Management's Discussion and Analysis of Financial Condition and Results of Operations

 

Results of Operations for 2001, 2002, and 2003

 

Management's Discussion and Analysis (MD&A) contains statements that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in "Issues and Uncertainties" and elsewhere in this report.

 

 

REVENUE

 

Our revenue growth rate was 10% in fiscal 2001, 12% in fiscal 2002, and 13% in fiscal 2003. Revenue growth in fiscal 2003 was driven primarily by multi-year licensing that occurred before the transition to our new licensing program (Licensing 6.0) in the first quarter of fiscal 2003. Prior to the July 31, 2002 transition date to Licensing 6.0, we experienced significant growth in multi-year licensing arrangements as customers enrolled in our maintenance programs, including Upgrade Advantage and Software Assurance. The revenue growth also reflected a $933 million or 13% increase associated with OEM licensing of Microsoft Windows operating systems and a $309 million or 23% increase in revenue from Microsoft Xbox video game consoles. Revenue growth in fiscal 2002 was led by the addition of $1.35 billion of Xbox video game system revenue and $1.20 billion of revenue growth from Microsoft Windows XP Professional and Home operating systems. Revenue growth in fiscal 2001 was driven primarily by licensing of Microsoft Windows 2000 Professional with $1.01 billion growth in revenue from Professional operating systems, and Server and Tools revenue growth of $852 million.

During the second quarter of fiscal 2002, we launched a new licensing program, Licensing 6.0, for volume licensing customers. Licensing 6.0 simplifies and improves our volume licensing program with Software Assurance, which gives customers the right to install any new release of products covered in the licensing agreement during the term of their coverage. The level of customer adoption of our new volume licensing programs will affect the mix of multi-year licensing agreements with a resulting impact on the timing of revenue recognition. In addition, the timing and extent of a recovery in consumer and corporate spending on PCs and information technology will be factors affecting revenue growth.

 

CONSOLIDATED OPERATING INCOME

 

Operating income grew 6% in fiscal 2001, 2% in fiscal 2002, and 11% in fiscal 2003. In fiscal 2003, the growth in operating income reflected an increase of $3.82 billion in revenue, partially offset by an increase of $2.52 billion in operating expenses, primarily related to employee and related costs associated with additional headcount and increased legal settlement expenses. In fiscal 2002, the growth in operating income reflected an increase of $3.07 billion in revenue, substantially offset by an increase of $2.88 billion in operating expenses, which included the onset of costs related to Xbox video game systems. In fiscal 2001, the growth in operating income reflected an increase of $2.34 billion in revenue, partially offset by an increase of $1.63 billion in operating expenses.

 

SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)

 

We revised our segments for fiscal year 2003. Our seven segments are:

 

·     Information Worker

·     Microsoft Business Solutions

·     MSN  

·     Mobile and Embedded Devices  

·     Home and Entertainment

 

The revenue and operating income/(loss) amounts in this MD&A are presented in accordance with U.S. GAAP. Segment Information appearing in Note 21 of the Notes to Financial Statements are presented in accordance with SFAS 131, Disclosures about Segments of an Enterprise and Related Information.

 

The following table presents our segment revenue and operating income, determined in accordance with U.S. GAAP:

 

(In millions)		Revenue				Operating Income/(Loss)
Year Ended June 30		2002		2003		2002			2003
Client		$   9,360		$ 10,394			$   7,576			$   8,400
Server and Tools		6,157		7,140			2,048			2,457
Information Worker		8,212		9,229			6,448			7,037
Microsoft Business Solutions		308		567			(176)			(254)
MSN		1,571		1,953			(641)			(299)
Mobile and Embedded Devices		112		156			(157)			(157)
Home and Entertainment		2,453		2,748			(874)			(924)
Other		192		-			(2,314)			(3,043)
Consolidated		$ 28,365		$ 32,187			$ 11,910			$ 13,217

 

Client

 

Client revenue was $8.17 billion, $9.36 billion, and $10.39 billion in 2001, 2002, and 2003. Client includes revenue from Windows XP Professional and Home, Windows 2000 Professional, and other standard Windows operating systems. In 2003, Client revenue growth was driven by OEM licensing revenue growth of $933 million and a 9 percentage point increase of the mix of the higher priced Windows Professional operating systems, the majority of which was in the OEM channel. Windows Professional revenue growth for fiscal 2003 was $1.59 billion or 31% compared to fiscal 2002, partially offset by a $573 million decline in revenue of earlier versions of Windows operating systems. Client operating profit for fiscal 2003 increased 11% primarily as a result of the 11% growth in revenue, partially offset by an increase in operating expenses, largely attributed to headcount additions and related costs.

In fiscal 2002, the growth in Client revenue reflected strong multi-year licensing revenue growth and a continued shift of sales to the higher priced Windows 2000 and Windows XP Professional operating system licensed through OEMs. OEM revenue grew $939 million, despite a 5% decline in reported OEM unit shipments. Fiscal 2001 revenue growth reflected the strong adoption of Windows 2000 Professional with professional operating systems revenue growth of $1.01 billion and a 7 percentage point mix increase to the higher priced Windows 2000 Professional and Windows NT Workstation operating systems, and a $91 million increase in revenue from Windows Me and Windows 98 operating systems.

We do not expect the revenue growth attributed to the mix toward the higher priced Windows Professional operating system to continue at previous levels into fiscal 2004. Additionally, variability between the reported OEM unit shipments and the underlying PC Market may continue as a result of the transition to new OEM licensing terms at the beginning of fiscal year 2003, under which OEMs are billed upon their acquisition of Certificates of Authenticity (COAs) rather than upon the shipment of PCs to their customers.

 

Server and Tools

 

Server and Tools revenue was $5.84 billion, $6.16 billion, and $7.14 billion in 2001, 2002, and 2003. Server and Tools consists of server software licenses and client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other servers. It also includes developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft consulting services. Total Server and Tools revenue grew $983 million or 16% in fiscal 2003, driven by an increase in Windows-based server shipments and growth in SQL Server and Exchange revenue. Server revenue, including CALs, grew $787 million or 18% from fiscal 2002 as a result of increased new and anniversary multi-year licensing agreements. Consulting and Premier product support services increased $91 million or 10% compared to fiscal 2002. Revenue from developer tools, training, certification, Microsoft Press and other services increased $105 million or 13%. Server operating profit for fiscal 2003 grew 20%, primarily as a result of the 16% increase in revenue.

In fiscal 2002, Server and Tools revenue increased 5% compared to fiscal 2001. Server revenue, including CALs, increased 9% versus fiscal 2001, driven by a 5% overall increase in Windows-based server shipments and increased deployment of Windows 2000 Server. Consulting and Premier product support services revenue was up $137 million or 17% compared to fiscal 2001, while revenue from developer tools, training, certification, Microsoft Press and other services was down $183 million or 18% from fiscal 2001. In fiscal 2001, Server and Tools revenue increased $852 million or 17% versus the prior year, as a result of the continued adoption of the Microsoft Enterprise Server offerings.

 

Information Worker

 

Information Worker revenue was $8.42 billion, $8.21 billion, and $9.23 billion in 2001, 2002, and 2003. Information Worker includes revenue from Microsoft Office, Microsoft Project, Visio, other information worker products, SharePoint Portal Server CALs, and professional product support services. The $1.02 billion or 12% increase in Information Worker revenue in fiscal year 2003 compared to fiscal 2002, was primarily due to growth in Office suites revenue associated with new and anniversary multi-year licensing agreements and a $264 million or 28% increase in revenue from the combined total of Project, Visio, and other standalone applications. Information Worker operating profit for fiscal year 2003 grew 9% compared to fiscal year 2002 led by the 12% increase in revenue, partially offset by a 24% growth in operating expenses related to headcount additions and marketing expenses.

In fiscal 2002, Information Worker licensing revenue declined $228 million or 3% during the year due to a shift in the sales mix to multi-year licensing agreements, which deferred revenue recognition to future years, and a $294 million or 14% decrease in consumer purchases in the Asia-Pacific region, most notably Japan, partially offset by a $189 million or 22% growth in OEM licensing revenue. In fiscal 2001, Information Worker revenue growth was less than 1% or $30 million.

 

Microsoft Business Solutions

 

Microsoft Business Solutions revenue was $106 million, $308 million, and $567 million in 2001, 2002, and 2003. Microsoft Business Solutions includes Microsoft Great Plains, Navision, and bCentral. Microsoft Business Solutions revenue for fiscal 2003 grew $259 million from fiscal 2002, of which $246 million was attributable to the acquisition of Navision at the beginning of the fiscal year. Microsoft Business Solutions operating loss for fiscal 2003 increased 44%, primarily due to operating losses associated with Navision, increases in sales and marketing expenses, research and development expenses, and acquisition related costs.

 

MSN

 

MSN revenue was $1.32 billion, $1.57 billion, and $1.95 billion in 2001, 2002, and 2003. MSN includes MSN Subscriptions and MSN Network services. Although total MSN subscribers at the end of fiscal 2003 were flat compared to the end of fiscal 2002, MSN Subscriptions revenue grew $112 million or 11% in fiscal year 2003 reflecting an increase in the number of non-promotion subscribers. MSN Network services revenue grew $270 million or 48% in fiscal 2003 as a result of growth in paid search and strong general advertising sales across all geographic regions. MSN operating loss for fiscal 2003 decreased 53%, primarily as a result of the growth in revenue and lower relative subscription acquisition and support costs.

In fiscal 2002, MSN Subscriptions revenue increased $229 million or 29% as a result of both a higher subscriber base and higher average revenue per subscriber due to a reduction in promotional subscriber programs. Revenue from MSN Network services increased $27 million or 5% led by online advertising. In fiscal 2001, revenue from MSN Network services grew $197 million or 58% led by online advertising. MSN Subscriptions revenue also grew $141 million or 22% from fiscal 2000 as a result of an increased subscriber base, partially offset by a decline in the average revenue per subscriber due to a larger mix of subscribers contracted under rebate programs.

 

Mobile and Embedded Devices

 

Mobile and Embedded Devices revenue was $86 million, $112 million, and $156 million in 2001, 2002, and 2003. Mobile and Embedded Devices includes Windows Mobile software, Windows Embedded device operating systems, MapPoint, and Windows Automotive. Revenue for fiscal 2003 grew $44 million driven by increased Pocket PC shipments and MapPoint licensing. Operating loss for fiscal 2003 was flat with the prior year as higher marketing expenses and headcount-related costs associated with product development offset the growth in revenue. Prior year revenue and operating loss for Mobile and Embedded Devices have been restated to reflect the reorganizations of MapPoint from Information Worker and Windows embedded device operating systems from Client to Mobile and Embedded Devices.

 

Home and Entertainment

 

Home and Entertainment revenue was $1.14 billion, $2.45 billion, and $2.75 billion in 2001, 2002, and 2003. Home & Entertainment includes the Xbox video game system, PC games, consumer software and hardware, and TV platform. Home and Entertainment revenue increased $295 million, as a result of sales of Xbox video game systems and related games which were available for all of fiscal 2003. Xbox revenue grew $309 million or 23% in fiscal 2003 reflecting a $779 million increase from higher volumes for Xbox consoles, games, and peripherals partially offset by a $470 million decrease due to price changes. Revenue from consumer hardware and software and PC games declined $14 million or 1% in fiscal 2003. Operating loss for fiscal 2003 increased 6% from the prior year as the product costs associated with the increased Xbox console sales and increased marketing expense more than offset the 12% increase in revenue.

In fiscal 2002, Home and Entertainment revenue growth from fiscal 2001 stemmed from $1.35 billion of sales of the Xbox video game system released in fiscal 2002. Learning and productivity software revenue and PC and online games declined $39 million or 3% in fiscal 2002 compared to fiscal 2001. In fiscal 2001, Home and Entertainment revenue declined $214 million or 16% from fiscal 2002.

 

Other

 

Revenue in the Other segment represents our majority ownership of Expedia, Inc., which was sold in February 2002, resulting in a decline in revenue from fiscal 2001. Acquisitions of Travelscape.com and VacationSpot.com by Expedia, Inc. in fiscal 2001 and increased product offerings from Expedia led to the strong revenue growth in fiscal 2001.

Operating loss includes Expedia, Inc. revenue and operating expenses, general and administrative expenses ($1.55 billion in 2002 and $2.10 billion in 2003), broad-based research and development expenses ($202 million in 2002 and $210 million in 2003), and certain corporate level sales and marketing costs ($526 million in 2002 and $688 million in 2003).

 

Foreign Currencies Impact

 

Our operating results are affected by foreign exchange rates. Approximately 27%, 25%, and 28% of our revenue was collected in foreign currencies during 2001, 2002, and 2003. Had the rates from fiscal 2002 been in effect in fiscal 2003, translated international revenue billed in local currencies would have been approximately $700 million lower. Certain manufacturing, selling distribution and support costs are disbursed in local currencies, and a portion of international revenue is hedged, thus offsetting a portion of the translation exposure.

 

OPERATING EXPENSES

 

Cost of Revenue

 

Cost of revenue includes manufacturing and distribution costs for products and programs sold, operation costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, and costs associated with the delivery of consulting services. Cost of revenue as a percent of revenue was 13.7% in 2001, 18.3% in 2002, and 17.7% in 2003. For fiscal 2003, cost of revenue was $5.69 billion compared to $5.19 billion in fiscal 2002. The primary driver of the decrease as a percentage of revenue in fiscal 2003 was a 0.2 percentage point decrease from Home and Entertainment products due to lower volumes and improved margins of Xbox video game consoles and a 0.4 percentage point decrease from MSN product and service costs in fiscal 2003 compared to fiscal 2002.

Cost of revenue in fiscal 2002 was $5.19 billion compared to $3.46 billion in fiscal 2001. The increase as a percentage of revenue in fiscal 2002 was due to an increase of 5.3 percentage points from Home and Entertainment primarily due to costs related to Xbox, partially offset by a 0.7 percentage point decrease due to a higher mix of revenue from licensing business. In fiscal 2001, cost of revenue was $3.46 billion, an increase of $453 million compared to fiscal 2000. The higher sales associated with MSN Subscription and MSN Network services resulting in increased support and service costs drove 0.4 of the 0.6 percentage point increase in total costs as a percentage of revenue.

 

Research and Development

 

Research and development expenses include payroll, employee benefits, and other headcount-related costs associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Research and development expenses for fiscal 2003 were $4.66 billion, an increase of 8% compared to fiscal 2002. The increase reflects a 7% increase in headcount-related costs, a 25% increase in third-party product development costs, and a 29% increase in testing laboratory equipment and expense. In fiscal 2002, research and development expenses were $4.31 billion compared to $4.38 billion in fiscal 2001. The decrease from fiscal 2001 was due to the discontinuation of amortization of goodwill in accordance with SFAS 142, Goodwill and Other Intangible Assets, $272 million which offset the 15% growth in headcount-related costs. In fiscal 2001, research and development expenses were $4.38 billion, an increase of 16% compared to fiscal 2000. The increase in research and development expenses resulted from a 11% increase in headcount-related costs and a 23% increase in investments in new product development.

 

Sales and Marketing

 

Sales and marketing expenses include payroll, employee benefits, and other headcount-related costs associated with sales and marketing personnel and advertising, promotions, tradeshows, seminars, and other programs. Sales and marketing expense as a percentage of revenue was 19.3% in 2001, 19.1% in 2002, and 20.3% in 2003. Sales and marketing expenses were $6.52 billion in 2003, compared to $5.41 billion in fiscal 2002. The increase in absolute dollars was due to a 20% increase in sales expenses related to headcount additions, principally related to the Enterprise and Small/Medium Business sales forces, and a 21% increase in marketing expenses.

In fiscal 2002, sales and marketing expenses were $5.41 billion, an increase of 11% from fiscal 2001. The sales and marketing expenses in absolute dollars increased due to a 20% increase in headcount-related costs partially offset by a 25% decline in MSN customer acquisition marketing costs and a 4% decline in all other marketing costs. In fiscal 2001, sales and marketing expenses were $4.89 billion compared to $4.13 billion in fiscal 2000. The 18% increase in sales and marketing from fiscal 2000 was primarily due to a 21% growth in headcount-related costs, and to a lesser extent, a 3% growth in higher marketing and sales expenses associated with MSN and other new sales initiatives.

 

General and Administrative

 

General and administrative costs include payroll, employee benefits, and other headcount-related costs associated with the finance, legal, facilities, certain human resources, other administrative headcount, and legal and other administrative fees. General and administrative costs in fiscal 2003 increased $554 million due to a charge of $750 million related to a settlement with AOL/Time Warner in the fourth quarter of 2003 and also due to a $256 million charge reflecting an increase in our estimate of costs related to resolving pending state antitrust and unfair competition consumer class action lawsuits. General and administrative expenses in fiscal 2002 increased due to a charge of approximately $660 million for estimated expenses related to resolving pending state antitrust and unfair competition consumer class action lawsuits and a 10% increase in headcount-related costs. In fiscal 2001, general and administrative costs decreased due to a lawsuit settlement charge recorded in fiscal 2000, partially offset by a 3% growth in headcount-related costs.

 

NON-OPERATING ITEMS, INVESTMENT INCOME/(LOSS), AND INCOME TAXES

 

Non-operating items

 

Losses on equity investees and other consist of our share of income or loss from investments accounted for using the equity method, and income or loss attributable to minority interests. The decrease in losses on equity investees and other in fiscal 2003 and 2002 was due to the divestiture of certain equity investments in fiscal 2002 in conjunction with the underlying performance of such entities. The increase in losses on equity investees and other in fiscal 2001 reflected an increase in the number of such investments during the year.

 

Investment Income/(Loss)

 

We recorded net investment income/(loss) in each year as follows:

 

(In millions)
Year Ended June 30	2001		2002		2003
Dividends	$    377		$   357		$    260
Interest	1,808		1,762		1,697
Net recognized gains/(losses) on investments:
Net gains on the sales of investments	3,175		2,379		909
Other-than-temporary impairments	(4,804)		(4,323)		(1,148)
Net unrealized losses attributable to derivative instruments	(592)		(480)		(141)
Net recognized gains/(losses) on investments	(2,221)		(2,424)		(380)
Investment income/(loss)	$    (36)		$  (305)		$ 1,577

 

Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. We employ a systematic methodology that considers available 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, the duration and extent to which the fair value is less than cost, as well as our intent and ability to hold the investment. 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, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.

In fiscal 2003, other-than-temporary impairments decreased mainly due to the lack of significant continued impairments in the cable and telecommunications sectors. Interest income decreased $65 million due to declining interest rates partially offset by a larger investment portfolio. Dividend income decreased $97 million primarily related to the exchange of AT&T 5% convertible preferred debt for common shares of AT&T Corporation during the year.

In fiscal 2002, other-than-temporary impairments primarily related to our investment in AT&T and other cable and telecommunication investments. Net gains on the sales of investments included a $1.25 billion gain on sale of our share of Expedia. Interest and dividend income decreased $66 million from fiscal 2001 as a result of lower interest rates and dividend income.

In fiscal 2001, other-than-temporary impairments primarily related to cable and telecommunication investments. Net gains from the sales of investments in fiscal 2001 included a gain from our investment in Titus Communications (which was merged with Jupiter Telecommunications) and the closing of the sale of Transpoint to CheckFree Holdings Corp. Interest and dividend income increased $591 million from fiscal 2000, reflecting a larger investment portfolio.

Income Taxes

 

Our effective tax rate for fiscal 2003 was 32%, reflecting a one-time benefit in the second quarter of $126 million from the reversal of previously accrued taxes. The tax reversal stems from a 9th Circuit Court of Appeals ruling in December 2002 overturning a previous Tax Court ruling that had denied tax benefits on certain revenue earned from the distribution of software to foreign customers. Excluding this reversal, the effective tax rate would have been 33%. The effective tax rate for fiscal 2001 and fiscal 2002 was 33% and 32%, respectively.

 

ACCOUNTING CHANGES

 

Effective July 1, 2001, we adopted SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. SFAS 141 requires business combinations to be accounted for using the purchase method of accounting. It also specifies the types of acquired intangible assets that are required to be recognized and reported separate from goodwill. SFAS 142 requires that goodwill and certain intangibles no longer be amortized, but instead tested for impairment at least annually. There was no impairment of goodwill upon adoption of SFAS 142. Goodwill amortization (on a pre-tax basis) was $311 million in fiscal 2001.

Effective July 1, 2000, we adopted SFAS 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. The adoption of SFAS 133 resulted in a cumulative pre-tax reduction to income of $560 million ($375 million after-tax) and a cumulative pre-tax reduction to other comprehensive income (OCI) of $112 million ($75 million after-tax). The reduction to income was mostly attributable to a loss of approximately $300 million reclassified from OCI for the time value of options and a loss of approximately $250 million reclassified from OCI for derivatives not designated as hedging instruments. The reduction to OCI was mostly attributable to losses of approximately $670 million on cash flow hedges offset by the reclassifications out of OCI of the approximately $300 million loss for the time value of options and the approximately $250 million loss for derivative instruments not designated as hedging instruments.

 

STOCK-BASED COMPENSATION

 

On July 8, 2003, we announced changes in employee compensation designed to help us continue to attract and retain the best employees, and to better align employee interests with those of our shareholders. Employees will be granted Stock Awards instead of stock options. The Stock Award program offers employees the opportunity to earn actual shares of our stock over time, rather than options that give employees the right to purchase stock at a set price. As part of the changes, we announced that a significant portion of stock-based compensation for more than 600 of our senior leaders will depend on growth in the number and satisfaction of our customers. We also indicated that we are working on a plan to enable employees to realize some value on the portion of their stock options that are currently out-of-the-money, by selling their options to a third-party financial institution. If approved, we expect to implement this plan by the end of 2003.

In addition to announcing changes to our employee compensation arrangements, we also indicated that we will adopt the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, effective July 1, 2003, and will report that change in accounting principle using the retroactive restatement method described in SFAS 148, Accounting for Stock-Based Compensation-Transition and Disclosure. Note 16 of the Notes to the Financial Statements provides pro forma income statements for 2001, 2002, and 2003 as if compensation cost for our stock option and employee stock purchase plans had been determined as prescribed by SFAS 123.

 

FINANCIAL CONDITION

 

Our cash and short-term investment portfolio totaled $49.05 billion at June 30, 2003, an increase of $10.40 billion from fiscal year 2002. The portfolio consists primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar denominated securities, but also includes foreign currency positions, in order to diversify financial risk. The portfolio is primarily invested in short-term securities to minimize interest rate risk and facilitate rapid deployment for immediate cash needs.

Unearned revenue as of June 30, 2003 was $9.02 billion, increasing $1.27 billion from June 30, 2002, reflecting the addition of new and anniversary multi-year licensing agreements, partially offset by continued recognition of unearned revenue from multi-year licensing in prior periods.

Cash flow from operations was $15.80 billion for fiscal 2003, an increase of $1.29 billion from fiscal 2002. The increase reflects a $2.16 billion increase in net income from fiscal year 2002 and an increase of $1.37 billion in unearned revenue, offset by an increase of $2.36 billion in recognition of unearned revenue. Cash used for financing was $5.22 billion in fiscal 2003, an increase of $651 million from the prior year. The increase reflects a cash dividend payment of $857 million in 2003 and an increase of $417 million in common stock repurchase, offsetting $623 million received for common stock issued. We repurchased 238.2 million shares of common stock under our share repurchase program in fiscal 2003. Cash used for investing was $7.21 billion in fiscal 2003, a decrease of $3.63 billion from fiscal 2002, due to stronger portfolio performance on sold and matured investments.

Cash flow from operations was $14.51 billion for fiscal 2002, an increase of $1.09 billion from fiscal 2001. The increase reflected strong growth in unearned revenue as a result of the significant number of customers that purchased Upgrade Advantage during the Licensing 6.0 transition period. This resulted in an increase in billings and a corresponding increase in the unearned revenue amount. Cash used for financing was $4.57 billion in fiscal 2002, a decrease of $1.01 billion from the prior year. The decrease reflected the repurchase of put warrants in the prior year. We repurchased 245.6 million shares of common stock under our share repurchase program in fiscal 2002. In addition, 10.2 million shares of common stock were acquired in fiscal 2002 under a structured stock repurchase transaction. We entered into the structured stock repurchase transaction in fiscal 2001, which gave us the right to acquire 10.2 million of our shares in exchange for an up-front net payment of $264 million. Cash used for investing was $10.85 billion in fiscal 2002, an increase of $2.11 billion from fiscal 2001.  

Cash flow from operations was $13.42 billion in fiscal 2001, an increase of $2.00 billion from the prior year. The increase was primarily attributable to the growth in revenue and other changes in working capital, partially offset by a decrease in the stock option income tax benefit, reflecting decreased stock option exercises by employees. Cash used for financing was $5.59 billion in fiscal 2001, an increase of $3.39 billion from the prior year. The increase primarily reflected the repurchase of put warrants in fiscal 2001, compared to the sale of put warrants in the prior fiscal year, as well as an increase in common stock repurchased. All outstanding put warrants were either retired or exercised during fiscal 2001. During fiscal 2001, we repurchased 178.1 million shares. Cash used for investing was $8.73 billion in fiscal 2001, a decrease of $658 million from the prior year.

We have no material long-term debt. Stockholders' equity at June 30, 2003 was $61.02 billion. 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 and computer systems for R&D, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $117 million on June 30, 2003. 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 or requirements for capital resources.

We believe existing cash and short-term investments together with funds generated from operations should be sufficient to meet operating requirements. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, as well as equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We continuously assess our investment management approach in view of our current and potential future needs.

 

Off-balance sheet arrangements

 

We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for operating leases was $281 million, $318 million, and $290 million in 2001, 2002, and 2003, respectively. Future minimum rental commitments under noncancellable leases, in millions of dollars, are: 2004, $218; 2005, $202; 2006, $172; 2007, $134; 2008, $116; and thereafter, $429.

We have unconditionally guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of Jupiter Telecommunication, Ltd., a Japanese cable company (Jupiter). These guarantees arose on February 1, 2003 in conjunction with the expiration of prior financing arrangements, including previous guarantees by us. The financing arrangements were entered into by Jupiter as part of financing its operations. As part of Jupiter's new financing agreement, we agreed to guarantee repayment by Jupiter of the loans of approximately $51 million. The estimated fair value and the carrying value of the guarantees was $10.5 million and did not result in a charge to operations. The guarantees are in effect until the earlier of repayment of the loans, including accrued interest and fees, or February 1, 2009. The maximum amount of the guarantees is limited to the sum of the total due and unpaid principal amounts, accrued and unpaid interest, and any other related expenses. Additionally, the maximum amount of the guarantees, denominated in Japanese yen, will vary based on fluctuations in foreign exchange rates. If we were required to make payments under the guarantees, we may recover all or a portion of those payments upon liquidation of Jupiter's assets. The proceeds from such liquidation cannot be accurately estimated due to the multitude of factors that would affect the valuation and realization of the proceeds in the event of liquidation.

In connection with various operating leases, we issued residual value guarantees, which provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2003, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability to us currently exists.

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. We evaluate estimated losses for such indemnifications under SFAS 5, Accounting for Contingencies, as interpreted by FIN 45. We consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnifications in our financial statements.

 

RECENTLY ISSUED ACCOUNTING STANDARDS

 

In January 2003, the FASB issued Interpretation 46, Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. Interpretation 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The consolidation requirements of Interpretation 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to transactions entered into prior to February 1, 2003 in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The adoption of the Interpretation on July 1, 2003 did not have a material impact on our financial statements.

In April 2003, the FASB issued SFAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS 133. The Statement is effective (with certain exceptions) for contracts entered into or modified after June 30, 2003. We do not believe the adoption of this Statement will have a material impact on our financial statements.

In May 2003, the FASB issued SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. The Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. While we do not believe the adoption of this Statement will have a material impact on our financial statements, we continue to assess the impact this Statement will have on certain of our share repurchase programs.

 

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, impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, and accounting for income taxes.

We account for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition. The application of SOP 97-2 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. End users receive certain elements of our products over a period of time. These elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, the fair value of which is recognized over the product's estimated life cycle. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product's estimated life cycle 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.

SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is other-than-temporarily impaired. This determination requires significant judgment. In making this judgment, we evaluate, among other factors, the duration and extent to which the fair value of an investment is less than its cost; the financial health of and near-term business outlook for the investee, including factors such as industry and sector performance, changes in technology, and operational and financing cash flow; and our intent and ability to hold the investment.

SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (July 1^st for Microsoft) and between annual tests in certain circumstances. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit.

We account for research and development costs in accordance with several accounting pronouncements, including SFAS 2, Accounting for Research and Development Costs, and SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. SFAS 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be 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 products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established are not material, and accordingly, we expense all research and development costs when incurred.

We are subject to various legal proceedings and claims, the outcomes of which are subject to significant uncertainty. SFAS 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency should be 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. 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 position or our results of operations.

SFAS 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of 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. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could materially impact our financial position or our results of operations.

 

ISSUES AND UNCERTAINTIES

 

This Annual Report on Form 10-K contains statements that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of issues and uncertainties such as those listed below and elsewhere in this report, which, among others, should be considered in evaluating our financial outlook.

 

Challenges to our Business Model

 

Since our inception, our business model has been based upon customers agreeing to pay a fee to license software developed and distributed by us. Under this commercial software model, software developers bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenues received from the distribution of their products. We believe the commercial software model has had substantial benefits for users of software, allowing them to rely on our expertise and the expertise of other software developers that have powerful incentives to develop innovative software that is useful, reliable, and compatible with other software and hardware. In recent years, there has been a growing challenge to the commercial software model, often referred to as the Open Source model. Under the Open Source model, software is produced by loosely associated groups of unpaid programmers, and the resulting software and the intellectual property contained therein is licensed to end users at substantially no cost. The most notable example of Open Source software is the Linux operating system. While we believe that our products provide customers with significant advantages in security and productivity, and generally have a lower total cost of ownership than Open Source software, the popularization of the Open Source model continues to pose a significant challenge to our business model, including recent efforts by proponents of the Open Source model to convince governments worldwide to mandate the use of Open Source software in their purchase and deployment of software products. To the extent the Open Source model gains increasing market acceptance, sales of our products may decline, we may have to reduce the prices we charge for our products, and revenues and operating margins may consequently decline.

 

Intellectual Property Rights

 

We defend our intellectual property rights, but unlicensed copying and use of software and intellectual property rights represents a loss of revenue to us. While this adversely affects U.S. revenue, the impact on revenue from outside the United States is more significant, particularly in countries where laws are less protective of intellectual property rights. Throughout the world, we actively educate consumers about the benefits of licensing genuine products and educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may not affect revenue positively and further deterioration in compliance with existing legal protections or reductions in the legal protection for intellectual property rights of software developers could adversely affect revenue.

From time to time we receive notices from others claiming we infringe their intellectual property rights. The number of these claims may grow. Responding to these claims may require us to enter into royalty and licensing agreements on unfavorable terms, require us to stop selling or to redesign affected products, or to pay damages or to satisfy indemnification commitments with our customers.

We have made and expect to continue making significant expenditures to acquire the use of technology and intellectual property rights, including via cross-licenses of broad patent portfolios.

 

New Products and Services

 

We have made significant investments in research, development and marketing for new products, services and technologies, including Microsoft .NET, Xbox, business applications, MSN, mobile and wireless technologies, and television. Significant revenue from new product and service investments may not be achieved for a number of years, if at all. Moreover, these products and services may never be profitable, and even if they are profitable, operating margins for these businesses are not expected to be as high as the margins historically experienced by us.

 

Litigation

 

As discussed in Note 20 - Contingencies of the Notes to Financial Statements, we are subject to a variety of claims and lawsuits. While we believe that none of the litigation matters in which we are currently involved will have a material adverse impact on our financial position or results of operations, it is possible that one or more of these matters could be resolved in a manner that ultimately would have a material adverse impact on our business, and could negatively impact our revenues, operating margins, and net income.

 

Declines in Demand for Software

 

If overall market demand for PCs, servers and other computing devices declines significantly, or consumer or corporate spending for such products declines, our revenue will be adversely affected. Additionally, our revenues would be unfavorably impacted if customers reduce their purchases of new software products or upgrades to existing products because new product offerings are not perceived as adding significant new functionality or other value to prospective purchasers. A significant number of customers purchased license agreements providing upgrade rights to specific licensed products prior to the transition to Licensing 6.0 in July 2002. These agreements will expire in 2004 and 2005 and the rate at which such customers renew these contracts could adversely affect future revenues. We are also committing significant investments in the next release of the Windows operating system, codenamed Longhorn. If this system is not perceived as offering significant new functionality or value to prospective purchasers, our revenues and operating margins could be adversely affected.

 

Product Development Schedule

 

The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Significant delays in new product releases or significant problems in creating new products, particularly any delays in the Longhorn operating system, could adversely affect our revenues.

 

General Economic and Geo-Political Risks

 

Continued softness in corporate information technology spending or other changes in general economic conditions that affect demand for computer hardware or software could adversely affect our revenues. Terrorist activity and armed conflict pose the additional risk of general economic disruption and could require changes in our international operations and security arrangements, thus increasing our operating costs. These conditions lend additional uncertainty to the timing and budget for technology investment decisions by our customers.

 

Competition

 

We continue to experience intensive competition across all markets for our products and services. These competitive pressures may result in decreased sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenues, gross margins and operating income.

 

Taxation of Extraterritorial Income

 

In August 2001, a World Trade Organization ("WTO") dispute panel determined that the tax provisions of the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 ("ETI") constitute an export subsidy prohibited by the WTO Agreement on Subsidies and Countervailing Measures. The U.S. government appealed the panel's decision and lost its appeal. If the ETI provisions are repealed and financially comparable replacement tax legislation is not enacted, the loss of the ETI tax benefit to us could be significant.