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MICROSOFT CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
(Edgar Glimpses Via Acquire Media NewsEdge) RESULTS OF OPERATIONS
Note About Forward-Looking Statements
Certain statements in this report, other than purely historical information,
including estimates, projections, statements relating to our business plans,
objectives, and expected operating results, and the assumptions upon which those
statements are based, are "forward-looking statements" within the meaning of the
Private Securities Litigation Reform Act of 1995, Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
Forward-looking statements may appear throughout this report, including without
limitation, the following sections: "Management's Discussion and Analysis," and
"Risk Factors." These forward-looking statements generally are identified by the
words "believe," "project," "expect," "anticipate," "estimate," "intend,"
"strategy," "future," "opportunity," "plan," "may," "should," "will," "would,"
"will be," "will continue," "will likely result," and similar expressions.
Forward-looking statements are based on current expectations and assumptions
that are subject to risks and uncertainties which may cause actual results to
differ materially from the forward-looking statements. A detailed discussion of
risks and uncertainties that could cause actual results and events to differ
materially from such forward-looking statements is included in the section
titled "Risk Factors" (Part II, Item 1A 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 ("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,
2012 and our financial statements and accompanying Notes to Financial Statements
in this Form 10-Q.
Microsoft is a technology leader focused on helping people and businesses
throughout the world realize their full potential. We create technology that
transforms the way people work, play, and communicate across a wide range of
computing devices.
We generate revenue by developing, licensing, and supporting a wide range of
software products, by offering an array of services, including cloud-based
services to consumers and businesses, by designing and selling hardware that
integrates 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, and income taxes.
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 anticipate the changing demands of customers, industry trends, and
competitive forces.
Key Opportunities and Investments
We invest research and development resources in new products and services in the
areas where we see significant opportunities to drive future growth. As we look
forward, the capabilities and accessibility of PCs, tablets, phones,
televisions, and other devices powered by rich software platforms and
applications continue to grow. With this trend, we believe the full potential of
software will be seen and felt in how people use these devices and the
associated services at work and in their personal lives.
Devices with End-User Services
We work with an ecosystem of partners to deliver a broad spectrum of Windows
devices. In some cases, we build our own devices, as we have chosen to do with
Xbox and Surface. In all our work with partners and on our own devices, we focus
on delivering seamless services and experiences across devices. As consumer
services and hardware advance, we expect they will continue to better complement
one another, connecting the devices people use daily to unique communications,
productivity, and entertainment services from Microsoft and our partners and
developers around the world.
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Windows 8 reflects this shift. Launched in October 2012 on a variety of
state-of-the-art hardware, Windows 8 is built to take advantage of our consumer
cloud services. Windows 8 is made for both personal and professional use and
unites the light, thin, and convenient aspects of a tablet with the power of a
PC. For example, Xbox Music, Video, Games, and SmartGlass applications make it
possible to select and experience entertainment across a range of devices by
simplifying and increasing the accessibility of those experiences. SkyDrive, our
cloud storage solution, connects content across all of a user's devices. Bing's
search technologies in Windows 8 are designed to help users get more done. Skype
has a new Windows 8 application and connects directly to the new Office.
The new Office is designed for Windows 8 and takes advantage of new mobile form
factors with touch and pen capabilities. It unlocks new experiences for reading,
note taking, meetings, and communications and brings social experiences directly
into productivity and collaboration scenarios. The combination of a Windows 8
tablet with OneNote and SkyDrive will transform how to take notes, annotate
documents, and share information.
Services for the Enterprise
Today, businesses face important opportunities and challenges. Enterprise IT
departments are asked to deploy technology that drives business strategy
forward. They decide what solutions will make employees more productive,
collaborative, and satisfied. They work to unlock business insights from a world
of data. At the same time, they must manage and secure corporate information
that employees access across a growing number of personal and corporate devices.
To address these opportunities, businesses look to our world-class business
applications like Microsoft Dynamics, Office, Exchange, SharePoint, Lync, and
our business intelligence solutions. They rely on our technology to manage
employee corporate identity and to protect their corporate data. And,
increasingly, businesses of all sizes are looking to Microsoft to realize the
benefits of the cloud.
Helping businesses move to the cloud is one of our largest opportunities.
Cloud-based solutions provide customers with software, services, and content
over the Internet by way of shared computing resources located in centralized
data centers. The shift to the cloud is driven by three important economies of
scale: larger data centers can deploy computational resources at significantly
lower cost per unit than smaller ones; larger data centers can coordinate and
aggregate diverse customer, geographic, and application demand patterns
improving the utilization of computing, storage, and network resources; and
multi-tenancy lowers application maintenance labor costs for large public
clouds. Because of the improved economics, the cloud offers unique levels of
elasticity and agility that enable new solutions and applications. For
businesses of all sizes, the cloud creates the opportunity to focus on
innovation while leaving non-differentiating activities to reliable and
cost-effective providers.
Unique to Microsoft, we continue to design and deliver cloud solutions that
allow our customers to use both the cloud and their on-premise assets however
best suits their own needs. For example, a company can choose to deploy Office
or Microsoft Dynamics on premises, as a cloud service, or a combination of both.
With Windows Server 2012, Windows Azure, and System Center infrastructure,
businesses can deploy applications in their own datacenter, a partner's
datacenter, or in Microsoft's datacenter with common security, management, and
administration across all environments, with the flexibility and scale they
desire. Our business customers tell us these hybrid capabilities are critical to
harnessing the power of the cloud so they can reach new levels of efficiency and
tap new areas of growth.
Our Future Opportunity
There are several distinct areas of technology that we are focused on driving
forward. Our goal is to lead the industry in these areas over the long term,
which we expect will translate to sustained growth well into the future. We are
investing significant resources in:
• Developing new form factors that have increasingly natural ways to use
them, including touch, gestures, and speech.
• Making technology more intuitive and able to act on our behalf, instead of
at our command, with machine learning.
• Building and running cloud services in ways that unleash new experiences
and opportunities for businesses and individuals.
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• Firmly establishing our Windows platform across the PC, tablet, phone,
server, and cloud to drive a thriving ecosystem of developers, unify the
cross-device user experience, and increase agility when bringing new
advances to market.
• Delivering new scenarios with improvements in how people learn, work,
play, and interact with one another.
We believe the breadth of our devices and services portfolio, our large, global
partner and customer base, and the growing Windows ecosystem position us to be a
leader in these areas.
Economic Conditions, Challenges and Risks
As discussed above, our industry is dynamic and highly competitive. We must
anticipate changes in technology and business models. Our model for growth is
based on our ability to initiate and embrace disruptive technology trends, to
enter new markets, both in terms of geographies and product areas, and to drive
broad adoption of the products and services we develop and market.
At Microsoft, we prioritize our investments among the highest long-term growth
opportunities. These investments require significant resources and are
multi-year in nature. The products and services we bring to market may be
developed internally, brought to market as part of a partnership or alliance, or
through acquisition.
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 worldwide by offering broad customer reach,
scale in resources, and competitive compensation.
Demand for our software, services, and hardware has a strong correlation to
global macroeconomic factors. The current macroeconomic factors remain dynamic.
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 the
highest in the second quarter of our fiscal year due to corporate calendar
year-end spending trends in our major markets and holiday season spending by
consumers. Our Entertainment and Devices Division is particularly seasonal as
its products are aimed at the consumer market and are in highest demand during
the holiday shopping season. Typically, the Entertainment and Devices Division
has generated approximately 40% of its yearly segment revenue in our second
fiscal quarter.
Unearned Revenue
Quarterly and annual revenue may be impacted by the deferral of revenue. See the
discussions below regarding revenue deferred on: sales of Windows 7 with an
option to upgrade to Windows 8 Pro at a discounted price (the "Windows Upgrade
Offer") and pre-sales of Windows 8 to original equipment manufacturers ("OEMs")
and retailers before general availability ("Windows 8 Pre-Sales") (collectively,
the "Windows Deferral"); sales of the current version of the Microsoft Office
system with a guarantee to be upgraded to the new Office at minimal or no cost
(the "Office Upgrade Offer") and pre-sales of the new Office to OEMs and
retailers before general availability ("Office Pre-Sales") (collectively, the
"Office Deferral"); and on sales of video games with the right to receive
specified software upgrades/enhancements (the "Video Game Deferral").
RESULTS OF OPERATIONS
Summary
(In millions, except percentages Three Months Ended Percentage
Six Months Ended Percentage
and per share amounts) December 31, Change December 31, Change
-----------------------------------------------------------------------------------------------------------------------
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2012 2011 2012 2011
Revenue $ 21,456 $ 20,885 3% $ 37,464 $ 38,257 (2)%
Operating income $ 7,771 $ 7,994 (3)% $ 13,079 $ 15,197 (14)%
Diluted earnings per share $ 0.76 $ 0.78 (3)% $ 1.28 $ 1.46 (12)%-----------------------------------------------------------------------------------------------------------------------
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Three months ended December 31, 2012 compared with three months ended
December 31, 2011
Revenue increased, primarily due to the launch of Windows 8 and Surface on
October 26, 2012, and strong sales of Server and Tools products and services,
offset in part by lower Entertainment and Devices revenue. During the three
months ended December 31, 2012, we recognized a net $622 million of revenue
related to the Windows Deferral, and we deferred a net $788 million of revenue
related to the Office Deferral and $380 million of revenue related to the Video
Game Deferral.
Operating income decreased, reflecting higher operating expenses, offset in part
by revenue growth. Key changes in operating expenses were:
• Sales and marketing expenses increased $547 million or 15%, primarily
reflecting advertising of Windows 8 and Surface.
• Research and development expenses increased $157 million or 7%, due mainly
to higher headcount-related expenses, primarily related to the
Entertainment and Devices Division.
Six months ended December 31, 2012 compared with six months ended December 31,
2011
Revenue decreased, primarily due to the deferral of certain Office, Windows, and
video game revenue and lower Entertainment and Devices revenue, offset in part
by strong sales of Server and Tools products and services and the launch of
Windows 8 and Surface. During the six months ended December 31, 2012, we
deferred $977 million of revenue related to the Office Deferral, a net $545
million of revenue related to the Windows Deferral, and $380 million of revenue
related to the Video Game Deferral.
Operating income decreased, reflecting lower revenue and increased cost of
revenue and operating expenses. Key changes in cost of revenue and operating
expenses were:
• Sales and marketing expenses increased $592 million or 9%, primarily
reflecting advertising of Windows 8 and Surface.
• Cost of revenue increased $445 million or 5%, reflecting payments made to
Nokia related to joint strategic initiatives, higher headcount-related
expenses, primarily related to Server and Tools, and increased product
costs associated with Surface, offset in part by lower volumes of Xbox 360
consoles sold.
• Research and development expenses increased $288 million or 6%, due mainly
to higher headcount-related expenses, primarily related to the
Entertainment and Devices Division.
SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)
The revenue and operating income (loss) amounts in this section are presented on
a basis consistent with accounting principles generally accepted in the U.S.
("U.S. GAAP") and include certain reconciling items attributable to each of the
segments. Segment information appearing in Note 17 - Segment Information of the
Notes to Financial Statements (Part I, Item I of this Form 10-Q) is presented on
a basis consistent with our current internal management reporting. Certain
corporate-level activity has been excluded from segment operating results and is
analyzed separately. We have recast certain prior period amounts within this
MD&A to conform to the way we internally managed and monitored segment
performance during the current fiscal year.
Windows Division
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages)
December 31, Change December 31, Change
------------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
Revenue $ 5,881 $ 4,741 24% $ 9,125 $ 9,615 (5)%
Operating income $ 3,296 $ 2,880 14% $ 4,950 $ 6,161 (20)%------------------------------------------------------------------------------------------------------------------------
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Windows Division develops and markets PC operating systems, related software,
and online services, and PC hardware products. This collection of software,
hardware, and services is designed to simplify everyday tasks through seamless
operations across the user's hardware and software. Windows Division offerings
consist of the Windows operating system, software, and services, Surface, and
Microsoft PC hardware products. The general availability of Surface, Windows 8,
and Windows 8 and Windows RT devices started on October 26, 2012.
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Excluding the impact of the Windows Deferral, approximately 65% of total Windows
Division revenue comes from Windows operating system software purchased by OEMs,
which they pre-install on equipment they sell. The remaining Windows Division
revenue is generated by commercial and retail sales of Windows, Surface, PC
hardware products, and online advertising.
Three months ended December 31, 2012 compared with three months ended
December 31, 2011
Windows Division revenue increased from the prior year, due in part to the
recognition of a net $622 million of revenue related to Windows Deferral, as
well as due to sales of Surface and Windows 8 upgrades. OEM revenue grew 17%,
reflecting the net Windows Deferral recognition and increased demand in our
distribution channels, offset in part by a decline in the x86 PC market.
Windows Division operating income increased, primarily due to revenue growth,
offset in part by higher sales and marketing expenses and cost of revenue. Sales
and marketing expenses increased $420 million or 49%, reflecting advertising
costs associated with the launch of Windows 8 and Surface. Cost of revenue
increased $293 million or 58%, including product costs associated with Surface
and Windows 8 and Windows 8 upgrade support costs.
Six months ended December 31, 2012 compared with six months ended December 31,
2011
Windows Division revenue decreased from the prior year, due in part to the
deferral of a net $545 million of revenue related to the Windows Upgrade Offer,
as well as due to a decline in the x86 PC market and continued higher relative
growth in emerging markets, where average selling prices are lower than
developed markets. The revenue decrease was offset in part by sales of Surface
and Windows 8 upgrades.
Windows Division operating income decreased, due mainly to lower revenue and
higher sales and marketing expenses and cost of revenue. Sales and marketing
expenses increased $368 million or 24%, reflecting advertising costs associated
with the launch of Windows 8 and Surface. Cost of revenue increased $292 million
or 30%, including product costs associated with Surface and Windows 8 and
Windows 8 upgrade support costs.
Server and Tools
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages)
December 31, Change December 31, Change
-----------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
Revenue $ 5,186 $ 4,737 9% $ 9,739 $ 8,953 9%
Operating income $ 2,121 $ 1,950 9% $ 3,858 $ 3,503 10%-----------------------------------------------------------------------------------------------------------------------
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Server and Tools develops and markets technology and related services that
enable information technology professionals and their systems to be more
productive and efficient. Server and Tools product and service offerings include
Windows Server, Microsoft SQL Server, Windows Azure, Visual Studio, System
Center products, Windows Embedded device platforms, and Enterprise Services.
Enterprise Services comprise Premier product support services and Microsoft
Consulting Services. We also offer developer tools, training, and certification.
Approximately 80% of Server and Tools revenue comes from product revenue,
including purchases through volume licensing programs, licenses sold to OEMs,
and retail packaged product, while the remainder comes from Enterprise Services.
Three months ended December 31, 2012 compared with three months ended
December 31, 2011
Server and Tools revenue increased in both product sales and Enterprise
Services. Product revenue increased $347 million or 9%, driven primarily by
growth in SQL Server, Windows Server, and System Center, reflecting continued
adoption of the Windows platform. Enterprise Services revenue grew $102 million
or 10%, due to growth in both Premier product support and consulting services.
Server and Tools operating income increased, primarily due to revenue growth,
offset in part by higher cost of revenue and sales and marketing expenses. Cost
of revenue increased $163 million or 17%, primarily reflecting higher
headcount-related expenses. Sales and marketing expenses grew $76 million or 7%,
reflecting increased fees paid to third-party enterprise software advisors and
corporate sales and marketing activities.
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Six months ended December 31, 2012 compared with six months ended December 31,
2011
Server and Tools revenue increased in both product sales and Enterprise
Services. Product revenue increased $560 million or 8%, driven primarily by
growth in SQL Server, System Center, and Windows Server, reflecting continued
adoption of the Windows platform. Enterprise Services revenue grew $226 million
or 12%, due to growth in both Premier product support and consulting services.
Server and Tools operating income increased, primarily due to revenue growth,
offset in part by higher cost of revenue and sales and marketing expenses. Cost
of revenue increased $273 million or 15%, primarily reflecting higher
headcount-related expenses. Sales and marketing expenses grew $124 million or
6%, reflecting increased fees paid to third-party enterprise software advisors
and corporate sales and marketing activities.
Online Services Division
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
--------------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
Revenue $ 869 $ 784 11% $ 1,566 $ 1,425 10%
Operating loss $ (283 ) $ (459 ) 38% $ (647 ) $ (973 ) 34%--------------------------------------------------------------------------------------------------------------------------
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Online Services Division ("OSD") develops and markets information and content
designed to help people simplify tasks and make more informed decisions online,
and to help advertisers connect with audiences. OSD offerings include Bing, Bing
Ads, MSN, and advertiser tools. Bing and MSN generate revenue through the sale
of search and display advertising, accounting for nearly all of OSD's annual
revenue.
Three months ended December 31, 2012 compared with three months ended
December 31, 2011
Online advertising revenue grew $109 million or 15% to $823 million, reflecting
continued growth in search advertising revenue, offset in part by decreased
display advertising revenue. Search revenue grew, primarily due to increased
revenue per search. According to third-party sources, Bing organic U.S. market
share for the month of December 2012 was approximately 16%, and grew 120 basis
points year over year. Bing-powered U.S. market share, including Yahoo!
properties, was approximately 26% for the month of December 2012, down 90 basis
points year over year.
OSD's operating loss was reduced by higher revenue and lower cost of revenue and
sales and marketing expenses. Cost of revenue decreased $72 million, driven by
lower traffic acquisition costs and Yahoo! reimbursement costs. Sales and
marketing expenses decreased $31 million or 16%, due mainly to decreased
advertising and corporate marketing activities.
Six months ended December 31, 2012 compared with six months ended December 31,
2011
Online advertising revenue grew $193 million or 15% to $1.5 billion, reflecting
continued growth in search advertising revenue, offset in part by decreased
display advertising revenue. Search revenue grew, primarily due to increased
revenue per search.
OSD's operating loss was reduced by higher revenue and lower cost of revenue and
sales and marketing expenses, offset in part by higher research and development
expenses. Cost of revenue decreased $163 million, driven by lower traffic
acquisition costs and Yahoo! reimbursement costs. Sales and marketing expenses
decreased $71 million or 19%, due mainly to decreased advertising and corporate
marketing activities. Research and development expenses increased $47 million or
8%, primarily reflecting higher headcount-related expenses.
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Microsoft Business Division
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
----------------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
Revenue $ 5,691 $ 6,310 (10)% $ 11,192 $ 11,945 (6)%
Operating income $ 3,565 $ 4,188 (15)% $ 7,214 $ 7,906 (9)%----------------------------------------------------------------------------------------------------------------------------
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Microsoft Business Division ("MBD") develops and markets software and online
services designed to increase personal, team, and organization productivity. MBD
offerings include the Microsoft Office system (comprising mainly Office,
SharePoint, Exchange, Lync, and Office 365), which generates over 90% of MBD
revenue, and Microsoft Dynamics business solutions. We evaluate MBD results
based upon the nature of the end user in two primary parts: business revenue,
which includes Microsoft Office system revenue generated through volume
licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which
includes revenue from retail packaged product sales and OEM revenue.
Three months ended December 31, 2012 compared with three months ended
December 31, 2011
MBD revenue decreased, due mainly to the deferral of $689 million of revenue
related to the Office Upgrade Offer and $99 million of revenue related to Office
Pre-Sales. This decrease was offset in part by overall increased sales of the
Microsoft Office system. Business revenue increased $196 million or 4%,
primarily reflecting growth in multi-year volume licensing revenue and a 12%
increase in Microsoft Dynamics revenue. Consumer revenue decreased $815 million
or 67%, driven primarily by the Office Deferral.
MBD revenue for the three months ended December 31, 2012 included an unfavorable
foreign currency impact of $103 million.
MBD operating income decreased, mainly due to lower revenue.
Six months ended December 31, 2012 compared with six months ended December 31,
2011
MBD revenue decreased, due mainly to the deferral of $876 million of revenue
related to the Office Upgrade Offer and $101 million of revenue related to
Office Pre-Sales. This decrease was offset in part by overall increased sales of
the Microsoft Office system. Business revenue increased $339 million or 4%,
primarily reflecting growth in multi-year volume licensing revenue and an 11%
increase in Microsoft Dynamics revenue. Consumer revenue decreased $1.1 billion
or 47%, driven by the Office Deferral and a decline in the x86 PC market.
MBD revenue for the six months ended December 31, 2012 included an unfavorable
foreign currency impact of $222 million.
MBD operating income decreased, mainly due to lower revenue, offset in part by
lower research and development expenses. Research and development expenses
decreased $78 million or 8%, primarily due to the capitalization of certain
Microsoft Office system software development costs, offset in part by increased
headcount-related expenses.
Entertainment and Devices Division
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
-----------------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
Revenue $ 3,772 $ 4,238 (11)% $ 5,719 $ 6,200 (8)%
Operating income $ 596 $ 517 15% $ 619 $ 860 (28)%-----------------------------------------------------------------------------------------------------------------------------
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Entertainment and Devices Division ("EDD") develops and markets products and
services designed to entertain and connect people. EDD offerings include the
Xbox 360 entertainment platform (which includes the Xbox 360 gaming and
entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox LIVE, and
Xbox 360 accessories), Mediaroom (our Internet protocol television software),
Skype, and Windows Phone, including related patent licensing revenue. We
acquired Skype on October 13, 2011, and its results of operations from that date
are reflected in our results discussed below.
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Three months ended December 31, 2012 compared with three months ended
December 31, 2011
EDD revenue decreased, primarily due to lower Xbox 360 platform revenue, offset
in part by higher Windows Phone revenue. Xbox 360 platform revenue decreased
$1.1 billion or 29%, due mainly to lower volumes of consoles sold and lower
video game revenue, offset in part by higher Xbox LIVE revenue. We shipped
5.9 million Xbox 360 consoles during the second quarter of fiscal year 2013,
compared with 8.2 million Xbox 360 consoles during the second quarter of fiscal
year 2012. Video game revenue decreased, primarily due to $380 million of
revenue deferred associated with the Video Game Deferral. Windows Phone revenue
increased $546 million, including patent licensing revenue and increased sales
of Windows Phone licenses.
EDD operating income increased, due mainly to lower cost of revenue and sales
and marketing expenses, offset in part by decreased revenue and increased
research and development expenses. Cost of revenue decreased $544 million or
19%, mainly due to decreased sales of Xbox 360 consoles, offset in part by
payments made to Nokia related to joint strategic initiatives and increased
royalties on Xbox LIVE content and video games. Sales and marketing expenses
decreased $92 million or 21%, primarily reflecting decreased Xbox 360 platform
marketing. Research and development expenses increased $98 million or 25%,
primarily reflecting higher headcount-related expenses.
Six months ended December 31, 2012 compared with six months ended December 31,
2011
EDD revenue decreased, primarily due to lower Xbox 360 platform revenue, offset
in part by higher Windows Phone revenue. Xbox 360 platform revenue decreased
$1.5 billion or 27%, due mainly to lower volumes of consoles sold and lower
video game revenue, offset in part by higher Xbox LIVE revenue. We shipped
7.5 million Xbox 360 consoles during the first half of fiscal year 2013,
compared with 10.5 million Xbox 360 consoles during the first half of fiscal
year 2012. Video game revenue decreased, primarily due to $380 million of
revenue deferred associated with the Video Game Deferral. Windows Phone revenue
increased $690 million, including patent licensing revenue and higher sales of
Windows Phone licenses.
EDD operating income decreased, due mainly to lower revenue and higher research
and development expenses, offset in part by lower cost of revenue and sales and
marketing expenses. Research and development expenses increased $235 million or
33%, primarily reflecting higher headcount-related expenses. Cost of revenue
decreased $392 million or 10%, mainly due to lower sales of Xbox 360 consoles,
offset in part by payments made to Nokia related to joint strategic initiatives.
Sales and marketing expenses decreased $90 million or 14%, primarily reflecting
decreased Xbox 360 platform marketing.
Corporate-Level Activity
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
--------------------------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
Corporate-level activity $ (1,524 ) $ (1,082 ) (41)% $ (2,915 ) $ (2,260 ) (29)%--------------------------------------------------------------------------------------------------------------------------------------
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Certain corporate-level activity is not allocated to our segments, including
costs of: broad-based sales and marketing; product support services; human
resources; legal; finance; information technology; corporate development and
procurement activities; research and development; costs of operating our retail
stores; and legal settlements and contingencies.
Corporate-level expenses increased, due mainly to increased retail stores
expenses, other increased headcount-related expenses, and higher intellectual
property licensing costs.
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COST OF REVENUE
Cost of Revenue
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
-------------------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
Cost of revenue $ 5,692 $ 5,638 1% $ 9,860 $ 9,415 5%
As a percent of revenue 27 % 27 % 0ppt 26 % 25 % 1ppt-------------------------------------------------------------------------------------------------------------------------------
-
Cost of revenue includes: manufacturing and distribution costs for products
sold, including Xbox and Surface, and programs licensed; operating costs related
to product support service centers and product distribution centers; costs
incurred to include software on PCs sold by OEMs, to drive traffic to our
websites, and to acquire online advertising space ("traffic acquisition costs");
costs incurred to support and maintain Internet-based products and services
including royalties; warranty costs; inventory valuation adjustments; costs
associated with the delivery of consulting services; and the amortization of
capitalized research and development costs.
Cost of revenue increased reflecting costs to manufacture Surface, higher
headcount-related expenses, and payments made to Nokia related to joint
strategic initiatives, offset in part by lower volumes of Xbox 360 consoles
sold. Headcount-related expenses increased 17% and 13% for the three and six
months ended December 31, 2012, respectively, primarily related to increased
Server and Tools headcount.
OPERATING EXPENSES
Research and Development
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
-------------------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
Research and development $ 2,528 $ 2,371 7% $ 4,988 $ 4,700 6%
As a percent of revenue 12 % 11 % 1ppt 13 % 12 % 1ppt-------------------------------------------------------------------------------------------------------------------------------
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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, reflecting an 8% and 5% increase in
headcount-related expenses during the three and six months ended December 31,
2012, respectively, primarily related to the Entertainment and Devices Division.
Sales and Marketing
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
-------------------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
Sales and marketing $ 4,309 $ 3,762 15% $ 7,254 $ 6,662 9%
As a percent of revenue 20 % 18 % 2ppt 19 % 17 % 2ppt-------------------------------------------------------------------------------------------------------------------------------
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Sales and marketing expenses include payroll, employee benefits, stock-based
compensation expense, and other headcount-related expenses associated with sales
and marketing personnel and the costs of advertising, promotions, trade shows,
seminars, and other programs.
Sales and marketing expenses increased, primarily reflecting advertising of
Windows 8 and Surface, and a 6% and 3% increase in headcount-related expenses
during the three and six months ended December 31, 2012, respectively.
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General and Administrative
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
--------------------------------------------------------------------------------------------------------------------------------
-
2012 2011 2012 2011
General and administrative $ 1,156 $ 1,120 3% $ 2,283 $ 2,283 0%
As a percent of revenue 5 % 5 % 0ppt 6 % 6 % 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 increased during the three months ended
December 31, 2012, due primarily to higher legal charges.
OTHER INCOME (EXPENSE) AND INCOME TAXES
Other Income (Expense)
The components of other income (expense) were as follows:
Three Months Ended Six Months Ended
(In millions) December 31, December 31,--------------------------------------------------------------------------------------------------------
--
2012 2011 2012 2011
Dividends and interest income $ 166 $ 182 $ 325 $ 393
Interest expense (105 ) (95 ) (200 ) (189 )
Net recognized gains on investments 43 315 28 318
Net losses on derivatives (65 ) (203 ) (61 ) (176 )
Net losses on foreign currency remeasurements (7 ) (4 ) (36 ) (44 )
Other (33 ) 50 169 46
-------------------------------------------------------------- -- - ------ -- - ------ -- - ------ --
Total $ (1 ) $ 245 $ 225 $ 348
-- ------ -- - ------ -- - ------ -- - ------ --
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 recognized in other
income (expense). These are generally offset by unrealized gains and losses in
the underlying securities in the investment portfolio and are recorded as a
component of other comprehensive income.
Three months ended December 31, 2012 compared with three months ended
December 31, 2011
Net recognized gains on investments decreased, primarily due to lower gains on
sales of equity and fixed-income securities, offset in part by lower
other-than-temporary impairments. Net losses on derivatives decreased, due to
lower losses on foreign currency derivatives and gains on equity derivatives in
the current period as compared to losses in the comparable period, offset in
part by losses on commodity and interest-rate derivatives in the current period
as compared to gains in the comparable period.
Six months ended December 31, 2012 compared with six months ended December 31,
2011
Net recognized gains on investments decreased, primarily due to lower gains on
sales of equity and fixed-income securities, offset in part by lower
other-than-temporary impairments. Net losses on derivatives decreased, due to
gains on commodity and equity derivatives in the current period as compared to
losses in the comparable period, offset in part by higher losses on foreign
currency derivatives and lower gains on interest-rate derivatives. For the six
months ended December 31, 2012, other includes a gain recognized upon the
divestiture of our 50% share in the MSNBC joint venture.
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Income Taxes
Our effective tax rates were approximately 18% and 20% for the three months
ended December 31, 2012 and 2011, respectively, and 18% and 20% for the six
months ended December 31, 2012 and 2011, 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, which have lower income tax
rates.
The current quarter effective tax rate is lower than our prior year's second
quarter effective tax rate, primarily due to adjustments to prior year tax
provision estimates and a favorable state court ruling. The current year
effective tax rate is lower than our prior year effective tax rate, primarily
due to the favorable impact of foreign currency exchange rate movements on our
foreign tax provisions.
Tax contingencies and other tax liabilities were $7.7 billion and $7.6 billion
as of December 31, 2012 and June 30, 2012, respectively, and are included in
other long-term liabilities. While we settled a portion of the I.R.S. audit for
tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain
under audit for those years. In February 2012, the I.R.S. withdrew its 2011
Revenue Agents Report and reopened the audit phase of the examination. As of
December 31, 2012, the primary unresolved issue relates to transfer pricing
which could have a significant impact on our financial statements if not
resolved favorably. We do not believe it is reasonably possible that the total
amount of unrecognized tax benefits will significantly increase or decrease
within the next 12 months, because we do not believe the remaining open issues
will be resolved within the next 12 months. We also continue to be subject to
examination by the I.R.S. for tax years 2007 to 2011.
FINANCIAL CONDITION
Cash, Cash Equivalents, and Investments
Cash, cash equivalents, and short-term investments totaled $68.3 billion as of
December 31, 2012, compared with $63.0 billion as of June 30, 2012. Equity and
other investments were $10.7 billion as of December 31, 2012, compared with $9.8
billion as of June 30, 2012. Our short-term investments are primarily 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. While we own
certain mortgage-backed and asset-backed fixed-income securities, our portfolio
as of December 31, 2012 does not contain material direct exposure to subprime
mortgages or structured vehicles that derive their value from subprime
collateral. The majority of our mortgage-backed securities is collateralized by
prime residential mortgages and carries a 100% principal and interest guarantee,
primarily from Federal National Mortgage Association, Federal Home Loan Mortgage
Corporation, and Government National Mortgage Association.
We routinely monitor our financial exposure to both sovereign and non-sovereign
borrowers and counterparties. Our gross exposures to our customers and
investments in Portugal, Italy, Ireland, Greece, and Spain are individually and
collectively not material.
Of the cash, cash equivalents, and short-term investments at December 31, 2012,
approximately $61 billion was held by our foreign subsidiaries and would be
subject to material repatriation tax effects. The amount of cash and investments
held by foreign subsidiaries subject to other restrictions on the free flow of
funds (primarily currency and other local regulatory) was approximately $579
million. As of December 31, 2012, approximately 84% of the short-term
investments held by our foreign subsidiaries were invested in U.S. government
and agency securities, approximately 5% were invested in corporate notes and
bonds of U.S. companies, and 3% were invested in U.S. mortgage-backed
securities, all of which are denominated in U.S. dollars.
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
balance sheet. Cash and/or security interests are received as collateral for the
loaned securities with the amount determined based upon the underlying security
lent and the creditworthiness of the
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borrower. Cash received is recorded as an asset with a corresponding liability.
Our securities lending payable balance was $21 million as of December 31, 2012.
Our average and maximum securities lending payable balances for the three months
ended December 31, 2012 were $174 million and $455 million, respectively. Our
average and maximum securities lending payable balances for the six months ended
December 31, 2012 were $509 million and $1.4 billion, respectively.
Intra-quarter 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.
treasuries. If quoted prices in active markets for identical assets or
liabilities are not available to determine fair value, then we use quoted prices
for similar assets and liabilities or inputs other than the quoted prices that
are observable either directly or indirectly. This pricing methodology applies
to our Level 2 investments such as corporate notes and bonds, foreign government
bonds, mortgage-backed securities, and agency securities. Level 3 investments
are valued using internally developed models with unobservable inputs. Assets
and liabilities measured using unobservable inputs are an immaterial portion of
our portfolio.
A majority of our investments are priced by pricing vendors and are generally
Level 1 or Level 2 investments as these vendors either provide a quoted market
price in an active market or use observable inputs for their pricing without
applying significant adjustments. Broker pricing is used mainly when a quoted
price is not available, the investment is not priced by our pricing vendors, or
when a broker price is more reflective of fair values in the market in which the
investment trades. Our broker-priced investments are generally labeled as Level
2 investments because the broker prices these investments based on similar
assets without applying significant adjustments. In addition, all of our
broker-priced investments have a sufficient level of trading volume to
demonstrate that the fair values used are appropriate for these investments. Our
fair value processes include controls that are designed to ensure appropriate
fair values are recorded. 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 decreased $1.1 billion to $13.3 billion for the six
months ended December 31, 2012, due mainly to changes in working capital,
including increases in inventory and other current assets, offset in part by
increased cash collections from customers. Cash used in financing decreased $1.4
billion to $3.9 billion, due mainly to $2.2 billion in proceeds from issuance of
debt, offset in part by a $585 million increase in dividends paid and a $314
million increase in cash used for common stock repurchases. Cash used in
investing increased $2.4 billion to $10.3 billion, due mainly to a $9.4 billion
increase in cash used for net investment purchases, maturities, and sales and a
$599 million increase in cash used for additions to property and equipment,
offset in part by an $8.0 billion decrease in cash used for acquisitions of
companies and intangible 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 to partially fund discretionary
business acquisitions, share repurchases, and other general corporate purposes.
As of December 31, 2012, the total carrying value and estimated fair value of
our long-term debt, including the current portion, were $14.2 billion and $15.2
billion, respectively. This is compared to a carrying value and estimated fair
value of $11.9 billion and $13.2 billion, respectively, as of June 30, 2012.
These estimated fair values are based on Level 2 inputs.
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The components of our long-term debt, including the current portion, and the
associated interest rates were as follows as of December 31, 2012:
Stated Effective
Interest Interest
Due Date Face Value Rate Rate
------------------------------------------------------------------------ --
(In millions)
Notes
September 27, 2013 $ 1,000 0.875 % 1.000 %
June 1, 2014 2,000 2.950 % 3.049 %
September 25, 2015 1,750 1.625 % 1.795 %
February 8, 2016 750 2.500 % 2.642 %
November 15, 2017 (a) 600 0.875 % 1.084 %
June 1, 2019 1,000 4.200 % 4.379 %
October 1, 2020 1,000 3.000 % 3.137 %
February 8, 2021 500 4.000 % 4.082 %
November 15, 2022 (a) 750 2.125 % 2.239 %
June 1, 2039 750 5.200 % 5.240 %
October 1, 2040 1,000 4.500 % 4.567 %
February 8, 2041 1,000 5.300 % 5.361 %
November 15, 2042 (a) 900 3.500 % 3.571 % --------------------------------------- -
Total 13,000
Convertible Debt
June 15, 2013 1,250 0.000 % 1.849 %
--------------------------------------- -
Total $ 14,250
--- ----------- -
(a) In November 2012, we issued $2.25 billion of debt securities. The notes are
senior unsecured obligations and rank equally with our other unsecured and
unsubordinated debt outstanding.
Interest on the notes is paid semi-annually. As of December 31, 2012, the
aggregate unamortized discount for our long-term debt, including the current
portion, was $62 million.
Notes
The Notes are senior unsecured obligations and rank equally with our other
unsecured and unsubordinated debt outstanding.
Convertible Debt
In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt
due on June 15, 2013 in a private placement offering. Proceeds from the offering
were $1.24 billion, net of fees and expenses, which were capitalized. Initially,
each $1,000 principal amount of notes was convertible into 29.94 shares of
Microsoft common stock at a conversion price of $33.40 per share. The conversion
ratio is adjusted periodically for dividends in excess of the initial dividend
threshold as defined in the debt agreement. As of December 31, 2012, the net
carrying amount of our convertible debt was $1.2 billion and the unamortized
discount was $9 million.
Prior to March 15, 2013, the notes will be convertible, only in certain
circumstances, into cash and, if applicable, cash, shares of Microsoft's common
stock, or a combination thereof, at our election. On or after March 15, 2013,
the notes will be convertible at any time. Upon conversion, we will pay cash up
to the aggregate principal amount of the notes and pay or deliver cash, shares
of our common stock, or a combination of cash and shares of our common stock, at
our election.
Because the convertible debt may be wholly or partially settled in cash, we are
required to separately account for the liability and equity components of the
notes in a manner that reflects our nonconvertible debt borrowing rate when
interest costs are recognized in subsequent periods. The net proceeds of $1.24
billion were allocated between debt for $1.18 billion and stockholders' equity
for $58 million with the portion in stockholders' equity representing the fair
value of the option to convert the debt.
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In connection with issuance of the notes, we entered into capped call
transactions with certain option counterparties who are initial purchasers of
the notes or their affiliates. The capped call transactions are expected to
reduce potential dilution of earnings per share upon conversion of the notes.
Under the capped call transactions, we purchased from the option counterparties
capped call options that in the aggregate relate to the total number of shares
of our common stock underlying the notes, with a strike price equal to the
conversion price of the notes and with an initial cap price equal to $37.16,
which is adjusted periodically to mirror any adjustments to the conversion
price. The purchased capped calls were valued at $40 million and recorded to
stockholders' equity.
Unearned Revenue
Unearned revenue at December 31, 2012 comprised mainly 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
billing coverage period and accounted for as subscriptions with revenue
recognized ratably over the billing coverage period. Unearned revenue at
December 31, 2012 also included payments for: the Windows Upgrade Offer;
post-delivery support and consulting services to be performed in the future; the
Office Deferral; Xbox LIVE subscriptions and prepaid points; the Video Game
Deferral; Microsoft Dynamics business solutions products; Skype prepaid credits
and subscriptions; OEM minimum commitments; 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 December 31, 2012:
(In millions)
-------------------------------- -
Three Months Ending,
March 31, 2013 $ 9,055
June 30, 2013 5,489
September 30, 2013 2,521
December 31, 2013 1,289
Thereafter 1,459
-------------------------------- -
Total $ 19,813
- ------- -
Share Repurchase Program
During the three and six months ended December 31, 2012, we repurchased
approximately 58 million and 91 million shares of Microsoft common stock for
$1.6 billion and $2.6 billion, respectively, under the repurchase program we
announced on September 22, 2008. All repurchases were made using cash resources.
As of December 31, 2012, approximately $5.6 billion remained of the $40.0
billion approved repurchase amount. The repurchase program expires September 30,
2013 but may be suspended or discontinued at any time without notice.
Dividends
Our Board of Directors declared the following dividends during the periods
presented:
Dividend
Declaration Date Per Share Record Date Total Amount Payment Date-------------------------------------------------------------------------------------------------------------
-
(in millions)
Fiscal Year 2013
September 18, 2012 $ 0.23 November 15, 2012 $ 1,933 December 13, 2012
November 28, 2012 $ 0.23 February 21, 2013 $ 1,926 March 14, 2013
Fiscal Year 2012
September 20, 2011 $ 0.20 November 17, 2011 $ 1,683 December 8, 2011
December 14, 2011 $ 0.20 February 16, 2012 $ 1,683 March 8, 2012
-------------------------------------------------------------------------------------------------------------
-
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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. 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 financial statements during the periods presented.
Other Planned Uses of Capital
We will continue to invest in sales, marketing, product support infrastructure,
and existing and advanced areas of technology. Additions to property and
equipment will continue, including new facilities, data centers, and computer
systems for research and development, sales and marketing, support, and
administrative staff. We have operating leases for most U.S. and international
sales and support offices and certain equipment. We have not engaged in any
related party transactions or arrangements with unconsolidated entities or other
persons that are reasonably likely to materially affect liquidity or the
availability of capital resources.
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 is 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, and cash flows from operations 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 repayment
schedules, 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
Recently Adopted Accounting Guidance
In September 2011, the Financial Accounting Standards Board ("FASB") issued
guidance on testing goodwill for impairment. The new guidance provides an entity
the option to first perform a qualitative assessment to determine whether it is
more likely than not that the fair value of a reporting unit is less than its
carrying amount. If an entity determines that this is the case, it is required
to perform the currently prescribed two-step goodwill impairment test to
identify potential goodwill impairment and measure the amount of goodwill
impairment loss to be recognized for that reporting unit (if any). If an entity
determines that the fair value of a reporting unit is greater than its carrying
amount, the two-step goodwill impairment test is not required. We adopted this
new guidance beginning July 1, 2012. Adoption of this new guidance did not have
a material impact on our financial statements.
In June 2011, the FASB issued guidance on presentation of comprehensive
income. The new guidance eliminated the option to report other comprehensive
income and its components in the statement of changes in stockholders'
equity. Instead, an entity is required to present either a continuous statement
of net income and other comprehensive income or in two separate but consecutive
statements. The new guidance also required entities to present reclassification
adjustments out of accumulated other comprehensive income by component in both
the statement in which net income is presented and the statement in which other
comprehensive income is presented. This guidance was amended in December 2011
when the FASB issued guidance which indefinitely defers presentation of
reclassification adjustments. We adopted this new amended guidance beginning
July 1, 2012. Adoption of this new amended guidance resulted only in changes to
presentation of our financial statements.
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Recent Accounting Guidance Not Yet Adopted
In December 2011, the FASB issued guidance enhancing disclosure requirements
about the nature of an entity's right to offset and related arrangements
associated with its financial instruments and derivative instruments. The new
guidance requires the disclosure of the gross amounts subject to rights of
set-off, amounts offset in accordance with the accounting standards followed,
and the related net exposure. The new guidance will be effective for us
beginning July 1, 2013. Other than requiring additional disclosures, we do not
anticipate material impacts on our financial statements upon adoption.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our financial statements and accompanying notes are prepared in accordance with
U.S. GAAP. Preparing financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets, liabilities,
revenue, and expenses. These estimates and assumptions are affected by
management's application of accounting policies. Critical accounting policies
for us include revenue recognition, impairment of investment securities,
goodwill, research and development costs, contingencies, income taxes, and
stock-based compensation.
Revenue Recognition
Software revenue recognition requires judgment, including whether a software
arrangement includes multiple elements, and if so, whether vendor-specific
objective evidence ("VSOE") of fair value exists for those elements. A portion
of revenue may be recorded as unearned due to undelivered elements. Changes to
the elements in a software arrangement, the ability to identify VSOE for those
elements, and the fair value of the respective elements could materially impact
the amount of earned and unearned revenue. Judgment is also required to assess
whether future releases of certain software represent new products or upgrades
and enhancements to existing products.
Windows 7 revenue is subject to deferral as a result of the Windows Upgrade
Offer, which started June 2, 2012. The offer provides significantly discounted
rights to purchase Windows 8 Pro to qualifying end-users that purchase Windows 7
PCs during the eligibility period. Microsoft is responsible for delivering
Windows 8 Pro to the end customer. Accordingly, revenue related to the allocated
discount for undelivered Windows 8 is deferred until it is delivered or the
redemption period expires.
Microsoft Office system revenue is subject to deferral as a result of the Office
Upgrade Offer, which started October 19, 2012. The Office Upgrade Offer allows
customers who purchase qualifying 2010 Microsoft Office system or Office for Mac
2011 products to receive, at no cost, a one-year subscription to Office 365 Home
Premium or the equivalent version of 2013 Microsoft Office system upon general
availability. Small business customers in applicable markets will also be
eligible for a three-month trial of Office 365 Small Business Premium.
Accordingly, estimated revenue related to the undelivered 2013 Microsoft Office
system and subscription services is deferred until the products and services are
delivered or the redemption period expires.
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) 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
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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
circumstances change that would more likely than not reduce the fair value of a
reporting unit below its carrying value. These events or circumstances could
include a significant change in the business climate, legal factors, operating
performance indicators, competition, or sale or disposition of a significant
portion of a reporting unit.
Application of the goodwill impairment test requires judgment, including the
identification of reporting units, assignment of assets and liabilities to
reporting units, assignment of goodwill to reporting units, and determination of
the fair value of each reporting unit. The fair value of each reporting unit is
estimated using a discounted cash flow methodology. This analysis requires
significant judgments, including estimation of future cash flows, which is
dependent on internal forecasts, estimation of the long-term rate of growth for
our business, estimation of the useful life over which cash flows will occur,
and determination of our weighted average cost of capital.
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. Disclosure of a contingency is required
if there is at least a reasonable possibility that a loss has been incurred. In
determining whether a loss should be accrued we evaluate, among other factors,
the degree of probability of an unfavorable outcome and the ability to make a
reasonable estimate of the amount of loss. Changes in these factors could
materially impact our 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 current and deferred income
tax assets and liabilities, accounting for interest and penalties associated
with tax positions, and income tax disclosures. Judgment is required in
assessing the future tax consequences of events that have been recognized in our
financial statements or tax returns. Variations in the actual outcome of these
future tax consequences could materially impact our financial statements.
Stock-Based Compensation
Stock-based compensation cost is measured at the grant date based on the fair
value of the award and is recognized as expense, net of estimated forfeitures,
over the requisite service period. Determining the fair value of stock-based
awards at the grant date requires judgment, including estimating expected
dividends. In addition, judgment is also required in estimating the amount of
stock-based awards that are expected to be forfeited. If actual results differ
significantly from these estimates, stock-based compensation expense and our
results of operations could be impacted.
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