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Microsoft
Corporation
Financial Highlights
Third Quarter 2002
(All
growth percentages are comparisons
to the comparable quarter of fiscal year 2001)
Revenue
Revenue for the third quarter of fiscal year 2002 was
$7.25 billion, an increase of 13% over the third quarter
of fiscal 2001. The revenue growth was driven primarily by
the continued globalization of the Microsoft Xbox video
game system and licensing of Microsoft Windows XP Home and
Professional operating systems.
Product
Revenue
Microsoft
currently 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
includes Desktop Applications; Desktop Platforms; and
Enterprise Software and Services. Desktop and Enterprise
Software and Services revenue was $6.00 billion for the
third quarter, an increase of 5% from $5.72 billion
recorded in the third quarter of the prior year.
Desktop Applications includes revenue from Microsoft
Office; Microsoft Project; Visio; client access licenses
(CALs) for Windows NT Server and Windows 2000 Server,
Exchange, and BackOffice; Microsoft Great Plains; and
bCentral. Revenue from Desktop Applications was $2.44
billion in the March quarter of fiscal 2002, increasing
slightly from the $2.41 billion in the prior year’s
March quarter. Office revenue declined slightly from the
prior year comparable quarter. Although, Office licensing
remains strong, a higher mix of multi-year licensing
agreements resulted in revenue deferred to future
quarters. Additionally, a decline in consumer purchases in
the Asia region, most notably Japan, led to a decrease in
Office revenue. Revenue from client access licenses
declined moderately in the third quarter due to a ramp up
in licensing of Exchange, BackOffice, and Windows NT
Server and Windows 2000 Server CALs in the prior year’s
comparable quarter and the impact of a growing annuity
licensing mix, which deferred revenue to future quarters.
Microsoft Great Plains revenue offset the decline in other
Desktop Applications revenue.
Desktop Platforms includes revenue from Windows XP
Professional and Home, Windows 2000 Professional, Windows
NT Workstation, Windows Me, Windows 98, and other desktop
operating systems. Desktop Platforms revenue was $2.29
billion in the third quarter, representing 11% growth from
the third quarter of the prior year. The quarterly revenue
growth reflected strong multi-year annuity licensing and a
continued mix shift to the higher priced Windows 2000 and
Windows XP Professional, offset by reported PC shipments
that were flat compared to the third quarter of fiscal
2001.
Enterprise Software and Services includes Server
Platforms; Server Applications; developer tools and
services; and Enterprise services. March quarter revenue
was $1.28 billion, increasing 2% from $1.25 billion in the
March quarter of fiscal 2001. Server Platforms revenue
growth was 6%, driven by a modest overall increase in
Windows-based server shipments and increased deployment of
Windows 2000 Server. Server Applications revenue grew
slightly from the prior year’s third quarter as SQL
Server revenue grew strongly but other .NET Enterprise
Server revenue was hampered by poor economic conditions
and weakness in IT investment. Enterprise services
revenue, representing consulting and product support
services, was up 9% compared to the prior year’s
comparable quarter. Revenue from developer tools, training
and certification, and other services declined 12% from
the March quarter of fiscal 2001. The mid-quarter release
of Visual Studio .NET drove a strong increase in
licensing, however, the higher mix of MSDN subscription
licensing offset this increase due to the deferment of
revenue to future quarters.
Consumer Software, Services, and Devices includes
Xbox video game system, MSN Internet access, MSN network
services, PC and online games, learning and productivity
software, mobility, and embedded systems. Consumer
Software, Services, and Devices revenue reached $1.07
billion in the third quarter of fiscal 2002, compared to
$460 million in the third quarter of the prior year. The
majority of the revenue growth from the prior year stemmed
from the launch of the Xbox video game system. MSN
Internet access revenue performed well as a result of an
increased subscriber base and an increase in the average
revenue per subscriber due to a change in mix to
non-promotional subscriber programs. Revenue from MSN
network services, despite a difficult economic environment
in the online advertising marketplace, grew strongly led
by performance-based advertising sales.
Consumer Commerce Investments include Expedia,
Inc., the HomeAdvisor online real estate service, and the
CarPoint online automotive service. Third quarter revenue
totaled $45 million, compared to $76 million in the prior
year’s third quarter. The decline in revenue compared to
a year ago reflects the sale of Microsoft’s share of
Expedia, Inc. during the third quarter of fiscal 2002.
Prior year revenue for Expedia, Inc. has been reclassified
to reflect the reporting change of merchant revenue to a
net basis, which represents the amount charged to the
customer less the amount paid to the supplier.
On February 4, 2002, USA Networks, Inc. (USA) shareholders
approved the merger transaction in which USA became the
controlling shareholder of Expedia, Inc. As part of the
transaction, Microsoft transferred all of its 33.7 million
Expedia shares and warrants. In return, Microsoft received
20.1 million shares of USA common stock, 12.8 million
shares of USA cumulative convertible preferred stock, and
14.2 million USA warrants.
Other primarily includes Hardware and Microsoft Press.
Other revenue was $137 million in the third quarter of
fiscal 2002, declining from $149 million reported in the
prior year’s March quarter. Lower sales of Microsoft
Press books due to the overall weakness in the consumer
market and lower hardware peripheral sales contributed to
the decline in revenue.
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 third quarter revenue was $2.29 billion, up 15%
from revenue of $1.99 billion in the comparable quarter of
fiscal 2001. Reported licenses were flat in the third
quarter compared to the prior year hampering revenue
growth. An increased mix of the higher priced Windows 2000
and Windows XP Professional licenses, the stabilization of
direct OEMs and a mix shift to system builder OEMs, led to
higher average revenue per license and contributed to the
overall OEM revenue growth.
South
Pacific and Americas Region revenue in the March
quarter was $2.76 billion, an increase of 16% compared to
$2.37 billion in the prior year’s March quarter. Revenue
from the United States was the primary driver of the
region’s revenue growth, reflecting continued strong
sales of Xbox. Strong licensing of the new Windows XP
operating systems and revenue from Microsoft Great Plains
also contributed to the growth. Other product offerings
influencing the growth included MSN Internet access
subscriptions and MSN Network services.
Europe,
Middle East, and Africa Region revenue was $1.39
billion, increasing 15% from the $1.20 billion reported in
the third quarter of the prior year. The majority of the
growth was a result of the launch of Xbox in the region.
Reported revenue was influenced by a higher mix of
multi-year licensing agreements in the third quarter of
fiscal 2002, which deferred revenue to future quarters.
Revenue growth from Windows XP Home and Professional
operating systems and Enterprise Software was healthy.
Revenue in the region would have increased 18% in the
third quarter if foreign exchange rates were constant with
those of the prior year.
Asia
Region revenue decreased 2% to $818 million from $836
million in the March quarter of the prior year. The
region’s revenue decline was impacted by deteriorating
economic conditions and declining consumer PC shipments,
which affected the sales of localized versions of
Microsoft Office XP, partially offset by the launch of
Xbox in the third quarter of fiscal 2002. Had foreign
exchange rates been constant with those of the third
quarter of 2001, revenue in the region would have grown
8%.
Translated
international revenue is affected by foreign exchange
rates. The net impact of foreign exchange rates on revenue
was negative in the March quarter compared to a year ago,
due to a weaker Japanese yen and European currencies
versus the U.S. dollar. Had the rates from the prior
year’s comparable quarter been in effect in the third
quarter of fiscal 2002, translated international revenue
billed in local currencies would have been approximately
$130 million higher. The net impact of foreign exchange
rates on revenue was also negative in the first nine
months of fiscal 2002 compared to a year ago, due to
weaker Japanese and European currencies versus the U.S.
dollar. 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
Effective July 1, 2001, Microsoft adopted
Statement of Financial Accounting Standards (SFAS) 141, Business
Combinations, and SFAS 142, Goodwill and Other
Intangible Assets. SFAS 141 requires business
combinations to be accounted for using the purchase method
of accounting. It also specifies the types of acquired
intangible assets that are required to be recognized and
reported separate from goodwill. SFAS 142 requires that
goodwill and certain intangibles no longer be amortized,
but instead tested for impairment at least annually. There
was no impairment of goodwill upon adoption of SFAS 142.
Goodwill amortization (on a pre-tax basis) was $70 million
in the third quarter of fiscal 2001.
Cost of revenue was $1.40 billion, or 19.3% of
revenue, in the third quarter, compared to $899 million,
or 14.0% of revenue, in the third quarter of the prior
year. The launch of the Xbox video game console worldwide
drove the majority of the increase from the prior year.
Research and development expenses in the third
quarter of fiscal 2002 were $1.07 billion, flat with the
third quarter of the prior year. R&D expenses
increased primarily due to higher Xbox and Windows XP
headcount-related and product development costs associated
with these new products. The discontinuation of goodwill
amortization in accordance with SFAS 142 in fiscal 2002
partially offset the growth in headcount and development
costs.
Sales and marketing expenses were $1.24 billion in
the March quarter, or 17.1% of revenue, compared to $1.20
billion in the March quarter of the prior year, or 18.7%
of revenue. Sales and marketing expenses as a percentage
of revenue decreased primarily due to the large relative
increase in revenue associated with the onset of Xbox
revenue. Lower relative marketing costs in MSN Network and
MSN Internet access, partially offset by the marketing
costs surrounding the international launch of Xbox and
higher relative headcount-related costs also contributed
to the decrease in sales and marketing expenses as a
percent of revenue.
General and administrative costs were $246 million
in the third quarter compared to $239 million in the
comparable quarter of the prior year led by increases in
headcount-related costs.
Non-operating Items, Investment Income/(Loss), and
Income Taxes
Losses on equity investees and other incorporates
Microsoft’s share of income or loss from investments
accounted for using the equity method, and income or loss
attributable to minority interests. Losses on equity
investees and other declined to $11 million in the third
quarter of fiscal 2002, compared to $46 million in the
comparable quarter of fiscal 2001, reflecting an increase
in the losses associated with the Company’s share of
MSNBC businesses, offset by a decrease in the number of
such investments during fiscal 2002. The decreased loss
was also attributed to the elimination of amortization of
goodwill on equity investments in accordance with SFAS 142
in fiscal 2002.
In the third quarter, the Company reported $739 million in
investment income. The investment income included $627
million of bond portfolio return and dividend income and
$112 million in other net recognized gains. Net recognized
gains included the $1.25 billion gain on the Expedia
transaction, a write down for other-than-temporary
impairments of $1.19 billion, net realized gains on equity
securities of $151 million, and $98 million in net losses
attributable to derivative instruments. The write down for
other-than-temporary impairments primarily related to the
Company’s investment in AT&T. In conjunction with
the definitive agreement to combine AT&T Broadband
with Comcast in a new company to be called AT&T
Comcast Corporation, Microsoft has agreed to exchange its
AT&T 5% convertible preferred debt for approximately
115 million shares of AT&T Comcast Corporation. It is
expected that the transaction will close by December 31,
2002. In the prior year comparable quarter, the Company
reported $706 million in investment income, which included
$725 million of bond portfolio income and dividends and
$19 million of other net recognized losses.
The
effective tax rate for fiscal 2002 is estimated to be 32%.
The effective tax rate for fiscal 2001 was 33%.
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 March 31, 2002, unearned revenue was $6.91 billion,
compared to $5.31 billion at March 31, 2001. Desktop
Applications unearned revenue was $3.03 billion, compared
to $2.05 billion at March 31, 2001. Desktop Platforms
unearned revenue was $3.10 billion, compared to $2.55
billion at March 31, 2001. Enterprise Software and
Services unearned revenue was $477 million, compared to
$387 million at March 31, 2001. Unearned revenue
associated with Consumer Software, Services, and Devices
and Other was $311 million, compared to $324 million a
year ago.
Financial Condition
Cash and short-term investments totaled $38.69 billion as
of March 31, 2002. Cash flow from operations was $4.12
billion in the March quarter of fiscal 2002, compared to
$4.01 billion in the comparable quarter of the prior year.
Cash flow from operations was $11.08 billion in the first
nine months of fiscal 2002, an increase of $1.23 billion
from the first nine months of the prior year. The increase
reflects strong growth in earned and unearned revenue.
Cash used for financing was $731 million in the first nine
months of fiscal 2002, a decrease of $3.22 billion from
the first nine months of the prior year. The decrease
reflects lower common stock repurchases and the repurchase
of put warrants in the prior year. During the first nine
months of fiscal 2002, the Company repurchased 35.9
million shares of common stock under its share repurchase
program, compared to 65.4 million shares repurchased in
the first nine months of the prior year. In addition, 2.6
million shares of common stock were acquired in the second
quarter of fiscal 2002 under a structured stock repurchase
transaction. The Company entered into the structured stock
repurchase transaction in the third quarter of fiscal 2001
and agreed to acquire 5.1 million of its shares (half in
October 2001 and half in June 2002) in exchange for an
up-front net payment of $264 million. Cash used for
investing was $9.15 billion in the first nine months of
fiscal 2002, an increase of $2.56 billion from the first
nine months of the prior year, reflecting the increase in
the investment portfolio.
Employee Stock Options (ESOs)
The Company encourages broad-based employee ownership of
Microsoft stock through an ESO program in which the
majority of employees are eligible to participate. At
March 31, 2002, 836 million vested and unvested options
were outstanding, compared to 5.415 billion common shares
outstanding.
Microsoft follows Accounting Principles Board Opinion
(APB) 25, Accounting for Stock Issued to Employees,
to account for ESOs, which generally does not require
income statement recognition of options granted at the
market price on the date of issuance. FICA and Medicare
payroll taxes associated with stock option exercises are
recorded as an expense. Other events such as the
accelerated vesting of options can also trigger recording
an expense. These costs were reflected in each operating
expense line item in the income statement.
Earnings per share calculations reflect exercised ESOs and
the dilutive effect of outstanding ESOs under the treasury
stock method. In addition, as required by SFAS 123, Accounting
for Stock-Based Compensation, the Company discloses
the value of ESO grants and employee stock purchase plans
using the Black-Scholes option valuation method and the
pro forma impact of expensing such value over the vesting
period of the ESOs in the notes to its annual financial
statements.
ESOs are often granted upon hire to new employees,
annually to the majority of employees, and non-annually to
certain other employees. In the following table, Microsoft
has electively disclosed the pro forma income statements
for the three and twelve months ended March 31, 2002 in
accordance with SFAS 123.
| Alternative
Presentation of Accounting for ESOs under SFAS
123 |
| (In
millions, except earnings per share)(Unaudited) |
| |
|
Three
Months Ended
March 31, 2002 |
|
Twelve
Months Ended
March 31, 2002 |
|
|
|
Reported
|
|
Pro
forma (1
|
)
|
Reported
|
|
Pro
forma (1
|
)
|
|
| |
|
|
|
|
|
|
|
|
| Revenue |
$
7,245 |
|
$
7,245 |
|
$27,689 |
|
$27,689 |
|
| Operating expenses: |
|
|
|
|
|
|
|
|
|
Cost
of revenue |
1,395 |
|
1,567 |
|
4,690 |
|
5,134 |
|
|
Research and
development |
1,066 |
|
1,474 |
|
4,487 |
|
6,174 |
|
|
Sales
and marketing |
1,240 |
|
1,449 |
|
5,223 |
|
6,497 |
|
|
General
and administrative |
246 |
|
343 |
|
1,502 |
|
1,795 |
|
|
| |
|
Total
operating expenses |
3,947 |
|
4,833 |
|
15,902 |
|
19,600 |
|
|
| Operating income |
3,298 |
|
2,412 |
|
11,787 |
|
8,089 |
|
| Losses
on equity investees and other |
(11 |
) |
(11 |
) |
(111 |
) |
(111 |
) |
| Investment income/(loss) |
739 |
|
739 |
|
(2,308 |
) |
(2,308 |
) |
|
| Income
before income taxes |
4,026 |
|
3,140 |
|
9,368 |
|
5,670 |
|
| Provision
for income taxes |
1,288 |
|
1,005 |
|
2,998 |
|
1,806 |
|
|
| Net
income |
$
2,738 |
|
$
2,135 |
|
$
6,370 |
|
$
3,864 |
|
|
| |
| Diluted
EPS |
$ 0.49 |
|
$
0.38 |
|
$
1.14 |
|
$
0.69 |
|
|
| Weighted
average shares outstanding |
5,564 |
|
5,564 |
|
5,570 |
|
5,570 |
|
|
| Options
granted |
6 |
|
6 |
|
46 |
|
46 |
|
|
|
| (1) |
Pro
forma information as if the Company applied SFAS
123 for ESOs granted after July 1, 1995. |
Microsoft, Great
Plains, Windows, Xbox, Visio, Windows NT, BackOffice,
bCentral, Visual Studio, MSN, HomeAdvisor, Carpoint, and
Microsoft Press are either registered trademarks or
trademarks of Microsoft Corporation or Great Plains in
the United States and/or other countries. The names of
actual companies and products mentioned herein may be
the trademarks of their respective owners.
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