Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2015

OR

 

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From                  to                 

Commission File Number: 0-14278

 


MICROSOFT CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Washington   91-1144442

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One Microsoft Way, Redmond, Washington   98052-6399
(Address of principal executive offices)   (Zip Code)

(425) 882-8080

(Registrant’s telephone number, including area code)

None

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x

  

Accelerated filer ¨

Non-accelerated filer ¨ (Do not check if a smaller reporting company)

  

Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class    Outstanding at October 15, 2015  


Common Stock, $0.00000625 par value per share

     7,987,913,152 shares   

 



Table of Contents

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended September 30, 2015

INDEX

 

                  Page  

PART I.

  FINANCIAL INFORMATION         
    Item 1.   Financial Statements         
        a)    Income Statements for the Three Months Ended September 30, 2015 and 2014      3   
        b)    Comprehensive Income Statements for the Three Months Ended September 30, 2015 and 2014      4   
        c)    Balance Sheets as of September 30, 2015 and June 30, 2015      5   
        d)    Cash Flows Statements for the Three Months Ended September 30, 2015 and 2014      6   
        e)    Stockholders’ Equity Statements for the Three Months Ended September 30, 2015 and 2014      7   
        f)    Notes to Financial Statements      8   
        g)    Report of Independent Registered Public Accounting Firm      30   
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations      31   
    Item 3.   Quantitative and Qualitative Disclosures About Market Risk      43   
    Item 4.   Controls and Procedures      44   

PART II.  

  OTHER INFORMATION         
    Item 1.   Legal Proceedings      44   
    Item 1A.   Risk Factors      44   
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds      53   
    Item 5.   Other Information      53   
    Item 6.   Exhibits      54   

SIGNATURE

     55   

 

2


Table of Contents

PART I

Item 1

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INCOME STATEMENTS

 

(In millions, except per share amounts) (Unaudited)             


Three Months Ended September 30,    2015     2014  

Revenue

   $   20,379      $   23,201   

Cost of revenue

     7,207        8,273   


 


Gross margin

     13,172        14,928   

Research and development

     2,962        3,065   

Sales and marketing

     3,333        3,728   

General and administrative

     1,084        1,151   

Impairment, integration, and restructuring

     0        1,140   


 


Operating income

     5,793        5,844   

Other income (expense), net

     (280     52   


 


Income before income taxes

     5,513        5,896   

Provision for income taxes

     893        1,356   


 


Net income

   $ 4,620      $ 4,540   
    


 


Earnings per share:

                

Basic

   $ 0.58      $ 0.55   

Diluted

   $ 0.57      $ 0.54   

Weighted average shares outstanding:

                

Basic

     7,996        8,249   

Diluted

     8,066        8,351   

Cash dividends declared per common share

   $ 0.36      $ 0.31   


See accompanying notes.

 

3


Table of Contents

PART I

Item 1

 

COMPREHENSIVE INCOME STATEMENTS

 

(In millions) (Unaudited)             


Three Months Ended September 30,    2015     2014  

Net income

   $   4,620      $   4,540   
    


 


Other comprehensive income (loss):

                

Net unrealized gains on derivatives (net of tax effects of $23 and $4)

     57        319   

Net unrealized losses on investments (net of tax effects of $(308) and $(102))

     (571     (189

Translation adjustments and other (net of tax effects of $(12) and $(47))

     (270     (81


 


Other comprehensive income (loss)

     (784     49   


 


Comprehensive income

   $ 3,836      $ 4,589   
    


 


See accompanying notes.

 

4


Table of Contents

PART I

Item 1

 

BALANCE SHEETS

 

(In millions) (Unaudited)             


     September 30,
2015
    June 30,
2015
 

Assets

                

Current assets:

                

Cash and cash equivalents

   $ 5,431      $ 5,595   

Short-term investments (including securities loaned of $129 and $75)

     93,924        90,931   


 


Total cash, cash equivalents, and short-term investments

     99,355        96,526   

Accounts receivable, net of allowance for doubtful accounts of $250 and $335

     11,444        17,908   

Inventories

     3,816        2,902   

Deferred income taxes

     1,447        1,915   

Other

     5,594        5,461   


 


Total current assets

     121,656        124,712   

Property and equipment, net of accumulated depreciation of $18,009 and $17,606

     15,046        14,731   

Equity and other investments

     11,438        12,053   

Goodwill

     17,142        16,939   

Intangible assets, net

     4,745        4,835   

Other long-term assets

     2,869        2,953   


 


Total assets

   $   172,896      $   176,223   
    


 


Liabilities and stockholders’ equity

                

Current liabilities:

                

Accounts payable

   $ 6,630      $ 6,591   

Short-term debt

     9,998        4,985   

Current portion of long-term debt

     750        2,499   

Accrued compensation

     3,450        5,096   

Income taxes

     607        606   

Short-term unearned revenue

     21,603        23,223   

Securities lending payable

     154        92   

Other

     6,207        6,766   


 


Total current liabilities

     49,399        49,858   

Long-term debt

     27,819        27,808   

Long-term unearned revenue

     2,784        2,095   

Deferred income taxes

     2,169        2,835   

Other long-term liabilities

     13,280        13,544   


 


Total liabilities

     95,451        96,140   


 


Commitments and contingencies

                

Stockholders’ equity:

                

Common stock and paid-in capital—shares authorized 24,000; outstanding 7,986 and 8,027

     68,093        68,465   

Retained earnings

     7,614        9,096   

Accumulated other comprehensive income

     1,738        2,522   


 


Total stockholders’ equity

     77,445        80,083   


 


Total liabilities and stockholders’ equity

   $ 172,896      $ 176,223   
    


 


See accompanying notes.

 

5


Table of Contents

PART I

Item 1

 

CASH FLOWS STATEMENTS

 

(In millions) (Unaudited)             


Three Months Ended September 30,    2015     2014  

Operations

                

Net income

   $ 4,620      $ 4,540   

Adjustments to reconcile net income to net cash from operations:

                

Depreciation, amortization, and other

     1,461        1,428   

Stock-based compensation expense

     674        646   

Net recognized losses on investments and derivatives

     101        55   

Excess tax benefits from stock-based compensation

     (282     (502

Deferred income taxes

     73        301   

Deferral of unearned revenue

     10,423        8,022   

Recognition of unearned revenue

       (11,355       (10,643

Changes in operating assets and liabilities:

                

Accounts receivable

     6,376        6,627   

Inventories

     (937     (483

Other current assets

     (280     (280

Other long-term assets

     (5     279   

Accounts payable

     (135     (659

Other current liabilities

     (2,024     (1,166

Other long-term liabilities

     (116     189   


 


Net cash from operations

     8,594        8,354   


 


Financing

                

Proceeds from issuance of short-term debt, maturities of 90 days or less, net

     4,890        2,999   

Proceeds from issuance of debt

     121        0   

Repayments of debt

     (1,750     (1,500

Common stock issued

     219        216   

Common stock repurchased

     (4,757     (2,888

Common stock cash dividends paid

     (2,475     (2,307

Excess tax benefits from stock-based compensation

     282        502   

Other

     (178     0   


 


Net cash used in financing

     (3,648     (2,978


 


Investing

                

Additions to property and equipment

     (1,356     (1,282

Acquisition of companies, net of cash acquired, and purchases of intangible and other assets

     (390     (141

Purchases of investments

     (37,570     (24,085

Maturities of investments

     5,686        1,693   

Sales of investments

     28,502        16,445   

Securities lending payable

     62        (367


 


Net cash used in investing

     (5,066     (7,737


 


Effect of exchange rates on cash and cash equivalents

     (44     (6


 


Net change in cash and cash equivalents

     (164     (2,367

Cash and cash equivalents, beginning of period

     5,595        8,669   


 


Cash and cash equivalents, end of period

   $ 5,431      $ 6,302   
    


 


See accompanying notes.

 

6


Table of Contents

PART I

Item 1

 

STOCKHOLDERS’ EQUITY STATEMENTS

 

(In millions) (Unaudited)             


Three Months Ended September 30,    2015     2014  

Common stock and paid-in capital

                

Balance, beginning of period

   $   68,465      $   68,366   

Common stock issued

     219        216   

Common stock repurchased

     (1,548     (1,368

Stock-based compensation expense

     674        646   

Stock-based compensation income tax benefits

     282        502   

Other, net

     1        0   


 


Balance, end of period

     68,093        68,362   


 


Retained earnings

                

Balance, beginning of period

     9,096        17,710   

Net income

     4,620        4,540   

Common stock cash dividends

     (2,862     (2,559

Common stock repurchased

     (3,240     (1,640


 


Balance, end of period

     7,614        18,051   


 


Accumulated other comprehensive income

                

Balance, beginning of period

     2,522        3,708   

Other comprehensive income (loss)

     (784     49   


 


Balance, end of period

     1,738        3,757   


 


Total stockholders’ equity

   $ 77,445      $ 90,170   
    


 


See accompanying notes.

 

7


Table of Contents

PART I

Item 1

 

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 — ACCOUNTING POLICIES

Accounting Principles

We prepare our unaudited interim consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). In the opinion of management, the unaudited interim consolidated financial statements reflect all adjustments of a normal recurring nature that are necessary for a fair presentation of the results for the interim periods presented. Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Microsoft Corporation 2015 Form 10-K filed with the U.S. Securities and Exchange Commission on July 31, 2015.

Principles of Consolidation

The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we are able to exercise significant influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method.

Recasting of Certain Prior Period Information

In June 2015, we announced a change in organizational structure as part of our transformation in the mobile-first, cloud-first world. During the first quarter of fiscal year 2016, the Company’s chief operating decision maker requested changes in the information that he regularly reviews for purposes of allocating resources and assessing performance. As a result, beginning in fiscal year 2016, we report our financial performance based on our new segments described in Note 18 – Segment Information. We have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance during fiscal year 2016. This change primarily impacted Note 9 – Goodwill, Note 14 – Unearned Revenue, and Note 18 – Segment Information, with no impact on consolidated net income or cash flows.

Estimates and Assumptions

Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates include: loss contingencies; product warranties; the fair value of, and/or potential impairment of goodwill and intangibles assets, for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; allowances for product returns; the market value of our inventory; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software arrangement, including the distinction between upgrades or enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our consolidated financial statements or tax returns; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.

Revenue Recognition for Windows 10 Licenses

Customers purchasing a Windows 10 license will receive unspecified updates and upgrades over the life of their Windows 10 device at no additional cost. As these updates and upgrades will not be sold on a stand-alone basis, we are unable to establish vendor specific objective evidence of fair value. Accordingly, revenue from licenses of Windows 10 will be recognized ratably over the estimated life of the related device, which ranges between two to four years.

 

8


Table of Contents

PART I

Item 1

 

Recent Accounting Guidance Not Yet Adopted

In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards, the Financial Accounting Standards Board issued a new standard related to revenue recognition. Under the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The new standard will be effective for us beginning July 1, 2018, and adoption as of the original effective date of July 1, 2017 is permitted. We anticipate this standard will have a material impact on our consolidated financial statements, and we are currently evaluating its impact.

NOTE 2 — EARNINGS PER SHARE

Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards.

The components of basic and diluted EPS are as follows:

 

(In millions, except earnings per share)             


Three Months Ended September 30,    2015     2014  

Net income available for common shareholders (A)

   $   4,620      $   4,540   

Weighted average outstanding shares of common stock (B)

     7,996        8,249   

Dilutive effect of stock-based awards

     70        102   


 


Common stock and common stock equivalents (C)

     8,066        8,351   
    


 


Earnings Per Share

                

Basic (A/B)

   $ 0.58      $ 0.55   

Diluted (A/C)

   $ 0.57      $ 0.54   


Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented.

NOTE 3 — OTHER INCOME (EXPENSE), NET

The components of other income (expense), net were as follows:

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Dividends and interest income

   $ 199      $ 225   

Interest expense

       (249       (161

Net recognized gains on investments

     2        79   

Net losses on derivatives

     (103     (134

Net gains (losses) on foreign currency remeasurements

     (36     78   

Other

     (93     (35


 


Total

   $ (280   $ 52   
    


 


Following are details of net recognized gains (losses) on investments during the periods reported:

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Other-than-temporary impairments of investments

   $ (35   $ (9

Realized gains from sales of available-for-sale securities

       107          118   

Realized losses from sales of available-for-sale securities

     (70     (30


 


Total

   $ 2      $ 79   
    


 


 

9


Table of Contents

PART I

Item 1

 

NOTE 4 — INVESTMENTS

Investment Components

The components of investments, including associated derivatives, but excluding held-to-maturity investments, were as follows:

 

(In millions)    Cost Basis    

Unrealized

Gains

   

Unrealized

Losses

   

Recorded

Basis

   

Cash

and Cash

Equivalents

   

Short-term

Investments

   

Equity

and Other

Investments

 


September 30, 2015

                                                        

Cash

   $ 3,555      $ 0      $ 0      $ 3,555      $ 3,555      $ 0      $ 0   

Mutual funds

     854        0        0        854        854        0        0   

Commercial paper

     10        0        (2     8        8        0        0   

Certificates of deposit

     1,115        0        0        1,115        965        150        0   

U.S. government and agency securities

     76,086        96        (48     76,134        49        76,085        0   

Foreign government bonds

     5,535        4        (40     5,499        0        5,499        0   

Mortgage- and asset-backed securities

     4,800        23        (6     4,817        0        4,817        0   

Corporate notes and bonds

     7,038        88        (79     7,047        0        7,047        0   

Municipal securities

     285        38        (1     322        0        322        0   

Common and preferred stock

     6,895        4,477        (522     10,850        0        0        10,850   

Other investments

     567        0        0        567        0        4        563   


 


 


 


 


 


 


Total

   $   106,740      $   4,726      $   (698   $   110,768      $   5,431      $   93,924      $   11,413   
    


 


 


 


 


 


 


 

(In millions)    Cost Basis    

Unrealized

Gains

   

Unrealized

Losses

   

Recorded

Basis

   

Cash

and Cash

Equivalents

   

Short-term

Investments

   

Equity

and Other

Investments

 


June 30, 2015

                                                        

Cash

   $ 3,679      $ 0      $ 0      $ 3,679      $ 3,679      $ 0      $ 0   

Mutual funds

     1,100        0        0        1,100        1,100        0        0   

Commercial paper

     1        0        0        1        1        0        0   

Certificates of deposit

     906        0        0        906        776        130        0   

U.S. government and agency securities

     72,843        76        (30     72,889        39        72,850        0   

Foreign government bonds

     5,477        3        (24     5,456        0        5,456        0   

Mortgage- and asset-backed securities

     4,899        23        (6     4,916        0        4,916        0   

Corporate notes and bonds

     7,192        97        (37     7,252        0        7,252        0   

Municipal securities

     285        35        (1     319        0        319        0   

Common and preferred stock

     6,668        4,986        (215     11,439        0        0        11,439   

Other investments

     597        0        0        597        0        8        589   


 


 


 


 


 


 


Total

   $   103,647      $   5,220      $   (313   $   108,554      $   5,595      $   90,931      $   12,028   
    


 


 


 


 


 


 


In addition to the investments in the table above, we also own corporate notes that are classified as held-to-maturity investments, which are included in equity and other investments on the balance sheet. These corporate notes are due October 31, 2023 and are measured at fair value on a nonrecurring basis. As of September 30, 2015 and June 30, 2015, the amortized cost and recorded basis of these corporate notes were both $25 million, with an estimated fair value that approximates the carrying value.

 

10


Table of Contents

PART I

Item 1

 

As of September 30, 2015 and June 30, 2015, the recorded bases of common and preferred stock that are restricted for more than one year or are not publicly traded were $700 million and $561 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not practicable for us to reliably estimate the fair value of these investments.

We lend certain fixed-income and equity securities to increase investment returns. These transactions are accounted for as secured borrowings and the loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. As of September 30, 2015, the collateral received under these agreements totaled $154 million which is primarily comprised of certificates of deposit.

Unrealized Losses on Investments

Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows:

 

     Less than 12 Months     12 Months or Greater          

Total

Unrealized

Losses

 
    


 


         
(In millions)    Fair Value     Unrealized
Losses
    Fair Value     Unrealized
Losses
    Total
Fair Value
   


September 30, 2015

                                                

Commercial paper

   $ 8      $ (2   $ 0      $ 0      $ 8      $ (2

U.S. government and agency securities

     3,341        (18     570        (30     3,911        (48

Foreign government bonds

     2,223        (12     70        (28     2,293        (40

Mortgage- and asset-backed securities

     3,384        (6     16        0        3,400        (6

Corporate notes and bonds

     3,984        (59     168        (20     4,152        (79

Municipal securities

     11        (1     0        0        11        (1

Common and preferred stock

     1,737        (393     348        (129     2,085        (522


 


 


 


 


 


Total

   $   14,688      $   (491   $   1,172      $   (207   $   15,860      $   (698
    


 


 


 


 


 


 

     Less than 12 Months     12 Months or Greater          

Total

Unrealized

Losses

 
    


 


         
(In millions)    Fair Value     Unrealized
Losses
    Fair Value     Unrealized
Losses
    Total
Fair Value
   


June 30, 2015

                                                

U.S. government and agency securities

   $ 6,636      $ (9   $ 421      $ (21   $ 7,057      $ (30

Foreign government bonds

     4,611        (12     18        (12     4,629        (24

Mortgage- and asset-backed securities

     3,171        (5     28        (1     3,199        (6

Corporate notes and bonds

     2,946        (29     104        (8     3,050        (37

Municipal securities

     36        (1     0        0        36        (1

Common and preferred stock

     1,389        (180     148        (35     1,537        (215


 


 


 


 


 


Total

   $   18,789      $   (236   $   719      $   (77   $   19,508      $   (313
    


 


 


 


 


 


Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of September 30, 2015.

 

11


Table of Contents

PART I

Item 1

 

Debt Investment Maturities

 

(In millions)    Cost Basis    

Estimated

Fair Value

 


September 30, 2015

                

Due in one year or less

   $   47,806      $   47,822   

Due after one year through five years

     43,017        43,071   

Due after five years through 10 years

     2,650        2,598   

Due after 10 years

     1,396        1,451   


 


Total

   $ 94,869      $ 94,942   
    


 


NOTE 5 — DERIVATIVES

We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible.

Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. dollar equivalents.

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. As of September 30, 2015 and June 30, 2015, the total notional amounts of these foreign exchange contracts sold were $9.7 billion and $9.8 billion, respectively.

Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments. As of September 30, 2015 and June 30, 2015, the total notional amounts of these foreign exchange contracts sold were $5.3 billion and $5.3 billion, respectively.

Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures. As of September 30, 2015, the total notional amounts of these foreign exchange contracts purchased and sold were $9.8 billion and $5.3 billion, respectively. As of June 30, 2015, the total notional amounts of these foreign exchange contracts purchased and sold were $9.7 billion and $11.0 billion, respectively.

Equity

Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of September 30, 2015, the total notional amounts of equity contracts purchased and sold for managing market price risk were $2.3 billion and $2.6 billion, respectively, of which $915 million and $1.2 billion, respectively, were designated as hedging instruments. As of June 30, 2015, the total notional amounts of equity contracts purchased and sold for managing market price risk were $2.2 billion and $2.6 billion, respectively, of which $1.1 billion and $1.4 billion, respectively, were designated as hedging instruments.

Interest Rate

Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts, and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of September 30, 2015, the total

 

12


Table of Contents

PART I

Item 1

 

notional amounts of fixed-interest rate contracts purchased and sold were $1.0 billion and $3.3 billion, respectively. As of June 30, 2015, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.0 billion and $3.2 billion, respectively.

In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of September 30, 2015 and June 30, 2015, the total notional derivative amounts of mortgage contracts purchased were $602 million and $812 million, respectively.

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or groups of credit risks. As of September 30, 2015, the total notional amounts of credit contracts purchased and sold were $585 million and $428 million, respectively. As of June 30, 2015, the total notional amounts of credit contracts purchased and sold were $618 million and $430 million, respectively.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swaps, futures, and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of September 30, 2015, the total notional amounts of commodity contracts purchased and sold were $710 million and $210 million, respectively. As of June 30, 2015, the total notional amounts of commodity contracts purchased and sold were $882 million and $316 million, respectively.

Credit-Risk-Related Contingent Features

Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of September 30, 2015, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted.

Fair Values of Derivative Instruments

Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation.

For derivative instruments designated as fair value hedges, the gains (losses) are recognized in earnings in the periods of change together with the offsetting losses (gains) on the hedged items attributed to the risk being hedged. For options designated as fair value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings.

For derivative instruments designated as cash-flow hedges, the effective portion of the gains (losses) on the derivatives is initially reported as a component of other comprehensive income (“OCI”) and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings.

For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense), net. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense), net.

 

13


Table of Contents

PART I

Item 1

 

The following table presents the fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk:

 

         September 30, 2015            June 30, 2015  
        


          


          Assets     Liabilities            Assets     Liabilities  
        


 


          


 


(In millions)        Short-term
Investments
    Other
Current
Assets
    Equity and
Other
Investments
    Other
Current
Liabilities
           Short-term
Investments
    Other
Current
Assets
    Equity and
Other
Investments
    Other
Current
Liabilities
 


Non-designated Hedge Derivatives

                                                                             

Foreign exchange contracts

       $ 21      $ 173      $ 0      $ (124             $ 17      $ 167      $ 0      $ (79

Equity contracts

         162        0        0        (25              148        0        0        (18

Interest rate contracts

         12        0        0        (25              7        0        0        (12

Credit contracts

         9        0        0        (8              16        0        0        (9


 


 


 


          


 


 


 


Total

       $   204      $ 173      $ 0      $ (182            $ 188      $ 167      $ 0      $ (118
        


 


 


 


          


 


 


 


Designated Hedge Derivatives

                                                                             

Foreign exchange contracts

       $ 6      $ 644      $ 0      $ (98            $ 56      $ 552      $ 0      $ (31

Equity contracts

         0        0        36        (49              0        0        25        (69


 


 


 


          


 


 


 


Total

       $ 6      $ 644      $ 36      $ (147            $ 56      $ 552      $ 25      $ (100


 


 


 


          


 


 


 


Total gross amounts of derivatives

       $ 210      $ 817      $ 36      $ (329            $   244      $   719      $ 25      $ (218
        


 


 


 


          


 


 


 


Gross derivatives either offset or subject to an enforceable master netting agreement

       $ 98      $ 817      $ 36      $ (329            $ 126      $ 719      $ 25      $   (218

Gross amounts of derivatives offset in the balance sheet

         (149       (120       (25     294                 (66     (71       (25     161   


 


 


 


          


 


 


 


Net amounts presented in the balance sheet

         (51     697        11        (35              60        648        0        (57

Gross amounts of derivatives not offset in the balance sheet

         0        0        0        0                 0        0        0        0   

Cash collateral received

         0        0        0        (318              0        0        0        (456


 


 


 


          


 


 


 


Net amount

       $ (51   $ 697      $ 11      $   (353            $ 60      $ 648      $ 0      $ (513
        


 


 


 


          


 


 


 


See also Note 4 – Investments and Note 6 – Fair Value Measurements.

 

14


Table of Contents

PART I

Item 1

 

Fair-Value Hedge Gains (Losses)

We recognized in other income (expense), net the following gains (losses) on contracts designated as fair-value hedges and their related hedged items:

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Foreign Exchange Contracts

                

Derivatives

   $   (81   $ 241   

Hedged items

     91          (242


 


Total amount of ineffectiveness

   $ 10      $ (1
    


 


Equity Contracts

                

Derivatives

   $ (33   $ (81

Hedged items

     33        81   


 


Total amount of ineffectiveness

   $ 0      $ 0   
    


 


Amount of equity contracts excluded from effectiveness assessment

   $ 19      $ (4


Cash Flow Hedge Gains (Losses)

We recognized the following gains (losses) on foreign exchange contracts designated as cash-flow hedges (our only cash flow hedges during the periods presented):

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Effective Portion

                

Gains recognized in OCI (net of tax effect of $28 and $4)

   $   161      $   335   

Gains reclassified from AOCI into revenue

   $ 109      $ 16   

Amount Excluded from Effectiveness Assessment and Ineffective Portion

                

Losses recognized in other income (expense), net

   $ (82   $ (68


We estimate that $546 million of net derivative gains included in AOCI at September 30, 2015 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during the three months ended September 30, 2015.

 

15


Table of Contents

PART I

Item 1

 

Non-Designated Derivative Gains (Losses)

Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), net, which were immaterial for the periods presented. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities and gains (losses) from foreign exchange rate changes on certain balance sheet amounts.

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Foreign exchange contracts

   $ 59      $   (233

Equity contracts

     34        10   

Interest-rate contracts

     (1     (6

Credit contracts

     (5     (5

Commodity contracts

       (84     (111


 


Total

   $ 3      $ (345
    


 


NOTE 6 — FAIR VALUE MEASUREMENTS

We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are:

 

   

Level 1—inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative investments primarily include U.S. government securities, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges.

 

   

Level 2—inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, common and preferred stock, mortgage- and asset-backed securities, U.S. government and agency securities, and foreign government bonds. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts.

 

   

Level 3—inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in common and preferred stock, and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. Our Level 3 derivative assets and liabilities primarily include equity derivatives.

We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary.

Our other current financial assets and our current financial liabilities have fair values that approximate their carrying values.

 

16


Table of Contents

PART I

Item 1

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis:

 

(In millions)      Level 1        Level 2        Level 3       

 

Gross Fair

Value

  

  

    Netting (a)     
 
Net Fair
Value
  
  


September 30, 2015

                                                

Assets

                                                

Mutual funds

   $ 854      $ 0      $ 0      $ 854      $ 0      $ 854   

Commercial paper

     0        8        0        8        0        8   

Certificates of deposit

     0        1,115        0        1,115        0        1,115   

U.S. government and agency securities

     73,336        2,803        0        76,139        0        76,139   

Foreign government bonds

     70        5,514        0        5,584        0        5,584   

Mortgage- and asset-backed securities

     0        4,811        0        4,811        0        4,811   

Corporate notes and bonds

     0        6,900        1        6,901        0        6,901   

Municipal securities

     0        322        0        322        0        322   

Common and preferred stock

     7,753        2,377        12        10,142        0        10,142   

Derivatives

     18        1,042        3        1,063        (294     769   


 


 


 


 


 


Total

   $   82,031      $   24,892      $   16      $   106,939      $   (294   $   106,645   
    


 


 


 


 


 


Liabilities

                                                

Derivatives and other

   $ 11      $ 281      $ 37      $ 329      $ (294   $ 35   


 

(In millions)      Level 1        Level 2        Level 3       

 

Gross Fair

Value

  

  

    Netting (a)     
 
Net Fair
Value
  
  


June 30, 2015

                                                

Assets

                                                

Mutual funds

   $ 1,100      $ 0      $ 0      $ 1,100      $ 0      $ 1,100   

Commercial paper

     0        1        0        1        0        1   

Certificates of deposit

     0        906        0        906        0        906   

U.S. government and agency securities

     71,930        955        0        72,885        0        72,885   

Foreign government bonds

     131        5,299        0        5,430        0        5,430   

Mortgage- and asset-backed securities

     0        4,917        0        4,917        0        4,917   

Corporate notes and bonds

     0        7,108        1        7,109        0        7,109   

Municipal securities

     0        319        0        319        0        319   

Common and preferred stock

     8,585        2,277        14        10,876        0        10,876   

Derivatives

     4        979        5        988        (162     826   


 


 


 


 


 


Total

   $   81,750      $   22,761      $   20      $   104,531      $   (162   $   104,369   
    


 


 


 


 


 


Liabilities

                                                

Derivatives and other

   $ 5      $ 159      $ 54      $ 218      $ (161   $ 57   


 

(a)

These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk.

The changes in our Level 3 financial instruments that are measured at fair value on a recurring basis were immaterial during the periods presented.

 

17


Table of Contents

PART I

Item 1

 

The following table reconciles the total “Net Fair Value” of assets above to the balance sheet presentation of these same assets in Note 4 – Investments.

 

(In millions)             


September 30,

2015

    June 30,
2015
 

Net fair value of assets measured at fair value on a recurring basis

   $ 106,645      $ 104,369   

Cash

     3,555        3,679   

Common and preferred stock measured at fair value on a nonrecurring basis

     700        561   

Other investments measured at fair value on a nonrecurring basis

     563        589   

Less derivative net assets classified as other current assets

     (697     (648

Other

     2        4   


 


Recorded basis of investment components

   $   110,768      $   108,554   
    


 


Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

During the three months ended September 30, 2015 and 2014, we did not record any material other-than-temporary impairments on financial assets required to be measured at fair value on a nonrecurring basis.

NOTE 7 — INVENTORIES

The components of inventories were as follows:

 

(In millions)             


September 30,

2015

    June 30,
2015
 

Raw materials

   $ 1,192      $ 1,100   

Work in process

     155        202   

Finished goods

     2,469        1,600   


 


Total

   $   3,816      $   2,902   
    


 


NOTE 8 — BUSINESS COMBINATIONS

Mojang Synergies AB

On November 6, 2014, we acquired Mojang Synergies AB (“Mojang”), the Swedish video game developer of the Minecraft gaming franchise, for $2.5 billion in cash, net of cash acquired. The addition of Minecraft and its community enhances our gaming portfolio across Windows, Xbox, and other ecosystems besides our own. The significant classes of assets and liabilities to which we allocated the purchase price were goodwill of $1.8 billion and identifiable intangible assets of $928 million, primarily marketing-related (trade names). The goodwill recognized in connection with the acquisition is primarily attributable to anticipated synergies from future growth, and is not expected to be deductible for tax purposes. We assigned the goodwill to More Personal Computing under our current segment structure. Identifiable intangible assets were assigned a total weighted-average amortization period of 6.3 years. Mojang has been included in our consolidated results of operations since the acquisition date.

Other

During the three months ended September 30, 2015, we completed five acquisitions for total cash consideration of $395 million. These entities have been included in our consolidated results of operations since their respective acquisition dates.

Pro forma results of operations have not been presented because the effects of these business combinations, individually and in aggregate, were not material to our consolidated results of operations.

 

18


Table of Contents

PART I

Item 1

 

NOTE 9 — GOODWILL

Changes in the carrying amount of goodwill were as follows:

 

(In millions)   

June 30,

2015

    Acquisitions     Other     September 30,
2015
 


Productivity and Business Processes

   $ 6,309      $ 120      $ (59   $ 6,370   

Intelligent Cloud

     4,917        181        (5     5,093   

More Personal Computing

     5,713        0        (34     5,679   


 


 


 


Total goodwill

   $   16,939      $   301      $   (98   $   17,142   
    


 


 


 


The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a recasting of the amounts allocated to goodwill retroactive to the periods in which the acquisitions occurred.

Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the above table. Also included in “Other” are business dispositions and transfers between business segments due to reorganizations, as applicable.

As discussed in Note 18 – Segment Information, during the first quarter of fiscal year 2016 the Company’s chief operating decision maker requested changes in the information that he regularly reviews for purposes of allocating resources and assessing performance. This resulted in a change in our operating segments and reporting units. We allocated goodwill to our new reporting units using a relative fair value approach. In addition, we completed an assessment of any potential goodwill impairment for all reporting units immediately prior to the reallocation and determined that no impairment existed.

NOTE 10 — INTANGIBLE ASSETS

The components of intangible assets, all of which are finite-lived, were as follows:

 

(In millions)    Gross
Carrying
Amount
    Accumulated
Amortization
   

Net

Carrying
Amount

    Gross
Carrying
Amount
    Accumulated
Amortization
   

Net

Carrying
Amount

 


    

September 30,

2015

   

June 30,

2015

 

Technology-based (a)

   $ 6,289              $ (3,517   $ 2,772      $ 6,187              $ (3,410   $ 2,777   

Marketing-related

     1,955                 (570     1,385        1,974                 (540     1,434   

Contract-based

     1,331                 (874     457        1,344                 (862     482   

Customer-related

     580                 (449     131        632                 (490     142   


          


 


 


          


 


Total

   $   10,155               $   (5,410   $   4,745      $   10,137               $   (5,302   $   4,835   
    


          


 


 


          


 


 

(a)

Technology-based intangible assets included $166 million and $116 million as of September 30, 2015 and June 30, 2015, respectively, of net carrying amount of software to be sold, leased, or otherwise marketed.

Intangible assets amortization expense was $242 million and $372 million for the three months ended September 30, 2015 and 2014, respectively. Amortization of capitalized software was $18 million and $40 million for the three months ended September 30, 2015 and 2014, respectively.

The following table outlines the estimated future amortization expense related to intangible assets held at September 30, 2015:

 

(In millions)       


Year Ending June 30,

        

2015 (excluding the three months ended September 30, 2015)

   $ 712   

2016

     804   

2017

     700   

2018

     568   

2019

     503   

Thereafter

     1,458   


Total

   $   4,745   
    


 

19


Table of Contents

PART I

Item 1

 

NOTE 11 — DEBT

Short-term Debt

As of September 30, 2015, we had $10.0 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.18% and maturities ranging from 21 days to 91 days. As of June 30, 2015, we had $5.0 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.11% and maturities ranging from 8 days to 63 days. The estimated fair value of this commercial paper approximates its carrying value.

We have two $5.0 billion credit facilities that expire on November 4, 2015 and November 14, 2018, respectively. These credit facilities serve as a back-up for our commercial paper program. As of September 30, 2015, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreements. No amounts were drawn against these credit facilities during any of the periods presented.

Long-term Debt

As of September 30, 2015, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $28.6 billion and $29.2 billion, respectively. This is compared to a carrying value and estimated fair value of our long-term debt of $30.3 billion and $30.5 billion, respectively, as of June 30, 2015. These estimated fair values are based on Level 2 inputs.

 

20


Table of Contents

PART I

Item 1

 

The components of our long-term debt, including the current portion, and the associated interest rates were as follows as of September 30, 2015 and June 30, 2015:

 

Due Date          

Face Value

September 30,
2015

   

Face Value

June 30,
2015

   

Stated
Interest

Rate

    

Effective
Interest

Rate

 


            (In millions)               

Notes

                                          

September 25, 2015

             $ *      $ 1,750        1.625%         1.795%   

February 8, 2016

              750        750        2.500%         2.642%   

November 15, 2017

              600        600        0.875%         1.084%   

May 1, 2018

              450        450        1.000%         1.106%   

December 6, 2018

              1,250        1,250        1.625%         1.824%   

June 1, 2019

              1,000        1,000        4.200%         4.379%   

February 12, 2020 (a)

              1,500        1,500        1.850%         1.935%   

October 1, 2020

              1,000        1,000        3.000%         3.137%   

February 8, 2021

              500        500        4.000%         4.082%   

December 6, 2021 (b)

              1,953        1,950        2.125%         2.233%   

February 12, 2022 (a)

              1,500        1,500        2.375%         2.466%   

November 15, 2022

              750        750        2.125%         2.239%   

May 1, 2023

              1,000        1,000        2.375%         2.465%   

December 15, 2023

              1,500        1,500        3.625%         3.726%   

February 12, 2025 (a)

              2,250        2,250        2.700%         2.772%   

December 6, 2028 (b)

              1,953        1,950        3.125%         3.218%   

May 2, 2033 (b)

              615        613        2.625%         2.690%   

February 12, 2035 (a)

              1,500        1,500        3.500%         3.604%   

June 1, 2039

              750        750        5.200%         5.240%   

October 1, 2040

              1,000        1,000        4.500%         4.567%   

February 8, 2041

              1,000        1,000        5.300%         5.361%   

November 15, 2042

              900        900        3.500%         3.571%   

May 1, 2043

              500        500        3.750%         3.829%   

December 15, 2043

              500        500        4.875%         4.918%   

February 12, 2045 (a)

              1,750        1,750        3.750%         3.800%   

February 12, 2055 (a)

              2,250        2,250        4.000%         4.063%   


                

Total

            $   28,721      $   30,463                    
             


 


                

 

(a)

In February 2015, we issued $10.8 billion of debt securities.

 

(b)

Euro-denominated debt securities.

 

*

Not applicable as notes were repaid in September 2015.

The notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. As of September 30, 2015 and June 30, 2015, the aggregate unamortized discount for our long-term debt, including the current portion, was $152 million and $156 million, respectively.

NOTE 12 — INCOME TAXES

Our effective tax rate for the three months ended September 30, 2015 and 2014 was 16% and 23%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico.

Tax contingencies and other income tax liabilities were $11.9 billion and $12.1 billion as of September 30, 2015 and June 30, 2015, respectively, and are included in other long-term liabilities. This decrease relates primarily to a partial settlement of the I.R.S. audit for tax years 2007 to 2009. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, and settled a portion of the I.R.S. audit for tax years 2007 to 2009 during the current quarter, we remain under audit for those years. In February 2012, the I.R.S. withdrew its

 

21


Table of Contents

PART I

Item 1

 

2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of September 30, 2015, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2015.

We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2015, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements.

NOTE 13 — RESTRUCTURING CHARGES

Phone Hardware Integration

In July 2014, we announced a restructuring plan to simplify our organization and align the purchase of Nokia Corporation’s (“Nokia”) Devices and Services business (“NDS”) with our company’s overall strategy (the “Phone Hardware Integration Plan”). Pursuant to the Phone Hardware Integration Plan, we eliminated approximately 19,000 positions in fiscal year 2015, including approximately 13,000 professional and factory positions related to the NDS business. The actions associated with the Phone Hardware Integration Plan were completed as of June 30, 2015.

In connection with the Phone Hardware Integration Plan, we incurred restructuring charges of $1.0 billion during the three months ended September 30, 2014, including severance expenses and other reorganization costs, primarily associated with our facilities consolidation. Total restructuring charges incurred under the Phone Hardware Integration Plan were $1.3 billion, all of which were recognized in fiscal year 2015.

Phone Hardware Restructuring

In June 2015, management approved a plan to restructure our phone business to better focus and align resources (the “Phone Hardware Restructuring Plan”), under which we will eliminate up to 7,800 positions in fiscal year 2016. The actions associated with the Phone Hardware Restructuring Plan are expected to be completed as of June 30, 2016.

To date, we have incurred restructuring charges of $780 million under the Phone Hardware Restructuring Plan, including severance expenses and other reorganization costs.

Restructuring charges associated with these plans were included in impairment, integration, and restructuring expenses in our consolidated income statement, and reflected in Corporate and Other in our table of operating income (loss) by segment in Note 18 – Segment Information.

Changes in the restructuring liability were as follows:

 

(In millions)

     Severance       

 

 

Asset

Impairments

and  Other

  

  

(a) 

    Total   


Restructuring liability as of June 30, 2015

   $ 588      $ 249      $ 837   

Restructuring charges

     0        0        0   

Cash paid

       (120     (19       (139

Other

     (19     0        (19


 


 


Restructuring liability as of September 30, 2015

   $ 449      $   230      $ 679   
    


 


 


 

(a)

Asset Impairments and Other” primarily reflects activities associated with the consolidation of our facilities and manufacturing operations, including asset write-downs as well as contract termination costs.

 

22


Table of Contents

PART I

Item 1

 

NOTE 14 — UNEARNED REVENUE

Unearned revenue by segment was as follows:

 

(In millions)             


    

September 30,

2015

    June 30,
2015
 

Productivity and Business Processes

   $ 10,719      $ 11,643   

Intelligent Cloud

     9,291        10,346   

More Personal Computing

     3,035        3,246   

Corporate and Other

     1,342        83   


 


Total

   $   24,387      $   25,318   
    


 


As of September 30, 2015, we deferred a net $1.3 billion related to Windows 10. Windows 10 revenue is recognized upon shipment in the More Personal Computing segment. The deferral and subsequent recognition of revenue is reflected in Corporate and Other.

NOTE 15 — CONTINGENCIES

Patent and Intellectual Property Claims

Motorola litigation

In 2010, Microsoft filed patent infringement complaints against Motorola Mobility (“Motorola”) with the International Trade Commission (“ITC”) and in U.S. District Court in Seattle for infringement of nine Microsoft patents by Motorola’s Android devices. Microsoft and Motorola filed additional claims against each other with the ITC, in federal district courts in Seattle, Wisconsin, Florida, and California, and in courts in Germany. On September 29, 2015, the parties reached an agreement providing for dismissal of all then-pending patent infringement actions, as described below.

International Trade Commission

In 2012, the ITC issued a limited exclusion order against Motorola on one Microsoft patent, which was affirmed on appeal. In 2013, Microsoft filed an action in U.S. District Court in Washington, D.C. seeking an order to compel enforcement of the ITC’s 2012 import ban against infringing Motorola products by the Bureau of Customs and Border Protection (“CBP”), after learning that CBP had failed to fully enforce the order. Following the September 29, 2015 agreement, the parties filed applications to release the exclusion order and dismiss the action against CBP.

In 2010, Motorola filed an action against Microsoft with the ITC alleging infringement of five Motorola patents by Xbox consoles and accessories and seeking an exclusion order to prohibit importation of the allegedly infringing Xbox products. At Motorola’s request, the ITC terminated its investigation of four Motorola patents. In 2013, the ITC affirmed there was no violation of the remaining Motorola patent. Motorola appealed the ITC’s decision to the U.S. Court of Appeals for the Federal Circuit. Following the September 29, 2015 agreement, the parties filed an application to dismiss the appeal.

U.S. District Court

The Seattle District Court case filed in 2010 by Microsoft as a companion to Microsoft’s ITC case against Motorola was stayed pending the outcome of the ITC case. Following the September 29, 2015 agreement, the parties filed an application to dismiss this action.

In 2010, Microsoft sued Motorola for breach of contract in U.S. District Court in Seattle, alleging that Motorola breached its commitments to standards-setting organizations to license to Microsoft certain patents on reasonable and non-discriminatory (“RAND”) terms and conditions. Motorola has declared these patents essential to the implementation of the H.264 video standard and the 802.11 Wi-Fi standard. In the Motorola ITC case described above and in suits described below, Motorola or a Motorola affiliate subsequently sued Microsoft on those patents in U.S. District Courts, in the ITC, and in Germany. In 2012, the Seattle District Court granted a partial summary judgment in favor of Microsoft ruling that (1) Motorola had committed to standards organizations to license its

 

23


Table of Contents

PART I

Item 1

 

declared-essential patents on RAND terms and conditions; and (2) Microsoft is a third-party beneficiary of those commitments. After trial, the Seattle District Court set per unit royalties for Motorola’s H.264 and 802.11 patents, which resulted in an immaterial Microsoft liability. In 2013, following trial of Microsoft’s breach of contract claim, a jury awarded $14.5 million in damages to Microsoft. Motorola appealed with respect to both the Court’s determination of royalties due Motorola and the jury’s award of damages against Motorola; in July 2015 the U.S. Court of Appeals for the Ninth Circuit affirmed the trial court’s judgment. Following the September 29, 2015 agreement, the parties filed an application to dispose of all issues remaining in this action.

Cases filed by Motorola in Wisconsin, California, and Florida, with the exception of one case in Wisconsin initially stayed and later dismissed without prejudice (a companion case to Motorola’s ITC action), were transferred to the U.S District Court in Seattle. The court stayed these cases on agreement of the parties. Following the September 29, 2015 agreement, the parties filed applications in Seattle and Wisconsin to dismiss these actions.

 

   

In the transferred cases, Motorola asserted 15 patents against a range of Microsoft products including mobile and PC operating system, productivity, server, communication, browser and gaming products.

 

   

In the Motorola action originally filed in California, Motorola asserted Microsoft violated antitrust laws in connection with Microsoft’s assertion of patents against Motorola that Microsoft agreed to license to certain qualifying entities on RAND terms and conditions.

 

   

In counterclaims, Microsoft asserted 14 patents against Motorola Android devices and certain Motorola digital video recorders.

Germany

In 2011, Motorola filed patent infringement actions in Germany against Microsoft and several Microsoft subsidiaries.

 

   

Motorola asserted two patents (both now expired) are essential to implementation of the H.264 video standard, and Motorola alleged that H.264 capable products including Xbox 360, Windows 7, Media Player, and Internet Explorer infringe those patents. In 2012, the German court issued an injunction (enforcement of which was enjoined by the Seattle court) relating to all H.264 capable Microsoft products in Germany, which Microsoft appealed. Following the September 29, 2015 agreement, this action will be dismissed.

 

   

Motorola asserted that one patent covers certain syncing functionality in the ActiveSync protocol employed by Windows Phone 7, Outlook Mobile, Hotmail Mobile, Exchange Online, Exchange Server, and Hotmail Server. In 2013, the court stayed the case in view of parallel nullity proceedings. Following the September 29, 2015 agreement, this action will be dismissed.

In lawsuits Microsoft filed in Germany in 2011 and 2012, Microsoft asserted that Motorola Android devices infringe Microsoft patents. In 2012, regional courts in Germany issued injunctions (later stayed in view of parallel nullity proceedings) on three of the Microsoft patents, which Motorola appealed. One judgment was affirmed on appeal. Following the September 29, 2015 agreement, these actions will be dismissed.

IPCom patent litigation

IPCom GmbH & Co. (“IPCom”) is a German company that holds a large portfolio of mobile technology-related patents spanning about 170 patent families and addressing a broad range of cellular technologies. IPCom has asserted 19 of these patents in litigation against Nokia and many of the leading cell phone companies and operators. In November 2014, Microsoft and IPCom entered into a standstill agreement staying all of the pending litigation against Microsoft to permit the parties to pursue settlement discussions.

InterDigital patent litigation

InterDigital Technology Corporation and InterDigital Communications Corporation (collectively, “IDT”) filed four patent infringement cases against Nokia in the ITC and in U.S. District Court for the District of Delaware between 2007 and 2013. We have been added to these cases as a defendant. IDT has cases pending against other defendants based on the same patents because most of the patents at issue allegedly relate to 3G and 4G wireless communications standards essential functionality. The cases involving us include three ITC investigations where IDT is seeking an order excluding importation of 3G and 4G phones into the U.S. and one active case in U.S. District Court in Delaware seeking an injunction and damages. The ITC issued a finding of no violation in all three investigations. The U.S. Court of Appeals for the Federal Circuit affirmed one of the ITC’s findings; IDT voluntarily dismissed the appeal in

 

24


Table of Contents

PART I

Item 1

 

another of the ITC matters. IDT has not yet appealed the no violation finding in the third ITC matter. The trial in the Delaware case is scheduled for November 2015. In September 2015, the United State Patent Trial and Appeal Board issued a final written decision that deemed unpatentable all asserted claims of the patent remaining at issue in the Delaware case in an inter partes review that is subject to appeal to the U.S. Court of Appeals for the Federal Circuit. In October 2015, the parties filed a stipulation to stay the Delaware case pending completion of the inter partes review, including all appeals and subsequent Patent Trial and Appeal Board proceedings. We filed an antitrust complaint against IDT in the District of Delaware in August 2015 asserting violations of Section 2 of the Sherman Act, alleging the unlawful exploitation of standard essential patents.

European copyright levies

We assumed from Nokia all potential liability due to Nokia’s alleged failure to pay “private copying levies” in various European countries based upon sale of memory cards and mobile phones that incorporate blank memory. The levies are based upon a 2001 European Union (“EU”) Directive establishing a right for end users to make copies of copyrighted works for personal or private use, but also allowing the collection of levies based upon sales of blank media or recording devices to compensate copyright holders for private copying. Various collecting societies in EU countries initiated litigation against Nokia, stating that Nokia must pay levies not only based upon sales of blank memory cards, but also phones that include blank memory for data storage on the phones, regardless of actual usage of that memory. The most significant cases against Nokia are pending in Germany and Austria, due to both the high volume of sales and high levy amounts sought in these countries. Since April 2015, we and other major manufacturers have been engaged in settlement negotiations with the German collecting society, with the aim of concluding negotiations by October 2015.

Other patent and intellectual property claims

In addition to these cases, there are approximately 65 other patent infringement cases pending against Microsoft.

Antitrust, Unfair Competition, and Overcharge Class Actions

A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products between 1999 and 2005.

We obtained dismissals or reached settlements of all claims made in the U.S. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. We estimate the total remaining cost of the settlements is approximately $100 million, all of which had been accrued as of September 30, 2015.

Three similar cases pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In 2010, the court in the British Columbia case certified it as a class action. After the British Columbia Court of Appeal dismissed the case, in 2013 the Canadian Supreme Court reversed the appellate court and reinstated part of the British Columbia case, which is now scheduled for trial in 2016. The other two cases are inactive.

Other Antitrust Litigation and Claims

GO Computer litigation

In 2005, GO Computer Inc. and co-founder Jerry Kaplan filed a complaint in California state court asserting antitrust claims under the Cartwright Act related to the business of the former GO Corporation in the early 1990s and its successor in interest, Lucent Corporation in the early 2000s. In September 2015, the parties settled all claims.

China State Administration for Industry and Commerce investigation

In 2014, Microsoft was informed that China’s State Administration for Industry and Commerce (“SAIC”) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAIC conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. SAIC has stated the investigation relates to compatibility, bundle sales, and file verification issues related to Windows and Office software.

 

25


Table of Contents

PART I

Item 1

 

Product-Related Litigation

U.S. cell phone litigation

Nokia, along with other handset manufacturers and network operators, is a defendant in 19 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We have assumed responsibility for these claims as part of the NDS acquisition and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining 10 cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines.

In 2013, defendants in the consolidated cases moved to exclude plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the court granted in part defendants’ motion to exclude plaintiffs’ general causation experts. The plaintiffs filed an interlocutory appeal. The District of Columbia Court of Appeals agreed to hear en banc defendants’ interlocutory appeal challenging the standard for evaluating expert scientific evidence. Trial court proceedings are stayed pending resolution of the appeal.

Canadian cell phone class action

Nokia, along with other handset manufacturers and network operators, is a defendant in a 2013 class action lawsuit filed in the Supreme Court of British Columbia by a purported class of Canadians who have used cellular phones for at least 1,600 hours, including a subclass of users with brain tumors. Microsoft was served with the complaint in June 2014 and has been substituted for the Nokia defendants. The litigation is not yet active as several defendants remain to be served.

Other

We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.

As of September 30, 2015, we accrued aggregate legal liabilities of $551 million in other current liabilities and $17 million in other long-term liabilities. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $1.5 billion in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our consolidated financial statements for the period in which the effects become reasonably estimable.

NOTE 16 — STOCKHOLDERS’ EQUITY

Share Repurchases

We repurchased the following shares of common stock through our share repurchase program during the periods presented:

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Shares of common stock repurchased

     89        43   

Value of common stock repurchased

   $   4,000      $   2,000   


The above table excludes shares repurchased to settle statutory employee tax withholding related to the vesting of stock awards. On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. The share repurchase program became effective on October 1, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. As of September 30, 2015, $17.9 billion remained of our $40.0 billion share repurchase program. All repurchases were made using cash resources.

 

26


Table of Contents

PART I

Item 1

 

Dividends

Our Board of Directors declared the following dividends during the periods presented:

 

Declaration Date   

Dividend

Per Share

    Record Date      Total Amount     Payment Date  


                  (in millions)        

September 15, 2015

   $   0.36        November 19, 2015       $   2,875        December 10, 2015   

September 16, 2014

   $ 0.31        November 20, 2014       $ 2,547        December 11, 2014   


The dividend declared on September 15, 2015 was included in other current liabilities as of September 30, 2015.

NOTE 17 — ACCUMULATED OTHER COMPREHENSIVE INCOME

The following table summarizes the changes in accumulated other comprehensive income by component:

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Derivatives

                

Accumulated other comprehensive income balance, beginning of period

   $ 590      $ 31   

Unrealized gains, net of tax effects of $28 and $4

     161        335   

Reclassification adjustments for gains included in revenue

     (109     (16

Tax expense included in provision for income taxes

     5        0   


 


Amounts reclassified from accumulated other comprehensive income

     (104     (16


 


Net current period other comprehensive income

     57        319   


 


Accumulated other comprehensive income balance, end of period

   $ 647      $ 350   


 


Investments

                

Accumulated other comprehensive income balance, beginning of period

   $ 3,169      $ 3,531   

Unrealized losses, net of tax effects of $(305) and $(74)

     (566     (138

Reclassification adjustments for gains included in other income (expense), net

     (8     (79

Tax expense included in provision for income taxes

     3        28   


 


Amounts reclassified from accumulated other comprehensive income

     (5     (51


 


Net current period other comprehensive loss

     (571     (189


 


Accumulated other comprehensive income balance, end of period

   $ 2,598      $ 3,342   


 


Translation adjustments and other

                

Accumulated other comprehensive income (loss) balance, beginning of period

   $   (1,237   $ 146   

Translation adjustments and other, net of tax effects of $(12) and $(47)

     (270     (81


 


Accumulated other comprehensive income (loss) balance, end of period

   $ (1,507   $ 65   


 


Accumulated other comprehensive income, end of period

   $ 1,738      $   3,757   
    


 


NOTE 18 — SEGMENT INFORMATION

In its operation of the business, management, including our chief operating decision maker, the company’s Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP.

In June 2015, we announced a change in organizational structure as part of our transformation in the mobile-first, cloud-first world. During the first quarter of fiscal year 2016, the Company’s chief operating decision maker requested

 

27


Table of Contents

PART I

Item 1

 

changes in the information that he regularly reviews for purposes of allocating resources and assessing performance. As a result, beginning in fiscal year 2016, we report our financial performance based on our new segments; Productivity and Business Processes, Intelligent Cloud, and More Personal Computing, and analyze operating income as the measure of segment profitability. We have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance.

Our reportable segments are described below.

Productivity and Business Processes

Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises:

 

   

Office Commercial, including volume licensing and subscriptions to Office 365 Commercial for products and services such as Microsoft Office, Exchange, SharePoint, and Skype for Business, and related Client Access Licenses (“CALs”).

 

   

Office Consumer, including Office sold through retail or through an Office 365 Consumer subscription, and Office Consumer Services, including Outlook.com, OneDrive, and consumer Skype services.

 

   

Microsoft Dynamics business solutions, including Dynamics ERP products, Dynamics CRM on-premises, and Dynamics CRM Online (“Microsoft Dynamics”).

Intelligent Cloud

Our Intelligent Cloud segment consists of our public, private, and hybrid server products and services that can power modern business. This segment primarily comprises:

 

   

Server products and services, including Windows Server, Microsoft SQL Server, Visual Studio, System Center, and related CALs, as well as Microsoft Azure.

 

   

Enterprise Services, including Premier Support Services and Microsoft Consulting Services.

More Personal Computing

Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and information technology professionals across screens of all sizes. This segment primarily comprises:

 

   

Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system, volume licensing of the Windows operating system (“Windows VL”), patent licensing, Windows Embedded, MSN display advertising, and Windows Phone licensing.

 

   

Devices, including phones, Surface, and Microsoft PC accessories.

 

   

Gaming, including Xbox hardware; Xbox Live, comprising transactions, subscriptions, and advertising; video games; and third-party video game royalties.

 

   

Search advertising.

Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue on certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit, and are generally allocated based on relative gross margin.

In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: legal, including settlements and fines; information technology; human resources; finance; excise taxes; field selling; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Revenue and expenses associated with non-Microsoft products sold in our retail stores are allocated from Corporate and Other to reportable segments as a marketing charge, using the stores as a sales channel, based on the related revenue sold through the stores. Certain corporate-level activity is not allocated to our segments, including impairment, integration, and restructuring expenses.

 

28


Table of Contents

PART I

Item 1

 

Segment revenue and operating income (loss) were as follows during the periods presented:

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Revenue

                

Productivity and Business Processes

   $ 6,306      $ 6,490   

Intelligent Cloud

     5,892        5,475   

More Personal Computing

     9,381        11,236   

Corporate and Other

     (1,200     0   


 


Total revenue

   $   20,379      $   23,201   
    


 


 

(In millions)             


Three Months Ended September 30,    2015     2014  

Operating income (loss)

                

Productivity and Business Processes

   $ 3,105      $ 3,338   

Intelligent Cloud

     2,400        2,106   

More Personal Computing

     1,562        1,619   

Corporate and Other

     (1,274     (1,219


 


Total operating income (loss)

   $    5,793      $    5,844   
    


 


Corporate and Other operating income (loss) includes impairment, integration, and restructuring expenses, adjustments to conform our internal accounting policies to U.S. GAAP, and other corporate-level activity not specifically allocated to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and depreciation.

Corporate and Other activity was as follows:

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Impairment, integration, and restructuring expenses

   $ 0      $ (1,140

Revenue reconciling amounts (a)

     (1,278     (44

Other

     4        (35


 


Total Corporate and Other

   $   (1,274   $   (1,219
    


 


 

(a)

Revenue reconciling amounts for the three months ended September 30, 2015, included a net $1.3 billion of revenue deferrals related to sales of Windows 10. Revenue reconciling amounts for the three months ended September 30, 2014 included a net $29 million of revenue deferrals related to sales of bundled products and services (“Bundled Offerings”).

Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment, and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.

 

29


Table of Contents

PART I

Item 1

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Microsoft Corporation

Redmond, Washington

We have reviewed the accompanying consolidated balance sheet of Microsoft Corporation and subsidiaries (the “Company”) as of September 30, 2015, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the three-month periods ended September 30, 2015 and 2014. These interim financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to such consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of June 30, 2015, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the year then ended (not presented herein); and in our report dated July 31, 2015 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 2015 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/S/ DELOITTE & TOUCHE LLP

Seattle, Washington

October 22, 2015

 

30


Table of Contents

PART I

Item 2

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Note About Forward-Looking Statements

This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: “Management’s Discussion and Analysis,” and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors” (Part II, Item 1A of this Form 10-Q), “Quantitative and Qualitative Disclosures about Market Risk” (Part I, Item 3 of this Form 10-Q), and “Management’s Discussion and Analysis” (Part I, Item 2 of this Form 10-Q). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise.

OVERVIEW

The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our Annual Report on Form 10-K for the year ended June 30, 2015, and our consolidated financial statements and the accompanying Notes to Financial Statements in this Form 10-Q.

Microsoft is a technology leader focused on building best-in-class platforms and productivity services for a mobile-first, cloud-first world. We strive to empower every person and every organization on the planet to achieve more. We develop and market software, services, and devices that deliver new opportunities, greater convenience, and enhanced value to people’s lives.

We generate revenue by developing, licensing, and supporting a wide range of software products, by offering an array of services, including cloud-based services to consumers and businesses, by designing, manufacturing, and selling devices that integrate with our cloud-based services, and by delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees, designing, manufacturing, marketing, and selling our products and services, datacenter costs in support of our cloud-based services, and income taxes.

In July 2015, we announced a restructuring of our phone business, including the creation of the Windows and Devices Group. This reinforces our strategy to create a vibrant Windows ecosystem with a single set of experiences across our first-party device family and original equipment manufacturer (“OEM”) offerings. Part of this strategy involves focusing our phone devices on a narrower range of customer categories and differentiating through the combination of hardware and software we are uniquely positioned to offer.

Highlights from the first quarter of fiscal year 2016 included:

 

   

We launched Windows 10 as a service that unites experiences across a wide range of devices with innovations that increase productivity and flexibility; Windows 10 is now running on 110 million devices around the world.

 

   

Our commercial cloud, which primarily comprises Office 365 Commercial, Microsoft Azure, and Dynamics CRM Online, reached an annualized run rate* exceeding $8.2 billion.

 

   

Office 365 Consumer subscribers increased to 18.2 million, with approximately 3 million subscribers added in the quarter.

 

   

Dynamics CRM Online enterprise installed base more than tripled year-over-year.

 

   

Microsoft Azure revenue and compute usage more than doubled year-over-year, and we now have over 20,000 Enterprise Mobility customers.

 

   

Xbox Live monthly active users grew 28% to 39 million.

 

31


Table of Contents

PART I

Item 2

 

*

Annualized run rate was calculated by multiplying September 2015 revenue by twelve months.

Industry Trends

Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers, industry trends, and competitive forces.

Economic Conditions, Challenges, and Risks

The market for software, devices, and cloud-based services is dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in devices and infrastructure will continue to increase our operating costs and may decrease our operating margins.

Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. Microsoft competes for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic.

Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. The strengthening of the U.S. dollar relative to certain foreign currencies throughout fiscal year 2015 negatively impacted reported revenue and reduced reported expenses from our international operations in the current period as compared to the prior year.

See a discussion of these factors and other risks under Risk Factors (Part II, Item 1A of this Form 10-Q).

Seasonality

Our revenue historically has fluctuated quarterly and has generally been highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers.

Unearned Revenue

Quarterly and annual revenue is impacted by the deferral of revenue, including:

 

   

Revenue deferred on Windows 10 licenses to reflect ratable recognition over the life of the device.

 

   

Revenue deferred on bundled products and services (“Bundled Offerings”).

If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable.

Reportable Segments

The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. Segment information appearing in Note 18 – Segment Information of the Notes to Financial Statements is also presented on this basis. All differences between our internal management reporting basis and accounting principles generally accepted in the United States (“U.S. GAAP”), along with certain corporate-level and other activity, are included in Corporate and Other.

 

32


Table of Contents

PART I

Item 2

 

In June 2015, we announced a change in organizational structure as part of our transformation in the mobile-first, cloud-first world. During the first quarter of fiscal year 2016, the Company’s chief operating decision maker requested changes in the information that he regularly reviews for purposes of allocating resources and assessing performance. As a result, beginning in fiscal year 2016, we report our financial performance based on our new segments; Productivity and Business Processes, Intelligent Cloud, and More Personal Computing, and analyze operating income as the measure of segment profitability. We have recast certain previously reported amounts to conform to the way we internally manage and monitor segment performance.

Our reportable segments are described below.

Productivity and Business Processes

Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises:

 

   

Office Commercial, including volume licensing and subscriptions to Office 365 Commercial for products and services such as Microsoft Office, Exchange, SharePoint, and Skype for Business, and related Client Access Licenses (“CALs”).

 

   

Office Consumer, including Office sold through retail or through an Office 365 Consumer subscription, and Office Consumer Services, including Outlook.com, OneDrive, and consumer Skype services.

 

   

Microsoft Dynamics business solutions, including Dynamics ERP products, Dynamics CRM on-premises, and Dynamics CRM Online (“Microsoft Dynamics”).

Intelligent Cloud

Our Intelligent Cloud segment consists of our public, private, and hybrid server products and services that can power modern business. This segment primarily comprises:

 

   

Server products and services, including Windows Server, Microsoft SQL Server, Visual Studio, System Center, and related CALs, as well as Microsoft Azure.

 

   

Enterprise Services, including Premier Support Services and Microsoft Consulting Services.

More Personal Computing

Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and information technology professionals across screens of all sizes. This segment primarily comprises:

 

   

Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system, volume licensing of the Windows operating system (“Windows VL”), patent licensing, Windows Embedded, MSN display advertising, and Windows Phone licensing.

 

   

Devices, including phones, Surface, and Microsoft PC accessories.

 

   

Gaming, including Xbox hardware; Xbox Live, comprising transactions, subscriptions, and advertising; video games; and third-party video game royalties.

 

   

Search advertising.

SUMMARY RESULTS OF OPERATIONS

 

(In millions, except percentages and per share amounts)   

Three Months Ended

September 30,

   

Percentage

Change

 


     2015     2014        

Revenue

   $    20,379      $    23,201        (12)%   

Gross margin

   $ 13,172      $ 14,928        (12)%   

Operating income

   $ 5,793      $ 5,844        (1)%   

Diluted earnings per share

   $ 0.57      $ 0.54        6%   


 

33


Table of Contents

PART I

Item 2

 

Revenue decreased $2.8 billion or 12%, primarily due to lower revenue from More Personal Computing and the impact of a net $1.3 billion revenue deferral related to Windows 10, offset in part by revenue growth in Intelligent Cloud. Revenue included an unfavorable foreign currency impact of approximately 5%. More Personal Computing revenue decreased, primarily due to lower revenue from phones, reflecting a change in strategy for the phone business. Intelligent Cloud revenue increased, primarily due to higher revenue from server products and services, including Microsoft Azure.

Operating income decreased slightly, primarily due to lower gross margin, offset in part by a reduction in impairment, integration, and restructuring expenses, as well as lower sales and marketing expenses. Gross margin decreased $1.8 billion or 12%, driven by Windows 10 net revenue deferrals, as well as lower gross margin from More Personal Computing and Productivity and Business Processes, offset in part by higher gross margin from Intelligent Cloud. Gross margin included an unfavorable foreign currency impact of approximately 6%.

Key changes in expenses were:

 

   

Cost of revenue decreased $1.1 billion or 13%, mainly due to lower phones sales.

 

   

Impairment, integration, and restructuring expenses were $1.1 billion in the prior year, comprised mainly of restructuring charges associated with our Phone Hardware Integration Plan.

 

   

Sales and marketing expenses decreased $395 million or 11%, mainly due to a decline in phones advertising and marketing program costs, and a reduction in headcount-related expenses. Sales and marketing expenses included a favorable foreign currency impact of approximately 6%.

Current year diluted earnings per share (“EPS”) was negatively impacted by Windows 10 revenue deferrals, which decreased EPS by $0.10. Prior year diluted EPS was negatively impacted by impairment, integration, and restructuring expenses, which decreased diluted EPS by $0.11.

SEGMENT RESULTS OF OPERATIONS

 

(In millions, except percentages)   

Three Months Ended

September 30,

   

Percentage

Change

 


     2015     2014        

Revenue

                        

Productivity and Business Processes

   $ 6,306      $ 6,490        (3)%   

Intelligent Cloud

     5,892        5,475        8%   

More Personal Computing

     9,381        11,236        (17)%   

Corporate and Other

     (1,200     0        *   


 


 


Total revenue

   $    20,379      $    23,201        (12)%   
    


 


       

Operating income (loss)

                        

Productivity and Business Processes

   $ 3,105      $ 3,338        (7)%   

Intelligent Cloud

     2,400        2,106        14%   

More Personal Computing

     1,562        1,619        (4)%   

Corporate and Other

     (1,274     (1,219     *   


 


 


Total operating income (loss)

   $ 5,793      $ 5,844        (1)%   
    


 


       

 

*

Not meaningful

Reportable Segments

Productivity and Business Processes

Productivity and Business Processes revenue decreased $184 million or 3%, mainly due to an unfavorable foreign currency impact of approximately 7%.

 

   

Office Consumer revenue decreased $105 million or 13%, driven by an unfavorable foreign currency impact of approximately 9% and a decline in the consumer PC market, offset in part by revenue growth from Office 365 Consumer, mainly due to recurring subscriptions.

 

34


Table of Contents

PART I

Item 2

 

   

Office Commercial revenue decreased $98 million or 2%, driven by an unfavorable foreign currency impact of approximately 7%, as well as lower transactional license volume, reflecting a decline in the business PC market. The decrease was offset in part by revenue growth from Office 365 Commercial, mainly due to an increase in subscribers and higher premium mix.

 

   

Microsoft Dynamics revenue increased 3%, mainly due to higher revenue from Dynamics CRM Online, driven by seat growth.

Productivity and Business Processes operating income decreased $233 million or 7%, driven by lower gross margin, offset in part by a reduction in operating expenses. Gross margin decreased $363 million or 6%, primarily due to the decline in Office revenue, as well as higher cost of revenue. Gross margin included an unfavorable foreign currency impact of approximately 7%. Cost of revenue increased $179 million or 21%, primarily due to the increasing cloud mix of revenue. Operating expenses decreased $130 million or 6%, driven by lower sales and marketing expenses. Sales and marketing expenses decreased $89 million or 7%, mainly due to a reduction in headcount-related expenses.

Intelligent Cloud

Intelligent Cloud revenue increased $417 million or 8%, mainly due to higher server products and services revenue, as well as higher Enterprise Services revenue. Intelligent Cloud revenue included an unfavorable foreign currency impact of approximately 6%. Our server products and services revenue grew $271 million or 6%, driven by higher revenue from premium versions of Microsoft SQL Server, Windows Server, and System Center, and 121% revenue growth from Microsoft Azure. Enterprise Services revenue grew $116 million or 9%, mainly due to growth in Premier Support Services.

Intelligent Cloud operating income increased $294 million or 14%, primarily due to higher gross margin, offset in part by higher operating expenses. Gross margin increased $334 million or 8%, driven by revenue growth from our server products and services. Gross margin included an unfavorable foreign currency impact of approximately 7%. Cost of revenue increased $83 million or 6%, driven by support for cloud services. Operating expenses increased $40 million or 2%.

More Personal Computing

More Personal Computing revenue decreased $1.9 billion or 17%, mainly due to lower revenue from Devices and Windows, offset in part by higher search advertising revenue. More Personal Computing revenue included an unfavorable foreign currency impact of approximately 4%.

 

   

Devices revenue decreased $1.8 billion or 49%, mainly due to lower revenue from phones, driven by the shift in strategy for the phone business, as well as lower Surface revenue. Phones revenue decreased $1.5 billion or 58%, as we sold 5.8 million Lumia phones and 25.5 million other non-Lumia phones in the first quarter of fiscal year 2016, compared with 9.3 million and 42.9 million sold, respectively, in the prior year. Surface revenue decreased $236 million or 26%, primarily driven by the release of Surface Pro 3 in June 2014.

 

   

Windows revenue decreased $322 million or 7%, mainly due to lower revenue from Windows OEM and patent licensing. Windows OEM revenue decreased $189 million or 6%, driven by declines in the business and consumer PC markets. Windows OEM Pro revenue declined 7%, slightly ahead of the performance of the business PC market. Windows OEM non-Pro revenue declined 4%, outperforming the consumer PC market, driven by a higher mix of premium licenses sold. Patent licensing revenue decreased, due to a decline in units and patent revenue per license, driven by a reduction in the average selling price of smartphones.

 

   

Search advertising revenue, excluding traffic acquisition costs, increased $127 million or 23%, primarily driven by growth in Bing, due to higher revenue per search and search volume.

 

   

Gaming revenue increased slightly, as growth in revenue from Xbox Live and video games was offset in part by lower Xbox hardware revenue. Xbox Live revenue increased 17%, driven by both higher volumes of transactions and revenue per transaction. Video games revenue grew 66%, driven by sales of Minecraft. We acquired Mojang AB, the Swedish video game developer of the Minecraft gaming franchise, in November 2014. Xbox hardware revenue decreased 17%, mainly due to lower volumes of Xbox 360 consoles sold.

More Personal Computing operating income decreased slightly, primarily due to lower gross margin, offset in part by lower operating expenses.

 

   

Gross margin decreased $564 million or 10%, reflecting lower revenue, primarily as a result of lower phones sales, offset in part by a reduction in cost of revenue. Gross margin included an unfavorable foreign currency impact of approximately 6%. Cost of revenue decreased $1.3 billion or 22%, driven by lower Devices cost of revenue.

 

35


Table of Contents

PART I

Item 2

 

   

Operating expenses decreased $507 million or 13%, mainly due to lower sales and marketing expenses and lower research and development expenses. Sales and marketing expenses decreased $308 million or 18%, driven by a decline in phones advertising and marketing program costs. Research and development expenses decreased $158 million or 9%, mainly due to lower headcount-related expenses, as well as capitalization of certain software development costs.

Corporate and Other

Corporate and Other revenue primarily comprises certain revenue deferrals, including those related to Windows 10 and Bundled Offerings, as well as revenue from non-Microsoft products sold in our retail stores. Corporate and Other operating income (loss) primarily comprises revenue deferrals and corporate-level activity not specifically allocated to a segment, including impairment, integration, and restructuring expenses.

Corporate and Other revenue decreased $1.2 billion, primarily due to the shift to ratable revenue recognition of Windows 10 in the current fiscal year. During the three months ended September 30, 2015, we deferred a net $1.3 billion of revenue related to Windows 10. During the three months ended September 30, 2014, we deferred a net $29 million of revenue related to Bundled Offerings.

Corporate and Other operating loss increased $55 million, primarily due to decreased revenue, offset in part by a $1.1 billion decline in impairment, integration, and restructuring expenses, reflecting prior year costs associated with the acquisition of Nokia Corporation’s Devices and Services business (“NDS”).

OPERATING EXPENSES

Research and Development

 

(In millions, except percentages)    Three Months Ended
September 30,
    Percentage
Change
 


     2015     2014        

Research and development

   $      2,962      $      3,065        (3)%   

As a percent of revenue

     15%        13%        2ppt   


Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code.

Research and development expenses decreased $103 million or 3%, driven by lower phones expenses and capitalization of certain software development costs associated with Office 2016 and Windows 10, partially offset by increased investment in Intelligent Cloud and Surface. Research and development expenses included a favorable foreign currency impact of approximately 2%.

Sales and Marketing

 

(In millions, except percentages)    Three Months Ended
September 30,
    Percentage
Change
 


     2015     2014        

Sales and marketing

   $      3,333      $      3,728        (11)%   

As a percent of revenue

     16%        16%        0ppt   


Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs.

 

36


Table of Contents

PART I

Item 2

 

Sales and marketing expenses decreased $395 million or 11%, primarily due to a decline in phones advertising and marketing program costs, and a reduction in headcount-related expenses, partially offset by Windows 10 marketing expenses. Sales and marketing expenses included a favorable foreign currency impact of approximately 6%.

General and Administrative

 

(In millions, except percentages)    Three Months Ended
September 30,
    Percentage
Change
 


     2015     2014        

General and administrative

   $      1,084      $      1,151        (6)%   

As a percent of revenue

     5%        5%        0ppt   


General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees.

General and administrative expenses decreased $67 million or 6%, mainly due to lower headcount-related expenses. General and administrative expenses included a favorable foreign currency impact of approximately 3%.

IMPAIRMENT, INTEGRATION, AND RESTRUCTURING EXPENSES

Impairment, integration, and restructuring expenses include costs associated with the impairment of goodwill and intangible assets related to our phone hardware business, employee severance expenses and costs associated with the consolidation of facilities and manufacturing operations related to restructuring activities, and systems consolidation and other business integration expenses associated with our acquisition of NDS.

Impairment, integration, and restructuring expenses were $1.1 billion during the three months ended September 30, 2014, comprised mainly of restructuring charges of $1.0 billion, including employee severance expenses and the write-down of certain assets in connection with our Phone Hardware Integration Plan. See Note 13 – Restructuring Charges of the Notes to Financial Statements for discussion of our restructuring plans.

OTHER INCOME (EXPENSE), NET

The components of other income (expense), net were as follows:

 

(In millions)             


Three Months Ended September 30,    2015     2014  

Dividends and interest income

   $      199      $      225   

Interest expense

       (249       (161

Net recognized gains on investments

     2        79   

Net losses on derivatives

     (103     (134

Net gains (losses) on foreign currency remeasurements

     (36     78   

Other

     (93     (35


 


Total

   $ (280   $ 52   
    


 


We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities and gains (losses) on certain balance sheet amounts from foreign exchange rate changes.

Dividends and interest income decreased due to lower yields offset in part by higher portfolio balances. Interest expense increased primarily due to higher outstanding long-term debt. Net recognized gains on investments decreased primarily due to lower gains on sales of equity and fixed income securities and higher other-than-temporary impairments. Net losses on derivatives decreased due to higher gains on equity derivatives and lower losses on commodity and interest rate derivatives, offset in part by higher losses on foreign exchange contracts. Other during the current period reflects a loss on a divestiture and recognized losses from certain joint ventures.

 

37


Table of Contents

PART I

Item 2

 

INCOME TAXES

Our effective tax rate for the three months ended September 30, 2015 and 2014 was 16% and 23%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico.

This quarter’s effective tax rate was lower than the prior year’s first quarter effective tax rate, primarily due to changes in the geographic mix of our business and lower non-deductible operating losses.

On July 27, 2015, the U.S. Tax Court issued an opinion in Altera Corp. v. Commissioner related to the treatment of stock-based compensation expense in an intercompany cost-sharing arrangement. A final decision has yet to be issued by the U.S. Tax Court due to other outstanding procedural issues. At this time, the U.S. Department of the Treasury has not withdrawn the requirement from its regulations to include stock-based compensation. The I.R.S. has the right to appeal the U.S. Tax Court decision. We concluded that no adjustment to our consolidated financial statements is appropriate at this time due to the uncertainties with respect to the ultimate resolution of this case.

Tax contingencies and other income tax liabilities were $11.9 billion and $12.1 billion as of September 30, 2015 and June 30, 2015, respectively, and are included in other long-term liabilities. This decrease relates primarily to a partial settlement of the I.R.S. audit for tax years 2007 to 2009. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, and settled a portion of the I.R.S. audit for tax years 2007 to 2009 during the current quarter, we remain under audit for those years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of September 30, 2015, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2015.

We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2015, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements.

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $99.4 billion as of September 30, 2015, compared with $96.5 billion as of June 30, 2015. Equity and other investments were $11.4 billion as of September 30, 2015 compared with $12.1 billion as of June 30, 2015. Our short-term investments are primarily to facilitate liquidity and for capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities.

Of the cash, cash equivalents, and short-term investments at September 30, 2015, $96.0 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was $2.1 billion. As of September 30, 2015, approximately 80% of the cash equivalents and short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 5% were invested in corporate notes and bonds of U.S. companies, and approximately 5% were invested in U.S. mortgage- and asset-backed securities, all of which are denominated in U.S. dollars.

 

38


Table of Contents

PART I

Item 2

 

Securities lending

We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Our securities lending payable balance was $154 million as of September 30, 2015. Our average and maximum securities lending payable balances for the three months ended September 30, 2015 were $201 million and $761 million, respectively. Intra-year variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities.

Valuation

In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, and U.S. government securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, common and preferred stock, foreign government bonds, mortgage- and asset-backed securities, U.S. government and agency securities, and certificates of deposit. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio.

A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.

Cash Flows

Cash flows from operations increased $240 million to $8.6 billion, mainly due to lower operating expenditures, offset in part by a decrease in cash received from customers. Cash used in financing increased $670 million to $3.6 billion, mainly due to a $1.9 billion increase in cash used for common stock repurchases, a $220 million decrease in excess tax benefits from stock-based compensation, and a $168 million increase in dividends paid, offset in part by a $1.8 billion increase in proceeds from issuances of debt, net of repayments. Cash used in investing decreased $2.7 billion to $5.1 billion, mainly due to a $2.6 billion decrease in cash used for net investment purchases, sales, and maturities.

Debt

We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. See Note 11 – Debt of the Notes to Financial Statements for further discussion.

Unearned Revenue

Unearned revenue at September 30, 2015 was comprised mainly of unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or annually at the beginning of each coverage period and accounted for as subscriptions with revenue recognized ratably over the coverage period. Unearned revenue at September 30, 2015 also included payments for: post-delivery support and consulting services to be performed in the future; Windows 10 licenses; Xbox Live subscriptions

 

39


Table of Contents

PART I

Item 2

 

and prepaid points; Microsoft Dynamics business solutions products; Office 365 subscriptions; Skype prepaid credits and subscriptions; Bundled Offerings; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria.

The following table outlines the expected future recognition of unearned revenue as of September 30, 2015:

 

(In millions)       


Three Months Ending,

        

December 31, 2015

   $ 9,336   

March 31, 2016

     6,831   

June 30, 2016

     4,180   

September 30, 2016

     1,256   

Thereafter

     2,784   


Total

   $   24,387   
    


Share Repurchases

During the three months ended September 30, 2015, we repurchased 89 million shares of our common stock for $4.0 billion under a $40.0 billion share repurchase plan approved by our Board of Directors on September 16, 2013. The share repurchase program became effective on October 1, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. While the program has no expiration date, we intend to complete it by December 31, 2016. As of September 30, 2015, $17.9 billion remained of our $40.0 billion share repurchase program. All repurchases were made using cash resources.

Dividends

See Note 16 – Stockholders’ Equity of the Notes to Financial Statements for further discussion.

Off-Balance Sheet Arrangements

We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact on our consolidated financial statements during the periods presented.

Other Planned Uses of Capital

We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years in support of our productivity and platform strategy. We have operating leases for most U.S. and international sales and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources.

Liquidity

We earn a significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect existing domestic cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, debt maturities, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.

 

40


Table of Contents

PART I

Item 2

 

Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates.

RECENT ACCOUNTING GUIDANCE

See Note 1 – Accounting Policies of the Notes to Financial Statements for further discussion.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories.

Revenue Recognition

Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can be accounted for as separate units of accounting, and if so, the fair value for each of the elements.

Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products. Certain volume licensing arrangements include a perpetual license for current products combined with rights to receive unspecified future versions of software products and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period.

Software updates are evaluated on a case-by-case basis to determine whether they meet the definition of an upgrade, which may require revenue to be deferred and recognized when the upgrade is delivered. If it is determined that implied post-contract customer support (“PCS”) is being provided, revenue from the arrangement is deferred and recognized over the implied PCS term. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available.

Microsoft enters into arrangements that can include various combinations of software, services, and hardware. Where elements are delivered over different periods of time, and when allowed under U.S. GAAP, revenue is allocated to the respective elements based on their relative selling prices at the inception of the arrangement, and revenue is recognized as each element is delivered. We use a hierarchy to determine the fair value to be used for allocating revenue to elements: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence, and (iii) best estimate of selling price (“ESP”). For software elements, we follow the industry specific software guidance which only allows for the use of VSOE in establishing fair value. Generally, VSOE is the price charged when the deliverable is sold separately or the price established by management for a product that is not yet sold if it is probable that the price will not change before introduction into the marketplace. ESPs are established as best estimates of what the selling prices would be if the deliverables were sold regularly on a stand-alone basis. Our process for determining ESPs requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable.

In January 2015, we announced Windows 10 will be free to all qualified existing users of Windows 7 and Windows 8.1. This offer differs from historical offers preceding the launch of new versions of Windows as it is being made available for free to existing users in addition to new customers after the offer announcement. We evaluated the nature and accounting treatment of the Windows 10 offer and determined that it represents a marketing and promotional activity, in part because the offer is being made available for free to existing users. As this is a marketing and promotional activity, revenue recognition of new sales of Windows 8 will continue to be recognized as delivered.

 

41


Table of Contents

PART I

Item 2

 

Customers purchasing a Windows 10 license will receive unspecified updates and upgrades over the life of their Windows 10 device at no additional cost. As these updates and upgrades will not be sold on a stand-alone basis, we are unable to establish VSOE. Accordingly, revenue from licenses of Windows 10 will be recognized ratably over the estimated life of the related device, which ranges between two to four years.

Impairment of Investment Securities

We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.

Goodwill

We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit.

Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital.

The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.

As of September 30, 2015, none of our reporting units were considered to be at risk of impairment.

Research and Development Costs

Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products.

Legal and Other Contingencies

The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements.

 

42


Table of Contents

PART I

Item 2, 3

 

Income Taxes

The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements.

Inventories

Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. The determination of market value and the estimated volume of demand used in the lower of cost or market analysis require significant judgment.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

RISKS

We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our consolidated financial statements.

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar.

Interest Rate

Our fixed-income portfolio is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities.

Equity

Our equity portfolio consists of global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global commodity indices and expect their economic risk and return to correlate with these indices.

 

43


Table of Contents

PART I, II

Item 3, 4, 1, 1A

 

VALUE-AT-RISK

We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP, but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed based on the historical volatilities and correlations among foreign exchange rates, interest rates, equity prices, and commodity prices, assuming normal market conditions.

The VaR is calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk.

The following table sets forth the one-day VaR for substantially all of our positions as of September 30, 2015 and June 30, 2015 and for the three months ended September 30, 2015:

 

(In millions)       


     September 30,
2015
    June 30,
2015
   

Three Months Ended
September 30,

2015

 
                    


Risk Categories                Average     High     Low  

Foreign currency

     $  218        $  120        $  158        $  258        $  103   

Interest rate

     $    57        $    51        $    56        $    62        $    50   

Equity

     $  156        $  149        $  150        $  160        $  137   

Commodity

     $    11        $    13        $    11        $    13        $      8   


Total one-day VaR for the combined risk categories was $324 million at September 30, 2015 and $237 million at June 30, 2015. The total VaR is 27% less at September 30, 2015, and 29% less at June 30, 2015, than the sum of the separate risk categories in the table above due to the diversification benefit of the combination of risks.

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal control over financial reporting during the quarter ended September, 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

See Note 15 – Contingencies of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for information regarding legal proceedings in which we are involved.

ITEM 1A. RISK FACTORS

Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock.

 

44


Table of Contents

PART II

Item 1A

 

We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins.

Competition in the technology sector

Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers.

Competition among platforms, ecosystems, and devices

An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms, applications, and services.

 

   

A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, and wearables. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform. We also offer some vertically-integrated hardware and software products and services; however, our competitors in smartphones and tablets have established significantly larger user bases. Shifting a portion of our business to a vertically integrated model will increase our cost of revenue and reduce our operating margins.

 

   

We derive substantial revenue from licenses of Windows operating systems on personal computers. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. In addition, some of our devices compete with products made by our OEM partners, which may affect their commitment to our platform.

 

   

The success of the Windows Phone platform is an important element of our goal to enhance personal productivity in a mobile-first and cloud-first world. The marketplace among mobile phone platforms is highly competitive. We may face issues in selecting, engaging, or securing support from operators and retailers for Windows phones due to, for instance, inadequate sales training or incentives, or insufficient marketing support for the Windows Phone platform.

 

   

Competing platforms have application marketplaces (sometimes referred to as “stores”) with scale and significant installed bases. The variety and utility of applications available on a platform are important to device purchasing decisions. Users incur costs to move data and buy new applications when switching platforms. To compete, we must successfully enlist developers to write applications for our marketplace and ensure that these applications have high quality, customer appeal, and value. Efforts to compete with competitors’ application marketplaces may increase our cost of revenue and lower our operating margins.

Business model competition

Companies compete with us based on a growing variety of business models.

 

   

Even as we transition to a mobile-first and cloud-first strategy, the license-based proprietary software model generates most of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model.

 

45


Table of Contents

PART II

Item 1A

 

   

Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products.

 

   

Some companies compete with us using an open source business model by modifying and then distributing open source software at nominal cost to end-users, and earning revenue on advertising or complementary services and products. These firms do not bear the full costs of research and development for the software. Some open source software vendors develop software that mimics the features and functionality of our products.

The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income.

Our increasing focus on services presents execution and competitive risks.    A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow as a productivity and platform company for the mobile-first and cloud-first world. At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which suite of cloud-based services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We are undertaking cultural and organizational changes to drive accountability and eliminate obstacles to innovation. The Company’s increasing reliance on data-driven insights is becoming more important to the success of key opportunities in monetization, customer perceptions of quality, and operational efficiency. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including:

 

   

Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share.

 

   

Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other television-related devices.

 

   

Continuing to enhance the attractiveness of our cloud platforms to third-party developers.

 

   

Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data.

 

   

Making our suite of cloud-based services platform agnostic, available on a wide range of devices and ecosystems, including those of our competitors.

It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income.

We make significant investments in new products and services that may not achieve expected returns.    We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, the Microsoft Office system, Bing, Windows Phone, Windows Server, the Windows Store, the Microsoft Azure Services platform, Office 365, other cloud-based services offerings, and the Xbox entertainment platform. We also invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment including PCs, tablets, phones, and gaming devices. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically.

 

46


Table of Contents

PART II

Item 1A

 

The launch of Windows 10, with free upgrades available to existing users of Windows 7 and 8.1, constitutes the most ambitious update effort we have ever undertaken. We have done extensive preparation and compatibility testing for applications and devices to help ensure a positive experience for our users installing Windows 10. However, if users have a negative upgrade experience, or the community reacts negatively to the process we are following to promote and undertake the upgrades, the reception of Windows 10 in the marketplace may be harmed. In addition, we anticipate that Windows 10 will enable new post-license monetization opportunities beyond initial license revenues. Our failure to realize these opportunities to the extent we expect could have an adverse impact on our revenues.

Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue.

Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business.    We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. These transactions and arrangements involve significant challenges and risks including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that we have difficulty integrating new employees, business systems, and technology, or that they distract management from our other businesses. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements, such as increased revenue, enhanced efficiencies, or increased market share, or the benefits may ultimately be smaller than we expected. These events could adversely affect our operating results or financial condition.

If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings.    We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We may be required to record a significant charge in our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations. For example, in the fourth quarter of fiscal year 2015, we recorded a $5.1 billion charge for the impairment of goodwill and a $2.2 billion charge for the impairment of intangible assets.

We may not earn the revenues we expect from our intellectual property rights.

We may not be able to adequately protect our intellectual property rights

Protecting our global intellectual property rights and combating unlicensed copying and use of our software and other intellectual property is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. Our revenue in these markets may grow slower than the underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate consumers about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue.

We may not receive expected royalties from our patent licenses

We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some instances, by licensing our patents to others in return for a royalty. Changes in the law may weaken our ability to prevent the use of

 

47


Table of Contents

PART II

Item 1A

 

patented technology or collect revenue for licensing our patents. These include legislative changes and regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties, or may contest the scope and extent of their obligations. Finally, the royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, selling price changes in products using licensed patents, or the difficulty of discovering infringements.

Third parties may claim we infringe their intellectual property rights.    From time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface and Lumia phones. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so.

We may not be able to protect our source code from copying if there is an unauthorized disclosure of source code.    Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If a significant portion of our source code leaks, we might lose future trade secret protection for that source code. It may become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the next paragraph.

Cyber-attacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our competitive position.

Security of Microsoft’s information technology

Threats to IT security can take a variety of forms. Individual and groups of hackers, and sophisticated organizations including state-sponsored organizations or nation-states themselves, may take steps that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software to attack our products and services and gain access to our networks and datacenters, using social engineering techniques, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Cyber threats are constantly evolving, thereby increasing the difficulty of detecting and successfully defending against them. Cyber threats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our network or data security could disrupt the security of our internal systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our competitive position, result in theft or misuse of our intellectual property or other assets, require us to allocate more resources to improved technologies, or otherwise adversely affect our business.

In addition, our internal IT environment continues to evolve. Often we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge.

Security of our products, services, devices, and customers’ data

Security threats are a particular challenge to companies like us whose business is technology products and services. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure to ensure the reliability of our services and the protection of their data. Hackers tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. The security of our products and services is important in our customers’ purchasing decisions.

 

48


Table of Contents

PART II

Item 1A

 

To defend against security threats, both to our internal IT systems and those of our customers, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide customers security tools such as firewalls and anti-virus software.

The cost of these steps could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install security patches. Any of these actions by customers could adversely affect our revenue. Actual or perceived vulnerabilities may lead to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenges. Legislative or regulatory action in these areas may increase the costs to develop, implement, or secure our products and services.

Disclosure of personal data could cause liability and harm our reputation.    As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of customer data we or our vendors store and manage. Improper disclosure could harm our reputation, lead to legal exposure to customers, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer data, perceptions that the privacy of personal information is not satisfactorily protected could inhibit sales of our products or services, and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer expectations or governmental rules or actions, may cause higher operating expenses.

We may have outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure.    Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Exchange Online, Office 365, SharePoint Online, OneDrive, Skype, Xbox Live, Microsoft Azure, Outlook.com, Windows Stores, and Microsoft Account services. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex. It requires that we maintain an Internet connectivity infrastructure that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data or insufficient Internet connectivity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, damage to our reputation and loss of current and potential users, subscribers, and advertisers, each of which may harm our operating results and financial condition.

Government litigation and regulatory activity relating to competition rules may limit how we design and market our products.    As a leading global software and device maker, we are closely scrutinized by government agencies under U.S. and foreign competition laws. An increasing number of governments are regulating competition law activities and this includes increased scrutiny in potentially large markets such as the European Union, the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business.

 

49


Table of Contents

PART II

Item 1A

 

The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. In 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments offered by Microsoft to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products.

Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices on our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. Because these jurisdictions only recently implemented competition laws, their enforcement activities are unpredictable.

Government regulatory actions and court decisions such as these may hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including:

 

   

We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely.

 

   

We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property.

 

   

The rulings described above may be precedent in other competition law proceedings.

 

   

We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions.

 

   

Our ability to realize anticipated Windows 10 post-sale monetization opportunities may be limited.

Our global operations subject us to potential liability under anti-corruption, trade protection, and other laws and regulations.    The Foreign Corrupt Practices Act and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents. From time to time, we receive inquiries from authorities in the U.S. and elsewhere and reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. While we devote substantial resources to our global compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws could result in significant fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Operations outside the U.S. may be affected by changes in trade protection laws, policies, and measures, and other regulatory requirements affecting trade and investment. We may be subject to legal liability and reputational damage if we sell goods or services in violation of U.S. trade sanctions on countries such as Iran, North Korea, Cuba, Sudan, and Syria.

Other regulatory areas that may apply to our products and online services offerings include user privacy, telecommunications, data storage and protection, and online content. For example, regulators may take the position that our offerings such as Skype are covered by laws regulating telecommunications services. Applying these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Increasing concern about government surveillance practices around the world

 

50


Table of Contents

PART II

Item 1A

 

may lead to increased regulation requiring local data hosting obligations or the use of domestic hosting providers. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity. Geopolitical instability may lead to sanctions and impact our ability to do business in some geographies.

Our business depends on our ability to attract and retain talented employees.    Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting efforts, or if we cannot retain key employees, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution.

We have claims and lawsuits against us that may result in adverse outcomes.    We are subject to a variety of claims and lawsuits. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact on our consolidated financial statements could occur for the period in which the effect of an unfavorable final outcome becomes probable and reasonably estimable.

We may have additional tax liabilities.    We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We regularly are under audit by tax authorities. Economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our consolidated financial statements in the period or periods in which that determination is made.

We earn a significant amount of our operating income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions to the U.S. may result in higher effective tax rates for the company. In addition, there have been proposals from Congress to change U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. Although we cannot predict whether or in what form any proposed legislation may pass, if enacted, it could have a material adverse impact on our tax expense and cash flows.

Our hardware and software products may experience quality or supply problems.    Our vertically-integrated hardware products such as Xbox consoles, Surface devices, phones, and other devices we design, manufacture, and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or address such issues through design, testing, or warranty repairs. We acquire some device components from sole suppliers. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity constraint or industry shortages, we may not obtain timely replacement supplies, resulting in reduced sales. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, phones, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer.

Our software products also may experience quality or reliability problems. The highly sophisticated software products we develop may contain bugs and other defects that interfere with their intended operation. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge.

Our global business exposes us to operational and economic risks.    Our customers are located in over 200 countries and a significant part of our revenue comes from international sales. The global nature of our business creates operational and economic risks. Emerging markets are a significant focus of our international growth strategy. The developing nature of these markets presents several risks, including deterioration of social, political,

 

51


Table of Contents

PART II

Item 1A

 

labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Although we hedge a portion of our international currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenue. Competitive or regulatory pressure to make our pricing structure uniform might require that we reduce the sales price of our software in the U.S. and other countries.

Catastrophic events or geopolitical conditions may disrupt our business.    A disruption or failure of our systems or operations because of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and magnifies the potential impact of prolonged service outages on our operating results.

Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may cause supply chain disruptions for hardware manufacturers, either of which may adversely affect our revenue. The long-term effects of climate change on the global economy or the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy or other natural resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services.

Adverse economic or market conditions may harm our business.    Worsening economic conditions, including inflation, recession, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Substantial revenue comes from our U.S. government contracts. An extended federal government shutdown resulting from failing to pass budget appropriations, adopt continuing funding resolutions or raise the debt ceiling, and other budgetary decisions limiting or delaying federal government spending, could reduce government IT spending on our products and services and adversely affect our revenue.

Our product distribution system relies on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption.

Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase.

We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by unusual events that affect global financial markets. A significant part of our investment portfolio comprises U.S. government securities. If global credit and equity markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our financial results.

 

52


Table of Contents

PART II

Item 2, 5

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Items 2(a) and (b) are not applicable.

(c) STOCK REPURCHASES

 

Period   Total Number
of Shares
Purchased
   

Average

Price Paid
per Share

    Total Number of
Shares Purchased as
Part of Publicly
Announced Plans
or Programs
   

Approximate Dollar Value of

Shares that May Yet be

Purchased under the Plans
or Programs

 


                       (in millions)  

July 1, 2015 – July 31, 2015

                 34,154,186        $  45.52                     34,154,186        $  20,328   

August 1, 2015 – August 31, 2015

             26,525,038        $  44.90                 26,525,038        $  19,137   

September 1, 2015 – September 30, 2015

             28,793,609        $  43.55                 28,793,609        $  17,883   


               89,472,833                         89,472,833           
            


                  


       

During the three months ended September 30, 2015, we repurchased 89 million shares of our common stock for $4.0 billion under a $40.0 billion share repurchase plan approved by our Board of Directors on September 16, 2013. The share repurchase program became effective on October 1, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. While the program has no expiration date, we intend to complete it by December 31, 2016. As of September 30, 2015, $17.9 billion remained of the $40.0 billion share repurchase program. All repurchases were made using cash resources. Our stock repurchases may occur through open market purchases or pursuant to a Rule 10b5-1 trading plan.

Excluded from this disclosure are shares repurchased to settle statutory employee tax withholding related to the vesting of stock awards.

ITEM 5. OTHER INFORMATION

Effective October 16, 2015, the Company amended the Senior Executive Severance Benefit Plan (the “Severance Plan”), which provides to certain executives who participate in the Company’s Executive Incentive Program a severance benefit if they are terminated without cause. As amended, this benefit consists of (i) a severance payment equal to one-times annual base salary plus target annual cash award, (ii) pro-rata payment of the executive’s annual cash award, (iii) six months of continued health care premiums under COBRA, (iv) twelve months of outplacement assistance, (v) continued vesting in stock awards that would otherwise vest in the 12 months after termination of employment, (vi) an extra year of credit towards eligibility for “retirement” under stock awards that are eligible for retirement-based vesting, and (vii) continued vesting in a pro-rata portion of any performance stock awards (with the number of shares being prorated equal to the lesser of the earned award shares or target award shares). There is no change-in-control provision in the Severance Plan. To receive the severance benefit, the executive is required to execute a separation agreement that includes a release of claims, confidentiality and non-disparagement provisions, and twelve-month non-compete/non-solicitation restrictions.

 

53


Table of Contents

PART II

Item 6

 

ITEM 6. EXHIBITS

 

  10.17*    Executive Officer Incentive Plan
  10.18*    Form of Executive Officer Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan
  10.21*    Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan (Service-Based)
  10.22*    Senior Executive Severance Benefit Plan
  10.25*    Form of Executive Officer Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan