STEVE BALLMER: Well, great. It is an honor and privilege to have a chance to be here with you today. I'm going to take the next half-hour or so and try to set out what I could only call a 50,000-foot context on the business and how we think about what we're trying to do with Microsoft overall, and then you're going to have a chance to hear at some length from folks about various parts of the business, and how those are doing.

At this meeting this time of year, what we really try to reflect on is shareholder value, and growth in shareholder value, and all that's going on with that. I'll tell you, in the course of dialogue with many of you over the year, you'll say, Are you guys focused? You're not focused. The truth is, this is a very important topic for us in a long-term sense. I think we've proven that we have a commitment to our shareholders, but our commitment is to folks who want to be with us for the long-term, because most of the bets, and things that we do in this business have a very long-term time horizon. Could I get the first slide, please. It's not working. The first slide please. Super.

If you take a look over the last five years, a lot has gone very well from a shareholder perspective. We've doubled profit and nearly doubled revenue in a five-year timeframe. At least, I would say, I think that's quite an achievement given that we started at $8.9 billion of operating income, which is pretty high level. We had a chance to return over $100 billion in share buybacks, and in dividends to our shareholders. And the install base of Windows computers this coming 12 months will reach 1 billion. If you stop and just think about that, parse that for a second, by the end of our fiscal year '08, there will be more PCs running Windows in the world than there are automobiles, which is at least to me kind of a mind-numbing concept. I think it talks about the way the value has been driven from the Windows PC, and all of the applications from Microsoft to third parties that go with it.

While we've been delivering these results, we've also been investing in our long-term future. We've acquired over 80 companies in that period of time. We have invested some $30 billion in R&D over that period of time. And the formula for long-term success does involve sustained growth, sustained investment in R&D, and acquisitions, and all of that will be required to keep up this kind of very strong operating performance.

The numbers in absolute are very large. I never stop marveling at the fact that the operating income, I think, is the highest of any company in the world that's not in the financial services business, and not in the oil business, and that puts a lot of pressure on us both to make big bets, to make a broad set of bets, and to execute very well on the bets that we make.

As I think about the company, at the company level, I think there are probably five things we really have to do very well, and that's what I want to comment on today. We've got to get the right people, the best and the brightest. That is absolutely essential, and I'll give you a little bit of an update there. I'm going to give you a few reflections on innovation, but the whole goal of Bill going first today was to really paint you a picture of some of the breadth of investments that this company is about in innovation.

Disruption. One of the fundamental sort of characteristics, if you will, of a technology business is, it is a business of disruption. If that scares people, as shareholders, they probably ought not be in our stock. It's always a fun thing to talk about, there are industries that have a lot more kind of linear evolution than this one does, and whether it's the PC revolution, the graphical user interface revolution, the client/server computing revolution, the Internet revolution, in our business embracing disruption and doing that very well has to be a fundamental characteristic of long-term success.

We as a company have chosen also to embrace multiple competencies, and I'll talk about what I mean. I've talked about this to shareholders before. I don't think it's well, our core competency in a sense is the development of software. If we're really going to be able to make the depth and breadth of investments that allow us to continue to prosper, to embrace disruption, to growth, this company has to build multiple business competencies, and you're going to hear me talk about that, particularly in the context of some of the areas of greatest investment for the company.

Last, but certainly not least, we do believe in a long-term approach. Two of our core values that we talk to our folks about are big, bold bets, big, bold bets, big, bold bets, and accountability. I get folks inside Microsoft who'll ask me, Aren't those two things a bit of a contradiction? Betting big, betting bold, betting for the long-term, and yet asking for short-term performance? And the truth is, I think, for this company to be great, we do have to do both of those things. We have to stay at big ideas, and good ideas for the long-term. Hopefully we get immediate payback, immediate success, immediate prosperity. But great things, at least in this business and life, don't always happen overnight. I think that's one of the great misnomers of the technology industry, or the great misconceptions of the technology industry, is that most success happens overnight. I think most successes in this business do, in fact, require long-term sustained investment, innovation, customer feedback. And certainly this company, and for those of you who are shareholders, of course, in the company, you have to understand that that's our perspective.

I've had a lot more meetings over the last few years with shareholders than ever before, and this is, of course, a tough one. A long-term investment horizon for many of you might be three years, and yet that might be a product cycle and a half for us. And so when we talk about long-term approach, we're generally talking about investment horizons and payback horizons that may be beyond your typical investment horizon. And yet, nonetheless, that's what I think has allowed this company to continue to a key thing that has allowed this company to continue to grow and prosper.

Ninety percent of the success in our business is really getting the right people, and I feel great because in the battle, if you will, for the best and brightest, you know, we're getting 90 percent of the people we go after. I had a chance yesterday to talk to about 700 summer interns who are here. Believe me, the recruiting competition for folks like that is intense, and I think everybody in the industry understands that if we screen somebody, invite them here for an internship, that's a pretty powerful recommendation. And yet most of those folks will come, and they'll join Microsoft, and they'll do a fantastic job for us over the course of the year, over the course of the years.

If you take a look at our research group, I think we did the math the other day, and something like 25 to 40 percent, I don't remember the number exactly, of all people who get a Ph.D. in the United States will have interned at Microsoft some time during their Ph.D. program. And many of those will come here and work. We had a very good year in recruiting. We hired almost 13,000 people, and we didn't grow our headcount as much as we hired, there's an attrition factor for those of you who are immediately running the math. But we made about 4,000 hires in product development areas, and our acceptance rates have been very, very good. In fact, we had a higher college acceptance rate than our average over the last 10 years. So our ability to attract and recruit the best and the brightest has been strong, and continues to improve.

We attrit about 8 percent of our people every year, 4 percent of that we call bad attrition, 3 percent is good. Both numbers are important. We're trying to drive down the bad attrition. Some of that is inevitable. You'll have people who, for a variety of reasons, want to retire, want to relocate, sometimes we'll lose to another company, although that's quite rare. And then you've got to have good attrition. It is really important to continue to make sure that you hold people accountable and at all levels of the organization, from the top down. We're taking people who are not performing, and really moving them on.

One of the things that's high on the people agenda is how we continue to attract the best and the brightest from around the world. And with everything that's going on, both in terms of how people think about relocation in the United States, immigration policy into this country, we continue to expand our footprint quite broadly, in terms of global R&D.

You see at the bottom of this slide all of the places in which we have R&D centers. Redmond is listed as one, a particularly big one. Silicon Valley is our second-biggest. Aachen in Germany, Belgrade in Serbia, we just opened up an R&D facility in Vancouver in British Columbia. We need to expand the capabilities to attract globally the best and brightest, no matter what the immigration policies may be here in the United States.

We've got about 25 percent of our R&D employees working outside of Redmond today, that includes other U.S. locations like Boston and Fargo, and Silicon Valley, Long Island, Raleigh, all of which are significant sites for us, but we're going to continue to really push on this.

The good news is, we also continue to recruit the best and the brightest from around the world to here in Redmond. I think last time I checked we've got about 1,000 people on our campus here who speak Russian, which is just an indication of what a good job we've been doing at bringing people from around the world to work here for us. So this is a big priority. I think we've had a very, very good year. But we're going to continue to both replace some of our attrition and continue to grow our headcount. And this remains right at the top of the priority list for all of our folks here at Microsoft.

The second thing that I had on my list was innovation. Bill talked about the innovation areas that I sometimes like to call the “Quest” areas, and what we're trying to do for the information worker, for IT, developers, what we're trying to do in the core platform. But it's been a fantastic, let me say, management process that really Bill has driven us to put in across the company, taking that long-term perspective, forcing us to think broad and deep. That's not to say we'll do everything on the list, frankly, but at least it forces us every year to say how broad, how deep, how broad, do we need to go.

Some investors I've talked to in the last year will say, Hey, why do you need to go broad, if I want to go broader than you I'll go buy somebody's stock who is in an area you're not in. I'm an investor, personally, in only one stock. So I want to see this company move in and keep pace with the exciting areas of innovation and value creation broadly for any company that's got software as a core competence.

I've talked with you in the past about the need for a broad set of innovation muscles. Not everything looks like three people in a garage for three months. Not everything looks like a Windows Vista project. We've got to be able to build and buy. We've got to be able to do small innovations and large. Products like Windows Vista or Office 2007 don’t get done by three people in a garage for three days. Yet, the power of the innovation in those products is really quite amazing. And yet we have smaller innovations, our robotics studio, Popfly, some of the things that we're doing in our Azyxxi product for the healthcare industry, Microsoft Surface, that do come out of very small-scale teams.

Some things we build -- Zune, our IPTV, or Mediaroom products, Surface, Silverlight -- and yet we also think it's important for us to be willing and able to buy companies that have innovative ideas and bring them in. The earlier we can do it, the cheaper we can get it done. You've this year seen us do a little bit more expensive acquisition than we'd ever done before in the form of aQuantive, but we've done a lot of smaller acquisitions, always buying people, talent, and innovation, like Medstory, like Gteko, and you'll hear about a few more of those over the course of the day today.

Innovation is really not a part-time job at Microsoft. Whether it's three guys in an office creating Popfly or a thousand people building the next version of Windows, our employees are thinking big, and thinking in an innovative form 100 percent of the time. And if there's one thing that at the end of the day, probably more than any other, that will determine our long-term fate, it's our ability to get the people and drive the innovation.

There are other challenges, but if we have that pipeline strong, which I think we do today, we're in very, very healthy shape.

The third thing I talked about was embracing disruption. And there is a big disruption going on in our business. And some investors will say it's scary, it's this, it's that, are you going to embrace it? We have no choice. Ten years ago people were talking about our embrace of the Internet revolution. The transformation of software to be software plus services is a phenomenon that we are embracing, we need to embrace, and frankly, any company who thinks their core competency is software better get to getting on this dimension.

Now, when I talk about it I talk about it quite broadly. I'm not talking just about consumer stuff, or just about advertising. I'm literally I literally believe that every piece of software, the basic core value, and the way software gets created will change over the next three, five, ten years. So every piece of software will have a client component, a server component, and service component from the cloud, that all gets managed and orchestrated out of that cloud infrastructure.

People tend to get, I think, weird and extreme about this, in my personal opinion. Some people say, Does that mean all computing moves to the cloud? Does all storage move to the cloud? Does everything essentially become a Web browser? I think that's wrong-minded. I think what the world actually wants in this transformation is what I would call the best of the four existing models of computation.

Each one of these today, you could call it model of computation, or model of user interface and computation, but there's the PC, or the desktop. It's got the richest user experience. You get online and offline access. You get personal control, and the ability to integrate, and mix, and match in the most flexible and arbitrary form. Nobody wants to give that away.

The Web, or online, you can just click and run anything, there's no installation. You just click and run a Web site, click and run an app, because this was designed with the cloud from the get go, anywhere access, and searching, and finding, and collaborating on things tends to be fairly built into the software. And there's a focus on low-cost, and scaled operations, which I think does drive down net-net the cost of computing.

Enterprise and server computing has a model today that's important, and it's not going to go away, the importance to companies of management, of security, of compliance, that's not going to disappear. So we can't pretend there will be a new model of computation that doesn't factor in that requirement.

And last, but not least, devices, people like that user interface, and computation model. Phones are actually, on balance, getting smarter. We're not moving towards the world of thin computing, we're moving towards the world of software plus services. And the software plus service model will bring the best of the desktop, the best of the Web, the best of the enterprise, and the best of devices together. When Ray Ozzie has a chance to talk with you later today, he's really going to talk about some of the elements that go into making that happen.

We're really quite far along, in terms of our own development on software plus services. I think of these as in buckets. There are things for individuals, there's things for businesses, there's things for developers and, in fact, there's technologies which are really enabling. There are software products, enterprise products, client products that really enable people, other software developers, to build software plus service. So we have stuff like Windows Live, and Office Live, Popfly, MSN, Live Search, Virtual Earth for individuals. I'm particularly charged up about what we're doing in business services. We have an offer now for managed communications and collaboration where we'll run the e-mail, the collab infrastructure for an enterprise account out of our own data centers. There's the small-business capabilities in Office Live. There's our new CRM Live product. The development facilities called “Titan” that go around that for business applications are quite exciting.

Ray will talk about new developer services, Windows Live, cloud infrastructure. We've announced Silverlight Streaming where we will host Silverlight applications of certain size and complexity. We've announced and have in beta something we call BizTalk Services for enterprise-to-enterprise communication, and queuing and relay, and, of course, in the server enabler area, the new Windows Server is far better in what it enables for Web site development, the new IIS 7. SQL Server is a staple now for Web site development. Visual Studio has more to facilitate the development of Web sites. Our adCenter products will be syndicateable this year, so we can offer an advertising business model to other developers. And, of course, on the client side, we have strong support in ActiveX in the browser. We are a leading provider of tools for AJAX development. We've had incredible enthusiasm for Silverlight for very rich media, run-everywhere Web sites. .NET, we're richer still, and with some technology we acquired last year, even classic Windows applications can get click-to-run capability across the Web.

So a lot of focus here on embracing this disruption; some of you will ask, is the business model better, worse, good? I'll give you kind of two easy perspectives. In the consumer market, the consumer market for traditional software has such high piracy, I view this as primarily upside. And in the business market, the fact that we can help not only with the software that provides capabilities, but we can also help take cost out of small/large business infrastructure is an opportunity to add more value and make more money. It doesn't mean we will, but I see this as a land of opportunity from a financial perspective, not something to be concerned about, if you will.

If you take a look then at the fourth element, this is fairly important. And this is the notion of multiple competencies. I think we are a company that has — and I've talked about this before, but I feel obliged to talk about it again, because I do get shareholders who will, let me just say, hammer me on this point. They'll ask, why do you have to do these new things, do you really need to do that? We grew up as what people like to call a desktop company. To this day, I'm not sure I know what a desktop company is, but I know we were a desktop company. That meant we knew how to do OEM business. We learned about developers. We learned about end users and consumers. Somehow Windows and Office was there, and that was our business.

About 18 years ago, we said we're going to go build another competency, or another big muscle. We're going to be an enterprise company. And we got told, and we got told, and we got told, and we got told, for years, by customers — forget investors now even, but just by customers — we're not an enterprise company. We don't get told that anymore. Today, we are the largest enterprise software company on the planet, and we focus on building the innovations, the enterprise value, the service infrastructure, the partnerships, the relationships with IT departments and IT pros to make that a very large business, and there's no accounting, and there's no 10-K that says what's a desktop, and what's an enterprise business. It's not the way we manage. But if you look at the part of our business that comes from big business, it's large, and for our growth profile, I would say thank goodness we made that investment.

We're investing today in two new capabilities. We are going to be an advertising company, and we are going to be a devices company. Being an advertising company means learning about online and operational efficiency. Advertising is a new business model. Now we don't just talk about ISVs, we talk about publishers. What's a publisher? It's an ISV in the modern world who also wants to accept advertising. That's kind of the definition. Different business model, different concern. We need to embrace that. We need to be world-class at that.

On the devices side, we need to embrace retail, hardware, hardware design where we need to do. The telecom industry, we're embracing, and that's essential for success with products like Windows Mobile, or our media room set-top box business. So we're bringing the same kind of vision and tenacity that are in our DNA that drove us into the enterprise business, into consumer devices and online services.

I will get asked, I am sure, at least once at the cocktail or lunch today, I will get asked, do you really need to do consumer device? And the answer is, we really do, because our ability to leverage our technology, our ability to innovation, our ability to drive growth, we need to have this business outlet for our software creativity to continue to grow, to continue to innovation, and continue to be relevant. And so we will build these capabilities. This is a little bit problematic for most investors, because most of the companies who have software as a competence have one business model. IBM has a business model. Cisco has a business model. SAP has a business model. Google has a business model. Apple has a business model. We are going to have multiple competencies, and multiple business models living all in the same body, and it almost means they need to be modeled and thought about separately. And certainly as we think about them, we are dead-set and serious about being world class in each and every one of these four dimensions.

Advertising: Kevin Johnson is going to come talk about what it means to become an advertising powerhouse. This is essential if our software plus services ambition on the end user, consumer side, and maybe even small businesses, is going to come to fruition. And Kevin will talk about some of the success, and some of what we've done. Suffice it to say, between the acquisitions that we've done — aQuantive, smaller acquisitions like ScreenTonic, some that you'll hear about even later on today — but between acquisitions, some of the appointments we've made, and talent we've placed into the business; Bill talked about Harry Shum from our research lab in China, who is focusing on research just around search and advertising. We are hell-bent and determined to allocate the talent, the resources, the money, the innovation, to absolutely become a powerhouse in the ad business.

The good news is, we're the number three seller of Internet advertising today. We sell primarily on our own sites, but we also sell Facebook, we now signed a deal to sell Digg, and a variety of other people. But we're number three; number three is better than number four, but not as good as number two or number one. And yet I think we'll bring this kind of tenacity that will enable us to, let's just say, make great strides.

If you think about consumer electronics, this is an area where we will participate in two different ways. Sometimes we will do hardware, software and service; sometimes we will do software and service and partner on hardware. In phones, we don't build the hardware, but we're focusing on a complete software and service experience to work with partners like Motorola, Samsung, HTC and many others.

In the case of Zune and Xbox, we are trying to do the experience end-to-end. For a variety of reasons, those are probably the business models that work best. In the case of Surface, the only way to kick Surface off as a concept was to really go ahead and do hardware, software and service ourselves. The interesting thing is, when we announced Surface we saw it as primarily a product for niche industrial markets, because the price was so high. Then we've just seen this outpouring of demand and interest, retailers who want to carry it, with somebody from the U.S. who has a lot of applications that they can imagine in some settings for the Surface yesterday. So we will invest quite broadly here.

People say, are you going to be world-class? Are you going to be world-class, does that mean you always need to do the hardware? The first question is, no, sometimes we'll do hardware, software, service, sometimes just software-service.

Number two, people ask are you going to partner the same way you did on Windows? And the answer is, probably we will partner differently, not that we will not have partnerships, but I'm not sure that the model between software developers and hardware vendors and Microsoft looks identical. Windows is the most, what we would call, open ecosystem in the world. We license the software, everybody comes in, Ollie, Ollie, in come free. I'm not sure that's going to deliver the best consumer experiences sometimes on these smaller-volume gadgets. So like with Xbox, we have what we call managed ecosystem. We do certify the applications, the partnerships. So you will see different techniques for partnering coming out of our initiatives in consumer electronics.

We have to learn from our mistakes. It was painful to announce the write-off that we had to announce. And yet we knew we had to take care of our customers. We are dedicated, we will have the talent, we will get the expertise, we will be world-class when we do hardware, and when we do services in the manufacturing, and distribution, and operations, and warranty and service of those experiences.

People ask me about competitors. I think we have four primary sources of competition. Other commercial software companies, classics; I think in that case we are leading. And any time we get a chance to compete with somebody who is competing just like we do traditionally, I feel very good that we know how to win. And you'll hear about a lot of things from Jeff Raikes as we get into business intelligence, CRM, and other areas. I feel very, very good about our competitive capability.

Open source: open source has been the issue that surrounds us. Could a commercial model like Microsoft compete with open source? And we've worked very hard on making the value of a commercial company surpass what the open source community can deliver, because frankly, it's not a business model we can embrace. It's inconsistent with shareholder value. And we've done a very good job, as you'll hear; for the first time in a few years we took some share back from Linux on the server the last quarter. And I think we've really got the formula sorted through.

I talked about advertising: We're emerging, but we're also looking to redefine the way online advertising gets done, because we have so much smaller a footprint than the two market leaders; this is a chance to invest in, or to reinvent and rethink the whole business model of online advertising.

Last, but not least, I've had a chance to talk about the competitors who we face, for whom consumer electronics is their core model. A good example of that would be Apple, or would be Sony. And in that case, we have to get the competitive capability to really be successful.

For most of the rest of the day we're going to use kind of a common framework, and it's a framework that I think is helpful and works well in the context of our long-term approach. I had a chance to talk with investors in New York earlier this year, and I listed seven growth opportunities for the company over the next three years, and I showed another six or seven which I think will become more material after a three-year time horizon.

All of these growth opportunities — and these are really growth in gross margin, I'm a gross-margin thinker. As soon as you start mixing multiple business models it probably makes more sense to think gross margin than it does revenue. I hope I can get our shareholders to model gross margin, instead of modeling revenue, because a dollar of Xbox revenue could be quite different than a dollar of Windows revenue.

But, each of these seven opportunities, based upon the long-term investment, and work we have done in the past, has an opportunity to generate over a half-a-billion dollars of gross-margin growth. Some of them have a chance to deliver a lot more than a half-a-billion of gross-margin growth over the next three years. But, there's Windows, the biggest one of those is actually selling more Windows PCs with our OEM customers.

The law of large numbers — and this is on a dollar statement. None of this is percentage, this is dollar contribution. Adding more value to the desktops of large corporations, by delivering new products, new technologies; Jeff Raikes will talk about that. The server market is growing, and we have a chance to take share. The SMB and consumer market, for productivity, is still largely unmined, because of piracy. We have a great opportunity for growth. I talked about advertising.

Xbox: Despite the hardware issues we've had, and the cost issues, Xbox really has attracted critical mass. And our ability to sell titles, third parties to sell titles, to attach Live is a great growth opportunity Robbie Bach will talk about. And we're selling a lot of units of Windows Mobile; we'll talk about the growth opportunity there.

If something is not on this slide, it doesn't mean it's important, or not important rather; it means we've probably estimated it has less than a half-a-billion of growth opportunity in the next three years, and there's a long list of things that are in the pipeline that we will continue to invest in, innovate in, and should be able to generate longer-term growth.

This is a chart you're not really designed to be able to read. This is a chart that actually lists at least most, not all, but many of the new products that we're hoping to ship in roughly the next 12 months. Not everything that's beyond, but some of these things may or may not make the 12-month period of time. But, for us to generate the kind of growth you expect, you want, that I think we can generate, does require an amazing flow of innovation and new products. And I just want you to feel very, very good about that, because I do.

From my view, I've never been more optimistic. We have more opportunity to deliver innovation, and growth in the next 10 years than even in the past 30 years of the company's history. And I think we're doing all the things we need to do to build for the long term, with great people, great innovation, not shying away from major disruptions, and building all of the competencies that this company will need to deliver superior financial returns into the future.

Enjoy the rest of the day. You get a chance to hear from a lot of different people, and I'll look forward to having a chance to take your questions during breakouts, and also in a formal Q&A at the end of the session.

Thank you all very much.

END

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