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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 September 30, 2016

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: 001-37845

 


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 October 14, 2016  


Common Stock, $0.00000625 par value per share

     7,775,350,501 shares   

 



Table of Contents

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended September 30, 2016

INDEX

 

                 Page  

PART I.

  FINANCIAL INFORMATION        
    Item 1.   Financial Statements        
        a)    Income Statements for the Three Months Ended September 30, 2016 and 2015     3   
        b)    Comprehensive Income Statements for the Three Months Ended September 30, 2016 and 2015     4   
        c)    Balance Sheets as of September 30, 2016 and June 30, 2016     5   
        d)    Cash Flows Statements for the Three Months Ended September 30, 2016 and 2015     6   
        e)    Stockholders’ Equity Statements for the Three Months Ended September 30, 2016 and 2015     7   
        f)    Notes to Financial Statements     8   
        g)    Report of Independent Registered Public Accounting Firm     30   
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations     31   
    Item 3.   Quantitative and Qualitative Disclosures About Market Risk     43   
    Item 4.   Controls and Procedures     44   

PART II.  

  OTHER INFORMATION        
    Item 1.   Legal Proceedings     45   
    Item 1A.   Risk Factors     45   
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds     54   
    Item 6.   Exhibits     55   

SIGNATURE

    56   

 

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 September 30,    2016     2015  

Revenue:

                

Product

   $   13,493      $   15,219   

Service and other

     6,960        5,160   


 


Total revenue

     20,453        20,379   


 


Cost of revenue:

                

Product

     3,581        4,035   

Service and other

     4,263        3,172   


 


Total cost of revenue

     7,844        7,207   


 


Gross margin

     12,609        13,172   

Research and development

     3,106        2,962   

Sales and marketing

     3,233        3,333   

General and administrative

     1,045        1,084   


 


Operating income

     5,225        5,793   

Other income (expense), net

     100        (280


 


Income before income taxes

     5,325        5,513   

Provision for income taxes

     635        611   


 


Net income

   $ 4,690      $ 4,902   
    


 


Earnings per share:

                

Basic

   $ 0.60      $ 0.61   

Diluted

   $ 0.60      $ 0.61   

Weighted average shares outstanding:

                

Basic

     7,789        7,996   

Diluted

     7,876        8,084   

Cash dividends declared per common share

   $ 0.39      $ 0.36   


See accompanying notes.

 

3


Table of Contents

PART I

Item 1

 

COMPREHENSIVE INCOME STATEMENTS

 

(In millions) (Unaudited)             


Three Months Ended September 30,    2016     2015  

Net income

   $   4,690      $   4,902   
    


 


Other comprehensive income (loss):

                

Net unrealized gains (losses) on derivatives (net of tax effects of $(2) and $23)

     (37     57   

Net unrealized gains (losses) on investments (net of tax effects of $44 and $(308))

     83        (571

Translation adjustments and other (net of tax effects of $7 and $(12))

     98        (270


 


Other comprehensive income (loss)

     144        (784


 


Comprehensive income

   $ 4,834      $ 4,118   
    


 


See accompanying notes.

 

4


Table of Contents

PART I

Item 1

 

BALANCE SHEETS

 

(In millions) (Unaudited)             


     September 30,
2016
    June 30,
2016
 

Assets

                

Current assets:

                

Cash and cash equivalents

   $ 13,928      $ 6,510   

Short-term investments (including securities loaned of $147 and $204)

     123,004        106,730   


 


Total cash, cash equivalents, and short-term investments

     136,932        113,240   

Accounts receivable, net of allowance for doubtful accounts of $284 and $426

     11,129        18,277   

Inventories

     3,122        2,251   

Other

     6,726        5,892   


 


Total current assets

     157,909        139,660   

Property and equipment, net of accumulated depreciation of $20,885 and $19,800

     19,224        18,356   

Equity and other investments

     10,486        10,431   

Goodwill

     17,907        17,872   

Intangible assets, net

     3,522        3,733   

Other long-term assets

     3,476        3,416   


 


Total assets

   $   212,524      $   193,468   
    


 


Liabilities and stockholders’ equity

                

Current liabilities:

                

Accounts payable

   $ 6,296      $ 6,898   

Short-term debt

     14,536        12,904   

Accrued compensation

     3,621        5,264   

Income taxes

     720        580   

Short-term unearned revenue

     26,304        27,468   

Securities lending payable

     210        294   

Other

     7,123        5,949   


 


Total current liabilities

     58,810        59,357   

Long-term debt

     60,154        40,557   

Long-term unearned revenue

     7,284        6,441   

Deferred income taxes

     1,564        1,476   

Other long-term liabilities

     14,340        13,640   


 


Total liabilities

     142,152        121,471   


 


Commitments and contingencies

                

Stockholders’ equity:

                

Common stock and paid-in capital—shares authorized 24,000; outstanding 7,784 and 7,808

     67,747        68,178   

Retained earnings

     944        2,282   

Accumulated other comprehensive income

     1,681        1,537   


 


Total stockholders’ equity

     70,372        71,997   


 


Total liabilities and stockholders’ equity

   $ 212,524      $ 193,468   
    


 


See accompanying notes.

 

5


Table of Contents

PART I

Item 1

 

CASH FLOWS STATEMENTS

 

(In millions) (Unaudited)             


Three Months Ended September 30,    2016     2015  

Operations

                

Net income

   $ 4,690      $ 4,902   

Adjustments to reconcile net income to net cash from operations:

                

Depreciation, amortization, and other

     1,816        1,461   

Stock-based compensation expense

     703        674   

Net recognized losses (gains) on investments and derivatives

     (311     101   

Deferred income taxes

     15        73   

Deferral of unearned revenue

     12,583        10,423   

Recognition of unearned revenue

       (12,904       (11,355

Changes in operating assets and liabilities:

                

Accounts receivable

     7,174        6,376   

Inventories

     (867     (937

Other current assets

     (966     (562

Other long-term assets

     (29     (5

Accounts payable

     (443     (135

Other current liabilities

     (361     (2,024

Other long-term liabilities

     449        (116


 


Net cash from operations

     11,549        8,876   


 


Financing

                

Proceeds from issuance (repayments) of short-term debt, maturities of 90 days or less, net

     (3,390     4,890   

Proceeds from issuance of debt

     24,977        121   

Repayments of debt

     (225     (1,750

Common stock issued

     241        219   

Common stock repurchased

     (4,362     (4,757

Common stock cash dividends paid

     (2,800     (2,475

Other

     (112     (178


 


Net cash from (used in) financing

     14,329        (3,930


 


Investing

                

Additions to property and equipment

     (2,163     (1,356

Acquisition of companies, net of cash acquired, and purchases of intangible and other assets

     (24     (390

Purchases of investments

     (57,181     (37,570

Maturities of investments

     8,659        5,686   

Sales of investments

     32,323        28,502   

Securities lending payable

     (84     62   


 


Net cash used in investing

     (18,470     (5,066


 


Effect of foreign exchange rates on cash and cash equivalents

     10        (44


 


Net change in cash and cash equivalents

     7,418        (164

Cash and cash equivalents, beginning of period

     6,510        5,595   


 


Cash and cash equivalents, end of period

   $ 13,928      $ 5,431   
    


 


See accompanying notes.

 

6


Table of Contents

PART I

Item 1

 

STOCKHOLDERS’ EQUITY STATEMENTS

 

(In millions) (Unaudited)             


Three Months Ended September 30,    2016     2015  

Common stock and paid-in capital

                

Balance, beginning of period

   $   68,178      $   68,465   

Common stock issued

     241        219   

Common stock repurchased

     (1,374     (1,548

Stock-based compensation expense

     703        674   

Other, net

     (1     1   


 


Balance, end of period

     67,747        67,811   


 


Retained earnings

                

Balance, beginning of period

     2,282        9,096   

Net income

     4,690        4,902   

Common stock cash dividends

     (3,025     (2,862

Common stock repurchased

     (3,003     (3,240


 


Balance, end of period

     944        7,896   


 


Accumulated other comprehensive income

                

Balance, beginning of period

     1,537        2,522   

Other comprehensive income (loss)

     144        (784


 


Balance, end of period

     1,681        1,738   


 


Total stockholders’ equity

   $ 70,372      $ 77,445   
    


 


See accompanying notes.

 

7


Table of Contents

PART I

Item 1

 

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 — ACCOUNTING POLICIES

Accounting Principles

We prepare our unaudited interim consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). In the opinion of management, the unaudited interim consolidated financial statements reflect all adjustments of a normal recurring nature that are necessary for a fair presentation of the results for the interim periods presented. 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 2016 Form 10-K filed with the U.S. Securities and Exchange Commission on July 28, 2016.

We have recast certain prior period amounts to conform to the current period presentation, with no impact on consolidated net income or cash flows.

Principles of Consolidation

The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we are able to exercise significant influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method.

Estimates and Assumptions

Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates include: loss contingencies; product warranties; the fair value of, and/or potential impairment of goodwill and intangible assets, for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; allowances for product returns; the market value of and volume of demand for our inventory; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software arrangement, including the distinction between upgrades or 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 on our consolidated financial statements or tax returns; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.

Product Revenue and Service and Other Revenue

Product revenue includes sales from operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; video games; hardware such as PCs, tablets, gaming and entertainment consoles, phones, other intelligent devices, and related accessories; and training and certification of computer system integrators and developers.

Service and other revenue includes sales from cloud-based solutions that provide customers with software, services, platforms, and content such as Office 365, Microsoft Azure (“Azure”), Microsoft Dynamics (“Dynamics”) CRM Online, and Xbox Live; solution support; and consulting services. Service and other revenue also includes sales from online advertising.

 

8


Table of Contents

PART I

Item 1

 

Recent Accounting Guidance Not Yet Adopted

Financial Instruments — Credit Losses

In June 2016, the Financial Accounting Standards Board (“FASB”) issued a new standard to replace the incurred loss impairment methodology in current U.S. GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. For trade and other receivables, loans, and other financial instruments, we will be required to use a forward-looking expected loss model rather than the incurred loss model for recognizing credit losses which reflects losses that are probable. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. The new standard will be effective for us beginning July 1, 2020, with early adoption permitted beginning July 1, 2019. Application of the amendments is through a cumulative-effect adjustment to retained earnings as of the effective date. We are currently evaluating the impact of this standard on our consolidated financial statements.

Leases

In February 2016, the FASB issued a new standard related to leases to increase transparency and comparability among organizations by requiring the recognition of lease assets and lease liabilities on the balance sheet. Most prominent among the amendments is the recognition of assets and liabilities by lessees for those leases classified as operating leases under previous U.S. GAAP. Under the new standard, disclosures are required to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. We will be required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach.

The new standard will be effective for us beginning July 1, 2019, with early adoption permitted. We currently anticipate early adoption of the new standard effective July 1, 2017 in conjunction with our adoption of the new revenue standard. Our ability to early adopt is dependent on system readiness, including software procured from third-party providers, and the completion of our analysis of information necessary to restate prior period financial statements.

We anticipate this standard will have a material impact on our consolidated financial statements. While we are continuing to assess all potential impacts of the standard, we currently believe the most significant impact relates to our accounting for office, retail, and datacenter operating leases.

Financial Instruments — Recognition, Measurement, Presentation, and Disclosure

In January 2016, the FASB issued a new standard to amend certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Most prominent among the amendments is the requirement for changes in the fair value of our equity investments, with certain exceptions, to be recognized through net income rather than other comprehensive income (“OCI”). The new standard will be effective for us beginning July 1, 2018. The application of the amendments will result in a cumulative-effect adjustment to our consolidated balance sheets as of the effective date. We are currently evaluating the impact of this standard on our consolidated financial statements.

Revenue from Contracts with Customers

In May 2014, the FASB issued a new standard related to revenue recognition. Under the new standard, revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The FASB has recently issued several amendments to the standard, including clarification on accounting for licenses of intellectual property and identifying performance obligations.

The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the cumulative catch-up transition method). We currently anticipate adopting the standard using the full retrospective method to restate each prior reporting period presented.

The new standard will be effective for us beginning July 1, 2018, and adoption as of the original effective date of July 1, 2017 is permitted. We currently anticipate early adoption of the new standard effective July 1, 2017. Our

 

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Table of Contents

PART I

Item 1

 

ability to early adopt using the full retrospective method is dependent on system readiness, including software procured from third-party providers, and the completion of our analysis of information necessary to restate prior period financial statements.

We anticipate this standard will have a material impact on our consolidated financial statements. While we are continuing to assess all potential impacts of the standard, we currently believe the most significant impact relates to our accounting for software license revenue. We expect revenue related to hardware, cloud offerings, and professional services to remain substantially unchanged. Specifically, under the new standard we expect to recognize Windows 10 revenue predominantly at the time of billing rather than ratably over the life of the related device. We also expect to recognize license revenue at the time of billing rather than over the subscription period from certain multi-year commercial software subscriptions that include both software licenses and Software Assurance. Due to the complexity of certain of our commercial license subscription contracts, the actual revenue recognition treatment required under the standard will be dependent on contract-specific terms, and may vary in some instances from recognition at the time of billing.

We currently believe that the net change in Windows 10 revenue from period to period is indicative of the net change in revenue we expect from the adoption of the new standard.

NOTE 2 — EARNINGS PER SHARE

Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards.

The components of basic and diluted EPS are as follows:

 

(In millions, except earnings per share)             


Three Months Ended September 30,    2016     2015  

Net income available for common shareholders (A)

   $   4,690      $   4,902   

Weighted average outstanding shares of common stock (B)

     7,789        7,996   

Dilutive effect of stock-based awards

     87        88   


 


Common stock and common stock equivalents (C)

     7,876        8,084   
    


 


Earnings Per Share

                

Basic (A/B)

   $ 0.60      $ 0.61   

Diluted (A/C)

   $ 0.60      $ 0.61   


Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented.

NOTE 3 — OTHER INCOME (EXPENSE), NET

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

 

(In millions)             


Three Months Ended September 30,    2016     2015  

Dividends and interest income

   $ 293      $ 199   

Interest expense

       (437       (249

Net recognized gains on investments

     405        2   

Net losses on derivatives

     (94     (103

Net losses on foreign currency remeasurements

     (52     (36

Other

     (15     (93


 


Total

   $ 100      $ (280
    


 


 

10


Table of Contents

PART I

Item 1

 

Following are details of net recognized gains (losses) on investments during the periods reported:

 

(In millions)             


Three Months Ended September 30,    2016     2015  

Other-than-temporary impairments of investments

   $ (18   $ (35

Realized gains from sales of available-for-sale securities

       483          107   

Realized losses from sales of available-for-sale securities

     (60     (70


 


Total

   $ 405      $ 2   
    


 


NOTE 4 — INVESTMENTS

Investment Components

The components of investments, including associated derivatives, but excluding held-to-maturity investments, were as follows:

 

(In millions)    Cost Basis    

Unrealized

Gains

   

Unrealized

Losses

   

Recorded

Basis

   

Cash

and Cash

Equivalents

   

Short-term

Investments

   

Equity

and Other

Investments

 


September 30, 2016

                                                        

Cash

   $ 3,473      $ 0      $ 0      $ 3,473      $ 3,473      $ 0      $ 0   

Mutual funds

     1,516        0        0        1,516        1,516        0        0   

Commercial paper

     745        0        0        745        645        100        0   

Certificates of deposit

     1,304        0        0        1,304        1,128        176        0   

U.S. government and agency securities

     112,619        116        (34     112,701        6,916        105,785        0   

Foreign government bonds

     5,709        9        (18     5,700        250        5,450        0   

Mortgage- and asset-backed securities

     4,599        24        (1     4,622        0        4,622        0   

Corporate notes and bonds

     6,440        108        (18     6,530        0        6,530        0   

Municipal securities

     284        59        0        343        0        343        0   

Common and preferred stock

     5,395        4,639        (161     9,873        0        0        9,873   

Other investments

     585        0        0        585        0        (2     587   


 


 


 


 


 


 


Total

   $   142,669      $   4,955      $   (232   $   147,392      $   13,928      $   123,004      $   10,460   
    


 


 


 


 


 


 


 

(In millions)    Cost Basis    

Unrealized

Gains

   

Unrealized

Losses

   

Recorded

Basis

   

Cash

and Cash

Equivalents

   

Short-term

Investments

   

Equity

and Other

Investments

 


June 30, 2016

                                                        

Cash

   $ 3,501      $ 0      $ 0      $ 3,501      $ 3,501      $ 0      $ 0   

Mutual funds

     1,012        0        0        1,012        1,012        0        0   

Commercial paper

     298        0        0        298        298        0        0   

Certificates of deposit

     1,000        0        0        1,000        868        132        0   

U.S. government and agency securities

     89,970        245        (11     90,204        100        90,104        0   

Foreign government bonds

     5,502        10        (18     5,494        731        4,763        0   

Mortgage- and asset-backed securities

     4,789        21        (2     4,808        0        4,808        0   

Corporate notes and bonds

     6,509        110        (35     6,584        0        6,584        0   

Municipal securities

     285        57        0        342        0        342        0   

Common and preferred stock

     5,597        4,452        (236     9,813        0        0        9,813   

Other investments

     590        0        0        590        0        (3     593   


 


 


 


 


 


 


Total

   $   119,053      $   4,895      $   (302   $   123,646      $   6,510      $   106,730      $   10,406   
    


 


 


 


 


 


 


 

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As of September 30, 2016 and June 30, 2016, the recorded bases of common and preferred stock that are restricted for more than one year or are not publicly traded were $802 million and $767 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not practicable for us to reliably estimate the fair value of these investments.

We lend certain fixed-income and equity securities to increase investment returns. These transactions are accounted for as secured borrowings and the loaned securities continue to be carried as investments on our consolidated balance sheets. 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. As of September 30, 2016 and June 30, 2016, the collateral received under agreements for loaned securities totaled $210 million and $294 million, which is primarily comprised of U.S. government and agency securities.

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

   


September 30, 2016

                                                

U.S. government and agency securities

   $   40,654      $ (26   $ 379      $ (8   $ 41,033      $ (34

Foreign government bonds

     5,081        (1     38        (17     5,119        (18

Mortgage- and asset-backed securities

     0        0        214        (1     214        (1

Corporate notes and bonds

     920        (4     484        (14     1,404        (18

Common and preferred stock

     523        (65     486        (96     1,009        (161


 


 


 


 


 


Total

   $ 47,178      $   (96   $   1,601      $   (136   $   48,779      $   (232
    


 


 


 


 


 


 

     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, 2016

                                                

U.S. government and agency securities

   $ 5,816      $ (3   $ 432      $ (8   $ 6,248      $ (11

Foreign government bonds

     3,452        (3     35        (15     3,487        (18

Mortgage- and asset-backed securities

     844        (1     322        (1     1,166        (2

Corporate notes and bonds

     1,180        (11     788        (24     1,968        (35

Common and preferred stock

     896        (147     390        (89     1,286        (236


 


 


 


 


 


Total

   $   12,188      $   (165   $   1,967      $   (137   $   14,155      $   (302
    


 


 


 


 


 


Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence.

 

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Debt Investment Maturities

 

(In millions)    Cost Basis    

Estimated

Fair Value

 


September 30, 2016

                

Due in one year or less

   $ 48,954      $ 48,970   

Due after one year through five years

     79,647        79,755   

Due after five years through 10 years

     1,745        1,788   

Due after 10 years

     1,354        1,432   


 


Total

   $   131,700      $   131,945   
    


 


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. dollar 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. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. As of September 30, 2016 and June 30, 2016, the total notional amounts of these foreign exchange contracts sold were $8.5 billion and $8.4 billion, respectively.

Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. As of September 30, 2016 and June 30, 2016, the total notional amounts of these foreign exchange contracts sold were $5.2 billion and $5.3 billion, respectively.

Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures. As of September 30, 2016, the total notional amounts of these foreign exchange contracts purchased and sold were $8.6 billion and $5.4 billion, respectively. As of June 30, 2016, the total notional amounts of these foreign exchange contracts purchased and sold were $12.0 billion and $11.7 billion, respectively.

Equity

Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of September 30, 2016, the total notional amounts of equity contracts purchased and sold for managing market price risk were $1.8 billion and $2.5 billion, respectively, of which $737 million and $986 million, respectively, were designated as hedging instruments. As of June 30, 2016, the total notional amounts of equity contracts purchased and sold for managing market price risk were $1.3 billion and $2.2 billion, respectively, of which $737 million and $986 million, respectively, were designated as hedging instruments.

Interest Rate

Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts, and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of September 30, 2016, the total

 

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notional amounts of fixed-interest rate contracts purchased and sold were $327 million and $2.2 billion, respectively. As of June 30, 2016, the total notional amounts of fixed-interest rate contracts purchased and sold were $328 million and $2.4 billion, respectively.

In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of September 30, 2016 and June 30, 2016, the total notional derivative amounts of mortgage contracts purchased were $546 million and $548 million, respectively.

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or groups of credit risks. As of September 30, 2016, the total notional amounts of credit contracts purchased and sold were $384 million and $271 million, respectively. As of June 30, 2016, the total notional amounts of credit contracts purchased and sold were $440 million and $273 million, respectively.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swaps, futures, and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of September 30, 2016, the total notional amounts of commodity contracts purchased and sold were $623 million and $195 million, respectively. As of June 30, 2016, the total notional amounts of commodity contracts purchased and sold were $631 million and $162 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 minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of September 30, 2016, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted.

Fair Values of Derivative Instruments

Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation.

For derivative instruments designated as fair value hedges, the gains (losses) are recognized in earnings in the periods of change together with the offsetting losses (gains) on the hedged items attributed to the risk being hedged. For options designated as fair value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings.

For derivative instruments designated as cash flow hedges, the effective portion of the gains (losses) on the derivatives is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings.

For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense), net. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense), net.

 

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The following table presents the fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude 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:

 

         September 30, 2016            June 30, 2016  
        


          


         Assets     Liabilities            Assets     Liabilities  
        


 


          


 


(In millions)       

Short-term

Investments

   

Other

Current

Assets

   

Equity and

Other

Investments

    Other
Current
Liabilities
           Short-term
Investments
    Other
Current
Assets
    Equity and
Other
Investments
    Other
Current
Liabilities
 


Non-designated Hedge Derivatives

                                                                             

Foreign exchange contracts

       $ 12      $ 134      $ 0      $ (68             $ 33      $ 156      $ 0      $ (296

Equity contracts

         20        0        0        (3              23        0        0        (16

Interest rate contracts

         5        0        0        (12              10        0        0        (25

Credit contracts

         5        0        0        (5              6        0        0        (5

Commodity contracts

         1        0        0        0                 0        0        0        0   


 


 


 


          


 


 


 


Total

       $ 43      $ 134      $ 0      $ (88            $ 72      $ 156      $ 0      $ (342
        


 


 


 


          


 


 


 


Designated Hedge Derivatives

                                                                             

Foreign exchange contracts

       $ 8      $ 346      $ 0      $ (71            $ 1      $ 392      $ 0      $ (263

Equity contracts

         0        0        8        (28              0        0        18        (25


 


 


 


          


 


 


 


Total

       $ 8      $ 346      $ 8      $ (99            $ 1      $ 392      $ 18      $ (288


 


 


 


          


 


 


 


Total gross amounts of derivatives

       $ 51      $ 480      $ 8      $ (187            $ 73      $ 548      $ 18      $ (630
        


 


 


 


          


 


 


 


Gross derivatives either offset or subject to an enforceable master netting agreement

       $ 50      $ 480      $ 8      $ (187            $ 69      $ 548      $ 18      $   (630

Gross amounts of derivatives offset on the balance sheet

           (54     (87       (23     161                   (74       (302       (25     398   


 


 


 


          


 


 


 


Net amounts presented on the balance sheet

         (4     393        (15     (26              (5     246        (7     (232

Gross amounts of derivatives not offset on the balance sheet

         0        0        0        0                 0        0        0        0   

Cash collateral received

         0        0        0        (245              0        0        0        (250


 


 


 


          


 


 


 


Net amount

       $ (4   $   393      $ (15   $   (271            $ (5   $ 246      $ (7   $ (482
        


 


 


 


          


 


 


 


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

 

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Fair-Value Hedge Gains (Losses)

We recognized in other income (expense), net the following gains (losses) on contracts designated as fair-value hedges and their related hedged items:

 

(In millions)             


Three Months Ended September 30,    2016     2015  

Foreign Exchange Contracts

                

Derivatives

   $ (48   $ (81

Hedged items

     68        91   


 


Total amount of ineffectiveness

   $ 20      $ 10   
    


 


Equity Contracts

                

Derivatives

   $   (10   $   (33

Hedged items

     10        33   


 


Total amount of ineffectiveness

   $ 0      $ 0   
    


 


Amount of equity contracts excluded from effectiveness assessment

   $ (3   $ 19   


Cash Flow Hedge Gains (Losses)

We recognized the following gains (losses) on foreign exchange contracts designated as cash-flow hedges:

 

(In millions)             


Three Months Ended September 30,    2016     2015  

Effective Portion

                

Gains recognized in other comprehensive income (net of tax effects of $1 and $28)

   $ 35      $ 161   

Gains reclassified from accumulated other comprehensive income into revenue

   $ 75      $   109   

Amount Excluded from Effectiveness Assessment and Ineffective Portion

                

Losses recognized in other income (expense), net

   $   (70   $ (82


We estimate that $289 million of net derivative gains included in AOCI at September 30, 2016 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during the three months ended September 30, 2016.

 

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Non-Designated Derivative Gains (Losses)

Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. 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), net, which were immaterial for the periods presented. 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 and gains (losses) from foreign exchange rate changes on certain balance sheet amounts.

 

(In millions)             


Three Months Ended September 30,    2016     2015  

Foreign exchange contracts

   $ (31   $ 59   

Equity contracts

     (17     34   

Interest-rate contracts

     4        (1

Credit contracts

     2        (5

Commodity contracts

     (22       (84


 


Total

   $   (64   $ 3   
    


 


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 U.S. government securities, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively 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, credit spreads, 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, common and preferred stock, mortgage- and asset-backed securities, U.S. government and agency securities, and foreign government bonds. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option 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 common and preferred stock, and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities.

We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary.

 

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Assets and Liabilities Measured at Fair Value on a Recurring Basis

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

 

(In millions)      Level 1        Level 2        Level 3       

 

Gross Fair

Value

  

  

    Netting (a)     
 
Net Fair
Value
 
  


September 30, 2016

                                                

Assets

                                                

Mutual funds

   $ 1,516      $ 0      $ 0      $ 1,516      $ 0      $ 1,516   

Commercial paper

     0        745        0        745        0        745   

Certificates of deposit

     0        1,304        0        1,304        0        1,304   

U.S. government and agency securities

     106,431        6,260        0          112,691        0          112,691   

Foreign government bonds

     10        5,723        0        5,733        0        5,733   

Mortgage- and asset-backed securities

     0        4,620        0        4,620        0        4,620   

Corporate notes and bonds

     0        6,502        1        6,503        0        6,503   

Municipal securities

     0        343        0        343        0        343   

Common and preferred stock

     6,696        2,377        18        9,091        0        9,091   

Derivatives

     6        533        0        539        (164     375   


 


 


 


 


 


Total

   $   114,659      $   28,407      $   19      $ 143,085      $   (164   $ 142,921   
    


 


 


 


 


 


Liabilities

                                                

Derivatives and other

   $ 3      $ 184      $ 0      $ 187      $ (161   $ 26   


 

(In millions)      Level 1        Level 2        Level 3       

 

Gross Fair

Value

  

  

    Netting (a)     
 
Net Fair
Value
 
  


June 30, 2016

                                                

Assets

                                                

Mutual funds

   $ 1,012      $ 0      $ 0      $ 1,012      $ 0      $ 1,012   

Commercial paper

     0        298        0        298        0        298   

Certificates of deposit

     0        1,000        0        1,000        0        1,000   

U.S. government and agency securities

     86,492        3,707        0        90,199        0        90,199   

Foreign government bonds

     10        5,705        0        5,715        0        5,715   

Mortgage- and asset-backed securities

     0        4,803        0        4,803        0        4,803   

Corporate notes and bonds

     0        6,361        1        6,362        0        6,362   

Municipal securities

     0        342        0        342        0        342   

Common and preferred stock

     6,918        2,114          18        9,050        0        9,050   

Derivatives

     6        633        0        639        (401     238   


 


 


 


 


 


Total

   $   94,438      $   24,963      $ 19      $   119,420      $   (401   $   119,019   
    


 


 


 


 


 


Liabilities

                                                

Derivatives and other

   $ 17      $ 613      $ 0      $ 630      $ (398   $ 232   


 

(a)

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

The changes in our Level 3 financial instruments that are measured at fair value on a recurring basis were immaterial during the periods presented.

 

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The following table reconciles the total “Net Fair Value” of assets above to the balance sheet presentation of these same assets in Note 4 – Investments.

 

(In millions)             


    

September 30,

2016

   

June 30,

2016

 

Net fair value of assets measured at fair value on a recurring basis

   $ 142,921      $ 119,019   

Cash

     3,473        3,501   

Common and preferred stock measured at fair value on a nonrecurring basis

     802        767   

Other investments measured at fair value on a nonrecurring basis

     587        593   

Less derivative net assets classified as other current assets

     (393     (246

Other

     2        12   


 


Recorded basis of investment components

   $   147,392      $   123,646   
    


 


Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

During the three months ended September 30, 2016 and 2015, we did not record any material other-than-temporary impairments on financial assets required to be measured at fair value on a nonrecurring basis.

NOTE 7 — INVENTORIES

The components of inventories were as follows:

 

(In millions)             


    

September 30,

2016

   

June 30,

2016

 

Raw materials

   $ 582      $ 612   

Work in process

     110        158   

Finished goods

     2,430        1,481   


 


Total

   $   3,122      $   2,251   
    


 


NOTE 8 — GOODWILL

Changes in the carrying amount of goodwill were as follows:

 

(In millions)   

June 30,

2016

    Acquisitions     Other     September 30,
2016
 


Productivity and Business Processes

   $ 6,678      $ 2      $ 22      $ 6,702   

Intelligent Cloud

     5,467        0        11        5,478   

More Personal Computing

     5,727        14          (14     5,727   


 


 


 


Total goodwill

   $   17,872      $   16      $ 19      $   17,907   
    


 


 


 


The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined.

Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the above table. Also included in “Other” are business dispositions and transfers between business segments due to reorganizations, as applicable.

 

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NOTE 9 — 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

 


    

September 30,

2016

   

June 30,

2016

 

Technology-based (a)

   $ 6,016              $ (3,847   $ 2,169      $ 5,970              $ (3,648   $ 2,322   

Marketing-related

     1,866                 (653     1,213        1,869                 (616     1,253   

Contract-based

     796                 (722     74        796                 (718     78   

Customer-related

     470                 (404     66        465                 (385     80   


          


 


 


          


 


Total

   $   9,148               $   (5,626   $   3,522      $   9,100               $   (5,367   $   3,733   
    


          


 


 


          


 


 

(a)

Technology-based intangible assets included $101 million and $115 million of net carrying amount of software to be sold, leased, or otherwise marketed as of September 30, 2016 and June 30, 2016, respectively.

Intangible assets amortization expense was $214 million and $242 million for the three months ended September 30, 2016 and 2015, respectively. Amortization of capitalized software was $14 million and $18 million for the three months ended September 30, 2016 and 2015, respectively.

The following table outlines the estimated future amortization expense related to intangible assets held as of September 30, 2016:

 

(In millions)       


Year Ending June 30,

        

2017 (excluding the three months ended September 30, 2016)

   $ 563   

2018

     685   

2019

     533   

2020

     456   

2021

     403   

Thereafter

     882   


Total

   $   3,522   
    


NOTE 10 — DEBT

Short-term Debt

As of September 30, 2016, we had $14.5 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.55% and maturities ranging from 47 days to 187 days. As of June 30, 2016, we had $12.9 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.43% and maturities ranging from 1 day to 99 days. The estimated fair value of this commercial paper approximates its carrying value.

We have two $5.0 billion credit facilities that expire on November 1, 2016 and November 14, 2018, respectively. These credit facilities serve as a back-up for our commercial paper program. As of September 30, 2016, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreements. No amounts were drawn against these credit facilities during any of the periods presented.

Long-term Debt

As of September 30, 2016, the total carrying value and estimated fair value of our long-term debt were $60.2 billion and $64.0 billion, respectively. As of June 30, 2016, the total carrying value and estimated fair value of our long-term debt were $40.6 billion and $44.0 billion, respectively. These estimated fair values are based on Level 2 inputs.

 

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The components of our long-term debt and the associated interest rates were as follows as of September 30, 2016 and June 30, 2016:

 

Due Date          

Face Value

September 30,

2016

   

Face Value

June 30,

2016

   

Stated

Interest

Rate

    

Effective

Interest

Rate

 


            (In millions)               

Notes

                                          

November 15, 2017

               600        600        0.875%         1.084%   

May 1, 2018

              450        450        1.000%         1.106%   

November 3, 2018

              1,750        1,750        1.300%         1.396%   

December 6, 2018

              1,250        1,250        1.625%         1.824%   

June 1, 2019

              1,000        1,000        4.200%         4.379%   

August 8, 2019 (a)

              2,500        *        1.100%         1.203%   

February 12, 2020

              1,500        1,500        1.850%         1.935%   

October 1, 2020

              1,000        1,000        3.000%         3.137%   

November 3, 2020

              2,250        2,250        2.000%         2.093%   

February 8, 2021

              500        500        4.000%         4.082%   

August 8, 2021 (a)

              2,750        *        1.550%         1.642%   

December 6, 2021 (b)

              1,967        1,944        2.125%         2.233%   

February 12, 2022

              1,500        1,500        2.375%         2.466%   

November 3, 2022

              1,000        1,000        2.650%         2.717%   

November 15, 2022

              750        750        2.125%         2.239%   

May 1, 2023

              1,000        1,000        2.375%         2.465%   

August 8, 2023 (a)

              1,500        *        2.000%         2.101%   

December 15, 2023

              1,500        1,500        3.625%         3.726%   

February 12, 2025

              2,250        2,250        2.700%         2.772%   

November 3, 2025

              3,000        3,000        3.125%         3.176%   

August 8, 2026 (a)

              4,000        *        2.400%         2.464%   

December 6, 2028 (b)

              1,967        1,944        3.125%         3.218%   

May 2, 2033 (b)

              617        611        2.625%         2.690%   

February 12, 2035

              1,500        1,500        3.500%         3.604%   

November 3, 2035

              1,000        1,000        4.200%         4.260%   

August 8, 2036 (a)

              2,250        *        3.450%         3.510%   

June 1, 2039

              750        750        5.200%         5.240%   

October 1, 2040

              1,000        1,000        4.500%         4.567%   

February 8, 2041

              1,000        1,000        5.300%         5.361%   

November 15, 2042

              900        900        3.500%         3.571%   

May 1, 2043

              500        500        3.750%         3.829%   

December 15, 2043

              500        500        4.875%         4.918%   

February 12, 2045

              1,750        1,750        3.750%         3.800%   

November 3, 2045

              3,000        3,000        4.450%         4.492%   

August 8, 2046 (a)

              4,500        *        3.700%         3.743%   

February 12, 2055

              2,250        2,250        4.000%         4.063%   

November 3, 2055

              1,000        1,000        4.750%         4.782%   

August 8, 2056 (a)

              2,250        *        3.950%         4.033%   


                

Total

            $   60,751      $   40,949                    
             


 


                

 

(a)

In August 2016, we issued $19.8 billion of debt securities.

 

(b)

Euro-denominated debt securities.

 

*

Not applicable

The notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. Effective July 1, 2016, we retrospectively adopted accounting guidance that requires debt issuance costs to be recorded as a deduction from the carrying amount of the debt liability, consistent with debt discounts. As of September 30, 2016 and June 30, 2016, the combined aggregate unamortized discount and debt issuance costs associated with our long-term debt were $597 million and $392 million, respectively.

 

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NOTE 11 — INCOME TAXES

Our effective tax rate for the three months ended September 30, 2016 and 2015 was 12% and 11%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico.

The increase in our current quarter effective tax rate compared to prior year was primarily due to changes in the mix of our income before income taxes between the U.S. and foreign countries, offset by an increase in the tax benefits relating to stock-based compensation.

Tax contingencies and other income tax liabilities were $12.3 billion and $11.8 billion as of September 30, 2016 and June 30, 2016, respectively, and are included in other long-term liabilities. This increase relates primarily to current period intercompany transfer pricing.

While we settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, and settled a portion of the IRS audit for tax years 2007 to 2009 during the first quarter of fiscal year 2016, we remain under audit for those years. In February 2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of September 30, 2016, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We also continue to be subject to examination by the IRS for tax years 2010 to 2016.

We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2016, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements.

NOTE 12 — RESTRUCTURING CHARGES

Phone Hardware Restructuring

In June 2015, management approved a plan to restructure our phone business to better focus and align resources (the “Phone Hardware Restructuring Plan”), under which we eliminated approximately 7,400 positions in fiscal year 2016.

In fiscal year 2015, we incurred restructuring charges of $780 million under the Phone Hardware Restructuring Plan, including severance expenses and other reorganization costs. In fiscal year 2016, we reversed $21 million of previously estimated restructuring charges related to contract termination costs. The actions associated with the Phone Hardware Restructuring Plan were substantially complete as of June 30, 2016, and are expected to be completed by the end of calendar year 2016.

2016 Restructuring

We periodically evaluate how to best deploy the company’s resources. In the fourth quarter of 2016, management approved restructuring plans that would result in job eliminations, primarily across our smartphone hardware business and global sales. In addition to the elimination of 1,850 positions that were announced in May 2016, approximately 2,850 roles globally will be reduced during fiscal year 2017 as an extension of the earlier plan. These actions are expected to be completed by the end of the current fiscal year.

In fiscal year 2016, we incurred restructuring charges of $501 million in connection with the 2016 restructuring plans, including severance expenses and other reorganization costs. We do not expect to incur additional charges for these restructuring plans in subsequent years.

 

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Restructuring charges associated with each of these plans were included in impairment, integration, and restructuring expenses on our consolidated income statement, and were reflected in Corporate and Other in our table of operating income (loss) by segment.

Changes in the restructuring liability were as follows:

 

(In millions)      Severance        Other (a)      Total   


Restructuring liability as of June 30, 2016

   $ 470      $   239      $ 709   

Restructuring charges

     0        0        0   

Cash paid

       (161     (15       (176


 


 


Restructuring liability as of September 30, 2016

   $ 309      $ 224      $ 533   
    


 


 


 

(a)

“Other” primarily reflects activities associated with the consolidation of our facilities and manufacturing operations, including contract termination costs and asset write-downs.

NOTE 13 — UNEARNED REVENUE

Unearned revenue by segment was as follows:

 

(In millions)             


    

September 30,

2016

   

June 30,

2016

 

Productivity and Business Processes

   $ 11,486      $ 12,497   

Intelligent Cloud

     10,322        11,472   

More Personal Computing

     3,298        3,334   

Corporate and Other

     8,482        6,606   


 


Total

   $   33,588      $   33,909   
    


 


Revenue from Windows 10 is primarily recognized at the time of billing in the More Personal Computing segment, and the deferral and subsequent recognition of revenue is reflected in Corporate and Other in the table above. As of September 30, 2016 and June 30, 2016, we deferred a net $8.5 billion and $6.6 billion, respectively, in revenue related to Windows 10.

NOTE 14 — COMMITMENTS AND CONTINGENCIES

Capital Lease Commitments

We have capital leases for datacenters and corporate offices. As of September 30, 2016 and June 30, 2016, assets recorded under capital leases were $1.1 billion and $865 million, respectively, and accumulated depreciation associated with capital leases was $72 million and $57 million, respectively. For the three months ended September 30, 2016, property and equipment acquired under capital leases was $267 million. We did not acquire any property and equipment under capital leases for the three months ended September 30, 2015. As of September 30, 2016 and June 30, 2016, capital lease obligations included in other current liabilities were $32 million and $25 million, respectively, and capital lease obligations included in other long-term liabilities were $1.0 billion and $761 million, respectively.

 

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Future minimum lease payments under non-cancellable capital leases as of September 30, 2016 are as follows:

 

(In millions)       


Year Ending June 30,       

2017 (excluding the three months ended September 30, 2016)

   $ 61   

2018

     83   

2019

     85   

2020

     87   

2021

     89   

Thereafter

     1,052   


Total (a)

   $   1,457   
    


 

(a)

As of September 30, 2016, capital leases included imputed interest of $410 million.

As of September 30, 2016, we had additional purchase obligations for capital leases executed but not yet recorded of $5.0 billion.

Other Commitments

On June 11, 2016, we entered into a definitive agreement to acquire LinkedIn Corporation (“LinkedIn”) for $196 per share in an all-cash transaction valued at $26.2 billion, inclusive of LinkedIn’s net cash (the “Merger Agreement”). We will finance the transaction primarily through the issuance of new indebtedness. The Merger Agreement has been unanimously approved by the Boards of Directors of Microsoft and LinkedIn, and has been approved by LinkedIn’s shareholders. We expect the acquisition will close in calendar year 2016, subject to satisfaction of certain regulatory approvals and other customary closing conditions. The acquisition is expected to accelerate the growth of LinkedIn, as well as Office 365 and Dynamics.

Patent and Intellectual Property Claims

IPCom patent litigation

IPCom GmbH & Co. (“IPCom”) is a German company that holds a large portfolio of mobile technology-related patents spanning about 170 patent families and addressing a broad range of cellular technologies. IPCom has asserted 19 of these patents in litigation against Nokia Corporation (“Nokia”) and many of the leading cell phone companies and operators. In November 2014, Microsoft and IPCom entered into a standstill agreement staying all of the pending litigation against Microsoft to permit the parties to pursue settlement discussions.

InterDigital patent litigation

InterDigital Technology Corporation and InterDigital Communications Corporation (collectively, “IDT”) filed four patent infringement cases against Nokia in the International Trade Commission (“ITC”) and in U.S. District Court for the District of Delaware between 2007 and 2013. We have been added to these cases as a defendant. IDT has cases pending against other defendants based on the same patents because most of the patents at issue allegedly relate to 3G and 4G wireless communications standards essential functionality. The cases involving us include three ITC investigations where IDT sought an order excluding importation of 3G and 4G phones into the U.S. and one active case in U.S. District Court in Delaware seeking an injunction and damages. Each of the ITC matters has been resolved in our favor. In September 2015, in an inter partes review the United States Patent Trial and Appeal Board issued a final written decision that deemed unpatentable all asserted claims of the patent remaining at issue in the Delaware case. IDT appealed this decision to the U.S. Court of Appeals for the Federal Circuit. The Delaware case has been stayed pending final completion of the inter partes review (including appeals and any subsequent proceedings in the Patent Office). We filed an antitrust complaint against IDT in the District of Delaware in August 2015 asserting violations of Section 2 of the Sherman Act, alleging unlawful exploitation of standard essential patents. That case is set for trial in September 2018.

 

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European copyright levies

We assumed from Nokia all potential liability due to Nokia’s alleged failure to pay “private copyright levies” in various European countries based upon sale of memory cards and mobile phones that incorporate blank memory. The levies are based upon a 2001 European Union (“EU”) Directive establishing a right for end users to make copies of copyrighted works for personal or private use, but also allowing the collection of levies based upon sales of blank media or recording devices to compensate copyright holders for private copying. Various collecting societies in EU countries initiated litigation against Nokia, stating it must pay levies not only based upon sales of blank memory cards, but also phones that include blank memory for data storage on the phones, regardless of actual usage of that memory. The most significant cases against Nokia were pending in Germany and Austria, due to both the high volume of sales and high levy amounts sought in these countries. We reached a settlement of the Austrian case in August 2016. In Germany, the only period for which settlement has not been reached is 2004-2007. In July, the German Supreme Court heard our appeal contesting the legality of the levy assessed on phones with music players and over five megabytes of memory. The Supreme Court vacated the lower court’s ruling, and we are awaiting the Supreme Court’s full opinion. We expect that the case will be remanded for further proceedings to set an appropriate levy for the 2004-2007 period.

Other patent and intellectual property claims

In addition to these cases, there were 58 other patent infringement cases pending against Microsoft as of September 30, 2016.

Antitrust, Unfair Competition, and Overcharge Class Actions

Antitrust and unfair competition class action lawsuits were filed against us in British Columbia, Ontario, and Quebec, Canada. All three have been certified on behalf of Canadian indirect purchasers who acquired licenses for Microsoft operating system software and/or productivity application software between 1998 and 2010.

The trial of the British Columbia action commenced in May 2016. The plaintiffs filed their case in chief in August 2016, setting out claims made, authorities, and evidence in support of their claims. A six-month oral hearing is scheduled to commence in September 2017, consisting of cross examination on witness affidavits. The Ontario and Quebec cases are inactive.

Other Antitrust Litigation and Claims

China State Administration for Industry and Commerce investigation

In 2014, Microsoft was informed that China’s State Administration for Industry and Commerce (“SAIC”) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAIC conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. SAIC has stated the investigation relates to compatibility, bundle sales, file verification issues related to Windows and Office software, and potentially other issues.

Product-Related Litigation

U.S. cell phone litigation

Nokia, along with other handset manufacturers and network operators, is a defendant in 19 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims as part of our acquisition of Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining 10 cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines.

In 2013, defendants in the consolidated cases moved to exclude plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the court granted in part defendants’ motion to exclude

 

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plaintiffs’ general causation experts. The plaintiffs filed an interlocutory appeal challenging the standard for evaluating expert scientific evidence, which the District of Columbia Court of Appeals agreed to hear en banc. Trial court proceedings are stayed pending resolution of the appeal.

Canadian cell phone class action

Nokia, along with other handset manufacturers and network operators, is a defendant in a 2013 class action lawsuit filed in the Supreme Court of British Columbia by a purported class of Canadians who have used cellular phones for at least 1,600 hours, including a subclass of users with brain tumors. Microsoft was served with the complaint in June 2014 and has been substituted for the Nokia defendants. The litigation is not yet active as several defendants remain to be served.

Other Contingencies

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 consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.

As of September 30, 2016, we accrued aggregate legal liabilities of $443 million in other current liabilities. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $1.6 billion in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our consolidated financial statements for the period in which the effects become reasonably estimable.

NOTE 15 — STOCKHOLDERS’ EQUITY

Share Repurchases

On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. The share repurchase program became effective on October 1, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. As of September 30, 2016, $3.5 billion remained of our $40.0 billion share repurchase program. All repurchases were made using cash resources.

On September 20, 2016, our Board of Directors approved a share repurchase program authorizing an additional $40.0 billion in share repurchases. This share repurchase program will commence following completion of the program approved on September 16, 2013, has no expiration, and may be suspended or discontinued at any time without notice.

We repurchased the following shares of common stock through our share repurchase program approved on September 16, 2013:

 

(In millions)             


Three Months Ended September 30,    2016     2015  

Shares of common stock repurchased

     63        89   

Value of common stock repurchased

   $   3,550      $   4,000   


The above table excludes shares repurchased to settle statutory employee tax withholding related to the vesting of stock awards.

 

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Dividends

Our Board of Directors declared the following dividends:

 

Declaration Date   

Dividend

Per Share

    Record Date      Total Amount     Payment Date  


                  (in millions)        

September 20, 2016

   $   0.39        November 17, 2016       $   3,036        December 8, 2016   

September 15, 2015

   $ 0.36        November 19, 2015       $ 2,868        December 10, 2015   


The dividend declared on September 20, 2016 was included in other current liabilities as of September 30, 2016.

NOTE 16 — ACCUMULATED OTHER COMPREHENSIVE INCOME

The following table summarizes the changes in accumulated other comprehensive income by component:

 

(In millions)             


Three Months Ended September 30,    2016     2015  

Derivatives

                

Accumulated other comprehensive income balance, beginning of period

   $ 352      $ 590   

Unrealized gains, net of tax effects of $1 and $28

     35        161   

Reclassification adjustments for gains included in revenue

     (75     (109

Tax expense included in provision for income taxes

     3        5   


 


Amounts reclassified from accumulated other comprehensive income

     (72     (104


 


Net current period other comprehensive income (loss)

     (37     57   


 


Accumulated other comprehensive income balance, end of period

   $ 315      $ 647   


 


Investments

                

Accumulated other comprehensive income balance, beginning of period

   $ 2,941      $ 3,169   

Unrealized gains (losses), net of tax effects of $182 and $(305)

     339        (566

Reclassification adjustments for gains included in other income (expense), net

     (394     (8

Tax expense included in provision for income taxes

     138        3   


 


Amounts reclassified from accumulated other comprehensive income

     (256     (5


 


Net current period other comprehensive income (loss)

     83        (571


 


Accumulated other comprehensive income balance, end of period

   $ 3,024      $ 2,598   


 


Translation adjustments and other

                

Accumulated other comprehensive loss balance, beginning of period

   $ (1,756   $ (1,237

Translation adjustments and other, net of tax effects of $7 and $(12)

     98        (270


 


Accumulated other comprehensive loss balance, end of period

   $   (1,658   $   (1,507


 


Accumulated other comprehensive income, end of period

   $ 1,681      $ 1,738   
    


 


NOTE 17 — SEGMENT INFORMATION

In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.

 

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Our reportable segments are described below.

Productivity and Business Processes

Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises:

 

   

Office Commercial, including volume licensing and subscriptions to Office 365 commercial for products and services such as Office, Exchange, SharePoint, and Skype for Business, and related Client Access Licenses (“CALs”).

 

   

Office Consumer, including Office sold through retail or through an Office 365 consumer subscription, and Office Consumer Services, including Skype, Outlook.com, and OneDrive.

 

   

Dynamics business solutions, including Dynamics ERP products, Dynamics CRM on-premises, and Dynamics CRM Online.

Intelligent Cloud

Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This segment primarily comprises:

 

   

Server products and cloud services, including Microsoft SQL Server, Windows Server, Visual Studio, System Center, and related CALs, as well as Azure.

 

   

Enterprise Services, including Premier Support Services and Microsoft Consulting Services.

More Personal Computing

Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across screens of all sizes. This segment primarily comprises:

 

   

Windows, including Windows original equipment manufacturer licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows Embedded; MSN display advertising; and Windows Phone licensing.

 

   

Devices, including Microsoft Surface, phones, and PC accessories.

 

   

Gaming, including Xbox hardware and Xbox software and services, comprising Xbox Live transactions, subscriptions, and advertising (“Xbox Live”), video games, and third-party video game royalties.

 

   

Search advertising.

Corporate and Other includes adjustments to conform our internal accounting policies to U.S. GAAP, and impairment, integration, and restructuring expenses. Significant internal accounting policies that differ from U.S. GAAP relate to Windows 10 revenue recognition.

Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue on certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit, and are generally allocated based on relative gross margin.

In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: legal, including settlements, and fines; information technology; human resources; finance; excise taxes; field selling; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain corporate-level activity is not allocated to our segments, including impairment, integration, and restructuring expenses.

 

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

 

(In millions)             


Three Months Ended September 30,    2016     2015  

Revenue

                

Productivity and Business Processes

   $ 6,658      $ 6,306   

Intelligent Cloud

     6,382        5,892   

More Personal Computing

     9,294        9,462   

Corporate and Other (a)

     (1,881     (1,281


 


Total revenue

   $   20,453      $   20,379   
    


 


 

(In millions)             


Three Months Ended September 30,    2016     2015  

Operating income (loss)

                

Productivity and Business Processes

   $ 3,120      $ 3,156   

Intelligent Cloud

     2,058        2,391   

More Personal Computing

     1,928        1,527   

Corporate and Other (a)

       (1,881       (1,281


 


Total operating income

   $ 5,225      $ 5,793   
    


 


 

(a)

Corporate and Other revenue and operating loss for the three months ended September 30, 2016 and 2015 consisted of net revenue deferrals related to sales of Windows 10.

Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment, and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Microsoft Corporation

Redmond, Washington

We have reviewed the accompanying consolidated balance sheet of Microsoft Corporation and subsidiaries (the “Company”) as of September 30, 2016, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the three-month periods ended September 30, 2016 and 2015. These interim financial statements are the responsibility of the Company’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 the Company as of June 30, 2016, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the year then ended (not presented herein); and in our report dated July 28, 2016 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 2016 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/S/ DELOITTE & TOUCHE LLP

Seattle, Washington

October 20, 2016

 

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

RESULTS OF OPERATIONS

Note About Forward-Looking Statements

This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors” (Part II, Item 1A of this Form 10-Q), “Quantitative and Qualitative Disclosures about Market Risk” (Part I, Item 3 of this Form 10-Q), and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (Part I, Item 2 of this Form 10-Q). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise.

OVERVIEW

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our Annual Report on Form 10-K for the year ended June 30, 2016, and our financial statements and the accompanying Notes to Financial Statements (Part 1, Item 1 of this Form 10-Q).

Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. Our strategy is to build best-in-class platforms and productivity services for a mobile-first, cloud-first world. We develop, license, and support a wide range of software products, services, and devices that deliver new opportunities, greater convenience, and enhanced value to people’s lives.

We generate revenue by licensing and supporting an array of software products, by offering a wide range of services, including cloud-based services to consumers and businesses, by designing, manufacturing, and selling devices that integrate with our cloud-based services, and by delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees; designing, manufacturing, marketing, and selling our products and services; datacenter costs in support of our cloud-based services; and income taxes.

Highlights from the first quarter of fiscal year 2017 included:

 

   

Commercial cloud annualized revenue run rate* exceeded $13 billion.

 

   

Office Commercial revenue grew 5%, driven by Office 365 commercial revenue growth of 51%.

 

   

Office 365 consumer subscribers increased to 24 million.

 

   

Microsoft Dynamics (“Dynamics”) revenue grew 11%, driven by Dynamics CRM Online revenue growth.

 

   

Server products and cloud services revenue grew 11%, driven by Microsoft Azure (“Azure”) revenue growth.

 

   

Azure revenue grew 116%, with Azure compute usage more than doubling year-over-year.

 

   

Search advertising revenue, excluding traffic acquisition costs, grew 9%, driven by increased revenue per search and search volume.

 

*

Commercial cloud annualized revenue run rate is calculated by multiplying revenue for the last month of the quarter by twelve for Office 365 commercial, Azure, Dynamics online, and other cloud properties.

In June 2016, we entered into a definitive agreement to acquire LinkedIn Corporation (“LinkedIn”) for $196 per share in an all-cash transaction valued at $26.2 billion, inclusive of LinkedIn’s net cash (the “Merger Agreement”). We will finance the transaction primarily through the issuance of new indebtedness. The Merger Agreement has been unanimously approved by the Boards of Directors of Microsoft and LinkedIn, and has been approved by LinkedIn’s shareholders. We expect the acquisition will close in calendar year 2016, subject to satisfaction of certain regulatory approvals and other customary closing conditions. The acquisition is expected to accelerate the growth of LinkedIn, as well as Office 365 and Dynamics.

 

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In May 2016, we announced the sale of our entry-level feature phone business for $350 million. The transaction is expected to close by the end of calendar year 2016, subject to regulatory approvals and other closing conditions.

In July 2015, we announced a plan to restructure our phone business to better focus and align resources. In May 2016, we announced plans to further streamline our smartphone hardware business. These changes in the phone business reinforce our strategy to create a vibrant Windows ecosystem with a single set of experiences across our first-party device family and original equipment manufacturer (“OEM”) offerings. Part of this strategy involves focusing our phone devices on a narrower range of customer categories and differentiating through the combination of hardware and software we are uniquely positioned to offer. As anticipated, our change in phone strategy resulted in a reduction in units sold and associated expenses in fiscal year 2016, and this trend is expected to continue in fiscal year 2017.

Industry Trends

Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces.

Economic Conditions, Challenges, and Risks

The market for software, devices, and cloud-based services is dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in devices and infrastructure will continue to increase our operating costs and may decrease our operating margins.

Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. Microsoft competes for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic.

Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. The strengthening of the U.S. dollar relative to certain foreign currencies throughout fiscal year 2016, and continuing into fiscal year 2017, negatively impacted reported revenue and reduced reported expenses from our international operations.

See a discussion of these factors and other risks under Risk Factors (Part II, Item 1A of this Form 10-Q).

Seasonality

Our revenue historically has fluctuated quarterly and has generally been 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.

Reportable Segments

The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. Segment information appearing in Note 17–Segment Information of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) is also presented on this basis. All differences between our internal management reporting basis and accounting principles generally accepted in the United States (“U.S. GAAP”), along with certain corporate-level and other activity, are included in Corporate and Other.

 

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During the periods presented, we reported our financial performance based on the following segments; Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. We expect to report the financial performance of LinkedIn as part of our Productivity and Business Processes segment.

Additional information on our reportable segments is contained in Note 17–Segment Information of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q).

SUMMARY RESULTS OF OPERATIONS

 

(In millions, except percentages and per share amounts)   

Three Months Ended

September 30,

   

Percentage

Change

 


     2016     2015        

Revenue

   $    20,453      $    20,379        0%   

Gross margin

   $ 12,609      $ 13,172        (4)%   

Operating income

   $ 5,225      $ 5,793        (10)%   

Diluted earnings per share

   $ 0.60      $ 0.61        (2)%   


Revenue increased $74 million, driven by growth in Intelligent Cloud and Productivity and Business Processes, offset in part by an increase in the net revenue deferral from Windows 10 and lower revenue from More Personal Computing. Windows 10 revenue is primarily recognized at the time of billing in the More Personal Computing segment, and the deferral and subsequent recognition of revenue is reflected in Corporate and Other. Intelligent Cloud revenue increased, primarily due to higher revenue from server products and cloud services. Productivity and Business Processes revenue increased, driven by higher revenue from Office 365. More Personal Computing revenue decreased, mainly due to lower revenue from Devices and Gaming, offset in part by higher revenue from Search advertising. Revenue included an unfavorable foreign currency impact of 2%.

Operating income decreased $568 million or 10%, primarily due to lower gross margin and an increase in research and development expenses, offset in part by lower sales and marketing expenses. Operating income included an unfavorable foreign currency impact of 5%. Gross margin decreased $563 million or 4%, driven by higher cost of revenue. Gross margin included an unfavorable foreign currency impact of 2%.

Key changes in expenses were:

 

   

Cost of revenue increased $637 million or 9%, mainly due to growth in our commercial cloud and Search advertising traffic acquisition costs, offset in part by a reduction in phone sales.

 

   

Research and development expenses increased $144 million or 5%, primarily due to increased strategic investments and acquisitions to drive cloud engineering, offset in part by a reduction in phone expenses.

 

   

Sales and marketing expenses decreased $100 million or 3%, primarily due to a reduction in phone expenses and Windows 10 launch-related expenses in the prior year, offset in part by increased investment to drive sales capacity in our commercial cloud.

Diluted earnings per share (“EPS”) was $0.60 for the three months ended September 30, 2016. Current year diluted EPS was negatively impacted by the net revenue deferral from Windows 10, which resulted in a decrease to diluted EPS of $0.16. Diluted EPS was $0.61 for the three months ended September 30, 2015. Prior year diluted EPS was negatively impacted by the net revenue deferral from Windows 10, which resulted in a decrease to diluted EPS of $0.09.

 

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SEGMENT RESULTS OF OPERATIONS

 

(In millions, except percentages)   

Three Months Ended

September 30,

   

Percentage

Change

 


     2016     2015        

Revenue

                        

Productivity and Business Processes

   $ 6,658      $ 6,306        6%   

Intelligent Cloud

     6,382        5,892        8%   

More Personal Computing

     9,294        9,462        (2)%   

Corporate and Other

     (1,881     (1,281     (47)%   


 


 


Total revenue

   $    20,453      $    20,379        0%   
    


 


       

Operating income (loss)

                        

Productivity and Business Processes

   $ 3,120      $ 3,156        (1)%   

Intelligent Cloud

     2,058        2,391        (14)%   

More Personal Computing

     1,928        1,527        26%   

Corporate and Other

     (1,881     (1,281     (47)%   


 


 


Total operating income

   $ 5,225      $ 5,793        (10)%   
    


 


       

Reportable Segments

Productivity and Business Processes

Revenue increased $352 million or 6%, primarily due to higher revenue from Office 365. Revenue included an unfavorable foreign currency impact of 2%.

 

   

Office Commercial revenue increased $264 million or 5%, driven by higher revenue from Office 365 commercial, mainly due to growth in subscribers, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to Office 365 commercial. Revenue included an unfavorable foreign currency impact of 3%.

 

   

Office Consumer revenue increased $58 million or 8%, driven by higher revenue from Office 365 consumer, mainly due to growth in subscribers.

 

   

Dynamics revenue increased 11%, mainly due to higher revenue from Dynamics CRM Online, driven by seat growth.

Operating income decreased slightly, primarily due to higher operating expenses. Operating expenses increased $35 million or 2%, mainly due to higher research and development expenses, driven by investments in cloud engineering. Operating income included an unfavorable foreign currency impact of 3%. Gross margin was flat, reflecting higher cost of revenue, offset by higher revenue. Gross margin included an unfavorable foreign currency impact of 2%. Cost of revenue increased $353 million or 34%, driven by an increased mix of cloud offerings.

Intelligent Cloud

Revenue increased $490 million or 8%, due to higher revenue from server products and cloud services. Revenue included an unfavorable foreign currency impact of 2%.

 

   

Server products and cloud services revenue grew $486 million or 11%, driven by Azure revenue growth of 116%, as well as growth in revenue from our server products licensed on-premises.

 

   

Enterprise Services revenue increased 1%, driven by growth in revenue from Premier Support Services and Microsoft Consulting Services, offset in part by a decline in revenue from custom support agreements.

Operating income decreased $333 million or 14%, primarily due to higher operating expenses. Operating expenses increased $408 million or 21%, mainly due to higher research and development expenses and sales and marketing expenses. Research and development expenses increased $196 million or 26% and sales and marketing expenses

 

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increased $191 million or 22%, driven by strategic investments and acquisitions to drive cloud engineering, sales capacity, and developer engagement. Operating income included an unfavorable foreign currency impact of 3%. Gross margin increased $75 million or 2%, mainly due to higher revenue, offset in part by higher cost of revenue. Gross margin included an unfavorable foreign currency impact of 2%. Cost of revenue increased $415 million or 27%, driven by an increased mix of cloud offerings.

More Personal Computing

Revenue decreased $168 million or 2%, mainly due to lower revenue from Devices and Gaming, offset in part by higher revenue from Search advertising.

 

   

Devices revenue decreased $493 million or 27%, mainly due to lower revenue from phones, offset in part by higher Microsoft Surface (“Surface”) revenue. Phone revenue decreased $799 million or 72%, driven by a reduction in volume of phones sold. Surface revenue increased $253 million or 38%, primarily driven by a higher mix of premium devices sold.

 

   

Gaming revenue decreased $110 million or 5%, primarily due to lower Xbox hardware revenue, offset in part by higher revenue from Xbox software and services. Xbox hardware revenue decreased 26%, mainly due to lower prices of consoles sold and a decline in volume of consoles sold. Xbox software and services revenue increased 6%, driven by a higher volume of Xbox Live transactions and revenue per transaction.

 

   

Search advertising revenue increased $409 million or 40%. Search advertising revenue, excluding traffic acquisition costs, increased 9%, primarily driven by growth in Bing, due to higher revenue per search and search volume.

 

   

Windows revenue increased slightly, mainly due to higher revenue from patent licensing. Windows OEM licensing (“Windows OEM”) revenue was flat, slightly ahead of the PC market. Windows OEM Pro revenue grew 1%, generally in line with the commercial PC market, and Windows OEM non-Pro revenue declined 1%, slightly outperforming the consumer PC market.

Operating income increased $401 million or 26%, primarily due to lower operating expenses. Operating expenses decreased $438 million or 13%, mainly due to lower sales and marketing expenses and research and development expenses. Sales and marketing expenses decreased $245 million or 18% and research and development expenses decreased $139 million or 9%, driven by a reduction in phone expenses. The decrease in sales and marketing expenses also reflects Windows 10 launch-related expenses in the prior year. Operating income included an unfavorable foreign currency impact of 5%. Gross margin decreased slightly, reflecting lower revenue, offset in part by a reduction in cost of revenue. Cost of revenue decreased $131 million or 3%, driven by a reduction in phone sales, offset in part by an increase in Search advertising traffic acquisition costs and Surface cost of revenue. Surface cost of revenue increased, primarily driven by a higher mix of premium devices sold. Gross margin included an unfavorable foreign currency impact of 2%.

Corporate and Other

Corporate and Other revenue is comprised of revenue deferrals related to Windows 10. Corporate and Other operating income (loss) is comprised of Windows 10 revenue deferrals and corporate-level activity not specifically allocated to a segment, including impairment, integration, and restructuring expenses.

Revenue decreased and operating loss increased, due to a $600 million increase in net revenue deferrals from Windows 10. During the three months ended September 30, 2016 and 2015, we deferred net revenue from Windows 10 of $1.9 billion and $1.3 billion, respectively.

OPERATING EXPENSES

Research and Development

 

(In millions, except percentages)    Three Months Ended
September 30,
    Percentage
Change
 


     2016     2015        

Research and development

   $      3,106      $      2,962        5%   

As a percent of revenue

     15%        15%        0ppt   


 

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Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code.

Research and development expenses increased $144 million or 5%, primarily due to increased strategic investments and acquisitions to drive cloud engineering, offset in part by a reduction in phone expenses.

Sales and Marketing

 

(In millions, except percentages)    Three Months Ended
September 30,
    Percentage
Change
 


     2016     2015        

Sales and marketing

   $      3,233      $      3,333        (3)%   

As a percent of revenue

     16%        16%        0ppt   


Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs.

Sales and marketing expenses decreased $100 million or 3%, primarily due to a reduction in phone expenses and Windows 10 launch-related expenses in the prior year, offset in part by increased investments to drive sales capacity in our commercial cloud.

General and Administrative

 

(In millions, except percentages)    Three Months Ended
September 30,
    Percentage
Change
 


     2016     2015        

General and administrative

   $      1,045      $      1,084        (4)%   

As a percent of revenue

     5%        5%        0ppt   


General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees.

General and administrative expenses decreased $39 million or 4%, primarily due to a reduction in phone expenses and lower employee-related expenses.

OTHER INCOME (EXPENSE), NET

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

 

(In millions)             


Three Months Ended September 30,    2016     2015  

Dividends and interest income

   $         293      $         199   

Interest expense

     (437     (249

Net recognized gains on investments

     405        2   

Net losses on derivatives

     (94     (103

Net losses on foreign currency remeasurements

     (52     (36

Other

     (15     (93


 


Total

   $ 100      $ (280
    


 


We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. Other than

 

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those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities and gains (losses) on certain balance sheet amounts from foreign exchange rate changes.

Dividends and interest income increased due to higher portfolio balances and yields on fixed-income securities. Interest expense increased due to higher outstanding long-term debt. Net recognized gains on investments increased primarily due to higher gains on sales of equity securities. Net losses on derivatives decreased slightly due to lower losses on commodity and foreign currency derivatives compared to the prior year and gains on interest rate derivatives as compared to losses in the prior year, offset in part by losses on equity contracts as compared to gains in the prior year. Other reflects losses recognized from certain joint ventures for both periods presented, and prior year includes losses from divestitures.

INCOME TAXES

Our effective tax rate for the three months ended September 30, 2016 and 2015 was 12% and 11%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico.

The increase in our current quarter effective tax rate compared to prior year was primarily due to changes in the mix of our income before income taxes between the U.S. and foreign countries, offset by an increase in the tax benefits relating to stock-based compensation.

Tax contingencies and other income tax liabilities were $12.3 billion and $11.8 billion as of September 30, 2016 and June 30, 2016, respectively, and are included in other long-term liabilities. This increase relates primarily to current period intercompany transfer pricing.

While we settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, and settled a portion of the IRS audit for tax years 2007 to 2009 during the first quarter of fiscal year 2016, we remain under audit for those years. In February 2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of September 30, 2016, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We also continue to be subject to examination by the IRS for tax years 2010 to 2016.

We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2016, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements.

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $136.9 billion as of September 30, 2016, compared with $113.2 billion as of June 30, 2016. Equity and other investments were $10.5 billion as of September 30, 2016, compared with $10.4 billion as of June 30, 2016. Our short-term investments are primarily intended to facilitate liquidity and for capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities.

Of the cash, cash equivalents, and short-term investments as of September 30, 2016, $111.1 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was $2.4 billion. As of September 30, 2016, approximately 83% of the

 

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cash equivalents and short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 4% were invested in corporate notes and bonds of U.S. companies, and approximately 4% were invested in U.S. mortgage- and asset-backed securities, all of which are denominated in U.S. dollars. The remaining cash equivalents and short-term investments held by our foreign subsidiaries were invested in foreign securities.

Securities lending

We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our consolidated balance sheets. 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. Collateral received is recorded as an asset with a corresponding liability. Our securities lending payable balance was $210 million as of September 30, 2016. Our average and maximum securities lending payable balances for the three months ended September 30, 2016 were $514 million and $1.2 billion, respectively. Intra-year variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities.

Valuation

In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, and U.S. government 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, common and preferred stock, foreign government bonds, mortgage- and asset-backed securities, U.S. government and agency securities, and certificates of deposit. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis 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 classified 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. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.

Cash Flows

Cash flows from operations increased $2.7 billion to $11.5 billion for the three months ended September 30, 2016, mainly due to an increase in cash received from customers and unsettled cash equivalent investments in government securities as of quarter end. Cash from financing increased $18.3 billion to $14.3 billion, mainly due to an $18.1 billion increase in proceeds from issuances of debt, net of repayments, and a $395 million decrease in cash used for common stock repurchases, offset in part by a $325 million increase in dividends paid. Cash used in investing increased $13.4 billion to $18.5 billion, mainly due to a $12.8 billion increase in cash used for net investment purchases, sales, and maturities, and an $807 million increase in cash used for additions to property and equipment, offset in part by a $366 million decrease in cash used for acquisitions of companies, net of cash acquired, and purchases of intangibles and other assets.

Debt

We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. See Note 10 – Debt of the Notes to Financial Statements (Part 1, Item 1 of this Form 10-Q) for further discussion.

 

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Unearned Revenue

Unearned revenue as of September 30, 2016 was comprised mainly of unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or annually at the beginning of each coverage period and accounted for as subscriptions with revenue recognized ratably over the coverage period. Unearned revenue as of September 30, 2016 also included payments for: Windows 10 licenses; post-delivery support and consulting services to be performed in the future; Office 365 subscriptions; Xbox Live subscriptions; Dynamics business solutions products; Skype prepaid credits and subscriptions; bundled products and services; and other offerings for which we have been paid in advance 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 September 30, 2016:

 

(In millions)       


Three Months Ending,

        

December 31, 2016

   $ 11,138   

March 31, 2017

     8,020   

June 30, 2017

     5,130   

September 30, 2017

     2,016   

Thereafter

     7,284   


Total

   $    33,588   
    


If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable.

Share Repurchases

On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. The share repurchase program became effective on October 1, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. As of September 30, 2016, $3.5 billion remained of our $40.0 billion share repurchase program. While the program has no expiration date, we intend to complete it by December 31, 2016.

On September 20, 2016, our Board of Directors approved a share repurchase program authorizing an additional $40.0 billion in share repurchases. This share repurchase program will commence following completion of the program approved on September 16, 2013, has no expiration, and may be suspended or discontinued at any time without notice.

During the three months ended September 30, 2016, we repurchased 63 million shares of Microsoft common stock for $3.6 billion under the share repurchase program approved on September 16, 2013. All repurchases were made using cash resources.

Dividends

See Note 15 – Stockholders’ Equity of the Notes to Financial Statements (Part 1, Item 1 of this Form 10-Q) for further discussion.

Off-Balance Sheet Arrangements

We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. 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. These obligations did not have a material impact on our consolidated financial statements during the periods presented.

 

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Other Planned Uses of Capital

In June 2016, we entered into a definitive agreement to acquire LinkedIn in an all-cash transaction valued at $26.2 billion, inclusive of LinkedIn’s net cash. We expect the acquisition will close in calendar year 2016, and we will finance the transaction primarily through the issuance of new debt.

We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years in support of growth in our cloud offerings. 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.

Liquidity

We earn a significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect existing domestic cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, debt maturities, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.

Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates.

RECENT ACCOUNTING GUIDANCE

See Note 1 – Accounting Policies of the Notes to Financial Statements (Part 1, Item 1 of this Form 10-Q) for further discussion.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories.

Revenue Recognition

Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can be accounted for as separate units of accounting, and if so, the fair value for each of the elements.

Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products. Certain volume licensing arrangements include a perpetual license for

 

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current products combined with rights to receive unspecified future versions of software products and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period.

Software updates are evaluated on a case-by-case basis to determine whether they meet the definition of an upgrade, which may require revenue to be deferred and recognized when the upgrade is delivered. If it is determined that implied post-contract customer support (“PCS”) is being provided, revenue from the arrangement is deferred and recognized over the implied PCS term. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available.

Microsoft enters into arrangements that can include various combinations of software, services, and hardware. Where elements are delivered over different periods of time, and when allowed under U.S. GAAP, revenue is allocated to the respective elements based on their relative selling prices at the inception of the arrangement, and revenue is recognized as each element is delivered. We use a hierarchy to determine the fair value to be used for allocating revenue to elements: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence, and (iii) best estimate of selling price (“ESP”). For software elements, we follow the industry-specific software guidance which only allows for the use of VSOE in establishing fair value. Generally, VSOE is the price charged when the deliverable is sold separately or the price established by management for a product that is not yet sold if it is probable that the price will not change before introduction into the marketplace. ESPs are established as best estimates of what the selling prices would be if the deliverables were sold regularly on a stand-alone basis. Our process for determining ESPs requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable.

In January 2015, we announced Windows 10 would be free to all qualified existing users of Windows 7 and Windows 8.1. This offer differs from historical offers preceding the launch of new versions of Windows as it is being made available for free to existing users in addition to new customers after the offer announcement. We evaluated the nature and accounting treatment of the Windows 10 offer and determined that it represents a marketing and promotional activity, in part because the offer is being made available for free to existing users. As this is a marketing and promotional activity, revenue recognition of new sales of Windows 8 will continue to be recognized as delivered.

Customers purchasing a Windows 10 license will receive unspecified updates and upgrades over the life of their Windows 10 device at no additional cost. As these updates and upgrades will not be sold on a stand-alone basis, we are unable to establish VSOE. Accordingly, revenue from licenses of Windows 10 is recognized ratably over the estimated life of the related device, which ranges between two to four years.

We currently are evaluating the impact of the new standard related to revenue recognition, which we anticipate will have a material impact on our consolidated financial statements. See Note 1 – Accounting Policies of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

Impairment of Investment Securities

We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.

Goodwill

We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or

 

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circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit.

Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital.

The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.

Research and Development Costs

Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products.

Legal and Other Contingencies

The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements.

Income Taxes

The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized on our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements.

Inventories

Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

RISKS

We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our consolidated financial statements.

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar.

Interest Rate

Our fixed-income portfolio is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities.

Equity

Our equity portfolio consists of global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global commodity indices and expect their economic risk and return to correlate with these indices.

VALUE-AT-RISK

We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP, but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed based on the historical volatilities and correlations among foreign exchange rates, interest rates, equity prices, and commodity prices, assuming normal market conditions.

The VaR is calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk.

 

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The following table sets forth the one-day VaR for substantially all of our positions as of September 30, 2016 and June 30, 2016 and for the three months ended September 30, 2016:

 

(In millions)       


    

September 30,

2016

   

June 30,

2016

   

Three Months Ended

September 30,

2016

 
                    


Risk Categories          Average     High     Low  

Foreign currency

     $  230      $     92        $  183      $   303      $     88   

Interest rate

     $    84      $     58        $    70      $     84      $     57   

Equity

     $  152      $   157        $  160      $   165      $   151   

Commodity

     $    11      $     12        $    11      $     12      $       9   


Total one-day VaR for the combined risk categories was $325 million as of September 30, 2016 and $225 million as of June 30, 2016. The total VaR is 32% and 29% less as of September 30, 2016 and June 30, 2016, respectively, than the sum of the separate risk categories in the table above due to the diversification benefit of the combination of risks.

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal control over financial reporting during the quarter ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

See Note 14 – Commitments and Contingencies of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for information regarding legal proceedings in which we are involved.

ITEM 1A. RISK FACTORS

Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock.

We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins.

Competition in the technology sector

Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers.

Competition among platforms, ecosystems, and devices

An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms, applications, and services.

 

   

A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, and wearables. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform. We also offer some vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins.

 

   

We derive substantial revenue from licenses of Windows operating systems on personal computers. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. In addition, some of our devices compete with products made by our OEM partners, which may affect their commitment to our platform.

 

   

Competing platforms have content and application marketplaces (sometimes referred to as “stores”) with scale and significant installed bases. The variety and utility of content and applications available on a platform are important to device purchasing decisions. Users sometimes incur costs to move data and buy new content and applications when switching platforms. To compete, we must successfully enlist developers to write applications for our marketplace and ensure that these applications have high quality, customer appeal, and value. Efforts to compete with competitors’ content and application marketplaces may increase our cost of revenue and lower our operating margins.

 

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Business model competition

Companies compete with us based on a growing variety of business models.

 

   

Even as we transition to a mobile-first and cloud-first strategy, the license-based proprietary software model generates most of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model.

 

   

Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products.

 

   

Some companies compete with us using an open source business model by modifying and then distributing open source software at nominal cost to end-users, and earning revenue on advertising or complementary services and products. These firms do not bear the full costs of research and development for the software. Some open source software vendors develop software that mimics the features and functionality of our products.

The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income.

Our increasing focus on services presents execution and competitive risks.    A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow as a productivity and platform company for the mobile-first and cloud-first world. At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which suite of cloud-based services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We are undertaking cultural and organizational changes to drive accountability and eliminate obstacles to innovation. The Company’s investment in gaining insights from data is becoming central to the value of the services we deliver to customers, to our operational efficiency and key opportunities in monetization, customer perceptions of quality, and operational efficiency. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including:

 

   

Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share.

 

   

Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other television-related devices.

 

   

Continuing to enhance the attractiveness of our cloud platforms to third-party developers.

 

   

Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data.

 

   

Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors.

It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income.

We make significant investments in new products and services that may not achieve expected returns.    We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, the Microsoft Office system, Bing, Windows Phone, Windows Server, the Windows Store, the Microsoft Azure Services platform, Office 365, other cloud-based offerings,

 

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and the Xbox entertainment platform. We also invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment including PCs, tablets, phones, and gaming devices. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically.

The launch of Windows 10, with free upgrades to existing users of Windows 7 and 8.1, has been the most ambitious update effort we have ever undertaken. We did extensive preparation and ongoing compatibility testing for applications and devices to help ensure a positive experience for our users installing Windows 10. We also consistently promoted the update to Windows 7 and 8.1 users. However, negative upgrade experiences could adversely affect the reception of Windows 10 in the marketplace and may lead to litigation or regulatory actions by customers and government agencies. In addition, we anticipate that Windows 10 will enable new post-license monetization opportunities beyond initial license revenues. Our inability to realize these opportunities to the extent we expect could have an adverse impact on our revenues. Finally, our practices around data collection, use, and management in Windows 10 are subject to regulatory review, and may result in decisions directing us to change these practices and imposing fines. If so, we could face negative public reaction, degraded user experiences, and reduced flexibility in product design.

Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue.

Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business.    We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. In June 2016, we announced our acquisition of LinkedIn for approximately $26.2 billion. The LinkedIn acquisition and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that we have difficulty integrating new employees, business systems, and technology, or that they distract management from our other businesses. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements, such as increased revenue, enhanced efficiencies, or increased market share, or the benefits may ultimately be smaller than we expected. These events could adversely affect our operating results or financial condition.

If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings.    We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We may be required to record a significant charge on our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations. For example, in the fourth quarter of fiscal year 2015, we recorded a $5.1 billion charge for the impairment of goodwill and a $2.2 billion charge for the impairment of intangible assets, and in the fourth quarter of fiscal year 2016 we recorded a $480 million charge for the impairment of intangible assets. The impairment charges for both periods related to our phone business. Our acquisition of LinkedIn will result in a significant increase in our goodwill and intangible asset balances.

We may not earn the revenues we expect from our intellectual property rights.

We may not be able to adequately protect our intellectual property rights

Protecting our intellectual property rights and combating unlicensed copying and use of our software and other intellectual property on a global basis is difficult. While piracy adversely affects U.S. revenue, the impact on revenue

 

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from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. Our revenue in these markets may grow slower than the underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate users about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue.

We may not receive expected royalties from our patent licenses

We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some instances, by licensing our patents to others in return for a royalty. Changes in the law may weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties, or may contest the scope and extent of their obligations. Finally, the royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, selling price changes in products using licensed patents, or the difficulty of discovering infringements.

Third parties may claim we infringe their intellectual property rights.    From time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface and Lumia phones. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so.

We may not be able to protect our source code from copying if there is an unauthorized disclosure of source code.    Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If a significant portion of our source code leaks, we might lose future trade secret protection for that source code. It may become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the next paragraph.

Cyber-attacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our competitive position.

Security of Microsoft’s information technology

Threats to IT security can take a variety of forms. Individual and groups of hackers, and sophisticated organizations including state-sponsored organizations or nation-states themselves, may take steps that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software to attack our products and services and gain access to our networks and datacenters, using social engineering techniques, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Cyber threats are constantly evolving, thereby increasing the difficulty of detecting and successfully defending against them. Cyber threats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our network or data security could disrupt the security of our internal systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our competitive position, result in theft or misuse of our intellectual property or other assets, require us to allocate more resources to improved technologies, or otherwise adversely affect our business.

 

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In addition, our internal IT environment continues to evolve. Often, we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge.

Security of our products, services, devices, and customers’ data

Security threats are a particular challenge to companies like us whose business is technology products and services. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure to ensure the reliability of our services and the protection of their data. Hackers tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. The security of our products and services is important in our customers’ purchasing decisions.

To defend against security threats, both to our internal IT systems and those of our customers, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide customers security tools such as firewalls and anti-virus software.

The cost of these steps could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install security patches. Any of these actions by customers could adversely affect our revenue. Actual or perceived vulnerabilities may lead to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenges. Legislative or regulatory action in these areas may increase the costs to develop, implement, or secure our products and services.

Disclosure of personal data could result in liability and harm our reputation.    As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of customer data we or our vendors store and manage. Improper disclosure could harm our reputation, lead to legal exposure to customers, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer data, perceptions that the collection, use and retention of personal information is not satisfactorily protected could inhibit sales of our products or services, and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer expectations or governmental rules or actions, may cause higher operating expenses.

We may have outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure.    Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Exchange Online, Microsoft Azure, Microsoft Account services, Office 365, OneDrive, SharePoint Online, Skype, Xbox Live, Outlook.com, and Windows Stores. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex. It requires that we maintain an

 

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Internet connectivity infrastructure that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data or insufficient Internet connectivity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, regulatory actions, damage to our reputation, and loss of current and potential users, subscribers, and advertisers, each of which may harm our operating results and financial condition.

Government litigation and regulatory activity relating to competition rules may limit how we design and market our products.    As a leading global software and device maker, we are closely scrutinized by government agencies under U.S. and foreign competition laws. An increasing number of governments are regulating competition law activities and this includes increased scrutiny in potentially large markets such as the European Union (“EU”), the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business.

The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows 10 can receive significant scrutiny under competition laws. For example, in 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments offered by Microsoft to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products.

Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices on our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. Because these jurisdictions only recently implemented competition laws, their enforcement activities are unpredictable.

Government regulatory actions and court decisions such as these may hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including:

 

   

We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely.

 

   

We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property.

 

   

The rulings described above may be precedent in other competition law proceedings.

 

   

We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions.