Business Context and Reporting Period
This Form 10-Q covers Microsoft Corporation for the quarterly period ended March 31, 2004 (Fiscal Q3 2004) and the nine months ended March 31, 2004. The filing includes unaudited financial statements and management discussion. The company operates in seven segments: Client, Server and Tools, Information Worker, Microsoft Business Solutions, MSN, Mobile and Embedded Devices, and Home and Entertainment.
Key Financial Metrics
| Metric | Q3 2004 | Q3 2003 | 9M 2004 | 9M 2003 |
|---|---|---|---|---|
| Revenue | $9,175 million | $7,835 million | $27,543 million | $24,122 million |
| Operating Income | $1,278 million | $2,744 million | $5,901 million | $8,005 million |
| Net Income | $1,315 million | $2,142 million | $5,478 million | $6,048 million |
| Diluted EPS | $0.12 | $0.20 | $0.50 | $0.55 |
| Cash from Operations | $4,970 million | $4,169 million | $12,968 million | $13,108 million |
| Cash & Short-term Investments | $56,407 million | $49,048 million | As of March 31, 2004 | |
| Stockholders' Equity | $70,580 million | $64,912 million | As of March 31, 2004 |
Debt and Liquidity: The company reported no material long-term debt. Liquidity is strong with total cash and short-term investments of $56.4 billion. Unearned revenue decreased to $7.5 billion from $9.0 billion in the prior fiscal year-end.
Material Changes vs. Prior Period
- Revenue Growth: Revenue increased 17% in Q3 and 14% for the nine months, driven by growth in Windows OEM licensing, Office 2003 adoption, Server products, and MSN advertising. Foreign exchange rates contributed approximately 5% to Q3 revenue growth.
- Operating Income Decline: Operating income fell 53% in Q3 and 26% for the nine months. This decline was primarily due to significant one-time charges:
- Sun Microsystems Settlement: A $1.92 billion charge recorded in Q3 (part of a $1.95 billion total payment made in April 2004).
- European Commission Fine: A $605 million accrual for a fine imposed by the EU regarding competition law violations.
- Stock-Based Compensation: A $2.21 billion expense in the nine-month period related to the completion of an employee stock option transfer program.
- Segment Performance:
- Client: Revenue up 16%; Operating income down 16% due to legal settlement expenses.
- Server and Tools: Revenue up 19%; Operating income turned negative ($635 million loss) due to $1.22 billion in legal settlement charges.
- Information Worker: Revenue up 18%; Operating income up 14%.
- MSN: Revenue up 16%; Operating income improved from a loss to $107 million profit, driven by advertising growth.
- Home and Entertainment: Revenue up 17% (Xbox volumes up 30%); Operating loss improved.
Guidance, Outlook, and Risks
- Outlook: Management expects PC shipments to grow in the low teens for the full fiscal year 2004. Server hardware shipment growth is expected to reach near mid-teens. Foreign exchange rates are expected to stabilize.
- Legal Contingencies:
- Antitrust: Ongoing appeals regarding the U.S. DOJ and state antitrust cases. The EU fine is being appealed.
- Class Actions: Settlements reached in multiple states (including California) with a maximum potential cost of $1.55 billion; estimated total cost to resolve is $1.0–$1.2 billion.
- Patent Litigation: Defending over 30 patent cases, including a $565 million judgment in the Eolas case (stayed pending appeal).
- Stock-Based Compensation: The company adopted SFAS 123 retroactively. New compensation plans now utilize stock awards rather than options. The option transfer program resulted in significant one-time expenses.
- Risks: Key risks include challenges from Open Source software, intellectual property infringement claims, security vulnerabilities, and potential declines in demand for PCs and servers.
Investor Verification Checklist
- One-Time Charges: Verify the impact of the $1.92 billion Sun settlement and $605 million EU fine on operating margins, noting these are non-recurring but significant.
- Stock Compensation: Review the $2.21 billion expense related to the stock option transfer program and its effect on future compensation costs.
- Unearned Revenue: Monitor the trend in unearned revenue ($7.5 billion), which decreased year-over-year, potentially indicating a shift in licensing mix or recognition timing.
- Legal Reserves: Assess the adequacy of the $972 million accrued liability for class action settlements and the potential for additional costs in patent litigation (e.g., Eolas).
- Cash Flow: Confirm that strong operating cash flow ($4.97 billion in Q3) remains sufficient to fund share repurchases ($1.6 billion in Q3) and dividends despite the legal charges.