To our shareholders, customers, partners, and employees:

Fiscal 2005 was another successful year for Microsoft. Customers around the world continue to benefit from our innovations, while our development of new technologies will position the company for future growth. With healthy demand across all our customer segments and channels, 2005 revenue increased by nearly $3 billion to a record $39.79 billion. Operating income increased by 61 percent.

During the past five years, Microsoft’s revenue increased 73 percent. We generated more than $162 billion in revenue over the past five years, and about $75 billion in net cash flow from operations. We returned $69 billion of this cash to shareholders in dividends and stock repurchases.

Meanwhile, we increased our annual investment in research and development by 23 percent since 2001. Our sixth research facility opened last year in Bangalore, India. We also continued to invest in strategic acquisitions. In 2005, they included Sybari Software, a leading provider of enterprise security solutions, and Groove Networks, a leading provider of collaboration software. And we continued allocating resources to reduce our legal risks. Last year we resolved many legal issues and settled class-action lawsuits in several states.

Our future prospects are strong. Before the end of calendar year 2005, several important new products will emerge from our pipeline. We will introduce a new generation of servers and tools with Microsoft^® SQL Server™ 2005, Visual Studio^® 2005, and BizTalk^® Server 2006. We will release Office Small Business Accounting 2006 and Microsoft CRM 3.0, a complete suite of powerful marketing, sales, and service capabilities. We also will launch Xbox 360™, a next-generation video game platform optimized for high-definition entertainment and online play. Next year, we will gather even more momentum with Windows^® Vista, our next-generation operating system, and a major upgrade of Office, among many other new products and services.

Empowering People for Success

Driven by passion for empowering people to achieve business success and realize their potential, each of our seven major business groups grew in 2005. Growth in Server and Tools was particularly strong, helped by rapid customer adoption of SQL Server. We released several important updates to our server products, including Microsoft Operations Manager 2005, Internet Security and Acceleration Server 2004, Virtual Server 2005, and Windows Server™ 2003 Service Pack 1.

Mobile and Embedded revenue increased 36 percent as we launched Windows Mobile™ 5.0, our software for mobile devices. We now partner with more than 40 mobile device makers and 68 mobile operators.

MSN^® achieved its second consecutive year of profitability, launching many new information and communications services as part of its innovative platform for online advertising, which we see as a large market opportunity. Among other innovations, MSN released a powerful new Web search engine and the MSN Search Toolbar with Windows Desktop Search. We launched MSN Music, which provides an easy way for consumers to find and download music online, and we launched MSN Spaces, a blog hosting service that attracted more than 18 million spaces within its first six months.

In our Home and Entertainment business, cumulative shipments of the Xbox^® video game system reached 22 million, and the Xbox Live^® online game service doubled its subscriber base to 2 million. The popular Halo^® 2 game, released in November 2004, generated $125 million in North American sales in one day, making its launch one of the largest in entertainment history.

Many other important products were launched by our Client, Information Worker, and Microsoft Business Solutions businesses: 64-bit editions of Windows XP Professional and Windows Server 2003; new versions of Windows XP for Media Centers and Tablet PCs; Office Live Communications Server 2005 and Office Communicator 2005; Office Live Meeting 2005; Office Outlook^® Live; and the Microsoft Business Solutions-Navision^® 4.0 software suite for small and mid-sized businesses.

Among business customers, our work to deliver greater business value through our software has brought wider recognition of the advantages of Microsoft technologies. In the past year, research reports from more than a dozen independent analyst firms concluded that the Windows Server System is superior to Linux in many important ways.

Multiple studies found that Windows has lower total cost of ownership, is more secure and reliable, and includes the industry’s most comprehensive customer indemnification protection. As a result, many enterprises are choosing Windows over other alternatives, or returning to Windows after trying Linux.

Growing Microsoft Through Innovation

In the years ahead, we believe that Microsoft will continue to succeed through innovation that enhances customers’ digital experiences at work, at home and on the go. We believe we are innovating across a broader spectrum of software technologies than any other company. We develop software for platforms and tools; communication and collaboration; information access and organization; entertainment; business and e-commerce; and devices. Through the synergies of these broad innovations, we are intent on accelerating Microsoft’s growth in three principal ways.

Growing our foundation businesses.    In our largest businesses today—the Windows Client, Information Worker, and Server and Tools groups—growth will be driven by hardware shipments and product upgrade cycles, accelerated by our forthcoming innovations such as Windows Vista and the new version of Office. Given the new technologies we will be delivering, we anticipate growth through increased share of growing segments. In servers, for example, we have opportunities to increase our share in Web servers, datacenters, mail servers, and high-performance computing.

In addition, we see opportunities to grow these businesses through reducing revenue lost to software piracy. We recently launched Windows Genuine Advantage, an initiative to enhance the benefits from licensing Microsoft software. We believe that rampant piracy in emerging economies will diminish over time as these economies become more integrated into the global economy.

Expanding our innovation portfolio.    We see opportunities to grow by developing best-of-class products and services that expand our technology offerings. Within our larger businesses, we are working to develop new technologies that offer greater value in meeting targeted customer needs. These technologies will be offered as new products and as higher-value and segmented versions of existing products, such as Windows Small Business Edition, Windows XP Professional Edition, and Windows XP Media Center Edition. Within our emerging businesses, we are also moving forward with a broad portfolio of technologies, with a goal of providing best-in-class products wherever we compete, such as gaming, software for mobile devices, small business applications, and Internet Protocol television.

Delivering software services.    While the PC and Windows remain at the center of consumer and business technology, Internet-based services are growing at dramatic rates. We are working across the company to infuse services into everything we do, and we expect both consumer and business services to be an important part of our future growth.

In the past several years, we have gained extensive experience in providing a range of online consumer services, many supported by advertising or subscriptions. Such services include Hotmail, the world’s largest free email service with over 205 million active accounts, MSN.com, one of the world’s most popular online portals, MSN Messenger, MSN Search, and Xbox Live, the world’s largest unified online console gaming service.

We are working to deliver several new services, including Windows OneCare Live, an integrated PC Health offering that combines security features as well as critical PC maintenance services. We also have expanded our range of services for businesses, such as Outlook Live and Office Live Meeting, which enables workers to collaborate interactively without the cost and hassle of business travel. Our acquisition of FrontBridge Technologies will enable us to provide managed services that enhance e-mail filtering and improve security for businesses. We see many other opportunities in managed services for businesses.

Protecting Customers, Helping Communities

As we drive for growth, we are also working to help protect the privacy and security of computer users everywhere through technological innovation, collaboration with industry and government, and education. With our own R&D and strategic acquisitions, we are making our products more secure and delivering comprehensive security solutions. In less than a year, customers have downloaded more than 218 million copies of Windows XP SP2, which helps protect against software worms and viruses. We are aggressively committed to building out our security technologies to fortify all of our products and services.

We are also deeply involved in working on behalf of the communities where we do business around the world. We focus on partnering to help extend the benefits of technology to more people and communities. Last year alone, Microsoft provided more than $334 million in cash and software to more than 9,000 nonprofit organizations. Through our Partners in Learning program, we have helped bring technology access and skills to 6.6 million students and educators in 99 countries.

We are more enthusiastic than ever about Microsoft’s opportunities to change the world for the better. We can pursue these opportunities because of your continued support. Thank you.

Bill Gates
Chairman and Chief Software Architect

Steven A. Ballmer
Chief Executive Officer