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Microsoft Corporation
2004 Annual Report

Table of contents

  • Page 1
    Microsoft Corporation 2004 Annual Report

  • Page 2
    ... Office System 2003, new versions of Windows XP for Media Center and for Tablet PCs, Exchange Server 2003, Windows Small Business Server 2003, BizTalk Server 2004, Speech Server 2004, MSN Messenger 6.2, Windows CE 5.0, and several new business solutions for small and mid-market customers...

  • Page 3
    ... the online gaming business. Looking ahead, we see myriad opportunities to create other entertaining digital experiences via platforms such as Xbox, Windows XP Media Center, and Microsoft TV, a product family that supports a range of digital video services including interactive programming guides...

  • Page 4
    ...the world. They create applications, provide computer services, and, in many other ways, build their businesses on our platform, generating local jobs and billions of dollars in tax revenue. A global study of 22,000 technology companies found that Microsoft's partners earn an average of $8 for every...

  • Page 5
    ... to employee equity compensation awards to offset the impact of the special dividend. The special dividend will be payable on December 2, 2004, to shareholders of record on November 17, 2004, conditioned upon shareholder approval of amendments to the employee stock plans at the annual meeting of...

  • Page 6
    ... seven product segments are: Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. See Note 18 - Segment Information of the Notes to Financial Statements for financial information regarding segment reporting. Client...

  • Page 7
    ... Office SharePoint Portal Server 2003. In addition, the Information Worker segment includes Microsoft Office Live Meeting Web conferencing service and professional product support. Historically, approximately 40 percent of Information Worker billed revenue comes from multi-year license agreements...

  • Page 8
    ... in revenue for the segment, including MSN Internet Access, Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, MSN Bill Pay, and MSN Radio Plus), and MSN Mobile services. The segment generates revenue principally from advertisers on the MSN Web sites, from...

  • Page 9
    ...Microsoft label, Xbox and Xbox Live operations, marketing, research, and sales and support. The segment leads the development efforts of our Home Products Division (HPD) product lines. It also carries out all retail sales and marketing for Microsoft Office, the Windows operating systems, Xbox, games...

  • Page 10
    ... and developers. We believe we are already helping reduce costs and increase business value with products such as Windows Server 2003, Visual Studio .NET, SMS 2003, the Dynamic Systems Initiative, and Microsoft Operations Manager 2005. IT Services for Smaller Business and Consumers: The MSN, Windows...

  • Page 11
    ... Internet users want communications experiences to build their social network on any device. We believe professionals and information workers want integrated, secure functionality that help them manage their personal and professional lives: personalized email, instant messaging, contact management...

  • Page 12
    ...support, tools, and training over a specified time period (generally three years). Similar to the Open program, customers can acquire licenses only, acquire licenses with Software Assurance, or renew Software Assurance upon the expiration of existing volume licensing agreements. Enterprise Agreement...

  • Page 13
    ... development tools and environment, compatibility with a broad base of hardware and software applications, security, and manageability. Information Worker. While we are the leader in business productivity software applications for personal computers, competitors to the Microsoft Office System...

  • Page 14
    ... for mobile or embedded devices; providing a flexible platform that allows customers and partners to build differentiated and profitable business models; and providing end users significant benefits such as ease of use, personal productivity, and better information management and control. Home and...

  • Page 15
    EMPLOYEES As of June 30, 2004, we employed approximately 57,000 people on a full-time basis, 37,000 in the United States and 20,000 internationally. Of the total, 24,000 were in product research and development, 16,000 in sales and marketing, 11,000 in product support and consulting services, 2,000 ...

  • Page 16
    ... worker productivity applications; business solutions applications; and software development tools. We provide consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, PC games and peripherals. Online...

  • Page 17
    ...to replacement PC and notebook sales in the enterprise segment in the second half of fiscal 2004. We estimate that total server hardware shipments grew 16%, with Windows Server shipments growing faster than the overall sector at 18% in fiscal 2004. The net impact of foreign exchange rates on revenue...

  • Page 18
    ... exchange rate benefit in fiscal 2005. We anticipate that we will renew between 10% and 30% of the expiring Upgrade Advantage program revenue through conversions to Software Assurance or migration to Enterprise Agreements. Total revenue expected to be recognized in our Information Worker, Server...

  • Page 19
    ...the employee stock option transfer program in fiscal 2004. Major investments in fiscal 2005 include development of the Windows Client next generation operating system (Longhorn), security programs, and marketing initiatives, including those related to Windows XP Service Pack 2 and other new products...

  • Page 20
    ... expenses related to headcount additions and marketing expenses. Fiscal 2005 Information Worker revenue is expected to be similar to fiscal 2004. We are expecting a reduction in revenue earned from our Upgrade Advantage licensing agreements and no anticipated foreign exchange rate benefit. The...

  • Page 21
    ... and support costs. MSN expects advertising revenue and revenue from subscriptions and transactions for premium Web services to increase in fiscal 2005. Advertising revenue should benefit from expected increases in Internet spending and additions to the advertising platform including music download...

  • Page 22
    ... from the employee stock option transfer program in the second quarter of fiscal 2004. Operating loss for fiscal 2003 grew 1% from the prior year as higher marketing expenses and headcount-related costs associated with product development offset the growth in revenue. We expect demand for mobile and...

  • Page 23
    ...include payroll, employee benefits, equity compensation and other headcountrelated costs associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and...

  • Page 24
    ..., a $605 million fine imposed by the European Commission in the third quarter of fiscal 2004, $280 million of stock-based compensation expense related to the employee stock option transfer program in the second quarter of fiscal 2004, other legal costs of approximately $104 million, and other...

  • Page 25
    ...expense for fiscal 2002 through 2004 by segment. (In millions, except expense per share) (1) 2002 2003 2004 Client Server and Tools Information Worker Microsoft Business Solutions MSN Mobile and Embedded Devices Home and Entertainment Corporate Stock-based employee compensation expense After-tax...

  • Page 26
    ... depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three-and-one-half years for Windows operating systems and two years for desktop applications. Unearned revenue also includes payments for online advertising for which the...

  • Page 27
    ... to employee equity compensation awards to offset the impact of the special dividend. The special dividend will be payable on December 2, 2004, to shareholders of record on November 17, 2004, conditioned upon shareholder approval of amendments to the employee stock plans at the annual meeting of...

  • Page 28
    ... AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Contractual obligations The following table summarizes our outstanding contractual obligations as of June 30, 2004: (In millions) (1) 2005 Payments due by period 2012 and 2006-2008 2009-2011 thereafter Total Long-term...

  • Page 29
    ... software represent new products or upgrades and enhancements to existing products. SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities...

  • Page 30
    ...time we receive notices from others claiming we infringe their intellectual property rights. The number of these claims may grow. Responding to these claims may require us to enter into royalty and licensing agreements on unfavorable terms, require us to stop selling or to redesign affected products...

  • Page 31
    ... "Security". New Products and Services. We have made significant investments in research, development and marketing for new products, services, and technologies, including Longhorn, Microsoft .NET, Xbox, business applications, MSN, and mobile and wireless technologies. Significant revenue from new...

  • Page 32
    ...: warranty and other claims for hardware products such as Xbox; sales channel disruption, such as the bankruptcy of a major distributor; the effects of the Consent Decree in U.S. v. Microsoft and Final Judgment in State of New York v. Microsoft on the Windows operating system and server business...

  • Page 33
    ... operating cost structures that align with revenue growth; the continued availability of third-party distribution channels for MSN service and other online services; factors associated with our international operations, as described under Operations on pages 9-10 of this report; and financial market...

  • Page 34
    ... Brownian motion is used to reflect the principle that fixed-income securities prices revert to maturity value over time. Value-at-risk is calculated by, first, simulating 10,000 market price paths over 20 days for equities, interest rates and foreign exchange rates, taking into account historical...

  • Page 35
    INCOME STATEMENTS (In millions, except earnings per share) Year Ended June 30 2002 (1) 2003 (1) 2004 Revenue Operating expenses: Cost of revenue Research and development Sales and marketing General and administrative Total operating expenses Operating income Losses on equity investees and other ...

  • Page 36
    ...: Accounts payable Accrued compensation Income taxes Short-term unearned revenue Other Total current liabilities Long-term unearned revenue Other long-term liabilities Commitments and contingencies Stockholders' equity: Common stock and paid-in capital - shares authorized 24,000; outstanding 10...

  • Page 37
    ... stock dividend Net cash used for financing Investing Additions to property and equipment Acquisition of companies, net of cash acquired Purchases of investments Maturities of investments Sales of investments Net cash used for investing Net change in cash and equivalents Effect of exchange rates...

  • Page 38
    ...' EQUITY STATEMENTS (In millions) Year Ended June 30 2002 (1) 2003 (1) 2004 Common stock and paid-in capital Balance, beginning of period Cumulative SFAS 123 retroactive adjustments Common stock issued Common stock repurchased Stock-based compensation expense Stock option income tax benefits...

  • Page 39
    ...rights to receive future versions of software products on a when-and-if-available basis under Open, Select, and Enterprise Agreement volume licensing programs. Premier support services agreements, MSN Internet Access subscriptions, Xbox Live, Microsoft bCentral subscriptions, and Microsoft Developer...

  • Page 40
    .... Costs related to insignificant obligations, which include telephone support for developer tools software, PC games, computer hardware, and Xbox, are accrued when the related revenue is recognized. Provisions are recorded for estimated returns, concessions, and bad debts. RESEARCH AND DEVELOPMENT...

  • Page 41
    ... also used to hedge the impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies and to manage other foreign currency exposures. Equities Price Risk. Equity investments are subject to market price risk. From time to time, we use and...

  • Page 42
    ... 1% to 15% of the sales price for desktop applications, depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three and one-half years for Windows operating systems and two years for desktop applications. PAGE 42

  • Page 43
    ... June 30 2003 2004 Volume licensing programs Undelivered elements Other Unearned revenue Unearned revenue by segment is as follows: (In millions) June 30 $5,472 2,847 696 $9,015 $5,075 2,358 744 $8,177 2003 2004 Client Server and Tools Information Worker Other segments Unearned revenue $3,165...

  • Page 44
    ... (In millions) June 30, 2003 Cost basis Unrealized gains Unrealized losses Recorded basis Cash and equivalents Short - term investments Equity and other investments Fixed maturity securities Cash Money market mutual funds Commercial paper Certificates of deposit U. S. Government and...

  • Page 45
    ... years Total Debt securities include fixed maturity securities. NOTE 4 INVESTMENT INCOME/(LOSS) $37,348 14,077 5,636 4,994 $62,055 $37,388 14,064 5,665 4,956 $62,073 The components of investment income/(loss) are as follows: (In millions) Year Ended June 30 2002 2003 2004 Dividends and interest...

  • Page 46
    ... / purchase accounting adjustments Balance as of June 30, 2003 Acquisitions / purchase accounting adjustments Balance as of June 30, 2004 Divestitures Client Server and Tools Information Worker Microsoft Business Solutions MSN Mobile and Embedded Devices Home and Entertainment Total $ 26...

  • Page 47
    ... $1.2 billion allocated to Microsoft Business Solutions; $281 million for the Rare Ltd. acquisition allocated to Home and Entertainment; and Placeware, Inc. with $180 million allocated to Information Worker. NOTE 9 INTANGIBLE ASSETS The components of finite-lived intangible assets are as follows...

  • Page 48
    ... 2003 2004 Current taxes: U.S. and state International Current taxes Deferred taxes Provision for income taxes U.S. and international ...2003 2004 Federal statutory rate Effect of: Extraterritorial income exclusion tax benefit Permanent reinvestment of foreign earnings Other reconciling items Total...

  • Page 49
    ...expiration dates between December 2005 and December 2006. Our board of directors has approved a program to repurchase shares of our common stock to reduce the dilutive effect of our stock option and stock purchase plans. A total of 618 million shares have been repurchased on open market transactions...

  • Page 50
    ... gave us the right to acquire such shares in exchange for an up-front net payment of $264 million. In any period, cash used in financing activities related to common stock repurchased may differ from the comparable change in Stockholders' Equity, reflecting timing differences between the recognition...

  • Page 51
    ...granting employees stock awards instead of stock options. The stock award program offers employees the opportunity to earn shares of our stock over time, rather than options that give employees the right to purchase stock at a set price. We also completed an employee stock option transfer program in...

  • Page 52
    ... on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants: Year Ended June 30 2002 2003 2004 Weighted average expected life in years Dividend per share Volatility Risk-free interest rate Employee stock options outstanding are...

  • Page 53
    ...Year Ended June 30 2002 2003 2004 Net income available for common shareholders (A) Weighted average outstanding shares of common stock (B) Dilutive effect of employee stock options and awards Common stock and common stock equivalents (C) Earnings per share: Basic (A/B) Diluted (A/C) $ 5,355 10,811...

  • Page 54
    ... segment. Placeware, located in Mountain View, California, facilitates secure, highly reliable, cross-firewall Web conferencing experiences allowing users to conduct business meetings online from a PC, and is part of our Real Time Collaboration business unit in the Information Worker segment...

  • Page 55
    ... estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnifications in our financial statements. Our product warranty accrual reflects management's best estimate of our probable...

  • Page 56
    ... purchases of a wide variety of platform-neutral computer hardware, software and related services. Since the beginning of 2003, we also reached similar agreements to settle all claims in a number of other states. The proposed settlements in these states are structured similarly to the California...

  • Page 57
    ... and mix of products for which claims will be made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims process. In accordance with SFAS 5, Accounting for Contingencies...

  • Page 58
    ... technology for use in developing new server software products and/or enhancing existing server software products, in order to improve interoperability. It provides a perpetual license between Microsoft and Sun pursuant to all subject intellectual property rights (including patents and trade secrets...

  • Page 59
    ... software licenses and client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other servers. Also includes developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft consulting services. Information Worker - Microsoft Office...

  • Page 60
    ... Manager and other business applications and services. MSN - Personal communication services, such as e-mail and instant messaging, information services, such as MSN Search and the MSN portals and channels, and paid services including MSN Internet access, MSN Premium Web services, and MSN Mobile...

  • Page 61
    ... to employee equity compensation awards to offset the impact of the special dividend. The special dividend will be payable on December 2, 2004, to shareholders of record on November 17, 2004, conditioned upon shareholder approval of amendments to the employee stock plans at the annual meeting of...

  • Page 62
    ... as of June 30, 2003 and 2004, and the related consolidated statements of income, cash flows, and stockholders' equity for each of the three years in the period ended June 30, 2004. These financial statements are the responsibility of the Corporation's management. Our responsibility is to...

  • Page 63
    ..., Platforms Group Robert J. (Robbie) Bach Senior Vice President, Home and Entertainment Douglas J. Burgum Senior Vice President, Microsoft Business Solutions David W. Cole Senior Vice President, MSN and Personal Services Group John G. Connors Senior Vice President; Chief Financial Officer Jean...

  • Page 64
    ... free service, visit the Open Enrollment site on the Investor Relations website at: http://www.microsoft.com/msft/investor/openenroll.mspx (c) 2004 Microsoft Corporation. All rights reserved. Microsoft, BizTalk, Great Plains, Hotmail, InfoPath, MSN, Outlook, SharePoint, Visual Studio, Windows, Xbox...

  • Page 65
    Your potential. Our passion.â„¢ Printed on recycled paper 0904 PART NO. 098-101107