COMPETITION

Every segment of the software business is competitive and subject to rapid technological change, evolving customer requirements, and changing business models. We face significant competition in all areas of our business and intense competition in many of them. Because technology advances rapidly, competitors 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 that have adopted the non-commercial software model. These firms typically provide customers with open source software at nominal cost and earn their revenue on complementary services and products. This approach allows these firms to compete without having to bear the full costs of software research and development.

In a sense, we also compete with pirated copies of our own 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. In addition, future versions of our products compete with the existing versions, which our licensed customers may choose to continue to use indefinitely. 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 by one or more of the factors described in this section, or as yet unidentified 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 and new devices that may reduce consumer demand for traditional personal computers. Competitors such as Mozilla offer software that competes with the Internet Explorer Web browsing capabilities of our Windows operating system products. Apple Computer, Real Networks, and many others compete with the media playback capabilities (Windows Media Player) of our Windows operating system products. We believe current and future versions of these and other aspects of Windows will continue to compete effectively with non-Microsoft browsers, media players, and other non-Microsoft programs on important attributes such as features, functionality, and security. We believe our operating system products compete effectively by delivering innovative software, 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 and 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 and 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 PC-based distributed client/server environments include Oracle, IBM, and Computer Associates.

Numerous commercial software vendors offer competing commercial software applications for connectivity (both Internet and intranet), security, hosting, and e-business servers. In addition, 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 the widely-deployed Apache Web Server.

Our products for software developers 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, total costs of ownership, 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 and personal 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, Novell, Red Hat, and local application developers in Europe and Asia. IBM (Smartsuite) and Corel (WordPerfect Suite) have significant installed bases with their office productivity products. Apple may preinstall certain of their application software products on various models of their PCs, competing directly with our applications. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors (Sun, Novell, Red Hat, IBM, and others) to sell under their brand. Corel’s suite, and many different local software suites around the world are aggressively priced for OEMs to preinstall on low-priced PCs. In addition to traditional client-side applications, Web-based offerings such as SimDesk can also provide an alternative to Microsoft Office System products.

Further, as customers have increasingly demanded additional functionality and products, including new server and service offerings, additional vendors are competing in the Information Worker segment, most notably in document management, collaboration tools, real time messaging and business intelligence. As just one example, Microsoft competes with IBM broadly in messaging and collaboration with our approach that spans multiple Information Worker products. We believe that our products compete effectively through ease of use, improving users’ personal productivity, providing tools for effective teaming and collaboration, better information management and control, and for many customers, a lower total cost of ownership than alternatives.

Microsoft Business Solutions.     The products of Microsoft Business Solutions are targeted at small and midsized businesses (SMB) and larger organizations and divisions of global enterprises. The SMB segment for business solutions is highly fragmented with many companies in this business. Well-known vendors focused on providing solutions for small and midsized businesses, such as Intuit and Sage, compete against us for a portion of this segment. The segment consisting of large organizations and divisions of global enterprises continues to be intensely competitive with a small number of primary vendors providing products and services such as SAP, Oracle/Peoplesoft and Siebel. In addition these large enterprise-focused vendors are repositioning some of their business applications to focus on the SMB segment, and divisions of global enterprises, and thus also compete against us for a portion of the market opportunity. Our business solution products also compete with hosted solutions offered by companies such as Salesforce.com. In addition, there are thousands of other vendors in specific localities or industries that offer their own solutions. We believe that our business solutions across financial management, supply chain management, and customer relationship management (CRM) compete effectively in our target segments by offering integrated solutions that address multiple segment needs across industries and vertical markets through consistent innovation that are delivered through a growing network of partners and Independent Software Vendors (ISVs).

MSN.     MSN competes with Yahoo!, Google, AOL, and a vast array of Web sites and portals that offer content and online services of all types to end users, and we compete with these organizations to provide advertising opportunities for merchants to reach their audiences. MSN also competes for narrowband internet access users with Earthlink, AOL and other ISPs for dial-up internet access in the United States. The global online advertising market has grown significantly over the past several years, and we anticipate this trend to continue especially in display and in search-based advertising. As a result competitors are aggressively developing internet services that provide enhanced functionality for end users in communication services, improvements in information services such as internet search, and advertising infrastructure and support services including more effective ways of connecting advertisers with audiences. We have built our own algorithmic search engine to provide end users with more relevant search results, broader selection of content, and expanded set of search services, and we are investing to support the continued growth of our advertising business. We are also investing in our communication services, and our technology, operations, and sales efforts to support the continued growth of our advertising business. We will continue to introduce new products and services aimed at attracting additional users by improving the user experience in an effort to increase our satisfaction levels with our end users and merchant customers. Due to the continuing trend of consumers migrating from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to continue to decline. We believe that we can compete effectively across the breadth of our internet services by providing users with software innovation in the form of information and communication services that help them find, discover, and experience what they want online and by providing merchants with effective advertising results through improved systems and sales support.

Mobile and Embedded Devices.     Windows Mobile software faces substantial competition from Nokia, Openwave Systems, PalmSource, QUALCOMM, and Symbian. The embedded operating system segment 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, Google, 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. We anticipate continued pricing pressure from our competitors. From time to time, we have responded to this pressure by reducing 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. The video game consoles have on average 5 to 7 year lifecycles. We have announced the expected release in the first half of fiscal year 2006 of a new console, the Xbox 360. Sony and Nintendo have also announced new versions of their game consoles. Success in this transition to the next generation of consoles depends on the computational power of the console, the ease of developing games for the console, the ability to provide new revenue sources such as advertising and downloadable content, and providing exclusive game content that is sought after by gamers. We believe the Xbox 360 is positioned well against competitive console products based on significant innovation in the hardware architecture, new developer tools, expanded revenue sources, and continued strong exclusive content from our 1 st party game franchises such as Halo.