Discussion & Analysis
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management's Discussion and Analysis ("MD&A") is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying Notes to Financial Statements.
OVERVIEW AND OUTLOOK
Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. We create technology that transforms the way people work, play, and communicate across a wide range of computing devices.
We generate revenue by developing, licensing, and supporting a wide range of software products and services, including cloud-based services, by designing and selling hardware, and by delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees, designing, manufacturing, marketing, and selling our products and services, and income taxes.
Industry Trends
Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to anticipate the changing demands of customers, industry trends, and competitive forces.
Key Opportunities and Investments
Based on our assessment of key technology trends and our broad focus on long-term research and development of new products and services, we see significant opportunities to drive future growth.
Smart connected devices
The price per unit of processing, storage, and networks continues to decline while at the same time devices increase in capability. As a result, the capabilities and accessibility of PCs, tablets, phones, televisions, and other devices powered by rich software platforms and applications continue to grow. At the same time, the information and services people use increasingly span multiple devices enabled by the adoption of cloud computing.
For example, the delivery and quality of unified entertainment experiences across devices is undergoing dramatic evolution. These rich media experiences include books, magazines, newspapers, games, movies, music, television, and social interactions with family, friends, and colleagues. At Microsoft, our approach is to simplify and increase the accessibility of these entertainment experiences to broaden market penetration of our software, hardware, and services.
Additionally, web content and social connections have increased tremendously as people spend more time online, while discoverability and accessibility has been transforming from direct navigation and document links. There is significant opportunity to deliver products and services that help users make faster, better decisions and complete tasks more simply when using their devices. Our approach is to use machine learning to understand user intent, and differentiate our products and services by focusing on the integration of speech, visual, social, and other elements to simplify people's interaction with the Internet.
We invest significant resources in enabling and developing smart connected devices that offer a unified, seamless experience across a common platform. Whether a PC, Windows Phone, Xbox 360, or the newly announced Surface devices, our goal is to provide users with a consistent and compelling experience through a common user interface and our services such as SkyDrive, Xbox LIVE, Bing, Skype, and our Windows Azure cloud platform.
Communications and productivity
The ubiquity of computing and software tools has transformed personal and business productivity. Over the last decade, Microsoft redefined software productivity beyond the rich Office client on the PC. Productivity scenarios now encompass unified communications such as instant messaging, voice, and video communications, business intelligence, collaboration, content management, and relationship management, all of which are increasingly available through server-side applications. These server applications can be hosted in the cloud by the customer, a partner, or by Microsoft. There are significant opportunities to bring to life productivity and communication scenarios across PCs, mobile, and other devices that connect to services. We invest significant resources in our products and services that make this possible – Dynamics, Exchange, Lync, Skype, Office, Office 365, SharePoint, Windows Live, and Windows Phone.
Cloud computing transforming the data center and information technology
Cloud-based solutions provide customers with software, services, and content over the Internet by way of shared computing resources located in centralized data centers. Computing is undergoing a long-term shift from client/server to the cloud, a shift similar in importance and impact to the transition from mainframe to client/server. The shift to the cloud is driven by three important economies of scale: larger data centers can deploy computational resources at significantly lower cost per unit than smaller ones; larger data centers can coordinate and aggregate diverse customer, geographic, and application demand patterns improving the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. Because of the improved economics, the cloud offers unique levels of elasticity and agility that enables new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers. We are devoting significant resources to developing cloud infrastructure, platforms, and applications including offerings such as Microsoft Dynamics Online, Microsoft SQL Azure, Office 365, Windows Azure, Windows Intune, and Windows Server.
Economic Conditions, Challenges, and Risks
As discussed above, our industry is dynamic and highly competitive. We must anticipate changes in technology and business models. Our model for growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we develop and market.
At Microsoft, we prioritize our investments among the highest long-term growth opportunities. These investments require significant resources and are multi-year in nature. The products and services we bring to market may be developed internally, brought to market as part of a partnership or alliance, or through acquisition.
Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. Microsoft competes for talented individuals worldwide by offering broad customer reach, scale in resources, and competitive compensation.
Demand for our software, services, and hardware has a strong correlation to global macroeconomic factors. The current macroeconomic factors remain dynamic. See a discussion of these factors and other risks under Risk Factors in our fiscal year 2012 Form 10-K.
Seasonality
Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated approximately 40% of its yearly segment revenue in our second fiscal quarter.
Unearned Revenue
Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions below regarding sales of earlier versions of the Microsoft Office system with a guarantee to be upgraded to the newest version of the Microsoft Office system at minimal or no cost (the "Office Deferral"), sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost (the "Windows 7 Deferral"), and sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price (the "Windows Upgrade Offer").
RESULTS OF OPERATIONS
Summary
| (In millions, except percentages and per share amounts) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| Revenue | $ 73,723 | $ 69,943 | $ 62,484 | 5% | 12% | ||||
| Operating income | $ 21,763 | $ 27,161 | $ 24,098 | (20)% | 13% | ||||
| Diluted earnings per share | $ 2.00 | $ 2.69 | $ 2.10 | (26)% | 28% |
Fiscal year 2012 compared with fiscal year 2011
Revenue increased primarily due to strong sales of Server and Tools products and services and the 2010 Microsoft Office system, offset in part by the decline in Windows operating system revenue primarily due to the deferral of $540 million of revenue relating to the Windows Upgrade Offer. Revenue in fiscal year 2012 also included Skype revenue from the date of acquisition.
Operating income decreased reflecting a goodwill impairment charge of $6.2 billion related to our OSD business segment. Other key changes in operating expenses were:
- Cost of revenue increased $2.0 billion or 13%, reflecting higher costs associated with providing Server and Tools products and services, payments made to Nokia related to joint strategic initiatives, higher Xbox 360 royalty costs, and other changes in the mix of products and services sold.
- Research and development expenses increased $768 million or 8%, due mainly to higher headcount-related expenses.
- General and administrative expenses increased $347 million or 8%, due mainly to higher headcount-related expenses and the full year impact of new Puerto Rican excise taxes, offset in part by decreased legal charges.
Headcount-related expenses were higher across the company reflecting a 4% increase in headcount from June 30, 2011 and changes in our employee compensation program.
Diluted earnings per share were negatively impacted by the non-tax deductible goodwill impairment charge, which decreased diluted earnings per share by $0.73. Prior year net income and diluted earnings per share reflected a partial settlement with the U.S. Internal Revenue Service ("I.R.S.") and higher other income. The partial settlement with the I.R.S. added $461 million to net income and $0.05 to diluted earnings per share in the prior year.
Fiscal year 2011 compared with fiscal year 2010
Revenue increased primarily due to strong sales of the Xbox 360 entertainment platform, the 2010 Microsoft Office system, and Server and Tools products, offset in part by lower Windows revenue. Revenue also increased due to the $254 million Office Deferral in fiscal year 2010 and the subsequent recognition of the Office Deferral during fiscal year 2011. Changes in foreign currency exchange rates had an insignificant impact on revenue.
Operating income increased reflecting the change in revenue, offset in part by higher operating expenses. Key changes in operating expenses were:
- Cost of revenue increased $3.2 billion or 26%, due to higher costs associated with our online offerings, including traffic acquisition costs, and increased volumes of Xbox 360 consoles and Kinect for Xbox 360 sold.
- Sales and marketing expenses increased $726 million or 5%, primarily reflecting increased advertising and marketing of the Xbox 360 platform, Windows Phone, and Windows and Windows Live, higher headcount-related expenses and increased fees paid to third-party enterprise software advisors.
- Research and development expenses increased $329 million or 4%, due mainly to higher headcount-related expenses.
- General and administrative expenses increased $159 million or 4%, due mainly to higher headcount-related expenses and new Puerto Rican excise taxes, partially offset by prior year transition expenses associated with the inception of the Yahoo! Commercial Agreement.
Diluted earnings per share increased, reflecting higher revenue, repurchases of common stock, and lower income tax expense, offset in part by higher operating expenses.
SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)
The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the U.S. ("U.S. GAAP") and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements is presented on a basis consistent with our current internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division.
Windows & Windows Live Division
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| Revenue | $ 18,373 | $ 19,033 | $ 19,491 | (3)% | (2)% | ||||
| Operating income | $ 11,460 | $ 12,211 | $ 12,895 | (6)% | (5)% |
Windows & Windows Live Division ("Windows Division") develops and markets PC operating systems, related software and online services, and PC hardware products. This collection of software, hardware, and services is designed to simplify everyday tasks through seamless operations across the user's hardware and software and efficient browsing capabilities. Windows Division offerings consist of the Windows operating system, software and services through Windows Live, and Microsoft PC hardware products.
Windows Division revenue is largely correlated to the PC market worldwide, as approximately 75% of total Windows Division revenue comes from Windows operating system software purchased by original equipment manufacturers ("OEMs") which they pre-install on equipment they sell. The remaining approximately 25% of Windows Division revenue is generated by commercial and retail sales of Windows and PC hardware products and online advertising from Windows Live.
Fiscal year 2012 compared with fiscal year 2011
Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 4% and sales of PCs to consumers decreased 1%. Excluding a decline in sales of netbooks, we estimate that sales of PCs to consumers grew approximately 5%. Taken together, the total PC market increased an estimated 0% to 2%. Relative to PC market growth, Windows Division revenue was negatively impacted by higher growth in emerging markets, where average selling prices are lower than developed markets, and the deferral of $540 million of revenue relating to the Windows Upgrade Offer.
Windows Division operating income decreased, due mainly to lower revenue and a $163 million or 10% increase in research and development expenses, primarily associated with the Windows 8 operating system.
Fiscal year 2011 compared with fiscal year 2010
Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 11% this year and sales of PCs to consumers declined approximately 1%. The decline in consumer PC sales included an approximately 32% decline in the sales of netbooks. Taken together, the total PC market increased an estimated 2% to 4%. Revenue was negatively impacted by the effect of higher growth in emerging markets, where average selling prices are lower, relative to developed markets, and by lower recognition of previously deferred Windows XP revenue. Considering the impact of the Windows 7 launch in the prior year, including $273 million of revenue recognized related to the Windows 7 Deferral, we estimate that Windows Division revenue was in line with the PC market.
Windows Division operating income decreased as a result of decreased revenue and higher sales and marketing expenses. Sales and marketing expenses increased $182 million or 6%, reflecting increased advertising of Windows and Windows Live.
Server and Tools
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| Revenue | $ 18,686 | $ 16,680 | $ 15,109 | 12% | 10% | ||||
| Operating income | $ 7,431 | $ 6,290 | $ 5,381 | 18% | 17% |
Server and Tools develops and markets technology and related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Visual Studio, System Center products, Windows Embedded device platforms, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training, and certification. Approximately 55% of Server and Tools revenue comes primarily from multi-year volume licensing agreements, approximately 25% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes from Enterprise Services.
Fiscal year 2012 compared with fiscal year 2011
Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $1.4 billion or 11%, driven primarily by growth in SQL Server, Windows Server, and System Center, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $595 million or 18%, due to growth in both Premier product support and consulting services.
Server and Tools operating income increased primarily due to revenue growth, offset in part by higher costs of providing products and services and increased sales and marketing expenses. Cost of revenue increased $682 million or 22%, primarily reflecting higher Enterprise Services headcount-related costs. Sales and marketing expenses grew $155 million or 4%, reflecting increased corporate marketing activities.
Fiscal year 2011 compared with fiscal year 2010
Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $1.2 billion or 10%, driven primarily by growth in Windows Server, SQL Server, and System Center, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $353 million or 12%, due to growth in both Premier product support and consulting services.
Server and Tools operating income increased due to revenue growth, offset in part by higher operating expenses. Cost of revenue increased $377 million or 13%, primarily reflecting a $323 million increase in expenses from providing Enterprise Services. Sales and marketing expenses increased $270 million or 7%, reflecting increased fees paid to third-party enterprise software advisors and increased corporate marketing activities.
Online Services Division
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| Revenue | $ 2,867 | $ 2,607 | $ 2,294 | 10% | 14% | ||||
| Operating loss | $ (8,121) | $ (2,657) | $ (2,408) | * | (10)% | ||||
| * Not meaningful | |||||||||
Online Services Division ("OSD") develops and markets information and content designed to help people simplify tasks and make more informed decisions online, and that help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising, accounting for nearly all of OSD's annual revenue.
Fiscal year 2012 compared with fiscal year 2011
Online advertising revenue grew $306 million or 13% to $2.6 billion, reflecting continued growth in search advertising revenue, offset in part by decreased display advertising revenue. Search revenue grew due to increased revenue per search, increased volumes reflecting general market growth, and share gains in the U.S. According to third-party sources, Bing organic U.S. market share for the month of June 2012 was approximately 16%, and grew 120 basis points year over year. Bing-powered U.S. market share, including Yahoo! properties, was approximately 26% for the month of June 2012, down 100 basis points year over year.
OSD's fiscal year 2012 operating loss reflects a goodwill impairment charge of $6.2 billion, which we recorded as a result of our annual goodwill impairment test in the fourth quarter. The non-cash, non-tax-deductible charge related mainly to goodwill acquired through our 2007 acquisition of aQuantive, Inc. While the search business has been improving, our expectations for future growth and profitability for OSD are lower than our previous estimates. We do not expect this impairment charge to affect OSD's ongoing business or financial performance.
Excluding the $6.2 billion goodwill impairment charge, OSD's operating loss was reduced by higher revenue and lower sales and marketing expenses and cost of revenue. Sales and marketing expenses decreased $321 million or 29%, due mainly to lower marketing spend. Cost of revenue decreased $213 million, driven by lower Yahoo! reimbursement costs, amortization, and online operating costs.
Fiscal year 2011 compared with fiscal year 2010
OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $351 million or 18% to $2.3 billion, reflecting continued growth in search and display advertising revenue, offset in part by decreased third-party advertising revenue. Search revenue grew due to increased volumes reflecting general market growth, share gains in the U.S., and our Yahoo! alliance, offset in part by decreased revenue per search primarily related to challenges associated with optimizing the adCenter platform for the new mix and volume of traffic from the combined Yahoo! and Bing properties. According to third-party sources, Bing organic U.S. market share for the month of June 2011 was approximately 14%, and grew 170 basis points year over year. Bing-powered U.S. market share, including Yahoo! properties, was approximately 27% for the month of June 2011.
OSD operating loss increased due to higher operating expenses, offset in part by increased revenue. Cost of revenue grew $647 million driven by costs associated with the Yahoo! search agreement and increased traffic acquisition costs. General and administrative expenses decreased $156 million or 58%, due mainly to transition expenses in the prior year associated with the inception of the Yahoo! Commercial Agreement. Research and development increased $123 million or 11% due to increased headcount-related costs.
Microsoft Business Division
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| Revenue | $ 23,991 | $ 22,514 | $ 19,256 | 7% | 17% | ||||
| Operating income | $ 15,719 | $ 14,657 | $ 11,849 | 7% | 24% |
Microsoft Business Division ("MBD") develops and markets software and online services designed to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (comprising mainly Office, SharePoint, Exchange, Lync, and Office 365), which generates over 90% of MBD revenue, and Microsoft Dynamics business solutions. We evaluate MBD results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue.
Fiscal year 2012 compared with fiscal year 2011
MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system. Business revenue increased $1.7 billion or 9%, primarily reflecting growth in multi-year volume licensing revenue, licensing of the 2010 Microsoft Office system to transactional business customers, and an 11% increase in Microsoft Dynamics revenue. Consumer revenue decreased $195 million or 4% due to the recognition of $254 million of revenue in the prior year associated with the Office Deferral. Excluding the fiscal year 2011 impact associated with the Office Deferral, consumer revenue increased $59 million, driven by increased sales of the 2010 Microsoft Office system.
MBD revenue for the year ended June 30, 2012 included a favorable foreign currency impact of $506 million.
MBD operating income increased, primarily due to revenue growth, offset in part by higher operating expenses. Cost of revenue increased $258 million or 16%, primarily due to higher online operation and support costs. Research and development expenses increased, due mainly to an increase in headcount-related costs.
Fiscal year 2011 compared with fiscal year 2010
MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system, the $254 million Office Deferral during fiscal year 2010, and the subsequent recognition of the Office Deferral during fiscal year 2011. Business revenue increased $2.1 billion or 14%, reflecting licensing of the 2010 Microsoft Office system to transactional business customers, growth in multi-year volume licensing revenue, and a 10% increase in Microsoft Dynamics revenue. Consumer revenue increased $1.1 billion or 33%, approximately half of which was attributable to the launch of Office 2010 and half of which was attributable to the Office Deferral during fiscal year 2010 and subsequent recognition of the Office Deferral during fiscal year 2011. Excluding the impact associated with the Office Deferral, consumer revenue increased $617 million or 17% due to sales of the 2010 Microsoft Office system.
MBD operating income increased due mainly to revenue growth, offset in part by higher operating expenses. Cost of revenue increased $328 million or 25%, primarily driven by higher online operation and support costs. Sales and marketing expenses increased, primarily driven by an increase in corporate and cross-platform marketing activities. Research and development costs increased, primarily as a result of capitalization of certain Microsoft Office system software development costs in the prior year.
Entertainment and Devices Division
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
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| Revenue | $ 9,593 | $ 8,915 | $ 6,079 | 8% | 47% | ||||
| Operating income | $ 364 | $ 1,257 | $ 517 | (71)% | 143% |
Entertainment and Devices Division ("EDD") develops and markets products and services designed to entertain and connect people. EDD offerings include the Xbox 360 entertainment platform (which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories), Mediaroom (our Internet protocol television software), Skype, and Windows Phone, including related patent licensing revenue. In November 2010, we released Kinect for Xbox 360. We acquired Skype on October 13, 2011, and its results of operations from that date are reflected in our results discussed below.
Fiscal year 2012 compared with fiscal year 2011
EDD revenue increased primarily reflecting Skype and Windows Phone revenue, offset in part by lower Xbox 360 platform revenue. Xbox 360 platform revenue decreased $113 million, due mainly to decreased volumes of Kinect for Xbox 360 sold and lower video game revenue, offset in part by higher Xbox LIVE revenue. We shipped 13.0 million Xbox 360 consoles during fiscal year 2012, compared with 13.7 million Xbox 360 consoles during fiscal year 2011. Video game revenue decreased due to strong sales of Halo Reach in the prior year.
EDD operating income decreased reflecting higher operating expenses, offset in part by revenue growth. Cost of revenue grew $900 million or 16%, primarily due to changes in the mix of products and services sold and payments made to Nokia related to joint strategic initiatives. Research and development expenses increased $356 million or 30%, primarily reflecting higher headcount-related expenses. Sales and marketing expenses increased $244 million or 28%, primarily reflecting the inclusion of Skype expenses.
Fiscal year 2011 compared with fiscal year 2010
EDD revenue increased primarily reflecting higher Xbox 360 platform revenue. Xbox 360 platform revenue grew $2.7 billion or 48%, led by increased volumes of Xbox 360 consoles, sales of Kinect for Xbox 360, and higher Xbox LIVE revenue. We shipped 13.7 million Xbox 360 consoles during fiscal year 2011, compared with 10.3 million Xbox 360 consoles during fiscal year 2010.
EDD operating income increased primarily reflecting revenue growth, offset in part by higher cost of revenue. Cost of revenue increased $1.8 billion or 49%, primarily reflecting higher volumes of Xbox 360 consoles and Kinect for Xbox 360 sold, and increased royalty costs resulting from increased sales of Xbox LIVE digital content. Research and development expenses increased $160 million or 15%, primarily reflecting higher headcount-related costs. Sales and marketing expenses grew $112 million or 15%, primarily reflecting increased Xbox 360 platform marketing activities.
Corporate-Level Activity
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| Corporate-level activity | $ (5,090) | $ (4,597) | $ (4,136) | (11)% | (11)% |
Certain corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; and legal settlements and contingencies.
Fiscal year 2012 compared with fiscal year 2011
Corporate-level expenses increased due mainly to full year Puerto Rican excise taxes, higher headcount-related expenses, and changes in foreign currency exchange rates. These increases were offset in part by lower legal charges, which were $56 million in fiscal year 2012 compared with $332 million in fiscal year 2011.
Fiscal year 2011 compared with fiscal year 2010
Corporate-level expenses increased due mainly to new Puerto Rican excise taxes, certain revenue related sales and marketing expenses, and increased headcount-related expenses. These increases were offset in part by lower legal charges, which were $332 million in fiscal year 2011 compared with $533 million in fiscal year 2010.
OPERATING EXPENSES
Cost of Revenue
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| Cost of revenue | $ 17,530 | $ 15,577 | $ 12,395 | 13% | 26% | ||||
| As a percent of revenue | 24% | 22% | 20% | 2ppt | 2ppt |
Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire online advertising space ("traffic acquisition costs"); costs incurred to support and maintain Internet-based products and services including royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs.
Fiscal year 2012 compared with fiscal year 2011
Cost of revenue increased reflecting higher headcount-related costs, payments made to Nokia, and changes in the mix of products and services sold. Headcount-related expenses increased 20%, primarily related to increased Enterprise Services headcount.
Fiscal year 2011 compared with fiscal year 2010
Cost of revenue increased primarily due to increased volumes of Xbox 360 consoles and Kinect for Xbox 360 sold, higher costs associated with our online offerings, including traffic acquisition costs, and higher expenses from providing Enterprise Services, as well as royalty costs relating to Xbox LIVE digital content sold.
Research and Development
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| Research and development | $ 9,811 | $ 9,043 | $ 8,714 | 8% | 4% | ||||
| As a percent of revenue | 13% | 13% | 14% | 0ppt | (1)ppt |
Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses 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.
Fiscal year 2012 compared with fiscal year 2011
Research and development expenses increased, primarily reflecting a 10% increase in headcount-related expenses.
Fiscal year 2011 compared with fiscal year 2010
Research and development expenses increased primarily due to a 5% increase in headcount-related expenses and the capitalization of certain software development costs in the prior year.
Sales and Marketing
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| Sales and marketing | $ 13,857 | $ 13,940 | $ 13,214 | (1)% | 5% | ||||
| As a percent of revenue | 19% | 20% | 21% | (1)ppt | (1)ppt |
Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs.
Fiscal year 2012 compared with fiscal year 2011
Sales and marketing expenses decreased slightly, primarily reflecting decreased advertising and marketing of the Xbox 360 platform, Windows Phone, and Bing, offset in part by a 5% increase in headcount-related expenses.
Fiscal year 2011 compared with fiscal year 2010
Sales and marketing expenses increased, primarily as a result of increased advertising and marketing of the Xbox 360 platform, Windows Phone, and Windows and Windows Live, a 5% increase in headcount-related expenses, and increased fees paid to third-party enterprise software advisors.
General and Administrative
| (In millions, except percentages) | 2012 | 2011 | 2010 | Percentage Change 2012 Versus 2011 |
Percentage Change 2011 Versus 2010 |
||||
| General and administrative | $ 4,569 | $ 4,222 | $ 4,063 | 8% | 4% | ||||
| As a percent of revenue | 6% | 6% | 7% | 0ppt | (1)ppt |
General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees.
Fiscal year 2012 compared with fiscal year 2011
General and administrative expenses increased, primarily due to a 10% increase in headcount-related expenses and a full year of Puerto Rican excise taxes, offset in part by a decrease in legal charges.
Fiscal year 2011 compared with fiscal year 2010
General and administrative expenses increased, primarily due to a 12% increase in headcount-related expenses and new Puerto Rican excise taxes, partially offset by prior year transition expenses associated with the inception of the Yahoo! Commercial Agreement.
Goodwill Impairment
We conducted our annual goodwill impairment test as of May 1, 2012 for all reporting units. This test, which was based on our most recent cash flow forecast, indicated that OSD's carrying value exceeded its estimated fair value. Accordingly, we recorded a non-cash, non-tax deductible goodwill impairment charge of $6.2 billion during the three months ended June 30, 2012, reducing OSD's goodwill from $6.4 billion to $223 million.
OTHER INCOME (EXPENSE) AND INCOME TAXES
Other Income (Expense)
The components of other income (expense) were as follows:
| (In millions) | |||||
| Year Ended June 30, | 2012 | 2011 | 2010 | ||
| Dividends and interest income | $ 800 | $ 900 | $ 843 | ||
| Interest expense | (380) | (295) | (151) | ||
| Net recognized gains on investments | 564 | 439 | 348 | ||
| Net losses on derivatives | (364) | (77) | (140) | ||
| Net gains (losses) on foreign currency remeasurements | (117) | (26) | 1 | ||
| Other | 1 | (31) | 14 | ||
| Total | $ 504 | $ 910 | $ 915 |
We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are recognized in other income (expense). These are generally offset by unrealized gains and losses in the underlying securities in the investment portfolio and are recorded as a component of other comprehensive income.
Fiscal year 2012 compared with fiscal year 2011
Dividends and interest income decreased due to lower yields on our fixed-income investments, offset in part by higher average portfolio investment balances. Interest expense increased due to our increased issuance of debt in the prior year. Net recognized gains on investments increased, primarily due to higher gains on sales of equity and fixed-income securities and a gain recognized on the partial sale of our Facebook holding upon the initial public offering on May 18, 2012, offset in part by higher other-than-temporary impairments. Other-than-temporary impairments were $298 million in fiscal year 2012, compared with $80 million in fiscal year 2011. Net losses on derivatives increased due to losses on commodity and equity derivatives in the current fiscal year as compared with gains in the prior fiscal year, offset in part by fewer losses on foreign exchange contracts in the current fiscal year as compared to the prior fiscal year. Changes in foreign currency remeasurements were primarily due to currency movements net of our hedging activities.
Fiscal year 2011 compared with fiscal year 2010
Dividends and interest income increased due to higher average portfolio investment balances, offset in part by lower yields on our fixed-income investments. Interest expense increased due to our increased issuance of debt. Net recognized gains on investments increased, primarily due to higher gains on sales of equity securities, offset in part by fewer gains on sales of fixed-income securities. Derivative losses decreased, primarily due to higher gains on commodity derivatives offset in part by higher losses on currency contracts used to hedge foreign currency revenue.
Income Taxes
Fiscal year 2012 compared with fiscal year 2011
Our effective tax rates for fiscal years 2012 and 2011 were approximately 24% and 18%, respectively. Our effective tax rates were lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which have lower income tax rates.
Our fiscal year 2012 effective rate increased by 6% from fiscal year 2011 mainly due to a nonrecurring $6.2 billion non-tax deductible goodwill impairment charge that was recorded in the fourth quarter of 2012. The goodwill impairment charge increased our effective tax rate by 10%. In addition, in fiscal years 2012 and 2011, we recognized a reduction of 21% and 16%, respectively, to the effective tax rate due to foreign earnings taxed at lower rates. In fiscal year 2011, we settled a portion of an I.R.S. audit of tax years 2004 to 2006, which reduced our income tax expense for fiscal year 2011 by $461 million and reduced the effective tax rate by 2%.
Changes in the mix of income before income taxes between the U.S. and foreign countries also impacted our effective tax rates and resulted primarily from changes in the geographic distribution of and changes in consumer demand for our products and services. As discussed above, Windows Division operating income declined $751 million in fiscal year 2012, while MBD and Server and Tools operating income increased $1.1 billion and $1.1 billion, respectively, during this same period. We supply Windows, our primary Windows Division product, to customers through our U.S. regional operating center, while we supply the Microsoft Office System, our primary MBD product, and our Server and Tools products to customers through our foreign regional operations centers. In fiscal years 2012 and 2011, our U.S. income before income taxes was $1.6 billion and $8.9 billion, respectively, and comprised 7% and 32%, respectively, of our income before income taxes. In fiscal years 2012 and 2011, the foreign income before income taxes was $20.7 billion and $19.2 billion, respectively, and comprised 93% and 68%, respectively, of our income before income taxes. The primary driver for the decrease in the U.S. income before income tax in fiscal year 2012 was the goodwill impairment charge.
Tax contingencies and other tax liabilities were $7.6 billion and $7.4 billion as of June 30, 2012 and 2011, respectively, and are included in other long-term liabilities. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for these years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit phase of the examination. As of June 30, 2012, the primary unresolved issue relates to transfer pricing which could have a significant impact on our financial statements if not resolved favorably. We believe our allowances for tax contingencies are appropriate. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the remaining open issues will be resolved within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2011.
Fiscal year 2011 compared with fiscal year 2010
Our effective tax rates for fiscal years 2011 and 2010 were approximately 18% and 25%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate and our prior year effective rate primarily due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which have lower income tax rates. In fiscal years 2011 and 2010, our U.S. income before income taxes was $8.9 billion and $9.6 billion, respectively, and comprised 32% and 38%, respectively, of our income before income taxes. In fiscal years 2011 and 2010, the foreign income before income taxes was $19.2 billion and $15.4 billion, respectively, and comprised 68% and 62%, respectively, of our income before income taxes. In fiscal years 2011 and 2010, the reduction of the U.S. federal statutory rate as a result of foreign earnings taxed at lower rates was 16% and 12%, respectively.
In addition, our effective tax rate was lower than in the prior year due to a partial settlement with the I.R.S. in the third quarter of fiscal year 2011 relating to the audit of tax years 2004 to 2006. This partial settlement reduced our income tax expense for fiscal year 2011 by $461 million.
FINANCIAL CONDITION
Cash, Cash Equivalents, and Investments
Cash, cash equivalents, and short-term investments totaled $63.0 billion as of June 30, 2012, compared with $52.8 billion as of June 30, 2011. Equity and other investments were $9.8 billion as of June 30, 2012, compared with $10.9 billion as of June 30, 2011. Our short-term investments are primarily to facilitate liquidity and for capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. While we own certain mortgage-backed and asset-backed fixed-income securities, our portfolio as of June 30, 2012 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of our mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association.
We routinely monitor our financial exposure to both sovereign and non-sovereign borrowers and counterparties. Our gross exposures to our customers and investments in Portugal, Italy, Ireland, Greece, and Spain are individually and collectively not material.
Of the cash, cash equivalents, and short-term investments at June 30, 2012, approximately $54 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash and investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was approximately $660 million. As of June 30, 2012, approximately 77% of the short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 10% were invested in corporate notes and bonds of U.S. companies, and 3% were invested in U.S. mortgage-backed securities, all of which are denominated in U.S. dollars.
Securities lending
We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Our securities lending payable balance was $814 million as of June 30, 2012. Our average and maximum securities lending payable balances for the fiscal year were $1.2 billion and $1.4 billion, respectively. Intra-year variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities.
Valuation
In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, and U.S. treasuries. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly.
This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio.
A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.
Cash Flows
Fiscal year 2012 compared with fiscal year 2011
Cash flows from operations increased $4.6 billion during the current fiscal year to $31.6 billion due mainly to increased revenue and cash collections from customers. Cash used for financing increased $1.0 billion to $9.4 billion due mainly to a $6.0 billion net decrease in proceeds from issuances of debt and a $1.2 billion increase in dividends paid, offset in part by a $6.5 billion decrease in cash used for common stock repurchases. Cash used in investing increased $10.2 billion to $24.8 billion due mainly to a $10.0 billion increase in acquisitions of businesses and purchases of intangible assets and a $1.4 billion decrease in cash from securities lending activities, partially offset by a $1.2 billion decrease in cash used for net purchases, maturities, and sales of investments.
Fiscal year 2011 compared with fiscal year 2010
Cash flows from operations increased $2.9 billion during the current fiscal year to $27.0 billion due mainly to increased revenue and cash collections from customers. Cash used in financing decreased $4.9 billion to $8.4 billion due mainly to a $5.8 billion increase in proceeds from issuance of debt, net of repayments, offset in part by a $602 million increase in cash paid for dividends. Cash used in investing increased $3.3 billion to $14.6 billion due to a $5.8 billion increase in purchases of investments, offset in part by a $2.5 billion increase in cash from securities lending.
Debt
We issued debt in prior periods to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were used to partially fund discretionary business acquisitions and share repurchases.
As of June 30, 2012, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $11.9 billion and $13.2 billion, respectively. This is compared with a carrying value and estimated fair value of $11.9 billion and $12.1 billion, respectively, as of June 30, 2011. These estimated fair values are based on Level 2 inputs.
The components of our long-term debt, including the current portion, and the associated interest rates and semi-annual interest record and payment dates were as follows as of June 30, 2012:
| Due Date | Face Value | Stated Interest Rate |
Effective Interest Rate |
Interest Record Date |
Interest Pay Date |
Interest Record Date |
Interest Pay Date |
||||||
| (In millions) | |||||||||||||
| Notes | |||||||||||||
| September 27, 2013 | $ 1,000 | 0.875% | 1.000% | March 15 | March 27 | September 15 | September 27 | ||||||
| June 1, 2014 | 2,000 | 2.950% | 3.049% | May 15 | June 1 | November 15 | December 1 | ||||||
| September 25, 2015 | 1,750 | 1.625% | 1.795% | March 15 | March 25 | September 15 | September 25 | ||||||
| February 8, 2016 | 750 | 2.500% | 2.642% | February 1 | February 8 | August 1 | August 8 | ||||||
| June 1, 2019 | 1,000 | 4.200% | 4.379% | May 15 | June 1 | November 15 | December 1 | ||||||
| October 1, 2020 | 1,000 | 3.000% | 3.137% | March 15 | April 1 | September 15 | October 1 | ||||||
| February 8, 2021 | 500 | 4.000% | 4.082% | February 1 | February 8 | August 1 | August 8 | ||||||
| June 1, 2039 | 750 | 5.200% | 5.240% | May 15 | June 1 | November 15 | December 1 | ||||||
| October 1, 2040 | 1,000 | 4.500% | 4.567% | March 15 | April 1 | September 15 | October 1 | ||||||
| February 8, 2041 | 1,000 | 5.300% | 5.361% | February 1 | February 8 | August 1 | August 8 | ||||||
| Total | 10,750 | ||||||||||||
| Convertible Debt | |||||||||||||
| June 15, 2013 | 1,250 | 0.000% | 1.849% | ||||||||||
| Total face value | $ 12,000 |
As of June 30, 2012, the aggregate unamortized discount for our long-term debt, including the current portion, was $56 million.
Notes
The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.
Convertible Debt
In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, which were capitalized. Initially, each $1,000 principal amount of notes was convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share. The conversion ratio is adjusted periodically for dividends in excess of the initial dividend threshold as defined in the debt agreement. As of June 30, 2012, the net carrying amount of our convertible debt was $1.2 billion and the unamortized discount was $19 million.
Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into cash and, if applicable, cash, shares of Microsoft's common stock, or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the notes and pay or deliver cash, shares of our common stock, or a combination of cash and shares of our common stock, at our election.
Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders' equity for $58 million with the portion in stockholders' equity representing the fair value of the option to convert the debt.
In connection with the issuance of the notes, we entered into capped call transactions with certain option counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with an initial cap price equal to $37.16, which is adjusted periodically to mirror any adjustments to the conversion price. The purchased capped calls were valued at $40 million and recorded to stockholders' equity.
Unearned Revenue
Unearned revenue at June 30, 2012 comprised mainly unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or annually at the beginning of each billing coverage period and accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Unearned revenue at June 30, 2012 also included payments for: post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions and prepaid points; the Windows Upgrade Offer; Microsoft Dynamics business solutions products; Skype prepaid credits and subscriptions; OEM minimum commitments; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria.
The following table outlines the expected future recognition of unearned revenue as of June 30, 2012:
| (In millions) | |
| Three Months Ending, | |
| September 30, 2012 | $ 6,874 |
| December 31, 2012 | 5,635 |
| March 31, 2013 | 4,323 |
| June 30, 2013 | 1,821 |
| Thereafter | 1,406 |
| Total | $ 20,059 |
Share Repurchases
On September 22, 2008, we announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. As of June 30, 2012, approximately $8.2 billion remained of the $40.0 billion approved repurchase amount. The repurchase program may be suspended or discontinued at any time without notice.
During the periods reported, we repurchased with cash resources: 142 million shares for $4.0 billion during fiscal year 2012; 447 million shares for $11.5 billion during fiscal year 2011; and 380 million shares for $10.8 billion during fiscal year 2010.
Dividends
During fiscal years 2012 and 2011, our Board of Directors declared the following dividends:
| Declaration Date | Dividend Per Share |
Record Date | Total Amount | Payment Date |
| (In millions) | ||||
| Fiscal Year 2012 | ||||
| September 20, 2011 | $ 0.20 | November 17, 2011 | $ 1,683 | December 8, 2011 |
| December 14, 2011 | $ 0.20 | February 16, 2012 | $ 1,683 | March 8, 2012 |
| March 13, 2012 | $ 0.20 | May 17, 2012 | $ 1,678 | June 14, 2012 |
| June 13, 2012 | $ 0.20 | August 16, 2012 | $ 1,676 | September 13, 2012 |
| Fiscal Year 2011 | ||||
| September 21, 2010 | $ 0.16 | November 18, 2010 | $ 1,363 | December 9, 2010 |
| December 15, 2010 | $ 0.16 | February 17, 2011 | $ 1,349 | March 10, 2011 |
| March 14, 2011 | $ 0.16 | May 19, 2011 | $ 1,350 | June 9, 2011 |
| June 15, 2011 | $ 0.16 | August 18, 2011 | $ 1,341 | September 8, 2011 |
Off-Balance Sheet Arrangements
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 and certain other matters. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. To date, we have not encountered significant costs as a result of these obligations and have not accrued in our financial statements any liabilities related to these indemnifications.
Contractual Obligations
The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2012:
| (In millions) | 2013 | 2014-2015 | 2016-2017 | Thereafter | Total | ||||
| Long-term debt: (a) | |||||||||
| Principal payments | $ 1,250 | $ 3,000 | $ 2,500 | $ 5,250 | $ 12,000 | ||||
| Interest payments | 344 | 616 | 491 | 3,457 | 4,908 | ||||
| Construction commitments (b) | 353 | 0 | 0 | 0 | 353 | ||||
| Operating leases (c) | 527 | 748 | 387 | 315 | 1,977 | ||||
| Purchase commitments (d) | 6,556 | 884 | 236 | 146 | 7,822 | ||||
| Other long-term liabilities (e) | 0 | 106 | 16 | 30 | 152 | ||||
| Total contractual obligations | $ 9,030 | $ 5,354 | $ 3,630 | $ 9,198 | $ 27,212 |
(a) See Note 12 – Debt of the Notes to Financial Statements.
(b) These amounts represent commitments for the construction of buildings, building improvements, and leasehold improvements.
(c) These amounts represent undiscounted future minimum rental commitments under noncancellable facilities leases.
(d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as construction commitments above.
(e) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $9.5 billion and other long-term contingent liabilities of $220 million (related to the antitrust and unfair competition class action lawsuits) from the amounts presented, as the amounts that will be settled in cash are not known and the timing of any payments is uncertain. We have also excluded unearned revenue of $1.4 billion and non-cash items of $202 million.
Other Planned Uses of Capital
On July 18, 2012, we acquired Yammer, Inc. ("Yammer"), a leading provider of enterprise social networks, for $1.2 billion in cash. Yammer will continue to develop its standalone service and will add an enterprise social networking service to Microsoft's portfolio of complementary cloud-based services.
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, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We have operating leases for most U.S. and international sales and support offices and certain equipment. 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 capital resources.
Liquidity
We earn a significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect existing domestic cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, debt repayment schedules, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.
Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates.
RECENT ACCOUNTING GUIDANCE
Recently Adopted Accounting Guidance
On July 1, 2011, we adopted guidance issued by the Financial Accounting Standards Board ("FASB") on disclosure requirements related to fair value measurements. The guidance requires the disclosure of roll-forward activities on purchases, sales, issuances, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). Adoption of this new guidance did not have a material impact on our financial statements.
On January 1, 2012, we adopted guidance issued by the FASB on accounting and disclosure requirements related to fair value measurements. The guidance limits the highest-and-best-use measure to nonfinancial assets, permits certain financial assets and liabilities with offsetting positions in market or counterparty credit risks to be measured at a net basis, and provides guidance on the applicability of premiums and discounts. Additionally, the guidance expands the disclosures on Level 3 inputs by requiring quantitative disclosure of the unobservable inputs and assumptions, as well as description of the valuation processes and the sensitivity of the fair value to changes in unobservable inputs. Adoption of this new guidance did not have a material impact on our financial statements.
Recent Accounting Guidance Not Yet Adopted
In December 2011, the FASB issued guidance enhancing disclosure requirements about the nature of an entity's right to offset and related arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. The new guidance will be effective for us beginning July 1, 2013. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption.
In September 2011, the FASB issued guidance on testing goodwill for impairment. The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the currently prescribed two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). If an entity determines that the fair value of a reporting unit is greater than its carrying amount, the two-step goodwill impairment test is not required. The new guidance will be effective for us beginning July 1, 2012.
In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in stockholders' equity. Instead, an entity will be required to present either a continuous statement of net income and other comprehensive income or in two separate but consecutive statements. This portion of the guidance will be effective for us beginning July 1, 2012 and will require financial statement presentation changes only. The new guidance also required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. However, in December 2011, the FASB issued guidance that indefinitely defers the guidance related to the presentation of reclassification adjustments.
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, goodwill, research and development costs, contingencies, income taxes, and stock-based compensation.
Revenue Recognition
Software revenue recognition 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. A portion of revenue may be recorded as unearned due to undelivered elements. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, and the fair value of the respective elements 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.
Windows 7 revenue is subject to deferral as a result of the Windows Upgrade Offer, which started June 2, 2012. The offer provides significantly discounted rights to purchase Windows 8 Pro to qualifying end users that purchase Windows 7 PCs during the eligibility period. Microsoft is responsible for delivering Windows 8 Pro to the end customer. Accordingly, revenue related to the allocated discount for undelivered Windows 8 is deferred until it is delivered or the redemption period expires.
Impairment of Investment Securities
We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative 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, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. 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, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.
Goodwill
We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit.
Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital.
The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.
Research and Development Costs
Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are 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 software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products.
Legal and Other Contingencies
The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is 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. In determining whether a loss should be accrued 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 statements.
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. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial statements.
Stock-Based Compensation
Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense, net of estimated forfeitures, over the requisite service period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be impacted.
STATEMENT OF MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS
Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management's estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America.
The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits.
The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States).
The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee.
Steven A. Ballmer
Chief Executive Officer
Peter S. Klein
Chief Financial Officer
Frank H. Brod
Corporate Vice President, Finance and Administration;
Chief Accounting Officer
