Microsoft Corporation Financial Highlights
Fourth Quarter and Fiscal Year 1999
(All growth percentages are comparisons
to the comparable period of fiscal 1998)
Revenue
Revenue of $5.76 billion in the June quarter of fiscal 1999 increased 39% over the fourth quarter of fiscal 1998. For the year, revenue was $19.75 billion, an increase of 29% over the prior year. Revenue growth reflected the continued adoption of Microsoft® Windows® operating systems, including Windows 98, Windows NTÒ Workstation, and Windows NT Server; along with the Company's server applications. Microsoft Office also was a driver of revenue growth, particularly in the June quarter with the release of the latest version of the suite of desktop applications, Microsoft Office 2000. Reported revenue also included $200 million related to fulfillment of the Microsoft Office 2000 Technology Guarantee. Certain customers acquiring Microsoft Office 97 or related applications are entitled to a free upgrade to the corresponding Microsoft Office 2000 application. The value of the upgrade expected to be redeemed by the customer is treated as unearned revenue until fulfillment of the upgrade. Unearned revenue of $200 million at June 30, 1999, related primarily to localized versions of Microsoft Office, will be earned upon fulfillment of the related upgrade.
Revenue growth was also positively impacted by a reduction in estimated channel returns of $250 million. The Company's business model continues to evolve from selling packaged products to selling organizational licenses and subscriptions. The Company's products are generally delivered to customers through a multi-tiered channel of distributors and resellers, but the distribution model is also changing for selected retail products that are now being shipped straight to resellers and other selected products that are now being shipped straight to customers. Due to these changes in channel mechanics and the business model, the risk of returns of product from distributors and resellers has declined. Accordingly, the estimate for future product returns was reduced.
As previously announced, the Company changed the way it reports revenue and costs associated with product support, consulting, MSN™ Internet access, and certification and training of system integrators. Amounts received from customers for these activities have been classified as revenue in a manner more consistent with Microsoft's primary businesses. Direct costs of these activities are classified as cost of revenue. Prior financial statements and disclosures have been reclassified for consistent presentation.
The Company also announced two changes related to the ratable recognition of revenue for a portion of its revenue. A new accounting rule that interprets AICPA Statement of Position (SOP) 97-2 requires companies to use the average sales price of each undelivered element of software arrangements. Prior authoritative guidance allowed a comparison of the total price differential between a product sold through different channels of distribution to derive the value of undelivered elements offered to customers acquiring product from one channel but not the other. Upon adoption of this new rule in the June quarter, the percentages of the total arrangement treated as unearned decreased. This change in the timing of revenue recognition reduces the amount of Windows and Office sales treated as unearned and increases the amount of revenue recognized upon shipment. Additionally, as part of the Company's long range planning process and a review of product shipment cycles, it was determined that the life cycle of Windows should be extended from two years to three years. The change in life cycle mostly offsets the change in unearned revenue percentages. The impact on the June quarter was to increase reported revenue $80 million.
Business Divisions
Windows platforms products, developed and marketed by the Consumer Windows Division and the Business and Enterprise Division, include primarily Windows 98, Windows NT Workstation, and Windows NT Server. Revenue grew 32% to $2.25 billion in the fourth quarter while annual revenue grew 35% to $8.50 billion. Windows-based units licensed through the PC original equipment manufacturer (OEM) channel, particularly Windows NT Workstation, increased strongly over the prior year. Organizational licensing of Windows NT Workstation and Windows 98 also contributed to the growth. Windows NT Server revenue growth was healthy during fiscal 1999, particularly in the fourth quarter.
Productivity applications and developer products include desktop applications, server applications, and developer tools. Revenue increased 48% to $2.93 billion in the June quarter. Fiscal 1999 revenue grew 25% to $8.82 billion. Revenue from Microsoft Office integrated suites, including the Standard, Professional, Premium, and Small Business Editions was very strong, reflecting the launch of Microsoft Office 2000 in many countries. Revenue also included the recognition of $200 million of previously unearned revenue, due to the impact of the Microsoft Office 2000 Technology Guarantee noted above. Server applications revenue, principally Microsoft Exchange Server and Microsoft SQL Server™, increased strongly over the comparable quarter of the prior year. Microsoft SQL Server 7.0 revenue was particularly robust. Developer tools revenue was steady.
Consumer, Commerce, and Other revenue was $593 million, up 26% from the comparable quarter of fiscal 1998. Fiscal 1999 revenue grew 25% to $2.43 billion. Online advertising revenue rose substantially and subscription revenue increased moderately, while revenue from hardware products, consumer software, and Microsoft Press was relatively flat.
Channels of Distribution
Microsoft distributes its products primarily through OEM licenses, organization licenses, and retail packaged products. OEM channel revenue represents license fees from original equipment manufacturers who pre-install Microsoft products, primarily on PCs. Microsoft has three major geographic sales and marketing organizations: the South Pacific and Americas Region; the Europe, Middle East, and Africa Region; and the Asia Region. Sales of organization licenses and retail packaged products via these channels are primarily through and to distributors and resellers.
Fourth quarter revenue from OEMs of $1.64 billion represented an increase of 27% over the comparable quarter of fiscal 1998. OEM revenue in fiscal 1999 totaled $6.40 billion, up 36% over fiscal 1998. PC shipment growth coupled with an increased penetration of higher value 32-bit operating systems drove the OEM revenue increase over the prior year.
For the June quarter, revenue in the South Pacific and Americas Region increased 48% to $2.36 billion. Office revenue was particularly strong, reflecting the launch of Microsoft Office 2000. Windows NT Server and server applications also showed strong growth. For the year, revenue grew 30% to $7.25 billion. Server applications, Windows NT Server, Windows NT Workstation, and Microsoft Office all exhibited solid year-over-year growth rates. Organizational licensing activity was strong. Revenue growth was solid in the U.S. and moderate in Latin America and the South Pacific.
In the Europe, Middle East, and Africa Region, fourth quarter revenue of $1.20 billion was up 33% compared to the fourth quarter of fiscal 1998. Windows NT Server, Windows NT Workstation, Microsoft Office, and server applications grew strongly compared to the prior year, particularly via organizational licensing. Fiscal 1999 revenue of $4.33 billion increased 24% over fiscal 1998. All major products grew strongly over fiscal 1998. Revenue growth was solid in the United Kingdom, Germany, and France, and was particularly high in Sweden, the Netherlands, and Spain.
Revenue in the Asia Region in the June quarter of $570 million increased 53% from the fourth quarter of the prior year, reflecting better local economic conditions and strong desktop applications revenue, particularly in Japan. For the year, revenue rose 20% to $1.78 billion. Japan, Taiwan, China, Hong Kong and Southeast Asia had moderate annual growth, while Korea grew very strongly. As discussed below, strengthening local currencies positively impacted translated revenue compared to the prior year, particularly in Japan.
Translated international revenue is affected by foreign exchange rates. The impact of foreign exchange rates on revenue was positive in the June quarter, as most local currencies were strong versus the U.S. dollar. Had the rates from the prior year been in effect in the fourth quarter of fiscal 1999, translated international revenue billed in local currencies would have been $25 million lower. The impact of exchange rate fluctuations on translated international revenue in fiscal 1999 was nominal. Certain manufacturing, selling, distribution, and support costs are disbursed in local currencies, and a portion of international revenue is hedged, thus offsetting a portion of the translation exposure.
Operating Expenses
Microsoft encourages broad-based employee ownership of Microsoft stock through an employee stock option (ESO) program in which most employees are eligible to participate. Historically, exercise prices of grants of ESOs were struck at the lowest price in the 30 days following July 1 for annual grants and the 30 days after the start date for new employees. In connection with this practice, which is no longer employed, a charge of $217 million was recorded in the fourth quarter for fiscal 1999 compensation expense. This charge was calculated under the provisions of Accounting Principles Board Opinion 25 (APB 25) and was not the result of adoption of Statement of Financial Accounting Standard 123 (SFAS 123). Fiscal 1999 expense was reflected in operating costs as follows (in millions):
Cost of revenue $ 44
Research and development 105
Sales and marketing 46
General and administrative 22
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Total $217
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Cost of revenue as a percent of revenue was 11.6% in the fourth quarter, down from 16.2% the prior year. For the year, cost of revenue as a percent of revenue was 14.3%, compared to 16.1% the prior year. The percentage decreases resulted from the trend in mix shift to OEM and organizational licenses, the recognition of previously unearned revenue related to the Office 2000 Technology Guarantee, and the recognition of revenue in connection with the reduction of the channel returns estimate. Additionally, cost of revenue was positively impacted by a reduction in estimates of obsolete inventory and other manufacturing costs of $67 million. As discussed above, the Company's business model continues to evolve toward licensing from sales of packaged products through distribution channels. Consequently, risks associated with manufacturing and holding physical product have declined.
Research and development expenses increased 27% in the fourth quarter to $940 million, driven primarily by higher development headcount-related costs, including the ESO charge. Annual research and development expense grew 14% to $2.97 billion, reflecting higher development headcount-related costs offset by lower infrastructure and third-party development costs.
Sales and marketing expenses were $900 million in the June quarter, which represented 15.6% of revenue, compared to 16.6% in the fourth quarter of the prior year. The decrease was due to lower relative marketing costs. Fiscal 1999 sales and marketing expenses of $3.23 billion were 16.4% of revenue while fiscal 1998 expenses as a percent of revenue were 18.5%. Total sales and marketing expense as a percent of revenue decreased due to lower relative sales expenses and lower relative marketing costs.
General and administrative costs were $297 million in the fourth quarter compared to $128 million in the June quarter of the prior year. For the year, general and administrative costs increased to $689 million from $433 million. The increases for the quarter and the year were due primarily to higher legal fees, litigation expense, and headcount-related costs necessary to support the Company's expanding operations.
Other expenses include primarily the recognition of Microsoft's share of joint venture activities, including DreamWorks Interactive and the MSNBC entities.
Nonoperating Items and Income Taxes
Fourth quarter investment income increased to $485 million from $214 million in the fourth quarter of the prior year. The increase was due to realized gains of approximately $100 million and the larger investment portfolio generated by cash from operations. Fiscal 1999 investment income totaled $1.80 billion, up from $703 million in fiscal 1998. The increase resulted from the larger investment portfolio coupled with realized gains from the sale of certain bond and equity securities.
Excluding the impact of the gain on the sale of Softimage in the first quarter, the effective tax rate for fiscal 1999 was 35%. The fiscal 1999 effective tax rate was lower than in fiscal 1998 due to a legislative clarification of the foreign sales corporation rules as they apply to software and the nondeductible write-off of WebTV® in-process technologies in the first quarter of fiscal 1998.
Unearned Revenue
A portion of Microsoft's revenue is earned ratably over the product life cycle or, in the case of subscriptions, over the period of the license agreement.
End-users receive certain elements of the Company's products over a period of time. These elements include browser technologies and technical support. Consequently, Microsoft's earned revenue reflects the recognition of the fair value of these elements over the product's life cycle. As noted above, during the fourth quarter of fiscal 1999 the Company was required to change the methodology of attributing the fair value to undelivered elements. The percentage of revenue recognized ratably ranges from approximately 15% to 25% of Windows desktop operating systems and approximately 10% to 25% of desktop applications, depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three years for Windows and 18 months for desktop applications. The Company also sells subscriptions to certain products via maintenance and certain organization license agreements. At June 30, 1999, Windows platforms products unearned revenue was $2.17 billion and unearned revenue associated with productivity applications and developer products totaled $1.95 billion. Unearned revenue for other miscellaneous programs totaled $116 million at June 30, 1999.
Balance Sheet and Cash Flow
Cash and short-term investments totaled $17.24 billion as of June 30, 1999. Accounts receivable were $2.25 billion, up sequentially due to the launch of Office 2000 near the end of the period and resultant higher volumes of packaged product shipments. Cash flow from operations in the June quarter was $2.60 billion.
Equity and other investments at June 30, 1999 were $14.37 billion. The large sequential increase was due to the purchase of $5 billion of AT&T convertible preferred securities and warrants, $600 million of Nextel Communications Inc. common stock, and an increase in the market value of publicly traded securities in the portfolio.
During the June quarter, the Company repurchased 18.1 million shares of common stock under its stock repurchase program. Microsoft repurchased a total of 43.8 million shares during fiscal 1999. During fiscal 1998, the Company repurchased 42 million shares under forward settlement structured repurchases and paid cash for a portion of the purchase price. In the March quarter of fiscal 1999, the Company settled the remainder by returning 28 million shares, based upon the stock price on the date of settlement. The timing and method of settlement was at the discretion of the Company. The differential between the cash paid and the price of Microsoft common stock on the date of the agreement was originally reflected in common stock and paid-in capital.
To enhance its stock repurchase program, Microsoft sells equity put warrants. These put warrants entitle the purchasers to sell shares of Microsoft common stock to the Company on certain dates at specified prices. On June 30, 1999, 163 million warrants were outstanding with strike prices ranging from $59 to $65 per share. These put warrant contracts permit a net-share settlement at the Company's option.
Employee Stock Options (ESOs)
The Company encourages broad-based employee ownership of Microsoft stock through an ESO program in which the majority of employees are eligible to participate. At June 30, 1999, 766 million vested and unvested options were outstanding, compared to 5,109 million common shares outstanding.
The Company follows APB Opinion 25 to account for ESO plans in its published financial statements. Generally, no compensation cost is recognized because the option exercise price is equal to the market price of the underlying stock on the date of grant. Earnings per share calculations reflect exercised ESOs and the effect of outstanding ESOs under the treasury stock method. In addition, as required by Statement of Financial Accounting Standard 123 (SFAS 123), the Company discloses the value of ESO grants using the Black-Scholes option valuation method and the proforma impact of expensing such value over the vesting period of the ESOs in the notes to its annual financial statements.
ESOs are a claim on the increase in the value of the Company and Microsoft does not believe that there is a single income statement presentation that adequately measures that claim. Since employees cannot sell their ESOs, there is no subsequent transaction that provides validation of the Black-Scholes value of the ESO expensed over the vesting period. Although not currently its practice, the Company could "hedge" its ESOs by purchasing offsetting call options when ESOs are granted. The assumed hedge with a third party provides a theoretical basis for measuring and recognizing the cost of ESOs when granted.
In an effort to aid understanding of the economic cost of the Company's ESO plan, we are providing alternative proforma "look-through" income statements as a supplemental presentation of accounting for stock options. In this presentation, the assumed use of cash to purchase offsetting call options is expensed in the quarter that the ESOs are granted and hedged. This cost, based on the Black-Scholes value of the options (using similar assumptions to those disclosed in the 1998 Annual Report), is expensed through the income statement operating expense line items. ESOs granted after 1995 are treated as if they had been hedged and are therefore excluded from the average number of shares outstanding used to calculate EPS. Also, interest income is reduced for the proforma use of cash to purchase the hedges. This alternative presentation of accounting for ESOs is not in accordance with generally accepted accounting principles because the cost of the offsetting call options is expensed immediately and the related ESOs are excluded from EPS calculations. Nevertheless Microsoft believes this is meaningful information to investors.
ESOs are often granted upon hire to new employees and annually to current employees. The annual grant, made in the first quarter of the fiscal year, represents the majority of ESOs granted during any given fiscal year. Accordingly, the alternative presentation will show the widest variance from reported EPS in that quarter. Proforma results for the trailing twelve months are presented as a basis for annualized analysis. As a basis for comparison Microsoft has also provided the proforma net income and diluted earnings per share disclosures required by SFAS 123. |
