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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_________________
FORM 10-Q/A
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 1997
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _____ TO ____
_________________
COMMISSION FILE NUMBER 0-14278
MICROSOFT CORPORATION
(Exact name of registrant as specified in its charter)
WASHINGTON 91-1144442
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (425) 882-8080
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]
The number of shares outstanding of the registrant's common stock as of April
30, 1998 was 2,464,072,255.
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MICROSOFT CORPORATION
FORM 10-Q/A
FOR THE QUARTER ENDED DECEMBER 31, 1997
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements Page
----
a) Income Statements
for the Three and Six Months Ended December 31, 1996 and 1997.......... 1
b) Balance Sheets
as of June 30, 1997 and December 31, 1997.............................. 2
c) Cash Flows Statements
for the Six Months Ended December 31, 1996 and 1997.................... 3
d) Notes to Financial Statements.......................................... 4
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations......................................... 8
PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................................... 12
Item 4. Submission of Matters to a Vote of Security Holders......................... 12
Item 6. Exhibits and Reports on Form 8-K............................................ 12
SIGNATURE....................................................................................... 13
Part I. Financial Information
ITEM 1. FINANCIAL STATEMENTS
MICROSOFT CORPORATION
INCOME STATEMENTS
(In millions, except earnings per share)(Unaudited)
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Three Months Ended Six Months Ended
Dec. 31 Dec. 31
1996 1997 1996 1997
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Revenue $2,680 $3,585 $4,975 $6,715
Operating expenses:
Cost of revenue 296 313 546 566
Research and development 485 627 917 1,194
Acquired in-process technology 0 0 0 296
Sales and marketing 737 876 1,362 1,664
General and administrative 81 106 167 201
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Total operating expenses 1,599 1,922 2,992 3,921
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Operating income 1,081 1,663 1,983 2,794
Interest income 105 157 197 299
Other expenses (46) (50) (95) (121)
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Income before income taxes 1,140 1,770 2,085 2,972
Provision for income taxes 399 637 730 1,176
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Net income 741 1,133 1,355 1,796
Preferred stock dividends 1 7 1 14
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Net income available for common $ 740 $1,126 $1,354 $1,782
shareholders
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Earnings per share:
Basic $ 0.31 $ 0.47 $ 0.57 $ 0.74
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Diluted $ 0.28 $ 0.42 $ 0.52 $ 0.67
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See accompanying notes.
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1
MICROSOFT CORPORATION
BALANCE SHEETS
(In millions)
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June 30 Dec. 31
1997 1997(1)
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ASSETS
Current assets:
Cash and short-term investments $ 8,966 $10,105
Accounts receivable 980 1,081
Other 427 450
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Total current assets 10,373 11,636
Property, plant, and equipment 1,465 1,478
Equipment investments 2,346 3,476
Other assets 203 250
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Total assets $14,387 $16,840
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LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 721 $ 867
Accrued compensation 336 248
Income taxes payable 466 631
Unearned revenue 1,418 2,038
Other 669 712
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Total current liabilities 3,610 4,496
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Commitments and contingencies
Stockholders' equity:
Convertible preferred stock -
shares authorized 100; outstanding 13 980 980
Common stock and paid-in capital -
shares authorized 8,000; outstanding
2,409 and 2,423 4,509 6,104
Retained earnings 5,288 5,260
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Total stockholders' equity 10,777 12,344
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Total liabilities and stockholders' equity $14,387 $16,840
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(1) Unaudited
See accompanying notes.
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MICROSOFT CORPORATION
CASH FLOWS STATEMENTS
(In million)(unaudited)
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Six Months Ended
Dec, 31
1996 1997
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CASH FLOWS FROM OPERATIONS
Net income $ 1,355 $ 1,796
Depreciation and amortization 306 497
Write-off of acquired in-process technologies 0 296
Unearned revenue 648 1,254
Recognition of unearned revenue from prior periods (195) (634)
Other current liabilities 256 297
Accounts receivable (326) (129)
Other current assets (43) (33)
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Net cash from operations 2,001 3,344
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CASH FLOWS USED FOR FINANCING
Common stock issued 314 328
Common stock repurchased (1,101) (1,596)
Put warrant proceeds 77 325
Preferred stock issued 980 0
Preferred stock dividends 0 (14)
Stock option income tax benefits 226 407
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Net cash used for financing 496 (550)
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CASH FLOWS USED FOR INVESTMENTS
Additions to property, plant, and equipment (216) (268)
Cash portion of WebTV purchase price 0 (190)
Equity investments and other (66) (1,164)
Short-term investments (1,725) (2,263)
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Net cash used for investments (2,007) (3,885)
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Net change in cash and equivalents 490 (1,091)
Effect of exchange rates on cash and equivalents 5 (33)
Cash and equivalents, beginning of period 2,601 3,706
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Cash and equivalents, end of period 3,096 2,582
Short-term investments, end of period 6,064 7,523
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Cash and short-term investments, end of period $ 9,160 $ 10,105
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See accompanying notes.
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3
MICROSOFT CORPORATION
NOTES TO FINANCIAL STATEMENTS
(Unaudited)
________________________________________________________________________________
BASIS OF PRESENTATION
In the opinion of management, the accompanying balance sheets and related
interim statements of income and cash flows include all adjustments (consisting
only of normal recurring items) necessary for their fair presentation in
conformity with generally accepted accounting principles. Preparing financial
statements requires management to make estimates and assumptions that affect the
reported amounts of assets, liabilities, revenue, and expenses. Examples include
provisions for returns and bad debts and the length of product life cycles and
buildings' lives. Actual results may differ from these estimates. Interim
results are not necessarily indicative of results for a full year. The
information included in this Form 10-Q should be read in conjunction with
Management's Discussion and Analysis and financial statements and notes thereto
included in the Microsoft Corporation 1997 Form 10-K.
STOCK SPLIT
On January 24, 1998, the Company's Board of Directors approved a two-for-one
stock split in the form of a 100% stock dividend, effective February 20, 1998
for shareholders of record February 6, 1998. Share and per share amounts have
been restated for the stock split.
EARNINGS PER SHARE
Basic earnings per share is calculated using the average number of common shares
outstanding. Diluted earnings per share is computed on the basis of the average
number of common shares outstanding plus the effect of outstanding stock options
using the "treasury stock" method and preferred shares using the "if-converted"
method.
Three Months Ended Six Months Ended
Dec. 31 Dec. 31
1996 1997 1996 1997
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Net income (A) $ 741 $ 1,133 $ 1,355 $ 1,796
Preferred stock dividends (1) (7) (1) (14)
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Net income available for common shareholders (B) $ 740 $ 1,126 $ 1,354 $ 1,782
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Average outstanding:
Common stock (C) 2,391 2,421 2,389 2,416
Preferred stock 2 19 1 19
Employee stock options 215 227 207 232
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Common stock and common stock equivalents (D) 2,608 2,667 2,597 2,667
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Earnings per share:
Basic (B/C) $ 0.31 $ 0.47 $ 0.57 $ 0.74
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Diluted (A/D) $ 0.28 $ 0.42 $ 0.52 $ 0.67
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UNEARNED REVENUE
Microsoft believes that Internet technologies are integral to its products and
has committed to integrating these technologies, such as its browser, Microsoft
Internet Explorer, into existing products at no additional cost to its
customers. Given this strategy and other support commitments such as telephone
support, Internet-based technical support, and unspecified product enhancements,
Microsoft recognizes approximately 20% of Windows operating systems revenue over
the product life cycles, currently estimated at two years. The unearned portion
of revenue from Windows operating systems was $860 million at June 30, 1997 and
$1.04 billion at December 31, 1997.
Since Office 97 is also tightly integrated with the rapidly evolving Internet,
and in the view of subsequent delivery of new Internet technologies,
enhancements, and other support, a ratable revenue recognition policy became
effective for Office 97 licenses beginning in the third quarter of fiscal 1997.
Approximately 20% of Office 97
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4
revenue is recognized ratably over the estimated 18-month product life cycle.
Unearned revenue associated with Office 97 totaled $300 million at June 30, 1997
and $570 million at December 31, 1997.
Unearned revenue also includes maintenance and other subscription contracts,
including custom enterprise license agreements.
STOCKHOLDERS' EQUITY
Microsoft repurchases its common stock on the open market. This program provides
shares for issuance to employees under the Company's stock option and stock
purchase plans. During the first half of fiscal 1998, the Company repurchased
7.4 million shares of Microsoft common stock in the open market. In addition,
under agreements with an independent third party, the Company purchased 21.3
million shares of stock through forward purchase arrangements. Under these two
arrangements, a portion of the purchase price will be paid in the next five or
six years and determined based upon the price of Microsoft common stock at that
time. The timing and method of payment (net-share or cash) is at the discretion
of the Company. The difference between the cash paid and the price of Microsoft
common stock on the date of the agreement is reflected in stockholders' equity.
To enhance its stock repurchase program, Microsoft sells equity put warrants to
independent third parties. These put warrants entitle the purchasers to sell
shares of Microsoft common stock to the Company on certain dates at specified
prices. On December 31, 1997, 46 million warrants were outstanding with strike
prices ranging from $63 to $65 per share. The warrants expire at various dates
between the fourth quarter of fiscal 1998 and the second quarter of fiscal 2001
and are exercisable only at maturity. These put warrant contracts permit a net-
share settlement at the Company's option, and do not result in a put warrant
liability on the balance sheet.
During December 1996, Microsoft issued 12.5 million shares of 2.75% convertible
exchangeable principal-protected preferred stock. Dividends are payable
quarterly in arrears. Preferred shareholders have preference over common
stockholders in dividends and liquidation rights. In December 1999, each
preferred share is convertible into common shares or an equivalent amount of
cash determined by a formula that provides a floor price of $39.938 and a cap of
$51.12 per preferred share. Net proceeds of $980 million from the issuance were
used to repurchase common shares.
ACQUISITION OF WEBTV
On August 1, 1997, the Company acquired WebTV Networks, Inc. (WebTV), an online
service that enables consumers to experience the Internet through their
televisions via set-top terminals. Microsoft paid $190 million in cash and $235
million of common stock for WebTV. The acquired net working capital of WebTV was
not material. The accompanying income statement reflects a one-time write-off of
in-process technologies under development by WebTV of $296 million.
CONTINGENCIES
On October 7, 1997, Sun Microsystems, Inc. brought suit against Microsoft in the
U.S. District Court for the Northern District of California. On October 14,
1997, Sun filed a First Amended Complaint (Complaint). The Complaint alleges
several claims against Microsoft, all related to the parties' relationship under
a March 11, 1996 Technology License and Distribution Agreement (Agreement)
concerning certain Java programming language technology. The Complaint alleges:
statutory and contractual trademark claims related to Microsoft's alleged
improper use of the Java Compatibility logo; a false advertising claim related
to statements Microsoft allegedly has made about its Java support and products;
a claim that Microsoft has breached the Agreement in several respects; a claim
that Microsoft allegedly made Sun's source code generally available to the
public; a claim for breach of the covenant of good faith and fair dealing; a
claim for unfair competition; a claim for intentional interference with
contractual relations between Sun and its customers or prospective customers;
and a claim that Microsoft induced software developers to breach their license
agreements with Sun. The Complaint seeks: a preliminary and permanent
injunction against Microsoft distributing certain products with the Java
Compatibility logo, and against distributing Internet Explorer 4.0 unless
certain alleged obligations are met; an order compelling Microsoft to perform
certain alleged obligations; an accounting; termination of the Agreement; and an
award of damages, including compensatory, exemplary and punitive damages, and
liquidated damages of $35 million for the alleged source code disclosure.
On October 27, 1997, Microsoft filed its Answer, Affirmative Defenses, and
Counterclaims (Answer). In its Answer, Microsoft denies Sun's claims, and
denies that Sun is entitled to any relief. Microsoft alleges that Sun agreed to
limit its remedies for all claims such as those alleged in the Complaint to
compensatory damages capped by the total license fees paid ($17.5 million over
the life of the Agreement). Microsoft specifically denies that Sun is entitled
to any injunctive relief. Although the Agreement does provide for liquidated
damages of $35 million if Microsoft makes Sun's Source Code generally available
to the public under certain conditions, Microsoft denies that there is any basis
for such a claim. Microsoft asserts other defenses to each of Sun's claims. In
addition, Microsoft alleges counterclaims against Sun, including claims that:
Sun has breached the Agreement in many respects; Microsoft is entitled to a
court order that Microsoft may terminate Sun's license under the Agreement to
certain Microsoft technology and otherwise determining the parties' rights and
responsibilities; Sun has breached the covenant of good faith and fair dealing;
and Sun has violated California's unfair competition statute. Microsoft also
alleges that it has put Sun on notice of other breaches of contract and that
Microsoft will seek to amend its counterclaim to state additional claims if
those breaches are not timely cured. Microsoft seeks a declaratory judgment
consistent with its claims and seeks compensatory damages consistent with the
limitations in the Agreement. On November 17, 1997, Sun filed a motion for
preliminary injunction seeking to enjoin Microsoft from using the Java
compatibility logo on IE 4.0 during the pendency of the litigation on the basis
that IE 4.0 does not pass certain Java compatibility tests. A hearing on this
motion was held on February 27, 1998. At the hearing, the court set September
4, 1998 as the date on which the court will hear all motions relating to the
interpretation of the parties' agreement.
On March 24, 1998, the court entered an order granting Sun's motion and
enjoining Microsoft from using the Java Compatibility Logo on Internet Explorer
4.0 and Microsoft Software Developers Kit for Java 2.0. Microsoft has taken
steps to fully comply with the order.
On May 12, 1998, Sun filed companion motions seeking a preliminary injunction
based on allegations of copyright infringement and unfair competition. Sun
requested an order enjoining Microsoft from distributing any Java Technology in
any operating system, browser, or developers tools, including Windows 98, IE 4.0
and JV++ 6.0, unless and until Microsoft includes with each such product an
implementation of the Java runtime environment that passes Sun's compatibility
test suite or an operable implementation of Sun's current Java runtime
environment. Sun also filed a motion to amend its complaint to include a claim
of copyright infringement. The new allegation alleges that Microsoft has
infringed Sun's copyrights in the Java Technology because it has used the
technology outside of the scope of the license agreement. The hearing for these
motions is set for July 31, 1998.
The parties are engaged in ongoing discovery in anticipation of the July 31 and
September 4 hearings.
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5
On October 20, 1997, the Antitrust Division of the U.S. Department of Justice
(DOJ) filed a Petition for An Order To Show Cause in United States District
Court for the District of Columbia. The DOJ contends that Microsoft has
violated a consent decree that was entered into by the DOJ and Microsoft on July
15, 1994, and approved by the Court on August 18, 1995, to conclude an earlier
investigation by the DOJ. In its petition, the DOJ contends that Microsoft has
violated the consent decree by including Internet Explorer technology in Windows
95, and by preventing original equipment manufacturers (OEMs) from removing
Internet Explorer functionality from versions of Windows 95 the OEMs are
licensed to install on computer systems they sell. In addition, the DOJ alleges
that certain non-disclosure agreements between Microsoft and its customers
prohibiting the release of confidential information without prior notice to the
other party are impairing the DOJ's ability to enforce the consent decree. The
DOJ's petition seeks an order from the Court requiring Microsoft to demonstrate
that it has not violated the consent decree. Microsoft does not believe it has
violated the consent decree and intends to vigorously contest this lawsuit.
On December 5, 1997, Judge Jackson heard oral argument on the DOJ's contempt
petition. On December 11, 1997, the court entered two orders. In the first
order, Judge Jackson denied the DOJ's contempt petition, and dismissed the DOJ's
request for relief concerning Microsoft's non-disclosure agreements because the
DOJ had failed to present evidence that the agreements had interfered with any
DOJ investigation. In addition, however, the court ruled that there were
disputed issues of fact regarding Microsoft's violation of the consent decree,
and concluded that the DOJ was likely to prevail on its claim that a violation
had occurred. The court entered a preliminary injunction sua sponte requiring
Microsoft not to condition the licensing of Windows 95 or any successor desktop
operating system on a computer manufacturer also licensing any Microsoft browser
software, including Internet Explorer 3.0 or 4.0. In the second order, the
court appointed Harvard Law Professor Lawrence Lessig as a special master, to
whom the court delegated the authority to conduct discovery, take evidence, and
make proposed findings of fact and conclusions of law on all issues in the case
by May 31, 1998.
Microsoft immediately appealed the preliminary injunction to the District of
Columbia Circuit Court of Appeals and sought an expedited hearing on the grounds
that there are substantial grounds for challenging Judge Jackson's order and
that Microsoft will incur irreparable harm if the appeal is not heard quickly.
The DOJ opposed expedited treatment. On December 30, 1997, the Court of Appeals
entered an order granting Microsoft's motion and set a schedule pursuant to
which oral argument was heard on April 21, 1998.
On December 23, 1997, Microsoft filed a motion in the District Court to revoke
the reference to a special master on the grounds that improper procedure was
used and that the scope of the reference was impermissibly broad. In addition,
Microsoft raised concerns about the impartiality of Professor Lessig based upon
statements in some of his writings. On January 15, 1998 the District Court
denied Microsoft's motion and refused to certify its ruling for appeal. On
January 16, 1998 Microsoft filed a petition for mandamus in the District of
Columbia Circuit Court of Appeals, seeking a stay of all proceedings by the
special master until the Court of Appeals could rule, and seeking an order
reversing the reference to the special master. On February 2, 1998 the Court of
Appeals ordered that the petition for mandamus would be consolidated with the
pending appeal and oral argument heard on April 21, 1998. The Court also stayed
all proceedings before the special master until it rules on the petition.
A panel of the Court of Appeals heard the case on April 21, 1998. The Court has
not yet ruled on the matters argued. On May 5, 1998, Microsoft also sought a
stay of the District Court's injunction insofar as it applied to Windows 98. On
May 12, 1998, the Court of Appeals granted Microsoft's request for a stay.
On May 18, 1998, the DOJ and a group of 20 state Attorneys General filed two
antitrust cases against Microsoft in the U.S. District Court for the District of
Columbia. The DOJ complaint alleges violations of Sections 1 and 2 of the
Sherman Act, including claims concerning allegedly exclusionary agreements in
violation of Section 1, unlawful "tying" of Internet browsing software with the
remainder of Windows in violation of Section 1, maintenance of a purported
monopoly in "PC operating systems" market in violation of Section 2, and
attempted monopolization of a so-called "Internet browser market" in violation
of Section 2. The DOJ Complaint seeks declaratory relief as to the violations
it asserts and preliminary and permanent injunctive relief regarding: the
inclusion of Internet browsing software (or other software products) as part of
Windows; the terms of agreements regarding non-Microsoft Internet browsing
software (or other software products); taking or threatening "action adverse" in
consequence of a person's failure to license or distribute Microsoft Internet
browsing software (or other software product) or distributing competing products
or cooperating with the government; and restrictions on the screens, boot-up
sequence, or
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6
functions of Microsoft's operating system products. The state Attorneys General
allege largely the same claims, together with claims that Microsoft is
"leveraging" its alleged monopoly power in the "market for operating system
software" to foreclose competition in the "separate market for Internet browser
software" in violation of Section 2, that Microsoft is maintaining a purported
monopoly in the "market for office productivity suite software" in violation of
Section 2, that Microsoft is tying unspecified other products (including Outlook
Express) to Windows in violation of Section 1, and various pendent state claims.
The states seek declaratory and preliminary and permanent injunctive relief
similar to that sought by the DOJ, together with statutory penalties under the
state law claims. The foregoing description is qualified in its entirety by
reference to the full text of the complaints and other papers on file in those
actions, cause numbers 98-1232 and 98-1233.
On May 22, 1998, a status conference was held before Judge Jackson. He granted
Microsoft's motion to consolidate the two actions, and granted Microsoft's
request to extend the time to respond to the motions for preliminary injunction
set forth in the local rules for the U.S. District Court for the District of
Columbia. The Court set the following dates: Microsoft's answer is due on July
28, 1998. Microsoft's brief in opposition to the preliminary injunction motions
is due on August 10, 1998. The plaintiffs' reply is due August 24, 1998. The
trial on the merits is scheduled to begin September 8, 1998. Microsoft believes
that the claims are without merit and intends to defend against them vigorously.
In other ongoing investigations, the DOJ and several state Attorneys General
have requested information from Microsoft concerning various issues.
Microsoft is also subject to various legal proceedings and claims that arise in
the ordinary course of business.
Management currently believes that resolving these matters will not have a
material adverse impact on the Company's financial position or its results of
operations.
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7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
Microsoft develops, manufactures, licenses, sells, and supports a wide range of
software products, including scalable operating systems for information
appliances, personal computers (PCs), and servers; server applications for
client/server environments; business and consumer productivity applications;
software development tools; and Internet and intranet software and technologies.
The Company has recently expanded its interactive content efforts, including
entertainment and information software programs, MSN/TM/, the Microsoft Network
online service, Internet-based services, and alliances with companies involved
with other forms of digital interactivity. Microsoft also sells personal
computer input devices and books, and researches and develops advanced
technologies for future software products.
REVENUE
Revenue of $3.59 billion in the second quarter of fiscal 1998 increased 34% over
the second quarter of fiscal 1997. On a year to date basis, revenue increased
35% from the prior year to $6.72 billion. The strong growth rate reflected the
continued adoption of Windows(R) 32-bit operating systems and Microsoft(R)
Office 97, particularly as Microsoft software is deployed across entire
organizations. Software license volume increases have been the principal factor
in the Company's revenue growth. The average selling price per license has
decreased, primarily because of general shifts in the sales mix from retail
packaged products to licensing programs, from new products to product upgrades,
and from stand-alone desktop applications to integrated product suites. Average
revenue per license from OEM licenses and organization license programs, such as
Microsoft Select, is lower than average revenue per license from retail
versions. Likewise, product upgrades have lower prices than new products. Also,
prices of integrated suites, such as Microsoft Office, are less than the sum of
the prices for the individual programs included in these suites when such
programs are licensed separately. Microsoft recognizes a portion of Windows
operating systems revenue over the products' life cycles. This revenue
recognition policy was extended to Office 97 licenses in the third quarter of
fiscal 1997. (See notes to financial statements.)
PRODUCT GROUPS
Platforms product revenue grew 26% to $1.88 billion in the second quarter,
compared to $1.49 billion in the comparable quarter of the prior year. Year to
date Platforms revenue was $3.58 billion in fiscal 1998 and $2.68 billion in
fiscal 1997. Platforms product group revenue is primarily licenses of PC
operating systems, business systems with client/server architectures, and
software development tools.
Windows 95 unit volume continued to build, as units licensed through the OEM
channel increased strongly. Additionally, revenue from the Microsoft Windows
NT(R) Workstation operating system showed healthy growth. The revenue growth
rate for Microsoft BackOffice(R) server and server applications products slowed
from the rapid rates experienced in prior periods.
Applications and Content product revenue increased 43% to $1.71 billion in the
December quarter. The comparable quarter of the prior year reflected additional
unearned revenue of $200 million to account for versions of Office for Windows
95 shipped during the quarter which carried a "technological guarantee" coupon
that entitled customers to a free upgrade to the corresponding Office 97 version
of the product. For the first half of fiscal 1998, revenue was $3.14 billion,
compared to $2.30 billion the prior year. Applications and Content product group
revenue includes primarily licenses of desktop and consumer productivity
applications, interactive media programs, and PC input devices. Integrated
suites generate most desktop application revenue. The primary programs in
Microsoft Office are Microsoft Word word processor, Microsoft Excel spreadsheet,
and Microsoft PowerPoint(R) presentation graphics program. Various versions of
Office, which are available for Windows 32-bit, Windows 16-bit, and Macintosh
operating systems, also include applications such as Microsoft Access database
management program, Microsoft Outlook/TM/ desktop manager, Microsoft Schedule+
calendar and scheduling program, and an email client license.
Revenue from the various Microsoft Office integrated suites, including the
Standard, Professional, and Small Business Edition, increased strongly, while
stand-alone versions of Microsoft Excel, Microsoft Word, and Microsoft
PowerPoint continued to decrease.
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8
SALES CHANNELS
Microsoft distributes its products primarily through OEM licenses,
organizational licenses, and retail packaged products. OEM channel revenue
represents license fees from original equipment manufacturers. Microsoft has
three major geographic sales and marketing organizations: the U.S. and Canada,
Europe, and elsewhere in the world (Other International). Sales of organization
licenses and packaged products in these channels are primarily to distributors
and resellers. The trend has continued toward a higher percentage of
organizational licensing versus packaged products.
Royalties from OEMs reached a record level. Revenue from the OEM channel was
$1.21 billion in the second quarter, up 40% over the prior year. Year to date,
OEM revenue was $2.20 billion compared to $1.53 billion the prior year. The
primary source of OEM revenue is the licensing of desktop operating systems. PC
shipment growth coupled with an increased penetration of higher value 32-bit PC
operating systems drove the OEM revenue increase.
For the second fiscal quarter, finished goods revenue in the U.S. and Canada
increased 31% to $993 million from $759 million the prior year. First half
revenue of $1.96 billion grew 25% over the prior year. The growth rate in the
U.S. and Canada reflected slowing growth of desktop applications and business
systems and flat shipments and licensing of retail versions of 32-bit personal
operating systems.
Second quarter revenue of $842 million in Europe grew 33% and second half
revenue of $1.48 billion grew 40% due to the increased popularity of
organizational licensing of Microsoft Office and Windows products and greater
demand for BackOffice family server products.
Other International channel revenue in the December quarter was $538 million,
compared to $424 million the prior year. Year to date revenue was $1.08 billion
in fiscal 1998 and $817 million in fiscal 1997. Key drivers of growth were
increased organizational licensing of Microsoft Office and sales of BackOffice
packaged product. The second quarter growth rate was lower than recent quarters
due to slowing growth in Japan, Australia, and Southeast Asia, which partially
offset strong growth in Mexico, Brazil, and other South American countries.
Microsoft's operating results are affected by foreign exchange rates. Since a
portion of local currency denominated revenue is hedged and much of the
Company's international manufacturing costs and operating expenses are also
incurred in local currencies, the impact of exchange rates is partially
mitigated.
OPERATING EXPENSES, NONOPERATING ITEMS, AND INCOME TAXES
Cost of revenue as a percent of revenue declined to 8.7% in the second quarter
from 11.0% the prior year. For the first half of fiscal 1998, cost of revenue as
a percent of revenue was 8.4% compared to 11.0% in fiscal 1997. The decrease was
due to the shifts in mix to CD-ROMs (which carry lower cost of goods than
disks), licenses to OEMs and organizations, and higher-margin Windows NT Server
and other BackOffice server products.
Research and development expenses increased 29% in the second quarter to $627
million and increased 30% in the first half to $1.19 billion, primarily driven
by higher development headcount-related costs, third party development, and
charges from purchased R&D.
On August 1, 1997, the Company acquired WebTV Networks, Inc. (WebTV), an online
service that enables consumers to experience the Internet through their
televisions via set-top terminals. Microsoft paid $425 million in stock and cash
for WebTV. The accompanying income statement reflects a one-time write-off of
in-process technologies under development by WebTV of $296 million.
Sales and marketing expenses were $876 million in the second quarter of fiscal
1998, which represented 24.4% of revenue, compared to 27.5% in the second
quarter of the prior year. On a year to date basis, sales and marketing expenses
of $1.66 billion represented 24.8% of revenue, compared to 27.4% in the first
half of fiscal 1997. The total expense as a percent of revenue decreased due to
lower relative marketing costs in the first quarter and lower relative support
costs in the second quarter of fiscal 1998.
General and administrative costs were $106 million in the second quarter
compared to $81 million in the comparable quarter of the prior year. In the
first half of fiscal 1998, general and administrative expenses were $201
million, compared to costs of $167 million the prior year.
- --------------------------------------------------------------------------------
9
Interest income increased as a result of a larger investment portfolio generated
by cash from operations. Other expenses include primarily the recognition of the
Company's share of joint venture activities, including DreamWorks Interactive
and the MSNBC entities.
The effective income tax rate increased due to the nondeductibility of the
write-off of the WebTV in-process technologies and amortization of other WebTV
intangible assets.
NET INCOME
Net income for the second quarter of fiscal 1998 was $1.13 billion. On a year to
date basis, net income was 26.7% of revenue in fiscal 1997 compared to 27.2% the
prior year. Excluding the one-time write-off of WebTV in-process R&D, net income
represented 31.2% of revenue in the first half of fiscal 1998. Earnings per
share without the write-off were $0.78, a 51% increase compared to the $0.52
earned during the same period the prior year.
FINANCIAL CONDITION
Microsoft's cash and short-term investment portfolio totaled $10.11 billion at
December 31, 1997. The portfolio is diversified among security types,
industries, and individual issuers. Microsoft's investments are generally liquid
and investment grade. The portfolio is invested predominantly in U.S. dollar
denominated securities, but also includes foreign currency positions in
anticipation of continued international expansion. The portfolio is primarily
invested in short-term securities to minimize interest rate risk and facilitate
rapid deployment in the event of immediate cash needs.
During 1996, Microsoft and National Broadcasting Company (NBC) established two
joint ventures: a 24-hour cable news and information channel and an interactive
online news service. Microsoft agreed to pay $220 million over a five-year
period for its interest in the cable venture and to pay one-half of operational
funding of both joint ventures for a multiyear period.
Microsoft has no material long-term debt and has $70 million of standby
multicurrency lines of credit to support foreign currency hedging and cash
management. Stockholders' equity at December 31, 1997 was $12.34 billion.
Microsoft will continue to invest in sales, marketing, and product support
infrastructure. Additionally, research and development activities will include
investments in existing and advanced areas of technology, including using cash
to acquire technology and to fund ventures and other strategic opportunities.
Additions to property and equipment will continue, including new facilities and
computer systems for R&D, sales and marketing, support, and administrative
staff. Commitments for constructing new buildings were $200 million on December
31, 1997.
Cash will also be used to repurchase common stock to provide shares for employee
stock option and purchase plans. Despite recent increases in stock repurchases,
the buyback program has not kept pace with employee stock option grants or
exercises. Beginning in fiscal 1990, Microsoft has repurchased 336 million
common shares for $7.8 billion while 756 million shares were issued under the
Company's employee stock option and purchase plans. The market value of all
outstanding stock options was $32.6 billion as of December 31, 1997. Microsoft
enhances its repurchase program by selling put warrants. During December 1996,
Microsoft issued 12.5 million shares of 2.75% convertible preferred stock. Net
proceeds of $980 million were used to repurchase common shares.
Management currently believes existing cash and short-term investments together
with funds generated from operations will be sufficient to meet operating
requirements for the next 12 months. Microsoft's cash and short-term investments
are available for strategic investments, mergers and acquisitions, other
potential large-scale cash needs that may arise, and to fund the continuation of
its stock buyback program to reduce the dilutive impact of the Company's
employee stock option and purchase programs.
Microsoft has not paid cash dividends on its common stock. The preferred stock
pays $2.196 per annum per share.
NEW ACCOUNTING PRONOUNCEMENT
During October 1997, the Accounting Standards Executive Committee (AcSEC) of the
American Institute of Certified Public Accountants issued Statement of Position
(SOP) 97-2, Software Revenue Recognition. The SOP is effective for transactions
entered into in fiscal years beginning after December 15, 1997. Different
informal and unauthoritative interpretations of certain provisions of SOP 97-2
have arisen. AcSEC is already deliberating amendments to SOP 97-2, including
deferral of the effective date of certain provisions of the SOP so AcSEC can
develop and issue an interpretation regarding the applicability and the method
of application of those provisions. Because of the uncertainties related to the
outcome of these amendments, the impact on the future financial results of the
Company is not currently determinable.
- --------------------------------------------------------------------------------
10
EMPLOYEE STOCK OPTIONS
The Company encourages broad-based employee ownership of Microsoft stock through
an employee stock option (ESO) program in which all employees are eligible to
participate. At December 31, 1997, 502 million vested and unvested options were
outstanding as compared to 2,423 million common shares outstanding.
The Company follows APB Opinion 25 to account for ESO plans in its published
financial statements. Accordingly, no compensation cost is recognized because
the option exercise price is equal to the market price of the underlying stock
on the date of grant. Earnings per share calculations reflect exercised ESOs and
the effect of outstanding ESOs under the treasury stock method. In addition, as
required by Statement of Financial Accounting Standard 123 (SFAS 123), the
Company discloses the value of ESO grants using the Black-Scholes option
valuation method and the proforma impact of expensing such value over the
vesting period of the ESOs in the notes to its annual financial statements.
ESOs are a claim on the increase in the value of the Company and Microsoft does
not believe that there is a single income statement presentation that adequately
measures that claim. Since employees cannot sell their ESOs, there is no
subsequent transaction that provides validation of the Blank-Scholes value of
the ESO expensed over the vesting period. Although not currently its practice,
the Company could "hedge" its ESOs by purchasing offsetting call options when
ESOs are granted. The assumed hedge with a third party provides a theoretical
basis for measuring and recognizing the cost of ESOs when granted.
In an effort to aid understanding of the economic cost of the Company's ESO
plan, we are providing alternative proforma "look-through" income statements as
a supplemental presentation of accounting for stock options. In this
presentation, the assumed use of cash to purchase offsetting call options is
expensed in the quarter that the ESOs are granted and hedged. The cost of ESO
grants, based on the Black-Scholes value (using similar assumptions to those
disclosed in the 1997 Annual Report), is expensed through the income statement
operating expense line items. Because ESOs granted after 1995 are assumed to be
hedged and therefore "neutralized," such ESOs are excluded from average shares
outstanding used to calculate EPS. Also, interest income is reduced for the
proforma use of cash to purchase the hedges. This alternative presentation of
accounting for ESOs is not in accordance with generally accepted accounting
principles because the cost of the offsetting call options is expensed
immediately and the related ESOs are excluded from EPS calculations.
Nevertheless Microsoft believes this is meaningful information to investors.
ESOs are granted upon hire to new employees and annually to current employees.
The annual grant, made in the first quarter of the fiscal year, represents the
majority of ESOs granted during any given fiscal year. Accordingly, the
alternative presentation will show the widest variance from reported EPS in that
quarter. Proforma results for the trailing twelve months are presented as a
basis for annualized analysis.
As a basis for comparison Microsoft has also provided the proforma net income
and diluted earnings per share disclosures required by SFAS 123. Since ESO
expense determined under SFAS 123 only recognizes expense for grants after July
1, 1995, Microsoft has also provided additional proforma information for all
ESOs vested during the periods presented.
ALTERNATIVE PRESENTATION OF ACCOUNTING FOR ESOS
(In millions, except earnings per share)(Unaudited)
- --------------------------------------------------------------------------------
Three Months Ended Twelve Months Ended
Dec. 31, 1997 Dec. 31, 1997
- ----------------------------------------------------------------------------------------------------
Reported Proforma(1) Reported Proforma(1)
- ----------------------------------------------------------------------------------------------------
Revenue $3,585 $3,585 $13,098 $13,098
Operating expenses:
Cost of revenue 313 315 1,105 1,152
Research and development 627 647 2,202 2,891
Acquired in-process technology 0 0 296 296
Sales and marketing 876 894 3,158 3,628
General and administrative 106 109 396 539
- ----------------------------------------------------------------------------------------------------
Total operating expenses 1,922 1,965 7,157 8,506
- ----------------------------------------------------------------------------------------------------
Operating income 1,663 1,620 5,941 4,592
Interest income 157 131 545 480
Other expenses (50) (50) (285) (285)
- ----------------------------------------------------------------------------------------------------
Income before income taxes 1,770 1,701 6,201 4,787
Provision for income taxes 637 612 2,306 1,799
- ----------------------------------------------------------------------------------------------------
Net income 1,133 1,089 3,895 2,988
Preferred stock dividends 7 7 22 22
- ----------------------------------------------------------------------------------------------------
Net income available for common shareholders $1,126 $1,082 $ 3,873 $ 2,966
====================================================================================================
Diluted earnings per share $ 0.42 $ 0.42 $ 1.47 $ 1.14
====================================================================================================
Weighted average shares outstanding 2,667 2,604 2,656 2,602
====================================================================================================
Options granted 1 1 34 34
====================================================================================================
Proforma impact of SFAS 123 (2)
Net income $1,017 $ 3,523
====================================================================================================
Diluted earnings per share $ 0.38 $ 1.33
====================================================================================================
Proforma impact of SFAS 123 (3)
Net income $ 993 $ 3,422
====================================================================================================
Diluted earnings per share $ 0.37 $ 1.29
====================================================================================================
(1) Proforma results as described in the preceding paragraphs.
(2) Proforma information as if the Company applied SFAS 123 for all ESOs
granted after July 1, 1995.
(3) Proforma information as if the Company applied SFAS 123 for all ESOs.
- --------------------------------------------------------------------------------
11
Part II. Other Information
ITEM 1. LEGAL PROCEEDINGS
See notes to financial statements.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual Meeting of Shareholders held on November 14, 1997, the following
proposal was adopted by the margins indicated:
To elect a Board of Directors to hold office until the next annual meeting
of shareholders and until their successors are elected and qualified.
Number of Shares
For Withheld
William H. Gates 2,178,032,808 13,838,368
Paul G. Allen 2,177,837,684 14,033,492
Jill E. Barad 2,160,725,012 31,146,164
Richard A. Hackborn 2,178,175,348 13,695,828
David F. Marquardt 2,177,884,684 13,986,492
William G. Reed, Jr. 2,178,304,002 13,567,174
Jon A. Shirley 2,178,359,104 13,512,072
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) Exhibits
27. Financial Data Schedule
(B) Reports on Form 8-K
Microsoft filed no reports on Form 8-K during the quarter ended December
31, 1997.
ITEMS 2, 3, AND 5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.
- --------------------------------------------------------------------------------
12
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Microsoft Corporation
Date: June 2, 1998 By: /s/ Gregory B. Maffei
-----------------------------------
Gregory B. Maffei,
Vice President, Finance;
Chief Financial Officer
(Principal Financial and Accounting
Officer and Duly Authorized Officer)
- --------------------------------------------------------------------------------
13
5
6-MOS
JUN-30-1998
DEC-31-1997
10,105
0
1,081
0
0
11,636
2,923
1,445
16,840
4,496
0
0
980
6,104
5,260
16,840
6,715
6,715
566
566
3,355
0
0
2,972
1,176
1,796
0
0
0
1,796
.74
.67
THIS STATEMENT HAS BEEN RESTATED AS A RESULT OF SFAS 128, EARNINGS PER
SHARE, AND APPLICABLE STOCK SPLITS.
