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MICROSOFT CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND(Edgar Glimpses Via Acquire Media NewsEdge) 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, 2014, and our consolidated financial statements and the accompanying Notes to Financial Statements in this Form 10-Q. Microsoft is a technology leader focused on being the productivity and platform company for the mobile-first and cloud-first world. We strive to reinvent productivity to empower people and organizations to do more and achieve more. We create technology that transforms the way people work, play, and communicate across a wide range of computing devices. 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. 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. Key Opportunities and Investments We see significant opportunities for growth by investing research and development resources in the following areas: • Digital work and life experiences. • Our cloud operating system. • Our devices operating system and hardware. With investments in these areas, we work to fulfill the evolving needs of our customers in a mobile-first and cloud-first world. We view mobility broadly-not just by devices, but by experiences. Today, people move just as quickly into new contexts as to new locations. Mobility goes beyond devices users carry with them as they move from place to place, to encompass the rich collection of data, applications, and services that accompany them as they move from setting to setting in their lives. Many of our customers are "dual users," employing technology for work or school and also in their personal lives. 33 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Digital work and life experiences We believe we can significantly enhance the digital lives of our customers using our broad portfolio of communication, productivity, and information services. We work to deliver digital work and life experiences that are reinvented for the mobile-first and cloud-first world. Productivity will be the first and foremost objective, to enable people to meet and collaborate more easily, and to effectively express ideas in new ways. We will design applications as dual-use with the intelligence to partition data between work and life while respecting each person's privacy choices. The foundation for these efforts will rest on advancing our leading productivity, collaboration, and business process tools including Skype, OneDrive, OneNote, Outlook, Word, Excel, PowerPoint, Bing, and Dynamics. We see opportunity in combining these services in new ways that are more contextual and personal, while ensuring people, rather than their devices, remain at the center of the digital experience. We will offer our services across ecosystems and devices outside our own. As people move from device to device, so will their content and the richness of their services. We strive to engineer applications so users can find, try, and buy them in friction-free ways. Cloud operating system Today, businesses face important opportunities and challenges. Enterprises are asked to deploy technology that advances business strategy. They decide what solutions will make employees more productive, collaborative, and satisfied, or connect with customers in new and compelling ways. They work to unlock business insights from a world of data. They rely on our technology to manage employee corporate identity, and to manage and secure corporate information accessed and stored across a growing number of devices. To achieve these objectives, increasingly businesses look to leverage the benefits of the cloud. Helping businesses move to the cloud is one of our largest opportunities, and we believe we work from a position of strength. The shift to the cloud is driven by three important economies of scale: larger datacenters can deploy computational resources at significantly lower cost per unit than smaller ones; larger datacenters can coordinate and aggregate diverse customer, geographic, and application demand patterns improving the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. The cloud creates the opportunity for businesses to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers. With Azure, we are one of very few cloud vendors that run at a scale that meets the needs of businesses of all sizes and complexities. We believe the combination of Azure and Windows Server makes us the only company with a public, private, and hybrid cloud platform that can power modern business. We are working to enhance the return on information technology ("IT") investment by enabling enterprises to combine their existing datacenters and our public cloud into a single cohesive infrastructure. Businesses can deploy applications in their own datacenter, a partner's datacenter, or in our datacenters with common security, management, and administration across all environments, with the flexibility and scale they desire. Our cloud enables richer employee experiences. We enable organizations to securely adopt software-as-a-service applications (both our own and third-party) and integrate them with their existing security and management infrastructure. We will continue to innovate with higher level services including identity and directory services, rich data storage and analytics services, machine learning services, media services, web and mobile backend services, and developer productivity services. To foster a rich developer ecosystem, our digital work and life experiences will also be extensible, enabling customers and partners to further customize and enhance our solutions, achieving even more value. Our strategy requires continuing investment in datacenters and other infrastructure to support our devices and services, and brings continued competition with Google, Amazon, and other well-established and emerging competitors. Devices operating system and hardware With our Windows devices operating system and hardware, we strive to set the standard for productivity experiences. We aim to deliver the richest and most consistent user experience for digital work and life scenarios on screens of all sizes-from phones, tablets, and laptops to TVs and large, multi-touch displays. We are investing to make Windows 34 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 the most secure, manageable, and capable operating system for the needs of a modern workforce. We are working to create a broad developer opportunity by enabling universal Windows applications to run across all device targets. We are developing new input/output methods like speech, pen, and gesture to power more personal computing experiences. We work with an ecosystem of partners to deliver a broad spectrum of Windows devices. We also build hardware to set the standard for productivity experiences and stimulate more demand for the entire Windows ecosystem, as we do with Surface, and following the acquisition of substantially all of Nokia Corporation's ("Nokia") Devices and Services business ("NDS") on April 25, 2014, phones. As consumer services and hardware advance, we expect they will continue to better complement one another, connecting the devices people use daily to unique communications, productivity, and entertainment services from Microsoft and our partners and developers. We anticipate many new mobile device categories and we anticipate experiences to emerge that span a variety of devices of all screen sizes. We will invest to be on the forefront of this innovation, focusing on dual users and their needs across work and life. Our future opportunity There are several distinct areas of technology that we aim to drive forward. Our goal is to lead the industry in these areas over the long-term, which we expect will translate to sustained growth. We are investing significant resources in: • Delivering new high-value digital work and digital life experiences to improve how people learn, work, play, and interact with one another. • Establishing our Windows platform across the PC, tablet, phone, server, other devices, and the cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Developing new devices that have increasingly natural ways to use them, including speech, pen, and gesture. • Applying machine learning to make technology more intuitive and able to act on our behalf, instead of at our command. We believe the breadth of our products and services portfolio, our large global partner and customer base, our growing ecosystem, and our ongoing investment in innovation position us to be a leader in these areas. 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. To support our strategy of reinventing productivity to empower every person and every organization to do more and achieve more, we announced a restructuring plan in July 2014. Through this restructuring, we strive to increase agility, streamline engineering processes, move faster and more efficiently, and simplify our organization. Even if we achieve these goals, the investments we are making in devices and infrastructure will increase our operating costs and may decrease our operating margins. With the acquisition of NDS, we expect our effective tax rate to increase as our business mix changes. We prioritize our investments among the highest long-term growth opportunities. These investments require significant resources and are multi-year in nature. The products and services we bring to market may be developed internally, as part of a partnership or alliance, or through acquisition. 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. See a discussion of these factors and other risks under Risk Factors (Part II, Item 1A of this Form 10-Q). 35 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 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. Our Computing and Gaming Hardware segment is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Computing and Gaming Hardware segment has generated approximately 50% of its yearly revenue in our second fiscal quarter. Unearned Revenue Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions below regarding revenue deferred on certain bundled products and services ("Bundled Offerings") and revenue deferred on pre-sales of Windows 8.1 to original equipment manufacturers ("OEMs") and retailers before general availability ("Windows 8.1 Pre-Sales"). 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. Operating expenses are not allocated to our segments. We have recast certain prior period amounts to conform to the current period presentation, with no impact on consolidated net income or cash flows. On April 25, 2014, we acquired substantially all of NDS. NDS has been included in our consolidated results of operations starting on the acquisition date. We report the financial performance of the acquired business in our Phone Hardware segment. Prior to the acquisition of NDS, financial results associated with our joint strategic initiatives with Nokia were reflected in our Devices and Consumer ("D&C") Licensing segment. The contractual relationship with Nokia related to those initiatives ended in conjunction with the acquisition. Our reportable segments are described below. Devices and Consumer Our D&C segments develop, manufacture, market, and support products and services designed to entertain and connect people, increase personal productivity, help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. Our D&C segments are: • D&C Licensing, comprising: Windows, including all OEM licensing ("Windows OEM") and other non-volume licensing and academic volume licensing of the Windows operating system and related software; non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers ("Office Consumer"); Windows Phone operating system, including related patent licensing; and certain other patent licensing revenue; • Computing and Gaming Hardware, comprising: Xbox gaming and entertainment consoles and accessories, second-party and third-party video game royalties, and Xbox Live subscriptions ("Xbox Platform"); Surface devices and accessories ("Surface"); and Microsoft PC accessories; • Phone Hardware, comprising: Lumia phones and other non-Lumia phones, beginning with our acquisition of NDS; and • D&C Other, comprising: Resale, including Windows Store, Xbox Live transactions, and Windows Phone Store; search advertising; display advertising; Office 365 Consumer, comprising Office 365 Home and Office 365 Personal; Studios, comprising first-party video games; non-Microsoft products sold in our retail stores; and certain other consumer products and services not included in the categories above. 36 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Commercial Our Commercial segments develop, market, and support software and services designed to increase individual, team, and organizational productivity and efficiency, including simplifying everyday tasks through seamless operations across the user's hardware and software. Our Commercial segments are: • Commercial Licensing, comprising: server products, including Windows Server, Microsoft SQL Server, Visual Studio, System Center, and related Client Access Licenses ("CALs"); Windows Embedded; volume licensing of the Windows operating system, excluding academic ("Windows Commercial"); Microsoft Office for business, including Office, Exchange, SharePoint, Lync, and related CALs ("Office Commercial"); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype; and • Commercial Other, comprising: Enterprise Services, including Premier Support Services and Microsoft Consulting Services; Commercial Cloud, comprising Office 365 Commercial, other Microsoft Office online offerings, Dynamics CRM Online, and Microsoft Azure; and certain other commercial products and online services not included in the categories above. SUMMARY RESULTS OF OPERATIONS Summary Three Months Ended Percentage (In millions, except percentages and per share amounts) September 30, Change ------------------------------------------------------------------------------------------------------- - 2014 2013 Revenue $ 23,201 $ 18,529 25% Gross margin $ 14,928 $ 13,384 12% Operating income $ 5,844 $ 6,334 (8)% Diluted earnings per share $ 0.54 $ 0.62 (13)%------------------------------------------------------------------------------------------------------- - Revenue increased $4.7 billion or 25%, reflecting the acquisition of NDS and growth across our consumer and commercial businesses, evidenced by higher revenue from our Commercial Cloud, Xbox Platform, Surface, and server products. Gross margin increased $1.5 billion or 12%, primarily due to higher revenue, offset in part by a $3.1 billion or 61% increase in cost of revenue. Cost of revenue increased mainly due to the acquisition of NDS, as well as higher volumes of Computing and Gaming devices sold. Operating income decreased $490 million or 8%, reflecting integration and restructuring expenses in the current fiscal year, as well as increased sales and marketing expenses and research and development expenses, offset in part by higher gross margin. Integration and restructuring expenses were $1.1 billion, or $0.11 in diluted earnings per share, primarily reflecting employee severance charges associated with our restructuring plan announced in July 2014 ("Restructuring Plan"). Key changes in operating expenses were: • Sales and marketing expenses increased $424 million or 13%, primarily due to NDS expenses. • Research and development expenses increased $298 million or 11%, due mainly to increased investment in new products and services in our Devices engineering group, including NDS expenses, and Cloud and Enterprise engineering group, reflecting ongoing commitment to our mobile-first and cloud-first strategy. 37 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 SEGMENT RESULTS OF OPERATIONS Devices and Consumer Three Months Ended Percentage (In millions, except percentages) September 30, Change ----------------------------------------------------------------------------- - 2014 2013 Revenue Licensing $ 4,093 $ 4,484 (9)% Hardware: Computing and Gaming Hardware 2,453 1,409 74% Phone Hardware 2,609 0 * ---------------------------------------------- - - -------- - -- -------- - Total D&C Hardware 5,062 1,409 * Other 1,809 1,554 16% ---------------------------------------------- - - -------- - -- -------- - Total D&C revenue $ 10,964 $ 7,447 47% - -------- - - -------- - Gross Margin Licensing $ 3,818 $ 3,920 (3)% Hardware: Computing and Gaming Hardware 479 205 134% Phone Hardware 478 0 * ---------------------------------------------- - - -------- - -- -------- - Total D&C Hardware 957 205 * Other 312 324 (4)% ---------------------------------------------- - - -------- - -- -------- - Total D&C gross margin $ 5,087 $ 4,449 14% - -------- - - -------- - * Not meaningful D&C revenue increased $3.5 billion or 47%, primarily due to the acquisition of NDS, as well as higher revenue from Xbox Platform and Surface. D&C gross margin increased $638 million or 14%, reflecting higher revenue, offset in part by higher cost of revenue. Cost of revenue increased $2.9 billion or 96%, due mainly to NDS, as well as increased Xbox Platform expenses. D&C Licensing D&C Licensing revenue decreased $391 million or 9%, due mainly to a $176 million decline in Windows Phone revenue, as well as lower revenue from licenses of Windows and Office Consumer. Windows Phone revenue decreased, primarily due to lower per unit royalties based upon the mix of devices sold by our licensees. Windows OEM revenue declined 2%, primarily due to declines of 4% in OEM Pro revenue and 1% in OEM non-Pro revenue, consistent with dynamics in the commercial and consumer PC markets. Office Consumer revenue declined 5%, reflecting the transition of customers to Office 365 Consumer. D&C Licensing gross margin decreased $102 million or 3%, primarily due to the decline in revenue, offset in part by a $289 million or 51% decrease in cost of revenue. D&C Licensing cost of revenue decreased, due mainly to a $239 million or 61% decline in traffic acquisition costs, primarily because our joint strategic initiatives with Nokia ended in conjunction with the acquisition of NDS. Computing and Gaming Hardware Computing and Gaming Hardware revenue increased $1.0 billion or 74%, primarily due to higher revenue from Xbox Platform and Surface. Xbox Platform revenue increased $538 million or 58%, due mainly to 102% higher volume and a 93% increase attributable to higher premium mix of consoles sold, offset in part by a decrease in revenue from third-party video games. Xbox One was released in November 2013, introduced into new markets in September 2014, and sells for a higher price than Xbox 360. We sold 2.4 million Xbox consoles during the first quarter of fiscal year 2015 compared with 1.2 million consoles during the first quarter of fiscal year 2014. Surface revenue increased $508 million or 127%, due mainly to an increased mix of Surface Pro units sold and their related accessories. The release of Surface Pro 3 in June 2014 contributed to a 126% increase, reflecting higher premium mix of devices sold. 38 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Computing and Gaming Hardware gross margin increased $274 million or 134%, due to higher revenue, offset in part by a $770 million or 64% increase in cost of revenue. Xbox Platform cost of revenue increased $623 million or 139%, due mainly to higher volumes of consoles sold and higher costs associated with Xbox One. Surface cost of revenue increased $157 million or 23%, due mainly to a higher cost per device sold, driven by Surface Pro 3. Phone Hardware Phone Hardware revenue was $2.6 billion, as we sold 9.3 million Lumia phones and 42.9 million non-Lumia phones during the three months ended September 30, 2014. We acquired NDS in the fourth quarter of fiscal year 2014. Phone Hardware gross margin was $478 million. Phone Hardware cost of revenue, including $139 million amortization of acquired intangible assets, was $2.1 billion. D&C Other D&C Other revenue increased $255 million or 16%, due mainly to higher online advertising, Office 365 Consumer, and first-party video games revenue. Online advertising revenue increased $129 million or 14%. Search advertising revenue increased 23%, driven primarily by growth in Bing, due to similar impacts attributable to higher revenue per search and search volume. This increase was offset in part by a 9% reduction in display advertising revenue, due to continued portal traffic and monetization declines. Office 365 Consumer revenue increased $87 million, reflecting subscriber growth, and we ended the first quarter of fiscal year 2015 with 7.1 million subscribers. First-party video games revenue increased $79 million, due mainly to the launch of Forza Horizon 2 and the re-release of certain Xbox 360 titles. D&C Other gross margin decreased slightly, due to a $267 million or 22% increase in cost of revenue, offset in part by higher revenue. D&C Other cost of revenue grew, due mainly to a $130 million or 21% increase in online advertising cost of revenue, reflecting support of online infrastructure. Cost of revenue also increased $57 million, due to higher first-party video games costs. Commercial Three Months Ended Percentage (In millions, except percentages) September 30, Change ----------------------------------------------------------------------------- - 2014 2013 Revenue Licensing $ 9,873 $ 9,611 3% Other 2,407 1,602 50% ---------------------------------------------- - - -------- - -- -------- - Total Commercial revenue $ 12,280 $ 11,213 10% - -------- - - -------- - Gross Margin Licensing $ 9,100 $ 8,805 3% Other 805 274 194% ---------------------------------------------- - - -------- - -- -------- - Total Commercial gross margin $ 9,905 $ 9,079 9% - -------- - - -------- - Commercial revenue increased $1.1 billion or 10%, due mainly to growth in revenue from our Commercial Cloud and on-premises licensing businesses. Office Commercial and Office 365 Commercial revenue grew 5%, collectively. Our server products revenue, including Microsoft Azure, grew 13%. Commercial gross margin increased $826 million or 9%. 39 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Commercial Licensing Commercial Licensing revenue increased $262 million or 3%, due primarily to increased revenue from our server products and Windows Commercial, offset in part by a decline in revenue from Office Commercial. Our server products revenue grew $406 million or 11%, driven primarily by higher premium mix of Microsoft SQL Server. Windows Commercial revenue grew $80 million or 10%, due to increased renewals and growth in our customer base. Office Commercial revenue declined $322 million or 7%, due mainly to customers transitioning to Office 365 Commercial. Commercial Licensing gross margin increased $295 million or 3%, in line with revenue. Commercial Other Commercial Other revenue increased $805 million or 50%, due to higher Commercial Cloud revenue and Enterprise Services revenue. Commercial Cloud revenue grew $662 million or 128%, due mainly to subscriber growth and a higher premium mix of Office 365 Commercial. Microsoft Azure revenue also grew 121%, reflecting a growing customer base, higher commitment levels, and increased usage. Enterprise Services revenue increased $142 million or 13%, due mainly to Premier Support Services, driven by growth in our core product support services. Commercial Other gross margin increased $531 million or 194%, due to higher revenue, offset in part by a $274 million or 21% increase in cost of revenue. The increase in cost of revenue was due mainly to higher datacenter and other online infrastructure expenses, reflecting increased support of our growing Commercial Cloud, as well as increased costs to deliver Enterprise Services revenue. Corporate and Other Three Months Ended Percentage (In millions, except percentages) September 30, Change -------------------------------------------------------------------------------- - 2014 2013 Revenue $ (43 ) $ (131 ) 67% Gross margin $ (64 ) $ (144 ) 56% -------------------------------------------------------------------------------- - Corporate and Other revenue comprises certain revenue deferrals, including those related to product and service upgrade offers and pre-sales of new products to OEMs prior to general availability. Corporate and Other revenue increased $88 million, primarily due to the timing of revenue deferrals compared to the prior year. During the three months ended September 30, 2014, we deferred a net $29 million of revenue related to Bundled Offerings. During the three months ended September 30, 2013, we deferred $113 million of revenue, primarily related to the Windows 8.1 Pre-Sales. Corporate and Other gross margin increased $80 million, due mainly to increased revenue. OPERATING EXPENSES Research and Development Three Months Ended Percentage (In millions, except percentages) September 30, Change ------------------------------------------------------------------------------ - 2014 2013 Research and development $ 3,065 $ 2,767 11% As a percent of revenue 13% 15% (2)ppt ------------------------------------------------------------------------------ - 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 increased $298 million or 11%, due mainly to increased investment in new products and services in our Devices engineering group, primarily $323 million of NDS expenses, and our Cloud and Enterprise engineering group, reflecting ongoing commitment to our mobile-first and cloud-first strategy. These increases were partially offset by a decline in research and development expenses in our Operating Systems engineering group, driven primarily by reduced headcount as part of the Restructuring Plan. 40 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Sales and Marketing Three Months Ended Percentage (In millions, except percentages) September 30, Change ------------------------------------------------------------------------------ - 2014 2013 Sales and marketing $ 3,728 $ 3,304 13% As a percent of revenue 16% 18% (2)ppt ------------------------------------------------------------------------------ - 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. Sales and marketing expenses increased $424 million or 13%, primarily due to NDS expenses. NDS sales and marketing expenses were $426 million during the three months ended September 30, 2014. General and Administrative Three Months Ended Percentage (In millions, except percentages) September 30, Change ---------------------------------------------------------------------------- - 2014 2013 General and administrative $ 1,151 $ 979 18% 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 increased $172 million or 18%, due mainly to NDS expenses, higher business taxes, and higher legal charges. NDS general and administrative expenses were $67 million during the three months ended September 30, 2014. INTEGRATION AND RESTRUCTURING Integration and restructuring expenses include employee severance expenses and costs associated with the consolidation of facilities and manufacturing operations, including asset write-downs and contract termination costs, resulting from our Restructuring Plan. Integration and restructuring expenses also include systems consolidation and other business integration expenses, as well as transaction fees and direct acquisition costs, associated with our acquisition of NDS. Integration and restructuring expenses were $1.1 billion during the three months ended September 30, 2014, due mainly to restructuring charges of $1.0 billion, including employee severance expenses and the write-down of certain assets in connection with our Restructuring Plan. See Note 13 - Restructuring Charges of the Notes to Financial Statements for discussion of our Restructuring Plan. 41 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 OTHER INCOME (EXPENSE) The components of other income (expense) were as follows: (In millions) ------------------------------------------------------------------- -- Three Months Ended September 30, 2014 2013 Dividends and interest income $ 225 $ 179 Interest expense (161 ) (118 ) Net recognized gains (losses) on investments 79 (7 ) Net losses on derivatives (134 ) (86 ) Net gains on foreign currency remeasurements 78 26 Other (35 ) 80 ------------------------------------------------------ -- - ----- -- Total $ 52 $ 74 - ----- -- - ----- -- 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). 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 other comprehensive income until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income into other income (expense). Dividends and interest income increased due to higher portfolio balances. Interest expense increased due to higher outstanding long-term debt. Net recognized gains on investments increased primarily due to higher gains on sales of fixed income securities and lower other-than-temporary impairments. Other-than-temporary impairments were $9 million in the current period, compared with $36 million in comparable period. Net losses on derivatives increased due to losses on commodity and interest rate derivatives in the current period compared to gains in the prior period, offset in part by lower losses on foreign exchange contracts. Other during the current period reflects recognized losses from certain joint ventures as compared to a recognized gain on a divestiture in the prior period. INCOME TAXES Our effective tax rate for the three months ended September 30, 2014 and 2013 was approximately 23% and 18%, 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 higher than the prior year's first quarter effective tax rate, primarily due to changes in the geographic mix of our business, non-deductible operating losses, and restructuring charges. Tax contingencies and other tax liabilities were $10.7 billion and $10.4 billion as of September 30, 2014 and June 30, 2014, respectively, and are included in other long-term liabilities. This increase relates primarily to current period quarterly growth relating to intercompany transfer pricing adjustments. While we settled a portion of the Internal Revenue Service ("I.R.S.") audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for those years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit phase of the examination. As of September 30, 2014, the primary unresolved issue relates to transfer pricing which could have a significant impact on our consolidated financial statements if not resolved favorably. 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 income 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 2013. 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 2013, 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. 42 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $89.2 billion as of September 30, 2014, compared with $85.7 billion as of June 30, 2014. Equity and other investments were $13.9 billion as of September 30, 2014 compared to $14.6 billion as of June 30, 2014. 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, 2014, approximately $83.4 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 approximately $2.1 billion. As of September 30, 2014, approximately 83% 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 1% were invested in U.S. mortgage-backed securities, all of which are denominated in U.S. dollars. 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 $191 million as of September 30, 2014. Our average and maximum securities lending payable balances for the three months ended September 30, 2014 were $399 million and $603 million, respectively. Intra-quarter 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-backed 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. 43 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Cash Flows Cash flows from operations increased $149 million to $8.4 billion, due mainly to increases in cash received from customers, offset in part by cash used for related product and operating expenditures. Cash used in financing decreased $418 million to $3.0 billion, due mainly to a $1.2 billion increase in proceeds from issuances of debt, net of repayments, offset in part by a $700 million increase in cash used for common stock repurchases. Cash used in investing increased $3.1 billion to $7.7 billion, due mainly to a $2.6 billion increase 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. As of September 30, 2014, we had $23.7 billion of issued and outstanding debt, comprising $3.5 billion of short-term debt and $20.2 billion of long-term debt, including the current portion. Short-term debt As of September 30, 2014, we had $3.5 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.10% and maturities ranging from 49 days to 56 days. The estimated fair value of this commercial paper approximates its carrying value. We have a $5.0 billion credit facility that expires on November 14, 2018, which serves as a back-up for our commercial paper program. As of September 30, 2014, we were in compliance with the only financial covenant in the credit agreement, 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 agreement. No amounts were drawn against the credit facility during any of the periods presented. Long-term debt As of September 30, 2014, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $20.2 billion and $21.3 billion, respectively. These estimated fair values are based on Level 2 inputs. 44 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 The components of our long-term debt, including the current portion, and the associated interest rates were as follows as of September 30, 2014: Stated Effective Interest Interest Due Date Face Value Rate Rate ----------------------------------------------------------------- - (In millions) Notes September 25, 2015 $ 1,750 1.625% 1.795% February 8, 2016 750 2.500% 2.642% November 15, 2017 600 0.875% 1.084% May 1, 2018 450 1.000% 1.106% December 6, 2018 1,250 1.625% 1.824% June 1, 2019 1,000 4.200% 4.379% October 1, 2020 1,000 3.000% 3.137% February 8, 2021 500 4.000% 4.082% December 6, 2021 (a) 2,211 2.125% 2.233% November 15, 2022 750 2.125% 2.239% May 1, 2023 1,000 2.375% 2.465% December 15, 2023 1,500 3.625% 3.726% December 6, 2028 (a) 2,211 3.125% 3.218% May 2, 2033 (b) 696 2.625% 2.690% June 1, 2039 750 5.200% 5.240% October 1, 2040 1,000 4.500% 4.567% February 8, 2041 1,000 5.300% 5.361% November 15, 2042 900 3.500% 3.571% May 1, 2043 500 3.750% 3.829% December 15, 2043 500 4.875% 4.918% ----------------------------------- - Total $ 20,318 -- --------- - (a) In December 2013, we issued €3.5 billion of debt securities. (b) In April 2013, we issued €550 million of debt securities. 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, 2014, the aggregate unamortized discount for our long-term debt, including the current portion, was $98 million. Unearned Revenue Unearned revenue at September 30, 2014 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, 2014 also included payments for: post-delivery support and consulting services to be performed in the future; Xbox Live subscriptions and prepaid points; Microsoft Dynamics business solutions products; Office 365 subscriptions; Bundled Offerings; Skype prepaid credits and subscriptions; 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. 45 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 The following table outlines the expected future recognition of unearned revenue as of September 30, 2014: (In millions) -------------------------------- - Three Months Ending, December 31, 2014 $ 9,187 March 31, 2015 6,495 June 30, 2015 3,896 September 30, 2015 1,135 Thereafter 1,825 -------------------------------- - Total $ 22,538 - ------- - Share Repurchases During the three months ended September 30, 2014, we repurchased 43 million shares of our common stock for $2.0 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. As of September 30, 2014, $33.1 billion remained of our $40.0 billion share repurchase program. All repurchases were made using cash resources. Dividends Our Board of Directors declared the following dividends during the periods presented: Dividend Declaration Date Per Share Record Date Total Amount Payment Date----------------------------------------------------------------------------------------------------------------------- - (in millions) September 16, 2014 $ 0.31 November 20, 2014 $ 2,559 December 11, 2014 September 16, 2013 $ 0.28 November 21, 2013 $ 2,332 December 12, 2013----------------------------------------------------------------------------------------------------------------------- - 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 In September 2014, we reached an agreement to acquire Mojang AB, the Swedish video game developer of the Minecraft gaming franchise, for approximately $2.5 billion in cash. We expect the acquisition to close in the second quarter of fiscal year 2015, subject to customary closing conditions and any regulatory review. 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 cloud and devices 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, 46 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 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 repayment schedules, 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. 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 Recently Adopted Accounting Guidance In March 2013, the Financial Accounting Standards Board ("FASB") issued guidance on a parent's accounting for the cumulative translation adjustment upon derecognition of a subsidiary or group of assets within a foreign entity. This new guidance requires that the parent release any related cumulative translation adjustment into net income only if the sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided. We adopted this new guidance beginning July 1, 2014. Adoption of this new guidance did not have a material impact on our consolidated financial statements. 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 FASB 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, 2017, and early adoption is not permitted. We anticipate this standard will have a material impact on our consolidated financial statements, and we are currently evaluating its impact. 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. 47 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 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. 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) 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. The valuation of acquired assets and liabilities, including goodwill, resulting from the acquisition of NDS, is reflective of the enterprise value based on the long-term financial forecast for the business. In this highly competitive and volatile market, it is possible that we may not realize our forecasts. Given the value assigned to goodwill in the purchase price allocation, we will closely monitor the performance of the business versus the long-term forecast to determine if any impairments arise. 48 -------------------------------------------------------------------------------- Table of Contents PART I Item 2, 3 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. 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. |