COMPETITION

The software business is intensely competitive and subject to rapid technological change, evolving customer requirements, and changing business models in every segment. We face significant competition in all areas of our business. The rapid pace of technological change continually creates new opportunities for existing competitors and start-ups and can quickly render existing technologies less valuable. Customer requirements and preferences continually change as other information technologies emerge or become less expensive, and as concerns such as security and privacy become more important. Our direct competitors include firms adopting alternative business models to the commercial software model. Firms adopting the non-commercial software model typically provide customers with open source software at nominal cost and earn revenue on complementary services and products, without having to bear the full costs of research and development for the open source software. Global software piracy - the unlawful copying and distribution of our copyrighted software products - deprives us of significant amounts of revenue on an annual basis. Future versions of our products compete with the existing versions licensed to our installed base of customers. This means that future versions must deliver significant additional value in order to induce existing customers to purchase a new version of our product.

Our competitive position may be adversely affected in the future by one or more of the factors described in this section, or as yet undefined additional factors that may arise.

Client.    Although we are the leader in PC operating system software products, we face strong competition from well-established companies and entities with differing approaches to the market. Competing commercial software products, including variants of Unix, are supplied by competitors such as IBM, Hewlett-Packard, Apple Computer, Sun Microsystems and others, which are vertically integrated in both software development and hardware manufacturing and have developed operating systems that they preinstall on their own computers. Personal computer OEMs who preinstall third-party operating systems may also license these firms' operating systems. The Linux operating system, which is also derived from Unix and is available without payment under a General Public License, has gained increasing acceptance as competitive pressures lead personal computer OEMs to reduce costs. The Microsoft Windows operating systems also face competition from alternative platforms, as well as innovative devices that may reduce consumer demand for traditional personal computers. We believe our operating system products compete effectively by delivering better innovation, an easy-to-use interface, compatibility with a broad range of hardware and software applications, and the largest support network for any operating system.

Server and Tools.    Our server operating system products face intense competition from a wide variety of competing server operating systems and server applications, offered by firms with a variety of market approaches. Vertically integrated computer manufacturers such as IBM, Hewlett-Packard, Sun Microsystems and others offer their own variant of Unix preinstalled on server hardware, and nearly all computer manufacturers offer server hardware for the Linux operating system. IBM's endorsement of Linux has accelerated its acceptance as an alternative to both traditional Unix and Windows server operating systems. Linux's competitive position has also benefited from the large number of compatible applications now produced by many leading commercial software developers as well as non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat.

We compete in the business of providing enterprise-wide computing solutions with several companies that provide competing solutions as well as middleware technology platforms. IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software developers that provide competing server applications for the PC-based distributed client/server environments include Oracle, IBM, and Computer Associates. There are also a number of non-commercial software server applications available.

Numerous commercial software vendors offer competing commercial software applications for connectivity (both Internet and intranet), security, hosting, and e-business servers. Additionally, IBM has a large installed base of Lotus Notes and cc:Mail, both of which compete with our collaboration and e-mail products. There are also a significant number of non-commercial software products that compete with our solutions, including Apache Web Server.

Our developer products compete against offerings from BEA Systems, Borland, IBM, Macromedia, Oracle, Sun Microsystems, and other companies.

We believe that our server products provide customers with significant advantages in innovation, performance (both relative to total costs of ownership and in absolute terms), productivity, applications development tools and environment, compatibility with a broad base of hardware and software applications, security, and manageability.

Information Worker.    While we are the leader in business productivity software applications for personal computers, competitors to the Microsoft Office System include many software application vendors such as Apple, Corel, IBM, Oracle, Sun Microsystems, and local application developers in Europe and Asia. IBM and Corel have significant installed bases with their office productivity products, and both have aggressive pricing strategies. Also, Apple and IBM preinstall certain of their application software products on various models of their PCs, competing directly with our applications. Corel's suite and Sun Microsystems' Star Office are aggressively priced and attractive for OEMs to preinstall on low-priced PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that is gaining popularity in certain market segments. In addition to traditional client-side applications, Web-based offerings such as SimDesk provide an alternative to Microsoft Office System products. In addition, IBM has a significant installed base of messaging and collaboration software. We believe that our products compete effectively by providing customers significant benefits, such as ease of use, personal productivity, support for effective teaming and collaboration, and better information management and control, and by providing many customers a lower total cost of ownership than alternatives.

Microsoft Business Solutions.    The small and mid-market business applications segment is highly fragmented and is intensely competitive in all sectors where we compete. We face competition from a large number of companies in this business. Well-known vendors focused on small and mid-market business solutions, such as Intuit and Sage (along with many others), compete against us for a portion of this segment. In addition, large-enterprise focused vendors, such as Oracle, PeopleSoft, and SAP, are repositioning some of their business applications to focus on small and medium-sized business and thus also compete against us for a portion of this segment. In addition, there are thousands of other vendors in specific localities or industries that offer their own enterprise resource planning (ERP), customer relationship management (CRM), and/or analytic solutions. We believe that our business applications products across financial management, supply chain management, and CRM compete effectively in our target segments by offering solutions and services that address multiple segment needs across industries through consistent innovation in product functionality delivered through a growing network of partners.

MSN.    MSN competes with Yahoo!, Google, AOL, Earthlink, U.S. cable and DSL providers, and a vast array of Web sites and portals that offer content and online services of all types. MSN also competes with traditional advertising and print media. As the broadband access market grows, we expect to have increasing opportunities to deliver rich and compelling services and experiences for consumers. MSN's advertising revenue has grown considerably over the last year, and we expect this trend to continue in display advertising as well as in search-based advertising, as online advertising continues to gain market acceptance. This growth has led to competitors aggressively pursuing both advertisers and consumers with expanded offerings and new technology. We are building our own algorithmic search engine and investing to support the continued growth of our advertising business. Due to the continuing trend of consumers migrating from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to decline. We believe our competitive advantage comes from our ability to empower people globally through information software and services that help them find, discover, and experience what they want online.

Mobile and Embedded Devices.    Windows Mobile software faces substantial competition from Nokia, Openwave Systems, PalmSource, QUALCOMM, and Symbian. The embedded operating system market is highly fragmented with many competitive offerings. Key competitors include IBM, Wind River, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. MapPoint competitors include DeLorme, MapInfo, Mapquest.com, Rand McNally, Webraska Mobile Technologies, and Yahoo! The telematics market is also highly fragmented, with competitive offerings from IBM and automotive suppliers building on various real-time operating system platforms from commercial Linux vendors, QNX Software Systems, Wind River, and others. We believe that our products compete effectively by providing a familiar development framework that enables developers to easily write and deploy innovative applications for mobile or embedded devices; providing a flexible platform that allows customers and partners to build differentiated and profitable business models; and providing end users significant benefits such as ease of use, personal productivity, and better information management and control.

Home and Entertainment.    The home and entertainment business is highly competitive and is characterized by limited platform life cycles, frequent introductions of new products and titles, and the development of new technologies. The markets for our products are characterized by significant price competition, and we anticipate continued pricing pressure from our competitors. These pressures have, from time to time, required us to reduce prices on certain products. Our competitors vary in size from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of price, product quality and variety, timing of product releases, and effectiveness of distribution and marketing.

Our Xbox hardware business competes with console platforms from Nintendo and Sony, both of which have a large established base of customers. In addition to competing against software published for non-Xbox platforms, our games business also competes with numerous companies that have been licensed by us to develop and publish software for the Xbox console. These competitors include Acclaim Entertainment, Activision, Atari, Capcom, Eidos, Electronic Arts, Sega, Take-Two Interactive, Tecmo, THQ, and Ubi Soft, among others. Success in the games business is increasingly driven by hit titles, which are difficult to develop and require substantial investments in development and marketing. In addition, other forms of entertainment such as music, motion pictures, and television compete against our entertainment software for consumer spending. We believe that our Xbox products compete effectively by providing customers benefits such as superior game console performance, exclusive game content, and innovative online multiplayer gaming through Xbox Live. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners.