STEVE BALLMER: Well, thanks. It's an honor and privilege to have a chance to be here with you all today.

You can tell we're being very economically conservative. I think I tell you every year how much I dislike this room, and we don't remodel it each year precisely because it's a real expensive activity. It's not as intimate as maybe we'd like, but I hope nonetheless we can have a really good -really good dialogue today.

I want to start with really a discussion of kind of my perspective about what's important to me, and what's important to our leadership team and our people. And I think it's important for context, because we're in an environment where there's a lot of change, a lot of growth, a lot of flux, a lot of investment, and at the end of the day having you have a perspective on what's important to us I think is very important.

I want to start with really a discussion of kind of my perspective about what's important to me, and what's important to our leadership team, and our people. And I think it's important for context, because we're in an environment where there's a lot of change, a lot of growth, a lot of flux, a lot of investment. At the end of the day, having you have a perspective on what's important to us, I think, is very important. We care about innovation. There's no question about that. We want to do exciting, innovative products that have impact, not innovation for innovation's sake, but innovation that drives impact on society. We talk about our mission as enabling people and businesses throughout the world to realize their full potential. That's about innovation and impact.

I care a lot about our people, and our teams, and our organization. The heart and soul of our company is the intellectual property and the transmission in some sense of the important benefits of the kinds of products that we bring. So we care a lot about our people and our team.

We love to compete. I think a lot of people in this audience think competition comes above all else, and of course, to succeed in business you have to compete. But, at the end of the day I'll say for me personally, as much as anything else on that list, I care a lot about the financial success, and financial performance of the company. And in some senses, the real key around here is to keep a balanced view of how to drive financial success, how to bootstrap that financial success with innovation, great people, great competition, and keep all of those things in correct balance.

I get up oftentimes in front of developer audiences and talk about how I love developers, developers, developers. I guess today it's all about shareholders, shareholders, shareholders, and as a shareholder, and a significant shareholder, I am deeply concerned about where we're going, and being responsible in terms of shareholder interest, and I deeply care about the long-term financial performance, stock price, dividend returns on our stock.

And you could say, okay, that doesn't merit saying, and yet in the technology business I think it really does merit saying. Certainly we've been involved in some very visible discussions with other companies of late where people sort of wondered, do these tech guys, do all they care about is kind of their babies, and where they're going, and competing, and blah-de-blah-de-blah. That's not us. We care very, very much about driving financial performance. And when I talk about our results in a minute or two, I don't think you get to be as profitable as our company is unless there's a starting foundation that says you really care about driving financial success and financial performance. And I wanted to kind of talk about that right off the bat, if you will.

We talk a lot about this mission of the company, enabling people and businesses throughout the world to realize their full potential. The thing I want to talk about today is, in some senses, our vision. How do we go about, if you will, our mission. And in some senses, what I would tell you is, we view our core capability, and the thing that we want to be world-class best in the world at is being able to develop high volume, super popular software, and we want to be flexible enough, and adaptable enough, and enough of a learning organization to apply that core skill in a variety of different ways, and through a variety of different business models to come to market. We grew up with the PC, a computer on every desk, and in every home, and we had this core capability that people referred to as our desktop, we were a desktop company. It meant we knew something about developers, and OEM licensing, and blah-de-blah.

About 20 years ago we said, we think the power of software isn't just something that can be applied to this new device, the personal computer, but really with what chips can do and software can do, mainframes can be replaced in the back ends of corporations. And so we applied the software capability to the server and enterprise business. And we had a lot we had to learn. We knew how to write software, we had some natural strengths and advantages, but there were some differences in the kinds and nature of software we had to write. We had to build new capabilities in sales and service, licensing and pricing, and business models. And here we are 20 years later with a very large server and enterprise business. And I'm very glad we made that investment patiently where, despite the fact for the first 10, maybe even 15 years, people repeatedly said, you're not going to be good at this.

In the case of the Internet, and I'll talk about this opportunity in depth, about 12-13 years ago, we said there's another opportunity out here. The way software is going to work is going to change. The possibilities for software in a world that is always connected will allow the world to digitize so much more information, and I'm going to talk about it in-depth. But we have great software skills, but we're still in the process of really building our rhythm, our business skills, our operations skills, our financial skills, our pricing skills, our critical mass. And yet we will go at it the same way we went at the server and enterprise business, and I trust with the same kind of positive financial return for shareholders.

And last, but certainly not least, with what's happened with Moore's law, you can put software basically in any PC, in any phone, and TV. And we started pursuing that about 13-14 years ago, and today, and you'll hear more about these businesses, between Xbox and what we're doing with Media room, and the TV, and Windows Mobile, we've come a long way. I think we still have a long way to go. Our PC muscle is very well developed. Our server and enterprise muscle is today very well developed. Our Internet and devices muscles are not yet as well developed, but they're coming on nicely in a financial sense, in a technology sense, in a go-to-market sense, and that's kind of the vision of how you weave together software, the power of the Internet across a world of devices, and basically four different approaches to business.

When I stop and think about the issues that affect our stock price, I have kind of a short list. I had a chance to talk to about 13,000 of our sales people last week in Atlanta. And our stock price is on their minds, for sure, and so I said, look, I wanted to comment to all of them about the things that I think drive shareholder value, drive our stock price. And I want to show you my little list. Some of these I'll comment on briefly, and you'll hear more on today. Some of these I'm going to comment on in great depth as part of my talk.

There's the Windows PC engine, at the end of the day, I sometimes say Windows is kind of the air that we breathe. We don't want to get a cold in Windows, it's a very important business to us. And that means that as many transformations happen in the PC business itself, we have to drive forward. We need new releases of Windows to keep the Windows PC vibrant and interesting. We're working on it.

We're kind of being attacked from a single competitor with a point of view that is much more closed, that offers much less choice, that's much more narrow, and yet we have to tell our story, and you'll hear more about that versus kind of where Apple is coming from, and make sure that the Windows PC doesn't just offer more choice, but it offers every choice that you can get on a Mac or other machine.

Windows PCs are changing form, they're getting smaller, they're getting cheaper, you can now buy $299 Windows PCs at Best Buy, and we have to be alert, and on our feet on product design, pricing, commercial terms. We're working that very hard.

Many of you know that we've had piracy issues in the fastest growing parts of the world, and in some senses you could say that's a big problem, I remind everybody every year it's a big opportunity, and we continue to work on sales, marketing, product design, pricing approaches, to really keep the engine healthy, so that our growth in our Windows business in some senses approximates the kind of growth that we see in the PC market.

There may be some substitution or addition of more low-priced offers versus high-priced, but I think this engine is actually healthier today than it was 12 months ago. We've done very good things both in the marketplace, and in SP1 in the Vista product. You'll hear more about that from Bill Veghte later today.

Growth opportunity in the enterprise, I'm going to touch on that briefly in a minute. I think, and certainly when I talk to employees people say, don't we deserve a PE that's so much higher than everybody else's, we're, after all, a tech company. And I say, well, I'm not sure being a tech company, per se, I think you've got a few issues. We're a tech company, they generally get higher PEs, but they generally get higher PEs because they have higher growth rates. And certainly we've had a fantastic growth rate. I think we've defied everybody's expectations to have grown earnings 18 percent per year compounded, over the last six years. And I think it's one of the most amazing sort of defiance of expectations ever, and we're going to keep working on it, but even with those kinds of growth rates there's still technology risk in this business, which I think affects our PE also.

There was the technology shift potentially to open source that we confronted four or five years ago, where we've done a very good job of competing against that new technology/business model. Today we live in a world where I think people worry about the risks in software plus services, and advertising, both of which I want to talk about during my talk today. And what do I tell our people, the only way to really win this game is to go out there and do it every day. Nobody talks as much today about the risks in our business that come from Linux and open source. They're still there, they're going to be there every day, and yet we've done a very, very good job, I think, in the marketplace versus those risks.

Success in online and mobile, if I was an investor and I sort of pulled to kind of a little listing of the big technology companies and asked, where has market cap really been created in our industry over the course of the last few years, you'd certainly say mobile and online, and you'd look to Google, you'd look to Apple, you'd look to RIM, and I claim that most of the market value that's been created has been created in a few companies and the focus there has been on these emerging opportunities in online and mobile.

We're going to talk to you today about how we think about the investment and return for us in online. There are a lot of reasons why I could tell you I wish we were where we'd like to be today, and we're not there, but the question is, going forward, is there a big batch of economic value for us to create, and we think the answer there is yes. And certainly in mobile the surface has yet to be scratched. We've got a great position. We actually have the number two- (behind Nokia) selling smart phone operating system platform, and Robbie Bach is going to talk some about the investments we're making to drive that forward.

And last, but certainly not least, in driving shareholder value is, you've got to earn money, return cash, and balance your willingness to invest correctly. I want to comment about those.

First, earnings growth, the blue line at the top is revenue, earnings per share is in yellow, cash returned to shareholders is in purple, the spike, if you recall maps to the special one-time, $3-a-share dividend that we did several years ago, and the green maps to the growth in operating income. As I say, I think we've really defied expectations. Over 18 percent annual profit growth over the last six years, and we will keep on defying those expectations.

I think there's a very good record. I get asked a lot, how do you decide how much operating income should grow next year, how much do you invest, how do you think about that, what's your philosophy on dividend, buy back. We've been -I think on the cash returned to shareholders we've been fairly consistent. We've been consistently adding to our dividend as we've grown our operating income.

At the same time, we've made a few acquisitions, but we've also put a lot of money out there in the form of share buybacks. This last year alone, we bought, between buyback and dividend, we returned $16 billion to shareholders. These are big numbers, and we are the kind of cash-generating company that actually has the wherewithal to continue to return a lot of cash to shareholders while growing operating income. We don't have big CAPEX the way, say, a Wal-Mart or an oil company does. What we do, our investment really comes in the form of growth typically, mostly in the form of growth in OPEX. Something that I know is very much on everybody's mind during the call. And yet, in a sense, it's all relatively small compared to total operating income, and the amount of money that we're able to return to shareholders. I'm not saying unimportant, but I'm just trying to give a sense of magnitude.

Chris said maybe it made sense for me to explain just a little bit how we think about FY '09, and where we're spending money. We announced that our OPEX would be up something about $4 billion in FY '09 versus FY '08. I'm not an expert, but I bet if you back out growth in operating expenses at stores in Wal-Mart, that ranks right up there as one of the largest increases in operating expense year over year of any company in two sequential years. So let me give you a little context.

Between fiscal year '07 and '08, you can see we grew R&D from about $7.1 to $8.2 billion. The trajectory, if you will, for fiscal year '09 is fairly straightforward. It turns out the only way R&D gets to move anything other than linearly forward is a little bit through the acquisitions that we do, and most of the acquisitions we do are relatively small. Even our biggest acquisition of the last year, the acquisition of FAST still brought a total of less than a thousand new people into Microsoft.

Sales and marketing, sales and marketing grows with new products, new initiative, and new geographies. Kevin Turner is going to talk about new geographies, I will tell you that as we move into the world of devices and the Internet, we are embarking on a growth path particularly in marketing spend more than sales, since the consumer businesses do require a level of marketing investment. We are certainly in every sort of per-unit basis we spend a lot less than, say, Apple does talking about and marketing PC, talking and marketing phones, et cetera. And so we do see growth, and that growth will, what shall I say, accelerate some in fiscal year '09 versus the growth we saw in fiscal year '08. We have new field initiatives, and we have new geographies which will be talked about.

And then there's G&A, our growth in G&A moderates in fiscal year '09, all of these numbers are without legal settlements. It seems like a more, what shall I say, continuous way to talk about things, because we get lumpiness in what we have for patents and other legal matters.

If you flip it around, and you take a look at it in terms of category, foreign exchange is in gray. You can see it sort of in the upper right. It's fairly uncontrollable. The key message here is, you'll find that on a discretionary basis, we actually have not invested as much money as you might think. We have accounting charges from acquisitions we've already talked to you about, amortization of IP, et cetera. That's some percentage of the increase, small. Stock comp, we are not changing our stock comp policy, but the fact of the matter is, the way our old option vesting was rolling through our P&L, and now our new stock awards, we were continuously declining, even though we've had the same grant policy on stock awards basically for about the last, whatever it is, five years. And so from an accounting sense it looks like we're increasing. I think I would highlight for you that there was some things in the math that made that complicated. But that is nondiscretionary, but looks like an accounting increase.

We're giving people a pay raise. We are a good payer. We are not a top of market payer. But we're a very good payer, and that's about where we want to be in the market. And our pay raises reflect that. We have something we call "bow wave." Bow wave basically means we'd better keep paying the people that we told you about last year, so in some senses without making any new investment, you just have to pay for a full year. People might not have worked a full year. That's actually a big number. You can see that. That's the dark green in the lower right. We bought a bunch of people who we now have to pay in acquisitions. That's expensive, but basically all reflects the past.

Then you get the three big new decisions, not old decisions, but new decisions, to invest in consumer marketing and phones, and in PCs, that's the purple. You get the light blue, the light blue reflects the investment in online which I'm going to talk about quite a bit myself this morning. And then you get the dark blue which really reflects new investments in what we might call the basic Microsoft enterprise and desktop businesses on the R&D and sales and marketing side. So in a sense, I think this is an unusual year, because so much of the cost increase is eaten up by things which are basically pre-committed, and we will talk to you about the three big investments, online, consumer marketing, and then everything else in the business which really means Server and Tools, MBD, and our field presence.

Let me touch briefly just on a couple of these things that I raised as shareholder issues. One of the things that I think is interesting is, as kind of press attention is moved around, the stuff that's hot in our industry today is everything consumer. There was a period right after 2000-2001 and the bubble burst where venture capital people, everybody was saying, stay away from consumer. The world is going enterprise. And there was a lot of attention to the enterprise opportunities in technology and not much on the consumer. That's now flipped back, and that's kind of normal and natural. And yet we see the most fantastic growth opportunities of all time in the enterprise. Desktop value, mail and collaboration, business intelligence, business applications, the server market despite virtualization is still exploding, enterprise search, the move of enterprises to host their infrastructure in the cloud that we call Microsoft Online, conferencing and IP telephony, management, virtualization software, the database and database application platform.

I think palpably we are about this close, Microsoft, able to claim that we're the number one enterprise software company in the world, which nobody would have been able to say 20 years ago, and yet we see nothing but opportunity. And, frankly, as Bob Muglia and Stephen Elop and Kevin Turner will discuss, our share positions in almost every one of these categories are just improving fantastically. And I think this is just an issue that is more off than on our shareholder's minds.

Technology risks shift, the big shift going on right now from a technology underpinning perspective is the shift to software plus services. This is more than just advertising search and online. Really every piece of software, every desktop software, every enterprise software, of course search and online, every device, gaming consoles, TVs, phones, everything is remapping to a world in which software gets created, distributed, updated, and priced somewhat differently based upon the shift to world of software plus services.

There's one technology risk shift that people highlight that I dispute, and I'll just put that out front. Some people say, will all computing get recentralized in the center, in the Internet cloud, in the data center? People like to talk about thin clients. The world doesn't believe in thin clients. Depending on who you talk to, they'll give you that speech in a different way. I'll say, I don't believe in thin clients, Windows is a great product, it's going to have a great role in the future.

If you go talk to some of our erstwhile competitors, they'll tell you, hey, we're actually building -we won't call it an operating system, but we're building a new thick client, it's called the browser, and we're just going to keep pouring more and more of essentially operating system capabilities into the browser. That's certainly what you'd hear from the Firefox folks, the Mozilla folks. You go talk to Apple, they've just come out with the richest phone client in history. Everybody believes, they may not say it the same way, but everybody believes that we're going to move to a world of balanced computation, stuff in the center, and stuff on the phones, on the TVs, and in the PCs. The real question isn't what's going to happen, but who is going to win, and how is it going to happen? We're embracing this, and we'll talk a lot more about this in our Professional Developers Conference this fall. We're bringing all of our server technologies, computation, storage, management out to the Internet.

We've changed our development and deployment paradigm. From a development perspective, we now have tools not only that allow you to write Windows and .NET applications, but we have tools that let you run -similar tools, the same tools, that let you write applications that run in the browser. What's the strategy? You teach people how to write applications whether they want to target a very rich client, or whether they want to be very universal through the browser, through something like Silverlight, and you have one body of skills, and you continue to get a certain percentage of those people who will opt up and support Windows, and the richest clients out there.

We're shifting the deployment model. People love, they just love, they love clicking and running things on the Internet. That's part of what makes the Internet fun. We have to make sure that the rich client model is as click to run, not install, wait, configure, click to run the way Internet applications are. User experience is changing in this world. The rich client has a different role. The rich client has to do natural user interface, and visualization. The tools have to help you manage your rich clients, multiple PCs, phones, TVs. The platform is changing as we think of software plus services in the context of what I might call Web 2.0 technologies. The services that let you contact people you know, colleagues, friends. That's fundamental platform infrastructures we've seen through some of the advances and work that's been shown at Facebook and others. Who are my friends, and how do I want to let them interact with me, and others interact with us, that's core platform infrastructure, and we're embracing that.

And last, but not least, people talk about advertising, but online subscription and online transactions for the enterprise and for the consumer are an important part. What's the fundamental message here? We're embracing -there is a technology shift. You could say shift means risk. I say risk means opportunity, it means an opportunity to seize and embrace this future in a very strong way, and that's certainly what we're trying to do.

People say, is this just a substitution factor, or do you actually get new opportunities?

The truth is, we get new opportunities. Today when we sell software, say, to an enterprise customer, we hand them a CD, and they go instance it. If we are instead running that server for them, if we're providing operations support, we see the opportunity not only to monetize the IP that would have been in the software license, but also to derive additional margin from the value add of being able to provide service-level agreements, and guarantees, and support. And see our overall sort of pool of opportunity increasing. We're the only player in this market who is building the future based on the present. We're building off of the strong enterprise presence we have, and moving those things to the cloud.

For the consumer, we're building off the core experiences that people actually mostly use, Windows and Office, and extending those to the world of online through Windows live and Office Live. We're driving up our Office presence in the consumer market. You'll see when Stephen Elop speaks, we've had perhaps the best year in many, many in driving unit volume increases of our Office software as we become more aggressive still on price relative to the market, and yet because of the elasticity in our business we're growing revenue and we're growing profit along with that.

So building on the present, but embracing this big technology shift across our entire product line. And this has just to do with our desktop business, and our server business, and our device business.

I'm going to talk a little bit now about kind of what we're doing in online and in search. Originally, I will tell you this was teed up differently, I was not going to give this part of the presentation. With org changes here, it seemed like today was a good day for me to get in front of you on this topic. In point of fact, we wish Kevin the best at his new assignment at Juniper. He's been a great contributor here, but we thought it made most sense to try to get our organization changes announced before today. So we moved things along a little faster than we might have, because we thought it was important that whoever got up here and talked about the big investment in online was actually still going to be here in three weeks. So you're stuck with me on this topic today.

I'm going to start by explaining why we're so excited about the Internet and online advertising, search, et cetera. The fundamental premise here, and I don't actually think this is controversial, I just think the magnitude of it might not be fully in people's head, is that everything in the world that can move to be delivered and embraced over an IP network, over the Internet, will be. Everything you read, everything you watch, everything you want to communicate, all of those experiences are going to happen over the Internet.

TV, the Internet; books, the Internet; magazines, the Internet; phone calls, the Internet; video conferences, the Internet; new forms of communications, RSS, blogs, wiki, publishing, advertising, the Internet; shopping, the Internet; online customer service, the Internet; content, community, commerce, all moving to the Internet, the Internet, the Internet, the Internet, the whole world goes digital. The size and magnitude of that is really unbelievable. It's unbelievable. We're talking about, in aggregate, one of the largest parts of the world's economy.

Search is interesting, it's not content, it's not community, and it's not commerce, but search is an important part, it's sort of a killer app, if you will, for this new world. How do I find the merchants, how do I find the people, how do I find the information that I want and need. It's a starting point to the world in which everything has moved to be digital.

So this is huge transformation in the world's economy, and it's a huge transformation that all of a sudden becomes as much a software opportunity as anything else, because as soon as you say video moves to the Internet, as soon as you say we're going to shop in new ways, now you can put intelligent, value added software, which runs either in devices, in data centers, or more typically in the core of the Internet itself, you can put smart software to work on these problems.

This is a transformation which is in its infancy. I know it may feel some days like it's all over. The story has been written. But, if you look at it today, the bulk of advertising and marketing in the world, the lion's share, is offline, not online. If you look at the time people are spending consuming video, it's shifting, but it's still primarily offline, not online. If you look at the phone calls, you may have a little sort of digital intelligence in your phone, but it's far less likely that the call itself is transformed, and that interaction being transformed by software.

And as we go out 5, 10 years from now, I mean literally, literally within 10 years you'll have digital screens that are this light, and this thin, and they're connected to the Internet. I will not bring paper, every surface that we walk up to and touch, and feel will be a window to the world of digital information. That is so powerful, and so compelling, and so big, and then the question is, what companies are really going to invest in the big opportunities around this. And certainly our company, if we want to create shareholder value, we need to run the businesses that we're in very well, but there's this huge, huge, huge new opportunity around the Internet and online, and we have to embrace that opportunity, and invest in that opportunity.

So when it comes to online, search, advertising, why are we pursuing this? I get this question from shareholders, why, why. There's at least a trillion dollars just of media, communications, and advertising, not all of which we can capture, but we don't have a lot of trillion dollar markets that are being transformed. That's such a big opportunity that at least at our scale, our size, our market cap, we have to seize and go after those opportunities.

Some people say, well, it's too expensive, why are you pursuing it? I'll give you a sort of a balanced way to think about it. This year our OSB loss was about 5 percent of operating income. And yet the amount of economic value we might create, we have the opportunity to create by pursuing this world in which everything goes digital, is certainly at least 40, 50, 60 percent or more of our total economic value today. And you say, if you have any belief that you can be competent and successful with patience, it's a relatively small percentage investment, from an overall Microsoft standpoint, in order to have a real opportunity at significant overall acceleration of our market value. I think it is a very good risk return, if you will, balanced risk return for us. How long is that going to go on? The answer is, I'm not sure, but we're going to need to continue to invest until we get greater scale in this business. It will be in an investment mode. I'm going to talk about that some.

Why else should we pursue it? Frankly, because search is one of the starting points on the Internet, I think it is the best place, oftentimes, to distribute new Internet services to the consumer. If you take a look at it, I think it's probably fair to say Gmail would not be as popular as it was if it had come from anybody who couldn't give it the kind of distribution and promotion, effectively, that Google gives it.

And last, but certainly not least, search is ripe for innovation. It has not been the most innovative category in the world. I mean, think back, what did search look like five years ago, 10 blue links on the left, some ads on the right, and maybe some ads on the top. What does it look like now, 10 blue links on the left, some ads on the right, and maybe something on the top. It is ripe for innovation. If you say to yourself, five years from now, 10 years from now will search be as humdrum, hard, 50 percent of searches don't actually lead to an answer to somebody's problem. Is this an area that's ripe for innovation, in user experience, natural language, semantic understanding, consumer experience? The business model hasn't been touched.

Give Google credit, they invented the business model that supports the modern search business, and yet it hasn't been touched. How do you involve the consumer? How do you move to a pay-for-action model? How do you reward the consumer, and involve the consumer economically? This is a category that's ripe for innovation. And that's important, because if it's not ripe for innovation, we shouldn't be doing what we're doing. We will not be able to be very successful by only doing what the market leader does.

On the other hand, if you turn to how do we succeed, we're going to have to ante up in a significant way to even be in this game. If you play poker, it's kind of like you have to meet the minimum pot to go play in the game, and I'm going to talk some about how I think about that.

Second strategy for us I call it focus, but in my own mind I think of it as kind of our Muhammed Ali, float like a butterfly, sting like a bee strategy. Pick focused areas of search, really innovate, change those areas, differentiate from the market leader. That doesn't mean Google won't come back and blah, blah, blah, blah, blah. But, Satya is going to talk about some of the important areas of focus and differentiation.

And last, but not least, we will work to reinvent the user model and the business model. I know this from past experience, it's often harder for the guy who is market leader to reinvent their category than it is for somebody who is, so to speak, the Avis of the business, number two and trying harder. And you'll see us do a lot, and Satya is going to talk a little bit about that in a minute.

We do have strength, we build from MSN, and Windows Live, and our ad strength. We're actually today the tenth largest seller of advertising in the United States, that includes all the traditional media companies, online, we're actually a very software advertising company, even if we're only number three in online advertising. And if you ask who else is going to pursue this transformation, the software and technology for the world as it goes digital, I think there's really only two companies on the planet who have both the capability and the staying power, Google, and Microsoft. And despite the fact that they're the big footprint guy, and we're just tiny little Microsoft in this one, working away, we at least have the wherewithal to continue to be in the game successfully

We need more relevant ads. It turns out that one of the big advantages the market leader has is they have more advertisers in their system. So if you look at two pages today, one from Google and one from Microsoft, the thing that's perhaps most interesting is, because they have more people bidding on advertising, they have more opportunity to serve up a relevant ad. A lot of our discussion around Yahoo! really centered as much on this issue as any other issue. How do we get enough advertisers to have a pool of advertising to change the whole advertising approach. And last, but not least, we're going to have to invest in search and advertising, in fantastic brand, and fantastic marketing.

To talk to you a little bit more about the transformations that we see happening on the advertising side I'm going to invite Brian McAndrews up on stage. He's Senior Vice President of our Advertiser and Publisher Group, former CEO of aQuantive, which we acquired about a year ago. And Brian is going to talk a little bit about online advertising.

BRIAN McANDREWS: Thank you, Steve. Thank you. Appreciate that. I think Steve did an excellent job of setting up the opportunity that we have in front of us here at Microsoft, and it's tremendous. And he obviously talked some about search, and Satya will come up here and Steve will come back and talk some more about search. What I wanted to do was broaden out the discussion and kind of put search in the context of the overall advertising ecosystem and specifically the ad platform.

So I think a lot of people talk about building an ad platform, we certainly talk about it here at Microsoft, but I'm not sure everybody explains exactly what they mean. So what I wanted to do was talk to you about today what we believe that ad platform is that we're building, and why we feel very good about our position and, really, the opportunity ahead of us.

So this chart up here just shows you, looking left to right, the basic ecosystem. You've got advertisers and agencies on the left, you've got publishers on the right; just like in the offline world, those advertisers and agencies are buying ad inventory from the publishers. In the offline world, that's a pretty straightforward transaction. In the online world, there is premium inventory being hand-sold, so to speak, direct-sold from the sales force to the agencies and advertisers. But even that transaction is more complicated online, of course, because it's digital, it's trackable, it's measurable, it's targetable, and so you need technology to do all that. You're collecting a tremendous amount of data.

So the types of tools that are available are buy-side tools that are used by the advertisers and agencies that help the -help to maximize the effectiveness and minimize the cost of all those transactions. And then on the sell side, of course, there are sell-side tools and services to help those publishers maximize revenue and minimize cost with inventory forecasting to figure out how best to sell their inventory.

So, again, as you can see in the middle, there's that direct-sold line. There's a lot of premium inventory being sold that way, again, with the benefit of tools. But something also big in this ecosystem and growing is the role of the network exchanges, and of course Steve talked about the search. And all of these play slightly different roles, but let me talk about the ad networks to begin with. The ad networks, of course, are helping publishers take that inventory that they're not selling at a premium, that inventory that we would call discretionary or remnant inventory, and helping them monetize it better. And the way the networks are doing that is aggregating inventory across multiple publishers, but also, very importantly, using technology and the data that they're collecting with these tools to help target those ads better and make them more valuable. So advertisers benefit by getting better return on their investments through the networks in many cases with this remnant inventory; publishers benefit by getting a higher return on the inventory that they couldn't sell at a high return and a premium themselves. So the ad networks are a growing part of this ecosystem and so they're kind of in the middle.

Exchanges are a new area and more nascent, but over time they will become more and more relevant. And, again, they’re about similarly helping the publishers make money, helping connect publishers and advertisers on inventory.

Search, I've written in the middle here too, it also of course is mainly on the publisher side where Google would sit, and obviously Live Search and Yahoo! where they would take a large chunk of that return. They don't share much of it with publishers, they are the publisher; but then there is also of course the network ads and contextual that allows you to have that network effect in the middle of this.

So this is kind of how we think. And then the last point I would say, the upper point, the data warehouse point, and this is a critical point: while this is all going on, you need to invest a lot to collect all this data and then utilize this data appropriately and accurately in real time and make really real-time decisions. So this is how we think about the advertising ecosystem and the different pieces of the platform.

I'd like to talk briefly about what are the pieces that we have, what are the pieces some of the other players have. So first I'll start with Microsoft. And going left to right on the bottom, we have Atlas Enterprise, the Atlas buy-side tool, leading tool, you know, probably neck and neck leading market share with DoubleClick in the U.S. and the U.K., and we're in multiple markets beyond that and expanding.

In the network space, we've got DRIVEpm and that is probably in terms of an inventory, probably the second-largest ad network in the U.S. right now behind Ad.com, was already growing significantly pre-acquisition, and now being part of Microsoft and combining with some of the Microsoft direct-response inventory, has grown significantly there. Of course search is in there in terms of Microsoft and having an asset there with adCenter to monetize the Live Search asset.

And then on the right side, Atlas AdManager, which is our sell-side tool, it is definitely a smaller market share than DoubleClick as a competitor, but we probably doubled our market share in the last year and we've added over 100 publishers. So we're growing that business significantly.

And then at the top, you see AdECN. This was an exchange acquired by Microsoft right around the same time as aQuantive about a year ago, and so we're in that space too. So basically having players in each of the key spaces -the one other thing I would mention which I think is important is if you look under the publishers, you see MSN. It's important to remember that Microsoft also has a very significant owned and operated business -MSN, Windows Live, Xbox LIVE -all the different properties that we have that are substantial already in many cases and in other cases growing significantly. And that's very important because it is a competitive advantage for us versus say a Google, who does not have a strong presence in that display space. It allows us to collect data; that data can be used in our network and in other areas to strengthen other parts of the platform. It also provides us with a sales force that knows how to sell display advertising -again, something that Google doesn't really have, that’s not part of their history, and that allows us to offer as part of our ad platform to publishers an end-to-end solution that includes the technology and the network offering as well as, if they choose, to have actually Salesforce. In several of our syndication deals that we've done with big players, that has been part of the attraction to those big players.

So that's kind of how we look today. And I'm going to talk in a minute about the emerging media areas. Let me talk for a second about Google. And of course they have a presence across the bottom here, the buy-side tools and services with DoubleClick DFA, Google of course being obviously the leader in search and very strong contextual, although that's obviously a minority of their revenue, and then DoubleClick being strong and currently the number-one player on the publisher side.

Other players. Let's talk about Yahoo! for a second. Yahoo! has of course the search presence and their position they've had in search. They're in the ad network space, they have Right Media in the exchange space, and then similarly, they also have that strong first-party presence that we have. Other players have pieces also such as in the network space, the bottom center, Ad.com, ValueClick are strong players in that space. 24/7 is a player in the publisher side ad serving space.

So this is kind of how we think about the ecosystem in the ad platform. And I guess I think the key take-aways are the following: One -and Steve was making this point- to be in this space and to have -to really be part of an ad platform takes a tremendous amount of investment. I mean, this is a scale game. You know, I get questions about the ad network business and is it being a commodity and there are so many ad networks out there and what's going to happen. And my answer is what's going to happen is there's going to be a tremendous amount of consolidation.

The ad networks game is a scale game. You are collecting data, you are out there in the market serving ads and collecting data, and the larger ad networks are the ones that can attract -can interact with more consumers, collect more data, utilize that data through expensive investments in R&D to then monetize it better for publishers. And at the end of the day, the publishers are going to want to work with the networks who make them the most money. And it's going to be very hard for little guys to do that and compete over time, so it's a scale game.

So this whole thing is a scale game -the data collection, the storage, the decisions that are made in the millisecond when a consumer comes to an ad and you're quickly saying, "What do I know about that consumer? What ad am I going to serve from the 500 or 1,000 advertisers that I have that is going to make the publisher the most money, that is going to make me, the network, the most money, that is going to drive the best results for an advertiser?" Those are very hard math problems, and there just aren't many players who can do it.

I think Steve said clearly that you would think about this, you would say there are probably two players that are positioned pretty well in this space and have the assets across the various areas and are going to be in it for the long haul, and clearly we're one of them. I think those are the key take-aways here.

The other point I would make, though, as I move to the next slide is there's also this whole area of emerging media. And I think Steve also spoke about this incredible trillion-dollar opportunity and how online right now is just a small, small piece of that. But our belief is all media are becoming digital, and as they do, we want to be there providing the tools and the analytics and building the marketplaces in digital media there.

So when you think about it, these are some of the many areas that we're already seeing beginning to emerge in the emerging media areas. And Microsoft has a presence in every single one of these and is investing and looking to that future. And I would argue if you look at our assets, again, versus even a Google. I mean, Google is obviously strong in one area, but when you think about the other areas, display, we're much stronger than they are. The network, display network, much stronger than they are. So there are areas where we have strengths, clearly they have strength in the one that everyone always wants to talk about. But I don't think -you know, when they sit in their strategy meetings, I'm sure they don't just sit back complacently and say, "Hey, we can just coast." They've got a lot of challenges as well.

So here are some of the areas that we're already investing because we believe in them: In-game advertising, dynamic in-game advertising; as you know, we acquired Massive. We're investing in that growth area. Mobile, that's an area where Microsoft clearly has an advantage. As Steve said, we've been investing in this area for 12 years and have significant investments in Windows Mobile. Robbie Bach is going to talk about what we're doing there. But from the advertising standpoint, you know, in May we launched in about seven countries where we're advertising in Windows Mobile. We've been advertising MSN Mobile in many countries for a while.

We made an investment in ScreenTonic in the mobile advertising space a couple of years ago. Video on demand; Atlas is really the only player there that has actually made moves in that space, made partnerships with the leading ad insertion companies in the video on demand space here in the U.S., people like Sea Change, C-Cor and Tandberg. We have partnerships with them, we've done pilots with Charter and other MSOs that have worked in the video-on-demand space. So, again, recognizing that TV is heading where the Internet is going, it's going to be more of an on-demand medium, it's going to involve more technology and analytics, and we are investing in those areas.

IPTV; of course we have an IPTV software platform in Media room as part of Microsoft. Interactive TV; as you may know, we recently acquired a company called Navic Networks. Navic works very closely with cable companies collecting data from I think 35 million set-top boxes, is a leader in the interactive TV space. So, again, now we have a foothold there and good relationships to build in this space, in the cable space and in the satellite space.

Other, you know, we're doing other things. We've announced Media Cart where we're actually doing digital advertising in supermarkets, you know, ad display related to what's in the shopping cart. So, again, these are areas where we are making significant investments. We have the ability to do that, we have the expertise to do that, and we feel very good about the fact that there's a tremendous, trillion-dollar opportunity and we are methodically going after it.

One point worth making here too is what we want to bring to advertisers; what they want is one view of the customer. You know, right now there can be separate ways of looking at things. You know, you can look at search and see results there, you can look in display and see results there. What we're bringing to the party is we're saying, you know, those results matter together, and we need to provide our advertisers with the ability to see that consumer, all the multiple touchpoints.

One of the big innovations we are bringing to the marketplace is called engagement mapping, which is a whole new way to measure online advertising. Traditionally, it's been the last-ad standard. What's the last ad you saw? What's the last ad you clicked? And that was actually pioneered by Atlas about 10 years ago. But it's now becoming more and more obsolete. What we're saying is, in fact, we recognize that if someone sees display ads on a bunch of different places -Yahoo!, MSN, ESPN- and then searches on Google, the way the measurement's done now, Google gets all the credit for that conversion on the Web site. In reality, we all know it's much more than that that played a role there.

So what we're doing is revolutionizing that and bringing a new way to measure that. And we just put out -Atlas just put out Digital Marketing Insight that showed that with a customer, Alltel that, in fact, customers of theirs who saw display ads and then searched were 56 percent more likely to make a purchase than customers who simply searched. So it's telling us what we already knew intuitively: those interactions matter.

So our goal here is to continue to invest in all digital media as they become digital, continue to invest in this ad platform, and provide one view of the customer for advertisers and provide better monetization for publishers. And we're trying to do innovative things for the industry like engagement mapping. Again, I think it's a lot of investment but we're excited about it and we have a tremendous amount of assets to move forward.

With that, I will turn it back over to Steve. Thank you very much.

STEVE BALLMER: Great. I want to turn a little bit now to kind of the financial perspective. This isn't a model exercise, this is not guidance, this is conceptual thinking, but I hope it is useful for you.

If you actually take a look inside our online business, in a sense, you could say -and they're not complete P&Ls, and they're not GAP, and they're not reported, but in some senses, we've got four business streams that we run: Windows Live, which is the extension to Windows, that provides communications, storage, file sharing, photo support, and in some senses, it's got a revenue stream, it helps us attract people into our ecosystem. We have over 400 million users of our Windows Live services around the world.

There's MSN -and you could say it is a community play. The world is about community, content, and commerce. Windows Live is certainly about community as a fundamental service and as a business. MSN is about content. Search, of course, is about search. And in some senses, we think about advertising as a business that is funded by these other businesses, but also as Brian talked about increasingly over time, funded by third-party publishers who we work with like Viacom and Facebook and others.

Essentially, what I did here was take a cut, what's going on in the revenue side. Price, what's going on with revenue per search or CPM rates for page views? What's going on for us in terms of volume, queries, page views, et cetera? What's going on with our R&D spend, particularly as a kind of percentage of revenue? Is it going up? Down? Flat? All the sales expense shows up in Microsoft advertising and gets kind of allocated back. What's going on with our marketing expense? CAPEX, and then contribution margin.

What we have today, actually, is a world in which our Windows Live business is a positive business for us, a positive business stream. Frankly, all of the dynamics in that business should give us operating margin leverage. That is, we ought to be able to grow revenue by and large in a way that exceeds expenses. We don't have much in the way of marketing expense. I'm doing Windows Live first on the left. We do have some increase in capital that will come primarily as we continue to hold more and more storage for people. Our R&D expense will be relatively flat, certainly as a percentage of revenue, contribution margin can grow.

The biggest things to worry about or think about, they're not negative, but we're going to need to invest in capital for storage, e-mail, photos, et cetera. And there could be a little bit of pressure on price. Certainly with the explosion not only in Windows Live but also in My Space and Facebook, this last year we had a little bit of pricing pressure on CPMs, and yet we think some of the technologies Brian talked about should help us get that going in a positive direction. So a good story on Windows Live.

On MSN, our CPM rates are pretty flat, our volumes are going up nicely around the world, our R&D expense is well under control, our marketing expense is under control, our capital is small relatively and not needing to grow. Good positive contribution today with, frankly, operating margin leverage. That's good.

Advertising -let me skip search for a minute- advertising primarily reflects the other business and, in fact, search has lower sales cost as a percentage of revenue than display businesses, and with the kind of technology Brian talked about, we're getting more leverage to drive selling cost as a percentage of revenue for our display businesses and MSN and Windows Live down, selling cost as a percentage of revenue. So a relatively -I'll say static story in terms of overall contribution margin on the advertising business.

The area of interest here ought to be search. For us, our RPM rates or revenue per thousand searches should go up. Certainly our query volumes were up about 40 percent year on year, which is fantastic. Our R&D expense is growing quite rapidly, our marketing expense, as I talked about in the context of fantastic brand and marketing needs to brow. Our CAPEX, growing, and that gives you a double-arrow down view of contribution margin.

In some senses, the combination of these things, the thing that you see reported externally is our online services business reflects these events. What that probably means to me and to you is we ought to spend a minute or two talking specifically now about the economics of the search business. It is, if you will, the drag. And yet, I've told you it is mission critical. It is the entry point for the world going digital, and frankly, Brian talked about all that intelligence we can use about consumers to deliver more relevant ads. The best information you get about a consumer is if you actually know what they're searching for.

So search is important to the quality of our ad platform, it's a starting point, it's a great business. Search is interesting. It's the only business where clearly people value advertising as part of the result. It's not clear people value ads everywhere, but they sure value it as part of a search-type experience.

So what do things look like in the search business? In the brown, you've got the Steve Ballmer Microsoft OSB kind of salient facts about the Google P&L. Let's face it, this is not about Yahoo!! I'll talk about Yahoo!! in a minute, blah, blah, blah, blah, blah, this is a two-horse race: Microsoft against Google. So we're sitting here saying, okay, we're in the game of anteing up, focusing, and reinventing. Ante, focus, reinvent. And you've got to look at that and what it means to us in the context of Google.

Google does about 500 billion queries a year, something like that. Worldwide -non-U.S. but worldwide- about $25 RPM. Microsoft is certainly a small fraction of Google's overall query. We are a small fraction, that is a well-known factoid. And, in fact, we are a small percentage on a global basis, but even in the U.S., we are not a large -what should I say? We are substantially below Google's RPM rates in the U.S. So on the revenue line, what is the strategic issue?

We'd like to increase our revenue per search, and the way to do that is to get more query. The more queries we get, the more advertisers we get, the more advertisers we get, the more keywords they bid on, the higher they bid, you get the virtuous cycle flowing. But it's absolutely important the first thing we do is get queries. And to get queries, we need relevant advertising which presents a bit of a catch-22. I'll talk about Yahoo! in a minute, but it was part of the catch-22. There are other alternative approaches around this catch-22 which I'm not going to talk about today, but we need to do things to bring advertisers in the system, to give great results, to drive queries, and then after we've got the query engine going, we can really drive the RPM machine.

Complicated strategic issues, but one in which I guess I'm trying to set your expectations that our overall RPM may not be able to accelerate as fast as we would like because we need to do the query part of this issue kind of on the front end.

O and O, which is owned and operated, this is basically on Google Web sites what does Google pay in attach. And they pay about $500 million, that's distribution of toolbars on Dell machines and various other places. Certainly, our total dollars may not have to be the same or can be the same as their total dollars. Since we are trying to change the business model -in fact we'll talk about things like Live cashback, the way we're trying to involve the consumer and give them an economic interest in what they do on the Web, to give them better values when they go to buy things. Certainly as a percentage of revenue, we are on a strategy that will essentially drive higher attach rates for our own search site than Google would see.

International is about half of Google's revenue. We have lower share in search outside the U.S. than we do inside the U.S. Therefore, it'll be more expensive for us to bootstrap everything. That's just a small reminder. Third-party gross margin. Google makes about $1.3 billion a year just serving up ads through Ad-Sense on everybody else's site. We're only going to compete with this selectively with the kind of publisher deals I talked about earlier, Facebook, et cetera, et cetera. We're not competing broadly, so that will not be a deep money sink, if you will, in our P&L.

COGS -most people think COGS are just a percentage of revenue and should be. That's not true in the search business. In the search business, you've got to invest in a certain minimum amount of capital expense just so that you can index all of the documents you need to index on the Web to be in the game. So in a sense, you could say COGS is a variable expense. I think you've got to think of it as sort of almost more of a fixed expense.

We won't have to be as high as Google's $2.3 billion because they're serving up so many more queries, but our COGS percentage will need to be quite a bit higher than theirs will just to keep up in the ante to index the largest volume of documents on the Web.

Google spends about $2.5 billion and growing on R&D. You can make your own assumptions, but they say publicly about 70 percent of that is in the core search and advertising areas. If you assume that at least some of that is on the periphery, the kinds of things that market leader can go after but the number-two guy in the market shouldn't go after, we're going to certainly have to think about the bogey as at least $1.2 billion or $1.5 billion a year to stay competitive, let alone reinvent on the R&D side. That is a big number.

Marketing, Google doesn't have to. We do. So we're going to have to spend to compete, and our sales expenses, particularly as we drive up our revenue per search, our sales expenses will be in line. If our revenue per search is lower, our sales expenses are going to look relatively higher.

So when people say to me, "How do you lose $1.2 billion in this business?" It's not Windows Live, it's not MSN, they're countervailing forces. When people say, "You're anteing, you're focusing, you're reinventing." I say, "Yeah, but we're anteing, and we're reinventing and we have some things we've got to do." And if you just look at the numbers, I actually think we're being relatively smart and efficient with the kinds of numbers we put up not relatively inefficient at all. And certainly Chris talked about some of the growth you'll see, and he'll give a little bit more discussion and color on that later on today.

But if we're going to be in this game and pursue that big, big opportunity in the world going digital and have the fundamental view that that means we've got to have a strong play, we're going to have to innovate, we have to reinvent, but we also do have to ante up. And as I said, the ante can look very large to you depending on your point of view. To me, it looks very smart relative to the competitive factors that we face, and it looks reasonable as a sort of investment payback return relative to the total opportunity available to us and our total operating income.

Now you say, "Are you going to succeed?" And I say, "Yes." And you say, "How do you know?" And I say, "Because we've got the best and the brightest. We will push ourselves, we will get outside the box because I have confidence in the people and team who are really working on this problem and in this area." And even with org changes and everything else, I guarantee you we've got really just the best team we have ever had in this area. We've got a lot of very clever ideas, we've got people galvanized in Microsoft Research to go after it, so I feel very -I'm not going to say it's not a big bet, it is. I'm not going to say it is not risky, it is. I'm not going to say it's unimportant, it is. And yet I'm excited to get after it. And I want you to understand kind of at least the economic framework I have around it.

Probably to fully appreciate that economic framework, I should talk about Yahoo! -whose' whatever it was now, six-plus months ago we were talking about 40-whatever, blah, blah, blah, billion for Yahoo!, and then we weren't, and then we were talking about a search deal, and then we weren't, and then we were talking about another search deal, and now we aren't. And that's where things are, just as a small summary. There's nothing under discussion between the two of us.

Yahoo!, for us, was always a tactic, not a strategy. Ante, focus, reinvent, the innovation, the investment in semantic expertise, that's the strategy. And yet when I talk to you about the need to change our position on the revenue per search curve, Yahoo! was a tactic to accelerate that. Advertisers scale for more advertising relevance and higher RPS. And we had R&D particularly and capital expense synergies by coming together. And at the right price and with the right speed of operation, it was a heck of a good tactic. At the wrong price and if it had had to stretch out over two administrations of regulatory review, blah, blah, blah, blah, blah, it was not a good tactic.

So we approached it, we had a firm time deadline because we wanted to be able to get our regulatory review in without administration shifts in Europe and the U.S. We offered, they didn't like, we left. Then we had a conversation about search and could we work together. A lot of good reasons to do it. We had one with management, we had one with Icahn, and we weren't able to come up with something that works. It's a tactic, and we are disciplined, we lost.

Why -people say, "But you have to buy this." No. It's a tactic. So why not buy Yahoo!? There was always going to be huge integration overhead in either buying Yahoo! or doing a search deal. And that's always part of the balance in terms of evaluating this option. Frankly, without a big commitment to buy Yahoo!, our flexibility in reinventing the search and advertising model, we have more flexibility. If we had put a 40-odd-billion dollars out there, we have to kind of lock in a little bit more on the current economic model in the business. And you may notice we announced Live cashback after our early acquisition discussions stopped.

We do have alternate paths for getting ad relevance up. I'm not going to talk about those today, but there is an internal path that does not require the acquisition. And just a small reminder, Yahoo! has no position really outside the United States and Japan. So the issues I talked about in terms of uphill battle in Europe and elsewhere, Yahoo! was really not part of that.

So it had to be a tactic, not a strategy, and it was, and we approached it in I think a reasonably disciplined way. I know Yahoo! likes to characterize somewhat differently. We had a set of principles, we talked about them, it didn't work out. Fine, we're done. We can move on. Does that mean that nobody will ever talk to anybody again? I suspect the answer to that question is also no. It's a long time in a big world, but we're comfortable proceeding as we are on our own with our people, with our strategy, independent innovation and I think what we really still have in search and advertising is a two-horse race.

Yahoo! will stay around. I'm sure they'll find their path. And yet, for the kind of ante we're taking about in this game, I think it really is just the two of us.

So with that, I'm going to wrap this part of my presentation. I'd like to invite Satya Nadella who runs the engineering efforts around search and advertising to come up and talk to you a little bit and show you a little bit some of the progress that we've made in search and give you a flavor on how we hope to ante, to focus, and to reinvent. Satya.

SATYA NADELLA: Thank you, Steve.

I'll try to look for the clicker. Good morning, everyone. That was quite a setup on Search, so I'm here to mostly talk about the progress we've made on Search. I want to mostly spend my time showing you a set of demos that sort of showcase the progress that we made over the last year. But I wanted to start off with a little bit of context on our strategy.

Steve talked about how it's – about anteing up, about focusing and reinventing. And that lines up very well with the three strategy pillars we have for Search, anteing up to deliver the best results, focusing our innovation agenda on delivering a core search experience that simplifies tasks, and lastly, to invent the business model itself that drives the business of Search. So that's really the three areas that we are focused on.