<PAGE>
================================================================================
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, 2000
[ ] 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, 2000 was 5,332,337,924.
================================================================================
<PAGE>
MICROSOFT CORPORATION
FORM 10-Q
For the Quarter Ended September 30, 2000
INDEX
<TABLE>
<CAPTION>
Part I. Financial Information
Item 1. Financial Statements Page
----
<S> <C>
a) Income Statements
for the Three Months Ended September 30, 1999 and 2000... 3
b) Balance Sheets
as of June 30, 2000 and September 30, 2000............... 4
c) Cash Flows Statements
for the Three Months Ended September 30, 1999 and 2000... 5
d) Stockholders' Equity Statements
for the Three Months Ended September 30, 1999 and 2000... 6
e) Notes to Financial Statements............................ 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations...................... 13
Item 3. Quantitative and Qualitative Disclosures About
Market Risk.............................................. 17
Part II. Other Information
Item 1. Legal Proceedings........................................ 18
Item 2. Changes in Securities and Use of Proceeds................ 18
Item 6. Exhibits and Reports on Form 8-K......................... 18
Signature............................................................... 19
</TABLE>
<PAGE>
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
1999 2000
----------------------------------------------------------------------------------------
<S> <C> <C>
Revenue $5,384 $5,800
Operating expenses:
Cost of revenue 712 859
Research and development 813 956
Sales and marketing 922 1,038
General and administrative 148 170
----------------------------------------------------------------------------------------
Total operating expenses 2,595 3,023
----------------------------------------------------------------------------------------
Operating income 2,789 2,777
Losses on equity investees and other (19) (52)
Investment income 550 1,127
----------------------------------------------------------------------------------------
Income before income taxes 3,320 3,852
Provision for income taxes 1,129 1,271
----------------------------------------------------------------------------------------
Income before accounting change 2,191 2,581
Cumulative effect of accounting change (net of
income taxes of $185) - (375)
----------------------------------------------------------------------------------------
Net income $2,191 $2,206
========================================================================================
Basic earnings per share:
Before accounting change $ 0.43 $ 0.49
Cumulative effect of accounting change - (0.07)
----------------------------------------------------------------------------------------
$ 0.43 $ 0.42
========================================================================================
Diluted earnings per share:
Before accounting change $ 0.40 $ 0.46
Cumulative effect of accounting change - (0.06)
----------------------------------------------------------------------------------------
$ 0.40 $ 0.40
========================================================================================
Average shares outstanding:
Basic 5,129 5,299
----------------------------------------------------------------------------------------
Diluted 5,527 5,557
========================================================================================
</TABLE>
See accompanying notes.
3
<PAGE>
MICROSOFT CORPORATION
Balance Sheets
(In millions)
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
June 30 Sept. 30
2000 2000 (1)
-----------------------------------------------------------------------------------------------------------
<S> <C> <C>
Assets
Current assets:
Cash and equivalents $ 4,846 $ 2,641
Short-term investments 18,952 22,070
-----------------------------------------------------------------------------------------------------------
Total cash and short-term investments 23,798 24,711
Accounts receivable 3,250 3,172
Deferred income taxes 1,708 1,734
Other 1,552 1,776
-----------------------------------------------------------------------------------------------------------
Total current assets 30,308 31,393
Property and equipment, net 1,903 1,973
Equity and other investments 17,726 20,525
Other assets 2,213 2,198
-----------------------------------------------------------------------------------------------------------
Total assets $52,150 $56,089
===========================================================================================================
Liabilities and stockholders' equity
Current liabilities:
Accounts payable $ 1,083 $ 1,101
Accrued compensation 557 420
Income taxes 585 442
Unearned revenue 4,816 4,766
Other 2,714 2,577
-----------------------------------------------------------------------------------------------------------
Total current liabilities 9,755 9,306
-----------------------------------------------------------------------------------------------------------
Deferred income taxes 1,027 1,440
-----------------------------------------------------------------------------------------------------------
Commitments and contingencies
Stockholders' equity:
Common stock and paid-in capital -
shares authorized 12,000; outstanding 5,283 and 5,316 23,195 26,661
Retained earnings, including accumulated other comprehensive
income of $1,527 and $1,459 18,173 18,682
-----------------------------------------------------------------------------------------------------------
Total stockholders' equity 41,368 45,343
-----------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $52,150 $56,089
===========================================================================================================
</TABLE>
(1) Unaudited
See accompanying notes.
4
<PAGE>
MICROSOFT CORPORATION
Cash Flows Statements
(In millions)(Unaudited)
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Three Months Ended
Sept. 30
1999 2000
----------------------------------------------------------------------------------------------------------
<S> <C> <C>
Operations
Net income $ 2,191 $ 2,206
Cumulative effect of accounting change, net of tax - 375
Depreciation, amortization, and other noncash items 345 250
Recognized net gains on investments (200) (599)
Stock option income tax benefits 1,215 453
Deferred income taxes (427) 608
Unearned revenue 1,253 1,457
Recognition of unearned revenue from prior periods (1,363) (1,507)
Accounts receivable 64 116
Other current assets (94) (211)
Other long-term assets (209) (61)
Other current liabilities 82 (127)
----------------------------------------------------------------------------------------------------------
Net cash from operations 2,857 2,960
----------------------------------------------------------------------------------------------------------
Financing
Common stock issued 461 375
Common stock repurchased (1,034) (1,752)
Put warrant proceeds 290 81
Preferred stock dividends (7) -
----------------------------------------------------------------------------------------------------------
Net cash used for financing (290) (1,296)
----------------------------------------------------------------------------------------------------------
Investing
Additions to property and equipment (139) (245)
Purchases of investments (7,035) (13,723)
Maturities of investments 786 1,570
Sales of investments 3,616 8,462
----------------------------------------------------------------------------------------------------------
Net cash used for investing (2,772) (3,936)
----------------------------------------------------------------------------------------------------------
Net change in cash and equivalents (205) (2,272)
Effect of exchange rates on cash and equivalents 19 67
Cash and equivalents, beginning of period 4,975 4,846
----------------------------------------------------------------------------------------------------------
Cash and equivalents, end of period $ 4,789 $ 2,641
==========================================================================================================
</TABLE>
See accompanying notes.
5
<PAGE>
MICROSOFT CORPORATION
Stockholders' Equity Statements
(In millions)(Unaudited)
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Sept. 30
1999 2000
----------------------------------------------------------------------------------------------
<S> <C> <C>
Convertible preferred stock
Balance $ 980 $ -
----------------------------------------------------------------------------------------------
Common stock and paid-in capital
Balance, beginning of period 13,844 23,195
Common stock issued 567 3,055
Common stock repurchased (38) (123)
Proceeds from sale of put warrants 290 81
Stock option income tax benefits 1,215 453
----------------------------------------------------------------------------------------------
Balance, end of period 15,878 26,661
----------------------------------------------------------------------------------------------
Retained earnings
Balance, beginning of period 13,614 18,173
----------------------------------------------------------------------------------------------
Net income 2,191 2,206
Other comprehensive income:
Cumulative effect of accounting change - (75)
Net gain on derivative instruments - 432
Net unrealized investment losses (344) (484)
Translation adjustments and other 24 59
----------------------------------------------------------------------------------------------
Comprehensive income 1,871 2,138
Preferred stock dividends (7) -
Common stock repurchased (996) (1,629)
----------------------------------------------------------------------------------------------
Balance, end of period 14,482 18,682
----------------------------------------------------------------------------------------------
Total stockholders' equity $31,340 $45,343
==============================================================================================
</TABLE>
See accompanying notes.
6
<PAGE>
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, as well as the
accounting change to adopt Statement of Financial Accounting Standards (SFAS)
133, Accounting for Derivative Instruments and Hedging Activities, necessary for
their fair presentation in conformity with U.S. 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, concessions 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
2000 Form 10-K. Certain reclassifications have been made for consistent
presentation.
Accounting Change
Effective July 1, 2000, Microsoft adopted SFAS 133, which establishes accounting
and reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts and for hedging activities. All
derivatives, whether designated in hedging relationships or not, are required to
be recorded on the balance sheet at fair value. If the derivative is designated
as a fair value hedge, the changes in the fair value of the derivative and of
the hedged item attributable to the hedged risk are recognized in earnings. If
the derivative is designated as a cash flow hedge, the effective portions of
changes in the fair value of the derivative are recorded in other comprehensive
income (OCI) and are recognized in the income statement when the hedged item
affects earnings. Ineffective portions of changes in the fair value of cash flow
hedges are recognized in earnings.
The adoption of SFAS 133 resulted in a pre-tax reduction to income of $560
million ($375 million after-tax) and a pre-tax reduction to OCI of $112 million
($75 million after-tax). The reduction to income is mostly attributable to a
loss of approximately $300 million reclassified from OCI for the time value of
options and a loss of approximately $250 million reclassified from OCI for
derivatives not designated as hedging instruments. The reduction to OCI is
mostly attributable to losses of approximately $670 million on cash flow hedges
offset by reclassifications out of OCI of the approximately $300 million
loss for the time value of options and the approximately $250 million loss for
derivative instruments not designated as hedging instruments. The net derivative
losses included in OCI as of July 1, 2000, will be reclassified into earnings
during the twelve months ended June 30, 2001.
The Company uses derivative instruments to manage exposures to foreign currency,
securities price, and interest rate risks. The Company's objectives for holding
derivatives are to minimize the risks using the most effective methods to
eliminate or reduce the impacts of these exposures.
Foreign Currency Risk
Certain forecasted transactions and assets are exposed to foreign currency risk.
The Company monitors its foreign currency exposures daily to maximize the
overall effectiveness of its foreign currency hedge positions. Principal
currencies hedged include the Euro, Japanese yen, British pound, and Canadian
dollar. Options used to hedge a portion of forecasted international revenue for
up to two years in the future are designated as cash flow hedging instruments.
Options and forwards not designated as hedging instruments under SFAS 133 are
also used to hedge the impact of the variability in exchange rates on accounts
receivable and collections denominated in certain foreign currencies.
Securities Price Risk
Strategic equity investments are subject to market price risk. From time to
time, the Company uses and designates options to hedge fair values and cash
flows, respectively, on certain equity securities. The security, or forecasted
sale thereof, selected for hedging is determined by market conditions, up-front
costs, and other relevant factors. Once established, the hedges are not
dynamically managed or traded, and are generally not removed until maturity.
Interest Rate Risk
Fixed-income securities are subject to interest rate risk. The fixed-income
portfolio is diversified and consists primarily of investment grade securities
to minimize credit risk. The Company routinely uses options, not designated as
hedging instruments, to hedge its exposure to interest rate risk in the event of
a catastrophic increase in interest rates.
7
<PAGE>
Other Derivatives
In addition, the Company may invest in warrants to purchase securities of other
companies as a strategic investment. Warrants that can be net share settled are
deemed derivative financial instruments and are not designated as hedging
instruments.
For options designated either as fair value or cash flow hedges, changes in the
time value are excluded from the assessment of hedge effectiveness. Hedge
ineffectiveness, determined in accordance with SFAS 133, had no impact on
earnings for the three months ended September 30, 2000. No fair value hedges or
cash flow hedges were derecognized or discontinued for the three months ended
September 30, 2000.
For the three months ended September 30, 2000, investment income included a net
gain of $20 million, comprised of a $207 million gain for changes in the time
value of options for fair value hedges, $6 million loss for changes in the time
value of options for cash flow hedges, and $181 million loss for changes in the
fair value of derivative instruments not designated as hedging instruments.
Derivative gains and losses included in OCI are reclassified into earnings at
the time forecasted revenue or the sale of an equity investment is recognized.
During the three months ended September 30, 2000, $29 million of derivative
gains were reclassified to revenue and $390 million of derivative losses were
reclassified to investment income. The derivative losses reclassified to
investment income were offset by gains on the item being hedged. The Company
estimates that $25 million of net derivative losses included in other
comprehensive income will be reclassified into earnings within the next twelve
months.
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,
outstanding put warrants using the "reverse treasury stock" method, 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 earnings per share)
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Three Months Ended
Sept. 30
1999 2000
-----------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Income before accounting change (A) $2,191 $2,581
Preferred stock dividends (7) -
-----------------------------------------------------------------------------------------------
Income available for common shareholders (B) 2,184 2,581
Cumulative effect of accounting change - (375)
-----------------------------------------------------------------------------------------------
Net income available for common shareholders $2,184 $2,206
===============================================================================================
Average outstanding shares of common stock (C) 5,129 5,299
Dilutive effect of:
Put warrants - 10
Preferred stock 14 -
Employee stock options 384 248
-----------------------------------------------------------------------------------------------
Common stock and common stock equivalents (D) 5,527 5,557
===============================================================================================
Earnings per share before accounting change:
Basic (B/C) $ 0.43 $ 0.49
===============================================================================================
Diluted (A/D) $ 0.40 $ 0.46
===============================================================================================
</TABLE>
8
<PAGE>
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 products over a period of
time. These elements include browser technologies and technical support.
Consequently, Microsoft's earned revenue reflects the recognition of the fair
value of these elements over the product's life cycle. The percentage of revenue
recognized ratably ranges from approximately 15% to 25% of Windows desktop
operating systems and approximately 10% to 20% of desktop applications,
depending on the terms and conditions of the license and prices of the elements.
Product life cycles are currently estimated at three years for Windows operating
systems and 18 months for desktop applications. The Company also sells
subscriptions to certain products via maintenance and certain organization
license agreements. At June 30, 2000 and September 30, 2000, Desktop
Applications unearned revenue was $1.84 billion and $1.68 billion, unearned
revenue associated with Desktop Platforms totaled $2.34 billion and $2.36
billion, and Enterprise Software and Services unearned revenue was $433 million
and $400 million. Unearned revenue associated with Consumer Software, Services,
and Devices and Other totaled $200 million and $328 million at June 30, 2000 and
September 30, 2000.
Stockholders' Equity
In August 2000, the Company announced a share repurchase program that provides
shares for issuance to employees under the Company's stock option and stock
purchase programs. During the first quarter of fiscal 2000 and 2001, the Company
repurchased 12.1 million and 25.5 million shares of Microsoft common stock.
To enhance its share 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.
On September 30, 2000, warrants to put 157 million shares were outstanding with
strike prices ranging from $70 to $78 per share. The put warrants expire between
December 2000 and March 2003. The outstanding put warrants permit a net-share
settlement at the Company's option and do not result in a put warrant liability
on the balance sheet.
During 1996, Microsoft issued 12.5 million shares of 2.75% convertible
exchangeable principal-protected preferred stock. The Company's convertible
preferred stock matured on December 15, 1999. Each preferred share was converted
into 1.1273 common shares.
Operational Transactions
In July 2000, the Company acquired a 22.98% shareholding in Telewest
Communications plc for approximately $2.6 billion in stock. Telewest is a
leading broadband cable communications operator in the United Kingdom.
Microsoft's investment in Telewest has been recorded as a cost method investment
as the contractual arrangements preclude Microsoft from exerting significant
influence over Telewest.
Investment Income
The components of investment income are as follows:
<TABLE>
<CAPTION>
Three Months Ended
Sept. 30
(In millions) 1999 2000
--------------------------------------------------------------------
<S> <C> <C>
Dividends $ 85 $ 97
Interest 265 431
Recognized net gains on investments 200 599
--------------------------------------------------------------------
Investment income $550 $1,127
====================================================================
</TABLE>
Contingencies
On October 7, 1997, Sun Microsystems, Inc. ("Sun") 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.
9
<PAGE>
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 (SDK) for Java 2.0. Microsoft has taken steps to fully comply
with the order.
On November 17, 1998, the Court entered an order granting Sun's request for a
preliminary injunction, holding that Sun had established a likelihood of success
on its copyright infringement claims, because Microsoft's use of Sun's
technology in its products was beyond the scope of the parties' license
agreement. The Court ordered Microsoft to make certain changes in its products
that include Sun's Java technology and to make certain changes in its Java
software development tools. The Court also enjoined Microsoft from entering into
any licensing agreements that were conditioned on exclusive use of Microsoft's
Java Virtual Machine. Microsoft appealed that ruling to the 9th Circuit Court of
Appeals on December 16, 1998.
On August 23, 1999 the 9th Circuit Court of Appeals vacated the November 1998
preliminary injunction and remanded the case to the District Court for further
proceedings. Sun immediately filed two motions to reinstate and expand the scope
of the earlier injunction on the basis of copyright infringement and unfair
competition. On January 25, 2000, the Court issued rulings on the two motions,
denying Sun's motion to reinstate the preliminary injunction on the basis of
copyright infringement and granting, in part, Sun's motion to reinstate the
preliminary injunction based on unfair competition. Microsoft is in compliance
with the terms of the partially reinstated preliminary injunction and will not
need to undertake any further action to comply with the terms of the injunction.
No trial date has been set.
The parties have filed multiple summary judgment motions on the interpretation
of the Agreement and on Sun's copyright and trademark infringement claims. On
February 25, 2000, the Court entered an order denying both parties' motions for
summary judgment as to whether the Agreement authorizes Microsoft to distribute
independently developed Java Technology. On April 5, 2000, the Trial Court
entered an order denying Sun's motion for summary judgment regarding the
interpretation of Section 2.7(a), which sets forth certain requirements that Sun
must meet when they deliver Java Technology to Microsoft. On May 9, 2000, the
Court entered an order granting Microsoft's motion to dismiss Sun's copyright
infringement claim. On May 25, and October 12, 2000, the Court also issued
tentative orders on many of the remaining summary judgment motions. These
motions will be set for oral argument at a hearing in December, 2000.
On May 18, 1998, the Antitrust Division of the U.S. Department of Justice (DOJ)
and a group of 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 product) 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 and ended with closing arguments on September 21, 1999. On
November 5, 1999, Judge Jackson issued his Findings of Fact. On April 3, 2000
the Court entered its Conclusions of Law, determining that Microsoft "tied"
Internet Explorer and Windows 95/98 in violation of Section 1 of the Sherman
Act, that Microsoft violated Section 2 of the Sherman Act by taking actions to
maintain its monopoly in the desktop-PC operating system market, and that
Microsoft attempted to monopolize the Internet browser market in violation of
Section 2 of the Sherman Act. The Court also held that Microsoft did not violate
Section 1 of the Sherman Act by entering into a number of contracts challenged
by the government. The Court established a schedule for consideration of the
remedy to be imposed in a final judgment. On April 28, 2000, the plaintiffs
submitted a joint proposed remedy that included a proposed break-up of Microsoft
into two companies, an operating systems company, and a company that would own
all of Microsoft's other products and businesses. Microsoft submitted its
proposed remedy and its proposal for further remedy proceedings on May 10, 2000.
On June 7, 2000, Judge Jackson entered the government's proposed order nearly
verbatim as his final judgment in the case. That judgment orders a divestiture
10
<PAGE>
that will create two separate companies, an "Operating Systems Business" and an
"Applications Business," to be implemented one year following a final decision
on appeal. It also provides for a broad range of "conduct" remedies that would
have gone into effect in 90 days, absent a stay. On June 13, 2000, Microsoft
appealed to the United States Court of Appeals. The Court of Appeals immediately
entered an order notifying the parties that the Court would hear all matters
related to this appeal en banc. The government then asked Judge Jackson to enter
an order certifying the case for direct appeal to the Supreme Court. On June 20,
2000, Judge Jackson certified the case for direct appeal to the Supreme Court
and simultaneously granted Microsoft's request to stay the entire remedy pending
final appeal. On September 26, 2000 the Supreme Court remanded Microsoft's
appeal to the Court of Appeals. Microsoft's opening brief to the Court of
Appeals is due on November 27, 2000. The government's brief is due on January
12, 2001, and Microsoft's reply is due on January 29, 2001. The Court has set
oral arguments on the appeals for February 26 and 27, 2001.
In other ongoing investigations, the DOJ and several state Attorneys General
have requested information from Microsoft concerning various issues. In
addition, the European Commission has instituted proceedings in which it alleges
that Microsoft has failed to disclose information that Sun claims it needs to
interoperate fully with Windows 2000 clients and has engaged in discriminatory
licensing of such technology. The remedies sought, though not fully defined,
include mandatory disclosure of Microsoft intellectual property concerning
Windows operating systems and imposition of fines. Microsoft denies the European
Commission's allegations and intends to contest the proceedings vigorously.
A large number of antitrust class action lawsuits have been initiated against
Microsoft. These cases allege that Microsoft has competed unfairly and
unlawfully monopolized alleged markets for operating systems and certain
software applications and seek to recover alleged overcharges that the
complaints contend Microsoft charged for these products. Microsoft believes the
claims are without merit and is vigorously defending the cases.
The Securities and Exchange Commission is conducting a non-public investigation
into the Company's accounting reserve practices. 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.
11
<PAGE>
Segment Information
(In millions)
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Desktop and Consumer
Enterprise Software, Consumer
Three Months Software Services, Commerce Reconciling
Ended Sept. 30 and Services and Devices Investments Other Amounts Consolidated
-------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
1999
Revenue $4,922 $ 332 $ 18 $154 $ (42) $5,384
Operating income (loss) 3,477 (173) (12) 2 (505) 2,789
-------------------------------------------------------------------------------------------------------------------------------
2000
Revenue $5,119 $ 463 $ 97 $156 $ (35) $5,800
Operating income (loss) 3,385 (261) (39) 20 (328) 2,777
-------------------------------------------------------------------------------------------------------------------------------
</TABLE>
Desktop and Enterprise Software and Services Revenue:
<TABLE>
<CAPTION>
Three Months Ended
Sept. 30
(In millions) 1999 2000
-------------------------------------------------------------------------------
<S> <C> <C>
Desktop Applications $2,233 $2,075
Desktop Platforms 1,779 1,992
-------------------------------------------------------------------------------
Desktop Software 4,012 4,067
Enterprise Software and Services 910 1,052
-------------------------------------------------------------------------------
Total Desktop and Enterprise Software
and Services $4,922 $5,119
===============================================================================
</TABLE>
In September 2000, Microsoft disclosed new segments to reflect the re-
organization around Microsoft .NET, the Company's vision for the next-generation
of Internet-based products and services. Prior year disclosures have been
restated for consistent presentation. Microsoft has four segments: Desktop and
Enterprise Software and Services; Consumer Software, Services, and Devices;
Consumer Commerce Investments; and Other. Desktop and Enterprise Software and
Services operating segment includes Desktop Applications, Desktop Platforms, and
Enterprise Software and Services. Desktop Applications include Microsoft Office,
Project, Visio, and client access licenses for Windows NT Server/2000, Exchange,
and BackOffice. Desktop Platforms include Windows 2000 Professional, Windows NT
Workstation, Windows Millennium Edition (Windows Me), Windows 98, and other
desktop operating systems. Enterprise Software and Services includes Windows NT
Server and Windows 2000 Server operating systems, SQL Server and client access
licenses, Exchange Server, developer tools, consulting services, product support
services, and training and certification. Consumer Software, Services, and
Devices operating segment includes MSN Internet access, MSN network services,
WebTV Internet access and services, gaming, learning and productivity software,
mobile and wireless devices, and embedded systems. Consumer Commerce Investments
operating segment includes Expedia, Inc., the HomeAdvisor online real estate
service, and the CarPoint online automotive service. Other primarily includes
Hardware and Press. Assets of the segments are not relevant for management of
the businesses nor for disclosure.
Segment information is presented in accordance with SFAS 131, Disclosures about
Segments of an Enterprise and Related Information. This standard is based on a
management approach, which requires segmentation based upon the Company's
internal organization and disclosure of revenue and operating income based upon
internal accounting methods. The Company's financial reporting systems present
various data for management to run the business, including profit and loss
statements (P&Ls) prepared on a basis not consistent with U.S. generally
accepted accounting principles. Reconciling items for revenue include certain
elements of unearned revenue and the treatment of certain channel inventory
amounts and estimates. In addition to the reconciling items for revenue,
reconciling items for operating income (loss) include general and administrative
expenses ($148 million in 1999 and $170 million in 2000), employee stock option
expense recognized in accordance with APB 25 ($69 million in 1999 and $90
million in 2000), certain research expenses ($36 million in 1999 and $39 million
in 2000), and other corporate level adjustments. The internal P&Ls use
accelerated methods of depreciation and amortization. Additionally, losses on
equity investees are classified in operating income for internal reporting
presentations.
12
<PAGE>
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 for a multitude of computing devices. Microsoft software
includes scalable operating systems for servers, personal computers (PCs), and
intelligent devices; server applications for client/server environments;
knowledge worker productivity applications; and software development tools. The
Company's online efforts include the MSN network of Internet products and
services and alliances with companies involved with broadband access and various
forms of digital interactivity. Microsoft also licenses consumer software
programs; sells hardware devices; provides consulting services; trains and
certifies system integrators and developers; and researches and develops
advanced technologies for future software products.
Management's Discussion and Analysis contains statements that are forward-
looking. These statements are based on current expectations that are subject to
risks and uncertainties. Actual results will vary because of factors such as PC
shipment growth; technological shifts; customer demand; competitive products and
pricing; product mix; product ship schedules; life cycles; terms and conditions;
litigation; and other issues discussed in the Company's 2000 Form 10-K.
Revenue
Revenue of $5.80 billion in the September quarter of fiscal 2001 increased 8%
over the first quarter of fiscal 2000. The revenue growth was driven by
licensing of Microsoft Windows NT Workstation, Windows 2000 Professional,
Windows Me, and SQL Server. Revenue from Consumer Software, Services, and
Devices also grew strongly. Reported revenue in the September quarter of fiscal
2000 was positively impacted by $150 million related to the fulfillment of the
Microsoft Office 2000 Technology Guarantee.
Product Revenue
Microsoft has four segments: Desktop and Enterprise Software and Services;
Consumer Software, Services, and Devices; Consumer Commerce Investments; and
Other. The Management Discussion and Analysis presentation of revenue differs
from that reported under the Company's Segment Information since reconciling
amounts are allocated to the segments.
Desktop and Enterprise Software and Services includes Desktop Applications,
Desktop Platforms, and Enterprise Software and Services. Desktop Applications
includes revenue from Microsoft Office, Project, Visio, and client access
licenses for Windows NT Server/2000, Exchange, and BackOffice. Revenue from
Desktop Applications was $2.14 billion in the September quarter of fiscal 2001,
compared to $2.21 billion in the prior year. Reported revenue from Microsoft
Office integrated suites in the September quarter of fiscal 2000 included $150
million of revenue related to the fulfillment of the Microsoft Office 2000
Technology Guarantee. Client access license revenue declined from the first
quarter of the prior year due to anticipation of the availability of new product
versions.
Desktop Platforms includes revenue from Windows 2000 Professional, Windows NT
Workstation, Windows Me, Windows 98, and other desktop operating systems.
Desktop Platforms revenue was $1.88 billion in the first quarter of fiscal 2001,
representing 13% growth from the first quarter of the prior year. Increased
migration to Windows 2000 Professional and the availability of Windows Me drove
revenue growth in Desktop Platforms. Although business PC shipments continue to
improve, they remain relatively soft compared to growth rates in the prior year
first quarter. In addition, Windows desktop operating systems average earned
revenue per licensed operating system decreased compared to the first quarter of
the prior fiscal year.
Enterprise Software and Services includes Windows NT Server and Windows 2000
Server operating systems, SQL Server and client access licenses, Exchange
Server, developer tools, consulting services, product support services, and
training and certification. Revenue in the September quarter increased 9% to
$1.04 billion. The Windows NT Server and Windows 2000 Server family of products
continues to make progress with new mission critical deployments. SQL Server
revenue growth, aided by the availability of SQL Server 2000 in mid-quarter, was
robust compared to the September quarter of fiscal 2000. Other server
application products revenue experienced declining growth from prior year's
first quarter due to unearned revenue associated with the Exchange 2000 Server
Technology Guarantee, and in the face of a new product release. Revenue from
consulting and product support services was strong.
13
<PAGE>
Consumer Software, Services, and Devices includes MSN Internet access, MSN
network services, WebTV Internet access and services, gaming, learning and
productivity software, mobile and wireless devices, and embedded systems.
Revenue reached $479 million in the first quarter of fiscal 2001, up 31% from
the first quarter of the prior year. MSN access and advertising revenue was up
over 50% on continued strong growth in both subscribers and web users. WebTV and
gaming revenue grew strongly, while revenue from learning and productivity
software was relatively flat. Revenue from mobile and wireless devices and
embedded systems also grew strongly, but from a relatively small base.
Consumer Commerce Investments include Expedia, Inc., the HomeAdvisor online real
estate service, and the CarPoint online automotive service. First quarter
revenue totaled $97 million, compared to $18 million in the prior year's first
quarter. Acquisitions of Travelscape.com and VacationSpot.com by Expedia, Inc.
and increased overall reach of all properties led to the strong revenue growth
compared to the prior year.
Other primarily includes Hardware and Press. Other revenue was $165 million in
the September quarter of fiscal 2001, declining slightly from $171 million in
the prior year's September quarter.
Distribution Channels
Microsoft distributes its products primarily through OEM licenses,
organizational licenses, online services and products, 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 organizational licenses and retail packaged products via these
channels are primarily to and through distributors and resellers.
OEM first quarter revenue was $1.82 billion, compared to $1.74 billion in the
comparable quarter of fiscal 2000. The relatively low growth in revenue was due
to continued sluggishness in business PC shipments and lower average earned
revenue per license due to increased sales to multinational customers. Migration
to Windows NT Workstation and Windows 2000 Professional in the OEM channel
continues to increase.
South Pacific and Americas Region revenue in the September quarter was $2.19
billion, up 17% compared to $1.87 billion in the prior year. Windows Me, Windows
NT Workstation, Windows 2000 Professional, SQL Server, enterprise consulting and
support services, and MSN online revenue were the primary drivers of the revenue
growth. The revenue growth for the quarter resulted primarily from increased
U.S. revenue.
Europe, Middle East, and Africa Region revenue was $1.09 billion, down 8% from
revenue of $1.18 billion in the first quarter of the prior year. The declining
growth was largely a result of weakening local currencies, which negatively
impacted translated revenue compared to the prior year. Revenue in the region
would have been flat compared to the first quarter of fiscal 2000 if foreign
exchange rates were constant with those of the prior year. The recognition of
revenue related to the fulfillment of the Microsoft Office 2000 Technology
Guarantee in the first quarter of fiscal 2000 also negatively impacted revenue
growth.
Asia Region revenue increased 19% to $708 million from the September quarter of
the prior year. The region's growth rate reflected strong revenue from localized
versions of Microsoft Office 2000, especially the Office Personal suite, Windows
NT Workstation and Windows 2000 Professional operating systems, and SQL Server.
Revenue grew strongly in nearly all countries in the Asia region. Strengthening
local currencies positively impacted translated revenue compared to the prior
year. First quarter 2001 revenue in the region would have grown 13% if foreign
exchange rates were constant with those of the prior year.
Translated international revenue is affected by foreign exchange rates. The net
impact of foreign exchange rates on revenue was negative in the September
quarter compared to a year ago, due to weaker European currencies versus the
U.S. dollar, offset partially by a stronger Japanese yen versus the U.S. dollar.
Had the rates from the prior year comparable quarter been in effect in the first
quarter of fiscal 2001, translated international revenue billed in local
currencies would have been $60 million higher. Certain manufacturing, selling,
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
Cost of revenue as a percent of revenue was 14.8% in the first quarter, up from
13.2% in the first quarter of the prior year. Higher online costs, consulting
and product support services costs, and additional retail packaged product costs
associated with the launch of Windows Me drove the increase over the prior
year's comparable
14
<PAGE>
quarter. Additionally, the September quarter of fiscal 2000 was positively
impacted by the recognition of previously unearned revenue related to the Office
2000 Technology Guarantee.
Research and development expenses in the first quarter increased 18% from the
first quarter of the prior year to $956 million. The growth was driven by higher
headcount-related costs, investments in new product initiatives, and development
costs for recently released products.
Sales and marketing expenses were $1.04 billion in the September quarter, or
17.9% of revenue, compared to $922 million in the first quarter of the prior
year, or 17.1% of revenue. Sales and marketing expenses as a percent of revenue
increased due to higher relative marketing costs associated with new product
releases and online marketing.
General and administrative costs were $170 million in the first quarter compared
to $148 million in the comparable quarter of the prior year. The increase
primarily reflects higher legal fees.
Nonoperating Items, Investment Income, and Income Taxes
Losses on equity investees and other incorporates Microsoft's share of income or
loss from the MSNBC entities, Avanade, Wireless Knowledge, and other investments
accounted for using the equity method. Losses on equity investees and other
increased to $52 million in the first quarter of fiscal year 2001 compared to
$19 million in the comparable quarter of the prior year, reflecting, in part,
the onset of costs associated with Avanade.
First quarter investment income increased to $1.13 billion from $550 million in
the first quarter of the prior year. Net realized gains on investments increased
$399 million reflecting a gain from Microsoft's investment in Titus
Communications (which was merged with Jupiter Telecommunications) and the
closing of the sale of Transpoint to CheckFree Holdings Corp. Net realized gains
in the September quarter of fiscal 2000 included a gain related to the sale of
Sidewalk. In addition, interest income increased $166 million due to the larger
investment portfolio.
Effective July 1, 2000, Microsoft adopted SFAS 133 which establishes accounting
and reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts and for hedging activities. All
derivatives, whether designated in hedging relationships or not, are required to
be recorded on the balance sheet at fair value. If the derivative is designated
as a fair value hedge, the changes in the fair value of the derivative and the
hedged item are recognized in earnings. If the derivative is designated as a
cash flow hedge, changes in the fair value of the derivative are recorded in
other comprehensive income and are recognized in the income statement when the
hedged item affects earnings.
The adoption of SFAS 133 resulted in a pre-tax reduction to income of $560
million ($375 million after-tax) and a pre-tax reduction to OCI of $112 million
($75 million after-tax). The reduction to income is mostly attributable to a
loss of approximately $300 million reclassified from OCI for the time value of
options and a loss of approximately $250 million reclassified from OCI for
derivative instruments not designated as hedging instruments. The reduction to
OCI is mostly attributable to losses of approximately $670 million on cash flow
hedges offset by the reclassifications of out of OCI of the approximately $300
million loss for the time value of options and the approximately $250 million
loss for derivative instruments not designated as hedging instruments.
The effective tax rate for fiscal 2001 is estimated to be 33%. The effective tax
rate for fiscal 2000 was 34%.
Financial Condition
Cash and short-term investments totaled $24.71 billion as of September 30, 2000.
Cash flow from operations was $2.96 billion in the September quarter of fiscal
2001, an increase of $103 million from the first quarter of the prior year. The
stock option income tax benefit decrease of $762 million, reflecting decreased
stock option exercises by employees given the decreased stock price, was more
than offset by changes in deferred taxes. Cash used for financing was $1.30
billion in the September quarter of fiscal 2001, an increase of $1.01 billion
from the first quarter of the prior year, which mostly reflected an increase in
common stock repurchases in the September quarter of fiscal 2001. During the
September quarter of fiscal 2001, the Company repurchased 25.5 million shares of
common stock under its share repurchase program, compared to 12.1 million shares
repurchased in the first quarter of the prior year. Cash used for investing was
$3.94 billion in the September quarter of fiscal 2001, an increase of $1.16
billion from the first quarter of the prior year, reflecting a net increase in
short-term investments of $1.06 billion in the first quarter of fiscal 2001
versus the prior year comparable quarter.
In July 2000, the Company acquired a 22.98% shareholding in Telewest
Communications plc for approximately $2.6 billion in stock. Telewest is a
leading broadband cable communications operator in the United Kingdom.
Microsoft has no material long-term debt and has $160 million of standby
multicurrency lines of credit to support foreign currency hedging and cash
management. Stockholders' equity at September 30, 2000 was $45.34 billion.
15
<PAGE>
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. Additions to property and equipment will continue,
including new facilities and computer systems for R&D, sales and marketing,
support, and administrative staff. Commitments for constructing new buildings
were $290 million on September 30, 2000.
In August 2000, the Company announced a share repurchase program that provides
shares for issuance to employees under the Company's stock option and stock
purchase programs. Since fiscal 1990, Microsoft has repurchased 790 million
common shares while 2.02 billion shares were issued under the Company's employee
stock option and purchase plans. The market value of all outstanding stock
options was $52 billion as of September 30, 2000. Microsoft enhances its
repurchase program by selling put warrants. During December 1996, Microsoft
issued 12.5 million shares of 2.75% convertible exchangeable preferred stock.
The Company's convertible preferred stock matured on December 15, 1999. Each
preferred share was converted into 1.1273 common shares.
Management believes existing cash and short-term investments together with funds
generated from operations will be sufficient to meet operating requirements. The
Company'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 share repurchase 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.
Recently Issued Accounting Standards
The Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin
(SAB) 101, Revenue Recognition in Financial Statements, in December 1999. The
SAB summarizes certain of the SEC staff's views in applying U.S. generally
accepted accounting principles to revenue recognition in financial statements.
In June 2000, the SEC issued SAB 101B, which delays the implementation date of
SAB 101 until no later than the fourth fiscal quarter of fiscal years beginning
after December 15, 1999. In October 2000, the SEC issued frequently asked
questions and answers about how the guidance in accounting standards and SAB 101
would apply to particular transactions. The Company does not believe that
adoption of this SAB will have a material impact on its financial statements.
16
<PAGE>
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company is exposed to foreign currency, interest rate, and securities price
risks. A portion of these risks is hedged, but fluctuations could impact the
Company's results of operations and financial position. The Company hedges the
exposure of accounts receivable and a portion of anticipated revenue to foreign
currency fluctuations, primarily with option contracts. The Company monitors its
foreign currency exposures daily to maximize the overall effectiveness of its
foreign currency hedge positions. Principal currencies hedged include the Euro,
Japanese yen, British pound, and Canadian dollar. Fixed income securities are
subject to interest rate risk. The portfolio is diversified and consists
primarily of investment grade securities to minimize credit risk. The Company
routinely uses options to hedge its exposure to interest rate risk in the event
of a catastrophic increase in interest rates. Many securities held in the
Company's equity and other investments portfolio are subject to price risk. The
Company uses options to hedge its price risk on certain highly volatile equity
securities.
The Company uses a value-at-risk (VAR) model to estimate and quantify its market
risks. The VAR model is not intended to represent actual losses in fair value,
but is used as a risk estimation and management tool. Assumptions applied to the
VAR model at June 30, 2000 and September 30, 2000 include the following: normal
market conditions; Monte Carlo modeling with 10,000 simulated market price
paths; a 97.5% confidence interval; and a 20-day estimated loss in fair value
for each market risk category. Accordingly, 97.5% of the time the estimated 20-
day loss in fair value would be nominal for foreign currency denominated
investments and accounts receivable at June 30, 2000 and September 30, 2000, and
would not exceed $211 million and $224 million at June 30, 2000 and September
30, 2000 for interest-sensitive investments or $1.02 billion or $928 million at
June 30, 2000 and September 30, 2000 for equity securities.
17
<PAGE>
Part II. Other Information
Item 1. Legal Proceedings
See notes to financial statements.
Item 2. Changes in Securities and Use of Proceeds
On September 12, 2000, the Company issued an aggregate of 753,660 of its common
shares pursuant to the acquisition by the Company of MongoMusic, Inc., a
Delaware corporation ("MongoMusic"). All of the Company common shares issued in
this transaction were issued in a non-public offering pursuant to an exemption
from the registration requirements of the Securities Act of 1933, as amended
(the "1933 Act"), under Section 4(2) of the 1933 Act. This sale was made without
general solicitation or advertising. The Company has filed a Registration
Statement on Form S-3 covering the resale of such securities. All net proceeds
from the sale of such securities will go to the selling shareholders who offer
and sell their shares. The Company has not received and will not receive any
proceeds from the sale of these common shares other than the assets and
liabilities of MongoMusic.
Reference is also made to the information on sales of put warrants described in
the accompanying notes to financial statements. All such transactions are exempt
from registration under Section 4(2) of the Securities Act of 1933. Each
transaction was privately negotiated and each offeree and purchaser was an
accredited investor/qualified institutional buyer. No public offering or public
solicitation was used by Microsoft in the placement of these securities.
Item 6. Exhibits and Reports on Form 8-K
(A) Exhibits
27.1 Financial Data Schedule for Three Months Ended September 30, 2000
27.2 Restated Financial Data Schedule for Year Ended June 30, 2000*
27.3 Restated Financial Data Schedule for Nine Months Ended March 31,
2000*
27.4 Restated Financial Data Schedule for Six Months Ended December 31,
1999*
27.5 Restated Financial Data Schedule for Three Months Ended September 30,
1999*
27.6 Restated Financial Data Schedule for Year Ended June 30, 1999*
27.7 Restated Financial Data Schedule for Nine Months Ended March 31,
1999*
27.8 Restated Financial Data Schedule for Six Months Ended December 31,
1998*
27.9 Restated Financial Data Schedule for Three Months Ended September 30,
1998*
27.10 Restated Financial Data Schedule for Year Ended June 30, 1998*
* Restated to reflect certain reclassifications that have been made for
consistent presentation.
(B) Reports on Form 8-K
The Company filed no reports on Form 8-K during the quarter ended September 30,
2000.
Items 3, 4, and 5 are not applicable and have been omitted.
18
<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 14, 2000 By: /s/ John G. Connors
-------------------------------------
John G. Connors
Senior Vice President, Finance and
Administration; Chief Financial
Officer
(Principal Financial and Accounting
Officer and Duly Authorized Officer)
19
