MSFT

Business Context and Reporting Period

This Form 10-Q covers Microsoft Corporation for the quarterly period ended March 31, 2002 (Fiscal Year 2002, Q3). The company develops, manufactures, and licenses software products, including operating systems, productivity applications, and server applications. Key business developments during the period included the global launch of the Xbox video game system and the continued rollout of Windows XP.

Key Financial Metrics

Margins (Q3 2002): Operating margin was approximately 45.5%. Cost of revenue increased to 19.3% of revenue, primarily due to the launch of Xbox.

Material Changes vs. Prior Period

• Revenue Growth: Revenue increased 13% year-over-year for both the quarter and the nine-month period. Growth was driven by the Xbox launch, Windows XP licensing, and MSN subscriber growth.
• Investment Income Volatility: Investment income dropped significantly for the nine-month period ($312 million vs. $2,584 million prior year) due to a $3.14 billion write-down for other-than-temporary impairments, primarily related to AT&T investments. This was partially offset by a $1.25 billion gain from the Expedia transaction.
• Accounting Changes: The company adopted SFAS 141 and SFAS 142, eliminating goodwill amortization. This resulted in a cumulative effect of accounting change reducing net income by $375 million in the nine-month period.
• Legal Contingency Charge: General and administrative expenses included a $660 million charge for a contingent liability related to overcharge class action lawsuits.
• Stock Repurchases: The company repurchased 35.9 million shares for $2.0 billion in the first nine months of 2002, a decrease from 65.4 million shares for $4.4 billion in the prior year.

Guidance, Outlook, and Risks

• Outlook: Management expects revenue growth to be influenced by the mix of multi-year licensing agreements and the recovery in corporate IT spending. Continued investment in Xbox, Tablet PC, and security solutions is anticipated.
• Legal Proceedings:
  • U.S. v. Microsoft: A settlement was reached with the DOJ and nine states; a hearing on approval was held in March 2002. Nine states and D.C. continue to litigate remedies.
  • Class Actions: A proposed settlement for overcharge class actions was rejected by the court in January 2002. The company recorded a $660 million liability but intends to vigorously defend the cases.
  • European Commission: Proceedings allege failure to disclose interoperability information; Microsoft denies allegations.
  • New Litigation: Lawsuits filed by Netscape, Be Incorporated, and Sun Microsystems alleging antitrust and unfair competition violations.
• Risks: Risks include market acceptance of new products (Xbox), reliance on sole-source suppliers for Xbox components, currency fluctuations (negative impact of weaker Yen and Euro), and potential impairment of investment securities.

Investor Verification Checklist

• Investment Portfolio Health: Verify the status of the AT&T investment write-down and the potential impact of the AT&T/Comcast merger on future investment income.
• Legal Exposure: Monitor the outcome of the non-settling states' remedies phase in the U.S. antitrust case and the status of the rejected class action settlement.
• Xbox Economics: Assess the profitability trajectory of the Xbox division, given the high cost of revenue (19.3%) and recent price reductions in Europe.
• Revenue Recognition: Review the impact of multi-year licensing agreements on the timing of revenue recognition, particularly for Office and Windows.
• Goodwill Amortization: Confirm the impact of the cessation of goodwill amortization on future earnings comparisons.