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Microsoft 10-Q 2010 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
For the Quarterly Period Ended September 30, 2010 OR
For the Transition Period From to Commission File Number: 0-14278
MICROSOFT CORPORATION (Exact name of registrant as specified in its charter)
(425) 882-8080 (Registrant’s telephone number, including area code) None (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Table of Contents
FORM 10-Q For the Quarter Ended September 30, 2010 INDEX
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ITEM 1. FINANCIAL STATEMENTS INCOME STATEMENTS
See accompanying notes.
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BALANCE SHEETS
See accompanying notes.
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CASH FLOWS STATEMENTS
See accompanying notes.
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STOCKHOLDERS’ EQUITY STATEMENTS
See accompanying notes.
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(Unaudited) NOTE 1 ACCOUNTING POLICIES Basis of Presentation and Use of Estimates In the opinion of management, the accompanying balance sheets and related interim statements of income, cash flows, and stockholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include: estimates of loss contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or goodwill impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Microsoft Corporation 2010 Form 10-K filed on July 30, 2010 with the U.S. Securities and Exchange Commission. Principles of Consolidation The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we exercise significant influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method. Recently Adopted Accounting Guidance On July 1, 2010, we adopted guidance issued by the Financial Accounting Standards Board (“FASB”) on revenue recognition. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product are no longer within the scope of the software revenue recognition guidance, and software-enabled products are now subject to other relevant revenue recognition guidance. Additionally, the FASB issued guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. Adoption of the new guidance did not have a material impact on our financial statements. On July 1, 2010, we also adopted guidance issued by the FASB on the consolidation of variable interest entities. The new guidance requires revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over such entities, and additional disclosures for variable interests. Adoption of the new guidance did not have a material impact on our financial statements. Recent Accounting Guidance Not Yet Adopted In January 2010, the FASB issued guidance to amend the disclosure requirements related to fair value measurements. The guidance requires the disclosure of roll forward activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The guidance will become effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, the adoption of this new guidance will not have a material impact on our financial statements.
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NOTE 2 EARNINGS PER SHARE Basic earnings per share is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted earnings per share are as follows:
We excluded 104 million shares and 224 million shares underlying stock-based awards from the calculations of diluted earnings per share for the three months ended September 30, 2010 and 2009, respectively, because their inclusion would have been anti-dilutive. In June 2010, we issued $1.25 billion of zero-coupon debt securities that are convertible into shares of our common stock if certain conditions are met. Shares of common stock into which the debt could convert were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive. See also Note 10 – Debt. NOTE 3 OTHER INCOME The components of other income were as follows:
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NOTE 4 INVESTMENTS Investment Components The components of investments, including associated derivatives, were as follows:
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Unrealized Losses on Investments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows:
Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of September 30, 2010. At September 30, 2010 and June 30, 2010, the recorded bases and estimated fair values of common and preferred stock and other investments that are restricted for more than one year or are not publicly traded were $242 million and $216 million, respectively. Debt Investment Maturities
NOTE 5 DERIVATIVES 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. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. currency equivalents.
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Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of September 30, 2010 and June 30, 2010, the total notional amounts of these foreign exchange contracts sold were $13.7 billion and $9.3 billion, respectively. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments. As of September 30, 2010 and June 30, 2010, the total notional amounts of these foreign exchange contracts sold were $534 million and $523 million, respectively. Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of September 30, 2010, the total notional amounts of these foreign exchange contracts purchased and sold were $4.3 billion and $4.0 billion, respectively. As of June 30, 2010, the total notional amounts of these foreign exchange contracts purchased and sold were $7.8 billion and $5.3 billion, respectively. Equity Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of September 30, 2010, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.4 billion and $659 million, respectively. As of June 30, 2010, the total notional amounts of designated and non-designated equity contracts purchased and sold were $918 million and $472 million, respectively. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of September 30, 2010, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.8 billion and $2.0 billion, respectively. As of June 30, 2010, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.1 billion and $1.8 billion, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of September 30, 2010 and June 30, 2010, the total notional derivative amount of mortgage contracts purchased were $516 million and $305 million, respectively. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low cost method of managing exposure to individual credit risks or groups of credit risks. As of September 30, 2010 and June 30, 2010, the total notional amounts of credit contracts purchased and sold were immaterial. Commodity We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swap, futures and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the
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purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of September 30, 2010, the total notional amounts of commodity contracts purchased and sold were $1.2 billion and $458 million, respectively. As of June 30, 2010, the total notional amounts of commodity contracts purchased and sold were $1.1 billion and $376 million, respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of September 30, 2010, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral is required to be posted. Fair Values of Derivative Instruments Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain (loss) is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For options designated as fair-value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments designated as cash-flow hedges, the effective portion of the derivative’s gain (loss) is initially reported as a component of other comprehensive income (“OCI”) and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from OCI into other income (expense). Following are the gross fair values of derivative instruments held at September 30, 2010 and June 30, 2010, excluding the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk:
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See also Note 4 – Investments and Note 6 – Fair Value Measurements. Fair-Value Hedges We recognized in other income the following gains (losses) on contracts designated as fair value hedges and their related hedged items:
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Cash-Flow Hedges We recognized the following gains (losses) related to foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the period):
We estimate that $3 million of net derivative losses included in OCI will be reclassified into earnings within the next 12 months. No significant amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur during the three months ended September 30, 2010. Non-Designated Derivatives Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), which were immaterial for the three months ended September 30, 2010 and 2009. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities.
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NOTE 6 FAIR VALUE MEASUREMENTS We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are:
We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary.
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Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis:
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The table below reconciles the total Net Fair Value of assets above to the balance sheet presentation of these same assets in Note 4 – Investments for September 30, 2010 and June 30, 2010.
Changes in Financial Instruments Measured at Level 3 Fair Value on a Recurring Basis The following tables present the changes during the three months ended September 30, 2010 and 2009 in our Level 3 financial instruments that are measured at fair value on a recurring basis. The majority of these instruments consist of investment securities classified as available-for-sale with changes in fair value included in OCI.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis During the three months ended September 30, 2010 and 2009, we did not record any other-than-temporary impairments on those assets required to be measured at fair value on a non-recurring basis.
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NOTE 7 INVENTORIES The components of inventories were as follows:
NOTE 8 GOODWILL Changes in our goodwill balances during the three months ended September 30, 2010 were as follows:
We do not expect any of the amounts recorded as goodwill to be deductible for tax purposes. The measurement period for purchase price allocations ends as soon as information on the facts and circumstances becomes available, but will not exceed 12 months. Adjustments in the purchase price allocation may require a recasting of the amounts allocated to goodwill retroactive to the period in which the acquisition occurred. Any change in the goodwill amounts resulting from foreign currency translations are presented as “other” in the above table. Also included within “other” are transfers between business segments due to reorganizations.
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NOTE 9 INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows:
Intangible assets amortization expense was $124 million and $149 million for the three months ended September 30, 2010 and 2009, respectively. The following table outlines the estimated future amortization expense related to intangible assets held at September 30, 2010:
NOTE 10 DEBT In September 2010, we issued $4.75 billion of debt securities. See further discussion of these securities under “Notes” below. As of September 30, 2010, we had $10.7 billion of issued and outstanding debt comprising $1.0 billion of commercial paper and $9.7 billion of long-term debt, including $1.3 billion of convertible debt. Short-term Debt As of September 30, 2010, our $1.0 billion of commercial paper issued and outstanding had a weighted average interest rate, including issuance costs, of 0.19% and maturities of 29 to 42 days. The estimated fair value of this commercial paper approximates its carrying value. We have a $1.0 billion 364-day credit facility, which expires on November 5, 2010, and which serves as a back-up for our commercial paper program. As of September 30, 2010, we were in compliance with the financial covenant in the credit facility agreement, which requires a coverage ratio be maintained of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against the credit facility during any of the periods presented.
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Long-term Debt Notes As of September 30, 2010, we had issued and outstanding $8.5 billion of debt securities as illustrated in the table below (collectively “the Notes”), including $4.75 billion of debt securities issued in September 2010. The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding. Convertible Debt In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, which were capitalized. Each $1,000 principal amount of notes is convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share. Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into cash and, if applicable, cash, shares of Microsoft’s common stock or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the notes and pay or deliver cash, shares of our common stock or a combination of cash and shares of our common stock, at our election. Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders’ equity for $58 million with the portion in stockholders’ equity representing the fair value of the option to convert the debt. In connection with the issuance of the notes, we entered into capped call transactions with certain option counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with a cap price equal to $37.16. The purchased capped calls were valued at $40 million and recorded to stockholders’ equity. As of September 30, 2010, the total carrying value and estimated fair value of our long-term debt, including convertible debt, were $9.7 billion and $10.1 billion, respectively. The estimated fair value is based on quoted prices for our publicly-traded debt as of September 30, 2010, as applicable. The components of long-term debt as of September 30, 2010 were as follows:
Interest on the 2013 Notes is payable semi-annually on March 27 and September 27 of each year to holders of record on the preceding March 15 and September 15. Interest on the 2014, 2019 and 2039 Notes is payable semi-annually on June 1 and December 1 of each year to holders of record on the preceding May 15 and November 15. Interest on the 2015 Notes is payable semi-annually on March 25 and September 25 of each year to holders of record on the preceding March 15 and September 15. Interest on the 2020 and 2040 Notes is payable semi-annually on April 1 and October 1 of each year to holders of record on the preceding March 15 and September 15.
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NOTE 11 INCOME TAXES Our effective tax rates were approximately 25% for the three months ended September 30, 2010 and 2009. Tax contingencies and other tax liabilities were $6.7 billion as of September 30, 2010 and $6.9 billion as of June 30, 2010, and were included in other long-term liabilities. NOTE 12 UNEARNED REVENUE The components of unearned revenue were as follows:
Unearned revenue by segment was as follows:
NOTE 13 COMMITMENTS AND GUARANTEES Yahoo! Commercial Agreement On December 4, 2009, we entered into a definitive agreement with Yahoo! whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites. The term of the agreement is 10 years subject to termination provisions after five years based on performance. Microsoft provided Yahoo! with revenue per search guarantees for a period of 18 months after implementation of the Microsoft search ads platform in each country. These guarantees are calculated, paid and trued-up periodically based on the cumulative reduction in revenue per search, if any, during the 18 month period from pre-implementation levels, except in the case of the U.S. and Canada where performance during each of the first two calendar quarters after implementation is independent and not cumulative. This is a rate guarantee and not a guarantee of search volume. We estimate the total cost of the revenue per search guarantees during the guarantee period could range between zero and $150 million; however, no amount has been recorded for the revenue per search guarantees as we do not believe that such liability exists at this time. Microsoft also agreed to reimburse Yahoo! for certain transition expenses incurred both before and after the effective date of the agreement. Finally, Microsoft also agreed to reimburse Yahoo! for certain costs of running algorithmic and paid search services prior to migration to Microsoft’s platform.
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Product Warranty Our aggregate product warranty liabilities, which are included in other current liabilities and other long-term liabilities, changed during the three months ended September 30, 2010 as follows:
NOTE 14 CONTINGENCIES Government Competition Law Matters We are subject to a Consent Decree and Final Judgment (“Final Judgments”) that resolved lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions. The Final Judgments imposed various constraints on our Windows operating system businesses. The Final Judgments are scheduled to expire in May 2011. In other ongoing investigations, various foreign governments and several state attorneys general have requested information from us concerning competition, privacy, and security issues. Antitrust, Unfair Competition, and Overcharge Class Actions A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under federal law and in 15 states. Courts refused to certify classes in two additional states. We have reached agreements to settle all claims that have been made to date in 19 states and the District of Columbia. The settlements in all states have received final court approval. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. We estimate the total cost to resolve all of the state overcharge class action cases will range between $1.9 billion and $2.0 billion. At September 30, 2010, we have recorded a liability related to these claims of approximately $621 million, which reflects our estimated exposure of $1.9 billion less payments made to date of approximately $1.2 billion mostly for vouchers, legal fees, and administrative expenses. The three cases pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. We have appealed this ruling. The other two actions have been stayed. Other Antitrust Litigation and Claims In November 2004, Novell, Inc. filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. In March 2010 the trial court granted summary judgment in favor of Microsoft as to all remaining claims. Novell has appealed that ruling.
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Patent and Intellectual Property Claims In 2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents (although this action began before the merger of Alcatel and Lucent in 2006, for simplicity we refer to the post-merger entity of Alcatel-Lucent). In April 2008, a jury returned a verdict in Alcatel-Lucent’s favor in a trial on a consolidated group of one video and three user interface patents. The jury concluded that we had infringed two user interface patents and awarded $367 million in damages. In June 2008, the trial judge increased the amount of damages to $512 million to include $145 million of interest. We appealed that award to the Federal Circuit. In December 2008, we entered into a settlement agreement resolving all other litigation pending between Microsoft and Alcatel-Lucent, leaving approximately $500 million remaining in dispute. In September 2009, the United States Court of Appeals for the Federal Circuit affirmed the liability award but vacated the verdict and remanded the case to the trial court for a re-trial of the damages ruling, indicating the damages previously awarded were too high. Trial on the remanded damages claim has been set for the first week of December 2010. In October 2003, Uniloc USA Inc., a subsidiary of a Singapore-based security technology company, filed a patent infringement suit in U.S. District Court in Rhode Island, claiming that product activation technology in Windows XP and certain other Microsoft programs violated a Uniloc patent. After we obtained a favorable summary judgment that we did not infringe any of the claims of this patent, the court of appeals vacated the trial court decision and remanded the case for trial. In April 2009, the jury returned a $388 million verdict against us, including a finding of willful infringement. In September 2009, the district court judge overturned the jury verdict, ruling that the evidence did not support the jury’s finding that Microsoft infringed the patent. Uniloc has appealed. In March 2007, i4i Limited Partnership sued Microsoft in U.S. District Court in Texas claiming that certain custom XML technology in Word 2003 and 2007 infringed i4i’s patent. In May 2009, a jury returned a verdict against us, finding damages of $200 million and that we willfully infringed the patent. In August 2009, the court denied our post-trial motions and awarded enhanced damages of $40 million and prejudgment interest of $37 million. The court also issued a permanent injunction prohibiting additional distribution of the allegedly infringing technology. We appealed and the appellate court stayed the injunction pending our appeal. In December 2009, the court of appeals rejected our appeal and affirmed the trial court’s judgment and injunction, except that the court of appeals modified the effective date of the injunction to January 11, 2010. In April 2010, the court of appeals denied our request for a rehearing. In August, 2010, we filed a petition seeking review by the U.S. Supreme Court. In addition to these cases, there are approximately 40 other patent infringement cases pending against Microsoft. Other We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of September 30, 2010, we had accrued aggregate liabilities of $870 million in other current liabilities and $375 million in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, there exists the possibility of adverse outcomes that we estimate could reach approximately $1.0 billion in aggregate beyond recorded amounts. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our financial statements for the period in which the effects become reasonably estimable. NOTE 15 STOCKHOLDERS’ EQUITY Share Repurchases We repurchased the following shares of common stock during the periods presented:
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We repurchased all shares with cash resources. As of September 30, 2010, approximately $19.7 billion remained of our $40.0 billion repurchase program that we announced on September 22, 2008. The repurchase program expires September 30, 2013 but may be suspended or discontinued at any time without notice. Dividends Our Board of Directors declared the following dividends during the periods presented:
The estimate of the amount to be paid as a result of the September 21, 2010 declaration was included in other current liabilities as of September 30, 2010. NOTE 16 SEGMENT INFORMATION In its operation of the business, management, including our chief operating decision maker, the Company’s Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segment information within this note is reported on that basis. Our five segments are Windows & Windows Live Division; Server and Tools; Online Services Division; Microsoft Business Division; and Entertainment and Devices Division. Due to the integrated structure of our business, certain revenue earned and costs incurred by one segment may benefit other segments. Revenue on certain contracts may be allocated among the segments based on the relative value of the underlying products and services. Costs that are identifiable are allocated to the segments that benefit to incent cross-collaboration among our segments so that one segment is not solely burdened by the cost of a mutually beneficial activity. Allocated costs may include those relating to development and marketing of products and services from which multiple segments benefit, or those costs relating to services performed by one segment on behalf of other segments. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: field selling; employee benefits; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain other corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; legal settlements and contingencies; and employee severance. We have recast certain prior period amounts within this note to conform to the way we internally managed and monitored segment performance during the current fiscal year.
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Segment revenue and operating income (loss) were as follows during the periods presented:
Reconciling amounts in the tables above and below include adjustments to conform our internal accounting policies to U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, depreciation, and amortization of stock-based awards. Significant reconciling items were as follows:
Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have reviewed the accompanying consolidated balance sheet of Microsoft Corporation and subsidiaries (the “Corporation”) as of September 30, 2010, and the related consolidated statements of income, cash flows, and stockholders’ equity for the three-month periods ended September 30, 2010 and 2009. These interim financial statements are the responsibility of the Corporation’s management. We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Microsoft Corporation and subsidiaries as of June 30, 2010, and the related consolidated statements of income, cash flows, and stockholders’ equity for the year then ended (not presented herein); and in our report dated July 30, 2010 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 2010 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /S/ DELOITTE & TOUCHE LLP Seattle, Washington October 28, 2010
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Business”, “Management’s Discussion and Analysis”, and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (refer to Part II, Item 1A of this Form 10-Q). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. OVERVIEW Management’s discussion and analysis is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. The following discussion should be read in conjunction with our Annual Report on Form 10-K for the year ended June 30, 2010 and the Consolidated Financial Statements and accompanying notes (“Notes”) included in this Form 10-Q. 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 and solution support services, and we train and certify computer system integrators and developers. We also design and sell hardware, including the Xbox 360 gaming and entertainment console and accessories, the Zune digital music and entertainment device and accessories, and Microsoft PC hardware products. Online offerings and information are delivered to consumers through Bing, Windows Live, Microsoft Office Web Apps, our MSN portals and channels, and to businesses through Microsoft Online Services offerings, such as Microsoft Dynamics CRM Online, Exchange Online, Windows Azure, SQL Azure 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 yearly segment revenues in our second fiscal quarter. In addition, quarterly revenues may be impacted by the deferral of revenue. See the discussions below regarding the deferral of revenue related to sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and of Windows 7 to retailers before general availability (the “Windows 7 Deferral”). All growth and percentage comparisons refer to the three months ended September 30, 2010, as compared with the three months ended September 30, 2009, unless otherwise noted.
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Summary
Revenue increased primarily due to strong sales of Windows 7, the 2010 Microsoft Office system, Server and Tools products, and the Xbox 360 console and video games. Revenue also increased due to the deferral in the prior year of approximately $1.5 billion of revenue related to the Windows 7 Deferral. Changes in foreign currency exchange rates had an insignificant impact on revenue. Operating income increased reflecting the change in revenue, offset in part by higher operating expenses. Key changes in operating expenses were:
Diluted earnings per share increased reflecting increased net income and the repurchase of 485 million shares during the 12 months ended September 30, 2010. Global macroeconomic factors have a strong correlation to demand for our software, services, hardware, and online offerings. The current macroeconomic factors remain dynamic and uncertain. Irrespective of global economic conditions, we are positive about our relative market position, our current product portfolio, and future product pipeline. Because we offer a wide range of products and services that enable companies to improve productivity and reduce costs, including cloud-based services, we believe that Microsoft is well-positioned to create new opportunities to increase revenue as the global economy improves. 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 U.S. (“U.S. GAAP”) and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 16 – Segment Information of the Notes to Financial Statements (Part I, Item I of this Form 10-Q) is presented on a basis consistent with our current internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current fiscal year.
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Windows & Windows Live Division
Windows & Windows Live Division (“Windows Division”) offerings consist of premium and standard edition Windows operating systems, and online software and services through Windows Live. Premium Windows operating systems are those that include additional functionality and are sold at a price above our standard editions. Premium editions include Windows 7 Home Premium, Professional, Ultimate, and Enterprise, as well as Windows Vista Business, Home Premium, Ultimate, and Enterprise. Standard editions include Windows 7 Starter and Home Basic, Windows Vista Starter and Home Basic, and Windows XP Home. Windows Live primarily generates revenue from online advertising. Windows Division revenue growth is largely correlated to the growth of PC purchases from original equipment manufacturers (“OEMs”) that pre-install versions of Windows operating systems because the OEM channel accounts for approximately 75% of total Windows Division revenue. The remaining approximately 25% of Windows Division revenue (“other revenue”) is generated by commercial and retail sales of Windows and online advertising from Windows Live. Windows Division revenue increased due to strong sales of Windows 7 and PC market growth. We estimate total worldwide PC shipments from all sources grew approximately 9% to 11%. OEM revenue increased $1.8 billion or 93%. Including revenue and units associated with the Windows 7 Deferral in the prior year, OEM revenue increased $364 million or 11%, while OEM license units increased 5%. The OEM revenue increase was driven by PC market growth, PC market strength among business customers, and the mix of versions of Windows licensed, partially offset by lower Windows attach rates in China and year-over-year changes in inventory in our distribution channels. Other revenue increased $125 million or 13%, driven primarily by commercial and retail sales of Windows 7. Windows Division operating income grew as a result of increased revenue, offset in part by higher operating expenses. Cost of revenue increased $22 million or 5%, primarily driven by higher traffic acquisition and royalty costs. Sales and marketing expenses increased $22 million or 4% reflecting advertising and marketing of Windows and Windows Live. Server and Tools
Server and Tools licenses products, applications, tools, content, and delivers Enterprise Services, all of which are designed to make information technology professionals, developers and their systems more productive and efficient. Server and Tools product and service offerings consist of Windows Server, Microsoft SQL Server, Windows Azure and other cloud and server offerings, and Windows Embedded device platforms. We also offer developer tools, training and certification. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. Server product offerings can be run on-site, in a partner-hosted environment, or in a Microsoft-hosted environment. We use multiple sales channels, including pre-installed OEM versions, sales through partners and sales directly to end customers. Approximately 50% of Server and Tools revenue comes from annuity volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes from Enterprise Services. Server and Tools revenue increased reflecting growth in product revenue and Enterprise Services revenue. Product revenue increased $343 million or 12%, driven primarily by growth in Windows Server, SQL Server, Enterprise CAL Suites and Windows Embedded revenue, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew $66 million or 9%, due to growth in both Premier product support services and consulting services.
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Server and Tools operating income increased primarily due to revenue growth, offset in part by a slight increase in operating expenses. Cost of revenue increased $55 million or 8%, reflecting higher costs associated with the delivery of services and online costs. Sales and marketing expenses decreased $38 million or 4%, primarily due to lower corporate marketing and advertising expenses. Online Services Division
Online Services Division (“OSD”) offerings include Bing, MSN, and advertiser and publisher tools. OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $55 million or 13% to $473 million, reflecting higher search and owned and operated display advertising revenue, offset in part by decreased third party advertising revenue. OSD operating loss increased due to higher cost of revenue and research and development expenses, offset in part by increased revenue. Cost of revenue grew $74 million driven by costs associated with the Yahoo! search agreement, partially offset by decreased online traffic acquisition costs. Research and development expenses increased $61 million or 27%, primarily due to headcount-related expenses related to the search portion of the business. Microsoft Business Division
Microsoft Business Division (“MBD”) offerings include 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. Microsoft Office system offerings generate over 90% of MBD revenue. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications. 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. MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system, which was released during the fourth quarter of fiscal year 2010. Business revenue increased $396 million or 11%, primarily reflecting licensing of the 2010 Microsoft Office system to transactional business customers, growth in multi-year licensing revenue, and a 4% increase in Microsoft Dynamics revenue. Consumer revenue increased $216 million or 26% due to sales of the 2010 Microsoft Office system and growth in the PC market. MBD operating income increased due mainly to revenue growth, offset in part by higher cost of revenue. Cost of revenue increased $81 million or 30%, primarily driven by higher costs of providing services and increased traffic acquisition costs.
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Entertainment and Devices Division
Entertainment and Devices Division (“EDD”) offerings include the Xbox 360 platform (which includes the Xbox 360 gaming and entertainment console, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories, including Kinect for Xbox 360 launching in November 2010), the Zune digital music and entertainment platform, PC game software, online games and services, Mediaroom (our Internet protocol television software), and Windows Phone. EDD revenue increased primarily reflecting higher Xbox 360 platform revenue. Xbox 360 platform revenue grew $409 million or 33%, primarily reflecting increased volumes of Xbox 360 consoles sold and higher Xbox 360 video game revenue led by Halo Reach. We shipped 2.8 million Xbox 360 consoles during the first quarter of fiscal year 2011, compared with 2.1 million Xbox 360 consoles during the first quarter of fiscal year 2010. Halo Reach launched in September 2010 generating approximately $350 million of revenue during the quarter. EDD operating income increased primarily reflecting revenue growth, offset in part by higher operating expenses. Cost of revenue increased $152 million or 19% primarily due to higher volumes of Xbox 360 consoles sold. Research and development expenses increased $65 million or 30%, primarily reflecting higher headcount-related expenses. Sales and marketing expenses increased $39 million or 27% due mainly to increased Xbox 360 platform marketing activities. Corporate-Level Activity
Certain corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; and legal settlements and contingencies. Corporate-level expenses increased due mainly to a $113 million increase in legal charges and a 6% increase in headcount-related expenses. OPERATING EXPENSES Cost of Revenue
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 include software on PCs sold by OEMs, to drive traffic to our Web sites and to 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. Cost of revenue increased primarily due to higher online costs and increased volumes of Xbox 360 consoles sold.
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Research and Development
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, and the amortization of purchased software code and services content. Research and development expenses increased, primarily reflecting a 5% increase in headcount-related expenses and higher third-party development and programming costs. Sales and Marketing
Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased slightly, primarily reflecting increased advertising and marketing of Windows and Windows Live and the Xbox 360 platform, offset in part by decreased corporate marketing and advertising expenses. General and Administrative
General and administrative expenses 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. General and administrative expenses increased primarily due to increased legal charges, as discussed under Corporate-Level Activity above, and an increase in headcount-related expenses.
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OTHER INCOME AND INCOME TAXES Other Income The components of other income were as follows:
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