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 March 31, 2011
OR
¨ | 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 incorporation or organization) |
(I.R.S. Employer Identification No.) | |
One Microsoft Way, Redmond, Washington | 98052-6399 | |
(Address of principal executive offices) | (Zip Code) |
(425) 882-8080
(Registrants telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed since last report)
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 ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Large accelerated filer x |
Accelerated filer ¨ | |
Non-accelerated filer ¨ (Do not check if a smaller reporting company) |
Smaller reporting company ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.
Class | Outstanding at April 21, 2011 | |||
Common Stock, $0.00000625 par value per share |
8,432,767,307 shares |
FORM 10-Q
For the Quarter Ended March 31, 2011
INDEX
2
PART I
Item 1
(In millions, except per share amounts) (Unaudited) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Revenue |
$ | 16,428 | $ | 14,503 | $ | 52,576 | $ | 46,445 | ||||||||
Operating expenses: |
||||||||||||||||
Cost of revenue |
3,897 | 2,755 | 11,869 | 9,225 | ||||||||||||
Research and development |
2,269 | 2,220 | 6,650 | 6,364 | ||||||||||||
Sales and marketing |
3,393 | 3,203 | 10,024 | 9,612 | ||||||||||||
General and administrative |
1,160 | 1,152 | 3,043 | 3,076 | ||||||||||||
Total operating expenses |
10,719 | 9,330 | 31,586 | 28,277 | ||||||||||||
Operating income |
5,709 | 5,173 | 20,990 | 18,168 | ||||||||||||
Other income |
316 | 168 | 762 | 821 | ||||||||||||
Income before income taxes |
6,025 | 5,341 | 21,752 | 18,989 | ||||||||||||
Provision for income taxes |
793 | 1,335 | 4,476 | 4,747 | ||||||||||||
Net income |
$ | 5,232 | $ | 4,006 | $ | 17,276 | $ | 14,242 | ||||||||
Earnings per share: |
||||||||||||||||
Basic |
$ | 0.62 | $ | 0.46 | $ | 2.03 | $ | 1.61 | ||||||||
Diluted |
$ | 0.61 | $ | 0.45 | $ | 2.01 | $ | 1.59 | ||||||||
Weighted average shares outstanding: |
||||||||||||||||
Basic |
8,420 | 8,767 | 8,511 | 8,846 | ||||||||||||
Diluted |
8,510 | 8,876 | 8,609 | 8,955 | ||||||||||||
Cash dividends declared per common share |
$ | 0.16 | $ | 0.13 | $ | 0.48 | $ | 0.39 | ||||||||
See accompanying notes.
3
PART I
Item 1
(In millions) | ||||||||
March 31, 2011 |
|
|
June 30, 2010 |
(1) | ||||
(Unaudited) | ||||||||
Assets |
||||||||
Current assets: |
||||||||
Cash and cash equivalents |
$ | 7,021 | $ | 5,505 | ||||
Short-term investments (including securities loaned of $1,171 and $62) |
43,129 | 31,283 | ||||||
Total cash, cash equivalents, and short-term investments |
50,150 | 36,788 | ||||||
Accounts receivable, net of allowance for doubtful accounts of $304 and $375 |
10,033 | 13,014 | ||||||
Inventories |
1,056 | 740 | ||||||
Deferred income taxes |
2,586 | 2,184 | ||||||
Other |
2,438 | 2,950 | ||||||
Total current assets |
66,263 | 55,676 | ||||||
Property and equipment, net of accumulated depreciation of $9,564 and $8,629 |
7,969 | 7,630 | ||||||
Equity and other investments |
10,748 | 7,754 | ||||||
Goodwill |
12,554 | 12,394 | ||||||
Intangible assets, net |
840 | 1,158 | ||||||
Other long-term assets |
1,353 | 1,501 | ||||||
Total assets |
$ | 99,727 | $ | 86,113 | ||||
Liabilities and stockholders equity |
||||||||
Current liabilities: |
||||||||
Accounts payable |
$ | 3,829 | $ | 4,025 | ||||
Short-term debt |
0 | 1,000 | ||||||
Accrued compensation |
2,917 | 3,283 | ||||||
Income taxes |
839 | 1,074 | ||||||
Short-term unearned revenue |
11,887 | 13,652 | ||||||
Securities lending payable |
1,245 | 182 | ||||||
Other |
3,325 | 2,931 | ||||||
Total current liabilities |
24,042 | 26,147 | ||||||
Long-term debt |
11,915 | 4,939 | ||||||
Long-term unearned revenue |
1,132 | 1,178 | ||||||
Deferred income taxes |
1,185 | 229 | ||||||
Other long-term liabilities |
8,001 | 7,445 | ||||||
Total liabilities |
46,275 | 39,938 | ||||||
Commitments and contingencies |
||||||||
Stockholders equity: |
||||||||
Common stock and paid-in capitalshares authorized 24,000; outstanding 8,431 and 8,668 |
63,234 | 62,856 | ||||||
Retained deficit, including accumulated other comprehensive income of $1,810 and $1,055 |
(9,782 | ) | (16,681 | ) | ||||
Total stockholders equity |
53,452 | 46,175 | ||||||
Total liabilities and stockholders equity |
$ | 99,727 | $ | 86,113 | ||||
(1) | Derived from audited financial statements. |
See accompanying notes.
4
PART I
Item 1
(In millions) (Unaudited) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Operations |
||||||||||||||||
Net income |
$ | 5,232 | $ | 4,006 | $ | 17,276 | $ | 14,242 | ||||||||
Adjustments to reconcile net income to net cash from operations: |
||||||||||||||||
Depreciation, amortization, and other |
720 | 694 | 2,077 | 1,955 | ||||||||||||
Stock-based compensation expense |
541 | 481 | 1,622 | 1,409 | ||||||||||||
Net recognized gains on investments and derivatives |
(122 | ) | (68 | ) | (377 | ) | (322 | ) | ||||||||
Excess tax benefits from stock-based compensation |
(5 | ) | (14 | ) | (14 | ) | (38 | ) | ||||||||
Deferred income taxes |
(59 | ) | (241 | ) | (324 | ) | 263 | |||||||||
Deferral of unearned revenue |
6,616 | 6,087 | 19,331 | 19,692 | ||||||||||||
Recognition of unearned revenue |
(7,026 | ) | (6,395 | ) | (21,189 | ) | (21,758 | ) | ||||||||
Changes in operating assets and liabilities: |
||||||||||||||||
Accounts receivable |
3,031 | 1,947 | 3,435 | 1,906 | ||||||||||||
Inventories |
(170 | ) | 77 | (258 | ) | 216 | ||||||||||
Other current assets |
(618 | ) | (361 | ) | (487 | ) | 90 | |||||||||
Other long-term assets |
(8 | ) | (81 | ) | 172 | (143 | ) | |||||||||
Accounts payable |
(51 | ) | 122 | (235 | ) | 89 | ||||||||||
Other current liabilities |
237 | 775 | (1,174 | ) | (146 | ) | ||||||||||
Other long-term liabilities |
354 | 364 | 1,197 | 1,014 | ||||||||||||
Net cash from operations |
8,672 | 7,393 | 21,052 | 18,469 | ||||||||||||
Financing |
||||||||||||||||
Short-term debt repayments, maturities of 90 days or less, net |
0 | (349 | ) | (186 | ) | (446 | ) | |||||||||
Proceeds from issuance of debt, maturities longer than 90 days |
2,239 | 851 | 6,960 | 2,592 | ||||||||||||
Repayments of debt, maturities longer than 90 days |
0 | (502 | ) | (814 | ) | (1,898 | ) | |||||||||
Common stock issued |
1,405 | 422 | 2,242 | 1,399 | ||||||||||||
Common stock repurchased |
(848 | ) | (2,023 | ) | (10,299 | ) | (7,430 | ) | ||||||||
Common stock cash dividends paid |
(1,349 | ) | (1,139 | ) | (3,830 | ) | (3,448 | ) | ||||||||
Excess tax benefits from stock-based compensation |
5 | 14 | 14 | 38 | ||||||||||||
Other |
(15 | ) | 0 | (40 | ) | 0 | ||||||||||
Net cash from (used in) financing |
1,437 | (2,726 | ) | (5,953 | ) | (9,193 | ) | |||||||||
Investing |
||||||||||||||||
Additions to property and equipment |
(658 | ) | (408 | ) | (1,713 | ) | (1,219 | ) | ||||||||
Acquisition of companies, net of cash acquired |
0 | (143 | ) | (69 | ) | (245 | ) | |||||||||
Purchases of investments |
(14,394 | ) | (11,217 | ) | (27,707 | ) | (25,994 | ) | ||||||||
Maturities of investments |
2,286 | 1,054 | 4,992 | 6,448 | ||||||||||||
Sales of investments |
5,738 | 4,927 | 9,768 | 12,705 | ||||||||||||
Securities lending payable |
(111 | ) | (117 | ) | 1,063 | 1,110 | ||||||||||
Net cash used in investing |
(7,139 | ) | (5,904 | ) | (13,666 | ) | (7,195 | ) | ||||||||
Effect of exchange rates on cash and cash equivalents |
28 | (30 | ) | 83 | (2 | ) | ||||||||||
Net change in cash and cash equivalents |
2,998 | (1,267 | ) | 1,516 | 2,079 | |||||||||||
Cash and cash equivalents, beginning of period |
4,023 | 9,422 | 5,505 | 6,076 | ||||||||||||
Cash and cash equivalents, end of period |
$ | 7,021 | $ | 8,155 | $ | 7,021 | $ | 8,155 | ||||||||
See accompanying notes.
5
PART I
Item 1
STOCKHOLDERS EQUITY STATEMENTS
(In millions) (Unaudited) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Common stock and paid-in capital |
||||||||||||||||
Balance, beginning of period |
$ | 61,646 | $ | 62,566 | $ | 62,856 | $ | 62,382 | ||||||||
Common stock issued |
1,405 | 372 | 2,242 | 1,399 | ||||||||||||
Common stock repurchased |
(240 | ) | (495 | ) | (3,220 | ) | (2,151 | ) | ||||||||
Stock-based compensation |
541 | 481 | 1,622 | 1,409 | ||||||||||||
Stock-based compensation income tax deficiencies |
(118 | ) | (407 | ) | (266 | ) | (522 | ) | ||||||||
Balance, end of period |
63,234 | 62,517 | 63,234 | 62,517 | ||||||||||||
Retained deficit |
||||||||||||||||
Balance, beginning of period |
(13,165 | ) | (18,283 | ) | (16,681 | ) | (22,824 | ) | ||||||||
Net income |
5,232 | 4,006 | 17,276 | 14,242 | ||||||||||||
Other comprehensive income: |
||||||||||||||||
Net unrealized gains (losses) on derivatives |
(70 | ) | 103 | (656 | ) | (258 | ) | |||||||||
Net unrealized gains on investments |
83 | 124 | 1,099 | 777 | ||||||||||||
Translation adjustments and other |
99 | (97 | ) | 311 | (36 | ) | ||||||||||
Comprehensive income |
5,344 | 4,136 | 18,030 | 14,725 | ||||||||||||
Common stock cash dividends |
(1,353 | ) | (1,132 | ) | (4,052 | ) | (3,429 | ) | ||||||||
Common stock repurchased |
(608 | ) | (1,528 | ) | (7,079 | ) | (5,279 | ) | ||||||||
Balance, end of period |
(9,782 | ) | (16,807 | ) | (9,782 | ) | (16,807 | ) | ||||||||
Total stockholders equity |
$ | 53,452 | $ | 45,710 | $ | 53,452 | $ | 45,710 | ||||||||
See accompanying notes.
6
PART I
Item 1
(Unaudited)
NOTE 1 ACCOUNTING POLICIES
Accounting Principles
In the opinion of management, the accompanying balance sheets and related interim statements of income, cash flows, and stockholders equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP). 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 information included in the Microsoft Corporation 2010 Form 10-K filed on July 30, 2010 with the U.S. Securities and Exchange Commission.
Principles of Consolidation
The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we exercise significant influence over but do not control the investee and are not the primary beneficiary of the investees activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method.
Estimates and Assumptions
Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include: estimates of loss contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or goodwill impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from managements estimates and assumptions.
Recently Adopted Accounting Guidance
On July 1, 2010, we adopted guidance issued by the Financial Accounting Standards Board (FASB) on revenue recognition. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product are no longer within the scope of the software revenue recognition guidance, and software-enabled products are now subject to other relevant revenue recognition guidance. Additionally, the FASB issued guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. Adoption of the new guidance did not have a material impact on our financial statements.
On July 1, 2010, we also adopted guidance issued by the FASB on the consolidation of variable interest entities. The new guidance requires revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over such entities, and additional disclosures for variable interests. Adoption of the new guidance did not have a material impact on our financial statements.
Recent Accounting Guidance Not Yet Adopted
In January 2010, the FASB issued guidance to amend the disclosure requirements related to fair value measurements. The guidance requires the disclosure of roll forward activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The guidance will become effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, the adoption of this new guidance will not have a material impact on our financial statements.
7
PART I
Item 1
NOTE 2 EARNINGS PER SHARE
Basic earnings per share is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted earnings per share are as follows:
(In millions, except earnings per share) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Net income available for common shareholders (A) |
$ | 5,232 | $ | 4,006 | $ | 17,276 | $ | 14,242 | ||||||||
Weighted average shares of common stock (B) |
8,420 | 8,767 | 8,511 | 8,846 | ||||||||||||
Dilutive effect of stock-based awards |
90 | 109 | 98 | 109 | ||||||||||||
Common stock and common stock equivalents (C) |
8,510 | 8,876 | 8,609 | 8,955 | ||||||||||||
Earnings per share: |
||||||||||||||||
Basic (A/B) |
$ | 0.62 | $ | 0.46 | $ | 2.03 | $ | 1.61 | ||||||||
Diluted (A/C) |
$ | 0.61 | $ | 0.45 | $ | 2.01 | $ | 1.59 | ||||||||
We excluded the following shares underlying stock-based awards from the calculations of diluted earnings per share because their inclusion would have been anti-dilutive:
(In millions) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Shares excluded from calculations of diluted EPS |
18 | 41 | 22 | 49 | ||||||||||||
The decrease in anti-dilutive shares is due mainly to the decrease in employee stock options outstanding.
In June 2010, we issued $1.25 billion of zero-coupon debt securities that are convertible into shares of our common stock if certain conditions are met. Shares of common stock into which the debt could convert were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive. See also Note 10 Debt.
NOTE 3 OTHER INCOME
The components of other income were as follows:
(In millions) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Dividends and interest income |
$ | 216 | $ | 204 | $ | 631 | $ | 604 | ||||||||
Interest expense |
(84 | ) | (38 | ) | (201 | ) | (114 | ) | ||||||||
Net recognized gains on investments |
187 | 137 | 339 | 299 | ||||||||||||
Net gains (losses) on derivatives |
(65 | ) | (69 | ) | 38 | 23 | ||||||||||
Net gains (losses) on foreign currency remeasurements |
55 | (56 | ) | (14 | ) | (24 | ) | |||||||||
Other |
7 | (10 | ) | (31 | ) | 33 | ||||||||||
Total |
$ | 316 | $ | 168 | $ | 762 | $ | 821 | ||||||||
8
PART I
Item 1
NOTE 4 INVESTMENTS
Investment Components
The components of investments, including associated derivatives, were as follows:
(In millions) | Cost Basis | Unrealized Gains |
Unrealized Losses |
Recorded Basis |
Cash and Cash Equivalents |
Short-term Investments |
Equity and Other Investments |
|||||||||||||||||||||
March 31, 2011 | ||||||||||||||||||||||||||||
Cash |
$ | 1,829 | $ | 0 | $ | 0 | $ | 1,829 | $ | 1,829 | $ | 0 | $ | 0 | ||||||||||||||
Mutual funds |
1,649 | 0 | 0 | 1,649 | 1,649 | 0 | 0 | |||||||||||||||||||||
Certificates of deposit |
1,248 | 0 | 0 | 1,248 | 970 | 278 | 0 | |||||||||||||||||||||
U.S. government and agency securities |
32,625 | 123 | (7 | ) | 32,741 | 874 | 31,867 | 0 | ||||||||||||||||||||
Foreign government bonds |
547 | 9 | (1 | ) | 555 | 0 | 555 | 0 | ||||||||||||||||||||
Mortgage-backed securities |
2,417 | 103 | (4 | ) | 2,516 | 0 | 2,516 | 0 | ||||||||||||||||||||
Corporate notes and bonds |
8,926 | 245 | (13 | ) | 9,158 | 1,699 | 7,459 | 0 | ||||||||||||||||||||
Municipal securities |
441 | 3 | (5 | ) | 439 | 0 | 439 | 0 | ||||||||||||||||||||
Common and preferred stock |
7,666 | 2,573 | (125 | ) | 10,114 | 0 | 0 | 10,114 | ||||||||||||||||||||
Other investments |
649 | 0 | 0 | 649 | 0 | 15 | 634 | |||||||||||||||||||||
Total |
$ | 57,997 | $ | 3,056 | $ | (155 | ) | $ | 60,898 | $ | 7,021 | $ | 43,129 | $ | 10,748 | |||||||||||||
(In millions) | Cost Basis | Unrealized Gains |
Unrealized Losses |
Recorded Basis |
Cash and Cash Equivalents |
Short-term Investments |
Equity and Other Investments |
|||||||||||||||||||||
June 30, 2010 | ||||||||||||||||||||||||||||
Cash |
$ | 1,661 | $ | 0 | $ | 0 | $ | 1,661 | $ | 1,661 | $ | 0 | $ | 0 | ||||||||||||||
Mutual funds |
1,120 | 0 | 0 | 1,120 | 1,120 | 0 | 0 | |||||||||||||||||||||
Commercial paper |
188 | 0 | 0 | 188 | 13 | 175 | 0 | |||||||||||||||||||||
Certificates of deposit |
348 | 0 | 0 | 348 | 68 | 280 | 0 | |||||||||||||||||||||
U.S. government and agency securities |
21,036 | 167 | (1 | ) | 21,202 | 1,822 | 19,380 | 0 | ||||||||||||||||||||
Foreign government bonds |
518 | 13 | 0 | 531 | 0 | 531 | 0 | |||||||||||||||||||||
Mortgage-backed securities |
3,137 | 135 | (7 | ) | 3,265 | 0 | 3,265 | 0 | ||||||||||||||||||||
Corporate notes and bonds |
7,450 | 289 | (18 | ) | 7,721 | 701 | 7,020 | 0 | ||||||||||||||||||||
Municipal securities |
726 | 22 | (1 | ) | 747 | 120 | 627 | 0 | ||||||||||||||||||||
Common and preferred stock |
6,640 | 1,030 | (418 | ) | 7,252 | 0 | 0 | 7,252 | ||||||||||||||||||||
Other investments |
507 | 0 | 0 | 507 | 0 | 5 | 502 | |||||||||||||||||||||
Total |
$ | 43,331 | $ | 1,656 | $ | (445 | ) | $ | 44,542 | $ | 5,505 | $ | 31,283 | $ | 7,754 | |||||||||||||
9
PART I
Item 1
Unrealized Losses on Investments
Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows:
Less than 12 Months | 12 Months or Greater | Total Unrealized Losses |
||||||||||||||||||||||
(In millions) | Fair Value | Unrealized Losses |
Fair Value | Unrealized Losses |
Total Fair Value |
|||||||||||||||||||
March 31, 2011 | ||||||||||||||||||||||||
U.S. government and agency securities |
$ | 286 | $ | (7 | ) | $ | 0 | $ | 0 | $ | 286 | $ | (7 | ) | ||||||||||
Foreign government bonds |
293 | (1 | ) | 0 | 0 | 293 | (1 | ) | ||||||||||||||||
Mortgage-backed securities |
75 | (3 | ) | 15 | (1 | ) | 90 | (4 | ) | |||||||||||||||
Corporate notes and bonds |
496 | (12 | ) | 25 | (1 | ) | 521 | (13 | ) | |||||||||||||||
Municipal securities |
174 | (5 | ) | 0 | 0 | 174 | (5 | ) | ||||||||||||||||
Common and preferred stock |
945 | (99 | ) | 160 | (26 | ) | 1,105 | (125 | ) | |||||||||||||||
Total |
$ | 2,269 | $ | (127 | ) | $ | 200 | $ | (28 | ) | $ | 2,469 | $ | (155 | ) | |||||||||
Less than 12 Months | 12 Months or Greater | Total Unrealized Losses |
||||||||||||||||||||||
(In millions) | Fair Value | Unrealized Losses |
Fair Value | Unrealized Losses |
Total Fair Value |
|||||||||||||||||||
June 30, 2010 | ||||||||||||||||||||||||
U.S. government and agency securities |
$ | 216 | $ | (1 | ) | $ | 0 | $ | 0 | $ | 216 | $ | (1 | ) | ||||||||||
Mortgage-backed securities |
105 | (6 | ) | 18 | (1 | ) | 123 | (7 | ) | |||||||||||||||
Corporate notes and bonds |
1,124 | (13 | ) | 89 | (5 | ) | 1,213 | (18 | ) | |||||||||||||||
Municipal securities |
66 | (1 | ) | 0 | 0 | 66 | (1 | ) | ||||||||||||||||
Common and preferred stock |
2,102 | (339 | ) | 190 | (79 | ) | 2,292 | (418 | ) | |||||||||||||||
Total |
$ | 3,613 | $ | (360 | ) | $ | 297 | $ | (85 | ) | $ | 3,910 | $ | (445 | ) | |||||||||
Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of March 31, 2011.
At March 31, 2011 and June 30, 2010, the recorded bases and estimated fair values of common and preferred stock and other investments that are restricted for more than one year or are not publicly traded were $319 million and $216 million, respectively.
Debt Investment Maturities
(In millions) | Cost Basis | Estimated Fair Value |
||||||
March 31, 2011 | ||||||||
Due in one year or less |
$ | 21,223 | $ | 21,294 | ||||
Due after one year through five years |
19,550 | 19,723 | ||||||
Due after five years through 10 years |
2,450 | 2,556 | ||||||
Due after 10 years |
2,981 | 3,084 | ||||||
Total |
$ | 46,204 | $ | 46,657 | ||||
10
PART I
Item 1
NOTE 5 DERIVATIVES
We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible.
Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. currency equivalents.
Foreign Currency
Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of March 31, 2011 and June 30, 2010, the total notional amounts of these foreign exchange contracts sold were $10.9 billion and $9.3 billion, respectively.
Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. As of March 31, 2011 and June 30, 2010, the total notional amounts of these foreign exchange contracts sold were $536 million and $523 million, respectively.
Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of March 31, 2011, the total notional amounts of these foreign exchange contracts purchased and sold were $5.8 billion and $4.6 billion, respectively. As of June 30, 2010, the total notional amounts of these foreign exchange contracts purchased and sold were $7.8 billion and $5.3 billion, respectively.
Equity
Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of March 31, 2011, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.7 billion and $1.4 billion, respectively. As of June 30, 2010, the total notional amounts of designated and non-designated equity contracts purchased and sold were $918 million and $472 million, respectively.
Interest Rate
Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of March 31, 2011, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.4 billion and $1.4 billion, respectively. As of June 30, 2010, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.1 billion and $1.8 billion, respectively.
In addition, we use To Be Announced forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of March 31, 2011 and June 30, 2010, the total notional derivative amount of mortgage contracts purchased were $828 million and $305 million, respectively.
Credit
Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low cost method of managing exposure to individual credit risks or groups of credit risks. As of March 31, 2011 and June 30, 2010, the total notional amounts of credit contracts purchased and sold were immaterial.
11
PART I
Item 1
Commodity
We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swap, futures, and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of March 31, 2011, the total notional amounts of commodity contracts purchased and sold were $1.5 billion and $520 million, respectively. As of June 30, 2010, the total notional amounts of commodity contracts purchased and sold were $1.1 billion and $376 million, respectively.
Credit-Risk-Related Contingent Features
Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of March 31, 2011, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted.
Fair Values of Derivative Instruments
Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation.
For a derivative instrument designated as a fair value hedge, the gain (loss) is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For options designated as fair value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings.
For derivative instruments designated as cash flow hedges, the effective portion of the derivatives gain (loss) is initially reported as a component of other comprehensive income (OCI) and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings.
For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from OCI into other income (expense).
Following are the gross fair values of derivative instruments designated as hedging instruments (designated hedge derivatives) and not designated as hedging instruments (non-designated hedge derivatives) that were held at March 31, 2011 and June 30, 2010. The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk.
12
PART I
Item 1
(In millions) | Foreign Exchange Contracts |
Equity Contracts |
Interest Rate Contracts |
Credit Contracts |
Commodity Contracts |
Total Derivatives |
||||||||||||||||||
March 31, 2011 | ||||||||||||||||||||||||
Assets |
||||||||||||||||||||||||
Non-designated hedge derivatives: |
||||||||||||||||||||||||
Short-term investments |
$ | 20 | $ | 197 | $ | 19 | $ | 15 | $ | 30 | $ | 281 | ||||||||||||
Other current assets |
76 | 0 | 0 | 0 | 0 | 76 | ||||||||||||||||||
Total |
$ | 96 | $ | 197 | $ | 19 | $ | 15 | $ | 30 | $ | 357 | ||||||||||||
Designated hedge derivatives: |
||||||||||||||||||||||||
Short-term investments |
$ | 0 | $ | 0 | $ | 0 | $ | 0 | $ | 0 | $ | 0 | ||||||||||||
Other current assets |
104 | 0 | 0 | 0 | 0 | 104 | ||||||||||||||||||
Total |
$ | 104 | $ | 0 | $ | 0 | $ | 0 | $ | 0 | $ | 104 | ||||||||||||
Total assets |
$ | 200 | $ | 197 | $ | 19 | $ | 15 | $ | 30 | $ | 461 | ||||||||||||
Liabilities |
||||||||||||||||||||||||
Non-designated hedge derivatives: |
||||||||||||||||||||||||
Other current liabilities |
$ | (74 | ) | $ | (12 | ) | $ | (5 | ) | $ | (14 | ) | $ | (26 | ) | $ | (131 | ) | ||||||
Designated hedge derivatives: |
||||||||||||||||||||||||
Other current liabilities |
$ | (229 | ) | $ | 0 | $ | 0 | $ | 0 | $ | 0 | $ | (229 | ) | ||||||||||
Total liabilities |
$ | (303 | ) | $ | (12 | ) | $ | (5 | ) | $ | (14 | ) | $ | (26 | ) | $ | (360 | ) | ||||||
(In millions) | Foreign Exchange Contracts |
Equity Contracts |
Interest Rate Contracts |
Credit Contracts |
Commodity Contracts |
Total Derivatives |
||||||||||||||||||
June 30, 2010 | ||||||||||||||||||||||||
Assets |
||||||||||||||||||||||||
Non-designated hedge derivatives: |
||||||||||||||||||||||||
Short-term investments |
$ | 15 | $ | 134 | $ | 12 | $ | 7 | $ | 8 | $ | 176 | ||||||||||||
Other current assets |
34 | 0 | 0 | 0 | 0 | 34 | ||||||||||||||||||
Total |
$ | 49 | $ | 134 | $ | 12 | $ | 7 | $ | 8 | $ | 210 | ||||||||||||
Designated hedge derivatives: |
||||||||||||||||||||||||
Short-term investments |
$ | 3 | $ | 0 | $ | 0 | $ | 0 | $ | 0 | $ | 3 | ||||||||||||
Other current assets |
563 | 0 | 0 | 0 | 0 | 563 | ||||||||||||||||||
Total |
$ | 566 | $ | 0 | $ | 0 | $ | 0 | $ | 0 | $ | 566 | ||||||||||||
Total assets |
$ | 615 | $ | 134 | $ | 12 | $ | 7 | $ | 8 | $ | 776 | ||||||||||||
Liabilities |
||||||||||||||||||||||||
Non-designated hedge derivatives: |
||||||||||||||||||||||||
Other current liabilities |
$ | (60 | ) | $ | (17 | ) | $ | (33 | ) | $ | (41 | ) | $ | (5 | ) | $ | (156 | ) | ||||||
Designated hedge derivatives: |
||||||||||||||||||||||||
Other current liabilities |
$ | (9 | ) | $ | 0 | $ | 0 | $ | 0 | $ | 0 | $ | (9 | ) | ||||||||||
Total liabilities |
$ | (69 | ) | $ | (17 | ) | $ | (33 | ) | $ | (41 | ) | $ | (5 | ) | $ | (165 | ) | ||||||
See also Note 4 Investments and Note 6 Fair Value Measurements.
13
PART I
Item 1
Fair Value Hedges
We recognized in other income the following gains (losses) related to foreign exchange contracts designated as fair value hedges (our only fair value hedges during the periods presented) and their related hedged items:
(In millions) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Derivatives |
$ | (28 | ) | $ | (2 | ) | $ | (78 | ) | $ | (106 | ) | ||||
Hedged items |
26 | 4 | 74 | 107 | ||||||||||||
Total |
$ | (2 | ) | $ | 2 | $ | (4 | ) | $ | 1 | ||||||
Cash Flow Hedges
We recognized the following gains (losses) related to foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the periods presented):
(In millions) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Effective portion |
||||||||||||||||
Gain (loss) recognized in OCI, net of tax effect of $(48) for the three months ended and $(315) for the nine months ended March 31, 2011, and $85 for the three months and $(26) for the nine months ended March 31, 2010 |
$ | (90 | ) | $ | 159 | $ | (587 | ) | $ | (48 | ) | |||||
Gain (loss) reclassified from OCI into revenue |
(30 | ) | 85 | 109 | 322 | |||||||||||
Amount excluded from effectiveness assessment and ineffective portion |
||||||||||||||||
Loss recognized in other income |
(123 | ) | (62 | ) | (226 | ) | (76 | ) | ||||||||
We estimate that $214 million of net derivative losses included in OCI will be reclassified into earnings within the next 12 months. No significant amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur during the three months and nine months ended March 31, 2011 and 2010.
Non-Designated Derivatives
Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), which were immaterial for the three months and nine months ended March 31, 2011 and 2010. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities.
(In millions) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Foreign exchange contracts |
$ | 51 | $ | 1 | $ | (34 | ) | $ | 91 | |||||||
Equity contracts |
8 | 8 | 39 | 24 | ||||||||||||
Interest-rate contracts |
8 | 8 | 20 | 20 | ||||||||||||
Credit contracts |
(3 | ) | 7 | 25 | 18 | |||||||||||
Commodity contracts |
48 | (35 | ) | 206 | 34 | |||||||||||
Total |
$ | 112 | $ | (11 | ) | $ | 256 | $ | 187 | |||||||
14
PART I
Item 1
NOTE 6 FAIR VALUE MEASUREMENTS
We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are:
| Level 1inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative investments primarily include U.S. treasuries, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. |
| Level 2inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, mortgage-backed securities, agency securities, certificates of deposit, and commercial paper. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. |
| Level 3inputs are generally unobservable and typically reflect managements estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in certain corporate bonds. We value these corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant to the fair values of the investments. Our Level 3 derivative assets and liabilities primarily comprise derivatives for foreign equities. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions to determine fair value for these derivatives. |
We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary.
15
PART I
Item 1
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis:
(In millions) |
Level 1 | Level 2 | Level 3 |
|
Gross Fair Value |
|
Netting | (a) | |
Net Fair Value |
| |||||||||||||
March 31, 2011 | ||||||||||||||||||||||||
Assets |
||||||||||||||||||||||||
Mutual funds |
$ | 1,649 | $ | 0 | $ | 0 | $ | 1,649 | $ | 0 | $ | 1,649 | ||||||||||||
Certificates of deposit |
0 | 1,248 | 0 | 1,248 | 0 | 1,248 | ||||||||||||||||||
U.S. government and agency securities |
24,834 | 7,907 | 0 | 32,741 | 0 | 32,741 | ||||||||||||||||||
Foreign government bonds |
127 | 440 | 0 | 567 | 0 | 567 | ||||||||||||||||||
Mortgage-backed securities |
0 | 2,515 | 0 | 2,515 | 0 | 2,515 | ||||||||||||||||||
Corporate notes and bonds |
0 | 8,898 | 65 | 8,963 | 0 | 8,963 | ||||||||||||||||||
Municipal securities |
0 | 439 | 0 | 439 | 0 | 439 | ||||||||||||||||||
Common and preferred stock |
9,737 | 51 | 5 | 9,793 | 0 | 9,793 | ||||||||||||||||||
Derivatives |
29 | 418 | 14 | 461 | (232 | ) | 229 | |||||||||||||||||
Total |
$ | 36,376 | $ | 21,916 | $ | 84 | $ | 58,376 | $ | (232 | ) | $ | 58,144 | |||||||||||
Liabilities |
||||||||||||||||||||||||
Derivatives and other |
$ | 124 | $ | 342 | $ | 0 | $ | 466 | $ | (232 | ) | $ | 234 | |||||||||||
(In millions) |
Level 1 | Level 2 | Level 3 |
|
Gross Fair Value |
|
Netting | (a) | |
Net Fair Value |
| |||||||||||||
June 30, 2010 | ||||||||||||||||||||||||
Assets |
||||||||||||||||||||||||
Mutual funds |
$ | 1,120 | $ | 0 | $ | 0 | $ | 1,120 | $ | 0 | $ | 1,120 | ||||||||||||
Commercial paper |
0 | 172 | 0 | 172 | 0 | 172 | ||||||||||||||||||
Certificates of deposit |
0 | 348 | 0 | 348 | 0 | 348 | ||||||||||||||||||
U.S. government and agency securities |
16,473 | 4,756 | 0 | 21,229 | 0 | 21,229 | ||||||||||||||||||
Foreign government bonds |
239 | 294 | 0 | 533 | 0 | 533 | ||||||||||||||||||
Mortgage-backed securities |
0 | 3,264 | 0 | 3,264 | 0 | 3,264 | ||||||||||||||||||
Corporate notes and bonds |
0 | 7,460 | 167 | 7,627 | 0 | 7,627 | ||||||||||||||||||
Municipal securities |
0 | 747 | 0 | 747 | 0 | 747 | ||||||||||||||||||
Common and preferred stock |
6,988 | 43 | 5 | 7,036 | 0 | 7,036 | ||||||||||||||||||
Derivatives |
22 | 745 | 9 | 776 | (207 | ) | 569 | |||||||||||||||||
Total |
$ | 24,842 | $ | 17,829 | $ | 181 | $ | 42,852 | $ | (207 | ) | $ | 42,645 | |||||||||||
Liabilities |
||||||||||||||||||||||||
Derivatives and other |
$ | 85 | $ | 137 | $ | 0 | $ | 222 | $ | (205 | ) | $ | 17 | |||||||||||
(a) | These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk. |
16
PART I
Item 1
The table below reconciles the total Net Fair Value of assets above to the balance sheet presentation of these same assets in Note 4 Investments for March 31, 2011 and June 30, 2010.
(In millions) | ||||||||
March 31, 2011 |
June 30, 2010 |
|||||||
Net fair value of assets measured at fair value on a recurring basis |
$ | 58,144 | $ | 42,645 | ||||
Cash |
1,829 | 1,661 | ||||||
Common and preferred stock measured at fair value on a nonrecurring basis |
319 | 216 | ||||||
Other investments measured at fair value on a nonrecurring basis |
634 | 502 | ||||||
Less derivative assets classified as other current assets |
(29 | ) | (544 | ) | ||||
Other |
1 | 62 | ||||||
Recorded basis of investment components |
$ | 60,898 | $ | 44,542 | ||||
Changes in Financial Instruments Measured at Level 3 Fair Value on a Recurring Basis
The following tables present the changes during the three months and nine months ended March 31, 2011 and 2010 in our Level 3 financial instruments that are measured at fair value on a recurring basis. The majority of these instruments consist of investment securities classified as available-for-sale with changes in fair value included in OCI.
(In millions) | Corporate Notes and Bonds |
Common and Preferred Stock |
Derivative Assets |
Total | ||||||||||||
Three Months and Nine Months Ended March 31, 2011 | ||||||||||||||||
Balance as of June 30, 2010 |
$ | 167 | $ | 5 | $ | 9 | $ | 181 | ||||||||
Total realized and unrealized gains (losses): |
||||||||||||||||
Included in other income (expense) |
2 | 0 | 7 | 9 | ||||||||||||
Included in other comprehensive income |
(2 | ) | 0 | 0 | (2 | ) | ||||||||||
Balance as of September 30, 2010 |
$ | 167 | $ | 5 | $ | 16 | $ | 188 | ||||||||
Total realized and unrealized gains (losses): |
||||||||||||||||
Included in other income (expense) |
2 | 0 | (1 | ) | 1 | |||||||||||
Included in other comprehensive income |
2 | 0 | 0 | 2 | ||||||||||||
Balance as of December 31, 2010 |
$ | 171 | $ | 5 | $ | 15 | $ | 191 | ||||||||
Total realized and unrealized gains (losses): |
||||||||||||||||
Included in other income (expense) |
34 | 0 | (1 | ) | 33 | |||||||||||
Included in other comprehensive income |
(55 | ) | 0 | 0 | (55 | ) | ||||||||||
Purchases, issuances and settlements |
(85 | ) | 0 | 0 | (85 | ) | ||||||||||
Balance as of March 31, 2011 |
$ | 65 | $ | 5 | $ | 14 | $ | 84 | ||||||||
Change in unrealized gains (losses) included in other income (expense) for the three months ended March 31, 2011 related to assets held as of March 31, 2011 |
$ | 1 | $ | 0 | $ | (1 | ) | $ | 0 | |||||||
Change in unrealized gains (losses) included in other income (expense) for the nine months ended March 31, 2011 related to assets held as of March 31, 2011 |
$ | 5 | $ | 0 | $ | 5 | $ | 10 | ||||||||
17
PART I
Item 1
(In millions) | Corporate Notes and Bonds |
Common and Preferred Stock |
Derivative Assets |
Total | ||||||||||||
Three Months and Nine Months Ended March 31, 2010 | ||||||||||||||||
Balance as of June 30, 2009 |
$ | 253 | $ | 5 | $ | 5 | $ | 263 | ||||||||
Total realized and unrealized gains (losses): |
||||||||||||||||
Included in other income (expense) |
1 | 0 | (2 | ) | (1 | ) | ||||||||||
Included in other comprehensive income |
(74 | ) | 0 | 0 | (74 | ) | ||||||||||
Balance as of September 30, 2009 |
$ | 180 | $ | 5 | $ | 3 | $ | 188 | ||||||||
Total realized and unrealized gains: |
||||||||||||||||
Included in other income (expense) |
1 | 0 | 1 | 2 | ||||||||||||
Included in other comprehensive income |
11 | 0 | 0 | 11 | ||||||||||||
Balance as of December 31, 2009 |
$ | 192 | $ | 5 | $ | 4 | $ | 201 | ||||||||
Total realized and unrealized gains: |
||||||||||||||||
Included in other income (expense) |
2 | 0 | 2 | 4 | ||||||||||||
Included in other comprehensive income |
0 | 0 | 0 | 0 | ||||||||||||
Balance as of March 31, 2010 |
$ | 194 | $ | 5 | $ | 6 | $ | 205 | ||||||||
Change in unrealized gains (losses) included in other income (expense) for the three months ended March 31, 2010 related to assets held as of March 31, 2010 |
$ | 2 | $ | 0 | $ | 2 | $ | 4 | ||||||||
Change in unrealized gains (losses) included in other income (expense) for the nine months ended March 31, 2010 related to assets held as of March 31, 2010 |
$ | 4 | $ | 0 | $ | 1 | $ | 5 | ||||||||
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
During the three months and nine months ended March 31, 2011 and 2010, we did not record any other-than-temporary impairments on those assets required to be measured at fair value on a nonrecurring basis.
NOTE 7 INVENTORIES
The components of inventories were as follows:
(In millions) | ||||||||
March 31, 2011 |
|
|
June 30, 2010 |
| ||||
Raw materials |
$ | 175 | $ | 172 | ||||
Work in process |
54 | 16 | ||||||
Finished goods |
827 | 552 | ||||||
Total |
$ | 1,056 | $ | 740 | ||||
18
PART I
Item 1
NOTE 8 GOODWILL
Changes in our goodwill balances during the three months and nine months ended March 31, 2011 were as follows:
(In millions) | Balance | Acquisitions | Purchase Accounting Adjustments and Other |
Balance | ||||||||||||
December 31, 2010 |
March 31, 2011 |
|||||||||||||||
Windows & Windows Live Division |
$ | 89 | $ | 0 | $ | 0 | $ | 89 | ||||||||
Server and Tools |
1,138 | 0 | 1 | 1,139 | ||||||||||||
Online Services Division |
6,373 | 0 | 0 | 6,373 | ||||||||||||
Microsoft Business Division |
4,091 | 0 | 49 | 4,140 | ||||||||||||
Entertainment and Devices Division |
811 | 0 | 2 | 813 | ||||||||||||
Total |
$ | 12,502 | $ | 0 | $ | 52 | $ | 12,554 | ||||||||
(In millions) | Balance | Acquisitions | Purchase Accounting Adjustments and Other |
Balance | ||||||||||||
June 30, 2010 |
March 31, 2011 |
|||||||||||||||
Windows & Windows Live Division |
$ | 77 | $ | 0 | $ | 12 | $ | 89 | ||||||||
Server and Tools |
1,118 | 13 | 8 | 1,139 | ||||||||||||
Online Services Division |
6,373 | 0 | 0 | 6,373 | ||||||||||||
Microsoft Business Division |
4,024 | 0 | 116 | 4,140 | ||||||||||||
Entertainment and Devices Division |
802 | 30 | (19 | ) | 813 | |||||||||||
Total |
$ | 12,394 | $ | 43 | $ | 117 | $ | 12,554 | ||||||||
We do not expect any of the amounts recorded as goodwill to be deductible for tax purposes. The measurement period for purchase price allocations ends as soon as information on the facts and circumstances becomes available, but will not exceed 12 months. Adjustments in the purchase price allocation may require a recasting of the amounts allocated to goodwill retroactive to the period in which the acquisition occurred. Any change in the goodwill amounts resulting from foreign currency translations are presented as other in the above table. Also included within other are transfers between business segments due to reorganizations.
NOTE 9 INTANGIBLE ASSETS
The components of intangible assets were as follows:
(In millions) | Gross Carrying Amount |
Accumulated Amortization |
Net Carrying Amount |
Gross Carrying Amount |
Accumulated Amortization |
Net Carrying Amount |
||||||||||||||||||
|
March 31, 2011 |
|
|
June 30, 2010 |
| |||||||||||||||||||
Contract-based |
$ | 1,067 | $ | (950 | ) | $ | 117 | $ | 1,075 | $ | (914 | ) | $ | 161 | ||||||||||
Technology-based |
2,328 | (1,736 | ) | 592 | 2,308 | (1,521 | ) | 787 | ||||||||||||||||
Marketing-related |
113 | (95 | ) | 18 | 114 | (86 | ) | 28 | ||||||||||||||||
Customer-related |
392 | (279 | ) | 113 | 390 | (208 | ) | 182 | ||||||||||||||||
Total |
$ | 3,900 | $ | (3,060 | ) | $ | 840 | $ | 3,887 | $ | (2,729 | ) | $ | 1,158 | ||||||||||
Intangible assets amortization expense was $162 million for the three months and $412 million for the nine months ended March 31, 2011 as compared with $198 million for the three months and $516 million for the nine months
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ended March 31, 2010. The following table outlines the estimated future amortization expense related to intangible assets held at March 31, 2011:
(In millions) | ||||
Year Ending June 30, | ||||
2011 (excluding the nine months ended March 31, 2011) |
$ | 128 | ||
2012 |
391 | |||
2013 |
245 | |||
2014 |
45 | |||
2015 |
19 | |||
2016 and thereafter |
12 | |||
Total |
$ | 840 | ||
NOTE 10 DEBT
Short-term Debt
During the nine months ended March 31, 2011, we repaid $1.0 billion of commercial paper, leaving zero outstanding.
On November 5, 2010, our $1.0 billion 364-day credit facility expired. This facility served as a back-up for our commercial paper program. No amounts were drawn against the credit facility during any of the periods presented.
Long-term Debt
As of March 31, 2011, both the total carrying value and estimated fair value of our long-term debt, including convertible debt, were $11.9 billion. The estimated fair value is based on quoted prices for our publicly-traded debt as of March 31, 2011, as applicable.
The components of long-term debt, the associated interest rates, and the semi-annual interest record and payment dates were as follows as of March 31, 2011:
Due Date | Face Value | Stated Rate |
Effective Rate |
Interest Record Date |
Interest Pay Date |
Interest Record Date |
Interest Pay Date |
|||||||||||||||||||||
(In millions) | ||||||||||||||||||||||||||||
Notes |
||||||||||||||||||||||||||||
September 27, 2013 |
$ | 1,000 | 0.875 | % | 1.000 | % | March 15 | March 27 | September 15 | September 27 | ||||||||||||||||||
June 1, 2014 |
2,000 | 2.950 | % | 3.049 | % | May 15 | June 1 | November 15 | December 1 | |||||||||||||||||||
September 25, 2015 |
1,750 | 1.625 | % | 1.795 | % | March 15 | March 25 | September 15 | September 25 | |||||||||||||||||||
February 8, 2016 |
750 | 2.500 | % | 2.642 | % | February 1 | February 8 | August 1 | August 8 | |||||||||||||||||||
June 1, 2019 |
1,000 | 4.200 | % | 4.379 | % | May 15 | June 1 | November 15 | December 1 | |||||||||||||||||||
October 1, 2020 |
1,000 | 3.000 | % | 3.137 | % | March 15 | April 1 | September 15 | October 1 | |||||||||||||||||||
February 8, 2021 |
500 | 4.000 | % | 4.082 | % | February 1 | February 8 | August 1 | August 8 | |||||||||||||||||||
June 1, 2039 |
750 | 5.200 | % | 5.240 | % | May 15 | June 1 | November 15 | December 1 | |||||||||||||||||||
October 1, 2040 |
1,000 | 4.500 | % | 4.567 | % | March 15 | April 1 | September 15 | October 1 | |||||||||||||||||||
February 8, 2041 |
1,000 | 5.300 | % | 5.361 | % | February 1 | February 8 | August 1 | August 8 | |||||||||||||||||||
Total |
10,750 | |||||||||||||||||||||||||||
Convertible debt |
||||||||||||||||||||||||||||
June 15, 2013 |
1,250 | 0.000 | % | 1.849 | % | |||||||||||||||||||||||
Total unamortized discount |
(85 | ) | ||||||||||||||||||||||||||
Total |
$ | 11,915 | ||||||||||||||||||||||||||
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Notes
As of March 31, 2011, we had issued and outstanding $10.8 billion of debt securities as illustrated in the table above (collectively the Notes), including $4.75 billion issued in September 2010 and $2.25 billion issued in February 2011. The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.
Convertible Debt
In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, which were capitalized. Each $1,000 principal amount of notes is convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share.
Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into cash and, if applicable, cash, shares of Microsofts common stock, or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the notes and pay or deliver cash, shares of our common stock, or a combination of cash and shares of our common stock, at our election.
Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders equity for $58 million with the portion in stockholders equity representing the fair value of the option to convert the debt.
In connection with the issuance of the notes, we entered into capped call transactions with certain option counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with a cap price equal to $37.16. The purchased capped calls were valued at $40 million and recorded to stockholders equity.
NOTE 11 INCOME TAXES
Our effective tax rates were approximately 13% and 25% for the three months ended March 31, 2011 and 2010, respectively, and 21% and 25% for the nine months ended March 31, 2011 and 2010, respectively. Our rates decreased and were lower than the U.S. federal statutory rate primarily due to the settlement of a portion of a U.S. Internal Revenue Service (I.R.S.) audit of tax years 2004 to 2006, which reduced our income tax expense for the third quarter by $461 million, and a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from continued emphasis on producing and distributing our products and services through our foreign regional operational centers in Ireland, Singapore and Puerto Rico, which are subject to lower income tax rates.
Tax contingencies and other tax liabilities were $7.2 billion and $6.9 billion as of March 31, 2011 and June 30, 2010, respectively, and were included in other long-term liabilities. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006, we remain under audit for these years. Subsequent to quarter end, the I.R.S. issued proposed adjustments for tax years 2004 to 2006 that we have not agreed to and intend to contest through the administrative process. The impact of these proposed adjustments on years currently open to examination could have a significant impact on our financial statements if not resolved favorably. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the audit will be concluded within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2010.
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NOTE 12 UNEARNED REVENUE
The components of unearned revenue were as follows:
(In millions) | ||||||||
March 31, 2011 |
|
|
June 30, 2010 |
| ||||
Volume licensing programs |
$ | 10,634 | $ | 12,180 | ||||
Undelivered elements |
165 | 624 | ||||||
Other |
2,220 | 2,026 | ||||||
Total |
$ | 13,019 | $ | 14,830 | ||||
Unearned revenue by segment was as follows:
(In millions) | ||||||||
March 31, 2011 |
|
|
June 30, 2010 |
| ||||
Windows & Windows Live Division |
$ | 1,370 | $ | 1,701 | ||||
Server and Tools |
4,883 | 5,282 | ||||||
Microsoft Business Division |
5,836 | 7,004 | ||||||
Other segments |
930 | 843 | ||||||
Total |
$ | 13,019 | $ | 14,830 | ||||
NOTE 13 COMMITMENTS AND GUARANTEES
Yahoo! Commercial Agreement
On December 4, 2009, we entered into a definitive agreement with Yahoo! whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites. The term of the agreement is 10 years subject to termination provisions after five years based on performance.
Microsoft provided Yahoo! with revenue per search guarantees for a period of 18 months after implementation of the Microsoft search ads platform in each country. These guarantees are calculated, paid and trued-up periodically based on the cumulative reduction in revenue per search, if any, during the 18-month period from pre-implementation levels, except in the case of the U.S. and Canada where performance during each of the first two calendar quarters after implementation is independent and not cumulative. This is a rate guarantee and not a guarantee of search volume. We estimate the total cost of the revenue per search guarantees during the guarantee period could range up to $150 million.
Microsoft also agreed to reimburse Yahoo! for certain transition expenses incurred both before and after the effective date of the agreement.
Finally, Microsoft also agreed to reimburse Yahoo! for certain costs of running algorithmic and paid search services prior to migration to Microsofts platform.
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Product Warranty
Our aggregate product warranty liabilities, which are included in other current liabilities and other long-term liabilities, changed during the three months and nine months ended March 31, 2011 as follows:
(In millions) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Balance, beginning of period |
$ | 202 | $ | 308 | $ | 240 | $ | 342 | ||||||||
Accrual for warranties issued |
14 | 27 | 46 | 121 | ||||||||||||
Adjustments to pre-existing warranties |
0 | 0 | 0 | (2 | ) | |||||||||||
Settlements of warranty claims |
(31 | ) | (77 | ) | (101 | ) | (203 | ) | ||||||||
Balance, end of period |
$ | 185 | $ | 258 | $ | 185 | $ | 258 | ||||||||
NOTE 14 CONTINGENCIES
Government Competition Law Matters
We are subject to a Consent Decree and Final Judgment (Final Judgments) that resolved lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions. The Final Judgments imposed various constraints on our Windows operating system businesses. The Final Judgments are scheduled to expire in May 2011.
In other ongoing investigations, various foreign governments and several state attorneys general have requested information from us concerning competition, privacy, and security issues.
Antitrust, Unfair Competition, and Overcharge Class Actions
A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under federal law and in 15 states. Courts refused to certify classes in two additional states. We have reached agreements to settle all claims that have been made to date in 19 states and the District of Columbia.
The settlements in all states have received final court approval. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. We estimate the total cost to resolve all of the state overcharge class action cases will range between $1.9 billion and $2.0 billion. At March 31, 2011, we have recorded a liability related to these claims of approximately $585 million, which reflects our estimated exposure of $1.9 billion less payments made to date of approximately $1.3 billion mostly for vouchers, legal fees, and administrative expenses.
The three cases pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. On April 15, 2011, the British Columbia Court of Appeal reversed the class certification ruling and dismissed the case, holding that indirect purchasers do not have a claim. We expect the plaintiffs will seek review by the Canadian Supreme Court. The other two actions have been stayed.
Other Antitrust Litigation and Claims
In November 2004, Novell, Inc. filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to Novells ownership
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of WordPerfect and other productivity applications during the period between June 1994 and March 1996. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. In March 2010 the trial court granted summary judgment in favor of Microsoft as to all remaining claims. Novell has appealed that ruling. The appeal was argued in March 2011 and we are awaiting a ruling.
Patent and Intellectual Property Claims
In 2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents (although this action began before the merger of Alcatel and Lucent in 2006, for simplicity we refer to the post-merger entity of Alcatel-Lucent). In April 2008, a jury returned a verdict in Alcatel-Lucents favor in a trial on a consolidated group of one video and three user interface patents. The jury concluded that we had infringed two user interface patents and awarded $367 million in damages. In June 2008, the trial judge increased the amount of damages to $512 million to include $145 million of interest. We appealed that award. In December 2008, we entered into a settlement agreement resolving all other litigation pending between Microsoft and Alcatel-Lucent, leaving approximately $500 million remaining in dispute. In September 2009, the court of appeals affirmed the liability award but vacated the verdict and remanded the case to the trial court for a re-trial of the damages ruling, indicating the damages previously awarded were too high. Trial on the remanded damages claim is set to begin in July 2011.
In October 2003, Uniloc USA Inc., a subsidiary of a Singapore-based company, filed a patent infringement suit in U.S. District Court in Rhode Island, claiming that product activation technology supporting Windows XP and certain other Microsoft programs violated a Uniloc patent. After we obtained a favorable summary judgment that we did not infringe any of the claims of this patent, the court of appeals vacated the trial court decision and remanded the case for trial. In April 2009, the jury returned a $388 million verdict against us, including a finding of willful infringement. In September 2009, the district court judge overturned the jury verdict, ruling that the evidence did not support the jurys findings either that Microsoft infringed the patent or was willful. Uniloc appealed, and in January 2011 the court of appeals reversed the district courts finding of non-infringement (thus reinstating the jury verdict of infringement) but affirmed the district courts ruling that Microsoft was not willful and affirmed the district courts grant of a new trial on damages. Uniloc has filed a petition seeking a rehearing of the appellate courts decision as to damages.
In March 2007, i4i Limited Partnership sued Microsoft in U.S. District Court in Texas claiming that certain custom XML technology in Word 2003 and 2007 infringed i4is patent. In May 2009, a jury returned a verdict against us, finding damages of $200 million and that we willfully infringed the patent. In August 2009, the court denied our post-trial motions and awarded enhanced damages of $40 million and prejudgment interest of $37 million. The court also issued a permanent injunction prohibiting additional distribution of the allegedly infringing technology. We appealed and the appellate court stayed the injunction pending our appeal. In December 2009, the court of appeals rejected our appeal and affirmed the trial courts judgment and injunction, except that the court of appeals modified the effective date of the injunction to January 11, 2010. In November 2010, the U.S. Supreme Court granted our petition seeking review of the case. Oral argument was heard April 18, 2011. We expect a decision by the end of June 2011.
In October 2010, we filed suit against Motorola with the International Trade Commission and in U.S. District Court in Washington for infringement of nine Microsoft patents by Motorolas Android-based smartphones. In addition, in November 2010, we filed suit against Motorola in U.S. District Court in Washington for breach of Motorolas contractual commitments to the Institute of Electrical and Electronics Engineers (IEEE) and International Telecommunications Union (ITU) to license identified patents related to wireless and video coding technologies under reasonable and non-discriminatory terms and conditions. In November 2010, Motorola filed two patent infringement actions against us in U.S. District Court in Wisconsin and one in U.S. District Court in Florida on a total of sixteen patents asserted variously against Windows, Windows Phone 7, Windows Mobile 6.5, Xbox, Bing Maps, Hotmail, Messenger, and Exchange Server.
In addition to these cases, there are approximately 50 other patent infringement cases pending against Microsoft.
Other
We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial statements, these matters are subject to inherent uncertainties and managements view of these matters may change in the future.
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As of March 31, 2011, we had accrued aggregate liabilities of $1.0 billion in other current liabilities and $301 million in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, there exists the possibility of adverse outcomes that we estimate could reach approximately $720 million in aggregate beyond recorded amounts. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our financial statements for the period in which the effects become reasonably estimable.
NOTE 15 STOCKHOLDERS EQUITY
Share Repurchases
We repurchased the following shares of common stock during the periods presented:
(In millions) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Shares of common stock repurchased |
30 | 67 | 381 | 250 | ||||||||||||
Value of common stock repurchased |
$ | 827 | $ | 2,000 | $ | 9,827 | $ | 7,028 | ||||||||
We repurchased all shares with cash resources. As of March 31, 2011, approximately $13.9 billion remained of our $40.0 billion repurchase program that we announced on September 22, 2008. The repurchase program expires September 30, 2013 but may be suspended or discontinued at any time without notice.
Dividends
Our Board of Directors declared the following dividends during the periods presented:
Declaration Date | Per Share Dividend |
Record Date | Total Amount | Payment Date | ||||||||||||
(in millions) | ||||||||||||||||
Fiscal Year 2011 | ||||||||||||||||
September 21, 2010 |
$ | 0.16 | November 18, 2010 | $ | 1,363 | December 9, 2010 | ||||||||||
December 15, 2010 |
$ | 0.16 | February 17, 2011 | $ | 1,349 | March 10, 2011 | ||||||||||
March 14, 2011 |
$ | 0.16 | May 19, 2011 | $ | 1,349 | June 9, 2011 | ||||||||||
Fiscal Year 2010 | ||||||||||||||||
September 18, 2009 |
$ | 0.13 | November 19, 2009 | $ | 1,152 | December 10, 2009 | ||||||||||
December 9, 2009 |
$ | 0.13 | February 18, 2010 | $ | 1,139 | March 11, 2010 | ||||||||||
March 8, 2010 |
$ | 0.13 | May 20, 2010 | $ | 1,130 | June 10, 2010 | ||||||||||
The estimate of the amount to be paid as a result of the March 14, 2011 declaration was included in other current liabilities as of March 31, 2011.
NOTE 16 SEGMENT INFORMATION
In its operation of the business, management, including our chief operating decision maker, the Companys Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segment information within this note is reported on that basis. Our five segments are Windows & Windows Live Division; Server and Tools; Online Services Division; Microsoft Business Division; and Entertainment and Devices Division.
Due to the integrated structure of our business, certain revenue earned and costs incurred by one segment may benefit other segments. Revenue on certain contracts may be allocated among the segments based on the relative value of the underlying products and services. Costs that are identifiable are allocated to the segments that benefit to incent cross-collaboration among our segments so that one segment is not solely burdened by the cost of a mutually beneficial activity. Allocated costs may include those relating to development and marketing of products and services
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from which multiple segments benefit, or those costs relating to services performed by one segment on behalf of other segments. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated.
In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: field selling; employee benefits; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain other corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; legal settlements and contingencies; and employee severance.
We have recast certain prior period amounts within this note to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Microsofts PC hardware business from Entertainment and Devices Division to Windows & Windows Live Division, Windows Embedded from Entertainment and Devices Division to Server and Tools, and Office for Mac from Entertainment and Devices Division to Microsoft Business Division, as well as implementing intersegment cost allocations between all segments related to the collaborative investment in mobile platform development.
Segment revenue and operating income (loss) were as follows during the periods presented:
(In millions) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Revenue |
||||||||||||||||
Windows & Windows Live Division |
$ | 4,393 | $ | 4,508 | $ | 14,083 | $ | 14,098 | ||||||||
Server and Tools |
4,107 | 3,709 | 12,461 | 11,237 | ||||||||||||
Online Services Division |
648 | 566 | 1,866 | 1,631 | ||||||||||||
Microsoft Business Division |
5,266 | 4,649 | 16,174 | 14,016 | ||||||||||||
Entertainment and Devices Division |
1,898 | 1,215 | 7,320 | 5,065 | ||||||||||||
Unallocated and other |
116 | (144 | ) | 672 | 398 | |||||||||||
Consolidated |
$ | 16,428 | $ | 14,503 | $ | 52,576 | $ | 46,445 | ||||||||
Operating income (loss) |
||||||||||||||||
Windows & Windows Live Division |
$ | 2,708 | $ | 2,919 | $ | 9,102 | $ | 9,312 | ||||||||
Server and Tools |
1,385 | 1,227 | 4,737 | 3,837 | ||||||||||||
Online Services Division |
(743 | ) | (729 | ) | (1,883 | ) | (1,698 | ) | ||||||||
Microsoft Business Division |
3,164 | 2,826 | 10,203 | 8,511 | ||||||||||||
Entertainment and Devices Division |
187 | 135 | 1,188 | 755 | ||||||||||||
Reconciling amounts |
(992 | ) | (1,205 | ) | (2,357 | ) | (2,549 | ) | ||||||||
Consolidated |
$ | 5,709 | $ | 5,173 | $ | 20,990 | $ | 18,168 | ||||||||
Reconciling amounts in the tables above and below include adjustments to conform our internal accounting policies to U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, depreciation, and amortization of stock-based awards.
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Significant reconciling items were as follows:
(In millions) | Three Months Ended March 31, |
Nine Months Ended March 31, |
||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Corporate-level activity (a) |
$ | (1,138 | ) | $ | (1,153 | ) | $ | (3,151 | ) | $ | (3,205 | ) | ||||
Stock-based compensation |
129 | 121 | 373 | 389 | ||||||||||||
Revenue reconciling amounts |
72 | (174 | ) | 536 | 253 | |||||||||||
Other |
(55 | ) | 1 | (115 | ) | 14 | ||||||||||
Total |
$ | (992 | ) | $ | (1,205 | ) | $ | (2,357 | ) | $ | (2,549 | ) | ||||
(a) | Corporate-level activity excludes stock-based compensation and revenue reconciling amounts presented separately in those line items. |
Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Microsoft Corporation
Redmond, Washington
We have reviewed the accompanying consolidated balance sheet of Microsoft Corporation and subsidiaries (the Corporation) as of March 31, 2011, and the related consolidated statements of income, cash flows, and stockholders equity for the three-month and nine-month periods ended March 31, 2011 and 2010. These interim financial statements are the responsibility of the Corporations management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to such consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Microsoft Corporation and subsidiaries as of June 30, 2010, and the related consolidated statements of income, cash flows, and stockholders equity for the year then ended (not presented herein); and in our report dated July 30, 2010 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 2010 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ Deloitte & Touche LLP
Seattle, Washington
April 28, 2011
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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
NOTE ABOUT FORWARD-LOOKING STATEMENTS
Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: Managements Discussion and Analysis, and Risk Factors. These forward-looking statements generally are identified by the words believe, project, expect, anticipate, estimate, intend, strategy, future, opportunity, plan, may, should, will, would, will be, will continue, will likely result, and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled Risk Factors (refer to Part II, Item 1A of this Form 10-Q). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise.
OVERVIEW
Managements discussion and analysis is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. The following discussion should be read in conjunction with our Annual Report on Form 10-K for the year ended June 30, 2010 and the Consolidated Financial Statements and accompanying notes (Notes) included in this Form 10-Q.
We generate revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for personal computers, servers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and video games. We provide consulting and product and solution support services, and we train and certify computer system integrators and developers. We also design and sell hardware, including the Xbox 360 console, the Kinect for Xbox 360, and accessories, and Microsoft PC hardware products. Online offerings and information are delivered to consumers through Bing, Windows Live, Xbox LIVE, Microsoft Office Web Apps, our MSN portals and channels, and to businesses through Microsoft Online Services offerings, such as Microsoft Dynamics CRM Online, Exchange Online, and SharePoint Online, and through Windows Azure and SQL Azure. We enable the delivery of online advertising across our broad range of digital media properties and on Bing through our proprietary adCenter platform.
Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated approximately 40% of its yearly segment revenues in our second fiscal quarter. In addition, quarterly revenues may be impacted by the deferral of revenue. See the discussions below regarding sales of earlier versions of the Microsoft Office system with a guarantee to be upgraded to the newest version of the Microsoft Office system at minimal or no cost (the Office Deferral).
Global macroeconomic factors have a strong correlation to demand for our software, services, hardware, and online offerings. The current macroeconomic factors remain dynamic and uncertain. Irrespective of global economic conditions, we are positive about our relative market position, our current product portfolio, and future product pipeline. Because we offer a wide range of products and services that enable companies to improve productivity and reduce costs, including cloud-based services, we believe that Microsoft is well-positioned to create new opportunities to increase revenue as the global economy improves. We remain focused on executing in the areas we can control by continuing to provide high value products at the lowest total cost of ownership while managing our expenses.
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All growth and percentage comparisons refer to the three months and nine months ended March 31, 2011, as compared with the three months and nine months ended March 31, 2010, unless otherwise noted.
RESULTS OF OPERATIONS
Summary
(In millions, except per share amounts and percentages) | Three Months Ended March 31, |
Percentage Change |
Nine Months Ended March 31, |
Percentage Change |
||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||
Revenue |
$ | 16,428 | $ | 14,503 | 13% | $ | 52,576 | $ | 46,445 | 13% | ||||||||||||||
Operating income |
$ | 5,709 | $ | 5,173 | 10% | $ | 20,990 | $ | 18,168 | 16% | ||||||||||||||
Diluted earnings per share |
$ | 0.61 | $ | 0.45 | 36% | $ | 2.01 | $ | 1.59 | 26% | ||||||||||||||
Three months ended March 31, 2011 compared with three months ended March 31, 2010
Revenue increased primarily due to strong sales of the Xbox 360 console, Kinect for Xbox 360, the 2010 Microsoft Office system, and Server and Tools products, offset in part by lower sales of Windows 7. Revenue also increased due to the $305 million Office Deferral during the three months ended March 31, 2010. Changes in foreign currency exchange rates had an insignificant impact on revenue.
Operating income increased reflecting an increase in revenue, offset in part by higher operating expenses. Key changes in operating expenses were:
| Cost of revenue increased $1.1 billion or 41%, due to increased volumes of Xbox 360 consoles and Kinect sensors sold and higher costs associated with our online offerings, including traffic acquisition costs and royalty costs relating to Xbox LIVE digital content sold, as well as due to higher expenses from providing Enterprise Services. |
| Sales and marketing expenses increased $190 million or 6%, primarily reflecting increased advertising and marketing of the Xbox 360 platform, Windows Phone, and Windows and Windows Live, and higher headcount-related expenses. |
| Research and development expenses increased $49 million or 2%, due mainly to higher headcount-related expenses. |
Diluted earnings per share increased reflecting higher revenue, repurchases of common stock, and a partial settlement with the U.S. Internal Revenue Service (I.R.S.), which added $0.05 to our diluted earnings per share, offset in part by higher operating expenses.
Nine months ended March 31, 2011 compared with nine months ended March 31, 2010
Revenue increased primarily due to strong sales of the Xbox 360 console, Kinect for Xbox 360, and video games, the 2010 Microsoft Office system, and Server and Tools products, offset in part by lower sales of Windows 7. Revenue also increased due to the $305 million Office Deferral during the nine months ended March 31, 2010 and the recognition of $254 million of revenue associated with the Office Deferral during the nine months ended March 31, 2011. Changes in foreign currency exchange rates had an insignificant impact on revenue.
Operating income increased reflecting the change in revenue, offset in part by higher operating expenses. Key changes in operating expenses were:
| Cost of revenue increased $2.6 billion or 29%, due to increased volumes of Xbox 360 consoles and Kinect sensors sold and higher costs associated with our online offerings, including traffic acquisition costs and royalty costs relating to Xbox LIVE digital content sold, as well as due to higher expenses from providing Enterprise Services. |
| Sales and marketing expenses increased $412 million or 4%, primarily reflecting increased advertising and marketing of the Xbox 360 platform, Windows Phone, and Windows and Windows Live, and higher headcount-related expenses. |
| Research and development expenses increased $286 million or 4%, due mainly to higher headcount-related expenses and third-party development and programming costs. |
Diluted earnings per share increased reflecting higher revenue, repurchases of common stock, and a partial settlement with the I.R.S., which added $0.05 to our diluted earnings per share, offset in part by higher operating expenses.
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SEGMENT PRODUCT REVENUE AND OPERATING INCOME (LOSS)
The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the U.S. (U.S. GAAP) and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 16 Segment Information of the Notes to Financial Statements (Part I, Item I of this Form 10-Q) is presented on a basis consistent with our current internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately.
We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Microsofts PC hardware business from Entertainment and Devices Division to Windows & Windows Live Division, Windows Embedded from Entertainment and Devices Division to Server and Tools, and Office for Mac from Entertainment and Devices Division to Microsoft Business Division, as well as implementing intersegment cost allocations between all segments related to the collaborative investment in mobile platform development.
Windows & Windows Live Division
(In millions, except percentages) | Three Months Ended March 31, |
Percentage Change |
Nine Months Ended March 31, |
Percentage Change |
||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||
Revenue |
$ | 4,445 | $ | 4,650 | (4)% | $ | 14,284 | $ | 14,713 | (3)% | ||||||||||||||
Operating income |
$ | 2,764 | $ | 3,073 | (10)% | $ | 9,338 | $ | 9,968 | (6)% | ||||||||||||||
Windows & Windows Live Division (Windows Division) develops and markets PC operating systems and related software and online services. The Windows Division offerings consist of multiple editions of the Windows operating system, software and services through Windows Live, and Microsoft PC hardware products.
Windows Division revenue growth is largely correlated to the growth of the PC market worldwide as approximately 75% of total Windows Division revenue comes from pre-installed versions of the Windows operating system purchased by original equipment manufacturers (OEMs). The remaining approximately 25% of Windows Division revenue (other revenue) is generated by commercial and retail sales of Windows and PC hardware products and online advertising from Windows Live.
Three months ended March 31, 2011 compared with three months ended March 31, 2010
Windows Division revenue was driven primarily by growth in PC market segments. We estimate that sales of PCs to businesses grew approximately 9% this quarter and that sales of PCs to consumers declined approximately 8%. The decline in consumer PC sales included an approximately 40% decline in the sales of Netbooks. Taken together the total PC market declined an estimated 1% to 3%. Considering the impact of the Windows 7 launch in the prior year, we estimate Windows Division revenue and OEM licenses were in line with the PC market. Revenue was also driven by growth in sales of multi-year licensing agreements to businesses and somewhat higher inventory and attach rates offset by higher relative growth in emerging markets.
Windows Division operating income decreased as a result of decreased revenue and higher sales and marketing expenses. Sales and marketing expenses increased $127 million or 21% reflecting increased corporate marketing activities and increased advertising of Windows and Windows Live.
Nine months ended March 31, 2011 compared with nine months ended March 31, 2010
Windows Division revenue was driven primarily by growth in PC market segments. We estimate that sales of PCs to businesses grew approximately 12% fiscal year to date and that sales of PCs to consumers declined approximately 1%. The decline in consumer PC sales included an approximately 30% decline in the sales of Netbooks. Taken together the total PC market increased an estimated 3% to 5%. Considering the impact of the Windows 7 launch in the prior year, we estimate Windows Division revenue was in line with the PC market. Revenue was also driven by growth in sales of multi-year licensing agreements to businesses offset by higher relative growth in emerging markets.
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Windows Division operating income decreased as a result of decreased revenue and higher sales and marketing expenses. Sales and marketing expenses increased $172 million or 9% reflecting increased advertising of Windows and Windows Live. Cost of revenue increased $17 million or 1%, primarily driven by higher traffic acquisition costs, partially offset by decreased product and services costs.
Server and Tools
(In millions, except percentages) | Three Months Ended March 31, |
Percentage Change |
Nine Months Ended March 31, |
Percentage Change |
||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||
Revenue |
$ | 4,104 | $ | 3,706 | 11% | $ | 12,453 | $ | 11,229 | 11% | ||||||||||||||
Operating income |
$ | 1,419 | $ | 1,270 | 12% | $ | 4,834 | $ | 3,979 | 21% | ||||||||||||||
Server and Tools develops and markets technology and related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Windows Embedded device platforms and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training and certification. Approximately 50% of Server and Tools revenue comes primarily from multi-year volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes from Enterprise Services.
Three months ended March 31, 2011 compared with three months ended March 31, 2010
Server and Tools revenue increased reflecting growth in both product and Enterprise Services. Product revenue increased $308 million or 10%, driven primarily by growth in Windows Server, SQL Server, and Enterprise Client Access License (CAL) Suites, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew $90 million or 12%, due to growth in both Premier product support and consulting services.
Server and Tools operating income increased primarily due to revenue growth, offset in part by higher operating expenses. Sales and marketing expenses increased $137 million or 13% reflecting increased corporate marketing activities and fees paid to third party enterprise software advisors. Cost of revenue increased $115 million or 17% reflecting higher expenses from providing Enterprise Services and online offerings.
Nine months ended March 31, 2011 compared with nine months ended March 31, 2010
Server and Tools revenue increased reflecting growth in both product and Enterprise Services. Product revenue increased $998 million or 11%, driven primarily by growth in Windows Server, SQL Server, Enterprise CAL Suites, and Windows Embedded, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew $226 million or 10%, due to growth in both Premier product support and consulting services.
Server and Tools operating income increased primarily due to revenue growth, offset in part by higher operating expenses. Cost of revenue increased $233 million or 11%, reflecting higher expenses from providing Enterprise Services and online offerings. Sales and marketing expenses increased $117 million or 4% reflecting increased fees paid to third party enterprise software advisors and headcount-related expenses.
Online Services Division
(In millions, except percentages) | Three Months Ended March 31, |
Percentage Change |
Nine Months Ended March 31, |
Percentage Change |
||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||
Revenue |
$ | 648 | $ | 566 | 14% | $ | 1,866 | $ | 1,633 | 14% | ||||||||||||||
Operating loss |
$ | (726 | ) | $ | (709 | ) | (2)% | $ | (1,829 | ) | $ | (1,649 | ) | (11)% | ||||||||||
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Online Services Division (OSD) develops and markets information and content that help people simplify tasks and make more informed decisions online, and that help advertisers connect with audiences. OSD offerings include Bing, MSN, and advertiser and publisher tools. Bing and MSN generate revenue through the sale of search and display advertising.
Three months ended March 31, 2011 compared with three months ended March 31, 2010
OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $84 million or 17% to $586 million, reflecting continued growth in search and display revenue, offset in part by decreased third party advertising revenue. Search revenue grew due to increased volumes reflecting general market growth and relative share gains in the U.S., offset in part by decreased revenue per search primarily related to challenges associated with optimizing the adCenter platform for the new mix and volume of traffic from the combined Yahoo! and Bing properties. Bings estimated U.S. market share increased approximately 25%.
OSD operating loss increased due to higher operating expenses, offset in part by increased revenue. Cost of revenue grew $292 million driven by costs associated with the Yahoo! search agreement and increased traffic acquisition costs. General and administrative expenses decreased $154 million due mainly to transition expenses in the prior year associated with the inception of the Yahoo! Commercial Agreement. Sales and marketing expenses decreased $39 million or 13% primarily due to lower amortization of intangible assets.
Nine months ended March 31, 2011 compared with nine months ended March 31, 2010
OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $255 million or 18% to $1.7 billion, reflecting continued growth in search and display revenue, offset in part by decreased third party advertising revenue. Search revenue grew due to increased volumes reflecting general market growth and relative share gains in the U.S., offset in part by decreased revenue per search primarily related to challenges associated with optimizing the adCenter platform for the new mix and volume of traffic from the combined Yahoo! and Bing properties. Bings estimated U.S. market share increased approximately 25%.
OSD operating loss increased due to higher operating expenses, offset in part by increased revenue. Cost of revenue grew $476 million driven by costs associated with the Yahoo! search agreement and traffic acquisition costs. Research and development expenses grew $128 million or 17%, primarily due to headcount-related expenses associated with the search portion of the business. General and administrative expenses decreased $157 million due mainly to transition expenses in the prior year associated with the inception of the Yahoo! Commercial Agreement.
Microsoft Business Division
(In millions, except percentages) | Three Months Ended March 31, |
Percentage Change |
Nine Months Ended March 31, |
Percentage Change |
||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||
Revenue |
$ | 5,252 | $ | 4,341 | 21% | $ | 16,409 | $ | 13,701 | 20% | ||||||||||||||
Operating income |
$ | 3,165 | $ | 2,542 | 25% | $ | 10,506 | $ | 8,285 | 27% | ||||||||||||||
Microsoft Business Division (MBD) develops and markets software and services designed to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (comprising mainly Office, SharePoint, Exchange and Lync), which generates over 90% of MBD revenue, and Microsoft Dynamics business solutions. We evaluate MBD results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue.
Three months ended March 31, 2011 compared with three months ended March 31, 2010
MBD revenue increased reflecting sales of the 2010 Microsoft Office system, which was released primarily during the fourth quarter of fiscal year 2010, as well as the $305 million Office Deferral during the three months ended March 31, 2010. Consumer revenue increased $525 million or 95%. Excluding the impact associated with the Office Deferral, consumer revenue increased $220 million or 26% due to sales of the 2010 Microsoft Office system. Business revenue increased $386 million or 10%, primarily reflecting licensing of the 2010 Microsoft Office system to transactional business customers, growth in multi-year volume licensing revenue, and a 10% increase in Microsoft Dynamics revenue.
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MBD operating income increased due mainly to revenue growth, offset in part by higher operating expenses. Sales and marketing expenses increased $150 million or 16%, due mainly to increased corporate and cross-platform marketing activities and charges related to intangible assets. Cost of revenue increased $80 million or 24%, primarily driven by higher online costs, costs of providing services, and increased amortization of capitalized software development costs. Research and development costs increased $58 million or 13%, primarily as a result of capitalization of certain Microsoft Office system software development costs in the prior year.
Nine months ended March 31, 2011 compared with nine months ended March 31, 2010
MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system, the $305 million Office Deferral during the third quarter of fiscal year 2010, and the recognition of $254 million of revenue associated with the Office Deferral during the nine months ended March 31, 2011. Business revenue increased $1.5 billion or 13%, reflecting licensing of the 2010 Microsoft Office system to transactional business customers, growth in multi-year volume licensing revenue, and a 7% increase in Microsoft Dynamics revenue. Consumer revenue increased $1.2 billion or 52%. The growth in consumer revenue includes the $305 million Office Deferral and recognition of $254 million of revenue associated with the Office Deferral. Excluding the impact associated with the Office Deferral, consumer revenue increased $663 million or 25% due to sales of the 2010 Microsoft Office system.
MBD operating income increased due mainly to revenue growth, offset in part by higher operating expenses. Cost of revenue increased $253 million or 28%, primarily driven by higher online costs and costs of providing services. Sales and marketing expenses increased $171 million or 6%, due mainly to increased corporate and cross-platform marketing activities and charges related to intangible assets. Research and development costs increased $73 million or 5%, primarily as a result of capitalization of certain Microsoft Office system software development costs in the prior year.
Entertainment and Devices Division
(In millions, except percentages) | Three Months Ended March 31, |
Percentage Change |
Nine Months Ended March 31, |
Percentage Change |
||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||
Revenue |
$ | 1,935 | $ | 1,210 | 60% | $ | 7,428 | $ | 5,024 | 48% | ||||||||||||||
Operating income |
$ | 225 | $ | 150 | 50% | $ | 1,292 | $ | 790 | 64% | ||||||||||||||
Entertainment and Devices Division (EDD) develops and markets products and services designed to entertain and connect people. EDD offerings include the Xbox 360 platform (which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories), Mediaroom (our Internet protocol television software), and Windows Phone. In November 2010, we released Kinect for Xbox 360 and the latest version of Windows Phone. Windows Phone revenue is recognized on a straight-line basis over the estimated economic life of the software.
Three months ended March 31, 2011 compared with three months ended March 31, 2010
EDD revenue increased primarily reflecting higher Xbox 360 platform revenue. Xbox 360 platform revenue grew $712 million or 69%, led by sales of Kinect sensors, increased volumes of Xbox 360 consoles, and higher Xbox LIVE revenues. We shipped 2.7 million Xbox 360 consoles and 2.4 million Kinect sensors (including those sold with consoles) during the third quarter of fiscal year 2011, compared with 1.5 million Xbox 360 consoles during the third quarter of fiscal year 2010. On April 21, 2011, we entered into definitive agreements to formalize an alliance with Nokia to enhance our Windows Phone opportunities and strategies for smartphones, productivity tools, mobile marketplace, and services.
EDD operating income increased primarily reflecting revenue growth, offset in part by higher cost of revenue. Cost of revenue increased $640 million or 104% primarily reflecting higher volumes of Xbox 360 consoles and Kinect sensors sold, and increased royalty costs resulting from increased Xbox LIVE digital content sold.
Nine months ended March 31, 2011 compared with nine months ended March 31, 2010
EDD revenue increased primarily reflecting higher Xbox 360 platform revenue. Xbox 360 platform revenue grew $2.4 billion or 52%, led by sales of Kinect sensors, increased volumes of Xbox 360 consoles and video games sold, and higher Xbox LIVE revenue. We shipped 11.9 million Xbox 360 consoles and 10.4 million Kinect sensors (including those sold with consoles) during the first nine months of fiscal year 2011, compared with 8.8 million Xbox 360 consoles during the first nine months of fiscal year 2010. Xbox 360 video game revenue increased primarily reflecting sales of Halo Reach and Kinect game titles.
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EDD operating income increased primarily reflecting revenue growth, offset in part by higher operating expenses. Cost of revenue increased $1.7 billion or 58% primarily reflecting higher volumes of Xbox 360 consoles and Kinect sensors sold, and increased royalty costs resulting from increased Xbox LIVE digital content sold. Research and development expenses increased $100 million or 14%, primarily reflecting higher headcount-related costs. Sales and marketing expenses grew $93 million or 16% primarily reflecting increased Xbox 360 platform marketing activities.
Nokia Strategic Alliance
On February 11, 2011, Microsoft and Nokia announced a strategic alliance to jointly create new mobile products and services and to extend established products and services to new markets. On April 21, 2011, the parties entered into definitive agreements to formalize this alliance.
Microsoft will license to Nokia and Nokia will adopt Windows Phone as Nokias primary smartphone platform. Microsoft will receive a running royalty at a competitive rate from Nokia for the Windows Phone platform, with minimum commitments reflecting the large volumes Nokia expects to ship. We will also provide Nokia with developer tools to accelerate developer support for Windows and Windows-related platforms. Microsoft and Nokia will collaborate on joint developer outreach and application sourcing. Microsofts Windows Marketplace infrastructure will support a new Nokia-branded application store. Participants in the Windows Phone ecosystem will be able to take advantage of Nokias billing agreements with operators in markets worldwide.
Nokia will deliver mapping, navigation, and location-based services to the Windows Phone ecosystem and will deliver a core set of mapping services for a broader set of Microsofts map-based offerings. Microsofts Bing and adCenter will power search and advertising on Nokias devices and services. Nokia will innovate and customize on the Windows Phone platform, contributing its expertise on hardware, design, and language support and will help bring Windows Phone to a broader range of price points, market segments and geographies. Microsoft will make annual payments to Nokia, in recognition of the unique nature of Nokias agreement with Microsoft and the contributions that Nokia is providing.
The agreements recognize the value of intellectual property portfolios and put in place mechanisms for exchanging rights to intellectual property. As part of these arrangements, Nokia will receive payments including consideration to be paid as part of a mutual release.
Corporate-Level Activity
(In millions, except percentages) | Three Months Ended March 31, |
Percentage Change |
Nine Months Ended March 31, |
Percentage Change |
||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||
Corporate-level activity |
$ | (1,138 | ) | $ | (1,153 | ) | 1% | $ | (3,151 | ) | $ | (3,205 | ) | 2% | ||||||||||
Certain corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; and legal settlements and contingencies. For the three months ended March 31, 2011, corporate-level expenses decreased due mainly to lower sales and marketing costs retained in corporate, offset in part by newly legislated Puerto Rican excise taxes and a 7% increase in headcount-related expenses. For the nine months ended March 31, 2011, corporate-level expenses decreased due mainly to lower sales and marketing costs retained in corporate, offset in part by newly legislated Puerto Rican excise taxes and a 4% increase in headcount-related expenses.
OPERATING EXPENSES
Cost of Revenue
(In millions, except percentages) | Three Months Ended March 31, |
Percentage Change |
Nine Months Ended March 31, |
Percentage Change |
||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||
Cost of revenue |
$ | 3,897 | $ | 2,755 | 41% | $ | 11,869 | $ | 9,225 | 29% | ||||||||||||||
As a percent of revenue |
24 | % | 19 | % | 5ppt | 23 | % | 20 | % | 3ppt | ||||||||||||||
Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our Web sites and to acquire online advertising space (traffic acquisition costs); costs incurred to support and maintain Internet-based products and services; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs. Cost of revenue increased primarily due to increased volumes of Xbox 360 consoles and Kinect sensors sold and higher costs associated with our online offerings, including traffic acquisition costs and royalty costs relating to Xbox LIVE digital content sold, as well as due to higher expenses from providing Enterprise Services.
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Research and Development
(In millions, except percentages) | Three Months Ended March 31, |
Percentage Change |
Nine Months Ended March 31, |
Percentage Change |
||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||
Research and development |
$ | 2,269 | $ | 2,220 | 2% | $ | 6,650 | $ | 6,364 | 4% | ||||||||||||||
As a percent of revenue |
14 | % | 15< |