BOB MUGLIA: With that, what I'd like to do is invite Stephen Elop up to join me, and we have a few minutes to do some question and answer.

Great, so we'll do the question and answer time now, so if you would raise your hand, and let's take paddle two over there.

QUESTION: Great, thanks. I wanted to follow up on those comments on the Gen 4 datacenter. There are advances there, and then the advances you're making in Azure. How do those set up to help you kind of gain share in the business? And then, how do you look at integrating those datacenter and those advances you've made with what you get with Yahoo?

Thanks.

BOB MUGLIA: So, I think one of the key attributes about the datacenter is, how can we build a platform both from a software perspective and a hardware perspective that has a leading-edge architecture in terms of cost, making you able to be more agile in terms of deploying new solutions more quickly, as well as being able to drive compute cycles out. And to do more, serve more for less money.

I mean, what Debra's team is really doing is, she's working with all of our hardware partners in the industry, all those major OEMs, Intel, AMD, basically the entire industry, to make sure that we are purchasing servers at a cost and providing an infrastructure at a cost that is the absolute lowest possible cost the industry can provide. And Microsoft has really moved into a very leadership role in that with the work we've done in the overall datacenter, and with the container architecture, and moving into the Gen 4.

What Windows Azure does is, it provides us with a service platform that really matches that low-cost architecture, a very agile environment. And so, whether it's our broad set of properties that we have, search, our broad set of Windows Live properties, Microsoft Online, or the many customers that will build applications on top of Windows Azure, it will be a very low cost provider for them with the most flexibility.

BILL KOEFOED: Great, who has our next question? Let's take two again over there, or one?

ADAM HOLT (Morgan Stanley): Hi, it's Adam Holt from Morgan Stanley.

Bob, I had two questions for you as we get into the 2008 R2 cycle. No. 1, it sounded like premium mix is now over 20 percent, that's a substantial improvement over the last several years. Where do you think that can go?

And No. 2, over the last five years, both Microsoft and Linux have outpaced the market by taking share. But now it sounds like you're more directly turning your sites on Linux because UNIX has gone basically almost to zero. How do you that? How do you be more effective there? What's the strategy?

BOB MUGLIA: Well, the premium mix has grown north of 20 percent, and that's been driven predominantly by virtualization. And we do see ourselves having the ability to continue to grow a few more points of that.

I can't predict how high we can actually get it, necessarily. I will tell you that as a general rule a premium mix—anything more than 30 percent would be an unusually high premium mix. But, I do see us continuing to take a few more points as virtualization and higher-end systems become more prominent. The downward draft against that is low-end systems like HTC, for example. So, as those systems expand, and with HTC growing faster than the market, that actually pulls the mix percentage down. What was the second question? The second question was—Linux, right, taking it away from the competition.

You said we've taken share—we've mostly taken share from UNIX and how does that change. Well, the first thing I'll say is, there's still share to be taken from UNIX. I mean, there are still Solaris computers out there. And there won't be many proprietary Spark systems out there for much longer. I can guarantee you that every Spark customer is looking at alternatives. So there's tremendous opportunity for those remaining systems, for us to go take share with industry-standard computing.

We have gotten into a world where it is clearly a two-horse race between Linux and Windows. And fundamentally, I come back to the foundation, if we do a better job for our customers we will gain share from Linux. We've been doing a better job and we've been gaining share, and it's my job to make sure we keep doing a better job.

BILL KOEFOED: Next question. So, four, way over there.

QUESTION: Yes, this is for Stephen. I'm curious, for the online version of Office, will there be a revenue and an operating profit uplift from those products? Will those more be bundled in with what people are getting? And more generally, what do you see as the trajectory as revenue per seat for the client business?

STEPHEN ELOP: You're talking about the Web applications?

QUESTION: That's right.

STEPHEN ELOP: So the Web applications, our expectation is, in the vast majority of scenarios they are associated with the revenue generation. So, a lot of people like to write this story, Web apps are free, what does that mean and so forth. But, in fact, in the vast majority of ways that they'll be used, they'll be used in conjunction with the rich client applications. So, if there's someone using a Web application for a particular scenario, that scenario often couples in with the rich client application. So, we look at it as a joint opportunity.

I mean, it is the case today that there are many, many people who are making use of free copies of Office, perhaps software they've borrowed, or what have you. And what we've had to consistently do is demonstrate through innovation and new scenarios that it's worth paying for Office going forward. And we've been very successful doing that. The Web applications are another example of a scenario we can pursue that actually drives continued success of the Office business.

As it relates to revenue per seat, that's a complicated question, because it's different in different markets under different circumstances. For example, broadly in the consumer market, really the most important factor in determining the right price for Office relates very directly to the elasticity curve and where you want to land on that curve, because of course revenue is a function of not just the price, but the quantity. And you've got to work with that. You've seen us experiment with that, with different price points in different geographies to drive revenue maximization, while being mindful of wanting to have a broad, broad coverage or broad share in the market as well.

In the enterprise space and small business, I gave some examples here, we've been very successful in maintaining price. You've also seen us do some things that will lead to simplification of our SKU structure with the Office 2010 strategy. We announced that a few weeks ago, the specific SKUs we were going out with. We're adding more value in particular areas. And, of course, all of that is designed to affect pricing and attach in a way that makes sense for the business. So, we're bullish on the long-term aspects. And very much—I know the press likes to write about the free Web apps. It's actually far more complicated than that in terms of how it drives revenue.

BILL KOEFOED: Who has the next question?

JOHN DIFUCCI (JP Morgan): Hi, it's John DiFucci from JP Morgan.

We heard Steve say earlier, and both of you, and Bob, we talked a little bit about it at lunch, about the product cycle coming up. It sounds like a lot of good things are coming out. I'm just trying to understand, is this something unique, because we sort of heard something similar with the launch of Vista, and it wasn't just an operating system, a lot of other things around it. And it certainly was, but it's sort of what Microsoft does as a good company. It improves upon its products, comes out with new products, and it continues to do that.

But, it sounds like the presentation today is that, OK, you have this new product cycle and it's something different, and it's something unique, and it's going to be better. If you can just sort of hit on that, because we're creating financial models, and wondering if there's an impact to the financial model here.

STEPHEN ELOP: I don't want to mess with your financial model, but let me just reiterate kind of what I said earlier on. And that is, not only is it a product cycle, not only is it the best productivity experience and a variety of other things we're doing, but something that we're emphasizing a great deal is the degree to which all of these pieces interoperate, support one another and drive a much larger up-sell opportunity broadly within an enterprise.

So we get into these competitive situations, and you all like to write, hey, Google, they're pitching e-mail to the enterprise. And it's like, you go and talk to the enterprise customers, and they say, well, hold on, what about collaboration, what about communications, what about these things? They recognize increasingly that it's the whole story that needs to be delivered, supported, delivered on an enterprise-ready basis. And that's very much what we're doing.

And so, what is exciting to me is actually not any particular feature, for example, that I demonstrated, but it's the fact that all of these elements are coming together and each one pulls the other and creates opportunities for up-sell, for example, through our CAL Suite program, where we can take them from Core CAL to E-CAL, and do that up-sell. I think very much the vision of an integrated business productivity infrastructure is really landing with our customers. And that's part of the reason we're seeing those big growth rates in those pillar products, SharePoint, CRM, unified communications. I mean, these things are just rocking, and the reason is they're all starting to take advantage of one another in a very useful way.

So that's the comment I'd make from our perspective.

BOB MUGLIA: We talked about it a little at lunch. We've seen some deferrals in terms of customers moving to the next-generation operating system. And so, we have an unusually large install base of XP out there. And with Windows 7 and the apparent savings they get in administrative cost savings, better security, better end-user experience, better application development productivity, all those things together, we expect that on the business side in particular we'll see a fairly strong movement for business customers moving to the next-generation operating system. I think the demos and some of the stuff Stephen and I showed, there is a combination of things like the BI scenarios, the self-service business intelligence scenarios, that drives some parts of our wave from the server side, like SQL Server, but it also helps drive Office.

BILL KOEFOED: Great. Who has our next question? Let's keep it right there.

QUESTION: Thanks.

Bob, a question for you. Most large enterprises have made a significant investment in VMware already. Can you give a little more detail on, what's the plan to attack their incumbency? I mean, does it start in small-, medium-type business and creep upward; does it go head-to-head in the enterprise; is it to be complementary? And then, where have you seen the best traction so far?

BOB MUGLIA: It's in businesses of all sizes. I mean, the larger businesses have a larger set of servers that are—a larger percentage of their servers virtualized, and thus they are higher penetrated in VMware. VMware is disproportionately less penetrated in smaller enterprises.

But we're seeing strengths in businesses of all sizes with Hyper-V and System Center. And the reason for this is fairly simple; it is unlike, say, one of the UNIX systems where you have an application that was written to it, and it took many man-years to develop that application, and moving it on to the Windows platform is a non-trivial act. Moving and using Hyper-V together in a VMware environment, or supplanting and replacing VMware is much more straightforward. It doesn't take years to move a virtual machine; it takes me 90 seconds to move a virtual machine.

And so, what we're seeing customers do is, they have an investment in servers that are running VMware. They'll probably leave those servers running VMware. There's no reason to touch those servers. But now they want to take their next 100 servers and virtualize that. Well, the first thing is, they look at the value proposition we provide, and they've got to consider us. As I said, when we talk to customers, we're winning 70 percent of the time. We're winning because we have a better price. We're winning because we provide the functionality customers need, and we have a more comprehensive solution. And we're winning even when VMware discounts to our price, even when they match our price, we're still beating them in our customers.

And what customers are saying is, they have these existing VMware systems, our product, System Center, actually manages VMware. We do a world-class job of managing VMware, so they can use one pane of glass to manage their legacy VMware environments together with their Hyper-V system.

BILL KOEFOED: Great. Who has the next question? Two.

TIM KLASELL (Thomas Weisel Partners): A question around Server 2008 R2. If there is a big Windows 7 upgrade in the enterprise, a number of enterprises are also going to have to upgrade their servers to get the benefits, a lot of the benefit. Can you give us an idea how many customers are already on 2008, and who is on prior versions, and how do you think about that revenue opportunity?

BOB MUGLIA: What typically happens with servers is the upgrade of servers is a fairly small percentage; less than 10 percent get upgraded to a new operating system. So, when you install an OS on a server, chances are that server will run its useful life running that operating system. Now, when you virtualize, obviously you can run multiple operating systems on a single piece of hardware.

So what we've seen is, as 2008 has become the product we've been offering, it has picked up the run rate of servers and it's growing very rapidly; so far the most rapid thing. Server 2003 still has a much larger install base because, of course, it's had five years out there in the marketplace. And as those servers are depreciated and replaced, in general, they're replaced with 2008. We expect R2 to do a similar sort of thing.

There are a set of roles where these things come together, but remember servers are used for a wide variety of different things. And so, if you look at all of the different kinds of applications, people will in general move to the new servers, the new versions of R2, as they buy new servers. And that's largely what will happen. And that's fine.

We have agreements with our customers that enable them to do that as they—our enterprise agreements enable them to do that. So we don't see—when we ship a new version of R2, because Windows 7 is hot, which it is, we won't see this massive spike in server sales, but what we will see is continued investment and continued growth of share of Windows Server.

BILL KOEFOED: Okay, let's take one last question, three, over there.

QUESTION: I have a question for Stephen, what kind of refresh could we get with Office 2010 product. It looks, anecdotally, you talk to people, a lot of them are still in Office 2003, some are on older versions. What is going to be so compelling about Office 2010 that you could get a refresh cycle? If you do, I would assume that it's good for your deferred revenue, probably shows up on your balance sheet. As a part two to that, I think Joan asked earlier, is the Office Web applications a defense or offense strategy? Is it really geared toward protecting your turf against Google, or is it really driving incremental revenue?

STEPHEN ELOP: In terms of what cycle looks like, when I think about Office 2010 and the elements that will fundamentally drive adoption and deployment, and usage, there's two things go along with that. One is, to the extent it's a beautiful companion with Windows 7 and there's a sense of a strong refresh cycle around Windows 7 and Office 2010 that goes along with that. When a corporation says time to upgrade, time to go through this cycle, I think it's going to help us a great deal.

So, the experience of using Office 2010 with Windows 7, it's excellent, and I expect a lot of corporations will be rolling that out as one package and taking it forward. So we're very excited about that.

The other thing fundamentally about Office 2010 is, it is the version of our software that demonstrates the best productivity experience from the PC to the mobile device, and also with the browser. All three of those pieces together, taking advantage of this generational shift through which we're going, which is about software plus services, the marriage of the cloud with the desktop environment, both of those things together, the server environment on-premise, in the cloud, Office 2010 is what lets a CIO say, OK, I can now embrace the next generation of how computing is done. So, we think that's going to be very, very significant as people assess it.

Now, in terms of defensive versus offensive, very clearly this is an offensive strategy for us to drive incremental reach within the customer base, to continue to draw people into the Office family who might have chosen just to borrow software instead of pay for it. It's very much about getting out there and generating revenue by attaching to people who previously maybe weren't formally in the family, but we think we can make them part of the family and lead through up-sell processes and so forth to drive revenue from that. So it's very much a go-forward attack, be-on-the-offense type of strategy.

BILL KOEFOED: Great, thank you very much, guys.

STEPHEN ELOP: Very good, thank you.

BOB MUGLIA: Great.

BILL KOEFOED: OK, now we're going to take a 10-minute break. After the break will be Chris Liddell, our chief financial officer. So, please keep it to 10 minutes, and we'll see you back after the break.

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