Fiscal 2002 was a year of solid revenue growth, significant product releases, and a continued focus on developing new technologies that position Microsoft for the future. Despite a challenging economic climate, revenues for the year increased by $3.07 billion to $28.37 billion, and operating income grew by $190 million to $11.91 billion.

Strong demand for Windows XP and other desktop software contributed to our positive performance. Revenue from enterprise software outpaced the highly competitive server market by a wide margin. And our consumer businesses saw a dramatic rise in sales, with the launch of the Xbox video game system and strong growth in MSN subscription income.

During the coming year, Microsoft will launch several important new products, including Windows XP Tablet PC Edition and Windows .NET Servers, and we plan to increase spending on research and development by 20 percent, to $5.2 billion. To reflect our role as an industry leader and to focus our efforts on the opportunities ahead, we have embraced a new corporate mission: to enable people and businesses throughout the world to realize their full potential. Delivering on this mission requires a clearly defined set of values and tenets. We are working to integrate these principles into everything we do.

INNOVATIVE PLATFORM LEADERSHIP

A highlight of the past year was the overwhelming market acceptance that greeted the launch of Windows XP, which brings enhanced reliability, security, and performance to PC users at home and work. The year also saw sustained momentum for Office XP, with more than 60 million licenses sold in the 12 months after its launch in May 2001. A new version of Office, scheduled for release in 2003, will enable users to communicate and collaborate in new ways with even greater ease.

Delivering on our vision of software that empowers people any time, any place, and on any device, we launched new versions of Windows for small and mobile devices, including Pocket PCs and set-top boxes for digital cable TV. Fall 2002 brings the launch of the first Tablet PCs, designed to boost productivity by combining the power and speed of a full-featured desktop computer with the flexibility and portability of a notepad.

One of our key goals is to expand our role as a provider of software solutions for small- and mid-sized businesses. In July 2002, we acquired Navision, a leading global provider of integrated software for financial management and other business processes. Combining Navision with Microsoft Great Plains to form Microsoft Business Solutions, we now offer a wide range of applications and services that enable companies to reduce costs, streamline operations, and improve service. We are planning many new products for this market, including a solution for customer relationship management that will launch this fiscal year.

THE PROMISE OF .NET AND XML WEB SERVICES

A significant portion of the company’s revenue growth over the next five years will come from Microsoft’s .NET architecture, which holds enormous potential to connect information, people, systems, and devices in fundamentally new and important ways. Using common industry standards based on XML, a universal language for describing and exchanging data, our goal is to enable seamless sharing of information across many platforms and programming languages, and over the Internet, with XML Web Services.

The potential of Web services is gaining wide support among software developers and leading technology providers. For example, the Web Services Interoperability Organization, formed by Microsoft and other industry leaders in early 2002 to provide guidance and best practices for developing XML Web services, now has more than 120 companies as members.

To provide software developers with the tools and infrastructure for building and deploying XML Web services and other .NET-connected solutions, we launched Visual Studio .NET and the .NET Framework in February 2002. In fiscal 2003 we plan to launch Windows .NET Servers, which will provide the most compelling platform for developing and hosting Web services and business solutions.

Companies that are helping to test the promising beta version of Windows .NET Servers foresee many benefits. JetBlue Airways, for example, plans to use it as the platform for a new reservations system and to secure access to its computers and facilities with fingerprint biometrics embedded in smart cards. The young airline has achieved a “paperless cockpit” by providing pilots with electronic versions of flight manuals that are automatically updated with an application that JetBlue developers wrote using Microsoft Visual Studio .NET. JetBlue credits Microsoft technology with helping it to limit spending on information technology to about 1.5 percent of revenues, in an industry where the average is about 5 percent.

DELIGHTING CONSUMERS

Our strategic investments in new consumer businesses brought gratifying results this past year, with more to come in 2003. In the eight months after our Xbox video game system launched in November 2001, 3.9 million consoles and 20 million Xbox games were sold. MSN, already the most popular portal destination on the Web, is now also the leading provider of broadband Internet access.

Microsoft and more than a dozen leading electronics manufacturers have developed a new line of flat-panel, cordless displays that enable consumers to extend their Windows XP experience to anywhere in the house. These Smart Displays will start appearing in stores in time for the 2002 holiday shopping season, as will PCs running our new Windows XP Media Center Edition, providing remote-control access to digital music, movies, and a built-in personal video recorder.

INVESTING IN THE FUTURE

We are focused on long-term success for Microsoft as a business, for our 50,000 employees, our shareholders, our industry, our customers, and the communities where we do business. Looking to the future, a few developments are noteworthy.

Antitrust Lawsuit
In November 2001, Microsoft and the Department of Justice announced a settlement of the three-year-old antitrust dispute. Nine state attorneys general joined in the settlement, while nine others decided to continue with the case. The settlement requires significant changes in how we do business, and Microsoft is fully committed to carrying out these responsibilities. The consent decree is a tough but reasonable compromise that is good for the industry, good for consumers, and good for the economy.

Trustworthy Computing
In January 2002, we outlined for employees what we believe is the highest priority for the company and for our industry over the next decade: building a computing environment for customers that is as reliable as the electricity that lights our homes. As a first step in achieving higher levels of reliability, security, privacy, and business integrity, Microsoft made many changes in our operational and business practices. Thousands of our engineers received special training in writing secure software. And we conducted intensive security analyses of every line of source code for Windows and other products.

These efforts are starting to show results. Security updates of Microsoft Outlook, for instance, were followed by a dramatic drop in the number of e-mail virus incidents. But given the complexity of computing and the fast pace of technological change, achieving truly Trustworthy Computing will take many years.

An Agile Business System
To streamline internal decision making, enhance entrepreneurship within Microsoft’s key businesses, and increase collaboration across groups, we instituted a number of changes to internal business systems. One of the most significant changes was giving the leaders of our key businesses the tools, resources, and responsibility for making the important decisions around product development, sales, marketing, and financial performance.

Business Integrity
During the past year, a number of major corporations were rocked by financial scandals that damaged shareholder wealth and confidence. At Microsoft, we take our responsibilities to shareholders, customers, partners, and employees very seriously. We aim to be open and candid about the condition of our business and the risks we face. We seek to properly assess assets so they are never overvalued, and we look hard for any costs or liabilities that should be reflected in our financial results. Consistent with the values of honesty and integrity that we strive to live by, we have long disclosed complete details of the diluting effect of employee stock options on Microsoft’s earnings.

Stock options are an important way that Microsoft attracts and encourages great employees. For the two of us, the vast majority of our individual net worth is invested in stock ownership of the business. Since Microsoft went public in 1986, we have never taken stock options, and we never will. We hope this provides further assurance that our personal interests are directly aligned with the long-term interests of all shareholders.

Finally, on a personal level, we feel incredibly privileged to play a role in bringing to life the technologies that will enable people and businesses to realize their full potential. Thank you for your support.

Bill Gates
Chairman and Chief Software Architect

Steven A. Ballmer
Chief Executive Officer