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Microsoft Corporation (NASDAQ:MSFT)

Q2 2006 Earnings Release Conference Call

January 26th 2006, 5:30 PM.

Executives:

Colleen Healy, Senior Director, Investor Relations

Chris Liddell, Chief Financial Officer

Scott Di Valerio, Corporate Vice President, Finance and Administration, Chief Accounting Officer

Analysts:

Adam Holt, JP Morgan

Rick Sherlund, Goldman Sachs

Charlie Di Bona, Sanford Bernstein

Mary Meeker, Morgan Stanley

Heather Bellini, UBS

Kash Rangan, Merrill Lynch

Brent Thill, Prudential

Jason Maynard, Credit Suisse First Boston

David Hilal, Friedman, Billings, Ramsey

Operator

Good afternoon and welcome to the Microsoft 2006 fiscal year 2nd quarter earnings conference call. Your lines have been placed on listen-only until the question and answer session of the conference. This call is being recorded. If you have any objections, please disconnect at this time. I will now turn the call over to Miss Colleen Healey, Senior Director, Investor Relations. Please go ahead.

Thanks Laura. Good afternoon everyone and thank you for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer, Scott Di Valerio Corp. VP, Finance and Administration, and Chief Accounting Officer and John C. Todd, deputy general counsel.

Today’s call will start with Chris providing some key takeaways for the second quarter of fiscal year 2006 and an overview of expectations for the rest of the fiscal year. Scott will then provide detail around our second quarter results and then turn it back to Chris for a more detailed discussion of our guidance for the third quarter and full fiscal year. After that, we’ll take your questions.

We filed our 10Q today in conjunction with our earnings release. Therefore, you have available the earnings release, MDNA, financial statements and footnotes. We have also posted our quarterly financial summary slide deck which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today.

You can find the earnings release, the 10Q and the quarterly financial summary slide deck on the investor relations website at www.microsoft.com/msft.

Today’s call will be recorded. Please be aware that if you decide to ask a question it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live web cast of our call at the Microsoft investor relations website.

A replay of the call will be available at the same place through the close of business on January 26, 2007.

This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report or any portion of it may result in civil and criminal penalties. Any recording or other use of or transmission of the text or audio to this call is not allowed without the express permission of Microsoft.

We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risk and uncertainty. Actual results could differ materially because of factors discussed in today’s earnings press release, in the comments made during the conference call and in the management discussion and analysis section of our 10Q or 2005 10K or other reports and filings with the securities and exchange commission. We do not take any duty to update any forward-looking statements.

With that, please click to slide number four, where Chris’s comments will begin. Chris?

Thank you colleen and good afternoon everyone, thanks for joining us on today’s call. I’d like to begin by highlighting the key points from our second quarter performance and take a look at the rest of fiscal year 2006.

We had a very good second quarter with highlights being three extremely successful product launches, good growth in our core businesses and delivery of operating income and earnings this year in line with expectations. We have been looking forward to this quarter as we kick off the broadest multi-year product cycle in the company’s history.

Looking back on quarter 2, we’re off to an excellent start. During the quarter we had significant on time and successful launches of products for both consumers and businesses.

The quarter’s new product launches created a lot of justifiable excitement in the marketplace. For example, the highly anticipated XBOX 360 had a phenomenal reception by consumers. Demand for the product has been high and we look forward to increasing the console availability in the second half of the fiscal year, with the addition of our third manufacturing partner.

Just as eagerly anticipated and well-received by business customers was SQL Server 2005 and Dynamic CRM 3.0. And during the quarter, we positioned ourselves well for continued momentum and setup pipeline success with two community technology preview releases of Windows Vista, the initial Beta releases of Office 12 and Exchange 12 and many Beta versions of our Window Live Update.

Our core software businesses enjoyed healthy growth, driven by strong demand from corporate customers and strong PC and Server unit segments.

Growth in client revenue and a robust PC environment was driven by consumer strength during the holiday season.

The real highlight for the quarter was that Server Tools continues its impressive string of double digit revenue growth. SQL Server generated over 20% of year over year revenue growth during the quarter, significantly outpacing the database market and our expectations from last quarter.

SQL Server 2005 is quite simply an outstanding product, meeting the needs of customers and we were delighted to have seen the faster than expected adoption at and after the launch.

We were pleased to see both business solutions and mobile and embedded devices continue their recent momentum and, in both cases, achieve operating profitability t his quarter.

While we do not expect them to remain consistently for the remainder of fiscal 2006, their strong revenue and profit performance reinforces their trajectory to exit emerging status sometime in fiscal 2007.

Lastly, during the quarter, we continue to have momentum on returning cash to shareholders. We announced a one cent increase in our quarterly dividend, equating to a 12 _ percent increase. And we purchased 7.7 billion dollars worth of our stock, our largest ever quarterly stock buyback.

Overall, we’re pleased with our performance in both Q2 and the first half of fiscal 2006.

So now, I’d like to make a few points about how the rest of the fiscal year is shaping up. First, we continue to expect double-digit revenue growth for fiscal 2006, driven by sustained momentum in our core software businesses and by strong demand for the XBOX 360.

Second, we will continue to invest in our businesses. As we mentioned on the last call, we are investing in our core businesses of client Information Worker and server tools for product launches. We will also continue to invest in MSN in order to bring rich and compelling services and content to our users and a world-class advertising platform to our advertisers. I’ll discuss a little bit more about the investment in MSN later in the call.

We’re confident that we’re making the right investments for products in the near-term horizon as well as initiatives and products that will benefit us longer-term. And even with these investments, we expect to deliver strong double-digit earnings growth the second half of the year.

So with those opening remarks, I’d like to turn the call over to Scott for more details on the quarter and then I will provide you with more details on the rest of the fiscal year.

Thanks, Chris, and good afternoon everyone. As Chris mentioned, Q2 is a good quarter overall, with revenues slightly below our guidance and bottom line results largely in line with our expectations. During the quarter, revenue was a record $11.8 billion up 9% from the prior year, driven by growth in our core software businesses and home entertainment. Operating income was $4.7 billion, which is at the high end of our expectations entering the quarter and driven by operating profitability in six of our seven busy seasons.

We delivered good earnings growth with earnings-per-share of $.34. When adjusted for tax-rated benefits realized in the quarter of $.01 per share, this is also at the high end of our guidance.

We kicked off a significant multi-year product cycle with launches of XBOX 360, SQL Server 2005, Dynamic CRM 3.0 and a host of other products. And, lastly, we returned over $8.5 billion to shareholders in the form of stock repurchases and dividends.

So while revenue is slightly below our guidance, we had a successful quarter, which I will highlight over the next several minutes.

I will start by discussing topline financial and business points and will follow with the revenue performance of each of the business units. Then I’ll wrap up with an overview of operating income performance as well as balance sheet and cash flow information.

All comparisons are meant to relate to the comparable quarter of last year, unless otherwise specified.

Our core businesses had another good quarter. Overall revenue growth was driven by server and tools revenues which grew 14% on the strength of SQL sales and client revenue growth of 8%, driven by the strength of PC hardware shipments. Add in a good quarter by Information Worker, and our three largest businesses grew revenue by a combined 9%, representing $785 million in absolute revenue growth.

Another key driver for the quart4r was the launch of XBOX 360 which drove home entertainment revenue growth of 13%. We’re also pleased with the continued momentum in our Microsoft Business Solutions and Mobile Imbedded Business units which grew 17% and 40%, respectively.

The IT spending environment was also largely in line with our expectations. The clear highlights were strong demand in the enterprise and continued strength of the PC and Server harder market growth. Demand was generally healthy across all customer segments and, from a regional perspective, EMEA and the emerging markets were relatively strong.

We estimate PC market growth during the quarter at 14-15%, which is stronger than we expected 3 months ago. A very strong holiday sales season resulted in consumer PC shipment growth outpacing business shipments for the third consecutive quarter. From a form factor perspective, growth in notebook PC shipments continues to outpace desktops.

PC unit demand was broad-based regionally with double-digit growth rates in all geographies, except for North America and Japan and emerging market growth rates continue to significantly outpace mature markets.

Our mix of product billings for the quarter was generally consistent year-over-year with roughly 35% from OEMs, 25% from multi-year licensing agreements, 20% from license-only sales and the balance from our other businesses.

We had good results, overall, from a volume licensing perspective with the strongest growth in enterprise agreements, where our renewal experience remains within our historical range of 65-70%. Select and open annuity results for the quarter are also very good, relative to non-annuity licensing.

Our unearned revenue balance ended the quarter where we expected it, at $8.8 billion, up slightly from the prior quarter and represents an 11% increase over the prior year. The sequential change in unearned balance was impacted by the relatively small amount of multi-year contract value that was up for renewal during the quarter, relative to prior year amounts.

Our contracted, not billed balance at the end of December was up sequentially and now exceeds $9 billion.

Before I get into the revenue details for each business group, I’d like to point out that the foreign exchange rate impact on revenue was not meaningful to our overall revenue growth.

So now, let’s move on to a discussion of revenue by business segment.

Client revenue grew 8%, driven by OEM revenue growth of 10%, offset by a 2% decline in commercial and retail licensing. The OEM revenue growth resulted from 15% license unit growth. The different between OEM licensing growth and revenue growth is caused primarily by a shift in channel mix toward larger OEMs with volume pricing, growing volume in emerging markets, and the relative strength of the consumer segment of the PC market, which results in higher volumes of Windows XP Home Edition and Media Center Edition, relative to total units sold.

As we discussed last quarter and consistent with the relative strength of the consumer segment of the market, we continue to see a change within the sales mix of our premium edition operating systems, licensed to OEMs. Our OEM premium mix is up 2 percentage points from the prior year, at 49%. A larger percentage of premium edition sales were made to consumers purchasing Windows Media Center, which carries a lower priced premium relatively to Windows Professional. All in all, we were pleased to see the significant market traction and continued growth for Windows Media Center edition, which has sold over 6.5 million licenses to date.

Server Tools continue to deliver double-digit revenue growth for the company, reflecting broad adoption of Windows Server System products and an exceptionally strong SQL Server 2005 product launch.

SQL Server 2005 provides a data management and analysis platform that enables organizations to reliably manage mission-critical information entered in complex business applications. Its business intelligence capabilities enable companies to gain greater insights from their business information. The value proposition of the product is outstanding and we’re delighted to see that many customers agree.

Revenue for the quarter was $2.9 billion, a 14% increase over the prior year. Continued share gains in the enterprise resulted in SQL Server revenue growth in excess of 20%. During the quarter, we also successfully launched digital studio 2005, BizTalk Server 2006, and Windows Server 2003R2, adding to our already strong product lineup.

Our enterprise services businesses also continued to show solid progress, with revenue growth of 17%.

Information Worker revenue was in line with our expectations, growth 5% to $3 billion. Revenue growth related to volume licensing and pre-installed versions of Office in Japan were strong.

This quarter we experienced an increased annuity mix in our overall billings, which we attribute to customers desiring to acquire both Office 2003 and Office 12 upon its release later this calendar year. During the quarter, we also released a preview of Office 5, our future services offering targeting small businesses as well as the technical data of Office 12, which garnered positive reviews from the industry.

MBS revenue was $242 million, which was higher than our expectations and up 17% from the prior year, driven by the early release of Microsoft Dynamics CRM 3.0 and strong results in EMEA. As a result of the strong revenue growth, we were pleased to see MBS achieve operating profitability in the quarter.

We also shipped new versions of Dynamics GP 9.0 and Dynamics SL 6.5 during the quarter.

MSN revenue was $593 million, down 2%, driven by advertising growth of 12%, offset by an expected decline of 33% in narrow-band access revenue. We are pleased with the display advertising, which grew in excess of 20% for the quarter. We improved display advertising pricing and increased our inventory while increasing the number of users of our services. Active Hotmail accounts grew to 230 million, compared to 191 million in the prior year. And, active Messenger accounts grew to 205 million, compared to the 156 million of the prior year.

As you know, we’re in the middle of a transition in search advertising business, moving from Yahoo’s platform to our own proprietary platform called MSN Ad Center, which we began testing in the US during the quarter. The ramp-up of a new ad platform requires significant investment from Microsoft, both in development costs as well as in reduced revenues related to fewer numbers of overall advertisers and resulting lower key word pricing. The good news is that response to our platform has been great and we are ramping up deployment by rapidly envoying advertisers and moving more search traffic to the platform.

On algorithmic search, we are continuing to grow query volume, improving relevance and are investing in several search verticals. We have recently launched mapping, the birds-eye flyover mapping service and are soon to launch news and images. We continue to invest in search for long term and believe there’s lots of innovation yet to come.

The decline in our narrow-band access revenue is in line with our expectations as customers continue to move on to broadband.

MBD revenue for the quarter grew 40% on broad strength across the Windows Imbedded and Windows Mobile product lines as we continue to capitalize on growing market demand for connected devices. Windows Mobile licenses for connected phone-enabled devices grew in excess of 70% from the prior year. Windows Imbedded product growth of 64% was driven by the increasing use of Windows CE and Windows XP Imbedded in a wide range of smart devices such as point of sale terminals and thin clients.

As a result of the strong revenue in the quarter, MBD also achieved it its first quarter of operating profitability.

Home and entertainment revenue growth for the quarter was 13%, driven by the XBOX 360 launch and solid growth of our consumer hardware and PC games product lines.

During the second quarter, XOB 360 achieved an unprecedented video game console launch, and we are thrilled with the results. We were first to market in 19 countries with XBOX 360 and have garnered record software attach rates, indicative of the strength of our games portfolio. On XBOX Live, we continue to lead the way in online gaming. Whereas, on XBOX Version 1, about one in ten customers are connected to the XBOX Live service, on XBOX 360 more than half of all consoles are connected.

We’re off to a strong, early start with all these factors and coupled with the continuing uncertainty of our competitors entering the next generation, we are right where we want to be.

Demand for XBOX 360 consoles has been incredibly strong and feedback on the platform has been incredibly positive. Our previous challenge in the quarter was meeting the high consumer demand for the console. We sold 1.5 million XBOX 360 consoles in the 2nd quarter, with 900,000 consoles in North America, 500,000 consoles in Europe and the remainder in Japan. This is lower than we expected due to component charges stemming from challenges in ramping supply of a complex product like XBOX 360. We believe that this is a short-term manufacturing challenge and we have taken steps to increase supply to meet the strong consumer demand for the console.

A key indicator of platform health is the attach rate for games and accessories. According to NPD, software attach for the XBOX 360 in the US was more than 4 per console and accessory attach was more than 3 per console for the quarter. Both are records with consumers purchasing nearly double the amount relative to any other console launch in history. The software results, in particular, highlight that we have launched XBOX 360 with an incredibly strong lineup of games.

XBOX Live continues to lead the way in defining online entertainment and is regarded as the standard by which all other online gaming services will be measured. Since the launch of XBOX 360, XBOX Live members have downloaded over 4 million pieces of high definition games, music and movie content from the XBOX Live marketplace.

Lastly, our XBOX Version 1 platform remains a great value to consumers. We sold over 2.2 million XBOX 1 consoles in the first half of the fiscal year, bringing the installed base to over 24 million worldwide, with 16 million in North America and 6 million in Europe. All the demand for XBOX 1 consoles and software sales was negatively impacted by the momentum and excitement surrounding the XBOX 360 launch.

Now for the rest of the income statement and balance sheet.

While revenue increased 9%, cost of revenue increased 19%. This increase was due to costs primarily associated with the XBOX 360 console volumes. The remainder of operating expenses increased about $750 million or 18%.

As we discussed in the past, we are investing aggressively in our businesses to satisfy customers and to compete and win in the marketplace. Investments this quarter were focused around the following areas: strong levels of high end investment in research and development focused on new product development examples of which include Windows Vista, Office 12, Longhorn Server, Exchange 12, MSN Ad Center, Search and Communications Services. Advertising focused primarily on our clients and worker information businesses as well as overall corporate branding. Increased hiring for field sales and marketing positions is scored in future revenue growth. Specifically in our enterprise and small and medium businesses sales forces as well as our Information Worker specialists. And, marketing spending associated with the product launches in the quarter including SQL Server 2005 and XBOX 360.

As you know, we have always taken a long-term view of our business. Today’s investments in product R&D and Sales and marketing lays out the foundation for future revenue and profit growth.

Investment income in other totally $400 million including $212 in net gains on investments and $185 in net losses on derivatives, primarily related to losses on foreign exchange contracts and commodity positions.

Our effective tax rate for eh quarter was about 29%; lower than expected due to a $108 million tax benefit associated with the settlement of state audits.

Now for a brief summary of the cash flow statement and balance sheet.

We generated over $2.2 billion in cash from operations, a 38% decline from prior year due to increased spending on XBOX 360 inventory and other changes in the working capital.

Of the over $8.5 billion returned to shareholders during the quarter, $7.7 billion was for the repurchase of 283 million shares, with the remainder for dividends. During the quarter our board of directors also announced a $.01 increase in the regularly quarterly dividend; bringing it to $.09 per share, per quarter.

Cash and equivalents in short term investments were down $5.4 billion and 13% sequentially for the first quarter, to $34.7 billion, reflective of the record amount of share repurchase activity in the second quarter.

So in summary, we achieved record revenue of 9% growth driven by our core businesses, representing over $1 billion in absolute revenue growth versus the prior year. We will continue to invest to fuel revenue and profit growth in the future. Our earning per share was at the high end of our expectations, excluding tax benefits for the quarter. We executed on key product launches kicking off a significant, multi-year product cycle and we repurchased our stock at record levels.

With that, let me turn it back to Chris who will provide you with our expectations for Q3 and the rest of fiscal 2006.

Thanks, Scott. As some of you may know, Scott’s in the process of transitioning into his new role as the head of the OEM group. Microsoft OEM Channel is obviously critical to the company’s success and we look forward to his contributions there. I’d certainly personally like to take this opportunity to thank Scott for all of his hard work and dedication in driving functional excellence across finance. Moving into his new role will allow Scott to continue forward in his already substantial impact here at Microsoft. However, I’m sure he will also dearly miss joining us here on these quarterly calls.

Now I’m going to spend my remaining time on the call giving you a view of what we are expecting for the third quarter and the rest of the full fiscal year. Please keep in mind that all of the gross figures that I am using reflect year-over-year grow to comparable period, unless otherwise noted.

Before giving specific financial guidance, let me outline some of our key assumptions around the economy and general demand in the industry. With calendar 2006 underway, we expect overall IT spending to remain healthy in the new year. We feel good about our ability to participate in any growth in the overall marketplace in the coming year. We estimate for the 3rd Quarter PC unit growth should be 11-13%, primarily as a result of higher than expected growth in the first half of fiscal 2006, we are raising our full fiscal year estimate to 12-14%.

Our expectation is that growth from the total server hardware market remain unchanged at 11-13% for the full fiscal year.

For our forecast, we’re assuming that changes in foreign exchange rates will not have a material impact on our year over year growth rates. So now for some detailed guidance.

For the full year, we’re tightening the revenue range that we gave you in October, as we now expect revenues to come in between $44.0 and $44.5 billion, representing growth of 11-12%. We’re forecasting the Q2 strength in our core software businesses to continue into the second half.

For the 3rd quarter we expect revenue up $10.9-$11.2 billion, representing year over year growth of 13-16%.

Revenue by business group is as follows:

For client, expect revenue growth to be 7-8% for the full fiscal year and 7-9% for the third quarter. We expect OEM units to grow roughly in line with the market, aided by growing traction in emerging markets. In server and tools we’re raising our expected revenue growth to 15-16% for the full fiscal year and 15-17% for the third quarter. We are forecasting continued corporate demand for our server products with SQL Server 2005 continuing to show strong market acceptance. Information Worker revenue should grow 5-6% for the full fiscal year and 6-7% for the 3rd quarter. As we move closer to the launch of Office 12, we expect corporate customers to increasingly prefer annuity licensing programs when evaluating Office purchases.

For Microsoft Business Solutions, we expect revenue growth to be 14-15% for the full fiscal year and approximately 16% for the 3rd quarter. Demand for our new Dynamic CRM 3.0 has been above our expectations and we’re forecasting the recent strength to continue through the 2nd half.

For MSN, we’re expecting revenue to be flat for both the full fiscal year and the 3rd quarter, which reflects slightly lower revenue expectations for this business in fiscal 2006, driven primarily by our plans to accelerate the rate at which we ramp up Ad Center to deliver our paid search results. While this is an important strategic decision for the long-term, it does have a dampening effect on revenue for search in the short term.

Additionally, as I spoke about earlier in the call, we will also be making additional investments to strengthen the competitive position of our internet services. Areas of investment include for example, global infrastructure, where we are investing in global infrastructure in order to provide high quality performance and reliability for our customers on a global basis. In Ad Center, we’ll be hiring a thousand support people to provide great end-to-end service for our advertising customers, investing in development talent to increase the range of functionality for advertisers, and thus increasing their ROI, increasing traffic to Ad Center to speed the transition from Yahoo’s network and finally, rolling out Ad Center to more countries globally, to provide end to end advertising solutions to our customers everywhere.

In Search, we’re investing in search verticals by increased development resources and via acquisitions. For example, we bought GeoTango, which is a 3D internet visualization technology company, to enhance Windows Live Local Search.

We’re confident that we’re making good investments for products on the near term horizon as well as for initiatives and products that will benefit us longer term.

Mobile and Embedded devices revenue should grow greater than 30% for the year and about 35% for the 3rd quarter, driven by a number of exciting new devices, based on Windows Mobile 5.0.

Home and Entertainment revenue is expected to growth between 35% and 45% for the year and between 80% and 100% for the 3rd quarter, which reflects a reduction of the revenue guidance that we gave you in October, primarily as a result of 2 factors. First, lower expectations for the XBOX 1 business as the moment around XBOX 360 has drawn some attention away from the previous platform. We expect to continue to sell the XBOX 1 console well into the calendar year 2006 and certainly see this as a stretching out of the sales cycle. There are 800 games currently available for the platform and we expect there will continue to be a great deal of new content from third party publishers in the coming years. Second, we have slightly slower expectations for our consumer hardware, software and PC games business. We’ve also lowered our estimate of XBOX 360 console sales in the first 90 days of launch from 2.75 – 3 million units to 2.5 million units due to supply constraints. Even so, we estimate that consumers will spend over $1.5 billion in total retail value on XBOX 360 consoles, games and peripherals in these first 90 days, which is indicative of the health and magnitude of the XBOX 360 launch.

As you know, we’re bringing on a third manufacturing partner, Salistica, next month to help in meeting strong consumer demand for the XBOX 360 console. For that reason, we are not adjusting our previously announced fiscal year console sales guidance of 4.5-5.5 million consoles and our revenue guidance, which is based on unit sales within that range.

We continue to expect great software sales for XBOX 360, resulting from a strong flow of new games for the platform over the coming months. By the end of June, XBOX 360 will have more than 50 high definition games from the best names in publishing.

We delivered an unprecedented global launch during the quarter and by the end of March, XBOX 360 will be available in nearly 30 countries and will remain on track to be the fastest selling video game console in history.

Operating income for the full fiscal year is expected to be between $17.9 billion and $18.3 billion, representing growth of 23-25%. Brief note, this full year guidance includes the charge we took in Q1 of $361 for the settlement of Real Networks. Before significant settlement and other such items, operating income for the full fiscal year is expected to be $18.3-$18.6 billion, representing double-digit growth of 10-12%.

For the 3rd quarter, operating income should be $4.5-$4.6 billion, representing 36-39% growth over the prior year or 11-13% growth if you exclude the $768 million settlement charge taken a year ago to quarter.

For diluted earnings per share, we’re tightening the range that we gave you in October by raising the low end of that by $.01. The range is $1.28-$1.31 for the full fiscal year on a GAAP basis. If you were to adjust for the Real Networks settlement charge of $.02 from the first quarter and the $.01 tax benefit in the 2nd quarter, earnings per share will be $1.29-$1.32. We expect GAAP earnings per share of $.32-$.33 for the 3rd quarter and expect to have an effective tax rate of 31% for the 3rd quarter and the remainder of the year.

On the balance sheet, we’re still expecting unearned revenue to finish the year up 8-10%, and it’s likely to be at the higher end of that range. We’re also raising our estimate on our contract and our billed balance to now finish the year above $9 billion. This is up from our prior guidance of finishing the year at $8 billion.

When you combine our overall revenue growth with the net increase in unearned and contracted not billed, you’ll find that our year over year booking performance for the company for fiscal 2006 is strong and we feel confident about how we will end the year.

So in closing, I’d like to say that I’m pleased with our 2nd quarter and our fiscal year ’06 performance on three counts; first, the customer reaction to our newly launched products has been fantastic. Second, our ability to deliver our products on time, which – given the style and complexity of our product range – reflects a great performance and an increasingly improved operational discipline. And last, we made our expense targets for the quarter.

With that, I’d like to hand the call back to Colleen so we can take some of your questions. Thank you.

Thank you Chris. Let’s now proceed to questions. We want to accommodate questions from as many of you as possible, so please avoid multi-part questions and limit yourself to just one question. Operator, will you please repeat your instructions?

Question-and-Answer Session

Thank you. We will now begin the question and answer session. If you would like to ask a question, please press star 1. To withdraw your request, you may press star 2. Once again, to ask a question, please press star followed by 1. Our first question comes from Adam Holt with JP Morgan.

Good afternoon. Two questions on the unearned commentary. To get to the higher end of the 8-10% growth for the year, when would you expect to start to see an acceleration in the Information Worker bookings in front of office? And secondly, can you talk about some of the things that you’re doing to try and accelerate client bookings as well, particularly with Vista enterprise?

We do actually have quite a large number of contracts that are maturing and that’s one of the reasons that we feel confident about the balance being at the high end of that range. The first half of the year was a relatively modest period for expires and the second half is a relatively high one. On the Information Worker side we’re actually already starting to see what we think is a shift away from fully-priced products to the enterprise side. So, we’re starting to see that impact already and we believe that will continue through the first half of this calendar year, second half of the fiscal year. On the client side…what was the question about client?

What other number of initiatives in place to try and drive long term contracts on the client side in the context of the Vista release? I was hoping you could update us on that and also talk about when we would expect to see that acceleration.

We haven’t built in the expectations on the enterprise side for the 2nd half. We certainly think we’ll start to see some year on year benefits as the calendar year proceeds and as we get closer to the Vista launch. We are seeing some benefits, for example, in the new software assurance product that we launched last year. So, as opposed to a declining trend that we’ve seen in previous quarters, that’s flattened out and it will improve but we haven’t built a lot of that into our expectations for the 2nd half of the fiscal year.

Thank you.

Thank you very much, Adam. Next question please?

Thank you, our next question comes from Rick Sherland with Goldman Sachs.

Thanks. Just first on a technicality…can you reconcile why the cash flow statement shows $7.4 billion of stock repurchase and you’re saying $7.7 billion in the text?

What’s going on there Rick is that not all of the buy-back fell within the quarter. So, the difference that you’re seeing is inter-quarter settlement. We’ll catch that up next quarter when it’s settled.

Okay. And the constraints on supply for XBOX 360, if you could just talk for a moment about that. Could you be more specific with us about what that is? It doesn’t seem that if it’s a supply constraint that adding Salistica necessarily helps that. If you can kind of add some clarity there.

As we said in our prepared remarks, we had some issues with some of the components. There’s nothing that we think is systematic to the extent that we’ve solved some of them or will be solving any that we haven’t resolved, in the short term. So, it’s not a constraint that we see that’s going to be significant going forward. Let me just reiterate, in terms of the volatility that we can expect in the first few weeks with a product of that significance, launched across 90 countries, loss is at the low end of our expectations and it’s not surprising from our perspective; we don’t think this is a significant issue for the first six months.

Thank you so much, Rick. Next question please?

Thank you. Our next question comes from Charly DiBono with Sanford Bernstein.

Hi. Can we turn to MSN for a second here? It looks like your search ads are slightly down year on year and basically flat sequentially. You talked a little bit about the impact that Ad Center’s having on your pricing, does that mean that in areas where you’re not Beta testing Ad Center that you’re not seeing any deterioration in search pricing? And then, what has your experience been in France and Singapore as you’ve gone live with the product? Are you seeing a recovery in pricing there? And a related question would be, what are you doing so that the deteriorating leverage you’re getting on your community in your partner ads?

I’ll take those in parts, Charlie. In terms of the Beta test thing, no there isn’t a positive impact from that. In fact, as we initially ramp up because the volumes are lower than what they are on the combined Microsoft/Yahoo platform, we actually see a deterioration in the pricing. That will take some time as we need to ramp up the critical mass and volume. So that has a negative impact. In terms of the expectations that we had of receptivity, that’s going in fact better than we had hoped for which is one of the reasons why we’re accelerating the ramp up. But it does have a negative impact. In terms of the overture of pricing, no I don’t believe we saw a deterioration of pricing on the non-Ad Center-based ads during the quarter. But as we’ve said before, we don’t have a lot of visibility in there, so the trends that we are seeing, unfortunately is something that is opaque to us. One of the reasons why we’re moving faster on Ad Center and taking control of our own destiny.

And what about the partner network where you’ve seen some deterioration as well?

It’s not significant in my mind, from a financial point of view. So I’m not entirely sure what you’re referring to from a numbers point of view, but there’s nothing systematical.

You mentioned it in your MDNA.

The partner issue is the partner-driven prices. So that’s the same question as overture. What we’re seeing a bit is for the partner-driven…in other words, the parts that we don’t control our own fate on, we’re seeing pricing pressure which surprises us a bit. We’re going to take our fate into our own hands and we’re going to ramp up ad center. Given that we’re ramping that up, we probably don’t have tons of life left on these partner-driven prices; it sort of is what it is and we’re sort of focused on making our Ad Center platform best-in-class.

Thank you.

You’re welcome. Next question please?

Thank you. Our next question comes from Mary Meeker with Morgan Stanley.

Thanks. I have a quick question; I think Brian may have one as well. Chris, for the last couple of quarters you’ve had very strong PC unit growth but client revenue growth has not been as strong. You drilled down all the reasons for that, emerging markets, mix, etc. But the delta is large, is this the kind of delta we should just expect on a go-forward basis as we go through our modeling?

I think you can realistically expect if not all that delta then some large part of it for the rest of this fiscal year. You take our guidance on PC unit growth and on revenue, that’s the delta that we expect based on those mix factors. Going into fiscal year ’07, I don’t know if you want to get into forecasting that at this stage, but we would certainly see for example fully-priced packaged product sales being different in our launch year with something like Vista, so that impact which is being measured would be something that would be different.

Do you think we could narrow it to something like a 300 basis-point difference?

To some extent, we’re already seeing in the quarter some narrowing. If you remember sort of last year we were down sort of mid- to high teens on commercial retail. We did see some narrowing this quarter, we’re down 2%. If you look at our guidance on the back half, it continues to narrow in terms of where we think the PC market is coming and where our revenue is coming and hopefully that’s some sort of indication about our expectations.

Okay that’s great. Thanks a lot.

Mary, the other factor is it depends a little on the absolute size of the PC growth. So as it gets larger, it’s tending to come from the consumer area which is tending to make it get bigger. So in a year where the PC growth was say lower, you might expect the gap, all things being equal, to be narrower.

Just a quick question to follow up on the 360. Are you still on target for the 4.5-5.5 million consoles by June? I know you put down a number of 4.25.

Yes, we are still on target in that range.

Great, thanks.

Next question, please?

Thank you our next question comes from Heather Bolidi with UBS.

Hi, thank you. I just wanted to follow up to Mary’s last question. I was wondering if at some point if Skeet Balmer said there’s a mix to higher-end SKUs, could you see the fact that the consumer is making the gap bigger right now as he just mentioned? Do you see that change with Vista in the big uptake of things such as Media Center with PC edition? And I guess the follow up would be there’s some concern in the market that Vista might not make it out for the 2006 holiday season. Is there any update you could provide for us on that? Thank you.

From our perspective we’ll still talking about Vista launching in the 2nd half of this calendar year so, nothing’s changed there. In terms of the swing in mix, we are seeing inside the consumer side of things a positive mix swing. For example, as you mentioned Media Center, so that is helping. But on the other side, in terms of emerging markets, and the growth that’s there relative to mature markets, if like a negative mix we have a lot of price points in those. So there’s a number of moving parts. But in terms of the consumer, consumer side of mature markets, we definitely see Media Center traction and that is helping us.

I just want to make sure.

I’d like to add to that…going back to our financial analyst’s meeting we have made some general comments about SKUs and having more differentiation within our SKU strategy, what you’re seeing for example with the SQL Server 2005 launch is we had 4 different SKUS, took the high end up, had a nice lower end SKU. In terms of software assurance announcements, Heather, you’ve heard us talk about Vista enterprise edition available to customers. So I think what you can expect to see and what you’re beginning to see from us is differentiation within our SKUs.

Great. Thank you.

Next question please?

Thank you. Our next question comes from Kash Rangdan with Merrill Lynch.

Hi, thank you very much. I was just wondering given that you’re seeing better attach rates with the XBOX 360 and the software component makes it look richer versus your prior expectation, why would that not be even a little bit more profitable to the degree that you might want to reconsider where you stand on BPS guidance on the positive side? That’s it, thanks.

Kash, we want to be sure we understand the question there. Can you just repeat it?

With better than expected attach rates for the game cartridge for the XBOX 360, and if you’re maintaining your forecast for unit shipments, it sounds like the high margin software component of the total revenues should be a positive that you might consider revising your APS forecast for fiscal 2006 on the upward side.

Thank you. Offsetting that to some extent is the XBOX 1 sales and the software associated with that and also HRB revenue in each of the segments. To the extent that they are profitable elements and we’re lowering those, then that has an offsetting impact.

And Kash, we’re just thrilled to see the unprecedented attach rate with the game console. Keep in mind that at this point it’s really the hard core enthusiasts that are getting involved in midnight madness. They may be more inclined to take the extra game, the extra peripherals. We want to be nice and conservative there and not necessarily forecast that too aggressively.

The other thing, Kash, is outside of the FCB segment, as Scott mentioned in prepared remarks, we are making some investments in MSN and Ad Center and some of the impacts of the small acquisitions that we’re doing in that area, for example GeoTango. So, that is also offsetting – from an operating income point of view – some of the other benefits.

Got it. Finally, in unearned revenue you talked about 8-10% growth in fiscal 2006; it looks like it’s growing actually north of that. The last 3 quarters it has been 12-13% so, is it just conservatism as you head into a product transition or anything else behind that forecast?

Yes, quite often on a quarter-by-quarter basis, relatively big swings depending on the seasonality and the expiration pattern. So, the 8-10% is just how we see it year on year, given what we see in the 2nd half. There’s nothing that’s more significant than that.

Thanks.

Thanks so much Kash. We only have time for 2-3 more questions. The next question please, operator?

Thank you, the next question comes from Brent Phillips with Prudential.

Thank you. Chris, you mentioned that CRM 3.0 was exceeding expectations. Are there any metrics to back up the success of that product in the market that you gave out with SQL Server 2005?

Just the revenue growth inside the overall segment. I don’t know if we split up the CRM in terms of growth, coming off such a low base, it was an extremely high number and I don’t think it will … it was triple digits, from memory. I’m not sure it will give you a good indicator. But in terms of actual dollars, it was just extremely well-received. And, if I could put it this way, the reason for the out performance in that particular segment, it was virtually all CRM, so that’s one way in order of magnitude form it.

Just to follow up to Heather’s question around Vista, you’re saying second half of the year; is there any more granularity. Will it make it in the back-to-school segment or should we expect a late ’06 ship?

At this stage, we really aren’t saying anything more than what we previously hit. Obviously, in the next quarterly call that we have in April we’ll foreshadow ’07 and we’ll certainly be happy to talk about it at that stage.

Fantastic, next question please?

Thank you. Our next question comes from Jason Maynard from Credit Suisse First Boston.

Hi, good afternoon. Given your interest in AOL, could you maybe talk from a corporate development perspective how you’re thinking about MSN and some of the other sort of advertising related businesses around that market? Outside of the investment that you’re making, obviously, in building better and whatnot?

I don’t want to obviously speculate on anything having to do with acquisitions. I think Steve has spoken quite openly and I certainly talked on previous calls on our willingness to consider acquisitions as a way of fueling growth. We have been doing a recently significant number of them. In fact we’ve been announcing roughly one a month. They’re small to medium-sized and to a large extent that’s the ones that we think really give us good value for our money. And, we certainly expect to continue to do some of that. But in terms of speculating on larger transactions or their impact on particular businesses, that’s not something I really want to do.

That’s fair. Maybe just any color you can give us on the composition of the strength of your SQL Server, like geography or if you can give a little detail on where you saw the…

Very broad-based really. It didn’t peak in any particular area or any particular segment. It was just incredibly well received across the board.

Thank you.

Thanks so much. We have time for one final question, operator.

Thank you, our next question comes from David Hiller with Friedman, Billings, Ramsey.

Great, thanks. Kind of a follow up to the Ad Center questions. Outside of France and Singapore, what are the milestones you have for launching Ad Center? Can you give us any specific dates or rough dates for the rest of this calendar year in terms of deployment of Ad Center? Thanks.

In the US I believe we have around 15-20% of our ads served in the US through Ad Center and trending towards 25%. I’m not sure I want to say there’s a particular date, but certainly by spring of this year I would say we’d expect the bulk of our US business to go through Ad Center.

Thank you.

Fantastic. Thanks so much everyone for joining us today. As I mentioned at the beginning of this call, this conference call will be available for replay on our investor relations website through close of business January 26th, 2007. In addition, you can hear the replay by dialing 800-695-0673 or for international calls dial 402-220-0304. The dial-in replay will be available through close of business February 3rd, 2006 and of course if you have any further questions, please feel free to call me or my team directly. Thanks again for joining us today.

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