MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS FOR FISCAL YEARS 2009, 2008, AND 2007
OVERVIEW
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial statements (“Notes”).
We generate revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for personal computers, servers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and video games. We provide consulting and product support services, and we train and certify computer system integrators and developers. We also design and sell hardware, including the Xbox 360 video game console, the Zune digital music and entertainment device, and peripherals. Online offerings and information are delivered through Bing, Windows Live, Office Live, our MSN portals and channels, and the Microsoft Online Services platform, which includes offerings for businesses, such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on Bing through our proprietary adCenter platform.
Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated approximately 40% of its annual segment revenues in our second fiscal quarter. In fiscal year 2007, our revenue was highest in the third quarter due to the recognition of $1.7 billion of revenue previously deferred from the Express Upgrade to Windows Vista and Microsoft Office Technology Guarantee programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system. The technology guarantee programs provided customers who purchased current products with free or discounted rights to Windows Vista and the 2007 Microsoft Office system when those products became available to consumers.
The unfavorable global economic environment adversely affected our business in fiscal year 2009 as consumers and businesses cut back on spending, which reduced PC shipments and IT investments. But because we offer a wide range of products that enable companies to improve productivity and reduce costs, and because we have a strong pipeline of products, including new versions of Windows and Office planned for release in fiscal year 2010, we believe that Microsoft is well-positioned to weather the economic downturn. As the global economy improves, this will create new opportunities to increase revenue. To further help weather the economic downturn, in fiscal year 2009 we made important adjustments to our cost structure and streamlined internal business processes.
Technological innovation is the foundation of our long-term growth and we intend to maintain our commitment to investment in research and development, engineering excellence, and delivering high-quality products and services to customers and partners. Recognizing that one of our primary business objectives is to help accelerate worldwide PC adoption and software upgrades, we continue to advance the functionality, security, and value of Windows operating systems. We remain focused on selling our products in emerging markets and reducing the amount of unlicensed software used in those markets.
We also continue to develop innovative software applications and solutions that we believe will enhance information worker productivity, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for small and mid-sized businesses. To sustain growth in the face of competition from other vendors of proprietary and open source software, our goal is to deliver products that provide the best platform for network computing – software that is easiest to deploy and manage, and that is most secure – with the lowest total cost of ownership.
In addition, we continue to invest in research and development in existing and new lines of business, including cloud computing, search, online solutions, business solutions, mobile computing, communication, entertainment, and other areas that we believe may contribute to our long-term growth. We also invest in research and development of advanced technologies for future software products. We believe that delivering innovative and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth.
This long-term focus on investment in research and development has enabled us to lay a foundation for future growth by delivering innovative products, creating opportunities for partners, and improving customer satisfaction. Our focus in fiscal year 2010 is to build on this foundation and to continue to execute well in key areas through ongoing innovation on our integrated software platform, by responding effectively to customer and partner needs, and by focusing internally on product excellence, business efficacy, and accountability across the company.
Summary of Results for Fiscal Years 2009, 2008, and 2007
| (In millions, except percentages and per share amounts) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Revenue | $58,437 | $60,420 | $51,122 | (3)% | 18% |
| Operating income | $20,363 | $22,271 | $18,438 | (9)% | 21% |
| Diluted earnings per share | $,(,1.62 | $,((1.87 | $(,(1.42 | (13)% | 32% |
Fiscal year 2009 compared with fiscal year 2008
Revenue declined across most segments primarily driven by weakness in the global PC market and the unfavorable economic environment. Foreign currency exchange rates accounted for a $486 million or one percentage point increase in revenue. Primary factors contributing to the decline include the following:
- Revenue from Windows operating systems declined reflecting PC market weakness, especially PCs sold to businesses, and a decline in the OEM premium mix.
- Revenue from our Entertainment and Devices Division decreased across most lines of business including Xbox 360 platform and PC game revenue which declined primarily as a result of decreased revenue per console due to price reductions during the past 12 months, partially offset by increased console sales and Xbox Live revenue.
The above declines were partially offset by increased server and server application revenue, reflecting recognition of deferred revenue from previously signed agreements and continued adoption of the Windows Server Platform and applications through SQL Server, Enterprise CAL Suites, and System Center products.
Operating income decreased primarily reflecting decreased revenue. Operating expenses were flat with decreased general and administrative and sales and marketing expenses offset by increased headcount-related expenses, cost of revenue, and employee severance charges.
- General and administrative expenses decreased $1.4 billion or 28%, primarily due to decreased costs for legal settlements and contingencies. We incurred $283 million of legal charges during the twelve months ended June 30, 2009 as compared to $1.8 billion during the twelve months ended June 30, 2008. The prior year costs were primarily related to the European Commission fine of $1.4 billion (€899 million).
- Sales and marketing expenses decreased $381 million or 3%, primarily driven by the resource management program. As part of that program, we reduced marketing and advertising expenses.
- Headcount-related expenses, excluding $330 million of employee severance charges, increased 7%, driven by a 2% increase in headcount during the past 12 months and an increase in salaries and benefits for existing headcount.
- Cost of revenue increased $557 million or 5%, primarily reflecting increased online costs, including online traffic acquisition, data center and equipment, and headcount-related costs, partially offset by decreased Xbox 360 platform costs.
In January 2009, we announced and implemented a resource management program to reduce discretionary operating expenses, employee headcount, and capital expenditures. As part of this program, we announced the elimination of up to 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010. During the twelve months ended June 30, 2009, we recorded employee severance charges of $330 million for the expected reduction in employee headcount.
Diluted earnings per share declined primarily reflecting decreased net income, partially offset by share repurchases during the past 12 months. We repurchased 318 million shares during the twelve months ended June 30, 2009.
Fiscal year 2008 compared with fiscal year 2007
Revenue growth was driven primarily by increased licensing of the 2007 Microsoft Office system, increased Xbox 360 platform sales, increased revenue associated with Windows Server and SQL Server, and increased licensing of Windows Vista. Foreign currency exchange rates accounted for a $1.6 billion or three percentage point increase in revenue during fiscal year 2008.
Operating income increased primarily reflecting increased revenue, partially offset by increased headcount-related expenses, increased costs for legal settlements and legal contingencies, and increased cost of revenue. Headcount-related expenses increased 12%, reflecting an increase in headcount during fiscal year 2008. We incurred $1.8 billion of legal charges during fiscal year 2008 primarily related to the European Commission fine of $1.4 billion (€899 million) as compared with $511 million of legal charges during fiscal year 2007. Cost of revenue increased $905 million or 8%, reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 costs. The decreased Xbox 360 costs reflect the $1.1 billion charge in fiscal year 2007 related to the expansion of our Xbox 360 warranty, partially offset by increased Xbox 360 product costs reflecting growth in unit console sales.
The diluted earnings per share growth was impacted by the $1.1 billion Xbox 360 charge in fiscal year 2007 and share repurchases during fiscal year 2008.
Fiscal Year 2010 Outlook
Global macroeconomic factors have a strong correlation to demand for our software, services, hardware, and online offerings. While we see the potential for improvement in calendar year 2010, we are unable to predict the actual timing. In the meantime, we are positive about our relative market position and our product delivery plans. In addition, we remain focused on executing in the areas we can control by continuing to provide high value products at the lowest total cost of ownership while managing our expenses.
SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)
The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the United States (“U.S. GAAP”) and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 22 – Segment Information and Geographic Data of the Notes to Financial Statements is presented on a basis consistent with our current internal management reporting, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures about Segments of an Enterprise and Related Information. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. Prior period amounts have been recast to conform to the way we internally managed and monitored performance at the segment level during the current period.
Client
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Revenue | $14,712 | $16,865 | $14,911 | (13%) | 13% |
| Operating income | $10,856 | $13,105 | $11,424 | (17%) | 15% |
Client offerings consist of premium and standard edition Windows operating systems. Premium editions are those that include additional functionality and are sold at a price above our standard editions. Premium editions include Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, Windows Vista Enterprise, Windows XP Professional, Windows XP Media Center, and Windows XP Tablet PC. Standard editions include Windows Vista Home Basic and Windows XP Home. Client revenue growth is directly impacted by growth of PC purchases from original equipment manufacturers (“OEMs”) that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. The differences between unit growth rates and revenue growth rates from year to year are affected primarily by changes in the mix of OEM Windows premium edition operating systems licensed as a percentage of total OEM Windows operating systems licensed (“OEM premium mix”). Additional differences in growth rates result from the impact from lower cost netbook PCs, which are sold with a lower cost version of Windows, changes in geographic mix, and changes in the channel mix of products sold by large, multinational OEMs versus those sold by local and regional system builders.
Fiscal year 2009 compared with fiscal year 2008
Client revenue decreased primarily as a result of PC market weakness, especially PCs sold to businesses. OEM revenue decreased $2.3 billion or 16% while OEM license units declined 2%. The decline in OEM revenue reflects a 10 percentage point decline in the OEM premium mix to 64%. Based on our estimates, total worldwide PC shipments from all sources experienced a decline of approximately 1% to growth of approximately 2%, driven by changes in demand in emerging and developed markets.
Client operating income decreased primarily reflecting decreased revenue and increased sales and marketing expenses. Sales and marketing expenses increased $122 million or 7%, primarily reflecting increased advertising and marketing.
Fiscal year 2008 compared with fiscal year 2007
Client revenue increased reflecting growth in licensing of Windows Vista. By the end of fiscal year 2008, more than 180 million Windows Vista licenses had been sold (approximately 130 million were sold during fiscal year 2008) and millions of enterprise seats had been deployed. OEM revenue increased $1.8 billion or 14%, driven by 16% growth in OEM license units. Revenue from commercial and retail licensing of Windows operating systems increased $202 million or 9%, primarily from Enterprise Agreements and anti-piracy efforts in emerging markets. During fiscal year 2008, the OEM premium mix increased seven percentage points to 74%, reflecting strong demand for Windows Vista Home Premium. We estimate total worldwide PC shipments from all sources grew approximately 12% to 14%, driven by demand in both emerging and mature markets.
Client operating income increased reflecting increased revenue, partially offset by increased sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $106 million or 7%, primarily reflecting increased expenses associated with our corporate sales force. Cost of revenue increased $116 million or 14%, primarily driven by Windows Vista product costs.
Other
The segment information discussed above is presented the way we internally managed and monitored performance at the business group level in fiscal years 2009, 2008, and 2007. Effective July 1, 2009, we reorganized the Windows Live operations from Online Services Business to Client to better align our strategies and focus in those areas.
Server and Tools
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Revenue | $14,126 | $13,102 | $11,104 | 8% | 18% |
| Operating income | $ ,5,327 | $$4,539 | $$3,571 | 17% | 27% |
Server and Tools licenses products, applications, tools, content, and services that are designed to make information technology professionals and developers more productive and efficient. Server and Tools offerings consist of server software licenses and client access licenses (“CAL”) for Windows Server, Microsoft SQL Server, and other server products. We also offer developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft Consulting Services. Server products can be run on-site, in a partner-hosted environment, or in a Microsoft-hosted environment. We use multiple channels for licensing, including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. We sell licenses both as one-time licenses and as multi-year volume licenses.
Fiscal year 2009 compared with fiscal year 2008
Server and Tools revenue increased reflecting growth in both product and services revenue. Server and server application revenue (including CAL) and developer tools revenue increased $809 million or 8%, primarily driven by growth in SQL Server, Enterprise CAL Suites, and System Center revenue. This growth reflects recognition of deferred revenue from previously signed agreements and continued adoption of the Windows Server Platform and applications. Consulting and Premier product support services revenue increased $215 million or 8%, primarily due to revenue from annuity support agreements. Foreign currency exchange rates accounted for a $140 million or one percentage point increase in revenue.
Server and Tools operating income increased primarily due to growth in product revenue, partially offset by increased research and development expenses and cost of revenue. Research and development expenses increased $168 million or 9%, primarily driven by increased headcount-related expenses. Cost of revenue increased $84 million or 3%, reflecting the growth in support, online, and consulting services.
Fiscal year 2008 compared with fiscal year 2007
Server and Tools revenue increased reflecting growth in product and services revenue and included a favorable impact from foreign currency exchange rates of $464 million or four percentage points. Server and server application revenue (including CAL revenue) and developer tools revenue increased $1.4 billion or 16%, primarily driven by growth in volume licensing of Windows Server and SQL Server products. This growth reflects broad adoption of the Windows Platform and applications with the releases of Windows Server 2008 and Visual Studio 2008 during fiscal year 2008. Consulting and Premier product support services revenue increased $593 million or 29%, primarily due to higher demand for consulting and support services by corporate enterprises.
Server and Tools operating income increased primarily due to growth in product revenue, partially offset by increased sales and marketing expenses, cost of revenue, and research and development expenses. Sales and marketing expenses increased $458 million or 13%, due to higher expenses associated with our corporate sales force. Cost of revenue increased $404 million or 19%, reflecting the growth in Consulting and Premier product support services. Research and development expenses increased $177 million or 10%, primarily driven by increased headcount-related expenses. Headcount-related expenses increased 6%, driven by an increase in headcount from the prior year-end.
Online Services Business
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Revenue | $(3,088) | $(3,214) | $,2,434) | (4)% | 32% |
| Operating loss | $(2,253) | $(1,222) | $),(604) | (84)% | (102)% |
Online Services Business (“OSB”) consists of an online advertising platform with offerings for both publishers and advertisers, personal communications services, such as email and instant messaging, online information offerings, such as Bing, and the MSN portals and channels around the world. We earn revenue primarily from online advertising, including search, display, email, messaging services, and advertiser and publisher tools. Revenue is also generated through subscriptions and transactions generated from online paid services digital marketing and advertising agency services, and from MSN narrowband Internet access subscribers (“Access”). During the first quarter of fiscal year 2008, we completed our acquisition of aQuantive, Inc. (“aQuantive”), a digital marketing business. aQuantive was consolidated into our results of operations starting August 10, 2007, the acquisition date.
Fiscal year 2009 compared with fiscal year 2008
OSB revenue decreased primarily as a result of decreased online advertising and access revenue. Online advertising revenue decreased $73 million or 3%, to $2.3 billion, reflecting a decrease in display advertising, partially offset by an increase in search advertising. Access revenue decreased $72 million or 28%, reflecting continued migration of subscribers to broadband or other competitively-priced service providers. Foreign currency exchange rates accounted for a $28 million or one percentage point decrease in revenue.
OSB operating loss increased due to increased cost of revenue and research and development expenses, and decreased revenue. Cost of revenue increased $692 million or 36%, primarily driven by increased online traffic acquisition, data center and equipment, and headcount-related costs. Research and development expenses increased $149 million or 13%, primarily due to increased headcount-related expenses.
Fiscal year 2008 compared with fiscal year 2007
OSB revenue increased driven by increased online advertising revenue and the inclusion of aQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased $550 million or 31%, to $2.3 billion. This increase reflects growth in our existing online advertising business and includes aQuantive online advertising revenue of $161 million. Agency revenue, which is solely derived from aQuantive, was $345 million during fiscal year 2008. Access revenue decreased $98 million or 28%, to $256 million, reflecting migration of subscribers to broadband or other competitively-priced service providers.
OSB operating loss increased driven by increased cost of revenue and other operating expenses, partially offset by increased revenue. Cost of revenue increased $796 million or 71%, primarily driven by increased data center and equipment costs, online content expenses, and aQuantive-related expenses. Sales and marketing expenses increased $311 million or 37%, primarily due to increased amortization of customer-related intangible assets of $94 million, increased headcount-related expenses, and increased marketing costs. Research and development expenses increased $177 million or 17%, and general and administrative expenses increased $114 million or 178%, primarily reflecting increased headcount-related expenses and merger and acquisition-related expenses. Headcount-related expenses increased 24%, driven by an increase in headcount from the prior year-end.
Other
The segment information discussed above is presented the way we internally managed and monitored performance at the business group level in fiscal years 2009, 2008, and 2007. Effective July 1, 2009, we reorganized the Windows Live operations from OSB to Client to better align our strategies and focus in those areas.
On July 29, 2009, we announced that we entered into a 10-year agreement with Yahoo! Inc. (“Yahoo”). Under terms of the agreement, Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo websites. We believe this agreement will allow us over time to improve the effectiveness and increase the value of our search offering through greater scale in search queries and an expanded and more competitive search and advertising marketplace. The transaction is subject to regulatory review. Both parties anticipate entering into more detailed definitive agreements prior to closing the transaction which is expected in calendar year 2010. See Note 24 – Subsequent Event of the Notes to Financial Statements.
Microsoft Business Division
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Revenue | $18,894 | $18,929 | $16,476 | –% | 15% |
| Operating income | $12,141 | $12,369 | $10,838 | (2)% | 14% |
Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office system offerings, which generate over 90% of MBD revenue, depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as content management, enterprise search, collaboration, unified communications, and business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. We evaluate our results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue.
Fiscal year 2009 compared with fiscal year 2008
MBD revenue was flat reflecting decreased consumer revenue offset by increased business revenue, and included a favorable impact from foreign currency exchange rates of $378 million or two percentage points. Consumer revenue decreased $525 million or 14%, primarily as a result of PC market weakness, a shift to lower-priced products, and pricing promotions on the 2007 Microsoft Office system. Business revenue increased $490 million or 3%, primarily reflecting growth in volume licensing agreement revenue and included a 7% decrease in Microsoft Dynamics customer billings. The growth in volume licensing agreement revenue primarily reflects recognition of deferred revenue from previously signed agreements.
MBD operating income decreased reflecting increased cost of revenue and research and development expenses, partially offset by decreased sales and marketing expenses. Cost of revenue increased $135 million or 14% primarily driven by expenses associated with Fast Search & Transfer ASA (“FAST”) which we acquired in April 2008, as well as online services infrastructure costs. Research and development expenses increased $119 million or 8%, primarily driven by an increase in headcount-related expenses associated with FAST. Sales and marketing expenses decreased $90 million or 2%, primarily driven by a decrease in corporate marketing activities and headcount-related costs associated with our corporate sales force.
Fiscal year 2008 compared with fiscal year 2007
MBD revenue increased reflecting growth in licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of $724 million or four percentage points. Business revenue increased $2.6 billion or 21%, primarily as a result of growth in volume licensing agreement revenue and strong transactional license sales to businesses. The increase in business revenue also included a 21% increase in Microsoft Dynamics customer billings. Consumer revenue decreased $131 million or 3%, reflecting the consumer launch of the 2007 Microsoft Office system in fiscal year 2007.
MBD operating income increased reflecting growth in revenue, partially offset by increased sales and marketing expenses, research and development expenses, and cost of revenue. Sales and marketing expenses increased $446 million or 13%, reflecting increased expenses associated with our corporate sales force. Research and development expenses increased $229 million or 18%, primarily driven by an increase in headcount-related expenses and a $35 million in-process research and development expense related to the acquisition of FAST. Cost of revenue increased $214 million or 27%, primarily driven by an increase in online services infrastructure costs and product costs related to retail packaged product sales. Headcount-related expenses increased 10%, driven by an increase in headcount from the prior year-end.
Entertainment and Devices Division
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Revenue | $7,753 | $8,206 | $(6,139) | (6)% | 34% |
| Operating income (loss) | $ ,,169 | $(,497 | $(1,898) | (66)% | * |
* Not meaningful
Entertainment and Devices Division (“EDD”) offerings include the Xbox 360 platform (which includes the Microsoft Xbox 360 video game console system, Xbox 360 video games, Xbox Live, and Xbox 360 accessories), the Zune digital music and entertainment platform, PC software games, online games and services, Mediaroom (our Internet protocol television software), the Microsoft Surface computing platform, mobile and embedded device platforms, and other devices. EDD leads the development efforts for our line of consumer software and hardware products including application software for Apple’s Macintosh computers and Microsoft PC hardware products, and is responsible for all retail sales and marketing for Microsoft Office and Windows operating systems.
Fiscal year 2009 compared with fiscal year 2008
EDD revenue decreased across most lines of business. Revenue from our non-gaming business decreased $292 million or 12%, primarily reflecting decreased Zune and PC hardware product revenue. Xbox 360 platform and PC game revenue decreased $161 million or 3%, primarily as a result of decreased revenue per Xbox 360 console due to price reductions during the past 12 months, partially offset by increased Xbox 360 console sales and increased Xbox Live revenue. We shipped 11.2 million Xbox 360 consoles during fiscal year 2009, compared with 8.7 million Xbox 360 consoles during fiscal year 2008. Foreign currency exchange rates accounted for a $74 million or one percentage point decrease in revenue.
EDD operating income decreased primarily due to decreased revenue and increased research and development expenses, partially offset by decreased cost of revenue. Research and development expenses increased $252 million or 16%, primarily reflecting increased headcount-related expenses associated with the Windows Mobile device platform, driven by recent acquisitions. Cost of revenue decreased $326 million or 7%, primarily due to decreased Xbox 360 platform costs.
Fiscal year 2008 compared with fiscal year 2007
EDD revenue increased primarily due to increased Xbox 360 platform sales. Xbox 360 platform and PC game revenue increased $1.7 billion or 41% as a result of increased Xbox 360 console sales, video game sales led by Halo 3, Xbox Live revenue, and Xbox 360 accessory sales. We shipped 8.7 million Xbox 360 consoles during fiscal year 2008, compared with 6.6 million Xbox 360 consoles during fiscal year 2007.
EDD operating income increased primarily due to increased revenue and decreased cost of revenue, partially offset by increased research and development expenses and sales and marketing expenses. Cost of revenue decreased $684 million or 13%, reflecting the impact of the $1.1 billion Xbox 360 charge in fiscal year 2007 (which primarily related to the warranty expansion), partially offset by increased Xbox 360 product costs related to increased unit console sales. Research and development expenses increased $242 million or 18%, primarily reflecting increased headcount-related expenses and costs related to the acquisition of Danger, including a $24 million in-process research and development expense. Sales and marketing expenses increased $89 million or 7%, primarily reflecting increased headcount-related expenses and increased bad debt expense. Headcount-related expenses increased 22%, driven by an increase in headcount from the prior year-end.
Corporate-Level Activity
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Corporate-level activity | $(5,877) | $(7,017) | $(4,893) | 16% | (43)% |
Certain corporate-level activity is not allocated to our segments. Those results include expenses such as broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, legal settlements and contingencies, and employee severance.
Fiscal year 2009 compared with fiscal year 2008
Corporate-level expenses decreased during the twelve months ended June 30, 2009, primarily reflecting decreased general and administrative and sales and marketing expenses, partially offset by employee severance charges of $330 million. General and administrative expenses decreased $1.4 billion or 28%, primarily due to decreased costs for legal settlements and contingencies. We incurred $283 million of legal charges during the twelve months ended June 30, 2009 as compared to $1.8 billion during the twelve months ended June 30, 2008. The prior year costs were primarily related to the European Commission fine of $1.4 billion (€899 million). Sales and marketing expenses decreased $412 million or 30%, reflecting the resource management program implemented in January 2009.
Fiscal year 2008 compared with fiscal year 2007
Corporate-level expenses increased, reflecting increased costs for legal settlements and legal contingencies and a 13% increase in headcount-related expenses. We incurred $1.8 billion of legal charges during fiscal year 2008 primarily related to the European Commission fine of $1.4 billion (€899 million) as compared with $511 million of legal charges during fiscal year 2007. The increase in headcount-related expenses reflects an increase in headcount from the prior year-end.
OPERATING EXPENSES
Cost of Revenue
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Cost of revenue | $12,155 | $11,598 | $10,693 | 5% | 8% |
| As a percent of revenue | 21% | 19% | 21% | 2ppt | (2)ppt |
Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs related to product support service centers and product distribution centers, costs incurred to drive traffic to our website and/or acquire online advertising space (“traffic acquisition costs”), costs incurred to support and maintain Internet-based products and services, warranty costs, inventory valuation adjustments, costs associated with the delivery of consulting services, and the amortization of capitalized research and development costs associated with software products that have reached technological feasibility.
Fiscal year 2009 compared with fiscal year 2008
Cost of revenue increased during the twelve months ended June 30, 2009, primarily reflecting increased online costs, including traffic acquisition, data center and equipment, and headcount costs, partially offset by decreased Xbox 360 platform costs.
Fiscal year 2008 compared with fiscal year 2007
Cost of revenue increased reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 costs. Xbox 360 costs decreased because of the $1.1 billion charge in fiscal year 2007 (which primarily related to the expansion of our Xbox 360 warranty coverage), partially offset by increased Xbox 360 product costs, reflecting growth in unit console sales.
Research and Development
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Research and development | $9,010 | $8,164 | $7,121 | 10% | 15% |
| As a percent of revenue | 15% | 14% | 14% | 1ppt | –ppt |
Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, the amortization of purchased software code and services content, and in-process research and development.
Fiscal year 2009 compared with fiscal year 2008
Research and development expenses increased during the twelve months ended June 30, 2009, primarily reflecting a 13% increase in headcount-related costs.
Fiscal year 2008 compared with fiscal year 2007
Research and development expenses increased reflecting increased headcount-related expenses, increased product development costs, and in-process research and development expenses related to acquisitions during fiscal year 2008. Headcount-related expenses increased 12%, reflecting an increase in headcount from the prior year-end.
Sales and Marketing
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Sales and marketing | $12,879 | $13,260 | $11,541 | (3)% | 15% |
| As a percent of revenue | 22% | 22% | 23% | –ppt | (1)ppt |
Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs.
Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For the twelve months ended June 30, 2009, $509 million of losses were reported as other income (expense). For the twelve months ended June 30, 2008 and 2007, $221 million and $86 million of gains, respectively, were previously recorded as a component of sales and marketing expense and have been recast as other income (expense).
Fiscal year 2009 compared with fiscal year 2008
Sales and marketing expenses decreased, primarily driven by the resource management program implemented in January 2009.
Fiscal year 2008 compared with fiscal year 2007
Sales and marketing expenses increased, primarily reflecting increased headcount-related expenses and increased corporate marketing and advertising campaigns. Headcount-related expenses increased 14%, driven by an increase in headcount from the prior year-end.
General and Administrative
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| General and administrative | $3,700 | $5,127 | $3,329 | (28)% | 54% |
| As a percent of revenue | 6% | 8% | 7% | (2)ppt | 1ppt |
General and administrative costs include payroll, employee benefits, stock-based compensation expense and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative headcount, and legal and other administrative fees.
Fiscal year 2009 compared with fiscal year 2008
General and administrative expenses decreased primarily reflecting decreased costs for legal settlements and legal contingencies. We incurred legal charges of $283 million in current year, as compared with $1.8 billion during fiscal year 2008. The fiscal year 2008 legal costs were primarily related to the European Commission fine of $1.4 billion (€899 million).
Fiscal year 2008 compared with fiscal year 2007
General and administrative expenses increased reflecting increased costs for legal settlements and legal contingencies, increased consulting and professional fees, and increased headcount-related expenses. We incurred $1.8 billion of legal charges during fiscal year 2008, primarily related to the European Commission fine, as compared with $511 million of legal charges during fiscal year 2007. Headcount-related expenses increased 7%, reflecting an increase in headcount from the prior year-end.
Employee Severance
In January 2009, we announced and implemented a resource management program to reduce discretionary operating expenses, employee headcount, and capital expenditures. As part of this program, we announced the elimination of up to 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010. During the current year, we recorded employee severance charges of $330 million for the expected reduction in employee headcount.
Other Income (Expense)
The components of other income (expense) were as follows:
| (In millions, except percentages) | 2009 | 2008 | 2007 | Percentage Change 2009 Versus 2008 |
Percentage Change 2008 Versus 2007 |
|---|---|---|---|---|---|
| Dividends and interest | $(,706 | $((888 | $1,319 | ||
| Net recognized gains (losses) on investments | (125) | 346 | 650 | ||
| Net gains (losses) on derivatives | (558) | 226 | (358) | ||
| Net gains (losses) on foreign currency remeasurements | (509) | 226 | 56 | ||
| Other | (56) | (143) | (4) | ||
| Total | $(542) | $1,543 | $1,663 | (135)% | (7)% |
Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For the twelve months ended June 30, 2009, $509 million of losses were reported as other income (expense). For the twelve months ended June 30, 2008 and 2007, $221 million and $86 million of gains, respectively, were previously recorded as a component of sales and marketing expense and have been recast as other income (expense).
Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments, including market declines subsequent to the period end. If the cost of an investment exceeds its fair value, among other factors, we evaluate general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established.
We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability.
We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are recognized in other income (expense). These are generally offset by unrealized gains and losses in the underlying securities in the investment portfolio and are recorded as a component of other comprehensive income.
Fiscal year 2009 compared with fiscal year 2008
Dividends and interest income decreased primarily reflecting lower interest rates on our fixed-income investments. Net recognized losses on investments increased primarily due to higher other-than-temporary impairments that were partially offset by gains on sales of certain equity investments held in our strategic investments portfolio. Other-than-temporary impairments were $862 million during the twelve months ended June 30, 2009, as compared with $312 million during the twelve months ended June 30, 2008 and increased primarily due to declines in equity values as a result of deterioration in equity markets. Net losses on derivatives increased primarily due to losses on equity, commodity, and interest rate derivatives in the current period as compared with gains in the prior period. Net losses on foreign currency remeasurements increased due to the strengthening of the U.S. dollar, particularly in the first half of the current fiscal year.
Fiscal year 2008 compared with fiscal year 2007
Dividends and interest income decreased reflecting lower interest rates on our fixed-income investments and a reduction in the average balance of interest-bearing investments owned. Net recognized gains on investments, which include other-than-temporary impairments of $312 million during fiscal year 2008 and $25 million during fiscal year 2007, decreased primarily due to declines in equity values as a result of the recent stock market decline. Net gains on derivatives increased primarily due to higher net gains on equity, commodity, and interest rate derivatives.
Income Taxes
Fiscal year 2009 compared with fiscal year 2008
Our effective tax rates in fiscal years 2009 and 2008 were 27% and 26%, respectively. While the fiscal year 2009 rate reflects a higher mix of foreign earnings taxed at lower rates, the rate increased from the prior year because the fiscal year 2008 rate reflects the resolution of tax positions relating to our agreement with the Internal Revenue Service (“IRS”) settling the 2000-2003 examination, partially offset by the European Commission fine which was not tax deductible. As a result of the settlement and the impact on subsequent years, we paid the IRS approximately $4.1 billion during fiscal year 2009.
Fiscal year 2008 compared with fiscal year 2007
Our effective tax rates in fiscal year 2008 and 2007 were 26% and 30%, respectively. The fiscal year 2008 rate was lower due to the items noted above.
FINANCIAL CONDITION
Cash, cash equivalents, and short-term investments totaled $31.4 billion as of June 30, 2009, compared with $23.7 billion as of June 30, 2008. Equity and other investments were $4.9 billion as of June 30, 2009, compared with $6.6 billion as of June 30, 2008. Our investments consist primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar-denominated securities, but also includes foreign-denominated securities in order to diversify risk. We invest primarily in short-term securities to facilitate liquidity and for capital preservation. As a result of the special dividend paid in the second quarter of fiscal year 2005 and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $22.8 billion at June 30, 2009. Our retained deficit is not expected to affect our future ability to operate, pay dividends, or repay our debt given our continuing profitability and strong cash and financial position.
In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, U.S. treasuries, and agency securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and certain agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio.
A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. Such controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.
While we own certain mortgage- and asset-backed fixed-income securities, our portfolio as of June 30, 2009 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of the mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association.
Debt
Short-term Debt
In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Pursuant to the authorization, we established a commercial paper program providing for the issuance and sale of up to $2.0 billion in short-term commercial paper. As of June 30, 2009, $2.0 billion of the commercial paper was issued and outstanding with a weighted average interest rate, including issuance costs, of 0.20% and maturities of 22 to 119 days.
In September 2008, we also entered into a $2.0 billion six-month senior unsecured credit facility, principally to support the commercial paper program. In November 2008, we replaced the six-month credit facility with a $2.0 billion 364-day credit facility. This credit facility expires on November 6, 2009. In March 2009, we entered into an additional credit facility. This $1.0 billion 364-day credit facility expires on March 12, 2010. As of June 30, 2009, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against these credit facilities during the year ended June 30, 2009.
Long-term Debt
In November 2008, we filed a shelf registration statement with the U.S. Securities and Exchange Commission that allows us to issue debt securities from time to time pursuant to the September 2008 authorization for debt financings of up to $6.0 billion. In May 2009, we issued $3.75 billion of debt securities under that registration statement as follows: $2.0 billion aggregate principal amount of 2.95% notes due 2014, $1.0 billion aggregate principal amount of 4.20% notes due 2019, and $750 million aggregate principal amount of 5.20% notes due 2039 (collectively “the Notes”). Interest on the Notes will be payable semi-annually on June 1 and December 1 of each year, commencing on December 1, 2009, to holders of record on the preceding May 15 and November 15. The Notes are senior unsecured obligations and will rank equally with our other unsecured and unsubordinated debt outstanding.
We intend to use the net proceeds from sales of the debt securities for general corporate purposes, which may include funding for working capital, capital expenditures, repurchases of our capital stock, and acquisitions.
Unearned Revenue
Unearned revenue is comprised of the following items:
Volume Licensing Programs
Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period.
Undelivered Elements
Represents the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis and free post-delivery telephone support. This revenue deferral is applicable for Windows XP and prior versions shipped as retail packaged products, products licensed to OEMs, and perpetual licenses for current products under our Open and Select volume licensing programs. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. Product life cycles are currently estimated at three and one-half years for Windows operating systems. Undelivered elements include $276 million of deferred revenue related to the Windows 7 Upgrade Option program. The program, which started June 26, 2009, allows customers who purchase PCs from participating computer makers or retailers with certain versions of Windows Vista to receive an upgrade to the corresponding version of Windows 7 at minimal or no cost. In addition, purchasers of retail packaged Windows Vista may also qualify for a free or discounted upgrade to the equivalent Windows 7 product with participating retailers in participating markets when the product becomes generally available.
Other
Represents payments for post-delivery support and consulting services to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Dynamics business solutions products, Xbox Live subscriptions, Mediaroom, and other offerings for which we have been paid upfront and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria.
The following table outlines the expected recognition of unearned revenue as of June 30, 2009:
| (In millions) | Recognition of Unearned Revenue |
|---|---|
| Three months ended: | |
| September 30, 2009 | $,,4,740 |
| December 31, 2009 | 4,120 |
| March 31, 2010 | 2,743 |
| June 30, 2010 | 1,400 |
| Thereafter | 1,281 |
| Total | $14,284 |
Cash Flows
Fiscal year 2009 compared with fiscal year 2008
Cash flow from operations decreased $2.6 billion due to payment of approximately $4.1 billion to the IRS in connection with our settlement of the 2000-2003 audit examination. This impact was partially offset by the fiscal year 2008 payment of the $1.4 billion (€899 million) European Commission fine. Cash used for financing decreased $5.5 billion primarily due to $5.7 billion of net cash proceeds from issuance of short-term and long-term debt in fiscal year 2009. Financing activities also included a $3.2 billion decrease in common stock repurchased, which was offset by a $2.9 billion decline in common stock issued. Cash used for investing increased $11.2 billion due to a $15.9 billion rise in purchases of investments along with a $1.7 billion decrease in cash from investment sales and maturities. These impacts were partially offset by a $7.2 billion decrease in cash paid for acquisition of companies, including the purchase of aQuantive in fiscal year 2008.
Fiscal year 2008 compared with fiscal year 2007
Cash flow from operations increased $3.8 billion due to an increase in cash received from customers driven by 18% revenue growth, partially offset by the $1.4 billion (€899 million) payment of the European Commission fine. Cash used for financing decreased $11.6 billion primarily due to a $15.0 billion decrease in common stock repurchases, partially offset by a $3.3 billion decrease in cash proceeds from the issuance of common stock. Cash used for investing was $4.6 billion for fiscal year 2008 as compared with cash provided of $6.1 billion for fiscal year 2007. This decrease was primarily due to a $6.9 billion increase in cash paid for acquisition of companies, reflecting the purchase of aQuantive in the first quarter of fiscal year 2008, a $918 million increase in purchases of property and equipment, and a $3.1 billion decrease in cash from combined investment purchases, sales, and maturities.
Stockholders’ equity at June 30, 2009, was $39.6 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $621 million on June 30, 2009. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling $475 million, $398 million, and $325 million, in fiscal years 2009, 2008, and 2007, respectively. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources.
Share Repurchases
On September 22, 2008, we announced the completion of the two repurchase programs approved by our Board of Directors during the first quarter of fiscal year 2007 to buy back up to $40.0 billion of Microsoft common stock. On September 22, 2008, we also announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. We repurchased 318 million shares for $8.2 billion during the fiscal year ended June 30, 2009; 101 million shares were repurchased for $2.7 billion under the repurchase program approved by our Board of Directors during the first quarter of fiscal year 2007 and 217 million shares were repurchased for $5.5 billion under the repurchase program approved by our Board of Directors during the first quarter of fiscal year 2009. As of June 30, 2009, approximately $34.5 billion remained of the $40.0 billion approved repurchase amount. All repurchases were made using cash resources. The repurchase program may be suspended or discontinued at any time without notice.
Dividends
During fiscal years 2009 and 2008, our Board of Directors declared the following dividends:
| Declaration Date | Per Share Dividend | Record Date | Total Amount | Payment Date |
|---|---|---|---|---|
| (in millions) | ||||
| (Fiscal year 2009) | ||||
| September 19, 2008 | $0.13 | November 20, 2008 | $1,157 | December 11, 2008 |
| December 10, 2008 | $0.13 | February 19, 2009 | $1,155 | March 12, 2009 |
| March 9, 2009 | $0.13 | May 21, 2009 | $1,158 | June 18, 2009 |
| June 10, 2009 | $0.13 | August 20, 2009 | $1,158 | September 10, 2009 |
| (Fiscal year 2008) | ||||
| September 12, 2007 | $0.11 | November 15, 2007 | $1,034 | December 13, 2007 |
| December 19, 2007 | $0.11 | February 21, 2008 | $1,023 | March 13, 2008 |
| March 17, 2008 | $0.11 | May 15, 2008 | $1,020 | June 12, 2008 |
| June 11, 2008 | $0.11 | August 21, 2008 | $,)998 | September 11, 2008 |
We believe existing cash, cash equivalents, and short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements, regular quarterly dividends, debt repayment schedules, and share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and cash equivalents, short-term investments, and equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs.
Off-Balance Sheet Arrangements
We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. We evaluate estimated losses for these indemnifications under SFAS No. 5, Accounting for Contingencies, as interpreted by Financial Accounting Standards Board Interpretation (“FIN”) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others. We consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements.
Contractual Obligations
The following table summarizes our outstanding contractual obligations as of June 30, 2009. We expect to fund these commitments with existing cash and cash equivalents, short-term investments and cash flows from operations.
| (In millions) | |||||
|---|---|---|---|---|---|
| Payments Due by Period | |||||
| Fiscal Years | 2010 | 2011-2013 | 2014-2016 | 2017 and Thereafter |
Total |
| Long-term debt:(a) | |||||
| Principal payments | $((,((– | $((,((– | $2,000 | $1,750 | $(3,750 |
| Interest payments | 145 | 420 | 302 | 1,023 | 1,890 |
| Construction commitments(b) | 621 | – | – | – | 621 |
| Lease obligations: | |||||
| Capital leases | 3 | 9 | 1 | – | 13 |
| Operating leases(c) | 457 | 931 | 520 | 477 | 2,385 |
| Purchase commitments(d) | 3,289 | 382 | 1 | – | 3,672 |
| Other long-term liabilities(e) | – | 110 | 4 | 2 | 116 |
| Total contractual obligations | $4,515 | $1,852 | $2,828 | $3,252 | $12,447 |
(a) See Note 12 – Debt of the Notes to Financial Statements.
(b) These amounts represent commitments for the construction of buildings.
(c) These amounts represent undiscounted future minimum rental commitments under noncancellable leases.
(d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as construction commitments above.
(e) We have excluded long-term tax contingencies and other tax liabilities of $5.5 billion and other long-term contingent liabilities of $407 million (related to the antitrust and unfair competition class action lawsuits) from the amounts presented, as the amounts that will be settled in cash are not known and the timing of any payments is uncertain. We have also excluded unearned revenue of $1.3 billion and non-cash items of $226 million.
RECENTLY ISSUED ACCOUNTING STANDARDS
Recently Adopted Accounting Pronouncements
On April 1, 2009, we adopted the Financial Accounting Standards Board (“FASB”) Staff Positions (“FSP”) FAS 157-4, FSP FAS 115-2 and FAS 124-2, and FSP FAS 107-1 and APB 28-1. These FSPs are intended to provide additional application guidance and enhance disclosures about fair value measurements and impairments of securities. FSP FAS 157-4 clarifies the objective and method of fair value measurement even when there has been a significant decrease in market activity for the asset being measured. FSP FAS 115-2 and FAS 124-2 establishes a new model for measuring other-than-temporary impairments for debt securities, including establishing criteria for when to recognize a write-down through earnings versus other comprehensive income. FSP FAS 107-1 and APB 28-1 expands the fair value disclosures required for all financial instruments within the scope of SFAS No. 107, Disclosures about Fair Value of Financial Instruments, to interim periods. Adoption of these FSPs did not have a significant impact on our accounting for financial instruments but did expand our associated disclosures.
On January 1, 2009, we adopted SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133. SFAS No. 161 requires additional disclosures about the Company’s objectives in using derivative instruments and hedging activities, the method of accounting for such instruments under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and its related interpretations, and tabular disclosures of the effects of such instruments and related hedged items on our financial position, financial performance, and cash flows. See Note 5 – Derivatives of the Notes to Financial Statements.
On July 1, 2008, we adopted SFAS No. 157, Fair Value Measurements, for all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. See Note 4 – Investments of the Notes to Financial Statements.
SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115, became effective for us on July 1, 2008. SFAS No. 159 gives us the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis with the difference between the carrying value before election of the fair value option and the fair value recorded upon election as an adjustment to beginning retained deficit. As of June 30, 2009, we had not elected the fair value option for any eligible financial asset or liability.
Recent Accounting Pronouncements Not Yet Adopted
In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R), which is effective for us beginning July 1, 2010. This Statement amends FIN 46(R), Consolidation of Variable Interest Entities an interpretation of ARB No. 51, to require revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over such entities, and additional disclosures for variable interests. We believe the adoption of this pronouncement will not have a material impact on our financial statements.
In February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS No. 157 for us to July 1, 2009, for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). We believe the adoption of the delayed items of SFAS No. 157 will not have a material impact on our financial statements.
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations, which replaces SFAS No. 141. The statement retains the fundamental requirements in SFAS No. 141 that the acquisition method of accounting (previously referred to as the purchase method of accounting) be used for all business combinations, but requires a number of changes, including changes in the way assets and liabilities are recognized as a result of business combinations. It also requires the capitalization of in-process research and development at fair value and requires the expensing of acquisition-related costs as incurred. In April 2009, the FASB issued FSP FAS 141(R)-1 which amends SFAS No. 141(R) by establishing a model to account for certain pre-acquisition contingencies. Under the FSP, an acquirer is required to recognize at fair value an asset acquired or a liability assumed in a business combination that arises from a contingency if the acquisition-date fair value of that asset or liability can be determined during the measurement period. If the acquisition-date fair value cannot be determined, then the acquirer should follow the recognition criteria in SFAS No. 5, Accounting for Contingencies, and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss – an interpretation of FASB Statement No. 5. SFAS No. 141(R) and FSP FAS 141(R)-1 are effective for us beginning July 1, 2009, and will apply prospectively to business combinations completed on or after that date. The impact of the adoption of SFAS No. 141(R) and FSP FAS 141(R)-1 will depend on the nature of acquisitions completed after the date of adoption.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51, which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be included in net income and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in net income. SFAS No. 160 is effective for us beginning July 1, 2009, and will apply prospectively, except for the presentation and disclosure requirements, which will apply retrospectively. We believe the adoption of SFAS No. 160 will not have a material impact on our financial statements.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for contingencies, accounting for income taxes, accounting for stock-based compensation, and accounting for product warranties.
Revenue Recognition
We account for the licensing of software in accordance with American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, Software Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (“VSOE”) of fair value exists for those elements.
A portion of the revenue related to Windows XP is recorded as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of revenue allocated to undelivered elements is based on the VSOE of fair value for those elements using the residual method or relative fair value method. Unearned revenue due to undelivered elements is recognized ratably on a straight-line basis over the related products’ life cycles. Revenue related to Windows Vista is not subject to a similar deferral because there are no significant undelivered elements. However, Windows Vista revenue is subject to deferral as a result of the Windows 7 Upgrade Option program which started June 26, 2009. The program allows customers who purchase PCs from participating computer makers or retailers with certain versions of Windows Vista to receive an upgrade to the corresponding version of Windows 7 at minimal or no cost. In addition, purchasers of retail packaged Windows Vista may also qualify for a free or discounted upgrade to the equivalent Windows 7 product with participating retailers in participating markets when the product becomes generally available. Accordingly, estimated revenue related to the undelivered Windows 7 product is deferred until the product is delivered.
Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products.
Impairment of Investment Securities
SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, Staff Accounting Bulletin No. 111, and FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments, provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other than temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.
Goodwill
SFAS No. 142, Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach.
During the second quarter of fiscal year 2009, we changed the date of our annual impairment test from July 1 to May 1. The change was made to more closely align the impairment testing date with our long-range planning and forecasting process. We believe the change in accounting principle related to changing our annual impairment testing date did not delay, accelerate, or avoid an impairment charge. We have determined that this change in accounting principle is preferable under the circumstances and does not result in adjustments to our financial statements when applied retrospectively. During fiscal year 2009, the annual impairment test was performed as of July 1, 2008 and was performed again as of May 1, 2009.
Research and Development Costs
We account for research and development costs in accordance with applicable accounting pronouncements, including SFAS No. 2, Accounting for Research and Development Costs, and SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. SFAS No. 86 specifies that costs incurred internally in researching and developing a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products.
Legal and Other Contingencies
The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS No. 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our results of operations, financial position, or our cash flows.
Income Taxes
SFAS No. 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Accruals for uncertain tax positions are provided for in accordance with the requirements of FIN No. 48, Accounting for Uncertainty in Income Taxes – An interpretation of FASB Statement No. 109. Under FIN No. 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN No. 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations, or cash flows.
Stock-Based Compensation
We account for stock-based compensation in accordance with SFAS No. 123(R), Share-Based Payment. Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be impacted.
Product Warranties
We account for product warranties in accordance with SFAS No. 5, Accounting for Contingencies. We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, over the life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary.
Statement of Management’s Responsibility for Financial Statements
Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America.
The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits.
The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States).
The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee.
Steven A. Ballmer
Chief Executive Officer
Christopher P. Liddell
Senior Vice President, Finance and Administration; Chief Financial Officer
Frank H. Brod
Corporate Vice President, Finance and Administration; Chief Accounting Officer