Microsoft Corporation F3Q06 (Qtr ended Mar 31 2006) Earnings Conference Call Transcript (MSFT)

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Microsoft Corporation (NASDAQ:MSFT)

F3Q06 Earnings Conference Call

April 27 2006, 5:30 PM EST


Colleen Healy - General Manager, IR

Chris Liddell - CFO


Steve Mahedy - Banc of America Securities

Charlie DiBona - Sanford Bernstein

Adam Holt - JPMorgan

Heather Bellini - UBS

Rick Sherlund - Goldman Sachs

Kash Rangan - Merrill Lynch

Robert Breza - RBC Capital Markets


Good afternoon, and welcome to the Microsoft 2006 fiscal year third quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead.

Colleen Healy

Good afternoon, everyone, and thank you for joining us today. This afternoon, I'm joined by Chris Liddell, Senior Vice President and Chief Financial Officer, and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the third quarter of fiscal year 2006 and an overview of expectations for Q4. I will then provide detail around our third quarter results and then turn it back to Chris for a more detailed discussion of our guidance for the fourth quarter and a preliminary look at our current expectations for fiscal year '07. After that, we will take your questions.

We filed our 10-Q today in conjunction with our earnings release. Therefore, you have available the earnings release, MD&A, 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 10-Q and the quarterly financial summary slide deck on the investor relations website at

Today's call is being 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 webcast of today's call at the Microsoft investor relations website. A replay of the call will be available at the same site through the close of business on April 27, 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 or transmission of the text or audio of today's 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 risks uncertainties. Actual results could differ materially, because of factors discussed in today's earnings press release and the comments made during this conference call and in the management's discussion and analysis section of our 10-Q, our 2005 Form 10-K and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement.

With that, please flip to slide 4, where Chris will begin his comments. Chris.

Chris Liddell

Thanks, Colleen and good afternoon, everyone. Thanks for taking the time to join us for today's call. I'm going to begin with the key points from our third quarter's performance and then take a look at quarter four and fiscal 2007. During the quarter, revenue growth accelerated to 13% from 9% in quarter two and 6% in quarter one. We had good market momentum of recently launched products, which remained strong, and we continued our execution on returning cash to shareholders.

Our operating income was, however, lower than we had guided in the quarter, which can be attributed in the following order to:

  1. Higher product costs associated with greater-than-expected Xbox 360 console shipments;
  2. Faster execution on our services strategy; and,
  3. An acceleration of marketing and readiness programs for both launched and upcoming products, and also hiring of world-class employees for new product development.

We continue to be pleased with the performance of our businesses, particularly in driving revenue. Revenue growth for our core businesses of Client, Information Worker and Server & Tools grew a combined 9% year-over-year for the quarter. We continue to see strong corporate demand and strength in PC and server hardware unit shipments.

Revenue growth of 29% in the business groups that have had recent product launches demonstrates our ability to choose the right places to focus our innovation efforts and make investments. Some specific examples are SQL Server, which continues to post impressive year-over-year growth rates. Its quarter three revenue growth, in excess of 30%, drove Server & Tools to its highest quarterly revenue growth rate for the year.

Also, Home & Entertainment, Mobile & Embedded & Business Solutions all had good sales quarters. Combined, they posted over $0.5 billion of absolute revenue growth over the prior-year period, which equates to 68% growth. In the quarter, we also made significant strides in ramping up the supply of Xbox 360 consoles.

We also continued our momentum on returning cash to shareholders, purchasing $4.9 billion worth of our stock, which brings us just over $15.5 billion of stock repurchases this fiscal year.

Now, I would like to make a few points about how the fiscal fourth quarter is shaping up. First, we continue to expect strong double-digit revenue growth, driven by sustained momentum across all of our businesses. Q4 is usually a seasonally good quarter for revenue in our Information Worker, Server & Tools and Business Solutions groups, and we expect that trend to continue. We also expect increasing growth from Home & Entertainment with the improving supply of Xbox 360 consoles.

Second, we will continue to accelerate the rate at which we invest in our business. Since we provided guidance three months ago, we have completed our senior-level strategy reviews and reassessed the strength of customer demand for our existing and potential new products. We see an increasing set of opportunities and, admittedly, challenges. We're going to target them with investments that leverage our ability to win.

As I mentioned on the last call, we're investing in our core businesses of Client, Information Worker and Server & Tools to prepare for the most significant wave of product launches in a decade.

We are aggressively investing in MSN to continue to meet the competitive challenges we see and develop and deploy a world-class set of online services, and we are quickening the pace of development in a number of high-growth new business areas. I will discuss these investments later in the call.

With that overview, I would like to turn the call over to Colleen for more details on the quarter, and then I will provide you with more details on our fourth quarter and a preliminary outlook for fiscal year 2007.

Colleen Healy

Thanks, Chris. As Chris mentioned, the accelerating revenue growth thus far in fiscal year '06 resulted in 13% growth during the quarter, which was driven by customer demand for our new products as well as healthy PC and server hardware sales. Specifically during the quarter, revenue was $10.9 billion, consistent with guidance entering the quarter. Operating income was $3.9 billion, which includes $397 million of legal charges and was lower than our guidance. Earnings per share were $0.29, which includes $0.03 for legal charges. And we returned over $5.8 billion to shareholders through stock repurchases and dividends.

I will highlight drivers of the strong revenue performance during the quarter, as well as outline the areas of incremental costs and investments. I will start by discussing top line financial and business momentum points, and I will follow up with revenue performance for each of the business groups. Then I will discuss operating expenses, and I will wrap up with an overview of operating income performance, as well as balance sheet and cash flow information. All growth comparisons I mention relate to the comparable quarter of last year, unless otherwise specified.

Revenue growth this quarter was driven by strong business and consumer market momentum for our new products. Server & Tools had yet another outstanding quarter, growing over 16%. Home & Entertainment grew 85% as Xbox sales more than doubled. MED and MBS grew 46% and 21%, respectively, on robust demand for our Windows Mobile and Microsoft Dynamics product lines.

Taken together, these four businesses grew revenue 29% and delivered roughly 75% of our absolute revenue growth for the quarter. We were also very pleased with the continued strength in PC shipments for the quarter, which resulted in Client revenue growth of 8%.

The IT spending environment was largely in line with our expectations. As mentioned, PC hardware and server market growth remains robust. Demand was generally healthy across all customer segments, and from a regional perspective, EMEA and emerging markets continue to be relatively strong.

We estimate PC market growth during the quarter at 12% to 13%, which was in line with our expectations three months ago. Consistent with the past several quarters, consumer PC shipment growth outpaced business shipments, and emerging market growth continued to significantly outpaced mature markets. PC unit demand was broad-based regionally, with double-digit growth rates in all geographies except for North America and Japan.

Our mix of product billings for the quarter was around 35% for OEMs, 27% for multi-year licensing agreements, 20% from license-only sales and the balance from our other businesses. This mix is different from the prior year, as a result of strong growth in our Home & Entertainment business and a shift from license only to multi-year licensing agreements.

We had good results overall from a volume licensing perspective, with strong renewals on enterprise agreements. In addition, select and open annuity results for the quarter were very strong relative to non-annuity licensing.

As a result of these robust annuity licensing results, our unearned revenue balance ended the quarter at $8.9 billion, which was a little higher than we had anticipated, and up 12% over the same period in prior year. Our contracted not billed balance at the end of March was lower sequentially and continued to exceed $9 billion. Taking into account our reported revenue and changes in the unearned and contracted not billed balances, you will find that our bookings growth for the quarter approached 15% overall and in excess of 10% for our core businesses of Client, Information Worker and Server & Tools.

Now, let's work our way through the P&L. Revenue growth for the quarter was negatively impacted by 1 percentage point due to foreign exchange rates. Breaking this down by business segment, Client revenue grew 8%, driven by OEM revenue growth of 10%, offset by a 6% decline in commercial and retail licensing.

The OEM revenue growth resulted from 16% license unit growth. As you have seen in previous quarters, the difference between OEM license unit growth and revenue growth is caused primarily by three factors:

  1. the shift in channel mix towards larger OEMs with volume pricing;
  2. growing volume in emerging markets; and,
  3. 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.

Consistent with the relative strength in the consumer segment of the market and the growing momentum behind Windows Media Center, we continue to see a change within the sales mix of our Premium Edition operating system licensed to OEMs. While OEM premium mix of 53% was up 4 percentage points from the prior year, a larger percentage of Premium Edition sales were made to consumers purchasing Windows Media Center, which carries a lower price relative to Windows Professional.

During the quarter, we made strides against piracy, as the pace of Windows unit sales outpaced the overall PC hardware market. The Company also recently signed a number of agreements to promote the use of Microsoft-licensed software with four of the leading PC OEMs serving the Chinese market.

Server & Tools delivered double-digit revenue growth for the 15th consecutive quarter, as the Windows server system enjoyed broad adoption. SQL Server is a hit with businesses, growing in excess of 30% this quarter. SQL Server revenue growth continues to dramatically outpace offerings from competitors in the database market. The value proposition SQL Server 2005 offers to businesses to enable them to simply and powerfully integrate, analyze and report their data is outstanding. Customers including enterprises are increasingly selecting SQL as the database to run their most demanding workloads for mission-critical applications.

Information Worker revenue grew 5% to $2.9 billion, driven by growth in all channels. We continue to see an increased shift to our annuity offerings when customers choose to license our Office products. We attribute this to customers' desire to acquire both Office 2003 and Office 2007 upon its release later this calendar year.

We have announced the Office 2007 suite line-up and pricing to customers. We have also rolled out the beta of Office Live. We have been pleased with the great response Office Live has received, with over 50,000 subscribers actively participating in the beta.

MBS revenue was $216 million, which was higher than our expectations and up 21% from the prior year, driven by 28% growth in license revenues, primarily in the ERP product line. We are happy with the traction that our Dynamics ERP and CRM products are receiving in the marketplace.

March marked a couple of important milestones for MBS. First, we had record turnout at our customer and partner event in Dallas, with over 5,500 customers and partners in attendance, which was over 1,000 more attendees than last year. Second, we also began our first national brand advertising campaign in a number of major publications.

MSN revenue was $561 million and down 3%, with advertising growth of 7%, offset by an expected decline of 31% in narrowband access revenue. Display advertising revenue grew for the quarter, led by strong growth in advertising on our home page, instant messaging and Hotmail properties. Advertisers are finding that the critical mass of users on MSN and Live makes those properties the place they need to be.

On the search advertising front, we made good progress during the quarter in transitioning our business from Yahoo!'s platform to our own platform. MSN Ad Center serviced over 70% of MSN's U.S. search traffic by the end of March, up from about 18% three months ago.

Because we are still building to a critical mass of advertisers on our platforms, and we experienced lower than expected performance from partner-driven search ad pricing, revenue per search fell from the prior year's period. Therefore, even though we experienced growth in search volumes, search ad revenue was down as we continue to transition to our proprietary ad platform, which we believe is the right business decision for the long term.

We continue to make progress on delivering Live enabled services, which are aimed at enhancing the Internet experience. During the quarter, we released five Live betas, averaging a beta release faster than every 20 days.

The MED group capitalized on the growing market demand for connected devices. Broad strength across the Windows Mobile and Windows Embedded product lines led to our fourth consecutive quarter of MED revenue growth in excess of 40%.

In particular, momentum behind our Windows Mobile product line continued to accelerate in the third quarter. Licenses for connected phone-enabled devices grew in excess of 85%, driven by device launches from leading manufacturing partners and mobile operators such as Palm, HTC, UTStarcom, Verizon Wireless, Cingular and T-Mobile. Also, mobile operators shipping Windows mobile-based devices increased from 93 in the prior quarter to over 115 in Q3.

Xbox revenue growth of 133% drove Home & Entertainment results for the quarter. We extended our market leadership position in next-generation gaming and turned a major corner in the quarter with our Xbox 360 console supply. We are now in nearly 30 countries, and console supply is ramping significantly. The number of games available for the platform continues to increase, with 80 expected to be available by the end of June. We are seeing tremendous momentum behind our Xbox Live service.

We're building on our strong early start and becoming increasingly optimistic in our console outlook for shipments. Consumer demand for Xbox 360 consoles remains very strong. Console supply increase throughout the quarter, due to improving component supplies and the addition of Celestica to Winstron and Flextronics in manufacturing. As a result, Q3 shipments of 1.7 million consoles were heavily weighted to the month of March.

Attach rates remain at record levels, although revenue in the quarter was slightly below forecast, due to the back-end nature of the console sales. According to NPD, our life-to-date attach in the US through March for software and peripherals was 4.5 and 3 per console, respectively, higher than any other gaming console at this point in its lifecycle. Despite a relatively small installed base, three of the top ten selling video games in the US in March were for the Xbox 360 platform.

Xbox Live momentum continues on a number of fronts. Over half of all Xbox 360 consoles sold connected to the service either through Silver or Gold tier memberships. Xbox Live Marketplace reached 10 million downloads of digital content in less than five months, and there have been over 4 million downloads from Xbox Live Arcade since launch.

The momentum and success of Xbox 360 has resulted in a faster-than-expected transition to next-generation gaming. As a result, our Xbox Version 1 software revenues in the quarter continued to decline and were softer than we expected.

Lastly, we extended our leadership position in IPTV software with Deutsche Telecom's announcement that it will launch its IPTV services across Germany later this year, using Microsoft IPTV Edition platform. This is our largest IPTV agreement in Europe to date and our second-largest worldwide.

Now, for the rest of the income statement and the balance sheet. While revenue increased 13% during the quarter, cost of revenue increased 49%, due primarily to Xbox 360 console volumes. The majority of the variance from our forecast was driven by strong Xbox 360 unit shipments, with the rest due in higher console costs.

Other operating expenses increased $427 million or 10% excluding legal charges. This was also higher than our expectations, due primarily to the following drivers.

First, we invested more aggressively in our MSN business to enhance the service experience of our users, our advertisers and our partners, as well as to increase our broad collection of assets to position ourselves for monetization over the long term. We are focused on building upon our strong momentum in display advertising, making enhancements to our ad platform, improving search and augmenting physical infrastructure.

Second, we increased investment in marketing and readiness programs across a number of different areas for recently launched products, as well as future product launches. This investment included global advertising and increased hiring for field sales and marketing positions, specifically and our enterprise and small and medium business sales forces.

Lastly, we continue to hire aggressively in support of R&D, focused on new product development, examples of which include Longhorn Server, Exchange 12 and Communication Services.

Even with these investments, if you set aside legal charges and the Home & Entertainment results, which are disproportionately impacted by negative margin console sales, you'll find that operating margins remained stable during the quarter, with operating income growth in line with revenue growth.

Investment income and other totaled $427 million, and our effective tax rate was 31%. Diluted shares outstanding for the quarter were 10.4 billion, down 5% from the prior year as the result of execution against our share repurchase program.

I would like to now provide a brief summary of the cash flow statement and the balance sheet. We generated over $4.5 billion in cash from operations, a 9% decline from prior year, due primarily to the timing and magnitude of legal settlement payments. Of the over $5.8 billion returned to shareholders during the quarter, $4.9 billion was for the repurchase of 181 million shares, of which $4.7 billion doubled in the quarter. We had about $6.4 billion remaining of our $30 billion approved repurchase program at the end of the quarter.

Cash and equivalents and short-term investments of $34.8 billion were up slightly from the second quarter, due to securities pledged as collateral under our securities lending program. The related balances due to the program can be seen in securities lending payable in current liabilities, largely offset by its corresponding amount in short-term investments.

So, in summary, we delivered accelerating double-digit revenue growth, driven by new product momentum and healthy PC and server hardware shipments. We achieved double-digit bookings growth in our core businesses in front of a big year of product launches.

Excluding the results of Home & Entertainment and legal charges, operating income grew in line with revenue, even with the big investments necessary to drive future revenue growth. We repurchased $4.9 billion in company stock, the second-largest quarterly share repurchase in company history. Chris will now provide you with our expectations for Q4 and fiscal 2007.

Chris Liddell

Thanks, Colleen. So, I am going to spend my remaining time on the call giving you a view of what we are expecting for the fourth quarter, followed by a preliminary snapshot of fiscal 2007. Please keep in mind that all of our growth figures that I will be using reflect year-over-year growth to the comparable period, unless otherwise noted.

Before giving specific financial guidance, let me outline some of the key assumptions that we've used for the fourth quarter. We estimate that for the fourth quarter, PC unit growth should be 10% to 11%. Our expectations for growth in the total server hardware market remain unchanged at 11% to 13% for the full fiscal year, and we're assuming that changes in foreign exchange rates will not have a major impact on our year-over-year growth rates in our forecast. Also, we continue to expect overall IT spending and our ability to participate in the marketplace to remain healthy.

So for some detailed guidance, we expect fourth quarter revenue of $11.5 billion to $11.7 billion, representing year-over-year growth of 13% to 15%. Revenue by business group is as follows. For Client, we expect revenue growth of 7% to 8% for the fourth quarter. We expect OEM units to grow roughly in line with the market, and we expect commercial and retail business growth to lag overall growth.

In Server & Tools, we're raising our expected revenue growth to 17% to 18% for the fourth quarter. We expect that the strong customer acceptance of SQL Server in the last two quarters will continue in the fourth quarter.

Information Worker revenue should grow 5% to 6% for the fourth quarter. We expect the increased annuity mix in our billings to continue as we move closer to the launch of Office 2007. And we will continue to look forward to releasing a broad public beta of Office 2007 this spring.

For Microsoft Business Solutions, we expect revenue growth to be between 11% and 13% for the fourth quarter. Our new Dynamics products have been met with great customer and partner enthusiasm, and we look forward to carrying that momentum into Q4 and beyond. Our new Dynamics branding campaign started in March and should provide good momentum going forward.

For MSN, we're expecting revenue to decline 4% to 5% for the fourth quarter. This reflects continued decreases in our access business, continued transition to Ad Center for delivering our paid search results, offset by growth in display revenue.

Mobile & Embedded Devices revenue should grow between 15% and 25% for the fourth quarter, driven by the availability of new devices based on Windows Mobile 5.0.

Home & Entertainment revenue is expected to grow 85% to 110% for the fourth quarter. This reflects a reduction in the implied revenue guidance we gave you in January, due primarily to lower expectations for the Xbox 1 business.

We continue to see very strong demand for Xbox 360 consoles, and we are making good progress in our ability to supply that demand. Because of this increased optimism and strong console shipments in Q3, we are tightening our previously announced fiscal year shipment guidance of 4.5 to 5.5 million consoles to the top end of that range, to 5.0 million to 5.5 million consoles.

Given the growing mix shift to annuity billings in front of key product launches in fiscal year '07, we are increasing our unearned guidance, and now expect unearned revenue to finish the year up 10% to 12%, up 2 percentage points from where we guided in January. We continue to estimate that our contracted not billed balance will finish the year above $9 billion.

So when you combine our overall revenue growth within the net increase in unearned and contracted not billed, you'll see that we are delivering strong year-over-year booking performance for the Company in fiscal 2006.

Operating income should be between $4 billion and $4.2 billion, representing 34% to 40% growth over the prior year, or 7% to 11% growth if you exclude legal charges of $756 million taken in that year-ago quarter. For fully-diluted earnings per share, we expect $0.30 per share for the fourth quarter, and expect to have an effective tax rate of 31% for quarter four.

So with quarter four guidance, we arrive at the following expectations for the full fiscal year 2006: revenue between $44.0 billion to $44.2 billion, representing year-over-year growth of 11%; operating income of $16.6 billion to $16.8 billion, including certain legal charges of $361 million in Q1 and $397 million in Q3.

For fully-diluted GAAP earnings per share, we expect $1.22 for fiscal year '06. If you were to adjust for certain legal charges of $0.02 a share in quarter one and $0.03 a share in quarter three and the tax benefit of $0.01 a share in quarter two, earnings per share would be $1.26.

The quarter four guidance is below the implied numbers we provided in January, and I would like to walk through three main drivers of the guidance change, which is split broadly evenly into the following areas.

First, we will experience higher product costs in order to enable us to deliver as many Xbox 360 consoles to the market as quickly as possible. We are making a strategic choice to produce and sell the maximum possible number of consoles to stretch our lead of installed base in this next generation over Sony.

This will, however, cost us some income growth in the short term. In Q3, we addressed console supply challenges through securing components and improving manufacturing yields. These additional costs are not expected to continue beyond quarter four.

Second, marketing partner readiness and increased hiring in our sales force for new and soon-to-be-released products will secure their success and drive momentum. These efforts are underway and will continue in quarter four and into fiscal 2007. Examples include an increased pace of Xbox 360 marketing to coincide with increased supply, working with our OEM partners on prelaunch Windows Vista readiness programs and continuing hiring of Information Worker solution specialists.

Third, we intend to quicken the pace of development on businesses where we can drive growth and build meaningful share. This includes such areas as services, unified communications and collaboration, business intelligence, security and high-performance computing. We also intend to gain growth step-ups through acquisitions. We have accelerated the pace of targeted acquisitions and the associated costs are included here.

In regards to services, we plan to scale global sales resources for Ad Center through the developer ad platform and increase our customer support activities to optimize the experience for our advertising partners.

We will also further develop and extend our search platform. This includes not only continuing to improve relevance, but also to move into critical developing areas such as local and mobile search.

We will continue to add new, significant content for our MSN and Live portals, while utilizing acquisitions to quickly fill out technology and other offerings, and increase our investments in infrastructure to ensure that we can deliver world-class performance to our customers around the world for Windows Live,, Xbox Live and Office Live.

We have been making good progress in various aspects of our services plan, such as the pace of transition to ads served by Ad Center and the continued increase in users, particularly on Hotmail and Messenger, where we added approximately 40 million Hotmail and 65 million Messenger accounts over the last year.

We're delighted to have Steve Berkowitz join the team to run the online business group. Steve was recently was a CEO of and brings to Microsoft a deep industry knowledge on how to successfully run an online business, including both search and advertising. We are looking to his contributions to help shape and drive our strategy in this space.

Although we expect that the investment areas for our services plan that I highlighted earlier will defer operating profitability for MSN in fiscal year '07, they will position us to better monetize our online businesses over the long term, through building volume of both searches and page views, using Ad Center to offer advertisers a superior platform from which to coordinate their marketing efforts and building the volume of ads run through Ad Center by increasing the number of advertisers on our platform and expanding Ad Center geographically.

I also want to highlight that our strategy in services is not competing against any single competitor in any one area, but to deliver value-added services across a broad array of scenarios. The online services market is clearly very competitive but has enormous potential for growth. We intend to compete in this space for the long term, and feel that our investments today will drive future success.

So at this point, I would like to discuss our preliminary view of fiscal 2007 as well. Our guidance represents our best current thinking about fiscal '07, and is subject to change as we finish our planning cycle during our fourth quarter. Consistent with our past practice, we are not providing specific business group assumptions beyond our fiscal year guidance. We will provide more details, including any new initiatives, as we typically do, on our next quarterly earnings call in July and all the strategic background at our financial analyst meeting in late July.

Our current fiscal 2007 revenue forecast is $49.5 billion to $50.5 billion, which represents growth of 12% to 14% over fiscal 2006, continuing the excellent '06 momentum. In absolute dollars, that represents between $5 billion in $6 billion of incremental revenue year over year.

Our expectation is for operating income of $18.7 billion to $19.3 billion, and fully-diluted earnings per share of $1.36 to $1.41, representing growth of 11% to 16% on a GAAP basis. If you were to remove certain legal charges and tax benefits from our '06 numbers, fiscal 2007 EPS growth would be 8% to 12%.

Now, let me outline a few key items that are necessary to understand our fiscal '07 guidance. First, at this early stage, we expect both the PC hardware market and the server hardware market growth rates to moderate from the growth rates we have seen this year.

Second, we are not forecasting any significant changes in foreign exchange rates. Actual foreign exchange rate movements will cause deviations from our forecast.

Third, we expect to see enterprise agreement renewal and discounting trends to be within their historical ranges.

Fourth, these figures assume the launch of Windows Vista and Office 2007 to business customers before the end of the calendar year 2006, with consumer availability in January. This will be the first time since calendar year 1995 that we have had simultaneous launches of these two flagship products. We're making considerable marketing and sales investments in these launches and, to a lesser extent, the launch of Exchange 12.

Fifth, we plan to continue to make significant investments that include the areas I mentioned with respect to Q4, such as continue to execute on our services vision, aggressively competing with our Xbox franchise and building new and existing business in high-growth markets.

Finally, this guidance assumes we finish out the remaining $6.4 billion of our buyback program no later than December 2006. We have not built in any additional amounts beyond that.

So I would like to close my prepared remarks today by putting this year into a broader context. Today, we believe we face the largest array of opportunities for growth and innovation the Company has ever seen. Software and software-driven services are playing an increasingly important role in shaping customer experiences at work and at home.

Progress made in such things as high bandwidth availability, lower computer and storage costs, hardware device innovation and improvements in processing per hour provide us with the opportunity to deliver software and services that enable seamless customer experiences in the area of services, entertainment, mobility and security, just to name a few. These markets will grow quickly over the next three to five years, as will the opportunity for us to innovate and increase our income for the benefit of shareholders.

We appreciate that every time we make an investment decision, it is traded between the short-term earnings and the long-term gain. However, we are willing to make those trade-offs, and believe that we have a unique opportunity at this part of the product cycle to drive substantial long-term growth.

Given the level of opportunity and activity, we look forward to having a very rich discussion with you on our plans for growth at our financial analyst meeting in July. So with that, I would like to hand the call back to Colleen so we can take some of your questions. Thank you.

Colleen Healy

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

Question-and-Answer Session


(Operator Instructions) Our first question is from Steve Mahedy, Banc of America Securities.

Steve Mahedy - Banc of America Securities

My question would be relative to fiscal year '07 guidance. You mentioned the moderation in the PC and server markets. Could you just give us a little detail on how you formulated the growth rates that you're assuming? And then also a tighter range on topline revenue relative to bottom-line; is there some flexibility on your spending during the course of the year, which perhaps would put us at the higher end of the EPS range?

Chris Liddell

In terms of PC market, we don't give out numbers at this stage, obviously. We have seen a moderation in the PC unit growth rate through the course of this year, so we were seeing 15% to 17% or thereabouts in quarter one, and it came down to 14% to 15% then 12% to 13%; and in the fourth quarter, as I just mentioned, we're talking about 10% to 11%.

So we have seen it come off, if you like, strong mid double digits to just about double-digit rates. So we're not expecting the trend to significantly weaken from that, but we expect that moderating number that would come out of the year to be more like what we expect for next year. So that's the basis of our expectations going into the new year.

In terms of the tightening of the range, to some extent it is influenced, clearly, by things like Xbox, where we could have quite a big sales variation, but not necessarily a big operating income variation, to the extent that the contribution from that business will not be as significant driving down to operating income.

So that's one of the reasons why you're seeing that variation. In terms of could we see expenses there being at the top end of the range, absolutely. Those are some of the decisions that we will have to make during the course of the year and as we round out our budgeting cycle going into the fiscal year.

Steve Mahedy - Banc of America Securities

You mentioned the PC moderation is clear and you can see the correlation there. However, in contrast, in the moderating server market, it still looks like you continue to see strong results there, given the product cycle. Is there a little bit of a detachment relative to what's happening in the server market, given your ability to gain more share there?

Chris Liddell

Again, it's quite a different trend, in terms of our sales relative to the server market. This is our sales relative to the PC market. So there's a lot of moving parts in the PC market. For example, our progress on piracy, the mix shift between consumer and business, and then the other moving part is our commercial and retail sales.

So all of those go into our expectation of Client revenue growth relative to PC growth. In the server market, we tend to expect our sales of underlying Windows Server to follow more closely the market. And then we have been able to and we certainly would hope to expect to be able to pick up market share in things like SQL Server.

Colleen Healy

We have been pretty consistent throughout the fiscal year thus far, expecting 11% to 13% hardware growth. The numbers directionally that we have given you for fiscal year '07, we feel, are right and it looks like in terms of third-party data, we're pretty much in line.


Our next question comes from Charlie DiBona, Sanford Bernstein.

Charlie DiBona - Sanford Bernstein

I was wondering if we could maybe talk a little bit about the margin structure and some of the add-backs for this quarter? In the legal expense add back for this quarter, are you adding back a reserve you might have taken related to the European EUR2 million a day fine? And is there any build-in for that fine into your guidance?

Chris Liddell

We don't specifically comment on individual ones, but if I can put it this way, there's no change from our previous position. So there's nothing inside the legal reserve as a result of a change.

Charlie DiBona - Sanford Bernstein

There is nothing inside the legal --

Chris Liddell

You asked whether there is anything in the legal reserve that results in a potential fine. All I'm saying is there's nothing in there -- there's no delta in that figure. I cannot comment on whether we had it in originally, because we don't give that level of detail out. But to the extent we did or didn't, it hasn't changed.

Charlie DiBona - Sanford Bernstein

So your guidance for next year -- does it include reserving EUR2 million a day?

Chris Liddell

Same comment -- there's no change in our previous assumption.

Charlie DiBona - Sanford Bernstein

So absent that, you see pretty substantial margin compression for next year, yet you have been talking about pulling forward expenses for Vista into the last couple of quarters and certainly into Q4 here. How do you reconcile those two things? It seems like you're spending fairly aggressively -- very aggressively -- through next year and not seeing leverage to your revenue acceleration.

Chris Liddell

At this stage, as you know, we're not giving business-by-business shape, so your comment is correct at the Company level. I will point back to some of our prepared remarks. Clearly, we have decided to aggressively invest in this next year in a number of areas, and they do add up.

Broadly, across the areas of marketing to launch new product, so clearly with Vista and Office 2007 coming, we will be spending in that area to ensure the success of that, building on some of the other businesses in the area.

So Xbox 360, we still see a big year in fiscal year '07 for that. IPTV will launch. We will have some marketing spend associated with that. Windows Mobile, we think, will potentially have a big year next year. Dynamics branding and then overall corporate advertising -- some of the work that you've seen.

So that's in the new products area. In terms of new opportunities, things that we are building which will be revenue-generating beyond fiscal year '07 -- the areas, again, that I talked about in prepared -- communications, collaboration, security and management, high-performance computing and also some of acquisitions we are doing.

Lastly, and we have foreshadowed this previously, the services strategy and, in particular, MSN is an area that we expect to invest aggressively next year. So you are correct. The net result of all of that, as we are guiding, will mean that we will not see an accompanying level of operating income growth equal to revenue growth. But we will still see, in our view, extremely good revenue growth. The combination of this year and next fiscal year with our guidance adds up to $10 billion to $11 billion of revenue growth.

So in our view, we are investing. We appreciate we're investing aggressively relative to some of your models, but we believe it's the right thing to do, to drive what we think is extremely good growth going forward.


Our next question comes from Adam Holt, JP Morgan.

Adam Holt - JP Morgan

Another question on the margins, if I could. Understanding you're not giving quarterly guidance, is it safe to assume the head count adds and a lot of the marketing expenditure is going to be front-end loaded for next year?

Secondly, are you making any assumptions around any kind of customer incentives during the holiday season to maybe give consumers that buy PCs Vista upgrade rights?

Chris Liddell

Sorry, I will have to give you the blanket answer that we're not going to give a lot of details about the shape of next year. I apologize for that, but that's the sort of stance. It's hard to half answer your question without doing that.

If I can talk about this fiscal year, where we are giving some numbers out, clearly, we have front-ended, if you like, some of the hiring associated with some of the product development that we see in future years. I'm certainly comfortable saying that; you can see that in our head count numbers.

I will comment on the positive aspect of that. There has certainly been a lot of commentary in the time that I've been at the Company about retention of people. What we are finding is we are having an extremely good time and being extremely successful in the market in hiring the people that we want. So the good news from my point of view is whilst it's a front-end cost, it's a good sign from an employment point of view.

In terms of the second half of your question, about tech guarantees, we're not commenting on that. Clearly, we will look at the shape of previous releases in terms of what is a sensible thing to do for our customers and partners as we get closer to the release. But with that being nine-odd months away, we are really not commenting at this stage on exactly what we might do or when we might do it.


Our next question comes from Heather Bellini, UBS.

Heather Bellini - UBS

Not to beat a dead horse here, but looking at the operating margin, is this a change in the strategy for the Company where, over the next few years, we might see revenue accelerate from these new product launches that you have talked about, but that the Company is willing to sacrifice earnings growth? I'm not just talking about fiscal year '07, but a change in strategy where you are just going to keep reinvesting back, where earnings growth is going to be below revenue growth and you're not going to get the type of margin leverage that I think people expected when the CFOs of all the different business units were put into place?

Chris Liddell

I can't give you specifics of the directional guidance for '08 and '09. I think we will talk more at the financial analyst meeting about our strategy and how that might play out. Again, if I can just talk to what we have put out today, clearly, from our point of view, we have made a strategic decision with respect to next year that, given the set of opportunities and the revenue growth potential that we see, we're willing to make that trade-off next year, and we've been willing to make the trade-off not only next year but to get ahead of it, if you like, in the third and fourth quarter as well.

So you are correct in that sense. I don't want to say or extrapolate at this stage and say you can necessarily expect that in fiscal year '08 and '09. We will talk more strategically when we get together and talk about strategy in July.


Our next question comes from Rick Sherlund, Goldman Sachs.

Rick Sherlund - Goldman Sachs

Chris, as I look at next year, the revenues look good. So I think that we collectively as analysts, have captured the opportunity for Vista okay on the revenue side. But the expenses, I've got to tell you, we're not that bad in forecasting expenses.

Your expenses are about $2.4 billion more than I have estimated. I don't know if you are just not ready to talk yet about the online businesses that you're building, but I don't think Xbox mix makes that big a difference in my model. I don't think spending a couple hundred million dollars more launching products makes that big a difference.

There's something like really big here that I'm not sure we have quite put our fingers on yet, but it sounds like you are building a Google or building a Yahoo! inside the Company. Ray Ozzie in this Fortune article said, this is real expensive. It's going to cost billions of dollars. I didn't know it was going to cost a couple billion dollars in '07, but that's what looks like to me.

It looks more like you are kind of really ramping up your online business and the decisions been to take a lot of the benefits of the product cycle that we're going to get next year and just plow that right back into the business to kind of gear up for battle in the online market. I'm just not sure if I'm missing something, but that's the way it comes across to me.

Chris Liddell

I'm certainly happy to address that. In terms of your $2.4 billion, I probably wouldn't get to the same number as that -- I don't, obviously, have visibility into your model, but relative to the starting base of fiscal year '06. I would characterize it as being a broad-based approach across multiple fronts.

I don't think there's any Trojan Horse there that we haven't talked about that is sitting below the surface that we don't want to talk about. I would say, to the extent there's a difference between your expectations of where we are coming in, I would list the sort of 12 to 15 things that I mentioned before, and we would be accelerating the pace in virtually all of those, relative to, possibly, your expectations.

So there are some big numbers there; that is certainly true. And there's certainly some big potential spending and opportunities that we foresee in the MSN Windows Live area. So that is certainly true. But we're not building into our guidance things that we're not talking about.

Rick Sherlund - Goldman Sachs

Are we going to talk more at the July analyst meeting about the online business?

Chris Liddell

Absolutely. Yes, that is an absolutely key and fundamental part of our strategy going forward, so yes, you can expect to hear a lot about that.

Rick Sherlund - Goldman Sachs

Because there is a lot going on there. I keep hearing more about it, but we haven't really had an articulation yet of what's going on. So we should anticipate that maybe we'll have a better understanding of what's going on there at the July analyst meeting?

Chris Liddell

Yes. I'm certainly happy to take that feedback, firstly. And secondly, we had foreseen that we would spend a reasonably high proportion of the time talking about that, to the extent that it's a new area, perhaps relative to some of the other ones that you have heard about previously.


Our next question comes from Kash Rangan, Merrill Lynch.

Kash Rangan - Merrill Lynch

Just following up on Rick's question earlier, the numbers certainly look big on that incremental expense side. I'm just curious to see if a material component of that incremental spending is from stock-based compensation? Because the times when you would publicly disclose that figure, as in fiscal '05, it was running at $2.4 billion.

So should we be thinking that there is another perhaps $1 billion or maybe even $0.5 billion or so of stock-based compensation that is being factored into your operating income?

Because we do hear about the enormous amounts of money being paid to hire some of the super sharp programmers in the Wall Street Journal, et cetera. So is that behind your thinking, or maybe not? If you can clarify, that will be great.

Chris Liddell

It's definitely not to do with increasing pay for the CFO, not from the billions, anyway. No, there's nothing that we are building in that is significant from a stock-based compensation point of view.

We only disclose the numbers historically rather than forecast, but you shouldn't expect to be surprised there and anything new or substantial. Clearly, we are hiring a large number of people, so you will see the expense associated with those people. But you won't see huge fundamental shifts in our pay structure.

Kash Rangan - Merrill Lynch

So I guess, when you report your operating income on a segment basis, we should start to see where exactly these investments are going in and how they are tracking to the way you explained the 15 different initiatives or whatnot, right?

Chris Liddell

That's correct. Yes, you will. We'll continue to try and be as transparent as possible, certainly, in retrospect.


Our final question comes from Robert Breza, RBC Capital Markets.

Robert Breza - RBC Capital Markets

Hi, thanks for taking my question. I'm wondering, Chris, can you talk a little bit about maybe how we should think about the shape of '07, just in terms of the product releases, knowing about the enterprise. Is there anything you can qualitatively tell us, look at the December quarter versus the March quarter?

Chris Liddell

Sorry, you just came in and out a little bit on your question there. But I got most of it, about the shape of the year. No, I'm sorry. I have to go back to what I said before, which is we are really sticking at this stage at a yearly rate.

I mean, clearly, with the launches coming for business availability in December and consumer availability in January, there's going to be some implications associated with that. We're already seeing some patterns of change, for example, in our Information Worker area. We're seeing a shift from license to annuity, and that could well be in anticipation of the benefits of Office 2007.

We will have some quarterly changes, almost certainly, associated with Xbox as a result of holiday season sales. So it will be some reasonably big quarterly trends that you can expect to see. But, I'm sorry, you will have to wait until July for us to give you the visibility into that.

Colleen Healy

Thank you, everybody, for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor relations website through close of business April 27, 2007.

In addition, you can hear the replay by dialing 866-454-2121, or for international calls, dial 203-369-1241. The dial-in replay will be available through the close of business May 5, 2006. Thanks again for joining us today.


Thank you. This does conclude today's conference call. We thank you for your participation.

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