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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 1998
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From _____ to ____
Commission File Number 0-14278
MICROSOFT CORPORATION
(Exact name of registrant as specified in its charter)
WASHINGTON 91-1144442
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (425) 882-8080
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [_]
The number of shares outstanding of the registrant's common stock as of October
31, 1998 was 2,493,566,949.
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MICROSOFT CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 1998
INDEX
PART I. FINANCIAL INFORMATION
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Page
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Item 1. Financial Statements
a) Income Statements
for the Three Months Ended September 30, 1997 and 1998.. 1
b) Balance Sheets
as of June 30, 1998 and September 30, 1998.............. 2
c) Cash Flows Statements
for the Three Months Ended September 30, 1997 and 1998.. 3
d) Stockholders' Equity Statements
for the Three Months Ended September 30, 1997 and 1998.. 4
d) Notes to Financial Statements........................... 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.......................... 9
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................ 13
Item 6. Exhibits and Reports on Form 8-K............................. 13
SIGNATURE................................................................... 14
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Part I. Financial Information
ITEM 1. FINANCIAL STATEMENTS
MICROSOFT CORPORATION
Income Statements
(In millions, except earnings per share)(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended
Sept. 30
1997 1998
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<S> <C> <C>
Revenue $3,130 $3,953
Operating expenses:
Cost of revenue 253 307
Research and development 567 611
Acquired in-process technology 296 0
Sales and marketing 788 830
General and administrative 95 99
Other expenses 71 24
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Total operating expenses 2,070 1,871
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Operating income 1,060 2,082
Investment income 142 261
Gain on sale 0 160
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Income before income taxes 1,202 2,503
Provision for income taxes 539 820
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Net income 663 1,683
Preferred stock dividends 7 7
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Net income available for common shareholders $ 656 $1,676
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Earnings per share (1):
Basic $ 0.27 $ 0.68
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Diluted $ 0.25 $ 0.62
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</TABLE>
(1) Earnings per share amounts for the three months ended September 30, 1997
have been restated to reflect a two-for-one stock split in February 1998.
See accompanying notes.
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MICROSOFT CORPORATION
Balance Sheets
(In millions)
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June 30 Sept. 30
1998 1998 (1)
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ASSETS
Current assets:
Cash and short-term investments $13,927 $ 17,242
Accounts receivable 1,460 1,153
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Other 502 569
Total current assets 15,889 18,964
Property and equipment 1,505 1,466
Equity investments 4,703 4,905
Other assets 260 234
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Total assets $22,357 $ 25,569
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LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 759 $ 845
Accrued compensation 359 307
Income taxes payable 915 1,244
Unearned revenue 2,888 3,133
Other 809 916
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Total current liabilities 5,730 6,445
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Commitments and contingencies
Stockholders' equity:
Convertible preferred stock -
shares authorized 100; outstanding 13 980 980
Common stock and paid-in capital -
shares authorized 8,000; outstanding 2,470 and 2,488 8,025 9,161
Retained earnings 7,622 8,983
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Total stockholders' equity 16,627 19,124
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Total liabilities and stockholders' equity $22,357 $ 25,569
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</TABLE>
(1) Unaudited
See accompanying notes.
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MICROSOFT CORPORATION
Cash Flows Statements
(In millions)(Unaudited)
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Three Months Ended
Sept. 30
1997 1998
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<S> <C> <C>
OPERATIONS
Net income $ 663 $ 1,683
Depreciation and amortization 228 179
Write-off of acquired in-process technology 296 0
Gain on sale 0 (160)
Unearned revenue 533 1,010
Recognition of unearned revenue from prior periods (280) (765)
Other current liabilities 53 360
Accounts receivable 180 341
Other current assets 7 (64)
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Net cash from operations 1,680 2,584
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FINANCING
Common stock issued 207 316
Common stock repurchased (913) (504)
Put warrant proceeds 280 225
Preferred stock dividends (7) (7)
Stock option income tax benefits 199 591
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Net cash from (used for) financing (234) 621
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INVESTMENTS
Additions to property and equipment (117) (106)
Cash portion of WebTV purchase price (190) 0
Cash proceeds from sale of Softimage 0 79
Equity investments and other (455) (35)
Short-term investments (429) (1,810)
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Net cash used for investments (1,191) (1,872)
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Net change in cash and equivalents 255 1,333
Effect of exchange rates on cash and equivalents (16) 19
Cash and equivalents, beginning of period 3,706 3,839
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Cash and equivalents, end of period 3,945 5,191
Short-term investments, end of period 5,689 12,051
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Cash and short-term investments, end of period $ 9,634 $17,242
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</TABLE>
See accompanying notes.
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MICROSOFT CORPORATION
Stockholders' Equity Statements
(In millions)(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended
Sept. 30
1997 1998
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<S> <C> <C>
CONVERTIBLE PREFERRED STOCK $ 980 $ 980
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COMMON STOCK AND PAID-IN CAPITAL
Balance, beginning of period 4,509 8,025
Common stock issued 526 334
Common stock repurchased (50) (14)
Structured repurchases price differential 166 0
Proceeds from sale of put warrants 280 225
Stock option income tax benefits 199 591
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Balance, end of period 5,630 9,161
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RETAINED EARNINGS
Balance, beginning of period 5,288 7,622
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Net income 663 1,683
Net unrealized investments gains 56 150
Translation adjustments and other (117) 43
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Comprehensive income 602 1,876
Preferred stock dividends (7) (7)
Common stock repurchased (1,029) (508)
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Balance, end of period 4,854 8,983
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Total stockholders' equity $11,464 $19,124
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</TABLE>
See accompanying notes.
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MICROSOFT CORPORATION
Notes to Financial Statements
(Unaudited)
BASIS OF PRESENTATION
In the opinion of management, the accompanying balance sheets and related
interim statements of income, cash flows, and stockholders' equity include all
adjustments (consisting only of normal recurring items) necessary for their fair
presentation in conformity with generally accepted accounting principles.
Preparing financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenue,
and expenses. Examples include provisions for returns and bad debts and the
length of product life cycles and buildings' lives. Actual results may differ
from these estimates. Interim results are not necessarily indicative of results
for a full year. The information included in this Form 10-Q should be read in
conjunction with Management's Discussion and Analysis and financial statements
and notes thereto included in the Microsoft Corporation 1998 Form 10-K.
STOCK SPLIT
In February 1998, outstanding shares of common stock were split two-for-one.
All prior share and per share amounts have been restated to reflect the stock
split.
EARNINGS PER SHARE
Basic earnings per share is computed on the basis of the weighted average number
of common shares outstanding. Diluted earnings per share is computed on the
basis of the weighted average number of common shares outstanding plus the
effect of outstanding preferred shares using the "if-converted" method, assumed
net-share settlement of common stock structured repurchases, and outstanding
stock options using the "treasury stock" method.
The components of basic and diluted earnings per share were as follows:
Earnings Per Share
(In millions, except per share amounts)
<TABLE>
<CAPTION>
Three Months Ended
Sept. 30
1997 1998
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<S> <C> <C>
Net income (A) $ 663 $1,683
Preferred stock dividends (7) (7)
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Net income available for common shareholders (B) $ 656 $1,676
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Average outstanding shares of common stock (C) 2,410 2,479
Dilutive effect of:
Common stock under structured repurchases 0 8
Preferred stock 19 12
Employee stock options 236 218
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Common stock and common stock equivalents (D) 2,665 2,717
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Earnings per share:
Basic (B/C) $ 0.27 $ 0.68
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Diluted (A/D) $ 0.25 $ 0.62
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</TABLE>
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UNEARNED REVENUE
A portion of Microsoft's revenue is earned ratably over the product life cycle
or, in the case of subscriptions, over the period of the license agreement.
End-users receive certain elements of the Company's platform products over a
period of time. These elements include browser and other Internet technologies,
technical support, and unspecified product enhancements such as service
releases, new device drivers, and patches. Consequently, the Company recognizes
the fair value of these elements, currently approximately 20% of Microsoft(R)
Windows(R) 98 and Windows 95 desktop operating systems OEM revenue, and
approximately 35% of retail version revenue, over the product's life cycle.
Approximately 20% of Microsoft Windows NT(R) Workstation and Windows NT Server
revenue is also recognized ratably. Product life cycles are currently estimated
at two years. The Company also sells subscriptions to platforms products via
maintenance and organization license agreements. At September 30, 1998,
platform products unearned revenue was $1.70 billion.
Likewise, end-users of the Company's applications products receive elements over
time, including telephone support, new Internet technologies, service releases,
and patches. Fair value of these elements, which is currently approximately 20%
of Office 97 applications and server applications revenue, is recognized ratably
over the estimated 18-month product life cycle. The Company also sells
subscriptions to applications and tools products, including maintenance and
organization license programs. Unearned revenue associated with applications
and tools products totaled $1.38 billion at September 30, 1998.
Unearned revenue associated with other miscellaneous programs totaled $52
million at September 30, 1998.
STOCKHOLDERS' EQUITY
Microsoft repurchases its common stock in the open market to provide shares for
issuance to employees under stock option and stock purchase plans. During the
first quarter of fiscal 1999, the Company repurchased 5.1 million shares of
Microsoft common stock in the open market. In addition, the Company has
executed structured repurchases with an independent third party. Under these
arrangements, a portion of the purchase price will be paid in the next five or
six years and determined based upon the price of Microsoft common stock at that
time. The timing and method of payment (net-share or cash) is at the discretion
of the Company. The differential between the cash paid and the price of
Microsoft common stock on the date of the agreement is reflected in common stock
and paid-in capital. There were no structured repurchases during the first
quarter of fiscal 1999, and 11.7 million shares were purchased under these
arrangements during the first quarter of fiscal 1998.
To enhance its stock repurchase program, Microsoft sells put warrants to
independent third parties. These put warrants entitle the holders to sell
shares of Microsoft common stock to the Company on certain dates at specified
prices, and permit a net-share settlement at the Company's option. On September
30, 1998, 75 million warrants were outstanding. The outstanding put warrants
expire between March 1999 and September 2001 and have strike prices ranging from
$76 to $88 per share.
During 1996, Microsoft issued 12.5 million shares of 2.75% convertible
exchangeable principal-protected preferred stock. Dividends are payable
quarterly in arrears. Preferred shareholders have preference over common
stockholders in dividends and liquidation rights. In December 1999, each
preferred share is convertible into common shares or an equivalent amount of
cash determined by a formula that provides a floor price of $79.875 and a cap of
$102.24 per preferred share. Net proceeds of $980 million were used to
repurchase common shares.
ACQUISITION OF WEBTV
In August 1997, Microsoft acquired WebTV Networks, Inc., an online service that
enables consumers to experience the Internet through their televisions via set-
top terminals based on proprietary technologies. Microsoft paid $425 million in
stock and cash for WebTV. The Company recorded an in-process technologies
write-off of $296 million in the first quarter of 1998.
SALE OF SOFTIMAGE
In August 1998, the Company sold a wholly-owned subsidiary, Softimage, Inc. to
Avid Technology, Inc. Microsoft received cash of $79 million and securities
valued at $85 million. A pretax gain of $160 million was recognized in the
first quarter of 1999. As part of a transitional service agreement, Microsoft
agreed to make certain development tools and management systems available to
Avid for use in the Softimage business.
6
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CONTINGENCIES
On October 7, 1997, Sun Microsystems, Inc. brought suit against Microsoft in the
U.S. District Court for the Northern District of California. Sun's Complaint
alleges several claims against Microsoft, all related to the parties'
relationship under a March 11, 1996 Technology License and Distribution
Agreement (Agreement) concerning certain Java programming language technology.
The Complaint seeks: a preliminary and permanent injunction against Microsoft
distributing certain products with the Java Compatibility logo, and against
distributing Microsoft Internet Explorer 4.0 unless certain alleged obligations
are met; an order compelling Microsoft to perform certain alleged obligations;
an accounting; termination of the Agreement; and an award of damages, including
compensatory, exemplary and punitive damages, and liquidated damages of $35
million for the alleged source code disclosure.
On March 24, 1998, the court entered an order enjoining Microsoft from using the
Java Compatibility logo on Internet Explorer 4.0 and the Microsoft Software
Developers Kit for Java 2.0. Microsoft has complied with the order.
On May 12, 1998, Sun filed companion motions seeking a preliminary injunction
based on allegations of copyright infringement and unfair competition. Sun
requested an order enjoining Microsoft from distributing any Java-based
technology in any operating system, browser, or developers tools, including
Windows 98, Internet Explorer 4.0 software, and the Visual J++(TM) 6.0
development system for the Java language, unless and until Microsoft includes
with each such product an implementation of the Java run-time environment that
passes Sun's compatibility test suite or an operable implementation of Sun's
current Java run-time environment. Hearings on these motions were held in
September 1998. A decision on the motions is still pending. The parties are also
currently scheduled to file summary judgment motions regarding the
interpretation of the Agreement on January 23, 1999 that will be scheduled for
hearing after February 26, 1999.
On October 20, 1997, the Antitrust Division of the U.S. Department of Justice
(DOJ) filed a Petition for An Order To Show Cause in United States District
Court for the District of Columbia. In its petition, the DOJ contends that
Microsoft has violated a 1994 consent decree by including Internet Explorer
technology in Windows 95, and by preventing OEMs from removing Internet Explorer
functionality from versions of Windows 95 the OEMs are licensed to install on
computer systems they sell.
On December 11, 1997, the district court entered two orders. In the first order,
Judge Thomas Penfield Jackson denied the DOJ's contempt petition, and dismissed
the DOJ's request for relief concerning Microsoft's non-disclosure agreements
because the DOJ had failed to present evidence that the agreements had
interfered with any DOJ investigation. In addition, however, the court ruled
that there were disputed issues of fact regarding Microsoft's violation of the
consent decree, and concluded that the DOJ was likely to prevail on its claim
that a violation had occurred. The court entered a preliminary injunction sua
sponte requiring Microsoft not to condition the licensing of Windows 95 or any
successor desktop operating system on a computer manufacturer also licensing any
Microsoft browser software, including Internet Explorer 3.0 or 4.0. In the
second order, the court appointed Harvard Law Professor Lawrence Lessig as a
special master, to whom the court delegated the authority to conduct discovery,
take evidence, and make proposed findings of fact and conclusions of law on all
issues in the case by May 31, 1998.
Microsoft immediately appealed the preliminary injunction to the District of
Columbia Circuit Court of Appeals. On May 5, 1998, Microsoft also sought a stay
of the District Court's injunction insofar as it applied to Windows 98. On May
12, 1998, the Court of Appeals granted Microsoft's request for a stay. The Court
of Appeals issued an opinion on Microsoft's appeal on June 23, 1998. It
unanimously reversed the trial court, both as to the entry of the injunction and
the reference to the special master. The opinion both cited procedural errors in
the issuance of the injunction and errors of substantive law in the
interpretation of the consent decree. The court remanded the case to Judge
Jackson for further proceedings consistent with the Court's opinion. There has
been no further action in that case since the Court of Appeals' decision.
Although the Court of Appeals could have reversed the district court solely on
procedural grounds, it chose to address at length the central issue in both the
consent decree case and in the new Sherman Act case brought by the DOJ and 20
state Attorneys General: whether Microsoft is unlawfully "tying" a "separate
product" known as Microsoft Internet Explorer to the Windows operating system.
Two members of the
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Court rejected the DOJ's main argument that Internet Explorer constitutes a
separate product because Microsoft treats it separately in some circumstances.
(One judge dissented in part from the reasoning in this part of the opinion.)
The Court's discussion of antitrust tying law, although made in the context of
the consent decree case, clearly provides guidance on many of the issues raised
in the new Sherman Act case.
On May 18, 1998, the DOJ and a group of 20 state Attorneys General filed two
antitrust cases against Microsoft in the U.S. District Court for the District of
Columbia. The DOJ complaint alleges violations of Sections 1 and 2 of the
Sherman Act. The DOJ complaint seeks declaratory relief as to the violations it
asserts and preliminary and permanent injunctive relief regarding: the inclusion
of Internet browsing software (or other software products) as part of Windows;
the terms of agreements regarding non-Microsoft Internet browsing software (or
other software products); taking or threatening "action adverse" in consequence
of a person's failure to license or distribute Microsoft Internet browsing
software (or other software products) or distributing competing products or
cooperating with the government; and restrictions on the screens, boot-up
sequence, or functions of Microsoft's operating system products. The state
Attorneys General allege largely the same claims, and various pendent state
claims. The states seek declaratory relief, and preliminary and permanent
injunctive relief similar to that sought by the DOJ, together with statutory
penalties under the state law claims. The foregoing description is qualified in
its entirety by reference to the full text of the complaints and other papers on
file in those actions, case numbers 98-1232 and 98-1233.
On May 22, 1998, Judge Jackson consolidated the two actions. The judge granted
Microsoft's motion for summary judgment as to the states' monopoly leverage
claim, and permitted the remaining claims to proceed to trial. Trial began on
October 19, 1998. Microsoft believes the claims are without merit and is
defending against them vigorously. In other ongoing investigations, the DOJ and
several state Attorneys General have requested information from Microsoft
concerning various issues.
Caldera, Inc. filed a lawsuit against Microsoft in July 1996. It alleges Sherman
Act violations relating to Microsoft licensing practices of MS-DOS and Windows
in the late 80's and early 90's essentially the same complaints that resulted in
the 1994 consent decree. Caldera claims to own the rights of Novell, Inc. and
Digital Research Inc. relating to DR-DOS and Novell DOS products. It also
asserts a claim that Windows 95 is a technological tie of Windows and MS-DOS.
Fact discovery is scheduled to end in November 1998, and trial is scheduled for
June 1999. Microsoft is vigorously defending the case.
Microsoft is also subject to various legal proceedings and claims that arise in
the ordinary course of business.
Management currently believes that resolving these matters will not have a
material adverse impact on the Company's financial position or its results of
operations.
8
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
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; the MSN(TM) network of Internet products and services; and alliances
with companies involved with other forms of digital interactivity. Microsoft
also sells personal computer input devices and books, and researches and
develops advanced technologies for future software products.
REVENUE
Revenue of $3.95 billion in the September quarter of fiscal 1999 increased 26%
over the first quarter of fiscal 1998. Revenue growth, while slowing, reflected
the continued adoption of Microsoft Windows 32-bit operating systems and
Microsoft Office 97, particularly as Microsoft software is deployed across
entire 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
programs 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 and BackOffice, are less than the
sum of the prices for the individual programs included in these suites when such
programs are licensed separately. An increased percentage of products and
programs included elements which were billed but unearned and recognized
ratably, such as platforms and applications programs, maintenance, and other
subscription models. See accompanying notes to financial statements.
Quarterly revenue is categorized by new product group and channel
classifications that correspond to internal reporting alignments. Prior period
revenue has been restated to conform to the new presentation and to provide a
basis for comparisons. Revenue is presented for three product groups:
Platforms; Applications and Tools; and Interactive Media and Other. Sales
channels are Original Equipment Manufacturers (OEM); the South Pacific and
Americas Region; the Europe, Middle East, and Africa Region; and the Asia
Region.
PRODUCT GROUPS
Platform product revenue grew 38% to $1.93 billion in the first quarter.
Windows units licensed through the OEM channel, including Windows 95, Windows
98, and Windows NT Workstation, increased strongly over the prior year. Retail
versions of Windows 98, which was released in June 1998, also contributed to the
growth. The revenue growth rate for Windows NT Server was healthy, but continued
to slow. Although revenue was not significant, sales of WebTV-based Internet X
terminals and WebTV service and preinstallations of Windows CE by OEMs on
intelligent devices were strong in 1998.
Applications and Tools product revenue increased 21% to $1.71 billion in the
September quarter. Desktop applications revenue growth was strong, led by
Microsoft Office integrated suites, including the Standard, Professional, and
Small Business Editions. The primary programs in Microsoft Office are the word
processor Microsoft Word, Microsoft Excel spreadsheet, and Microsoft
PowerPoint(R) presentation graphics program. Various versions of Office, which
are available for 32-bit versions of Windows, 16-bit versions of Windows, and
Macintosh operating systems, also include Microsoft Access database management
program, Microsoft Outlook(R) messaging and collaboration client, or other
programs. Microsoft Project 98 also contributed to the quarterly desktop
applications growth. Server applications revenue, including Microsoft Exchange
Server and Microsoft SQL Server(TM), continued to slow from the rapid growth
rates experienced in prior quarters. The Visual Studio(R) 6.0 development
system, an integrated set of software development tools, was recently released,
leading to healthy tools shipments.
Interactive Media and Other revenue was $316 million, down slightly from the
comparable quarter of fiscal 1998. Revenue from Microsoft Press; hardware; and
learning, entertainment, and productivity titles was relatively flat. Although
not material, revenue from desktop finance products and interactive online
services increased from the prior year.
9
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SALES CHANNELS
Microsoft distributes its products primarily through OEM licenses,
organizational licenses, and retail packaged products. OEM channel revenue
represents license fees from original equipment manufacturers who pre-install
Microsoft products, primarily on PCs. Microsoft has three major geographic
sales and marketing organizations: the South Pacific and Americas Region; the
Europe, Middle East, and Africa Region; and the Asia Region. 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 organizational licensing versus packaged products.
First quarter revenue from OEMs of $1.37 billion represented an increase of 39%
over the comparable quarter of fiscal 1998. PC shipment growth coupled with an
increased penetration of higher value 32-bit operating systems drove the OEM
revenue increase over the prior year.
For the September quarter, revenue in the South Pacific and Americas Region
increased 29% to $1.44 billion. This high growth rate reflected the launch of
Windows 98 and strong sales of integrated suites of desktop applications,
particularly through organization license programs. In addition to steady
growth in the U.S., revenue increased strongly in Brazil and Australia.
In the Europe, Middle East, and Africa Region, first quarter revenue of $839
million was up 23% compared to the first quarter of fiscal 1998. Organizational
licensing of desktop applications grew strongly when compared to the prior year.
Revenue growth was solid in Germany, the United Kingdom, and France, and
particularly high in Sweden, Spain, and Poland.
Revenue in the Asia Region in the September quarter of $307 million decreased
11% from the first quarter of the prior year. Revenue was flat in Japan and
decreased in Southeast Asia due to economic issues and weak currencies. As
discussed below, the strengthening U.S. dollar negatively impacted translated
revenue compared to the prior year, particularly in Japan.
Translated international revenue is effected by foreign exchange rates. Had the
rates from the prior year been in effect in the first quarter of fiscal 1999,
international revenue billed in local currencies would have been $100 million
higher, due to weaknesses in currencies versus the U.S. dollar. Certain
manufacturing, marketing, distribution, and support costs are disbursed in local
currencies, and a portion of international revenue is hedged, thus offsetting a
portion of the translation exposure.
OPERATING EXPENSES, NONOPERATING ITEMS, AND INCOME TAXES
Cost of revenue as a percent of revenue decreased to 7.8% in the first quarter
from 8.1% in the prior year. 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 servers and client access licenses in the
BackOffice(R) product family, offset by costs of WebTV.
Research and development expenses increased 8% in the first quarter to $611
million, driven primarily by higher development headcount-related costs, offset
by lower third-party development costs.
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 for WebTV.
Fiscal 1998 results reflect a one-time write-off of in-process technologies
under development by WebTV Networks of $296 million.
Sales and marketing expenses were $830 million in the September quarter which
represented 21.0% of revenue, compared to 25.2% in the first quarter of the
prior year. The total expense as a percent of revenue decreased due to lower
relative sales expenses and marketing.
General and administrative costs were $99 million in the first quarter compared
to $95 million in the September quarter of the prior year, increasing, in part,
due to higher legal costs.
Other expenses include primarily the recognition of Microsoft's share of joint
venture activities, including DreamWorks Interactive and the MSNBC entities.
First quarter investment income increased to $261 million from $142 million in
the first quarter of the prior year. The increase was due to the larger
investment portfolio generated by cash from operations.
In August 1998, Microsoft sold its Softimage subsidiary to Avid Technology, Inc.
A pretax gain of $160 million was recorded in the first quarter of fiscal 1999.
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Excluding the tax impact of the gain on the sale of Softimage, the effective tax
rate for the September quarter was 35%, less than the 45% rate in the first
quarter of fiscal 1998 due to a legislative clarification of the foreign sales
corporation rules as they apply to software and the nondeductible write-off of
WebTV in-process technologies.
NET INCOME
Net income for the first quarter of fiscal 1999 was $1.68 billion. Excluding
the gain on the sale of Softimage in the first quarter fiscal 1999, net income
of $1.52 billion represented 38.5% of revenue. Excluding the write-off of WebTV
in-process technologies in the first quarter of fiscal 1998, net income of $959
million represented 30.6% of revenue. The increase in net income as a percent
of revenue was due to lower relative operating expenses and higher investment
income.
FINANCIAL CONDITION
Microsoft's cash and short-term investment portfolio totaled $17.24 billion at
September 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 September 30, 1998 was $19.12 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 $360
million on September 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 352 million common shares while 830 million shares were issued
under the Company's employee stock option and purchase plans. The market value
of all outstanding stock options was $50 billion as of September 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.
11
<PAGE>
YEAR 2000
The Year 2000 presents concerns for business and consumer computing. Aside from
the well-known problems with the use of certain 2-digit date formats as the year
changes from 1999 to 2000, the Year 2000 is a special case leap year, and dates
such as 9/9/99 were used by certain organizations for special functions. The
problem exists for many kinds of software and hardware, including mainframes,
mini-computers, PCs, and embedded systems. The consequences of the Year 2000
issue may include systems failures and business process interruption.
Microsoft is continuing to test its products and gather and produce information
about Microsoft technologies impacted by the Year 2000 transition. Certain
older products will not be tested. First, Microsoft is classifying its tested
products into categories of compliance: compliant, compliant with minor issues,
and not compliant. Most of the products tested are either compliant or
compliant with minor issues, as defined. Second, if a product is stated to be
non-compliant, Microsoft plans to provide information as to how an organization
could avoid possible Year 2000 issues regarding that product. Microsoft is
issuing patches and/or workarounds (at no additional charge) for most, but not
all, known issues. Third, Microsoft is working to help organizations find
solutions to Year 2000 problems, including technologies and services offered by
Microsoft and other companies. 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 products and business and technical
issues is available at the Microsoft Year 2000 Resource Center web site
(www.microsoft.com/year2000). 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, and has started the
remediation and certification process. Although assessment, testing, and
remediation 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 critical processes that rely on internal systems.
Microsoft is undertaking steps to identify its third-party supply chain and
vendors and 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 direct resellers to avoid any business interruptions
in 2000. For major third-parties with known issues, 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. Others believe a majority
of IT financial resources will be devoted to fixing older mainframe software in
lieu of funding purchases of PC software or 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.
12
<PAGE>
Part II. Other Information
ITEM 1. LEGAL PROCEEDINGS
See notes to financial statements.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) Exhibits
27. Financial Data Schedule
(B) Reports on Form 8-K
Microsoft filed no reports on Form 8-K during the quarter ended September
30, 1998.
ITEMS 2, 3, 4, AND 5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.
13
<PAGE>
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Microsoft Corporation
Date: November 12, 1998 By: /s/ Gregory B. Maffei
---------------------
Gregory B. Maffei,
Vice President, Finance;
Chief Financial Officer
(Principal Financial and Accounting
Officer and Duly Authorized Officer)
14
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
ACCOMPANYING FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> SEP-30-1998
<PERIOD-END> SEP-30-1998
<CASH> 17,242
<SECURITIES> 0
<RECEIVABLES> 1,153
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 18,964
<PP&E> 3,152
<DEPRECIATION> 1,686
<TOTAL-ASSETS> 25,569
<CURRENT-LIABILITIES> 6,445
<BONDS> 0
0
980
<COMMON> 9,161
<OTHER-SE> 8,983
<TOTAL-LIABILITY-AND-EQUITY> 25,569
<SALES> 3,953
<TOTAL-REVENUES> 3,953
<CGS> 307
<TOTAL-COSTS> 307
<OTHER-EXPENSES> 1,564
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 2,503
<INCOME-TAX> 820
<INCOME-CONTINUING> 1,683
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<EPS-PRIMARY> .68
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