up— particularly in Server and Tools—been up, slightly flat in Client and MBD.

A good picture, going forward, what are the things in fiscal year '07 and '08 that are going to drive margins? In the Client business the SKU structure will change the margins around, launch costs will be a drag in fiscal year '07, and emerging markets, where we tend to get a lot of monetization than in maturer markets. So, the structure will change because of those factors.

In MBD, similar issues, launch costs next year will impact it. In their case, and I'll talk a little bit more about where we're spending our investment money, they are putting a big effort into the high-growth businesses. There that $100 billion opportunity that Jeff talked about requires funding, and we intend to fund—certainly next year and probably into fiscal year '08—that business.

Server and Tools, just a wonderful story, not only growing fast from a revenue point of view, it's growing fast from a margin expansion point of view. How much that will continue will depend on our ability, in particular, to get revenue per server going forward. The upfront investment, because we are looking at opportunities, the $15 billion that I talked about, we are looking at opportunities there that we invest in, and services margin, there's a high services component in Server and Tools.

These are areas where we are heavily focused on what the margin structure looks like, over the cycle that we are talking about. We will at times make investments, to spend money on launches, so we're not committing to keep the margin flat, but they are businesses where over the long term obviously we're very conscious of margins.

Different picture altogether in our two other businesses, in online services and entertainment division, and clearly this is part of the reason why our margin structure is changing. In both of those cases they were unprofitable in fiscal year '06, in both cases, because of conscious decisions that we made. In Entertainment and Devices, we had a thing called Xbox that we launched. We made a conscious decision to spend as much as we possibly could to get as big a head start as we could in that business, and inherently because of its high cost of goods sold, it's a business where margins come down.

Online services, we made a conscious decision to shift to adCenter, which cost us, and we are making decisions around investment, particularly in the areas that Ray and Kevin talked about. What can you expect going forward? We will continue to invest in online services; I make no prediction of what the margin structure will look like, but that is going to be the most volatile margin part of the business, because it's the one where we intend to make big bets going forward. In terms of Entertainment and Devices, Robbie talked to you about sustainable profitability, so if you like put in fiscal year '08 a PIN that's above zero, and assume that the margins are going to improve between here and there.

So where are we spending our money, and how disciplined are we on spending it? I gave more visibility last week to the areas where we are spending the additional amount of operating expenditure in fiscal year '07 relative to fiscal year '06. Collectively, it adds up to $2.7 billion—$300 million in general operating costs and acquisitions, $450 million of marketing and launch-related costs, $450 million in sales force and general marketing, $500 million in collective on online services, and $1 billion in what we consider to be high-growth products and businesses. And if you like, in terms of the investment capital, the way we think about it, you can take the $1 billion, and most of the $500 million, and part of the $300 million and think about that as investment operating expense.

If I take those parts of the pie and talk a little bit about how we think about investment going forward, the first two lots of $450, which add up to $900 million, the return on investment in that is the benefits we get associated in particular with launches, but also generating our ongoing stream of revenue. That will be helping us drive a record $5 to $6 billion of revenue growth next year, so $900 million relative to $5 to $6 billion. I'm incredibly happy with, in particular, what Kevin Turner is doing in the field, applying increasing discipline and science to marketing return on investment, and really focusing not only on what we spend, but what we get out of it, both components to ROI, and taking a cross-company and cross-customer approach, where we leverage our scale, and get an integrated approach to the market.

The $300 on operating costs, in there is acquisitions, acquisition costs. We have been very acquisitive—I talked about that earlier—we have been very acquisitive. In particular over the last year, we bought 23 companies for $649 million; that's about two a month, and we're continuing that. So we've either announced or completed four since the end of the fiscal year, in the last month. So we will—we have, and we expect to continue to be acquisitive, but with those acquisitions come high year-one costs. Generally speaking, we have to write off deal costs, people transition costs, and some of the amortization of intangibles associated with the acquisitions. Inside this $300 million is a component for acquisitions that we expect to do, but as yet have not identified or allocated to specific businesses.

The $500 million additional that we intend to spend on online services—again, I'd just say, that's across a broad range of activities, not only adCenter, which is most obvious, but some of our products associated with the Live strategy, search, and also outside of the traditional MSN businesses you think about, Office Live, CRM Live, and Xbox Live.

Last, but not least, $1 billion on high-growth products and businesses. This is the biggest part of the additional spend that we have. It is across a wide range of business opportunities. You have heard about all of them so far already today, things like unified communications and business intelligence. And if I look at the way that we think about the ROI approach in that area, and go back to a slide that Craig just showed you, the characteristic that we have in these is a long timeframe with a big investment required. I guess that's obvious, but the accounting implications, in the way we think about ROI, aren't necessarily.

So on the next chart, I'm just taking the one Craig showed you, and putting a more economic focus. In essence, we think about ROI relatively simply, it's the amount of investment that we need to put in below the line, relative to the economic value that we'll create from the opportunity. That's a function of the market size of the opportunity, the market share that we believe we can achieve, the margin structure that's inherent in those products, and the growth rate associated with them. In this case we're taking, depending on the opportunity, a three- to seven-year view of that.

Now, from an accounting point of view, we obviously account on a vertical slice, year-by-year basis. So the little dotted lines would be like years. In most cases, as I think Craig alluded to, it can be two or three years before these investments are profitable. So we account for the spend on a year-by-year basis, which means when we are in high-investment phases, as we are at the moment, it impacts our accounting, because we've spent virtually all of that money.

From an ROI point of view we think about it from a horizontal perspective, what is the economic value over the lifetime of the opportunity, and people ask me, what's your discount rate, what's your hurdle rate from an MPV point of view? And the answer is, discount rate is easy, that's about 10.7 percent; hurdle rate a little bit more difficult, but it's significantly higher than that, because the opportunities we have, if we are successful, are orders of magnitude more economic value than we spend on them.

So it's not the hurdle rate that's important, because that's 5 to 10 times the amount of investment we're talking about, it's where do we actually believe we can create the winning position in the market with the margin structure. It's much more important is our ability, which is what we pressure-test through our strategic planning exercise on our ability to actually deliver a winning investment strategy.

In terms of just making the trains run, you heard from Kevin Turner about the approach that we are taking in terms of maximizing the value we get on the spend dollars that we have inside of a year. And, again, very happy with the progress we're making there on some very basic business fundamentals of driving business excellence around execution and operational excellence, and looking at simple measures of productivity and driving those.

Last issue, and then I'll wrap up, is communication. We are conscious of communications—obviously an incredibly important issue for us—and conscious of the fact that we had a disconnect in the third quarter between the way that we were thinking about the business and the way that you were thinking about it. And in order to understand that and then solve it, you need to understand the internal cadence of the company. We go through our strategic planning review in the second quarter, which is our December quarter. We then take that and set targets in the third quarter, and then do detailed budgets in the fourth quarter just finished.

Doing the targets allows us to get the visibility to the next fiscal year, that allows us to give guidance to you on our third quarter call. Doing the detailed budgeting allows us to give the detailed numbers that I gave you last week. Unfortunately, that's a disconnect with your cadence where you're starting to look at the next fiscal year around the end of the second quarter, around the December-January-February time. So what we're thinking about doing there, and certainly a commitment from our perspective, is we will look at some new form of communication around the January-February timeframe—something Steve and I will do. We are not certain exactly how we will do that, and we will give you feedback on it. It won't be fiscal guidance—we aren't going to give numbers out there, because at that stage we won't have them to give. But certainly we will give you strategic guidance and talk about some of the thinking that we have and give you some sort of insight into our thinking strategically to minimize the chance that we have a disconnect between the way we are viewing the world and the way that you are doing it.

As well on the communication front, we are going to think about—at the moment we have this huge spike in communication, called Financial Analysts Meeting, which happens today, and then a quiet period for most of the rest of the year. We're going to think about how we de-emphasize Financial Analysts Meeting—we're certainly still going to have it and do it in currently the same way, but we have an emerging group of business leaders who we will give you progressively more exposure to, to talk about the strategies that they have, and look for events and opportunities to have much more of a continuous flow of information.

Lastly, before I summarize, let me talk to you what can you expect from us for the next fiscal year. This summarizes what I talked about last week. Our Client we expect to grow 8 to 10 percent, so a good chance on the top end that we will have double-digit growth for Client next year. Server and Tools, that business model will just continue in very much the same vein as what we see, growing at 14 to 15 percent. MBD we expect again some of the client. There's a good chance if we really execute well, we'll grow at 10 percent next year, double digits. Online services, 7 to 11 percent, driven in particular around the ramp in adCenter. And E&D, another great year, 31 to 46 percent, driven around the guidance in particular that we gave you with Xbox sales of 8 to 10 million units.

What does it mean for the company overall? We expect on the revenue side to grow 12 to 14 percent, so it will be an acceleration from the year that we just came out of. We see operating income growing 8 to 10 percent, lower than total revenue for reasons that I talked about in terms of the relative mix of businesses. But earnings per share, and in particular given the benefits of the $20 billion tender, will grow faster than revenue next year.

We always remind you of the risk factors in opportunities, as well as the normal ones associated with Linux, foreign exchange risk, and legal. I would particularly point out obviously this is a huge year for us in terms of product launches. Executing on those product launches and the customer acceptance of them is a big swing factor on the risk side. But we also talk about—we talk about risks, we tend to also think about it from an opportunity point of view.

This is the second year of the biggest product wave the company has ever had. Our ability to actually deliver on that from an opportunity perspective will not only influence FY '07; it will be a big determinant for what the shape of FY '08 looks like.

So, to summarize, FY '06, a good year. We managed to achieve earnings per share and revenue target. FY '07, a big year coming up, the same basic profile.

In terms of the seven issues that I hear continuously in the way that we think about it, growth rate in core businesses has grown at double digits for the last three years. We expect that to continue in the year that you see coming up.

You've heard about our strategy to win online. It is broad-based, it is deep, and we are investing against it. You can expect the entertainment division to be profitable in fiscal year '08, and see a path towards that. We are committed to continue to return cash in the most efficient fashion. We will retain the cash that we think we need for business reasons, but we will look to return the cash in the most opportunistic way going forward.

Our overall margin structure will change, but it will change more around the business mix changes than an underlying deterioration of the businesses themselves. Our investment discipline—we do make big bids, and we're not apologetic about that, and we will continue to make big bids, even if they have an accounting implication. But all of them will be made with an economic value focus.

And, lastly, we will continue to look at how we can take your feedback and continue to look at how we can communicate most effectively with you—not only on our earnings calls, not only at FAM, but also on a continuous basis.

Thanks, all, for your time. I look forward to taking some questions later. And you now have a 20-minute break. Thank you. (Applause.)

END

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This presentation may contain statements that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in the management discussion and analysis section of Microsoft's most recent Form 10-Q and Microsoft's most recent earnings release. Microsoft does not undertake any duty to update any forward-looking statements.