Management’s Discussion and Analysis
Results of Operations for
1996, 1997, and 1998
Microsoft develops,
manufactures, licenses, and supports a wide range of software products, including scalable
operating systems for intelligent devices, personal computers (PCs), and servers; server
applications for client/server environments; business and consumer productivity
applications; software development tools; and Internet and intranet software and
technologies. The Company’s interactive efforts include entertainment and information
software programs; MSN, the Microsoft Network online service; Internet-based services; and
alliances with companies involved with various forms of digital interactivity. Microsoft
also sells personal computer input devices and books, and researches and develops advanced
technologies for future software products.
Revenue
The Company’s revenue
growth rate continued to slow, from 46% in the fiscal year ended June 30, 1996 and 31% in
fiscal 1997 to 28% in fiscal 1998. Revenue growth was particularly strong in 1996 due to
the retail introduction of the Microsoft Windows 95 operating system. The 1997 and 1998
growth rates, although slower than that of 1996, reflected the continued adoption of
Windows 32-bit operating systems and Microsoft Office 97, particularly as Microsoft
software is deployed across entire corporate, academic, and governmental organizations.
Software license volume increases have been the principal factor in Microsoft’s
revenue growth. The average selling price per license has decreased, primarily because of
general shifts in the sales mix from retail packaged products to licensing programs, from
new products to product upgrades, and from stand-alone desktop applications to integrated
product suites. Average revenue per license from original equipment manufacturer (OEM)
licenses and organization license programs is lower than average revenue per license from
retail versions. Likewise, product upgrades have lower prices than new products. Also,
prices of integrated suites, such as Microsoft Office, are less than the sum of the prices
for the individual programs included in these suites when such programs are licensed
separately. During each of the three years an increased percentage of products and
programs included elements which were billed but unearned and recognized ratably, such as
Windows operating systems, Office 97, maintenance, and other subscription models.
 Product
groups
Platform product revenue was $4.11 billion, $5.97 billion, and $7.64 billion in 1996,
1997, and 1998. Platform revenue is primarily licenses of PC operating systems; business
systems with client/server, Internet, and intranet architectures; and software development
tools.
The Company’s principal
desktop platform products are its 32-bit operating systems: Windows 95, Windows 98, and
Windows NT Workstation. Released in August 1995, Windows 95 was a successor to the MS-DOS®
and Microsoft Windows 3.x operating systems. Windows NT Workstation version 4.0
was released in fiscal 1997. Windows 98 became available at the end of fiscal 1998.
Although the growth rate of new PC shipments slowed, desktop operating systems contributed
to revenue growth as shipments of new PCs preinstalled with such systems increased during
the three-year period. Additionally, increased penetration of higher value 32-bit
operating systems, particularly Windows NT Workstation, led to growth in 1996, 1997, and
1998. In 1996, retail license sales of Windows 95 were a major factor in the Platform
revenue increase, reflecting the typical sales pattern for major operating system
upgrades. Also in 1996, a portion of Windows operating system revenue became subject to
ratable recognition.
Business systems products
offer an enterprise-wide distributed client/server, Internet, and intranet environment
based on the Microsoft Windows NT Server operating system, Microsoft Exchange Server,
Microsoft SQL Server, and other server applications in the Microsoft BackOffice family of
products. Revenue from these products increased strongly due to greater corporate demand,
particularly for intranet solutions, although the growth rate slowed in 1998.
Although revenue was not
significant, sales of WebTV terminals and service, and preinstallations of Windows CE by
OEMs on intelligent devices were strong in 1998.
Independent software vendors,
corporate developers, and solutions developers license tools such as the Microsoft Visual
Basic® development system to develop software for Windows operating systems
and the Internet. Revenue from developer products increased steadily in 1996 and 1997 and
was flat in 1998.
 Applications
and Content revenue was $4.56 billion, $5.39 billion, and $6.84 billion in 1996, 1997, and
1998. Applications and Content revenue includes primarily licenses of desktop and consumer
productivity applications, interactive media programs, and PC input devices. Microsoft
Office for Windows 95 was released in fiscal 1996 and Microsoft Office 97 was released in
fiscal 1997. Applications and Content revenue grew 27% in 1996, 18% in 1997, and 27% in
1998. The lower growth rate in 1997 was due primarily to the application of the ratable
revenue recognition model for Office 97.
Absolute increases in desktop
applications revenue during the three-year period were led by the various Microsoft Office
integrated suites, including Standard, Professional, and Small Business Editions. The
primary programs in Microsoft Office are the word processor Microsoft Word, Microsoft
Excel spreadsheet, and Microsoft PowerPoint® presentation graphics program.
Various versions of Office, which are available for the 32-bit version of Windows, the
16-bit version of Windows, and Macintosh operating systems, also include Microsoft Access
database management program, Microsoft Outlook™ messaging and collaboration client,
or other programs. Revenue from stand-alone versions of Microsoft Excel, Word, and
PowerPoint continued to decrease as the sales mix shifted to integrated product suites.
Microsoft Project scheduling and project management program revenue increased during the
three-year period.
Microsoft offers a broad
range of interactive media products, which also showed moderate growth. Products include
CD-ROM multimedia reference titles and programs for home and small office productivity,
children’s creativity, and entertainment. In addition to the Microsoft Network,
online Internet services include travel information and reservations, local event
information, and car buying information.
The Company also markets
input devices. Mouse and gaming device sales increased while keyboard revenue was steady
during the three-year period.
Sales channels
The Company distributes its products
primarily through OEM licenses, organization licenses, and retail packaged products. OEM
channel revenue represents license fees from original equipment manufacturers. Microsoft
has three major sales and marketing geographies: the United States and Canada, Europe, and
elsewhere in the world (Other International). Sales of organization licenses and packaged
products in these channels are primarily to distributors and resellers. The trend has
continued toward a higher percentage of organization licensing versus packaged products.
OEM channel revenue was $2.50
billion in 1996, $3.48 billion in 1997, and $4.72 billion in 1998. The primary source of
OEM revenue is the licensing of desktop operating systems, and OEM revenue is highly
dependent on PC shipment volume.
U.S. and Canadian channel
revenue was $2.68 billion, $3.41 billion, and $4.36 billion in 1996, 1997, and 1998.
Revenue in Europe was $2.02 billion, $2.54 billion, and $3.15 billion in 1996, 1997, and
1998. Growth rates have been lower in Europe than in other geographic areas due to higher
existing market shares and a more dramatic shift to licensing programs. Other
International channel revenue was $1.47 billion in 1996, $1.93 billion in 1997, and $2.26
billion in 1998. Growth rates were higher in the Other International channel in 1996 and
1997 due to customers accepting newly localized products, particularly in Japan, and
penetration in emerging markets. However, revenue was relatively flat in Japan and
Southeast Asia in 1998 due to economic issues and weak currencies.
The Company’s operating
results are affected by foreign exchange rates. Approximately 34%, 32%, and 34% of the
Company’s revenue was collected in foreign currencies during 1996, 1997, and 1998.
Since a portion of local currency revenue is hedged and much of the Company’s
international manufacturing costs and operating expenses are also incurred in local
currencies, the impact of exchange rates is partially mitigated.
Operating Expenses
Cost of revenue
As a percentage of revenue, cost of revenue was 13.7% in 1996, 9.6% in 1997, and 8.3% in
1998. The decrease was due to the shifts in mix to CD-ROMs (which carry lower cost of
goods than disks), licenses to OEMs and organizations, and higher-margin Windows NT
Server, other servers, and client access licenses in the BackOffice product family. In
1998, the decrease was offset somewhat by costs of WebTV.
Research and
development
Microsoft continued to invest heavily in the future by funding research and
development (R&D). Expense increases of 67% in 1996, 34% in 1997, and 30% in 1998
resulted primarily from development staff headcount growth and higher levels of
third-party development costs in many areas, particularly Windows-based platforms,
including desktop operating systems, server systems, and consumer appliances, along with
Internet and intranet technologies. R&D costs also increased for desktop and server
applications, development tools, and interactive media initiatives such as MSN and other
online services.
In August 1997, the Company
acquired WebTV Networks, Inc., an online service that enables consumers to experience the
Internet through their televisions via set-top terminals. Microsoft paid $425 million in
stock and cash. The accompanying income statement reflects a one-time write-off of
in-process technologies under development by WebTV Networks of $296 million.
Sales and marketing
The increase in the absolute dollar amount of sales and marketing expenses in the
three-year period was due primarily to expanded product-specific marketing programs, such
as Windows 95 in 1996, Office 97 in 1997, and Windows 98 in 1998. Sales and marketing
costs as a percentage of revenue decreased due to moderate headcount growth. Microsoft
brand advertising and product support expenses declined in 1997, but rose slightly in
1998.
General and
administrative
Increases in general and administrative expenses were attributable to higher legal costs
and growth in the number of people and computer systems necessary to support overall
increases in the scope of the Company’s operations.
Other expenses
Other expenses increased due to recognition of Microsoft’s share of joint venture
activities, including DreamWorks Interactive and the MSNBC entities.
Interest Income and Income
Taxes
Interest income increased
primarily as a result of a larger investment portfolio generated by cash from operations.
The effective income tax rate was 35.0% in 1996 and 1997. The effective income tax rate
increased to 36.9% in 1998 due to the nondeductible write-off of WebTV in-process
technologies.
Net Income
Net income as a percent of
revenue increased in 1996, 1997, and 1998 due to the lower relative cost of revenue, sales
and marketing expenses, and general and administrative expenses, partially offset by
investments in research and development, joint ventures, and WebTV.
Financial Condition
Microsoft’s cash and
short-term investment portfolio totaled $13.93 billion at June 30, 1998. The portfolio is
diversified among security types, industries, and individual issuers. Microsoft’s
investments are generally liquid and investment grade. The portfolio is invested
predominantly in U.S. dollar denominated securities, but also includes foreign currency
positions in anticipation of continued international expansion. The portfolio is primarily
invested in short-term securities to minimize interest rate risk and facilitate rapid
deployment in the event of immediate cash needs.
Microsoft also invests in
equities, including financial investments and strategic technology companies in many
areas. During 1997, Microsoft invested $1.0 billion in Comcast Corporation, a cable
television and diversified telecommunications company. Comcast Special Class A common
stock and convertible preferred stock are included in equity investments at fair market
value on the balance sheet.
During 1996, Microsoft and
National Broadcasting Company (NBC) established two MSNBC joint ventures: a 24-hour cable
news and information channel and an interactive online news service. Microsoft agreed to
pay $220 million over a five-year period for its interest in the cable venture, to pay
one-half of operational funding of both joint ventures for a multiyear period, and to
guarantee a portion of MSNBC debt.
Microsoft has no material
long-term debt and has $100 million of standby multicurrency lines of credit to support
foreign currency hedging and cash management. Stockholders’ equity at June 30, 1998
was $16.63 billion.
Microsoft will continue to
invest in sales, marketing, and product support infrastructure. Additionally, research and
development activities will include investments in existing and advanced areas of
technology, including using cash to acquire technology and to fund ventures and other
strategic opportunities. Additions to property and equipment will continue, including new
facilities and computer systems for research and development, sales and marketing,
support, and administrative staff. Commitments for constructing new buildings were $420
million on June 30, 1998.
Cash will also be used to
repurchase common stock to provide shares for employee stock option and purchase plans.
The buyback program has not kept pace with employee stock option grants or exercises.
Beginning in fiscal 1990, Microsoft has repurchased 347 million common shares while 807
million shares were issued under the Company’s employee stock option and purchase
plans. The market value of all outstanding stock options was $48 billion as of June 30,
1998. Microsoft enhances its repurchase program by selling put warrants. During December
1996, Microsoft issued 12.5 million shares of 2.75% convertible preferred stock. Net
proceeds of $980 million were used to repurchase common shares.
Management believes existing
cash and short-term investments together with funds generated from operations will be
sufficient to meet operating requirements for the next 12 months. Microsoft’s cash
and short-term investments are available for strategic investments, mergers and
acquisitions, other potential large-scale cash needs that may arise, and to fund an
increased stock buyback program over historical levels to reduce the dilutive impact of
the Company’s employee stock option and purchase programs.
Microsoft has not paid cash
dividends on its common stock. The preferred stock pays $2.196 per annum per share.
Issues and Uncertainties
Microsoft does not provide
forecasts of future financial performance. While Microsoft management is optimistic about
the Company’s long-term prospects, the following issues and uncertainties, among
others, should be considered in evaluating its growth outlook.
Rapid technological
change and competition
Rapid change, uncertainty due to new and emerging technologies, and fierce competition
characterize the PC software industry. The pace of change has recently accelerated due to
the Internet and new programming languages, such as Java.
Future initiatives
The Company is expanding its efforts to provide and support mission-critical systems to
large enterprises. Scalability of BackOffice server and application products, total cost
of ownership of Windows- and Office-based systems, information storage unification, user
interface simplification, and Internet and intranet integration are also major focus
areas. Additionally, Microsoft is committed to providing technologies, operating systems,
and interactive content for the future convergence of PCs, televisions, and the Internet.
Future revenue from these initiatives may not duplicate historical revenue growth rates.
PC growth rates
The underlying PC unit growth rate and percentage of new PCs acquired as replacement units
directly impact the Company’s software revenue growth. The PC shipment growth rate
may continue to decrease and the replacement rate may continue to increase, reducing
future software revenue opportunity.
Product ship
schedules
Delays in new-product releases dampen revenue growth rates and can cause operational
inefficiencies that impact manufacturing and distribution logistics, independent software
vendor (ISV) and OEM relationships, and customer support expenses.
Customer acceptance
While the Company performs extensive
usability and beta testing of new products, user acceptance and corporate penetration
rates ultimately dictate the success of development and marketing efforts.
Prices
Future product prices may
decrease from historical levels, depending on competitive market and cost factors.
European and Asian software prices vary by country and are generally higher than in the
United States to cover localization costs and higher costs of distribution. Increased
global license agreements, European monetary unification, or other factors could erode
such price uplifts in the future.
Earnings process
An increasingly higher percentage of the
Company’s revenue is subject to ratable recognition. Subsequent product support and
delivery of unspecified enhancements require the applicable portion of revenue for certain
products to be recognized over the product’s life cycle. This policy may be required
for additional products, depending on specific license terms and conditions. Also,
maintenance and other subscription programs may continue to increase in popularity,
particularly with organizations.
Saturation
Product upgrades, which enable users to
upgrade from earlier versions of the Company’s products or from competitors’
products, have lower prices and margins than new products. As the desktop applications
market has become saturated, the sales mix has shifted from standard products to upgrade
products. This trend is likely to continue.
Organization licenses
Average revenue per unit from organization
license programs is lower than average revenue per unit from retail versions shipped
through the finished goods channels. Unit sales under licensing programs may continue to
increase.
Channel mix
Average revenue per license is lower from OEM
licenses than from retail versions, reflecting the relatively lower direct costs of
operations in the OEM channel. An increasingly higher percentage of revenue was achieved
through the OEM channel during 1997 and 1998.
Cost of revenue
Although cost of revenue as a percentage of
revenue decreased in 1997 and 1998, it varies with channel mix, product mix within
channels, and usage of online operations. The trend of declining cost of revenue as a
percentage of revenue is unlikely to continue in 1999.
Pay and participation
model
Microsoft employees currently receive
salaries, incentive bonuses, other fringe benefits, and stock options. New government
regulations, poor stock price performance, or other factors could diminish the value of
the option program to current and prospective employees and force the Company into more of
a cash compensation model. Had the Company paid employees in cash the grant date
Black-Scholes value of options vested in 1996, 1997, and 1998, the pretax expense would
have been approximately $450 million, $620 million, and $850 million.
Long-term research
and development investment cycle
Developing and localizing software is
expensive and the investment in product development often involves a long payback cycle.
The Company plans to continue significant investments in software research and development
and related product opportunities from which significant revenue is not anticipated for a
number of years. Management expects total spending for research and development in 1999 to
increase over spending in 1998.
Sales, marketing, and
support investments
The Company’s plans for 1999 include
accelerated investments in its sales, marketing, and support groups.
Foreign exchange
A large percentage of the Company’s
sales, costs of manufacturing, and marketing is transacted in local currencies. As a
result, the Company’s international results of operations are subject to foreign
exchange rate fluctuations.
Investments value
sensitivity
The Company’s investment
portfolio is subject to interest rate and market price risk. A 10% increase in treasury
security yields would reduce the carrying value of interest-sensitive securities at June
30, 1998 by $128 million, and a 10% decrease in market values would reduce the carrying
value of the Company’s publicly traded equity securities by $300 million. Many of
these equity securities are highly volatile stocks.
Intellectual property
rights
Microsoft diligently defends its intellectual
property rights, but unlicensed copying of software represents a loss of revenue to the
Company. While this adversely affects U.S. revenue, revenue loss is even more significant
outside of the United States, particularly in countries where laws are less protective of
intellectual property rights. Throughout the world, Microsoft actively educates consumers
on the benefits of licensing genuine products and educates lawmakers on the advantages of
a business climate where intellectual property rights are protected. However, continued
efforts may not affect revenue positively.
Future growth rate
The revenue growth rate in 1999 may not
approach the level attained in prior years. As discussed previously, operating expenses
are expected to increase in 1999. Because of the fixed nature of a significant portion of
such expenses, coupled with the possibility of slower revenue growth, operating margins in
1999 may decrease from those in 1998.
Litigation
Litigation regarding intellectual property
rights, patents, and copyrights occurs in the PC software industry. In addition, there are
government regulation and investigation risks along with other general corporate legal
risks.
Year 2000
The Year 2000 presents potential concerns for
business and consumer computing. The consequences of this issue may include systems
failures and business process interruption. It may also include additional business and
competitive differentiation. Aside from the well-known calculation problems with the use
of 2-digit date formats as the year changes from 1999 to 2000, the Year 2000 is a special
case leap year and in many organizations using older technology, dates were used for
special programmatic functions.
The problem exists for many
kinds of software and hardware, including mainframes, mini computers, PCs, and embedded
systems. Microsoft is in the process of gathering, testing, and producing information
about Microsoft technologies impacted by the Year 2000 transition. First, Microsoft
classified its core products into categories of compliance: compliant, compliant with
minor issues, and not compliant. Second, if a product is stated to be non-compliant,
Microsoft will provide information as to how an organization could bring that product into
compliance. Microsoft is issuing patches and/or workarounds at no additional charge for
most issues. Third, Microsoft is working to help organizations find solutions to Year 2000
problems. The technologies and services offered by Microsoft and companies it works with
can be components in overall Year 2000 solutions. Microsoft is assisting companies with
the task of recognizing how disparate technologies can fit together to create a viable
solution set.
Current information about the
Company’s product, business, and technical concerns is available at the Microsoft
Year 2000 Resource Center Web site.
The Web site also contains information about obtaining software patches to resolve various
Year 2000 issues in certain Microsoft products. Information on the Company’s Web site
is provided to customers for the sole purpose of assisting in planning for the transition
to the Year 2000. Such information is the most currently available concerning the behavior
of the Company’s products in the next century and is provided "as is"
without warranty of any kind. However, variability of definitions of
"compliance" with the Year 2000 and of different combinations of software,
firmware, and hardware will likely lead to lawsuits against the Company. The outcome of
such lawsuits and the impact on the Company are not estimable at this time.
The Year 2000 issue also
affects the Company’s internal systems, including information technology (IT) and
non-IT systems. Microsoft is assessing the readiness of its systems for handling the Year
2000. Although the assessment is still underway, management currently believes that all
material systems will be compliant by the Year 2000 and that the cost to address the
issues is not material. Nevertheless, Microsoft is creating contingency plans for certain
internal systems.
All organizations dealing
with the Year 2000 must address the effect this issue will have on their third-party
supply chain. Microsoft is undertaking steps to identify its vendors and to formulate a
system of working with key third-parties to understand their ability to continue providing
services and products through the change to 2000. Microsoft will work directly with its
key vendors, distributors, and resellers, and partner with them if necessary, to avoid any
business interruptions in 2000. For these key third-parties, contingency plans will be
developed.
Resolving Year 2000 issues is
a worldwide phenomenon that will likely absorb a substantial portion of IT budgets and
attention in the near term. Certain industry analysts believe the Year 2000 issue will
accelerate the trend toward distributed PC-based systems from mainframe systems, while
others believe a majority of IT resources will be devoted to fixing older mainframe
software in lieu of large-scale transitions to systems based on software such as that sold
by Microsoft. The impact of the Year 2000 on future Microsoft revenue is difficult to
discern but is a risk to be considered in evaluating future growth of the Company.
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