Attached files

file filename
EXCEL - IDEA: XBRL DOCUMENT - MICROSOFT CORPFinancial_Report.xls
EX-3.2 - BYLAWS OF MICROSOFT CORPORATION - MICROSOFT CORPdex32.htm
EX-3.1 - AMENDED AND RESTATED ARTICLES OF INCORPORATION OF MICROSOFT CORPORATION - MICROSOFT CORPdex31.htm
EX-15 - LETTER REGARDING UNAUDITED INTERIM FINANCIAL INFORMATION - MICROSOFT CORPdex15.htm
EX-12 - COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES - MICROSOFT CORPdex12.htm
EX-31.2 - SECTION 302 CERTIFICATION OF CFO - MICROSOFT CORPdex312.htm
EX-32.2 - SECTION 906 CERTIFICATION OF CFO - MICROSOFT CORPdex322.htm
EX-32.1 - SECTION 906 CERTIFICATION OF CEO - MICROSOFT CORPdex321.htm
EX-31.1 - SECTION 302 CERTIFICATION OF CEO - MICROSOFT CORPdex311.htm
EX-10.20 - RESIGNATION AGREEMENT BETWEEN CHRISTOPHER LIDDELL AND MICROSOFT CORP. - MICROSOFT CORPdex1020.htm
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended December 31, 2009

OR

 

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From                  to                 

Commission File Number: 0-14278

 


MICROSOFT CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Washington   91-1144442

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One Microsoft Way, Redmond, Washington   98052-6399
(Address of principal executive offices)   (Zip Code)

(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.

 

Large accelerated filer x

  

Accelerated filer ¨

Non-accelerated filer ¨ (Do not check if a smaller reporting company)

  

Smaller reporting company ¨

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.

 

Class    Outstanding at January 25, 2010

Common Stock, $0.00000625 par value per share

   8,770,460,922 shares

 



Table of Contents

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended December 31, 2009

INDEX

 

                 Page

PART I.

  FINANCIAL INFORMATION    
    Item 1.   Financial Statements    
        a)    Income Statements for the Three and Six Months Ended December 31, 2009 and 2008   3
        b)    Balance Sheets as of December 31, 2009 and June 30, 2009   4
        c)    Cash Flows Statements for the Three and Six Months Ended December 31, 2009 and 2008   5
        d)    Stockholders’ Equity Statements for the Three and Six Months Ended December 31, 2009 and 2008   6
        e)    Notes to Financial Statements   7
        f)    Report of Independent Registered Public Accounting Firm   26
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations   27
    Item 3.   Quantitative and Qualitative Disclosures About Market Risk   42
    Item 4.   Controls and Procedures   43

PART II.

  OTHER INFORMATION    
    Item 1.   Legal Proceedings   43
    Item 1A.   Risk Factors   44
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds   49
    Item 4.   Submission of Matters to a Vote of Security Holders   49
    Item 6.   Exhibits   51

SIGNATURE

  52

 

PAGE    2


Table of Contents

PART I

Item 1

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INCOME STATEMENTS

 

(In millions, except per share amounts) (Unaudited)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2009     2008     2009     2008  

Revenue

   $   19,022      $   16,629      $   31,942      $   31,690   

Operating expenses:

                                

Cost of revenue

     3,628        3,907        6,470        6,755   

Research and development

     2,079        2,290        4,144        4,573   

Sales and marketing

     3,619        3,662        6,409        6,706   

General and administrative

     1,124        831        1,865        1,718   

Employee severance

     59               59          


 


 


 


Total operating expenses

     10,509        10,690        18,947        19,752   


 


 


 


Operating income

     8,513        5,939        12,995        11,938   

Other income (expense)

     370        (301     653        (309


 


 


 


Income before income taxes

     8,883        5,638        13,648        11,629   

Provision for income taxes

     2,221        1,464        3,412        3,082   


 


 


 


Net income

   $ 6,662      $ 4,174      $ 10,236      $ 8,547   
    


 


 


 


Earnings per share:

                                

Basic

   $ 0.75      $ 0.47      $ 1.15      $ 0.95   

Diluted

   $ 0.74      $ 0.47      $ 1.14      $ 0.94   

Weighted average shares outstanding:

                                

Basic

     8,856        8,903        8,885        8,994   

Diluted

     8,951        8,914        8,975        9,052   

Cash dividends declared per common share

   $ 0.13      $ 0.13      $ 0.26      $ 0.26   


See accompanying notes.

 

PAGE    3


Table of Contents

PART I

Item 1

 

BALANCE SHEETS

 

(In millions)    December 31,     June 30,  


2009       2009 (1) 
     (Unaudited)        

Assets

                

Current assets:

                

Cash and cash equivalents

   $ 9,422      $ 6,076   

Short-term investments (including securities loaned of $2,654 and $1,540)

     26,677        25,371   


 


Total cash, cash equivalents, and short-term investments

     36,099        31,447   

Accounts receivable, net of allowance for doubtful accounts of $506 and $451

     11,196        11,192   

Inventories

     589        717   

Deferred income taxes

     2,056        2,213   

Other

     2,547        3,711   


 


Total current assets

     52,487        49,280   

Property and equipment, net of accumulated depreciation of $8,170 and $7,547

     7,402        7,535   

Equity and other investments

     6,976        4,933   

Goodwill

     12,368        12,503   

Intangible assets, net

     1,346        1,759   

Deferred income taxes

            279   

Other long-term assets

     1,517        1,599   


 


Total assets

   $   82,096      $   77,888   
    


 


Liabilities and stockholders’ equity

                

Current liabilities:

                

Accounts payable

   $ 3,171      $ 3,324   

Short-term debt

     2,249        2,000   

Accrued compensation

     2,417        3,156   

Income taxes

     721        725   

Short-term unearned revenue

     11,361        13,003   

Securities lending payable

     2,911        1,684   

Other

     2,885        3,142   


 


Total current liabilities

     25,715        27,034   

Long-term debt

     3,746        3,746   

Long-term unearned revenue

     1,167        1,281   

Deferred income taxes

     377          

Other long-term liabilities

     6,808        6,269   

Commitments and contingencies

                

Stockholders’ equity:

                

Common stock and paid-in capital—shares authorized 24,000; outstanding 8,811 and 8,908

     62,566        62,382   

Retained deficit, including accumulated other comprehensive income of $1,322 and $969

     (18,283     (22,824


 


Total stockholders’ equity

     44,283        39,558   


 


Total liabilities and stockholders’ equity

   $ 82,096      $   77,888   
    


 


 

(1)

Derived from audited financial statements.

See accompanying notes.

 

PAGE    4


Table of Contents

PART I

Item 1

 

CASH FLOWS STATEMENTS

 

(In millions) (Unaudited)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2009     2008     2009     2008  

Operations

                                

Net income

   $   6,662      $   4,174      $   10,236      $   8,547   

Adjustments to reconcile net income to net cash from operations:

                                

Depreciation, amortization, and other noncash items

     615        632        1,261        1,217   

Stock-based compensation

     485        417        928        860   

Net recognized losses (gains) on investments and derivatives

     (188 )     139        (254 )     175   

Excess tax benefits from stock-based compensation

     (15     (2     (24     (46

Deferred income taxes

     550        454        504        830   

Deferral of unearned revenue

     6,926        5,969        13,605        10,155   

Recognition of unearned revenue

     (9,126     (6,364     (15,363     (12,408

Changes in operating assets and liabilities:

                                

Accounts receivable

     (2,789     (1,647     (41 )     2,338   

Other current assets

     1,244        797        590        239   

Other long-term assets

     16        (69     (62     (185

Other current liabilities

     285        614        (954     (3,938

Other long-term liabilities

     304        668        650        1,368   


 


 


 


Net cash from operations

     4,969        5,782        11,076        9,152   


 


 


 


Financing

                                

Short-term borrowings (repayments), maturities of 90 days or less, net

     (475 )     21        (97 )     1,996   

Proceeds from issuance of debt, maturities longer than 90 days

     1,046               1,741          

Repayments of debt, maturities longer than 90 days

     (573 )            (1,396 )       

Common stock issued

     729        96        977        324   

Common stock repurchased

     (3,867     (2,820     (5,407     (9,313

Common stock cash dividends

     (1,152     (1,157     (2,309     (2,155

Excess tax benefits from stock-based compensation

     15        2        24        46   


 


 


 


Net cash used in financing

     (4,277     (3,858     (6,467     (9,102


 


 


 


Investing

                                

Additions to property and equipment

     (376     (842     (811     (1,620

Acquisition of companies, net of cash acquired

     (63     (450     (102     (827

Purchases of investments

     (4,287     (6,596     (14,777     (10,842

Maturities of investments

     1,896        290        5,394        754   

Sales of investments

     3,361        5,700        7,778        12,775   

Securities lending payable

     (623     (601     1,227        (2,144


 


 


 


Net cash used in investing

     (92     (2,499     (1,291     (1,904

Effect of exchange rates on cash and cash equivalents

     (1     (83     28        (139


 


 


 


Net change in cash and cash equivalents

     599        (658     3,346        (1,993

Cash and cash equivalents, beginning of period

     8,823        9,004        6,076        10,339   


 


 


 


Cash and cash equivalents, end of period

   $ 9,422      $ 8,346      $ 9,422      $ 8,346   
    


 


 


 


See accompanying notes.

 

PAGE    5


Table of Contents

PART I

Item 1

 

STOCKHOLDERS’ EQUITY STATEMENTS

 

(In millions) (Unaudited)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2009     2008     2009     2008  

Common stock and paid-in capital

                                

Balance, beginning of period

   $   62,293      $   61,655      $   62,382      $   62,849   

Common stock issued

     779        86        1,027        312   

Common stock repurchased

     (923     (674     (1,656     (2,571

Stock-based compensation

     485        417        928        860   

Stock-based compensation income tax deficiencies

     (68     (91     (114     (58

Other, net

            (1     (1 )       


 


 


 


Balance, end of period

     62,566        61,392        62,566        61,392   


 


 


 


Retained deficit

                                

Balance, beginning of period

     (21,081     (28,061     (22,824     (26,563

Net income

     6,662        4,174        10,236        8,547   

Other comprehensive income:

                                

Net unrealized gains (losses) on derivatives

     (42 )     473        (361 )     766   

Net unrealized gains (losses) on investments

     65        (514     653        (912

Translation adjustments and other

     (35     (251     61        (409


 


 


 


Comprehensive income

     6,650        3,882        10,589        7,992   

Common stock cash dividends

     (1,140     (1,147     (2,297     (2,304

Common stock repurchased

     (2,712     (1,588     (3,751     (6,039


 


 


 


Balance, end of period

     (18,283     (26,914     (18,283     (26,914


 


 


 


Total stockholders’ equity

   $ 44,283      $ 34,478      $ 44,283      $ 34,478   
    


 


 


 


See accompanying notes.

 

PAGE    6


Table of Contents

PART I

Item 1

 

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1    ACCOUNTING POLICIES

Basis of Presentation

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 2009 Form 10-K filed on July 30, 2009 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 but do not exercise control and are not the primary beneficiary 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.

Subsequent Events

We evaluated events occurring between the end of our fiscal quarter, December 31, 2009 and January 28, 2010 when the financial statements were issued.

Recently Adopted Accounting Guidance

On July 1, 2009, we adopted guidance issued by the Financial Accounting Standards Board (“FASB”) on business combinations. The guidance retains the fundamental requirements 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 and measured 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. We have applied this guidance to business combinations completed since July 1, 2009.

On July 1, 2009, we adopted the guidance issued by the FASB that changes the accounting and reporting for non-controlling interests. Non-controlling interests are to 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 are to be accounted for as equity transactions. In addition, net income attributable to a non-controlling interest is to be included in net income and, upon a loss of control, the interest sold, as well as any interest retained, is to be recorded at fair value with any gain or loss recognized in net income. Adoption of the new guidance did not have a material impact on our financial statements.

On July 1, 2009, we adopted the guidance on fair value measurement for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Adoption of the new guidance did not have a material impact on our financial statements.

 

PAGE    7


Table of Contents

PART I

Item 1

 

Recent Accounting Guidance Not Yet Adopted

In January 2010, the FASB issued guidance to amend the disclosure requirements related to recurring and nonrecurring fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of 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 January 1, 2010, except for the disclosure on the roll forward activities for Level 3 fair value measurements, which will become effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, adoption of this new guidance will not have a material impact on our financial statements.

In October 2009, the FASB issued guidance on revenue recognition that will become effective for us beginning July 1, 2010, with earlier adoption permitted. 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 will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be 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. We believe adoption of this new guidance will not have a material impact on our financial statements.

In June 2009, the FASB issued guidance on the consolidation of variable interest entities, which is effective for us beginning July 1, 2010. 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. We believe adoption of this new guidance will not have a material impact on our financial statements.

NOTE 2    EARNINGS PER SHARE

Basic earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of 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:

 

(In millions, except earnings per share)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2009     2008     2009     2008  

Net income available for common shareholders (A)

   $   6,662      $   4,174      $   10,236      $   8,547   

Weighted average shares of common stock outstanding (B)

     8,856        8,903        8,885        8,994   

Dilutive effect of stock-based awards

     95        11        90        58   


 


 


 


Common stock and common stock equivalents (C)

     8,951        8,914        8,975        9,052   
    


 


 


 


Earnings per share:

                                

Basic (A/B)

   $ 0.75      $ 0.47      $ 1.15      $ 0.95   

Diluted (A/C)

   $ 0.74      $ 0.47      $ 1.14      $ 0.94   


We excluded the following shares underlying stock-based awards from the calculations of diluted earnings per share because their inclusion would have been anti-dilutive:

 

(In millions)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2009     2008     2009     2008  

Shares excluded from calculations of diluted EPS

     101        517        155        326   


 

PAGE    8


Table of Contents

PART I

Item 1

 

NOTE 3    OTHER INCOME (EXPENSE)

The components of other income (expense) were as follows:

 

(In millions)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2009     2008     2009     2008  

Dividends and interest

   $   159      $   175      $    324      $   382   

Net recognized gains on investments

     92        270        162        399   

Net gains (losses) on derivatives

     96        (409     92        (574

Net gains (losses) on foreign currency remeasurements

     (23     (350     32        (529

Other

     46        13        43        13   


 


 


 


Total

   $ 370      $ (301   $ 653      $ (309
    


 


 


 


Other-than-temporary impairments included in net recognized gains on investments were $6 million and $24 million for the three months and six months ended December 31, 2009, respectively, as compared with $262 million and $334 million during the three months and six months ended December 31, 2008, respectively.

NOTE 4    INVESTMENTS

Investment Components

The components of investments, including associated derivatives, were as follows:

 

(In millions)    Cost Basis     Unrealized
Gains
    Unrealized
Losses
    Recorded
Basis
   

Cash

and Cash
Equivalents

    Short-term
Investments
   

Equity

and Other
Investments

 


December 31, 2009                                           

Cash

   $ 2,151      $      $      $ 2,151      $ 2,151      $      $   

Mutual funds

     1,713                      1,713        1,662        51          

Commercial paper

     2,440                      2,440        1,816        624          

Certificates of deposit

     3,292                      3,292        3,058        234          

U.S. government and agency securities

     12,542        50        (9     12,583        415        12,168          

Foreign government bonds

     3,530        84        (3     3,611               3,611          

Mortgage-backed securities

     3,981        91        (4     4,068               4,068          

Corporate notes and bonds

     5,411        288        (14     5,685        200        5,485          

Municipal securities

     539        1        (2 )     538        120        418          

Common and preferred stock

     5,171        1,432        (116     6,487                      6,487   

Other investments

     507                      507               18        489   


 


 


 


 


 


 


Total

   $   41,277      $   1,946      $   (148   $   43,075      $   9,422      $   26,677      $   6,976   
    


 


 


 


 


 


 


 

PAGE    9


Table of Contents

PART I

Item 1

 

(In millions)    Cost Basis     Unrealized
Gains
    Unrealized
Losses
    Recorded
Basis
    Cash
and Cash
Equivalents
    Short-term
Investments
    Equity
and Other
Investments
 


June 30, 2009                                           

Cash

   $ 2,064      $      $      $ 2,064      $ 2,064      $      $   

Mutual funds

     1,007               (25     982        900        82          

Commercial paper

     2,601                      2,601        400        2,201          

Certificates of deposit

     555                      555        275        280          

U.S. government and agency securities

     13,450        21        (5     13,466        2,369        11,097          

Foreign government bonds

     3,450        71        (4     3,517               3,517          

Mortgage-backed securities

     3,353        81        (16     3,418               3,418          

Corporate notes and bonds

     4,361        287        (52     4,596               4,596          

Municipal securities

     255        2        (1     256        68        188          

Common and preferred stock

     4,015        627        (182     4,460                      4,460   

Other investments

     465                      465               (8     473   


 


 


 


 


 


 


Total

   $   35,576      $   1,089      $   (285   $   36,380      $   6,076      $   25,371      $   4,933   
    


 


 


 


 


 


 


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:

 

     Less than 12 Months     12 Months or Greater          

Total

Unrealized
Losses

 
    


 


         
(In millions)    Fair Value    Unrealized
Losses
    Fair Value     Unrealized
Losses
    Total
Fair Value
   


December 31, 2009                                    

U.S. government and agency securities

   $ 568    $ (9   $      $      $ 568      $ (9

Foreign government bonds

     1,395      (1     491        (2     1,886        (3

Mortgage-backed securities

     391      (2     20        (2     411        (4

Corporate notes and bonds

     397      (5     183        (9     580        (14

Municipal securities

     110      (2     —          —          110        (2

Common and preferred stock

     887      (58     243        (58     1,130        (116

  


 


 


 


 


Total

   $   3,748    $     (77   $   937      $     (71   $   4,685      $   (148
    

  


 


 


 


 


 

     Less than 12 Months     12 Months or Greater          

Total

Unrealized
Losses

 
    


 


         
(In millions)    Fair Value     Unrealized
Losses
    Fair Value     Unrealized
Losses
    Total
Fair Value
   


June 30, 2009                                     

Mutual funds

   $ 3      $ (1   $ 77      $ (24   $ 80      $ (25

U.S. government and agency securities

     4,033        (5                   4,033        (5

Foreign government bonds

     1,444        (3     669        (1     2,113        (4

Mortgage-backed securities

     503        (16                   503        (16

Corporate notes and bonds

     713        (10     504        (42     1,217        (52

Municipal securities

     16        (1                   16        (1

Common and preferred stock

     1,154        (135     120        (47     1,274        (182


 


 


 


 


 


Total

   $   7,866      $   (171   $   1,370      $   (114   $   9,236      $   (285
    


 


 


 


 


 


At December 31, 2009 and June 30, 2009, 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 $209 million and $204 million, respectively. The estimated fair values are based on publicly available market information or other estimates determined by management. Unrealized losses on fixed-income securities are primarily attributable to

 

PAGE    10


Table of Contents

PART I

Item 1

 

changes in interest rates. Unrealized losses on 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 December 31, 2009.

Debt Investment Maturities

 

(In millions)    Cost Basis     Estimated
Fair Value
 


Due in one year or less

   $ 9,837      $ 9,845   

Due after one year through five years

     14,945        15,240   

Due after five years through 10 years

     2,617        2,708   

Due after 10 years

     4,337        4,423   


 


Total

   $   31,736      $   32,216   
    


 


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.

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. Options 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 December 31, 2009, the total notional amount of such foreign exchange contracts sold was $9.1 billion. 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 December 31, 2009, the total notional amount of these foreign exchange contracts sold was $3.7 billion. 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 December 31, 2009, the total notional amounts of these foreign exchange contracts purchased and sold were $4.5 billion and $4.6 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 December 31, 2009, the total notional amounts of designated and non-designated equity contracts purchased and sold were immaterial.

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 December 31, 2009, the total notional amount of fixed-interest rate contracts purchased and sold were $1.7 billion and $653 million, 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 December 31, 2009, the total notional derivative amount of mortgage contracts purchased was $858 million.

 

PAGE    11


Table of Contents

PART I

Item 1

 

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 December 31, 2009, 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 and futures contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they are low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of December 31, 2009, the total notional amounts of commodity contracts purchased and sold were $692 million and $22 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 December 31, 2009, 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

Following are the gross fair values of derivative instruments held at December 31, 2009, 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:

 

(In millions)    Foreign
Exchange
Contracts
    Equity
Contracts
    Interest
Rate
Contracts
    Credit
Contracts
    Commodity
Contracts
    Total
Derivatives
 


Assets

                                                

Derivatives not designated as hedging instruments:

                                                

Short-term investments

   $ 13      $ 112      $ 5      $ 7      $ 26      $ 163   

Other current assets

     80                                    80   


 


 


 


 


 


Total

   $ 93      $ 112      $ 5      $ 7      $ 26      $ 243   

Derivatives designated as hedging instruments:

                                                

Short-term investments

   $ 87      $      $      $      $      $ 87   

Other current assets

     284                                    284   


 


 


 


 


 


Total

   $ 371      $      $      $      $      $ 371   
    


 


 


 


 


 


Total assets

   $   464      $   112      $   5      $   7      $   26      $   614   
    


 


 


 


 


 


 

PAGE    12


Table of Contents

PART I

Item 1

 

(In millions)    Foreign
Exchange
Contracts
    Equity
Contracts
    Interest
Rate
Contracts
    Credit
Contracts
    Commodity
Contracts
    Total
Derivatives
 


Liabilities

                                                

Derivatives not designated as hedging instruments:

                                                

Other current liabilities

   $ (39   $ (5   $ (6   $ (42   $ (9   $ (101

Derivatives designated as hedging instruments:

                                                

Other current liabilities

   $ (103   $      $      $      $      $ (103


 


 


 


 


 


Total liabilities

   $   (142   $   (5   $   (6   $   (42   $   (9   $   (204
    


 


 


 


 


 


See also Note 4 – Investments and Note 6 – Fair Value Measurements.

Fair-Value Hedges

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.

We recognized in other income (expense) the following gains (losses) on foreign exchange contracts designated as fair value hedges (our only fair value hedges during the period) and their related hedged items:

 

(In millions)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


          2009          2009  

Derivatives

             $   89                $   (104

Hedged items

          (85          103   


      


Total

        $ 4           $ (1
         


      


Cash-Flow Hedges

For a derivative instrument designated as a cash-flow hedge, 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.

We recognized the following gains (losses) related to foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the period):

 

(In millions)   

Three Months Ended
December 31,

  

Six Months Ended
December 31,

 


          2009         2009  

Effective portion

                         

Gain (loss) recognized in OCI, net of tax effect of $1 and $(111)

             $ 2              $   (207

Gain reclassified from accumulated OCI into revenue

        $ 68         $ 237   

Amount excluded from effectiveness assessment and ineffective portion

                         

Gain (loss) recognized in other income (expense)

        $   26         $ (14


 

PAGE    13


Table of Contents

PART I

Item 1

 

We estimate that $92 million of net derivative gains 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 and six months ended December 31, 2009.

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 and six months ended December 31, 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, 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).

 

(In millions)   

Three Months Ended
December 31,

  

Six Months Ended
December 31,


          2009         2009

Foreign exchange contracts

             $      47            $      90

Equity contracts

          7           16

Interest-rate contracts

          9           12

Credit contracts

          2           11

Commodity contracts

          54           69

       

Total

        $ 119         $ 198
         

       

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:

 

   

Level 1—inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative investments primarily include domestic and international equities, U.S. treasuries and agency securities, and exchange-traded mutual funds. Our Level 1 derivative assets and liabilities include those traded on exchanges.

 

   

Level 2—inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, mortgage-backed securities, certificates of deposit, certain agency securities, foreign government bonds, and commercial paper. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter options, futures, and swap contracts.

 

   

Level 3—inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in certain corporate bonds. We value these corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant to the fair values of the investments. Our Level 3 derivative assets and liabilities primarily comprise derivatives for foreign equities. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions to determine fair value for these derivatives.

 

PAGE    14


Table of Contents

PART I

Item 1

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following tables present the fair values of our financial instruments that are measured at fair value on a recurring basis:

 

(In millions)

     Level 1        Level 2        Level 3       
 
Gross Fair
Value
  
  
    Netting (1)     
 
Net Fair
Value
  
  


December 31, 2009                                     

Assets

                                                

Mutual funds

   $   1,713       $       $       $   1,713       $      $   1,713    

Commercial paper

            2,450               2,450               2,450   

Certificates of deposit

            3,292               3,292               3,292   

U.S. government and agency securities

     9,321        3,246               12,567               12,567   

Foreign government bonds

     472        3,050               3,522               3,522   

Mortgage-backed securities

            4,083               4,083               4,083   

Corporate notes and bonds

            5,381        192        5,573               5,573   

Municipal securities

            538               538               538   

Common and preferred stock

     6,233        39        5        6,277               6,277   

Derivatives

     22        588        4        614        (149     465   


 


 


 


 


 


Total

   $   17,761      $   22,667      $   201      $   40,629      $   (149   $   40,480   
    


 


 


 


 


 


Liabilities

                                                

Derivatives

   $ 7      $ 197      $      $ 204      $ (147   $ 57   


(In millions)

     Level 1        Level 2        Level 3       
 
Gross Fair
Value
  
  
    Netting (1)     
 
Net Fair
Value
  
  


June 30, 2009                                     

Assets

                                                

Mutual funds

   $ 982       $       $       $ 982       $      $ 982    

Commercial paper

            2,601               2,601               2,601   

Certificates of deposit

            555               555               555   

U.S. government and agency securities

     7,134        6,105               13,239               13,239   

Foreign government bonds

     501        3,022               3,523               3,523   

Mortgage-backed securities

            3,593               3,593               3,593   

Corporate notes and bonds

            4,073        253        4,326               4,326   

Municipal securities

            256               256               256   

Common and preferred stock

     4,218        28        5        4,251               4,251   

Derivatives

     5        623        5        633        (235     398   


 


 


 


 


 


Total

   $   12,840      $   20,856      $   263      $   33,959      $   (235   $   33,724   
    


 


 


 


 


 


Liabilities

                                                

Derivatives

   $ 5      $ 344      $      $ 349      $ (231   $ 118   


 

(1)

This table includes the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists. These amounts also include fair value adjustments related to our own credit risk and counterparty credit risk.

 

PAGE    15


Table of Contents

PART I

Item 1

 

Changes in Financial Instruments Measured at Level 3 Fair Value on a Recurring Basis

The following tables present the changes during the three months and six months ended December 31, 2009 and 2008 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 other comprehensive income.

 

(In millions)    Corporate
Notes and
Bonds
    Common
and
Preferred
Stock
    Derivative
Assets
    Total  


Three Months and Six Months Ended December 31, 2009                         

Balance as of June 30, 2009

   $     253      $     5       $   5      $   263   

Total realized and unrealized gains (losses):

                                

Included in other income (expense)

     1               (2 )        (1 )   

Included in other comprehensive income

     (74 )                      (74 )   


 


 


 


Balance as of September 30, 2009

   $   180      $ 5      $ 3      $   188   

Total realized and unrealized gains:

                                

Included in other income (expense)

     1               1        2   

Included in other comprehensive income

     11                      11   


 


 


 


Balance as of December 31, 2009

   $   192      $ 5      $ 4      $   201   
    


 


 


 


Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2009 related to assets held as of December 31, 2009

   $ 1      $      $ 1      $ 2   

Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2009 related to assets held as of December 31, 2009

   $ 2      $      $ (1   $ 1   


(In millions)    Corporate
Notes and
Bonds
    Common
and
Preferred
Stock
    Derivative
Assets
    Total  


Three Months and Six Months Ended December 31, 2008                         

Balance as of June 30, 2008

   $   138      $ 8      $   71      $   217   

Total realized and unrealized gains (losses):

                                

Included in other income (expense)

     (9 )        (4 )        48        35   

Included in other comprehensive income

     (29 )                      (29

Purchases, issuances, and settlements

                       (104 )          (104 )   

Transfers in and out of Level 3

     11                      11   


 


 


 


Balance as of September 30, 2008

   $   111      $ 4      $ 15      $ 130   

Total realized and unrealized gains (losses):

                                

Included in other income (expense)

     1        (2            (1

Included in other comprehensive income

     10                      10   

Purchases, issuances, and settlements

                   (15     (15

Transfers in and out of Level 3

     (1                   (1


 


 


 


Balance as of December 31, 2008

   $ 121      $ 2      $      $     123   
    


 


 


 


Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2008 related to assets held as of December 31, 2008

   $      $ (2   $      $ (2

Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2008 related to assets held as of December 31, 2008

   $ (9   $ (5   $ 1      $ (13


Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

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 our 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.

 

PAGE    16


Table of Contents

PART I

Item 1

 

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. During the three months and six months ended December 31, 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. The following table presents prior period balances for those assets required to be measured at fair value on a nonrecurring basis and the associated losses recognized during the three months and six months ended December 31, 2008:

 

(In millions)    December 31,
2008
    Level 1     Level 2     Level 3     Total
Losses
 


Assets                                         

Common and preferred stock

   $     164       $     —       $     —       $     164       $     (85 )   


 


 


 


 


Total

   $     164      $     —      $     —      $     164      $     (85
    


 


 


 


 


NOTE 7    INVENTORIES

The components of inventories were as follows:

 

(In millions)    December 31,     June 30,

2009     2009

Raw materials

            $ 100       $   170 

Work in process

         11        45

Finished goods

         478        502


 

Total

       $   589      $   717
        


 

NOTE 8    BUSINESS COMBINATIONS

During the six months ended December 31, 2009, we acquired four entities for total consideration of $110 million, substantially all of which was paid in cash. During this period, we also sold three entities for total consideration of $602 million, including Razorfish in the second quarter of fiscal year 2010. These entities have been included in or removed from our consolidated results of operations since their acquisition or sale dates, respectively. Pro forma results of operations have not been presented because the effects of these business combinations, individually and in the aggregate, were not material to our consolidated results of operations.

NOTE 9    GOODWILL

Following are details of the changes in our goodwill balances during the three months and six months ended December 31, 2009:

 

(In millions)    Balance     Acquisitions     Purchase
Accounting
Adjustments
and Other
    Balance  


September 30,

2009

  

  

   

 

December 31,

2009

  

  

Windows & Windows Live Division

   $ 77        $       $       $ 77    

Server and Tools

     1,070        49               1,119   

Online Services Division

     6,633               (261     6,372   

Microsoft Business Division

     3,998               (2     3,996   

Entertainment and Devices Division

     804                      804   


 


 


 


Total

   $   12,582      $     49      $     (263   $   12,368   
    


 


 


 


 

PAGE    17


Table of Contents

PART I

Item 1

 

(In millions)    Balance     Acquisitions     Purchase
Accounting
Adjustments
and Other
    Balance  


      
 
June 30,
2009
  
  
 

 

 

December 31,

2009

  

  

Windows & Windows Live Division

   $ 77       $       $       $ 77    

Server and Tools

     1,038        82        (1     1,119   

Online Services Division

     6,657               (285     6,372   

Microsoft Business Division

     3,927        3        66        3,996   

Entertainment and Devices Division

     804                      804   


 


 


 


Total

   $   12,503      $     85      $     (220   $   12,368   
    


 


 


 


None of the amounts recorded as goodwill are expected 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 table above. Also included within “other” is $263 million for the three months ended December 31, 2009 and $286 million for the six months ended December 31, 2009 of goodwill associated with business dispositions. See also Note 8.

In connection with the disposal of Razorfish, we performed an interim impairment analysis of our Online Services Division goodwill balance during the first quarter of fiscal year 2010. No impairment of goodwill was identified.

NOTE 10    INTANGIBLE ASSETS

The components of intangible assets, all of which are finite-lived, were as follows:

 

(In millions)    Gross
Carrying
Amount
    Accumulated
Amortization
    Net
Carrying
Amount
    Gross
Carrying
Amount
    Accumulated
Amortization
    Net
Carrying
Amount

      

 

December 31,

2009

  

  

 

 

 

June 30,

2009

Contract-based

   $ 1,087       $ (884 )      $ 203       $ 1,087       $ (855 )      $ 232

Technology-based

     2,158        (1,284     874        2,033        (1,090     943

Marketing-related

     117        (78     39        188        (97     91

Customer-related

     445        (215     230        732        (239     493


 


 


 


 


 

Total

   $   3,807      $   (2,461   $   1,346      $   4,040      $   (2,281   $   1,759
    


 


 


 


 


 

We generally amortize acquired intangibles on a straight-line basis over their estimated weighted average lives. Intangible assets amortization expense was $169 million for the three months and $318 million for the six months ended December 31, 2009 as compared with $145 million for the three months and $285 million for the six months ended December 31, 2008. The following table outlines the estimated future amortization expense related to intangible assets held at December 31, 2009:

 

(In millions)     

Year Ending June 30,     

2010 (excluding the six months ended December 31, 2009)

   $ 264

2011

     509

2012

     346

2013

     205

2014 and thereafter

     22

Total

   $   1,346
    

 

PAGE    18


Table of Contents

PART I

Item 1

 

NOTE 11    DEBT

In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Our initial commercial paper program provided for the issuance and sale of up to $2.0 billion. Following the issuance of our long-term debt in May 2009, we increased the commercial paper program and issued an additional $250 million of commercial paper during the six months ended December 31, 2009. As of December 31, 2009, we had $2.25 billion of commercial paper and $3.75 billion of long-term debt issued and outstanding.

Short-term Debt

As of December 31, 2009, our $2.25 billion of commercial paper issued and outstanding had a weighted average interest rate, including issuance costs, of 0.14% and maturities of 16 to 210 days. The estimated fair value of this commercial paper approximates its carrying value.

In November 2009, we replaced our $2.0 billion and $1.0 billion credit facilities with a $2.25 billion 364-day credit facility, which expires on November 5, 2010. This facility serves as a back-up for our commercial paper program. As of December 31, 2009, we were in compliance with the financial covenant in the credit facility, 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 facilities during the six months ended December 31, 2009.

Long-term Debt

As of December 31, 2009, we had issued and outstanding $3.75 billion of debt securities 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 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. The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.

As of December 31, 2009, the total carrying value and estimated fair value of our long-term debt were $3.75 billion and $3.77 billion, respectively. The estimated fair value is based on quoted prices for our publicly-traded debt as of December 31, 2009.

NOTE 12    INCOME TAXES

Our effective tax rate was 25% for both the three months and six months ended December 31, 2009, as compared with 26% for the three months and 27% for the six months ended December 31, 2008. The fiscal year 2010 rate reflects a higher mix of foreign earnings taxed at lower rates.

Tax contingencies and other tax liabilities were $6.1 billion as of December 31, 2009 and $5.5 billion as of June 30, 2009, and were included in other long-term liabilities.

NOTE 13    UNEARNED REVENUE

The components of unearned revenue were as follows:

 

(In millions)   

December 31,

    June 30,

            2009        2009

Volume licensing programs

        $   10,058       $   11,350

Undelivered elements

          600        1,083

Other

          1,870        1,851


 

Total

        $ 12,528      $ 14,284
         


 

 

PAGE    19


Table of Contents

PART I

Item 1

 

Unearned revenue by segment was as follows:

 

(In millions)    December 31,     June 30,  


2009     2009  

Windows & Windows Live Division

           $ 1,736       $ 2,345   

Server and Tools

          4,227        4,732   

Microsoft Business Division

          5,680        6,508   

Other segments

          885        699   


 


Total

        $   12,528      $   14,284   
         


 


NOTE 14    PRODUCT WARRANTIES

We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranties, 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 warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly re-evaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary.

Our aggregate product warranty liabilities, which are included in other current liabilities and other long-term liabilities on our balance sheets, changed during the three months and six months ended December 31, 2009 as follows:

 

(In millions)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


          2009          2009  

Balance, beginning of period

             $   289                $   342   

Accrual for warranties issued

          61             94   

Adjustments to pre-existing warranties

          (2          (2

Settlements of warranty claims

          (40          (126


      


Balance, end of period

        $ 308           $ 308   
         


      


NOTE 15    CONTINGENCIES

Government Competition Law Matters

In March 2004, the European Commission issued a competition law decision that, among other things, ordered us to license certain Windows server protocol technology to our competitors. In March 2007, the European Commission issued a statement of objections claiming that the pricing terms we proposed for licensing the technology as required by the March 2004 decision were “not reasonable.” Following additional steps we took to address these concerns, the Commission announced on October 22, 2007 that we were in compliance with the March 2004 decision and that no further penalty should accrue after that date. On February 27, 2008, the Commission issued a fine of $1.4 billion (899 million) relating to the period prior to October 22, 2007. In May 2008, we filed an application with the European Court of First Instance to annul the February 2008 fine. We paid the $1.4 billion (899 million) fine in June 2008, pending the outcome of the appeal.

On December 16, 2009, the European Commission announced that it had adopted a decision that renders legally binding commitments offered by Microsoft to address the Commission’s concerns regarding competition in Web browsing software. This decision ends the Commission’s investigation. It does not address whether a violation of European Commission competition law occurred. The commitments offered by Microsoft broadly ensure that computer manufacturers will remain free to install any browser on the PCs they ship, and they provide for a Web browser “choice screen” to be offered to end users throughout Europe. The Commission had opened its investigation in January 2008 following a complaint filed with the Commission by Opera Software ASA.

 

PAGE    20


Table of Contents

PART I

Item 1

 

In January 2008, the Commission also opened a competition law investigation that relates primarily to interoperability with respect to our Microsoft Office family of products. This investigation resulted from complaints filed with the Commission by a trade association of Microsoft’s competitors. Microsoft has made a number of proposals to address the Commission’s competition law concerns in this area. The Commission announced on December 16, 2009 that it welcomed these proposals and that it will take them into account in assessing this matter.

We are also 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.

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.

The settlements in all states have received final court approval. Cases in Canada have not been settled. We estimate the total cost to resolve all of the overcharge class action cases will range between $1.8 billion and $2.0 billion. The actual cost depends on factors such as the claim rate, the quantity and mix of products for which claims are made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims. At December 31, 2009, we have recorded a liability related to these claims of approximately $700 million, which reflects our estimated exposure of $1.8 billion less payments made to date of approximately $1.1 billion mostly for vouchers, legal fees, and administrative expenses.

Other Antitrust Litigation and Claims

In November 2004, Novell, Inc. filed a complaint in U.S. District Court for the District of Utah, 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. This case was transferred to the District of Maryland. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. Both parties appealed, and in October 2007, the court of appeals affirmed the decision of the trial court, and remanded the case to that court for further proceedings. Summary judgment motions were filed in October 2009, and will be heard in March 2010. If any claims survive those motions, the case will be transferred back to Utah for trial.

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 April 2009, the

 

PAGE    21


Table of Contents

PART I

Item 1

 

U.S. Patent and Trademark Office, after a reexamination of the remaining patent in dispute, determined that the patent was invalid and Alcatel-Lucent has appealed that ruling. On September 11, 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.

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. On September 29, 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. On December 22, 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. We are seeking a rehearing before the court of appeals.

There are over 50 other patent infringement cases pending against Microsoft, 10 of which are set for trial in fiscal year 2010. These cases include a lawsuit filed against Microsoft by VirnetX Inc. in U.S. District Court in Texas in which VirnetX asserts that various Microsoft products including Windows client and server operating systems software and communications software infringe patents relating to certain secure Internet communications. Trial is scheduled for March 2010.

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 December 31, 2009, we had accrued aggregate liabilities of approximately $900 million in other current liabilities and approximately $400 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 be up to $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 16    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 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010. As of September 30, 2009, we had reduced our overall number of positions by approximately 5,000 and headcount by approximately 4,600.

In November 2009, we identified an additional 800 positions for elimination based on our efforts to manage our expenses. Severance expense of approximately $52 million associated with these additional eliminations was reflected in our second quarter financial statements. To date, we have had a headcount reduction of approximately 5,300 under our resource management efforts.

 

PAGE    22


Table of Contents

PART I

Item 1

 

The changes in our employee severance liabilities related to our resource management efforts during the three months and six months ended December 31, 2009 were as follows:

 

(In millions)   

Three Months Ended
December 31,

    Six Months Ended
December 31,
 


     2009     2009  

Balance, beginning of period

            $      42               $    127   

Additional accruals

         52            52   

Adjustments

         7            7   

Cash payments

         (70         (155


     


Balance, end of period

       $ 31          $ 31   
        


     


NOTE 17    STOCKHOLDERS’ EQUITY

Share Repurchases

We repurchased the following shares of common stock during the periods presented:

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2009     2008     2009     2008  

Shares of common stock repurchased

     125        94        183        318   

Value of common stock repurchased

   $   3,583      $   2,234      $   5,028      $   8,200   


We repurchased all shares with cash resources. As of December 31, 2009, approximately $29.5 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:

 

Declaration Date    Per Share
Dividend
    Record Date    Total Amount     Payment Date

                (in millions)      

Fiscal year 2010

                         

September 18, 2009

   $   0.13      November 19, 2009    $   1,152      December 10, 2009

December 9, 2009

   $ 0.13      February 18, 2010    $ 1,145      March 11, 2010

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

The estimate of the amount to be paid as a result of the December 9, 2009 declaration was included in other current liabilities as of December 31, 2009.

NOTE 18    SEGMENT INFORMATION

In its operation of the business, management reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. Our five segments are: Windows & Windows Live Division; Server and Tools; Online Services Division; Microsoft Business Division; and Entertainment and Devices Division. 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, including moving Windows Live from Online Services Division to Windows & Windows Live Division, Mobile Services from Online Services Division to Entertainment and Devices Division, and Razorfish from Online Services Division to Corporate. Razorfish was disposed of during the second quarter of fiscal year 2010.

 

PAGE    23


Table of Contents

PART I

Item 1

 

Segment revenue and operating income (loss) were as follows during the periods presented:

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2009     2008     2009     2008  

Revenue

                                

Windows & Windows Live Division

   $ 5,073      $ 3,930      $ 9,058      $ 8,041   

Server and Tools

     3,848        3,775        7,285        7,214   

Online Services Division

     581        595        1,067        1,108   

Microsoft Business Division

     4,749        4,893        9,155        9,810   

Entertainment and Devices Division

     2,938        3,256        4,829        5,149   

Unallocated and other

     1,833        180        548        368   


 


 


 


Consolidated

   $   19,022      $   16,629      $   31,942      $   31,690   
    


 


 


 


Operating income (loss)

                                

Windows & Windows Live Division

   $ 3,516      $ 2,550      $ 6,324      $ 5,409   

Server and Tools

     1,370        1,336        2,606        2,336   

Online Services Division

     (478     (378     (972     (704

Microsoft Business Division

     2,914        2,991        5,747        6,096   

Entertainment and Devices Division

     361        103        654        237   

Reconciling amounts

     830        (663     (1,364     (1,436


 


 


 


Consolidated

   $ 8,513      $ 5,939      $ 12,995      $ 11,938   
    


 


 


 


Because of our integrated business structure, operating costs included in one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to incent shared efforts. Management will continually evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

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.

Reconciling amounts include adjustments to conform with 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, and accelerated depreciation and amortization of stock-based awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity, including certain legal settlements, accruals for legal contingencies, and accruals for employee severance. For the three months ended December 31, 2009, reconciling amounts include the recognition of previously deferred revenue related to sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and sales of Windows 7 to original equipment manufacturers and retailers before general availability.

 

PAGE    24


Table of Contents

PART I

Item 1

 

Significant reconciling items were as follows:

 

(In millions)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2009     2008     2009     2008  

Corporate-level activity (1)

   $   (1,291   $   (979   $   (2,229   $   (2,086

Stock-based compensation

     109        191        229        371   

Revenue reconciling amounts

     1,787        116        421        303   

Other

     225        9        215        (24


 


 


 


Total

   $ 830      $ (663   $ (1,364   $ (1,436
    


 


 


 


 

(1)

Corporate-level activity excludes stock-based compensation and revenue reconciling amounts presented separately in those line items.

 

PAGE    25


Table of Contents

PART I

Item 1

 

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 December 31, 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for the three-month and six-month periods ended December 31, 2009 and 2008. 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, 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated July 29, 2009 we expressed an unqualified opinion on those consolidated financial statements (which report includes an explanatory paragraph regarding the adoption of new accounting standards). In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 2009 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

January 28, 2010

 

PAGE    26


Table of Contents

PART I

Item 2

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Note About Forward-Looking Statements

Certain statements in Management’s Discussion and Analysis (“MD&A”), 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. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “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). 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, 2009 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 video game console, the Zune digital music and entertainment device, and peripherals. Online offerings and information are delivered through Bing, Windows Live, Office Live, Xbox 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 yearly segment revenues in our second fiscal quarter. In addition, quarterly revenues may be impacted by the deferral of revenue. See the discussion below regarding the deferral of revenue related to Windows 7, which negatively impacted revenue for the first quarter of fiscal year 2010 and positively impacted revenue for the second quarter of fiscal year 2010.

All growth and percentage comparisons refer to the three months and six months ended December 31, 2009, as compared with the three months and six months ended December 31, 2008, unless otherwise noted.

Summary

 

(In millions, except per share amounts and percentages)    Three Months Ended
December 31,
    Percentage
Change
   Six Months Ended
December 31,
    Percentage
Change

     2009     2008          2009     2008      

Revenue

   $   19,022      $   16,629      14%    $   31,942      $   31,690      1%

Operating income

   $ 8,513      $ 5,939      43%    $ 12,995      $ 11,938      9%

Diluted earnings per share

   $ 0.74      $ 0.47      57%    $ 1.14      $ 0.94      21%

 

PAGE    27


Table of Contents

PART I

Item 2

 

Three months ended December 31, 2009 compared with three months ended December 31, 2008

Revenue increased mainly due to the launch of Windows 7 on October 22, 2009. Operating income increased reflecting increased revenue and decreased operating expenses in most categories.

 

   

Cost of revenue decreased $279 million or 7%, primarily reflecting decreased Xbox 360 console costs and cost controls, offset in part by increased online costs, mainly traffic acquisition costs.

 

   

Research and development expenses decreased $211 million or 9%, primarily reflecting a decrease in third-party development and programming costs, a decrease in headcount, and the capitalization of certain software development costs.

 

   

General and administrative expenses increased $293 million or 35%, primarily due to increased legal charges.

Diluted earnings per share increased primarily reflecting increased net income and share repurchases during the past 12 months. We repurchased 183 million shares during the 12 months ended December 31, 2009.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

Revenue increased mainly due to the launch of Windows 7 on October 22, 2009. Operating income increased reflecting increased revenue and decreased operating expenses in most categories.

 

   

Research and development expenses decreased $429 million or 9%, primarily reflecting a decrease in third-party development and programming costs, a decrease in headcount, and the capitalization of certain software development costs.

 

   

Sales and marketing expenses decreased $297 million or 4%, due mainly to cost controls and decreased corporate marketing and advertising spending.

 

   

Cost of revenue decreased $285 million or 4%, primarily reflecting decreased Xbox 360 console costs and cost controls, offset in part by increased online costs, mainly traffic acquisition costs.

 

   

General and administrative expenses increased $147 million or 9%, primarily due to increased legal charges, offset in part by cost controls.

Diluted earnings per share increased primarily reflecting increased net income and share repurchases during the past 12 months.

Demand for our software, services, hardware, and online offerings has a strong correlation to global macroeconomic factors. While we see the potential for improvement in calendar year 2010, the timing is uncertain. 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 of America (“U.S. GAAP”) and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 18 – Segment Information of the Notes to Financial Statements (Part I, Item I) 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 section to conform to the way we internally managed and monitored segment performance during fiscal year 2010, including moving Windows Live from Online Services Division to Windows & Windows Live Division, Mobile Services from Online Services Division to Entertainment and Devices Division, and Razorfish from Online Services Division to Corporate. Razorfish was disposed of in the second quarter of fiscal year 2010.

 

PAGE    28


Table of Contents

PART I

Item 2

 

Windows & Windows Live Division

 

(In millions, except percentages)   

Three Months Ended

December 31,

    Percentage
Change
   Six Months Ended
December 31,
    Percentage
Change

     2009     2008          2009     2008      

Revenue

   $      6,904      $      4,064      70%    $      9,528      $      8,337      14%

Operating income

   $ 5,394      $ 2,712      99%    $ 6,854      $ 5,761      19%

Windows & Windows Live (“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, Windows 7 Professional, Windows 7 Ultimate, Windows 7 Enterprise, Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, and Windows Vista Enterprise. Standard editions include Windows 7 Starter, Windows 7 Home Basic, Windows Vista Home Basic, and Windows XP Home. Windows Live primarily generates revenue from online advertising.

Windows Division 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 approximately 80% of total Windows Division revenue. The remaining approximately 20% of Windows Division revenue (“other revenue”) is generated by commercial and retail sales of Windows and online advertising from Windows Live. In the first quarter of fiscal year 2010, we deferred revenue (the “Windows 7 Deferral”) associated with sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and with sales of Windows 7 to retailers before general availability. We recognized the majority of this deferred revenue in the second quarter after launching Windows 7 on October 22, 2009.

Three months ended December 31, 2009 compared with three months ended December 31, 2008

Windows Division revenue increased due to strong sales of Windows 7 and PC market improvement. We estimate total worldwide PC shipments from all sources grew approximately 15% to 17%. OEM revenue increased $2.3 billion or 72%. Excluding $1.7 billion of revenue recognized related to the Windows 7 Deferral, OEM revenue increased $664 million or 21%, while OEM license units increased 22%. The OEM revenue increase was primarily driven by PC market growth, higher Windows attach rates across all regions, channels, and types of PCs and the restoration of normal OEM inventory levels, offset in part by PC market changes, including stronger growth of consumer PCs versus business PCs and of emerging markets versus developed markets. Other revenue increased $511 million or 60% driven primarily by strong Windows 7 retail sales.

Windows Division operating income increased as a result of increased revenue, offset in part by increased operating expenses. Cost of revenue increased $81 million or 25%, primarily driven by increased retail product costs, traffic acquisition costs and royalties. Sales and marketing expenses increased $113 million or 18% reflecting increased advertising and marketing campaigns for the launch of Windows 7.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

Windows Division revenue increased primarily as a result of strong sales of Windows 7 and PC market improvement. We estimate total worldwide PC shipments from all sources grew approximately 8% to 10%. OEM revenue increased $708 million or 11%. Excluding the recognition of $248 million of revenue associated with the Windows 7 Deferral, OEM revenue increased $460 million or 7%, while OEM license units increased 14%. The OEM revenue increase was primarily driven by PC market growth, higher Windows attach rates across all regions, channels, and types of PCs and the restoration of normal OEM inventory levels, offset in part by PC market changes, including stronger growth of consumer PCs versus business PCs and of emerging markets versus developed markets. Other revenue increased $483 million or 29% driven primarily by strong Windows 7 retail sales.

 

PAGE    29


Table of Contents

PART I

Item 2

 

Windows Division operating income increased as a result of increased revenue, offset in part by increased operating expenses. Cost of revenue increased $122 million or 19%, primarily driven by increased retail product costs, traffic acquisition costs, and royalties. Research and development expenses decreased $76 million or 11%, primarily as a result of capitalization of certain software development costs and completion of Windows 7 product development. Sales and marketing expenses increased $74 million or 6%.

Server and Tools

 

(In millions, except percentages)   

Three Months Ended

December 31,

    Percentage
Change
   Six Months Ended
December 31,
    Percentage
Change

     2009     2008          2009     2008      

Revenue

   $      3,844      $      3,755      2%    $      7,278      $      7,172      1%

Operating income

   $ 1,491      $ 1,375      8%    $ 2,767      $ 2,409      15%

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 product 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 and certification. Our services offerings include 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. Approximately 50% of Server and Tools revenue comes from annuity volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, fully packaged product and licenses sold to OEMs, and the remainder comes from services.

Three months ended December 31, 2009 compared with three months ended December 31, 2008

Server and Tools revenue increased reflecting growth in product revenue, offset in part by a decline in services revenue. Product revenue increased $103 million or 3%, primarily driven by growth in Windows Server, Enterprise CAL Suites and System Center revenue. The growth in product revenue reflects continued adoption of Windows platform applications. Services revenue declined $14 million or 2%, primarily due to decreased revenue from consulting services.

Server and Tools operating income increased primarily due to product revenue growth and a decrease in research and development expenses. Research and development expenses decreased $41 million or 7%, primarily driven by decreased headcount-related expenses and third-party development and programming costs.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

Server and Tools revenue increased reflecting growth in product revenue, offset in part by a decline in services revenue. Product revenue increased $138 million or 2%, primarily driven by growth in Enterprise CAL Suites, System Center and SQL Server revenue. The growth in product revenue reflects increased revenue from annuity volume licensing agreements and continued adoption of Windows platform applications. Services revenue declined $32 million or 2%, primarily due to decreased revenue from consulting services.

Server and Tools operating income increased primarily due to product revenue growth and decreases in all operating expense categories. Sales and marketing expenses decreased $87 million or 4%, primarily due to a decrease in headcount-related expenses and corporate marketing expenses. Research and development expenses decreased $70 million or 6%, primarily driven by reduced third-party development and programming costs and headcount-related expenses. Cost of revenue decreased $66 million or 5%, reflecting the decline in demand for consulting services. General and administrative expenses decreased $27 million or 14%, due to decreased headcount-related expenses.

 

PAGE    30


Table of Contents

PART I

Item 2

 

Online Services Division

 

(In millions, except percentages)    Three Months Ended
December 31,
    Percentage
Change
       Six Months Ended
December 31,
    Percentage
Change

     2009     2008              2009     2008      

Revenue

   $         581      $         609      (5)%        $      1,067      $      1,132      (6)%

Operating loss

   $ (466   $ (320   (46)%        $ (950   $ (635   (50)%

Online Services Division (“OSD”) consists of an online advertising platform with offerings for both publishers and advertisers, 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, and advertiser and publisher tools. Revenue is also generated through subscriptions and transactions generated from online paid services and from MSN narrowband Internet access subscribers (“Access”).

Three months ended December 31, 2009 compared with three months ended December 31, 2008

OSD revenue decreased as a result of lower Access and online advertising revenue. Access revenue decreased $14 million or 29%, reflecting continued migration of subscribers to broadband or other competitively-priced service providers. Online advertising revenue decreased $11 million or 2%, to $516 million, reflecting a decrease in display advertising and advertiser and publisher tools revenue, offset in part by an increase in search revenue. Foreign currency exchange rates accounted for a $13 million or two percentage point increase in revenue.

OSD operating loss increased mainly due to increased cost of revenue and decreased revenue, offset in part by decreased research and development expenses. Cost of revenue increased $171 million or 50%, primarily driven by higher online traffic acquisition costs. Research and development expenses decreased $49 million or 17%, primarily due to decreased third-party development and programming costs and headcount-related expenses.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

OSD revenue decreased primarily as a result of lower online advertising and Access revenue. Online advertising revenue decreased $32 million or 3%, to $934 million, primarily reflecting a decrease in display advertising and advertiser and publisher tools revenue. Access revenue decreased $28 million or 29%, reflecting continued migration of subscribers to broadband or other competitively-priced service providers.

OSD operating loss increased mainly due to increased cost of revenue and decreased revenue, offset in part by decreased research and development expenses. Cost of revenue increased $347 million or 54%, primarily driven by higher online traffic acquisition costs. Research and development expenses decreased $88 million or 16%, primarily due to decreased third-party development and programming costs.

Yahoo! Commercial Agreement

On December 4, 2009, we entered into a definitive 10-year agreement with Yahoo! Inc. (“Yahoo”) whereby 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; we expect to close the transaction in fiscal year 2010.

Microsoft Business Division

 

(In millions, except percentages)   

Three Months Ended

December 31,

    Percentage
Change
       Six Months Ended
December 31,
    Percentage
Change

     2009     2008              2009     2008      

Revenue

   $      4,745      $      4,881      (3)%        $      9,149      $      9,835      (7)%

Operating income

   $ 3,010      $ 3,021      —%        $ 5,867      $ 6,199      (5)%

 

PAGE    31


Table of Contents

PART I

Item 2

 

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. 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 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.

Three months ended December 31, 2009 compared with three months ended December 31, 2008

MBD revenue decreased reflecting decreased business revenue partially offset by increased consumer revenue. Business revenue decreased $231 million or 6%, primarily reflecting a decline in licensing the 2007 Microsoft Office system to transactional business customers, offset in part by a 1% increase in Microsoft Dynamics revenue. Consumer revenue increased $95 million or 12%, primarily as a result of growth in the PC market.

MBD operating income was flat reflecting decreased revenue, offset by decreased sales and marketing and research and development expenses. Sales and marketing expenses decreased $81 million or 7%, primarily driven by a decrease in corporate marketing activities and headcount-related costs associated with our corporate sales force. Research and development expenses decreased $64 million or 15%, primarily as a result of capitalization of certain Microsoft Office system software development costs.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

MBD revenue decreased reflecting decreased business and consumer revenue. Business revenue decreased $392 million or 5%, primarily reflecting a decline in licensing the 2007 Microsoft Office system to transactional business customers and a 2% decrease in Microsoft Dynamics revenue, offset in part by growth in multi-year volume licensing agreement revenue. The growth in multi-year volume licensing agreement revenue primarily reflects recognition of deferred revenue from previously signed agreements. Consumer revenue decreased $295 million or 15%, primarily as a result of pricing promotions in the first half of fiscal year 2009 that drove increased licensing in that period, a shift to lower-priced products, and a decline in licensing the 2007 Microsoft Office system.

MBD operating income decreased due mainly to decreased revenue, offset in part by decreased sales and marketing and research and development expenses. Sales and marketing expenses decreased $262 million or 12%, primarily driven by a decrease in corporate marketing activities and headcount-related costs associated with our corporate sales force. Research and development expenses decreased $95 million or 11%, primarily as a result of capitalization of certain Microsoft Office system software development costs and lower headcount-related expenses.

Entertainment and Devices Division

 

(In millions, except percentages)    Three Months Ended
December 31,
    Percentage
Change
       Six Months Ended
December 31,
    Percentage
Change

     2009     2008              2009     2008      

Revenue

   $      2,902      $      3,256      (11)%        $      4,793      $      5,149      (7)%

Operating income

   $ 375      $ 130      188 %        $ 686      $ 290      137 %

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 (including Zune HD, which was released in September 2009), PC software games, online games and services, Mediaroom (our Internet protocol television software), the Microsoft Surface computing platform, Windows 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.

 

PAGE    32


Table of Contents

PART I

Item 2

 

Three months ended December 31, 2009 compared with three months ended December 31, 2008

EDD revenue decreased reflecting a $295 million or 12% decline in Xbox 360 platform and PC game revenue. This decrease was due mainly to decreased revenue from Xbox 360 video games, decreased Xbox 360 consoles sold, and decreased revenue per console, offset in part by increased Xbox LIVE revenue. The decreased revenue from Xbox 360 video games was due primarily to the release of two significant games in the second quarter of the prior year. We shipped 5.2 million Xbox 360 consoles during the second quarter of fiscal year 2010, compared with 6.0 million Xbox 360 consoles during the second quarter of fiscal year 2009. The decreased revenue per console resulted from price reductions during the past 12 months. Non-gaming revenue decreased $59 million or 8%, primarily reflecting decreased sales of Zune digital music and entertainment devices and Windows Mobile device platforms. Foreign currency exchange rates accounted for a $49 million or two percentage point increase in revenue.

EDD operating income increased due to reduced operating expenses. Cost of revenue decreased $478 million or 23%, primarily due to lower Xbox 360 console costs, offset in part by increased royalties to partners related to increased Xbox LIVE transactions. Sales and marketing expenses decreased $75 million or 15%, primarily due to decreased marketing for the Xbox 360 platform. Research and development expenses decreased $50 million or 10%, primarily reflecting decreased headcount-related expenses and third-party development and programming costs.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

EDD revenue decreased reflecting decreases in Xbox 360 platform and PC game revenue, as well as decreased revenue from the non-gaming portion of the business. Xbox 360 platform and PC game revenue decreased by $199 million or 5% due mainly to decreased Xbox 360 consoles sold, decreased revenue per console, and decreased revenue from Xbox 360 games, offset in part by increased Xbox LIVE revenue. We shipped 7.3 million Xbox 360 consoles during the first half of fiscal year 2010, compared with 8.3 million Xbox 360 consoles during the first half of fiscal year 2009. The decreased revenue per console resulted from price reductions during the past 12 months. The decreased revenue from Xbox 360 video games was due primarily to the release of two significant games in the second quarter of the prior year. Non-gaming revenue decreased $157 million or 11%, primarily reflecting decreased sales of Zune digital music and entertainment devices and Window Mobile device platforms.

EDD operating income increased due to reduced operating expenses. Cost of revenue decreased $581 million or 19%, primarily due to lower Xbox 360 console costs, offset in part by increased royalties to partners related to increased Xbox LIVE transactions. Sales and marketing expenses decreased by $59 million or 8%, primarily due to decreased marketing for the Xbox 360 platform. Research and development expenses decreased $113 million or 12%, primarily reflecting decreased headcount-related expenses and third-party development and programming costs.

Corporate-Level Activity

 

(In millions, except percentages)    Three Months Ended
December 31,
    Percentage
Change
       Six Months Ended
December 31,
    Percentage
Change

     2009     2008              2009     2008      

Corporate-level activity

   $     (1,291 )      $     (979 )      (32)%        $     (2,229 )      $     (2,086 )      (7)%

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, and legal settlements and contingencies. Corporate-level expenses increased, primarily reflecting an increase in legal charges, offset in part by cost controls and for the six months ended December 31, 2009, by decreased partner payments. Legal charges were approximately $290 million during the three months ended December 31, 2009.

 

PAGE    33


Table of Contents

PART I

Item 2

 

OPERATING EXPENSES

Cost of Revenue

 

(In millions, except percentages)    Three Months Ended
December 31,
    Percentage
Change
       Six Months Ended
December 31,
    Percentage
Change

     2009     2008              2009     2008      

Cost of revenue

   $      3,628      $      3,907      (7)%        $      6,470      $      6,755      (4)%

As a percent of revenue

     19     23   (4)ppt          20     21   (1)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 websites 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. Cost of revenue decreased reflecting decreased Xbox 360 platform costs and cost controls, offset in part by increased online costs, including traffic acquisition costs.

Research and Development

 

(In millions, except percentages)    Three Months Ended
December 31,
    Percentage
Change
       Six Months Ended
December 31,
    Percentage
Change

     2009     2008              2009     2008      

Research and development

   $      2,079      $      2,290      (9)%        $      4,144      $      4,573      (9)%

As a percent of revenue

     11     14   (3)ppt          13     14   (1)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. The decrease in research and development expenses during the three months and six months ended December 31, 2009 was primarily driven by a decrease in third-party development and programming costs, a 3% reduction in headcount-related expenses, and the capitalization of certain software development costs.

Sales and Marketing

 

(In millions, except percentages)   

Three Months Ended

December 31,

    Percentage
Change
       Six Months Ended
December 31,
    Percentage
Change

     2009     2008              2009     2008      

Sales and marketing

   $      3,619      $      3,662      (1)%        $      6,409      $      6,706      (4)%

As a percent of revenue

     19     22   (3)ppt          20     21   (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. Sales and marketing expenses decreased primarily as a result of decreased corporate marketing and advertising campaigns, and for the six months ended December 31, 2009, a 3% reduction in headcount-related expenses.

 

PAGE    34


Table of Contents

PART I

Item 2

 

General and Administrative

 

(In millions, except percentages)   

Three Months Ended

December 31,

    Percentage
Change
       Six Months Ended
December 31,
    Percentage
Change

     2009     2008              2009     2008      

General and administrative

   $      1,124      $      831      35%        $      1,865      $      1,718      9%

As a percent of revenue

     6     5   1ppt          6     5   1ppt

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 during the three months and six months ended December 31, 2009 primarily driven by increased legal charges, offset in part by an 8% decrease in headcount-related expenses for the six months ended December 31, 2009.

OTHER INCOME (EXPENSE) AND INCOME TAXES

Other Income (Expense)

The components of other income (expense) were as follows:

 

(In millions, except percentages)   

Three Months Ended

December 31,

    Percentage
Change
       Six Months Ended
December 31,
    Percentage
Change

     2009     2008              2009     2008      

Dividends and interest

   $         159       $      175      (9)%        $        324       $      382      (15)%

Net recognized gains on investments

     92        270      (66)%          162        399      (59)%

Net gains (losses) on derivatives

     96        (409   *          92        (574   *

Net gains (losses) on foreign currency
remeasurements

     (23     (350   (93)%          32        (529   *

Other

     46        13      254 %          43        13      231 %


 


          


 


   

Total

   $ 370      $ (301   *        $ 653      $ (309   *
    


 


          


 


   

 

*

Not meaningful

Three months ended December 31, 2009 compared with three months ended December 31, 2008

Dividends and interest decreased primarily due to increased interest expense on our long-term debt and lower interest rates on our fixed-income investments, offset in part by higher average investment portfolio balances. Net recognized gains on investments decreased primarily due to sales of certain equity investments held in our strategic investments portfolio in the prior period, offset in part by lower other-than-temporary impairments. Other-than-temporary impairments were $6 million during the three months ended December 31, 2009, as compared with $262 million during the three months ended December 31, 2008 and decreased primarily due to improvements in market conditions. Net gains on derivatives increased across all asset classes in the current period as compared with losses in the prior period. Net losses from foreign currency remeasurements declined due to a weakening U.S. dollar. Other includes a gain on the divestiture of Razorfish.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

Dividends and interest decreased primarily due to increased interest expense on our long-term debt and lower interest rates on our fixed-income investments, offset in part by higher average investment portfolio balances. Net recognized gains on investments decreased primarily due to sales of certain equity investments held in our strategic investments portfolio in the prior period, offset in part by lower other-than-temporary impairments. Other-than-temporary impairments were $24 million during the six months ended December 31, 2009, as compared with $334 million during the six months ended December 31, 2008 and decreased primarily due to improvements in market conditions. Net gains on derivatives increased across all asset classes as compared to the prior period. Net gains from foreign currency remeasurements compared to net losses in the prior period were due to a weakening U.S. dollar. Other includes a gain on the divestiture of Razorfish.

 

PAGE    35


Table of Contents

PART I

Item 2

 

Income Taxes

Our effective tax rate was 25% for both the three months and six months ended December 31, 2009, as compared with 26% for the three months and 27% for the six months ended December 31, 2008. The fiscal year 2010 rate reflects a higher mix of foreign earnings taxed at lower rates.

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $36.1 billion as of December 31, 2009, compared with $31.4 billion as of June 30, 2009. Equity and other investments were $7.0 billion as of December 31, 2009, compared with $4.9 billion as of June 30, 2009. 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 currency-denominated securities in order to diversify risk. We invest primarily in short-term securities to facilitate liquidity and for capital preservation.

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 December 31, 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.

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. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability.

Debt

In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Our initial commercial paper program provided for the issuance and sale of up to $2.0 billion. Following the issuance of our long-term debt in May 2009, we increased the commercial paper program and issued an additional $250 million of commercial paper during the six months ended December 31, 2009. As of December 31, 2009, we had $2.25 billion of commercial paper and $3.75 billion of long-term debt issued and outstanding.

 

PAGE    36


Table of Contents

PART I

Item 2

 

Short-term Debt

As of December 31, 2009, our $2.25 billion of commercial paper issued and outstanding had a weighted average interest rate, including issuance costs, of 0.14% and maturities of 16 to 210 days. In November 2009, we replaced our $2.0 billion and $1.0 billion credit facilities with a $2.25 billion 364-day credit facility, which expires on November 5, 2010. This facility serves as a back-up for our commercial paper program. As of December 31, 2009, we were in compliance with the financial covenant in the credit facility, which requires a coverage ratio maintained of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against the credit facilities during the six months ended December 31, 2009.

Long-term Debt

As of December 31, 2009, we had issued and outstanding $3.75 billion of debt securities 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 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. The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.

We are using 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 at December 31, 2009 comprised mainly unearned revenue from volume licensing programs. Unearned revenue from 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. Unearned revenue at December 31, 2009 also included payments for: unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis for Windows XP; post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions; Microsoft Dynamics business solutions products; unspecified enhancements for Zune HD; the Windows 7 Upgrade Option program; online advertising for which the advertisement has yet to be displayed; 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 future recognition of unearned revenue as of December 31, 2009:

 

(In millions)       


Three Months Ending,       

March 31, 2010

   $ 4,975   

June 30, 2010

     3,384   

September 30, 2010

     1,924   

December 31, 2010

     1,078   

Thereafter

     1,167   


Total

   $   12,528   
    


See Note 13 – Unearned Revenue of the Notes to Financial Statements (Part I, Item 1).

Retained Deficit

As a result of the special dividend paid in the second quarter of fiscal year 2005 and common stock repurchased, our retained deficit, including accumulated other comprehensive income, was $18.3 billion at December 31, 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.

 

PAGE    37


Table of Contents

PART I

Item 2

 

Cash Flows

Cash flow from operations increased $1.9 billion to $11.1 billion for the six months ended December 31, 2009. This increase was due mainly to payment of approximately $3.1 billion to the Internal Revenue Service in the prior year as a result of our settlement of the 2000-2003 audit examination, offset in part by a decrease in cash received from customers in the current year.

Cash used for financing was $6.5 billion for the six months ended December 31, 2009, a decrease of $2.6 billion from the corresponding period of the prior year. This decrease was due mainly to a $3.9 billion decrease in common stock repurchases, offset in part by a $1.7 billion decrease in net proceeds from debt and short-term borrowings.

Cash used in investing was $1.3 billion for the six months ended December 31, 2009, a decrease of $613 million from the corresponding period of the prior year. This decrease reflects lower additions to property and equipment.

Share Repurchases

During the three months and six months ended December 31, 2009, we repurchased 125 million and 183 million shares of Microsoft common stock for $3.6 billion and $5.0 billion, respectively, under the repurchase plan we announced on September 22, 2008. As of December 31, 2009, approximately $29.5 billion remained of the $40.0 billion approved repurchase amount. All repurchases were made using cash resources. 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:

 

Declaration Date    Per Share
Dividend
    Record Date    Total Amount     Payment Date

                (in millions)      

Fiscal year 2010

                         

September 18, 2009

   $   0.13      November 19, 2009    $   1,152      December 10, 2009

December 9, 2009

   $ 0.13      February 18, 2010    $ 1,145      March 11, 2010

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

Other Planned Uses of Capital

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. We have operating leases for most U.S. and international sales and support offices and certain equipment. 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.

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.

 

PAGE    38


Table of Contents

PART I

Item 2

 

Off-Balance Sheet Arrangements

We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our 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.

RECENT ACCOUNTING GUIDANCE

Recently Adopted Accounting Guidance

On July 1, 2009, we adopted guidance issued by the Financial Accounting Standards Board (“FASB”) on business combinations. The guidance retains the fundamental requirements 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 and measured 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. We have applied this guidance to business combinations completed since July 1, 2009.

On July 1, 2009, we adopted the guidance issued by the FASB that changes the accounting and reporting for non-controlling interests. Non-controlling interests are to 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 are to be accounted for as equity transactions. In addition, net income attributable to a non-controlling interest is to be included in net income and, upon a loss of control, the interest sold, as well as any interest retained, is to be recorded at fair value with any gain or loss recognized in net income. Adoption of the new guidance did not have a material impact on our financial statements.

On July 1, 2009, we adopted the guidance on fair value measurement for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). 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 recurring and nonrecurring fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of 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 January 1, 2010, except for the disclosure on the roll forward activities for Level 3 fair value measurements, which will become effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, adoption of this new guidance will not have a material impact on our financial statements.

In October 2009, the FASB issued guidance on revenue recognition that will become effective for us beginning July 1, 2010, with earlier adoption permitted. 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 will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be 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. We believe adoption of this new guidance will not have a material impact on our financial statements.

In June 2009, the FASB issued guidance on the consolidation of variable interest entities, which is effective for us beginning July 1, 2010. 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. We believe adoption of this new guidance will not have a material impact on our financial statements.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our financial statements and accompanying notes are prepared in