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Financial Analyst Meeting 2006
July 27, 2006

COLLEEN HEALY: We're going to set up for our first Q&A session of the day. We're going to keep that a little bit on the shorter side to get back on track here for lunch. I know it's a bit late for people on the East Coast. While they're setting up, let me just remind you to fill out the speaker evaluation forms through the Online Communication Network that will enter you into the drawing for those prizes.

Also, let me remind you that if you'd like to submit a question via the CommNet, please go ahead and do that. The questions that you submit now really will most likely be taken in the afternoon session.

If you're having a tough time getting access to the CommNet, just raise your yellow flag and someone will come to help you.

In a moment, I'm going to invite our panel on stage, and you will see Investor Relations representatives around the room. They have paddles. If you have a question, please raise your hand and they'll come to you with the paddles.

With that, let me please welcome to the stage Ray Ozzie, Kevin Johnson, Jeff Raikes, and Robbie Bach. (Applause.)

So again, if you do have a question, please raise your hand. While the paddles are making their way around, I'm going to take a first question off of the CommNet site that you submitted. And this one, I think, is for you, Robbie, which is, please talk about how you're going to balance your partnership relationships on PlaysForSure and other media initiatives with the Zune platform. In other words, how are partners reacting to you on the Windows Media Player hardware side?

ROBBIE BACH: Well, really, our approach, I think, is actually pretty straightforward. PlaysForSure continues as it is today. Windows continues to be a great media platform for people to work on. We're going to continue to support that. We're going to encourage people to continue working with PlaysForSure and the interfaces that interact with Media Player and all the technologies that are in the core platform of Windows, which is, in fact, what the Zune team will do as well. They'll work with those same interfaces and produce their own product.

So in some ways it's similar to what we did in the Xbox world. When we came out with Xbox, which was a console, some people said, "Well, gosh, that's going to compete with gaming on Windows." In fact, what we did was we continued to work with the Windows gaming environment and worked with Xbox, and over time those two things actually ended up working together to help build a better gaming platform for us overall. So we're going to keep working with our partners on those fronts and hope that, between what we do on PlaysForSure and what we do with Zune, we can scale the Windows ecosystem to be the leader in that space.

COLLEEN HEALY: Thanks, Robbie. Let's go with paddle number two, please.

CHARLIE DIBONA (Sanford Bernstein): Hi. Charlie DiBona, Sanford Bernstein.

Actually, I'm not sure whether this is—I want to talk about the issue of community and the building of community, so I guess, Kevin, probably towards you most. Is it really a question here of technology, sort of a "build it and people will come," or are there other attributes you need to bring to the table to develop a community around these platforms you're building?

And then can you also sort of talk about it in the context of the sort of burgeoning communities that are developing around competitors like Google as they look like they're sort of stretching to be platform players themselves? How do you deal with their sort of establishing their communities? And how do you compete with them on that front?

KEVIN JOHNSON: Well, I think, first, the fact that we've seen the significant growth of Live IDs and just usage, even if it's just one service that we offer—you know, it's customers coming in and saying, "Hey, there's some value in the experience instead of services," that's created, you know, this breadth of reach to customers. And there are opportunities then, since a lot of these services have to do with communication, to start to create their contacts—their friends, their families, the communities that they're associated with. And we've seen—I think one of the reasons that we've had such dramatic growth in success of Spaces, for example, is it builds on that concept of people having their contacts and the relationships, and they create community with one another. And when you launch a new server like Spaces, it just becomes viral and it just takes off very rapidly.

So I think the asset of having this broad connection to users through the Live IDs and the fact that a lot of the services are communications-related, that people want to interact with, and the fact that we've created the address book and those contact assets, has enabled things like Spaces to become viral. And I think that opens up opportunity for other services that really play toward the bias of community in the way that people like to interact with one another. I think it's a base to build from.

Do you want to add to it, Ray?

RAY OZZIE: You know, actually, the most effective community asset that we have, I think, right now is the Xbox Live community. You know, community is always really based on word of mouth. Something very appealing about a service makes you want to talk about it to someone else and spread it like that. And I think that from my perspective, the biggest single thing that we can do from the community's perspective is to ensure that the experiences we deliver are incredibly compelling and communities will naturally evolve around this.

COLLEEN HEALY: Thank you. Number one, please.

TRIP CHOWDHRY (Global Equities Research): Thank you. Trip Chowdhry with Global Equities Research.

Two questions for Ray Ozzie. First, you're doing a great job on the consumer side of the mash-up with Virtual Earth. You have partnership with Pictometry, I believe, as well as Traffic.com.

I was trying to understand, how does the business model evolve where you create a platform where services are being provided by third parties? And who bears the responsibility for service-level agreements?

The second question I have is on Web 2.0 technologies. It seems like J2EE versus .NET is very historical right now. The new technologies like AJAX and Ruby on Rails are the new competitive threats that you may face. And what is your answer to this new stuff? Thank you.

RAY OZZIE: Why don't I take the latter question, and I'm going to let Kevin deal with the former, if that's all right.

KEVIN JOHNSON: I'll take the element of the question that had to do with service levels. And clearly, from an operational standpoint, the investments we're making in having the infrastructure and the operational capabilities so that we can not only have the highest level of services we can provide, but also do it in the most efficient, cost-effective manner, is a major focus of what we were doing in the Windows Live platform. And that's why we've brought together the groups under a single leader, Blake Irving, who is leading not only the software development, but the datacenters and the operational capabilities, so that we can ensure we can deliver on the level of service that customers expect, whether it's an end-user customer using the service, or a business, or a developer who has written an application that does a mash-up of some service we provide. And so that's a key focus of that Live platform group.

RAY OZZIE: In terms of development frameworks, which is really the right word there, we're in an era where there are broad variety of experience-delivery mechanisms as I was saying, from rich client code, which is where the PC came from, to AJAX-based models, to Flash-based models. There are a number of different things. As a company, we must invest in frameworks for each relevant audience, and we use our Visual Studio tools to kind of bring those together. There are specific application frameworks for developing in the gaming environment, for the PC gaming environment, for the phone, and so on. And so it's a complex answer. I don't believe that there is a single competitive technology such as J2EE that, in its era, where you can say, this is .NET versus J2EE. But the reality is, we must create the frameworks for delivery of different types of those experiences.

COLLEEN HEALY: Thank you. Panel Number 2, please.

RICK SHERLUND (Goldman Sachs): Thanks. Rick Sherlund, Goldman Sachs, for Ray.

Ray, as we think about the desktop environment that you've dominated for years versus the online environment, where Yahoo or Google maybe has had more experience, if you could articulate for us what you think Microsoft's unique strengths are that allow you to enter that market, and I think we've heard ecosystem, partners, and a few other things, but I would just like to make sure I have an understanding of what you think your kind of unique capabilities are that give you competitive advantage as you begin to engage more on that platform.

And then, secondly, in terms of how we should think about the revenue opportunity, I don't know if it's appropriate to think about how much revenue you get per user in a desktop environment versus the annual revenue you can get from a user in the online environment, how complementary that might be versus cannibalizing, and sort of how we think about the revenue opportunity over time?

RAY OZZIE: Well, I think, from my standpoint, I believe that we're in the early days of seeing how the Internet impacts all of our lives. I know it seems that it's how could we spend any more time with that kind of technology, but I believe that Microsoft through its various offerings across the divisions has touch with many people and understands their requirements. And if you look at the enterprise, I believe we haven't even scratched the surface of understanding what is the right blend of how we deliver services that work within the enterprise seamlessly with things that people want to do outside.

I believe Microsoft is in a very good position with respect to its touch and understanding in many markets, and because of our experience and presence in terms of multiple delivery platforms. I do not believe the Web is the be-all and end-all of experience delivery. I believe that mobile devices are an amazingly important thing. I believe the PC is an amazingly important thing. And there are other experience delivery mechanisms, such as the television, and cable set-top box, and the console game and other things. I believe we're moving toward a world where the right model is to holistically think about what experience we're trying to deliver, create programming frameworks that enable developers to deliver those experiences in an appropriate way across those devices. And I think we're very well-positioned for that.

In terms of models, you know, I believe there are three primary models: licensing, subscription, and transactions—sorry, advertising, transactions, and subscriptions—and different mixes of those will occur in different markets. Advertising is more relevant to consumers than it is inside the enterprise, the subscription model represented by Software Assurance, for example, is very well-embraced in the enterprise. I believe that if we deliver the experiences holistically, there will be a services opportunity that's attached to the licensing opportunity for many types of software in some markets. In other markets, it may be that the way that the user wants to pay for it is more oriented towards advertising than a combination of subscription and others. But my intuition, based on my experience, says that this is more of an additive model than it is a replacement.

COLLEEN HEALY: Thank you. Number 3, please.

ADAM HOLT (JP Morgan): Hi, Adam Holt from JP Morgan. You all have said on a number of occasions that you don't expect Vista to drive a meaningful acceleration in PC growth. How important, I guess, Kevin, for you, in your view, is a January consumer launch to your ability to hit 8 to 10 percent growth for next year? And, secondly, as you look at the premium mix target of 52 to 54 percent for next year, is that sort of a near-term target, and do you think those rates can get meaningfully higher as you get a little bit further into the product cycle?

KEVIN JOHNSON: Well, first of all, I think my comments, we've got a project plan that says business availability in November, and consumer availability in January, and that's still a very valid plan. My comments earlier this morning were to reinforce the fact that we've got to ship a quality product. So, getting the product right, we're going to ship the product when it's ready. We continue to get great feedback, we continue to work on the product, and as we march toward release candidate one, we're just taking it milestone by milestone. So, there's no data points that says our project plan for the November business availability and the January consumer availability is going to change. However, there's more work to be done. And I'm being realistic and pragmatic about the fact that we've got to focus on the priority of shipping a great product.

Now, that is the priority, because shipping a great product really is what has the impact in the marketplace, and so we will be very focused on that. I think as we ship that particular product your question of how material is it to ensure that that product releases and is available to consumers in January, I think it's certainly part of the range of revenue and the plan. It's important for us to get that product out in the market, but if it's not January, is it that material? I don't think it's that material, but there is some upgrade revenue that you would say the number of months left in the fiscal year would shift out. But, right now, we're still on the plan that says we're going to have that product available in November for business, and in January for consumers. And we're going to continue to execute against that.

In terms of the premium mix, I think the degree to which we are effective in our marketing, and our outreach to customers around the value proposition that we have in Windows Vista in the new SKU structure, will determine is 52 to 54 percent just the beginning, and is there more upside there, and so I think we're going to have to wait and see how we get to market, and how receptive customers are to the premium SKUs and the value proposition we have. If we've done a good job in that value proposition and we execute well, perhaps there's some upside in premium mix long-term, as we go to market.

COLLEEN HEALY: We likely have time for one, maybe two more questions. Paddle number one, please.

GENE MUNSTER (Piper Jaffray): Good afternoon, it's Gene Munster from Piper Jaffray, and the question is for Robbie. You mentioned that the spending on the Zune is going to lag the Xbox spending, almost significantly lag it. Should we read in that that you will not be subsidizing Zune, in terms of the initial price, or subsidizing some sort of music library conversion? If the answer is no, how should we think about how you unseat FairPlay?

ROBBIE BACH: I think I wasn't actually speaking to the specifics of the hardware or not. The business model in many respects is just fundamentally different. If you look where Apple makes their money in that space, it's predominantly not on iTunes, it's not on the service. It's actually on the hardware. So it's just not—the businesses are just completely different. Most of the investment we've put into Xbox was actually in cost of goods. There was a hardware subsidy we chose, because of how we chose to get in the market, and the competitive approach we took to competing with Sony.

In the music space the model is just fundamentally different, and in fact, today most of the economics actually is in the hardware. Over time you might see that change. I certainly think there are opportunities for that to change over time, but that's the way it appears right up front. The other big expense you have to think about here is actually marketing. Remember that this is—we have to drive a new brand, Zune. We've got to drive adoption amongst people. We have to drive people who think of iPod as the brand in that space to think about other things. So we had that in Xbox, as well, but it's more relevant in this case, because we don't have the hardware subsidy that just overshadows the rest of the financial.

So there's a combination of what we have to do in marketing, to build the brand and build the awareness, and get the buzz going, and some work we'd have to do just in pure development to build a new business. I don't think there's anything specific about how we think about the hardware, really, to talk about.

COLLEEN HEALY: Thank you.

Number three, please.

JOHN MCPEAK (Prudential): Thank you. It's John McPeak at Prudential. Robbie, when you hit profitability in Xbox, what's your assumption order of magnitude on the attach rate per console?

ROBBIE BACH: I don't know the number on the attach rate at the time we hit profitability. If you look at a successful model, I think Sony announced today on their performance for PS2 they've gotten to almost 10 games per console worldwide. Certainly, if you look over the life cycle of what you want to do on a console you have to be able to get into the 9, 10, 11 attach rate for it to be big-scale profitable. You can make money at much less than that if your business model is appropriate. Nintendo makes money with an attach rate that's significantly lower than Sony's is, and their business model is a little bit different, because they're more first-party oriented.

So when I look at the life cycle of Xbox 360, we have to believe we can get into that attach rate territory. Certainly with Xbox 1 we've proven we can match what Sony does on attach rate. We've got that track record. We've got the content portfolio behind us. So there isn't a specific target for profitability based on attach rate, I couldn't, even if I wanted to tell you the number, I couldn't tell you the exact number on attach at that time, but over the lifecycle you have to think 9, 10, 11 is the range you have to be in to feel good about how you're driving the business.

COLLEEN HEALY: Thank you. Let's take another question. Number two.

LAURA LEDERMAN (William Blair): Yes, Laura Lederman with William Blair. Can you talk a little bit in more detail about IPTV? What are the challenges in terms of getting it adopted, when do you think it will be a large size business, a little bit about your business model, so we can sort of frame it in our minds? Thank you.

ROBBIE BACH: Sure, I'll just give you a status check on where IPTV is. We've been in development now for several years on that product. It's basically a client-server application where we've developed client software that goes on the set-top box, plus server software that goes in the head end, the telecom or communications provider, or cable provider, for that matter. We're in trials with multiple companies and have been now for a little over a year. We will have our first commercial rollouts this fall. Actually, we've had one already with Swiss Comm. We've had limited trials with real commercial releases with AT&T and a few others, but the bigger commercial rollouts happen this fall with AT&T, Deutsch Telecom, and BT.

That business is actually in a good space to sort of drive growth. Now, the question becomes, getting into the different markets, how fast video delivery from what you would say is a non-traditional video source catches on. Certainly in the U.S. cable is a strong competitor, satellite is a strong competitor. So the telecom companies have to compete with that. But, I think they're well-positioned. I think we're giving them a great product. So as they roll out by territory, and in the U.S. it's really by state and locality because of the way the TV delivery system works, you're going to see that happen.

In Europe the environment is a little bit different. Today satellite delivery systems aren't like they are in the U.S. The regulatory environment is actually different in Europe. Over-the-air broadcast is actually more common there. So the technology is a little bit different, some of the work we're doing for those companies is a little bit different, and I think you'll see the rollout take a little bit of a different pace.

Ultimately it's our view that there's going to be a very vibrant market with satellite, cable, and DSL delivery of video. The idea that you'll think of that as TV is going to get stretched a little bit, as well, because the traditional TV broadcast model really is changing. And IPTV is a big part of that, and actually is a core set of technology that is not limited just to the telecom space. It's certainly stuff that's applicable in the cable space, and ultimately in the satellite space, as well.

LAURA LEDERMAN: And your business model?

ROBBIE BACH: The business model for that is a licensing model. Think of it as it's us licensing client-server software to the telco operator. I'm sorry. I should have gotten to that. It's a—think of it in many ways it's not different from the SQL Server model or any of the other types of client-server environment, Exchange model, that we have. There are little subtleties that are different, but basically that model.

COLLEEN HEALY: Great. Thank you. That concludes our Q&A session. It was a lot of fun. Let's do it again this afternoon. And we'll see you for lunch in the McKinley Room. Thanks, gentlemen.

END

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